UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C.  20549





Form
10-KSB





(Mark
One)





x
            ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934





For the
fiscal year ended September 30, 2008





 ̈
            TRANSITION
      REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934





For the
transition period from ________ to   ________





Commission
file number 000-22849





Onstream Media Corporation


(Name of
small business issuer in its charter)





Florida
                        
                        65-0420146(State
      or other jurisdiction of incorporation or organization)
                        
                        (I.R.S.
      Employer
                          Identification
      No.)
  1291
      SW 29 AvenuePompano
      Beach, Florida
                            
                            33069(Address
      of principal executive offices)
                            
                            (Zip
      Code)





Issuer's
telephone number 954-917-6655





Securities
registered under Section 12(b) of the Exchange Act:





Title
      of each class
                      
                      Name
      of each exchange on which registeredNone
                      
                      not
      applicable





Securities
      registered under Section 12(g) of the Exchange Act:
                  
                  common
      stock(Title
      of class)





Check
whether the issuer is not required to file reports pursuant to Section 13 or
15(d) of the Exchange Act   ̈










Check
whether the issuer (1) filed all reports required to be filed by Section 13 or
15(d) of the Exchange Act during the past 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 xNo  ̈





Check if
there is no disclosure of delinquent filers in response to Item 405 of
Regulation S-B contained in this form, and no disclosure will be contained, to
the best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-KSB or any
amendment to this Form 10-KSB.  ̈





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





State
issuer's revenues for its most recent fiscal year. $17,587,223 for the 12 months
ended September 30, 2008.





State the
aggregate market value of the voting and non-voting common equity held by
non-affiliates computed by reference to the price at which the common equity was
sold, or the average bid and asked prices of such common equity, as of a
specified date within the past 60 days. (see definition of affiliate in Rule
12b-2 of the Exchange Act.) The aggregate market value of the common equity held
by non-affiliates computed at the closing price of the registrant’s common stock
on December 5, 2008 is approximately $12.0 million.





State the
number of shares outstanding of each of the issuer's class of common equity, as
of the latest practicable date.  As of December 5, 2008, 42,788,975
shares of common stock were issued and outstanding.





DOCUMENTS
INCORPORATED BY REFERENCE





If the
following documents are incorporated by reference, briefly describe them and
identify the part of the Form 10-KSB (e.g., Part I, Part II, etc.) into which
the document is incorporated: (1) any annual report to security holders; (2) any
proxy or information statement; and (3) any prospectus filed pursuant to Rule
424(b) of the Securities Act of 1933 ("Securities Act").  Not
Applicable.





Transitional
Small Business Disclosure Form (check one):  Yes  ̈No x









CERTAIN
CAUTIONARY STATEMENTS REGARDING FORWARD-LOOKING INFORMATION





Certain
statements in this annual report on Form 10-KSB contain or may contain
forward-looking statements that are subject to known and unknown risks,
uncertainties and other factors which may cause actual results, performance or
achievements to be materially different from any future results, performance or
achievements expressed or implied by such forward-looking statements. These
forward-looking statements were based on various factors and were derived
utilizing numerous assumptions and other factors that could cause our actual
results to differ materially from those in the forward-looking statements. These
risks, uncertainties and other factors include, but are not limited to, our
ability to implement our strategic initiatives (including our ability to
successfully complete, produce, market and/or sell the DMSP and/or our ability
to eliminate cash flow deficits by increasing our sales), economic, political
and market conditions and fluctuations, government and industry regulation,
interest rate risk, U.S. and global competition, and other factors affecting the
Company's operations and the fluctuation of the Company's common stock price,
and other factors discussed elsewhere in this report and in other documents
filed by the Company with the Securities and Exchange Commission from time to
time. Most of these factors are difficult to predict accurately and are
generally beyond our control. You should consider the areas of risk described in
connection with any forward-looking statements that may be made herein. Readers
are cautioned not to place undue reliance on these forward-looking statements,
which speak only as of September 30, 2008. Readers should carefully review this
Form 10-KSB in its entirety, including but not limited to our financial
statements and the notes thereto and the risks described in "Item 1.
Business—Risk Factors." Except for our ongoing obligations to disclose material
information under the Federal securities laws, we undertake no obligation to
release publicly any revisions to any forward-looking statements, to report
events or to report the occurrence of unanticipated events. Actual results could
differ materially from the forward-looking statements. In light of these risks
and uncertainties, there can be no assurance that the forward-looking
information contained in this report will, in fact, occur. For any
forward-looking statements contained in any document, we claim the protection of
the safe harbor for forward-looking statements contained in the Private
Securities Litigation Reform Act of 1995.





When used
in this Annual Report, the terms "we", "our", and "us” refers to Onstream Media
Corporation, a Florida corporation, and its subsidiaries.





PART
I





ITEM
      1.
            DESCRIPTION
      OF BUSINESS





Our
Business, Products and Services





We are a
leading online service provider of live and on-demand Internet video, corporate
audio and web communications and content management applications.  We
had approximately 110 full time employees as of September 30, 2008, with
operations organized in two main operating groups:





·
            Digital
      Media Services Group


·
            Audio
      and Web Conferencing Services Group





Products and services provided by each
of the groups are:





Digital
Media Services Group





Our
Digital Media Services Group consists of our Webcasting division, our DMSP
(“Digital Media Services Platform”) division, our UGC (“User Generated Content”)
division, our Smart Encoding division and our Travel division.  This
group represented approximately 44.6% and 54.7% of our revenues for the years
ended September 30, 2008 and 2007, respectively. These revenues are comprised
primarily of fees for hosting/storage, search/retrieval and
distribution/streaming of digital assets as well as encoding and production
fees.




3





Our
Webcasting division, which operates primarily from facilities in Pompano Beach,
Florida, provides an array of corporate-oriented, web-based media services to
the corporate market including live audio and video webcasting and on-demand
audio and video streaming for any business, government or educational
entity. This includes online webcasting services, a cost effective means
for corporations to broadcast conference calls live, making them available to
the investing public, the media and to anyone worldwide with Internet access.
The Webcasting division also has a sales and production support office in New
York City as well as additional production and back-up webcasting facilities in
our San Francisco office. We market the webcasting services through a direct
sales force and through channel partners, also known as
resellers.  Each webcast can be heard and/or viewed live, and then
archived for replay, with an option for accessing the archived material through
a company's own web site. These webcasts primarily communicate corporate
earnings and other financial information; product launches and other marketing
information; training, emergency or other information directed to employees; and
corporate or other special events.





Our DMSP
division provides an online, subscription based service that includes access to
enabling technologies and features for our clients to acquire, store, index,
secure, manage, distribute and transform these digital assets into saleable
commodities. In December 2004 we completed our acquisition of an entity formerly
named Onstream Media Corporation that we now identify as Acquired Onstream.
Acquired Onstream was a development stage company founded in 2001 with the
business objective of developing a feature rich digital asset management service
and offering the service on a subscription basis over the Internet. This service
was the initial version of what became the DMSP, which is comprised of four
separate products - encoding, storage, search/retrieval and distribution.
Although a limited version of the DMSP was released in November 2005, the first
complete version was made available to our customers in October
2006.





Our UGC
division, which also operates as Auction Video, provides a video ingestion and
flash encoder that can be used by our clients on a stand-alone basis or in
conjunction with the DMSP. In March 2007 we completed the acquisition of Auction
Video. The primary assets acquired included the video ingestion and flash
transcoder as well as related technology and patents pending.





Our Smart
Encoding division, which operates primarily from facilities in San Francisco,
California, provides both automated and manual encoding and editorial services
for processing digital media, using a set of coordinated technologies and
processes that allow the quick and efficient online search, retrieval and
streaming of this media, which can include photos, videos, audio, engineering
specs, architectural plans, web pages, and many other pieces of business
collateral.





Our
Travel division, which operates primarily from Pompano Beach, Florida, produces
and distributes Internet-based multi-media streaming videos related to hotels,
resorts, time-shares, golf facilities, and other travel
destinations.





On May
29, 2008 we entered into a Definitive Merger Agreement with Narrowstep, Inc.
(“Narrowstep”), which merger was not yet consummated as of the filing date of
this 10-KSB. Narrowstep is a provider of Internet TV services supporting content
providers, broadcasters, telecommunications companies and corporations
worldwide. When this merger is closed, Narrowstep will become our IPTV
(“Internet Protocol Television”) division which in turn will be part of our
Digital Media Services Group.




4





Audio
and Web Conferencing Services Group





Our Audio
and Web Conferencing Services Group includes a) our Infinite Conferencing
(“Infinite”) division, which operates primarily from facilities in the New York
City area and provides “reservationless” and operator-assisted audio and web
conferencing services and b) our EDNet division, which operates primarily from
facilities in San Francisco, California and provides connectivity within the
entertainment and advertising industries through its managed network, which
encompasses production and post-production companies, advertisers, producers,
directors, and talent.





This
group represented approximately 55.4% and 45.3% of our revenues for the years
ended September 30, 2008 and 2007, respectively. These revenues are comprised
primarily of network access and usage fees as well as the sale and rental of
communication equipment.





See Note
7 to the Consolidated Financial Statements for a discussion of the changes made
as to which divisions are included in the two groups discussed above, as
compared to our previous 10-Q and 10-K filings.





Sales
and Marketing





We use a variety of marketing methods,
including our internal sales force and channel partners, also known as
resellers, to market our products and services. One key element of our marketing
strategy has been to enter into distribution agreements with recognized leaders
in each of the markets for our products and services. By offering our products
and services in conjunction with the distributors’ products, we believe these
distribution agreements enable us to take advantage of the particular
distributors' existing marketing programs, sales forces and business
relationships. Contracts with these distributors generally range from one to two
years and may be terminable earlier based on certain contractual
provisions.





We have
expanded our marketing efforts during the past year through the use of public
relations and telemarketing firms. We intend to continue these actions during
the coming year, as well as the introduction of targeted television and radio
advertising, as well as direct mail. See Item 6 – Liquidity and Capital
Resources.





No single
customer has represented more than 10% of our consolidated revenues during the
years ended September 30, 2008 or 2007.





Competition





We operate in highly competitive and
rapidly changing business segments. We expect our competition to intensify. We
compete with:





·
            other
      web sites, Internet portals and Internet broadcasters to acquire and
      provide content to attract users;




·
            video
      and audio conferencing companies and Internet business service
      broadcasters;




·
            online
      services, other web site operators and advertising
    networks;




·
            traditional
      media, such as television, radio and print;
and




·
            end-user
      software products.





Our webcasting products and services
fall into two competitive areas: live or archived financial and fair-disclosure
related conferences, and all other live or archived webcast productions for the
corporate, financial, educational and government segments.  In the
financial conferences area, we compete with ON24, IVT, WILink, Talkpoint, Wall
Street Transcripts, Netbriefings, PTEK Holdings, Shareholder.com, Thomson
Financial Group, ViaVid and others that offer live webcasts of quarterly
earnings conference calls. This list includes entities that are currently active
resellers of our services and not in significant competition with us, but could
compete with us under certain circumstances. For other webcast production, we
compete with other smaller geographically local entities.  Our
production services, however, have been in demand by some of our competitors,
and from time to time we have provided services to these
companies.  The nature of the streaming media sector of the Internet
market is highly interdependent while being competitive.




5





While there is competition for the
provision of digital media services by our Digital Media Services Group, this is
a relatively new product and environment with few established professional
services providers. We believe that our approach of partnering with
complimentary technology providers such as SAIC, Autonomy/Virage Application
Services, Adobe Systems and Microsoft reduces the number of full-scale
competitors in our markets. We also believe that our strategic offering of
integrated webcasting, multi-screen encoding, intelligent syndication with broad
spectrum video indexing services, all as part of a unified and scalable digital
media platform (the DMSP) provides significant differentiation from our
competitors. However, companies that compete in some portion of the digital
media services market targeted by us include Ascent Media, Neulion, BrightCove,
Maven Networks (Yahoo), VitalStream (Internap), and thePlatform (Comcast). There
are video publishing platforms that compete with our DMSP, including those
offered by Move Networks, ExtendMedia, the Feedroom, Ooyala and
others.





Competition for audio and web
conferencing is primarily segregated between the low-cost, low-service offerings
such as FreeConference.Com and other more high-end providers such as Premiere
Global Services. Our Infinite division services a niche market for audio and web
conferencing services primarily for SMB (small to medium size) companies looking
for superior customer service at an affordable rate. This division's niche also
includes a growing demand for lead generation “webinars” (seminars presented via
the Internet), which it addresses by offering a dedicated account manager to
coordinate a customized solution for each event.




Competition for the audio and video
networking services provided by our EDNet division is based upon the ability to
provide equipment, connectivity and technical support for disparate
audio and video communications systems and to provide interoperable
compatibility for proprietary and off-the-shelf codecs. Due to the difficulty
and expense of developing and maintaining private digital networks, bridging
services, engineering availability and service quality, we believe that the
number of audio networking competitors is small and will remain so. Our primary
video networking competitors are video and audio appliance dealers that source
encoding, decoding and transport hardware.  This division's advantage is
the provision of a total solution including system design, isochronous (a data
flow type used for streaming audio and video) connection and broadband
connection sourcing, and custom software connectivity applications that include
a comprehensive digital path for radio and television commercial transport.
However, companies that compete in some portion of the audio and video
networking services market targeted by us include Telestream, Globix, Acceris,
Media Link, Savvis, Digital Generation (DG) Systems, Globecast, SohoNet,
Pathfire, Source Elements and Ascent Media.




Government
Regulation





Although there are currently few laws
and regulations directly applicable to the Internet, it is likely that new laws
and regulations will be adopted in the United States and elsewhere covering
issues such as broadcast license fees, copyrights, privacy, pricing, sales taxes
and characteristics and quality of Internet services. It is possible that
governments will enact legislation that may be applicable to us in areas such as
content, network security, encryption and the use of key escrow, data and
privacy protection, electronic authentication or "digital" signatures, illegal
and harmful content, access charges and retransmission activities. Moreover, the
applicability to the Internet of existing laws governing issues such as property
ownership, content, taxation, defamation and personal privacy is uncertain. The
majority of such laws was adopted before the widespread use and
commercialization of the Internet and, as a result, do not contemplate or
address the unique issues of the Internet and related technologies. Any such
export or import restrictions, new legislation or regulation or governmental
enforcement of existing regulations may limit the growth of the Internet,
increase our cost of doing business or increase our legal exposure, which could
have a material adverse effect on our business, financial condition and results
of operations.




6





By distributing content over the
Internet, we face potential liability for claims based on the nature and content
of the materials that we distribute, including claims for defamation, negligence
or copyright, patent or trademark infringement, which claims have been brought,
and sometimes successfully litigated, against Internet companies. To protect our
company from such claims, we maintain general liability insurance (including
umbrella coverage) of approximately $4.0 million. The general liability
insurance may not cover all potential claims of this type or may not be adequate
to indemnify us for any liability to which we may be exposed. Any liability not
covered by insurance or in excess of insurance coverage could have a material
adverse effect on our business, results of operations and financial
condition.





Our audio
and video networking services are conducted primarily over telephone lines,
which are heavily regulated by the various Federal and other agencies. Although
we believe that the responsibility for compliance with those regulations
primarily falls on the local and long distance telephone service providers and
not us, the Federal Communications Commission (FCC) recently issued an order
that requires conference calling companies to remit Universal Service Fund (USF)
contribution payments on customer usage associated with conference calls. This
obligation requires Infinite to register as a reporting company with the FCC, as
well as to file both quarterly and annual reports regarding the revenues derived
from conference calling.





Intellectual
Property





Our success depends in part on our
ability to protect our intellectual property. To protect our proprietary rights,
we rely generally on copyright, trademark and trade secret laws, confidentiality
agreements with employees and third parties, and agreements with consultants,
vendors and customers, although we have not signed such agreements in every
case.





As part
of our March 2007 acquisition of Auction Video, a pending United States patent
was assigned to us covering certain aspects of uploading live webcam images. A
parallel filing was done to protect these patent rights on an international
basis, via the filing of a “Patent Cooperation Treaty Request”. We are
currently pursuing the final approval of this patent application and in March
2008 retained the law firm of Hunton & Williams to assist in expediting the
patent approval process and to help protect rights related to our UGV (User
Generated Video) technology. In April 2008, we revised the original patent
application primarily for the purpose of splitting it into two separate
applications, which, while related, are being evaluated separately by the U.S.
Patent Office.





Despite such protections, a third party
could, without authorization, copy or otherwise obtain and use our content. We
can give no assurance that our agreements with employees, consultants and others
who participate in development activities will not be breached, or that we will
have adequate remedies for any breach, or that our trade secrets will not
otherwise become known or independently developed by competitors.





We may pursue the registration of
certain of our trademarks and service marks in the United States, although we
have not secured registration of all our marks. In addition, the laws of some
foreign countries do not protect our proprietary rights to the same extent as do
the laws of the United States, and effective copyright, trademark and trade
secret protection may not be available in such jurisdictions. In general, there
can be no assurance that our efforts to protect our intellectual property rights
through copyright, trademark and trade secret laws will be effective to prevent
misappropriation of our content. Our failure or inability to protect our
proprietary rights could materially adversely affect our business, financial
condition and results of operations.




7




Employees





At December 5, 2008 we had
approximately 110 full time employees, of whom 60 were design, production and
technical personnel, 26 were sales and marketing personnel and 24 were general,
administrative and executive management personnel. None of the employees are
covered by a collective bargaining agreement and our management considers
relations with our employees to be good.





General





We were formed under the laws of the
State of Florida in May 1993.Our executive offices
are located at 1291 SW 29th Avenue, Pompano Beach, Florida 33069. Our telephone
number at that location is (954) 917-6655.





RISK
FACTORS





Before
you invest in our securities, you should be aware that there are various risks.
Additional risks and uncertainties not presently known to us or that we
currently believe to be immaterial may also adversely affect our business. You
should consider carefully these risk factors, together with all of the other
information included in or incorporated by reference into this prospectus before
you decide to purchase our securities. If any of the following risks and
uncertainties develops into actual events, our business, financial condition or
results of operations could be materially adversely affected.





We
have an accumulated deficit and we anticipate continuing losses that will
eventually result in significant liquidity and cash flow problems absent a
material increase in our revenues.





We have
incurred losses since our inception, and have an accumulated deficit of
approximately $102.2 million as of September 30, 2008. Although cash
provided by operations was approximately $69,000 for the year ended
September 30, 2008, we had a net loss of approximately $6.6 million for that
period. Also, although we had approximately $674,000 of cash as of
September 30, 2008, we had a working capital deficit of approximately $1.4
million at that date.





We have projected capital
expenditures for the next twelve months of approximately $1.2 million (including
the payment of $334,000 in accounts payable at September 30, 2008 which will not
be reflected as capital expenditures in our cash flow statement until it is
paid), which includes software and hardware upgrades to both our Digital
Services Media Platform (“DMSP”) as well as our webcasting system
infrastructure. We also anticipate additional operating expenses in fiscal year
2009 related to the continuation of our marketing program expansion that began
in previous fiscal years, although we cannot guarantee that this expansion will
be continued or that our marketing efforts will be successful.
 
 On May 29, 2008 we entered into a
Definitive Merger Agreement with Narrowstep, which merger has not yet been
consummated. There are several risks associated with the merger, which are
discussed in separate risk factor sections below. Also, in the event the merger
agreement is terminated without it being consummated, we would recognize an
expense of approximately $418,000, resulting from the write off of merger
related costs already incurred by us and reflected as an asset on our balance
sheet as of September 30, 2008.
 
 We cannot assure that our revenues will
continue to increase, nor can we assure that they will not decrease. The DMSP
was first placed in service with third-party customers in November 2005, but
related revenues to date, particularly in relation to the cost of the DMSP (and
our related acquisition of Acquired Onstream), have been limited and we cannot
assure what the future sales activity will be. As long as our cash flow from
operations remains insufficient to completely fund operations, we will continue
depleting our cash and other financial resources. As a result of the uncertainty
as to the ability of our operations to generate working capital, we may be
required to delay or cancel certain of the projected capital expenditures, some
of the planned marketing expenditures, or other planned expenses, which could
adversely affect our ability to expand our business and operations during fiscal
2009.




8




Our
operations have historically been financed primarily through the issuance of
equity and debt. Our future working capital requirements depend primarily on the
rate at which we can decrease our use of cash to fund operations, which is in
turn dependent on an increase in our revenues. Cash used for operations will be
affected by numerous known and unknown risks and uncertainties including, but
not limited to, our ability to successfully sell the DMSP, market our other
existing products and services, the degree to which competitive products and
services are introduced to the market, and our ability to control overhead
expenses as we grow. We are constantly evaluating our cash needs and existing
burn rate, in order to make appropriate adjustments in operating expenses. If
our current burn rate continues or increases, we will need to eventually raise
additional working capital, which we cannot assure will be successfully
raised.If
we raise additional capital through the issuance of debt, this will result in
increased interest expense. If we raise additional funds through the issuance of
equity or convertible debt securities, the percentage ownership of our company
held by existing shareholders will be reduced and those shareholders may
experience significant dilution. No assurances can be given that we will be
successful in obtaining additional capital, or that such capital will be
available on terms acceptable to us. If we are unable to raise additional
working capital if and when needed, we may be required to curtail some of our
operations.





Narrowstep
has incurred net losses and negative cash flow from operations since
inception.  Our ability to control or reduce Narrowstep’s negative
cash flow may adversely affect our financial condition.





As of
August 31, 2008, Narrowstep had an accumulated deficit of approximately $38.5
million.  It has financed its operations primarily through private
equity and convertible debt financings and currently does not have the liquidity
or financing available to fund its operations for the next 12 months without
raising additional capital or incurring indebtedness.  Narrowstep’s
revenues for the six months ended August 31, 2008 decreased by $1,256,336, or
44%, to $1,620,414 as compared to $2,876,750, for the six months ended August
31, 2007.  Narrowstep’s cash balance was approximately $1.4 million as
of August 31, 2008 and its net cash used in operations was approximately $2.7
million for the six months ended August 31, 2008.





The U.S.
Digital Millennium Copyright Act (“DMCA”) includes statutory licenses for the
performance of sound recordings and for the making of recordings to facilitate
transmissions.  The DMCA generally does not specify the rate and terms
of the licenses, which are determined by voluntary negotiations among the
parties or, for certain compulsory licenses where voluntary negotiations are
unsuccessful, by arbitration proceedings known as CARP proceedings, supervised
by the U.S. Copyright Office. Past CARP proceedings have resulted in proposed
rates for statutory webcasting that were significantly in excess of rates
requested by webcasters.  CARP proceedings relating to music
subscription and non-subscription services offering music programming that
qualify for various licenses under U.S. copyright law are
pending.  Neither we nor Narrowstep can predict the outcome of CARP
proceedings and may elect instead to directly license music content for
Narrowstep subscriptions and/or non-subscription services, either alone or in
concert with other affected companies.  Such licenses may only apply
to music performed in the United States, and the availability of corresponding
licenses for international performances is unclear.  There may be
future CARP proceedings relating to music subscription delivery services, which
may also adversely affect the online distribution of music and Narrowstep’s
ability to deliver music programming.  Depending on the rates and
terms adopted for the statutory licenses, Narrowstep’s business could be harmed
by increasing its cost of doing business, as well as by increasing the cost of
doing business for Narrowstep’s customers.




9


We do not
anticipate that Narrowstep’s revenues or cash position will improve, and based
on Narrowstep’s most recently reported operating cash deficit will likely
deteriorate further, prior to the merger (except as it relates to cash proceeds
from the anticipated one time issuance of Narrowstep Series A preferred
stock).  Therefore, we cannot be certain when Narrowstep will operate
profitably, if ever, and if in light of our own cash deficits, we will be able
to absorb ongoing losses of Narrowstep, without adversely affecting our own
operations and financial condition.




The
anticipated benefits of the Narrowstep acquisition may not be realized which
could adversely affect our operating results and/or financial
condition.





We
entered into the merger agreement with Narrowstep with the expectation that the
merger will result in various benefits that cannot be quantified at this
time.  Achieving these benefits will depend in part on the integration
of the Narrowstep business with our operations.  This integration may
be a complex, time-consuming and expensive process that, without proper planning
and implementation, could significantly disrupt the Narrowstep and/or Onstream
business.  The challenges involved in this integration include the
following:





·
            demonstrating
      to Narrowstep’s existing customers that the merger will not result in
      adverse changes in client service standards or business focus and helping
      such customers conduct business easily with
us;





·
            coordinating
      and rationalizing research and development activities to enhance
      introduction of new products and technologies with reduced
      cost;





·
            combining
      product offerings;





·
            coordinating
      sales and marketing efforts to communicate effectively the capabilities of
      Narrowstep and Onstream; and





·
            preserving
      distribution, marketing or other important relationships of both
      Narrowstep and Onstream, and resolving potential conflicts that may
      arise.





The
integration of the Narrowstep business with our operations may not be
successfully completed in a timely manner, or at all, and we may not achieve the
intended benefits at the levels expected or at all. If we fail to achieve the
expected benefits our results of operations and/or financial condition may be
adversely affected.





We
may be unable to successfully market or sell the Digital Media Services Platform
(“DMSP”).





Our
December 2004 purchase of Acquired Onstream included the partially completed
Digital Media Services Platform (“DMSP”), which subsequent to the acquisition we
completed and began to recognize related revenues in December 2005. Goodwill
from the Onstream Merger was approximately $8.4 million at September 30, 2008
and property and equipment as of September 30, 2008 included approximately $1.4
million (net of depreciation) related to the DMSP. Although we believe there is
a market for the DMSP, which had approximately 300 monthly recurring subscribers
as of December 5, 2008, DMSP and hosting revenues were only approximately $1.4
million for the year ended September 30, 2008 and we do not know when, if ever,
that we will generate sufficient revenues from this product to recover our
remaining capitalized costs plus our ongoing operating costs. Our inability to
successfully market and/or sell the DMSP could have a material adverse effect on
our financial condition and results of operations.




10





A
substantial portion of our assets are comprised of goodwill and other
unamortized intangible assets, which may be subject to future impairment and
result in financial statement write-offs.





Our prior
acquisitions of several businesses, including the Onstream Merger and the
Infinite Merger, have resulted in significant increases in goodwill and other
unamortized intangible assets. Goodwill and other unamortized intangible assets,
which include acquired customer lists, were approximately $25.4 million at
September 30, 2008, representing approximately 75% of our total assets and 91%
of the book value of shareholder equity. In addition, property and equipment as
of September 30, 2008 includes approximately $1.4 million (net of depreciation)
related to the DMSP.





If there
is a material change in our business operations, the value of the intangible
assets we have acquired could decrease significantly. On an ongoing basis, we
will evaluate, partially based on discounted expected future cash flows, whether
the carrying value of such intangible assets may no longer be recoverable, in
which case an additional charge to earnings may be necessary. Any future
determination requiring the write-off of a significant portion of unamortized
intangible assets, although not requiring any additional cash outlay, could have
a material adverse effect on our financial condition and results of
operations.





Our
common shares may be delisted from NASDAQ, which would affect our ability to
complete the Narrowstep merger as well as raise capital, and could also result
in penalties under covenants of previous financial
transactions.





Our
securities are listed on the NASDAQ Capital Market.  In January 2008,
we were notified by NASDAQ that we were not in compliance with Marketplace Rule
4310(c)(4), which is necessary in order to be eligible for continued listing on
the NASDAQ Capital Market.  The notice letter from NASDAQ indicated
that our non-compliance was as a result of the bid price of ONSM common stock
closing below $1.00 per share for the preceding thirty consecutive business days
and we were given 180 calendar days, or until July 2, 2008, to regain compliance
with the Rule.  On July 3, 2008, we were notified by NASDAQ that we
were not considered compliant with the Rule as of that date, but because we met
all other initial listing criteria for the NASDAQ Capital Market, we were
granted an additional 180 calendar days, or until December 30, 2008, to regain
compliance with the Rule. On October 22, 2008, we received a letter from NASDAQ
stating that NASDAQ had recently suspended enforcement of the bid price listing
requirement through January 19, 2009, which on December 19, 2008 was extended to
April 20, 2009.  As a result, all companies presently in a bid price
compliance period will remain at the same stage of the process they were when
the NASDAQ announced the suspension and will not be subject to delisting for
that concern, and accordingly we will have until at least July 6, 2009 to regain
compliance with this requirement.  We may be considered compliant,
subject to the NASDAQ staff’s discretion, if ONSM common stock closes at $1.00
per share or more for a minimum of ten consecutive business days before the July
6, 2009 deadline.  Onstream cannot assure you that it will be
compliant by July 6, 2009, or that it will remain compliant, or that its
securities will continue to be listed on NASDAQ in the future.





On
October 1, 2008 we received a letter from NASDAQ stating that our common stock
is subject to delisting since we failed to hold the required annual shareholder
meeting by September 30, 2008, the end of our fiscal year. We attended a hearing
with the NASDAQ Listing Qualifications Panel on November 20, 2008, at which time
we appealed the deficiency and sought an extension of the annual meeting date
requirement. On December 22, 2008, we received a letter from NASDAQ stating that
the NASDAQ Listing Qualifications Panel had granted our request that our
securities continue to be listed on NASDAQ, provided that we hold our annual
shareholder meeting on or before February 28, 2009.  Notwithstanding
the Panel’s decision to continue our common stock’s listing on the NASDAQ
Capital Market, the Panel issued us a public reprimand for our failure to hold
an annual meeting for the prior fiscal year in a timely manner. We believe that
this listing requirement would be met by the shareholder meeting contemplated in
the joint proxy statement/S-4 prospectus now filed with the SEC but not yet
declared effective.




11




With
respect to the Narrowstep merger, if NASDAQ delists our securities from trading
or its Listing Qualifications Panel delays the additional listing of the shares
of our common stock to be issued in connection with the merger, we could face
significant material adverse consequences, including:





·
            the
      merger may be substantially
delayed;





·
            the
      issuance of our securities in connection with the merger may require
      compliance with the individual securities laws or "blue sky" laws of
      several states.  Compliance with blue sky laws may be time
      consuming and costly and could result in delay of the
    merger;





·
            a
      limited availability of market quotations for our
    securities;





·
            the
      determination that our common stock is a "penny stock," which would
      require brokers trading in our common stock to adhere to more stringent
      rules and possibly resulting in a reduced level of trading activity in the
      secondary trading market for our common
stock;





·
            more
      limited amount of news and analyst coverage for
  us;





·
            decreased
      ability to issue additional securities or obtain additional financing in
      the future; and





·
            decreased
      ability of our security holders to sell their securities in certain
      states.




In the
event our common stock is not listed or quoted, or is suspended from trading on
an eligible market for a period of 20 or more trading days (which need not be
consecutive), the purchasers of the 8% Senior Convertible Debentures and the 8%
Subordinated Convertible Debentures may require us to redeem any shares obtained
from the conversion of those notes and still held, for 115% of the market value
for the previous five days. In addition to the above, the 8% Convertible
Debentures and the Additional 8% Convertible Debentures provide cash penalties
of 1% of the original purchase price per month, for each month that the common
stock underlying those securities and the related warrants is not listed for a
period of 3 or more trading days (which need not be consecutive) on the NASDAQ
Capital Market, until the situation is cured. Due to the fact that that there is
no established mechanism for reporting to us changes in the ownership of these
shares after  they are originally issued, we are unable to quantify
how many of these shares are still held by the original recipient and thus
subject to the above provisions. However, we believe that the applicability of
these provisions would be limited by equity and/or by statute to a certain
timeframe after the original security purchase.




In the event our common shares are
delisted for more than five (5) consecutive trading days then we are liable to
the purchasers of approximately $11.0 million of our common shares in March and
April 2007, for a compensatory payment (pro rated on a daily basis) of one and
one-half percent (1.5%) per month until the situation is cured, such payment
based on the purchase price of the shares still held and provided that such
payments may not exceed ten percent (10%) of the initial purchase price of the
shares with respect to any one purchaser. Due to the fact that that there is no
established mechanism for reporting to us changes in the ownership of these
shares after  they are originally issued, we are unable to quantify
how many of these shares are still held by the original recipient and thus
subject to the above provisions. However, we believe that the applicability of
this provision would be limited by equity and/or by statute to a certain
timeframe after the original security purchase.
  12


The
value of Onstream common stock may be adversely affected by market volatility
and prevent sale of currently outstanding shares at a profit, or at
all.





Historically,
there has been volatility in the market price for our common stock, as well as
limited trading volume. The trading price and trading volume of Onstream common
stock may continue to fluctuate in response to various factors, many of which
are beyond Onstream’s control.





Our
quarterly operating results, changes in general conditions in the economy, the
financial markets or the marketing industry, or other developments affecting us
or our competitors, could cause the market price of our common stock to
fluctuate substantially. We expect to experience significant fluctuations in our
future quarterly operating results due to a variety of factors. Factors that may
adversely affect our quarterly operating results include:





·
            the
      announcement or introduction of new services and products by us and our
      competitors,




·
            our
      ability to upgrade and develop our systems in a timely and effective
      manner,




·
            our
      ability to retain existing clients and attract new clients at a steady
      rate, and maintain client
satisfaction,




·
            the
      level of use of the Internet and online services and the rate of market
      acceptance of the Internet and other online services for transacting
      business,




·
            technical
      difficulties, system downtime, or Internet
  brownouts,




·
            the
      amount and timing of operating costs and capital expenditures relating to
      expansion of our business and
operations,




·
            changes
      in accounting rules, particularly those related to the expensing of stock
      options, accounting for uncertainty in income taxes, fair value accounting
      and business combinations,




·
            government
      regulation, and




·
            general
      economic conditions and economic conditions specific to the
      Internet.




As a
result of these factors, in one or more future quarters, our operating results
may fall below the expectations of securities analysts and investors. In this
event, the market price of our common stock would likely be materially adversely
affected.  In addition, the stock market in general and the market prices
for Internet-related companies in particular, have experienced extreme
volatility that often has been unrelated to the operating performance of those
companies. These broad market and industry fluctuations may adversely affect the
price and trading volume of our common stock, regardless of our operating
performance. Many factors other than our operating performance could influence
the price and volume, including:




·
            future
      announcements concerning our competitors or principal customers, such as
      quarterly operating results, changes in earnings estimates by analysts,
      technological innovations, new product introductions, governmental
      regulations, or litigation,





·
            the
      liquidity within the market for our common
  stock,




13




·
            sales
      or purchases by us or by our officers, directors, other insiders and large
      stockholders,





·
            investor
      perceptions concerning the prospects of our business and the digital media
      and webcasting services industry,





·
            market
      conditions and investor sentiment affecting market prices of equity
      securities of high technology and/or Internet related companies,
      and





·
            general
      economic, political and market conditions, such as recessions or
      international currency
fluctuations.





If
the Narrowstep merger is delayed or not completed, the price of our common stock
may decline to the extent that the current market price of that stock reflects a
market assumption that the merger will be completed and that the related
benefits will be realized, or a market perception that the merger was not
consummated due to an adverse change in our business.





The
Narrowstep merger is subject to the receipt of certain consents and approvals.
It is possible that the required consents and approvals may not be obtained on a
timely basis.  A substantial delay in obtaining any required approvals
may jeopardize or delay completion of the merger.  A delay or failure
to complete the merger could negatively impact our stock price and our future
business and financial results because of, among other things, the disruption
that would occur as a result of uncertainties relating to a failure to complete
the merger.  If the merger is delayed or not completed for any reason,
we could be subject to several risks, including the following:





·
            having
      had the focus of our management directed toward the merger and integration
      planning instead of on our core business and other opportunities that
      could have been beneficial to us;





·
            incurring
      substantial transaction costs related to the merger;
  and





·
            being
      required to address adversary actions directed at us as a result of the
      merger being delayed or not
completed.





In
addition, our business may be harmed, and the prices of our stock may decline as
a result, to the extent that customers, suppliers and others believe that we
cannot compete in the marketplace as effectively without the merger or otherwise
remain uncertain about our future prospects in the absence of the merger.
Similarly, our current and prospective employees may experience uncertainty
about their future roles and choose to pursue other opportunities, which could
adversely affect us if the merger is not completed.  The realization
of any of these risks may materially adversely affect our business, financial
results, financial condition and stock price.





The
Merger Agreement may be terminated under certain specified events, including by
either Onstream or Narrowstep if the Effective Time has not occurred on or prior
to November 30, 2008. Onstream and Narrowstep are currently negotiating to
extend this termination date, which negotiations may result in changes to other
terms of the transaction.





Some
of our directors and executive officers have interests in the Narrowstep merger
that could be different from the interests of our stockholders. In addition, the
Stockholder Representative and the Contingent Value Rights Representative is a
significant stockholder of Onstream and Narrowstep and therefore the performance
of his duties under the merger agreement and the contingent value rights
agreement may create a potential conflict of interest.




14





Certain
of our directors and executive officers have interests in the Narrowstep merger
that could be different from, or in addition to, the interests of our
stockholders, in that the terms of the employment contracts of five members of
Onstream’s executive management provide that options will be issuable as a
result of the consummation of the merger. The details related to these options
are described more fully in Item 10 – Executive Compensation.





The Board
of Directors of Narrowstep selected W. Austin Lewis IV to act as the Stockholder
Representative under the merger agreement and as the Contingent Value Rights
Representative under the contingent value rights agreement.  Pursuant
to the terms of the merger agreement and the contingent value rights agreement,
Mr. Lewis is required to perform certain duties on behalf of the former
stockholders of Narrowstep, including confirming or disputing our calculation of
the exchange ratio under the merger agreement and the amount of consideration,
if any, payable under the contingent value rights agreement.  Mr.
Lewis is the principal owner of Lewis Asset Management Corp., Lewis Opportunity
Fund and LAM Opportunity Fund, and as such the beneficial owner of approximately
3,414,893 shares of our common stock.  In addition, pursuant to the
merger agreement, Lewis Asset Management Corp., Lewis Opportunity Fund and/or
LAM Opportunity Fund will receive in aggregate approximately 1,767,387
additional shares of our common stock and 11,506,667 contingent value rights in
exchange for the shares of Narrowstep common and preferred stock beneficially
owned by them or expected to be owned by them on the effective date of the
merger.





In
addition, Lewis Opportunity Fund and LAM Opportunity Fund hold in aggregate
warrants to purchase 26,250 shares of our common stock at $1.50 per share and
warrants to purchase 2,770,000 shares of Narrowstep common stock, the latter
which will be assumed by us upon the merger and converted into warrants to
purchase 132,383 shares of our common stock at prices from $3.50 to $10.34 per
share, with a weighted average price of $5.75 per share and which will also
result in the issuance of up to 2,770,000 contingent value rights in the event
the warrants are exercised within 25 months after the effective date of the
merger. Further, Mr. Lewis executed voting agreements with respect to his
beneficially owned common shares in both Onstream and Narrowstep. Because of his
ownership interest in Onstream, Mr. Lewis may be presented with circumstances
where his duties under the merger agreement and the contingent value rights
agreement conflict with his financial interest in Onstream.  Pursuant
to the terms of the merger agreement and the contingent value rights agreement,
the former Narrowstep stockholders do not have the right to remove Mr. Lewis as
the Stockholder Representative and may only remove Mr. Lewis as the Contingent
Value Rights Representative by action of the holders of a majority of the
contingent value rights.  Mr. Lewis is not required to recuse himself
from any situation where a conflict of interest may exist and will not be liable
to the former Narrowstep stockholders for any act or omission as Stockholder
Representative or Contingent Value Rights Representative except to the extent
such act or omission has been held by a court of competent jurisdiction to
constitute willful misconduct or gross negligence.





If
the selling security holders listed in our more recent registration statements
(including the pending S-4 related to Narrowstep) all elect to sell their shares
of our common stock at the same time, the market price of our shares may
decrease.





It is
possible that the selling security holders listed in our more recent
registration statements on Forms S-3 (declared effective in July 2006 and June
2007) will offer all of the shares for sale. Further, because it is possible
that a significant number of shares could be sold at the same time hereunder,
the sales, or the possibility thereof, may have a depressive effect on the
market price of our common stock.




15





In
addition, sales by Narrowstep stockholders of large numbers of Onstream common
stock after the merger may adversely affect Onstream's stock price. Onstream
will issue maximum of 20,000,000 and a minimum of 10,100,000 (8,100,000 shares
to Narrowstep common stockholders and 2,000,000 shares to Narrowstep Series A
Preferred stockholders) shares of Onstream common stock in the merger, plus
200,000 Onstream common shares for fees. If Onstream issues the maximum of
20,200,000 shares, then Narrowstep stockholders would own approximately 32% of
Onstream common stock outstanding after the merger.  If Onstream
issues the minimum of 10,300,000 shares, then Narrowstep stockholders would own
approximately 19% of Onstream common stock outstanding after the
merger.  The shares issued to Narrowstep stockholders will be freely
tradable following the merger, except shares held by affiliates of
Onstream.  The sale of these shares or the perception that such sales
may be made may cause substantial fluctuations in the price of Onstream common
stock over short time periods.  Onstream may also issue up to
1,969,965 shares of Onstream common stock in connection with the exercise of
Narrowstep warrants following the effective time of the merger.





The
exercise of options and warrants, as well as the conversion of shares of our
Series A-10 Convertible Preferred Stock will be dilutive to our existing common
shareholders.





As of September 30, 2008 there were
outstanding options and warrants to purchase a total of 15,155,731 shares of our
common stock, with an average exercise price of $1.56 per share and
approximately 681,000 of the shares underlying those options registered and
exercisable from $1.00 to $1.10 per share.  In addition, as of
September 30, 2008 there were 74,841 shares of our Series A-10 Convertible
Preferred Stock outstanding, which are convertible at $1.00 per share into
748,410 shares of our common stock and will be automatically converted on
December 31, 2008.  The closing ONSM share price was $0.30 per share
on December 5, 2008.
 
 We
may be exposed to potential risks relating to our internal controls over
financial reporting and our ability to have those controls attested to by our
independent auditors.





As
directed by Section 404 of the Sarbanes-Oxley Act of 2002, the Securities and
Exchange Commission adopted rules requiring public companies to include a report
of management on the company's internal controls over financial reporting in
their annual reports, including Form 10-KSB. In addition, the independent
registered public accounting firm auditing a company's financial statements must
also attest the operating effectiveness of the company's internal controls. We
were subject to these requirements for the first time for the fiscal year ended
September 30, 2008 and as a result, we evaluated our internal control systems in
order to allow our management to report on our internal controls, as a required
part of this Annual Report on Form 10-KSB. In addition to this requirement, our
independent registered public accounting firm will be required to attest to the
operating effectiveness of the company's internal controls, as a required part
of our Annual Report on Form 10-KSB beginning with our report for the fiscal
year ended September 30, 2010.





While we
have expended significant resources in developing the necessary documentation
and testing procedures required by Section 404 of the Sarbanes-Oxley Act of
2002, and expect to continue such expenditures, there is a risk that we will not
comply with all of the requirements imposed thereby. At present, there is no
precedent available with which to measure compliance adequacy. Accordingly,
there can be no positive assurance that we will receive a positive attestation
from our independent auditors.





In the
event we identify significant deficiencies or material weaknesses in our
internal controls that we cannot remediate in a timely manner or we are unable
to receive a positive attestation from our independent auditors with respect to
our internal controls, investors and others may lose confidence in the
reliability of our financial statements and our ability to obtain equity or debt
financing could suffer.





In
addition to the above, in the event that our independent registered public
accounting firm is unable to rely on our internal controls in connection with
their audit of our financial statements, and in the further event that they are
unable to devise alternative procedures in order to satisfy themselves as to the
material accuracy of our financial statements and related disclosures, it is
possible that we would receive a qualified or adverse audit opinion on those
financial statements. In that event, the quotation of our common stock on the
NASDAQ Capital Market could be adversely affected. In addition, investors and
others may lose confidence in the reliability of our financial statements and
our ability to obtain equity or debt financing could suffer.




16





Provisions
of our articles of incorporation and bylaws may delay or prevent a take-over,
which may not be in the best interests of our shareholders.





Provisions
of our articles of incorporation and bylaws may be deemed to have anti-takeover
effects, which govern when and by whom special meetings of our shareholders may
be called, and which provisions may delay, defer or prevent a takeover attempt.
In addition, certain provisions of the Florida Business Corporation Act also may
be deemed to have certain anti-takeover effects which include that control of
shares acquired in excess of certain specified thresholds will not possess any
voting rights unless these voting rights are approved by a majority of a
corporation's disinterested shareholders. As a result of such anti-takeover
provisions, it may be more difficult to implement a change in control even if
the shareholders desire a change in control.





In
addition, our articles of incorporation authorize the issuance of up to
5,000,000 shares of preferred stock with such rights and preferences as may be
determined from time to time by our board of directors, of which 74,841 shares
of our Series A-10 Convertible Preferred Stock were issued and outstanding at
September 30, 2008. Our board of directors may, without shareholder approval,
issue preferred stock with dividends, liquidation, conversion, voting or other
rights that could adversely affect the voting power or other rights of the
holders of our common stock.





ITEM
      2.
              DESCRIPTION
      OF PROPERTY





We lease:





·
            an
      approximately 16,500 square foot facility at 1291 SW 29th
      Street in Pompano Beach, Florida, which serves as our corporate
      headquarters and houses the majority of our webcasting production,
      marketing and distribution activities.  Our lease
      expires on September 15, 2010 and provides for a two-year renewal
      option. The monthly base rental is approximately $21,400 (including our
      share of property taxes and common area expenses) with annual five percent
      (5%) increases.





·
            an
      approximately 8,500 square foot facility at 200 Vallejo Street in San
      Francisco, which serves as administrative headquarters for the DMSP and
      Smart Encoding divisions of the Digital Media Services Group, as well as
      the EDNet division of the Audio and Web Conferencing Services Group, and
      houses the centralized network hub for electronically bridging affiliate
      studios. In addition, the facility operates as a backup to Florida for
      webcasting operations. Our lease expires on April 30, 2009 and provides
      for one five-year renewal option at 95% of fair market
      value.   The monthly base rental is approximately $18,000
      (including month-to-month parking) with annual increases up to five
      percent (5%).





·
            an
      approximately 3,000 square foot facility at 56 Main Street in Millburn,
      New Jersey, which houses the Infinite Conferencing audio and web
      conferencing operations. Our monthly rental is approximately $6,800 and
      the lease expires on July 31, 2009.




17




·
            business
      offices located at 440 Ninth Avenue, New York City, New
      York.  These offices total approximately 1,000 square feet and
      serve primarily for webcasting sales activities and backup to
      Florida-based webcasting operations. Our monthly rental is approximately
      $6,600 and the lease expires on December 31,
  2009.





·
            small
      limited purpose office space in Colorado, as well as equipment space at
      co-location or other equipment housing facilities in South Florida;
      Atlanta, Georgia; Jersey City, New Jersey; San Francisco, California and
      Colorado Springs, Colorado.





ITEM
      3.
              LEGAL
      PROCEEDINGS





We are involved in litigation and
regulatory investigations arising in the ordinary course of business. While the
ultimate outcome of these matters is not presently determinable, it is the
opinion of management that the resolution of these outstanding claims will not
have a material adverse effect on our financial position or results of
operations.





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





None.


PART
II





ITEM
      5.
              MARKET
      FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS AND SMALL BUSINESS
      ISSUER PURCHASES OF EQUITY
SECURITIES





Our common stock is quoted on the
NASDAQ Capital Market, under the trading symbol "ONSM." The following table sets
forth the high and low closing sale prices for our common stock as reported on
the NASDAQ Capital Market for the period from October 1, 2006 through December
5, 2008. These prices do not include retail mark-ups, markdowns or commissions,
and may not necessarily represent actual transactions.





High
                      
                      
                      LowFISCAL
      YEAR 2007First
      Quarter
                      
                      $
                      3.15
                      
                      
                      $
                      0.46Second
      Quarter
                      
                      $
                      3.59
                      
                      
                      $
                      2.28Third
      Quarter
                      
                      $
                      3.15
                      
                      
                      $
                      2.19Fourth
      Quarter
                      
                      $
                      2.34
                      
                      
                      $
                      1.20FISCAL
      YEAR 2008First
      Quarter
                      
                      $
                      1.66
                      
                      
                      $
                      0.80Second
      Quarter
                      
                      $
                      1.03
                      
                      
                      $
                      0.62Third
      Quarter
                      
                      $
                      0.99
                      
                      
                      $
                      0.66Fourth
      Quarter
                      
                      $
                      0.83
                      
                      
                      $
                      0.29FISCAL
      YEAR 2009First
      Quarter (to Dec 5)
                      
                      $
                      0.47
                      
                      
                      $
                      0.24





On
December 5, 2008, the last reported sale price of the common stock on the NASDAQ
Capital Market was $0.30 per share.   As of December 5, 2008
there were approximately 562 shareholders of record of the common
stock.




18





Dividend
Policy





We have
never declared or paid any cash dividends on our common stock.  We
currently expect to retain future earnings, if any, to finance the growth and
development of our business. Dividends related to the Series A-10 Convertible
Preferred are cumulative and must be fully paid by us prior to the payment of
any dividend on our common stock.





Recent
Sales of Unregistered Securities





During
the period from August 4, 2008 through September 30, 2008, we issued 40,703
unregistered shares of common stock for consulting, financial advisory and legal
services. The services are being provided over periods ranging up to three
months, and will result in a professional fees expense of approximately $27,400
over the service period. None of these shares were issued to Company directors
or officers.





During
the period from October 1, 2008 through December 5, 2008, we issued 5,348
unregistered shares of common stock for consulting, financial advisory and legal
services. The services are being provided over a one month period and will
result in a professional fees expense of approximately $2,000 over the service
period. None of these shares were issued to Company directors or
officers.





On
November 11, 2008, we issued 158,000 unregistered shares of common stock for
interest on $1,000,000 face value convertible debentures for the period from
June 2008 through October 2008. The shares were in satisfaction of
interest expense of approximately $48,740 recognized over that period. None
of these shares were issued to Company directors or officers.





All of
the above securities were offered and sold without such offers and sales being
registered under the Securities Act of 1933, as amended (together with the rules
and regulations of the Securities and Exchange Commission (the "SEC")
promulgated thereunder, the "Securities Act"), in reliance on exemptions
therefrom as provided by Section 4(2) and Regulation D of the Securities Act of
1933, for securities issued in private transactions. The recipients were either
accredited or otherwise sophisticated investors and the certificates evidencing
the shares that were issued contained a legend restricting their transferability
absent registration under the Securities Act of 1933 or the availability of an
applicable exemption therefrom. The purchasers had access to business and
financial information concerning our company. Each purchaser represented that he
or she was acquiring the shares for investment purposes only, and not with a
view towards distribution or resale except in compliance with applicable
securities laws.




19





Securities
Authorized for Issuance Under Equity Compensation Plans





The following table sets forth
securities authorized for issuance under equity compensation plans, including
our 1996 Stock Option Plan, our 2007 Equity Incentive Plan, individual
compensation arrangements and any other compensation plans as of September 30,
2008.





Plan Category
                                
                                Number
      of securities
                                  to
      be issued upon
                                  exercise
      of
                                  outstanding
      options,
                                  warrants
      and rights
                                
                                
                                Weighted
      average
                                  exercise
      price of
                                  outstanding
                                  options,
      warrants
                                  and
      rights
                                
                                
                                Number
      of securities
                                  remaining
      available for
                                  future
      issuance under
                                  equity
      compensation
                                  plans
      (excluding
                                  securities
      reflected in
                                  column
      (a))(a)
                                
                                
                                (b)
                                
                                
                                (c)1996
      Stock Option Plan (1)
                                
                                4,043,000
                                
                                
                                $
                                1.07
                                
                                
                                None2007
      Equity Incentive Plan (2)
                                
                                4,060,000
                                
                                
                                $
                                1.56
                                
                                
                                1,915,000Equity
      compensation plans approved by shareholders (3)
                                
                                2,420,284
                                
                                
                                $
                                2.08
                                
                                
                                NoneEquity compensation plans not approved by
      shareholders
                                
                                None
                                
                                
                                
                                —
                                
                                
                                None





1)
              On
      February 9, 1997, the Board of Directors and a majority of the Company's
      shareholders adopted the 1996 Stock Option Plan (the "Plan"), On April 11,
      2002, an amendment to the Plan, ratified by the shareholders, reserved an
      aggregate of 733,334 plan options and added an equity compensation
      component. On December 15, 2004, a majority of our shareholders voted to
      increase the number of shares available for issuance under the plan to
      3,500,000. On September 13, 2005, a majority of our shareholders voted to
      increase the number of shares available for issuance under the plan to
      6,500,000 (up to 4,500,000 shares available for issuance as options and up
      to another 2,000,000 shares available for stock grants). The Company may
      no longer issue additional options or stock grants under the Plan – see
      footnote 2 below.





2)
              On
      September 18, 2007, the Company’s Board of Directors and a majority of the
      Company's shareholders adopted the 2007 Equity Incentive Plan (the “New
      Plan”), which authorized the issuance of up to 6,000,000 shares of ONSM
      common stock pursuant to stock options, stock purchase rights, stock
      appreciation rights and/or stock awards for employees, directors and
      consultants. The options and stock grants authorized for issuance under
      the New Plan were in addition to those already issued under the Plan,
      although the Company may no longer issue additional options or stock
      grants under the Plan.





3)
              On
      December 15, 2004, a majority of our shareholders voted to issue 1,631,390
      Non Plan options to certain executives, directors and other management in
      connection with the Onstream Merger and 800,000 Non Plan options to
      certain executives in connection with their employment contracts. 11,106
      of these Non Plan options had expired as of September 30,
      2008.




20





ITEM
6.   MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF
OPERATION





The
following discussion should be read together with the information contained in
the Consolidated Financial Statements and related Notes included in the annual
report.





Overview





We are a
leading online service provider of live and on-demand Internet video, corporate
web communications and content management applications.  We had
approximately 110 full time employees as of December 5, 2008, with operations
organized in two main operating groups:





·
            Digital
      Media Services Group


·
            Web
      and Audio Conferencing Services
Group





Our
Digital Media Services Group consists of our Webcasting division, our DMSP
(“Digital Media Services Platform”) division, our UGC (“User Generated Content”)
division, our Smart Encoding division and our Travel division.





Our
Webcasting division, which operates primarily from facilities in Pompano Beach,
Florida, provides an array of corporate-oriented, web-based media services to
the corporate market including live audio and video webcasting and on-demand
audio and video streaming for any business, government or educational
entity,  Our DMSP division, which operates primarily from
facilities in San Francisco, California provides an online, subscription based
service that includes access to enabling technologies and features for our
clients to acquire, store, index, secure, manage, distribute and transform these
digital assets into saleable commodities. Our UGC division, which also operates
as Auction Video and operates primarily from facilities in Colorado Springs,
Colorado, provides a video ingestion and flash encoder that can be used by our
clients on a stand-alone basis or in conjunction with the DMSP. Our Smart
Encoding division, which operates primarily from facilities in San
Francisco, California provides both automated and manual encoding and editorial
services for processing digital media, using a set of coordinated technologies
and processes that allow the quick and efficient online search, retrieval and
streaming of this media, which can include photos, videos, audio, engineering
specs, architectural plans, web pages, and many other pieces of business
collateral.  Our Travel division, which operates primarily from
facilities in Pompano Beach, Florida, produces and distributes Internet-based
multi-media streaming videos related to hotels, resorts, time-shares, golf
facilities, and other travel destinations.





Our Web
and Audio Conferencing Services Group includes a) our Infinite Conferencing
(“Infinite”) division, which operates primarily from facilities in the New York
City area and provides “reservationless” and operator-assisted audio and web
conferencing services and b) our EDNet division, which operates
primarily from facilities in San Francisco, California and provides connectivity
within the entertainment and advertising industries through its managed network,
which encompasses production and post-production companies, advertisers,
producers, directors, and talent.





For
segment information related to the revenue and operating income of these groups,
see Note 7 to the Consolidated Financial Statements.





Fiscal
2008 Highlights





In
December 2007, we entered into a line of credit arrangement with a financial
institution under which we could borrow up to an aggregate of $1.0 million for
working capital, collateralized by our accounts receivable. In August 2008 the
maximum allowable borrowing amount was increased to $1.6 million and we had
received $1.2 million funding under this arrangement as of September 30, 2008
and $1.55 million funding under this arrangement as of December 5, 2008. The
outstanding balance bears interest at prime plus 8% per annum (prime plus 11%
from December 2, 2008), payable monthly in arrears.




21




On May
29, 2008, we entered into an Agreement and Plan of Merger (the “Merger
Agreement”) to acquire Narrowstep, Inc. (“Narrowstep”), a Delaware corporation
with most of its employees and facilities located in the United Kingdom.
Narrowstep is a provider of Internet TV services supporting content providers,
broadcasters, telecommunications companies and corporations worldwide. The
initial Narrowstep Merger Agreement was amended twice (on August 13, 2008 and on
September 15, 2008) and on September 23, 2008, we filed a combination Proxy/Form
S-4 for the transaction with the SEC. As a result of the SEC’s comments, we
filed an amended Proxy/Form S-4 on November 6, 2008. The SEC has provided us
with comments on this amended Proxy/Form S-4, which we believe will not require
a long period of time for us to address. However, we are unable to file further
amendments to the Proxy/Form S-4 until after the fiscal 2008 audit is completed
and the related Form 10-KSB is filed with the SEC.





During
the period from June 3, 2008 through July 8, 2008 we received an aggregate of
$1.0 million from seven accredited individuals and other entities (the
“Lenders”), under a software and equipment financing arrangement. We issued
Notes to those Lenders, which are collateralized by specifically designated
software and equipment owned by us with a cost basis of approximately $1.5
million, as well as a subordinated lien on certain other of our assets to the
extent that the designated software and equipment, or other software and
equipment added to the collateral at a later date, is not considered sufficient
security for the loan. Under this arrangement, the Lenders received 10,000
restricted ONSM common shares for each $100,000 lent to us, and will also
receive interest at 12% per annum, which we may pay in restricted ONSM common
shares in accordance with a defined formula. We may prepay the Notes, which have
a three (3) year maturity date, at any time upon ten (10) days' prior written
notice to the Lenders during which time the Lender may choose to convert the
Note to restricted ONSM common shares.  In the event of such
repayment, all interest accrued and due for the remaining unexpired loan period
is due and payable and may be paid in cash or restricted ONSM common shares in
accordance with a defined formula.





See
Liquidity and Capital Resources.





Revenue
Recognition





Revenues
from recurring service are recognized when (i) persuasive evidence of an
arrangement exists between us and the customer, (ii) the good or service has
been provided to the customer, (iii) the price to the customer is fixed or
determinable and (iv) collectibility of the sales prices is reasonably
assured.


Our
Digital Media Services Group recognizes revenues from the acquisition, editing,
transcoding, indexing, storage and distribution of its customers’ digital media,
as well as from live and on-demand internet webcasting and internet distribution
of travel information.
 
 Charges
to customers by the DMSP division are generally based on a monthly subscription
fee, as well as charges for hosting, storage and professional services. Fees
charged to customers for customized applications or set-up are recognized as
revenue at the time the application or set-up is completed. Charges to customers
by the Smart Encoding and UGC divisions are generally based on the activity or
volumes of such media, expressed in megabytes or similar terms, and are
recognized at the time the service is performed. This division also provides
hosting, storage and streaming services for digital media, which are provided
via the DMSP.





The
Webcasting division charges for live and on-demand webcasting at the time an
event is accessible for streaming over the Internet. The Travel division
recognizes production revenue at the time of completion of the related video or
website. Travel distribution revenue is recognized when a user watches a video
on the Internet, if charged on a per hit basis, or over the term of the
contract, if charged as a fixed monthly fee.
 
 Our Audio
and Web Conferencing Services Group recognizes revenue from audio and web
conferencing as well as customer usage of digital telephone
connections.
  22


The
Infinite division generally charges for audio conferencing and web conferencing
services on a per-minute usage rate, although webconferencing services are also
available for a monthly subscription fee allowing a certain level of usage.
Audio conferencing and web conferencing revenue is recognized based on the
timing of the customer’s use of those services.


The EDNet
division primarily generates revenue from customer usage of digital telephone
connections controlled by them. EDNet purchases digital phone lines from
telephone companies and sells access to the lines, as well as separate
per-minute usage charges. Network usage and bridging revenue is recognized based
on the timing of the customer’s usage of those services.





We
include the DMSP and UGC divisions’ revenues, along with the Smart Encoding
division’s revenues from hosting, storage and streaming, in the DMSP and Hosting
revenue caption. We include the Travel division revenues, the EDNet division’s
revenues from equipment sales and rentals and the Smart Encoding division’s
revenues from encoding and editorial services in the Other Revenue
caption.





Results
of Operations





Our
consolidated net loss for the fiscal year ended September 30, 2008 was
approximately $6.6 million ($0.16 loss per share) as compared to a loss of
approximately $14.8 million ($0.48 loss per share) for the prior fiscal year, a
decrease in our loss of approximately $8.2 million (56%). The decreased net loss
was primarily due to a significant number of conversions to equity of the 8%
Senior and Subordinated Convertible Debentures in the prior fiscal year and the
resulting write-off of unamortized discount as interest expense at that time, as
well as conversions of notes payable to equity during that same period and the
resulting write-off of prepaid interest and fees. Similar transactions did not
occur in the fiscal year ended September 30, 2008.
 
 In
addition to the above, our results of operations for the fiscal year ended
September 30, 2008 included a full year of operating results for Auction Video
and Infinite Conferencing. However, because the acquisitions of those entities
were completed by us on March 27, 2007 and April 27, 2007, respectively, a full
year of those entities’ operating results were not reflected in our results of
our operations for the fiscal year ended September 30, 2007.
  23





The
following table shows, for the periods presented, the percentage of revenue
represented by items on our consolidated statements of operations.




Years Ended September 30,2008
                    
                    
                    2007Revenue:DMSP
      and hosting
                    
                    
                    8.2
                    %
                    
                    
                    6.4
                    %Network
      usage
                    
                    
                    12.7
                    
                    
                    
                    17.4Webcasting
                    
                    
                    33.7
                    
                    
                    
                    39.4Audio
      and web conferencing
                    
                    
                    41.3
                    
                    
                    
                    26.4Other
                    
                    
                    4.1
                    
                    
                    
                    10.4Total
      revenue
                    
                    
                    100.0
                    %
                    
                    
                    100.0
                    %Cost
      of revenue:DMSP
      and hosting
                    
                    
                    3.5
                    %
                    
                    
                    2.9
                    %Network
      usage
                    
                    
                    5.3
                    
                    
                    
                    7.4Webcasting
                    
                    
                    12.1
                    
                    
                    
                    14.2Audio
      and web conferencing
                    
                    
                    8.4
                    
                    
                    
                    4.5Other
                    
                    
                    3.7
                    
                    
                    
                    6.7Total
      costs of revenue
                    
                    
                    33.0
                    %
                    
                    
                    35.7
                    %Gross
      margin
                    
                    
                    67.0
                    %
                    
                    
                    64.3
                    %Operating
      expenses:Compensation
                    
                    
                    52.6
                    %
                    
                    
                    55.1
                    %Professional
      fees
                    
                    
                    11.2
                    
                    
                    
                    27.6Other
      general and administrative
                    
                    
                    15.6
                    
                    
                    
                    18.0Depreciation
      and amortization
                    
                    
                    24.0
                    
                    
                    
                    25.6Total
      operating expenses
                    
                    
                    103.4
                    %
                    
                    
                    126.3
                    %Loss
      from operations
                    
                    
                    (36.4
                    )%
                    
                    
                    (62.0
                    )%Other
      income (expense), net:Interest
      income
                    
                    
                    -
                    %
                    
                    
                    0.6
                    %Interest
      expense
                    
                    
                    (1.3
                    )
                    
                    
                    (61.6
                    )Debt
      extinguishment loss
                    
                    
                    -
                    
                    
                    
                    (1.1
                    )Other
      income, net
                    
                    
                    0.4
                    
                    
                    
                    2.3Total
      other income (expense), net
                    
                    
                    (0.9
                    )%
                    
                    
                    (59.8
                    )%Net
      loss
                    
                    
                    (37.3
                    )%
                    
                    
                    (121.8
                    )%




24


The
following table is presented to illustrate our discussion and analysis of our
results of operations and financial condition.  This table should be
read in conjunction with the consolidated financial statements and the notes
therein.





For the years ended
                  September 30,
                
                
                Increase (Decrease)2008
                
                
                2007
                
                
                Amount
                
                
                PercentTotal
      revenue
                
                $
                17,587,223
                
                
                $
                12,115,045
                
                
                $
                5,472,178
                
                
                
                45.2
                %Total
      costs of revenue
                
                
                5,811,025
                
                
                
                4,319,085
                
                
                
                1,491,940
                
                
                
                34.5
                %Gross
      margin
                
                
                11,776,198
                
                
                
                7,795,960
                
                
                
                3,980,238
                
                
                
                51.1
                %General
      and administrative expenses
                
                
                13,963,452
                
                
                
                12,207,877
                
                
                
                1,755,575
                
                
                
                14.4
                %Depreciation
      and amortization
                
                
                4,215,669
                
                
                
                3,099,940
                
                
                
                1,115,729
                
                
                
                36.0
                %Total
      operating expenses
                
                
                18,179,121
                
                
                
                15,307,817
                
                
                
                2,871,304
                
                
                
                18.8
                %Loss
      from operations
                
                
                (6,402,923
                )
                
                
                (7,511,857
                )
                
                
                (1,108,934
                )
                
                
                (14.8
                )%Other
      (expense)
                
                
                (158,535
                )
                
                
                (7,246,196
                )
                
                
                (7,087,661
                )
                
                
                (97.8
                )%Net
      loss
                
                $
                (6,561,458
                )
                
                $
                (14,758,053
                )
                
                $
                (8,196,595
                )
                
                
                ( 55.5
                )%





Revenues
and Gross Margin





Consolidated
operating revenue was approximately $17.6 million for the fiscal year ended
September 30, 2008, an increase of approximately $5.5 million (45%) from the
corresponding prior fiscal year, primarily due to increased revenues of the
Audio and Web Conferencing Services Group.


Audio and
Web Conferencing Services Group revenues were approximately $9.7 million for the
fiscal year ended September 30, 2008, an increase of approximately $4.2 million
(77%) from the prior fiscal year. This increase was primarily due to an increase
of approximately $4.1 million of audio and web conferencing revenues recognized
from the Infinite division, to approximately $7.3 million from approximately
$3.2 million in the corresponding prior fiscal year period. We acquired Infinite
on April 27, 2007, and thus these prior fiscal year revenues represent only five
months of operations by Infinite after the acquisition date.





In August
2008, we announced that our Infinite division signed a reseller agreement with
Copper Conferencing, one of the nation’s leading, carrier-class conferencing
services providers for small and medium-sized businesses. Under the new
agreement, Infinite will provide Copper Conferencing with its audio and web
conferencing services, as well as customized applications. In October 2008, we
announced the hiring of Mr. Scott Lee, an experienced executive in sales and
other strategic areas, as Vice President, Business Development for Infinite.
Based on the Copper Conferencing relationship and our expectations that under
Mr. Lee’s direction, the Infinite sales force will focus on entering into
agreements with similar organizations to provide Infinite’s audio and web
conferencing services, we expect the fiscal 2009 revenues of the Audio and Web
Conferencing Services Group to exceed the corresponding fiscal 2008
amounts.





Digital
Media Services Group revenues were approximately $7.9 million for the fiscal
year ended September 30, 2008, an increase of approximately $1.2 million (19%)
from the prior fiscal year. This increase was  primarily due to an
approximately $1.2 million (24%) increase in Webcasting division sales over the
prior fiscal year, arising from increased production services sales and a
continuation of the past growth in our sales of higher priced video webcasts.
Our revenues from audio webcasts, although having a much lower per-event price
than video webcasts, have also increased significantly in fiscal 2008 as
compared to fiscal 2007, primarily due to an approximately $510,000 increase in
revenues generated via a single reseller of our financial webcasts. The number
of webcasts produced increased to approximately 6,800 webcasts for the year
ended September 30, 2008, versus approximately 4,500 webcasts for the prior
fiscal year, and the average revenue per webcast event decreased to
approximately $872 for the current fiscal year as compared to approximately
$1,052 for the prior fiscal year.




25




The
number of webcasts reported above, as well as the resulting calculation of the
average revenue per webcast event, does not include any webcast events
attributed with $100 or less revenue, based on our determination that excluding
such low-priced or even no-charge events increases the usefulness of this
statistic. The prior period numbers presented herein have been calculated on the
same basis.





Revenues
from the DMSP and hosting divisions, also part of the Digital Media Services
Group, were approximately $1.4 million for the fiscal year ended September 30,
2008, an increase of approximately $662,000 (85%) from the prior fiscal year.
This increase was due to (i) an approximately $352,000 increase in hosting and
bandwidth charges to certain larger DMSP customers serviced by our Smart
Encoding division and (ii) an approximately $304,000 increase in DMSP “store and
stream” revenues.





The above
Digital Media Services Group revenue increases were partially offset by (i) an
approximately $367,000 decrease in sales to a single customer from approximately
$462,000 in fiscal 2007 to approximately $95,000 in fiscal 2008, as well as (ii)
an approximately $260,000 decrease in sales due to the January 2007
discontinuance of encoding and editorial work for Discovery Education,
Inc.





We have
made the following recent announcements with respect to our government related
sales activity:


·
              In
      April 2007 we announced our selection as a member of the Qwest
      Communications International team that was awarded a stake in Networx
      Universal, the largest communications services contract in the world.
      Qwest and its team members will participate in the U.S. government program
      to provide leading-edge voice, data and video services, including managed
      and secure advanced data networks, to federal agencies nationwide. Our
      role as part of the Qwest team will be providing comprehensive video and
      audio encoding services and webcasting for live and archived distribution
      of content via a wide range of digital delivery networks. Although we have
      not yet recognized revenue related to Qwest, we have responded to several
      related requests for proposals from government agencies, ranging in size
      from $250,000 per year to several million dollars, although there is no
      assurance that these contracts will be ultimately awarded to
      us.





·
              In
      November 2007 we announced that we had been awarded a stake in a
      three-year Master Services Agreement (MSA) by the State of California to
      provide video and audio streaming services to the state and participating
      local governments. We recognized related revenues of approximately
      $226,000 during the year ended September 30,
  2008.





·
              In
      August 2008 we announced that we had been awarded three new multi-year
      public sector webcasting services contracts with the United States Nuclear
      Regulatory Commission (NRC), CaliforniaStateDepartment of
      Technology Services (DTS), and California State Board of Equalization
      (BOE), for an allocated total of $1.5 million in contract awards.  We
      are servicing these contracts in cooperation with Akamai, as one of their
      resellers.


We have
recently completed several feature enhancements to our proprietary webcasting
platform, including embedded Flash video and animations as well as a webinar
service providing the means to hold a virtual seminar online in real time and
both audio and video editing capabilities. Additional upgrades expected include
storage and search of webcasts in the DMSP by March 2009.




26




We
recently announced an upgrade to our webcasting service, featuring broadcast
quality video using the industry standard 16:9 aspect ratio and called Visual
Webcaster HDTM. The new upgrade includes the ability to use high definition
cameras and other HD sources input via SDI (Serial Digital Interface) into our
encoders, providing a broadcast-quality experience. In addition, we have
recently launched iEncodeTM, a full-featured, turnkey, standalone webcasting
solution, designed to operate inside a corporate LAN environment with multicast
capabilities.  Although initial releases of both Visual Webcaster HD and
iEncode are available, in an upgrade scheduled for March 2009 or before, they
will be fully compatible with the DMSP for archiving, intelligent indexing and
retrieval.




As of
September 30, 2008, we had approximately 252 monthly recurring subscribers to
the “Store and Stream” application of the DMSP, which was developed as a focused
interface for small to medium business (SMB) clients. Most of these subscribers
started service in October 2007 or later. We expect this DMSP customer base to
continue to grow, especially as we add reporting and other features to this
interface. Accordingly, we are developing an additional version of the DMSP
platform called “Streaming Publisher”, which we expect to launch in the second
quarter of fiscal 2009. Streaming Publisher is designed to provide enhanced
capabilities for advanced users such as publishers, media companies and other
content developers. The new Streaming Publisher upgrade to the DMSP directly
addresses the developing online video advertising market and
will  include features such as automated transcoding (the ability to
convert media files into multiple file formats), player picker (the ability to
create various video players and detailed usage reports), as well as advanced
permission, security and syndication features. Users of the basic Store and
Stream version of the DMSP may easily upgrade to the Streaming Publisher version
for a higher monthly fee.




In
addition to the development of these additional features and products, we have
made significant progress on our development of an enhanced video search
function, which is now referred to as Video Search Engine Optimization (VSEO).
VSEO is based on the substantial software and hardware infrastructure purchased
primarily from Autonomy/Virage plus the allocation of internal resources from
our programming and development professionals.  VSEO is expected to be
released during calendar 2009.




In
addition to the “Store and Stream” and “Streaming Publisher” applications of the
DMSP, we have entered into strategic partnership and other agreements with
several entities assisting us in the deployment via the DMSP of enabling
technologies necessary to create social networks with integrated professional
and user generated multimedia content, such as found on YouTube, MySpace and
other similar platforms.





One of
the key components of our March 2007 acquisition of Auction Video was the video
ingestion and flash transcoder, already integrated into the DMSP as an integral
component of the services offered to social network providers and other User
Generated Video (UGV) applications. Auction Video’s technology is being used in
various applications such as online Yellow Pages listings, delivering video to
mobile phones, multi-level marketing and online newspaper classified
advertisements, and can also provide for direct input from webcams and other
imaging equipment. In addition, our Auction Video service was approved by eBay
to provide video hosting services for eBay users and PowerSellers (high volume
users of eBay). The Auction Video acquisition is another strategic step in
providing a complete range of enabling, turnkey technologies for our clients to
facilitate “video on the web” applications, which we believe will make the DMSP
a more competitive option as an increasing number of companies look to enhance
their web presence with digital rich media and social applications.


In
addition to the beneficial effect of the Auction Video technology on DMSP
revenues, we believe that our ownership of that technology will provide us with
other revenue opportunities, including software sales and licensing fees,
although the timing and amount of these revenues cannot be assured. In March
2008 we retained the law firm of Hunton & Williams to assist in expediting
the patent approval process and helping protect our rights related to our patent
pending UGV technology. In April 2008, we revised the original patent
application primarily for the purpose of splitting it into two separate
applications, which, while related, are being evaluated separately by the U.S.
Patent Office. As a result of this technology, plus other enhancements to the
DMSP as noted above and our increased sales and marketing focus on opportunities
with social networks and other high-volume users of digital rich media, as well
as a result of sales of the Streaming Publisher version of the DMSP, expected to
be launched in the second quarter of fiscal 2009, we expect the fiscal 2009 DMSP
and hosting revenues to exceed the corresponding fiscal 2008
amounts.


27


In
October 2008, we announced the hiring of Mr. Daniel Debaun, an experienced
executive in sales and other strategic areas, as Vice President, Business
Development for the iEncode product, and we expect sales from that product to
increase in fiscal 2009.  We also expect increased webcasting and
other revenues as a result of increased government contract activity, including
the items noted above. Therefore, due to these anticipated increases in both
DMSP and hosting revenues, as well as webcasting revenues, we expect the fiscal
2009 revenues of the Digital Media Services Group to exceed the corresponding
fiscal 2008 amounts.
 
 The
proposed acquisition of Narrowstep, if consummated as anticipated in February
2009, will also increase the fiscal 2009 revenues of the Digital Media Services
Group, as compared to corresponding fiscal 2008 amounts. Narrowstep is a
provider of Internet TV services supporting content providers, broadcasters,
telecommunications companies and corporations worldwide.





Consolidated
gross margin was approximately $11.8 million for the fiscal year ended September
30, 2008, an increase of approximately $4.0 million (51%) from the prior fiscal
year.  This increase was primarily due to an increase of approximately
$3.1 million of gross margin on the audio and web conferencing revenues
recognized from the Infinite division, to approximately $5.8 million from
approximately $2.7 million in the prior fiscal year. We acquired Infinite on
April 27, 2007, and thus these prior fiscal year revenues and gross margins
represent only the five months of operations by Infinite after the acquisition
date. We also experienced an approximately $744,000 (24%) increase in webcasting
gross margin over the prior fiscal year. This increase in webcasting gross
margin was primarily due to an increase in the number of events, as discussed
above, which allowed us to better leverage the fixed portion of our webcasting
costs.





The
consolidated gross margin percentage was 67.0% for the year ended September 30,
2008, versus 64.3% for the prior fiscal year. This increase was primarily due to
an 80.0% gross margin percentage on Infinite’s audio and web conferencing
revenues, which is higher than our historical gross margin experience prior to
the Infinite acquisition.





Based on
our expectations of increased sales as discussed above, we expect consolidated
gross margin (in dollars) for fiscal year 2009 to exceed the prior fiscal year
amounts, although such increase cannot be assured.





Operating
Expenses





Consolidated
operating expenses were approximately $18.2 million for the fiscal year ended
September 30, 2008, an increase of approximately $2.9 million (19%) over the
prior fiscal year, primarily from increased compensation and depreciation and
amortization expense.
 
 Compensation
expense for the fiscal year ended September 30, 2008 was approximately $2.6
million (39%) greater than the prior fiscal year. This increase is primarily due
to (a) approximately $1.4 million of increased compensation expense recognized
by our Infinite division, primarily because we acquired Infinite on April 27,
2007 and the prior fiscal year compensation expense includes only the five
months of operations by Infinite after the acquisition date, (b) approximately
$830,000 of increased executive and administrative staff compensation, primarily
the impact of non-cash equity compensation arising from service and
performance-based options granted in connection with new executive employment
contracts approved by our Board in September 2007, as well as the effect of
contractual raises and (c) approximately $270,000 of increased DMSP division
compensation, primarily arising from development and programming staff
increases.
  28


Depreciation
and amortization expense for the fiscal year ended September 30, 2008 was
approximately $1.1 million (36%) greater than the prior fiscal year. This
increase was primarily due to the amortization and depreciation of the tangible
and intangible assets acquired as a result of our March 2007 acquisition of
Auction Video and our April 2007 acquisition of Infinite Conferencing, which was
only recognized in the corresponding prior fiscal year period for the six and
five month periods after their respective acquisition dates.





Professional
fee expense for the fiscal year ended September 30, 2008 was approximately $1.4
million (41%) less than the prior fiscal year. This decrease is primarily due to
lower non-cash expenses related to equity-based compensation (shares and
options) paid for financial and other consulting services rendered during fiscal
2008 as compared to fiscal 2007.





Although,
as a result of increased revenues and gross margin, we expect our consolidated
operating expenses for fiscal year 2009 to exceed the corresponding prior year
amounts, we expect that percentage increase to be less than the percentage
increase in the gross margin dollars for fiscal year 2009.





Other
Expense





Other
expense of approximately $158,000 for the fiscal year ended September 30, 2008
represented the significant reduction of the approximately $7.5 million in
interest expense recognized for the fiscal year ended September 30, 2007. This
was primarily due to a significant number of conversions to equity of the 8%
Senior and Subordinated Convertible Debentures in the fiscal year ended
September 30, 2007 and the resulting write-off of unamortized discount as
interest expense at that time, as well as conversions of notes payable to equity
during the fiscal 2007 year and the resulting write-off of prepaid interest and
fees. Similar transactions did not occur in the fiscal year ended September 30,
2008 and interest expense for that period was only approximately
$245,000.





As of
September 30, 2008, we had outstanding interest bearing debt with a total face
amount of approximately $2.9 million, which was primarily comprised of (i) $1.2
million in borrowings outstanding ($1.55 million as of December 5, 2008) for
working capital under a line of credit arrangement with a financial institution,
collateralized by our accounts receivable and bearing interest at prime plus 8%
(prime plus 11% from December 2, 2008), (ii) convertible debentures for
financing software and equipment purchases with a balance of $1.0 million at
September 30, 2008 and incurring interest expense at 12% per annum and (iii)
notes payable to former shareholders of Infinite Conferencing, with a balance of
$458,399 at September 30, 2008 and incurring interest expense at 12% per annum.
In addition to these interest amounts, we are also recognizing interest expense
as a result of amortizing discount on these debts. As compared to the
approximately $2.9 million as of September 30, 2008, our interest bearing debt
totaled approximately $400,000 as of September 30, 2007 and we therefore
anticipate our interest expense during fiscal 2009 to be greater than the
corresponding prior year amounts.





In
accordance with the accounting rules for debt extinguishments, the renegotiated
note payable to J&C Resources was recorded at its fair value at the date the
modifications, primarily conversion rights, were approved by our Board of
Directors, which value was significantly higher than the value at the time the
modifications were renegotiated with the lender two weeks earlier. That
accounting resulted in our recognition of a non-cash debt extinguishment loss
during the fiscal year ended September 30, 2007 of $135,000, which was the
difference between the $435,000 fair value of the ONSM shares that the note was
convertible into as of the Board approval date and the $300,000 face value of
the note. At the time it was renegotiated, the note was convertible into ONSM
shares with a value equal to or less than the face value of the
note.




29




Liquidity
and Capital Resources





Our
financial statements for the fiscal year ended September 30, 2008 reflect a net
loss of approximately $6.6 million, although cash provided by operations for
that period was approximately $69,000. Although we had cash of approximately
$674,000 at September 30, 2008, working capital was a deficit of approximately
$1.4 million at that date.





During
fiscal 2008, we obtained financing from two primary sources – a) a line of
credit arrangement (the “Line”) collateralized by our accounts receivable, under
which we have borrowed $1.2 million as of September 30, 2008 (and $1.55 million
as of December 5, 2008) and b) convertible debentures (“Notes”) collateralized
by certain software and equipment, which we issued for total gross proceeds of
$1.0 million and still outstanding as of September 30, 2008.





The
maximum allowable borrowing amount under the Line is now $1.6 million, subject
to certain formulas with respect to the amount and aging of the underlying
receivables. The outstanding balance bears interest at prime plus 8% per annum
(prime plus 11% from December 2, 2008), payable monthly in arrears.





The
Notes, which we issued during June and July 2008, may be converted to restricted
ONSM common shares at any time six (6) months after issuance and prior to their
three (3) year maturity date, at the Lender’s option, based on a conversion
price equal to seventy-five percent (75%) of the average ONSM closing price for
the thirty (30) trading days prior to the date of conversion, but in no event
may the conversion price be less than $0.80 per share. In the event the Notes
are converted prior to maturity, interest on the Notes for the remaining
unexpired loan period will be due and payable in additional restricted ONSM
common shares in accordance with the same formula. Notwithstanding the above, we
have the right in our sole discretion to allow the Lender to convert the Note
into restricted ONSM common shares during the first six months after issuance
for any reason.





The Notes
bear interest at 12% per annum,  payable every 6 months in cash or, at
our option, in restricted ONSM common shares, based on a conversion price equal
to seventy-five percent (75%) of the average ONSM closing price for the thirty
(30) trading days prior to the date the applicable payment is due. The first
interest payment date was October 31, 2008 and we satisfied the interest
obligation of approximately $48,740 through that date by the issuance of 158,000
unregistered shares of our common stock.





There is
minimal additional borrowing capacity available under the current terms and
limits of the Line. However, we believe that we could obtain additional
financing based on approximately $700,000 collateralized by software and
equipment purchased and paid for by us during the past year, which is not
included in the $1.5 million of software and equipment identified as collateral
for the currently outstanding convertible debentures. Although we have made no
arrangements for this financing and cannot assure that we would be able to
ultimately obtain it and if we did obtain it, on what terms, we believe that
this is a potentially viable alternative to obtain sufficient capital resources
to fund our continued operations.





In
accordance with the terms of our acquisition of Infinite Conferencing, we agreed
that in the event the accumulated gross proceeds of the sale of certain shares
issued in connection with that acquisition were less than a contractually
defined amount, we would pay the difference. On December 27, 2007, the former
Infinite shareholders notified us that those shares had been sold by them for
proceeds which would require us to pay an additional $958,399. We recorded this
amount as a liability as of December 31, 2007, which was offset by a reduction
in additional paid in capital and on February 14, 2008, we paid $100,000 against
this obligation.




30




On March
12, 2008, we executed promissory notes (the “Infinite Notes”) for the remaining
aggregate balance due of $858,399 plus interest accruing at 12% per annum on the
outstanding balance from February 15, 2008 until the July 10, 2009 maturity.
Note payments of (i) $100,000 (one hundred thousand dollars) were paid on March
15, 2008 and (ii) $50,000 (fifty thousand dollars) were paid monthly from April
through November 2008. Additional payments of (iii) $50,000 (fifty thousand
dollars) will be due on the 10th of the following seven months and (iv) the
final payment of $8,399 plus accrued interest will be due on July 10, 2009. The
Infinite Notes are collateralized by all of our assets other than accounts
receivable and are subordinated to the first $4.0 million of our debt
outstanding from time to time. The Infinite Notes may be prepaid without penalty
and all principal and interest thereunder, as well as the legal expenses, is
payable in cash.  The Infinite Notes provide that if any of certain
identified events of default occur, which includes a scheduled payment not made
and remaining unpaid after five days notice from the Infinite Shareholders, then
or at any time during the continuance of the event of default, the Infinite
Shareholders, at their option, may accelerate the maturity of the Infinite Notes
and require all accrued interest and other amounts to become immediately due and
payable.





We expect
increases in our operating expenses during fiscal year 2009 related to the
continuation of our marketing program expansion that began in previous fiscal
years, although we cannot guarantee that this expansion will be continued or
that our marketing efforts will be successful.


On May
29, 2008, we entered into an Agreement and Plan of Merger (the “Merger
Agreement”) to acquire Narrowstep, Inc. (“Narrowstep”), a Delaware corporation
with most of its employees and facilities located in the United Kingdom.
Narrowstep is a provider of Internet TV services supporting content providers,
broadcasters, telecommunications companies and corporations worldwide. The
merger is not expected to be consummated until February 2009. The terms of the
Merger Agreement call for a minimum issuance of 10.1 million ONSM common shares,
as well as the assumption of certain Narrowstep warrants. In addition, we could
be required to issue up to an additional 9.9 million ONSM common shares, subject
to the achievement of certain revenues from the Narrowstep business during the
eighteen-month period beginning six months after the consummation of the
merger.





Prior to
the consummation of the merger, we expect to incur incremental
acquisition-related costs of approximately $490,000 payable in cash, of which
approximately $418,000 had been included in other non-current assets on our
balance sheet as of September 30, 2008, including approximately $141,000 paid as
of that date. Additional cash closing costs of approximately $210,000 will be
incurred once the merger is consummated.  If the Merger Agreement is
terminated under certain circumstances specified in the Merger Agreement,
Narrowstep may be required to pay us a termination fee of $377,000.





In
connection with, and in anticipation of, the acquisition, we entered into an
employment contract with an individual who was employed by Narrowstep as a
consultant upon the signing of the Definitive Agreement and will become an
employee (and the Managing Director) of Narrowstep on the Effective Date,
although our obligations under the contract are not contingent on the closing of
the merger. The terms of this contract include base fees/salary of $20,000 per
month (pro-rated for initial part-time service), a recoverable draw of $2,000
per month for the first six months, to be deducted from future paid commissions
if applicable, commissions of 1% on Narrowstep’s sales that are 25% above
annualized existing revenue and 2% on sales that are 50% above annualized
existing revenue, reimbursement of travel and moving expenses up to $16,000, as
well as certain option grants.





Although
Narrowstep reported cash used in operating activities of approximately $2.7
million for the six months ended August 31, 2008, this included a number of
one-time expenses associated with the termination of leases and other
commitments as well as expenses related to the merger. In addition, Narrowstep
reported cash and short term investments totaling approximately $1.4 million as
of August 31, 2008 and has committed to selling preferred shares for additional
cash proceeds of $1.0 million prior to the merger.




31




Although
Narrowstep has agreed to use its commercially reasonable efforts to operate its
business in accordance with a restructuring plan (the “Plan”) attached as an
exhibit to the Merger Agreement, which is designed to significantly reduce or
eliminate substantial costs related to Narrowstep’s facility leases, selling,
general and administrative expenses, public company and headquarters costs, and
other professional fees and services, we anticipate that the operations of
Narrowstep could still be generating operating cash deficits at the time the
merger is consummated. In addition, it is possible that we will need to incur
additional cash expenses in connection with capital expenditures needed to
continue or expand those operations. However, we believe that the anticipated
Narrowstep cash balance as of the consummation of the merger, including the
additional proceeds from the sale of preferred shares as discussed above, will
be sufficient to fund such operating cash deficits and capital expenditures
until such time as the Narrowstep operations are cash flow positive, although
this cannot be assured.





Projected
capital expenditures for the next twelve months total approximately $1.2 million
which includes software and hardware upgrades to the DMSP, the webcasting system
and the audio and web conferencing infrastructure. This total includes the
payment of approximately $334,000 reflected by us as accounts payable at
September 30, 2008 (which will not be reflected as capital expenditures in our
cash flow statement until paid).  This total does not include capital
expenditures that may be necessary as a result of the Narrowstep acquisition, as
discussed above. In addition, certain of these projected capital expenditures
may be financed, deferred past the twelve month period or cancelled
entirely.





As of
December 5, 2008, there were approximately 681,000 registered options and
warrants outstanding, excluding options held by directors and employees, to
purchase ONSM shares with exercise prices from $1.00 to $1.10 per share. The
closing ONSM share price was $0.30 per share on December 5, 2008.





Our
accumulated deficit was approximately $102.2 million at September 30, 2008. We
have incurred losses since our inception and our operations have been financed
primarily through the issuance of equity and debt. Cash used for operations will
be affected by numerous known and unknown risks and uncertainties including, but
not limited to, our ability to successfully market and sell the DMSP, market our
other existing products and services, the degree to which competitive products
and services are introduced to the market, and our ability to control overhead
expenses as we grow.





Other
than working capital which may become available to us through the exercise of
outstanding options and warrants or from further borrowing against our
receivables and/or equipment, we do not presently have any additional sources of
working capital other than cash on hand and cash, if any, generated from
operations. There are no assurances whatsoever that any options or warrants will
be exercised, that we will be able to further borrow against our receivables
and/or equipment, or that we will increase our revenues and/or control our
expenses to a level sufficient to continue and/or provide positive cash
flow.





We cannot
assure that our revenues will continue at their present levels, nor can we
assure that they will not decrease. Although we believe there is a market for
the DMSP, which had approximately 300 monthly recurring subscribers as of
December 5, 2008, the current level of DMSP and hosting revenues ($1.4 million
for the year ended September 30, 2008) is less than our related operating
expenses plus continuing development and other capital costs and we do not know
when, if ever, that we will generate sufficient revenues from this product to
cover those costs and expenses. As long as our cash flow from sales remains
insufficient to completely fund operating expenses, financing costs and capital
expenditures, we will continue depleting our cash and other financial resources.
As a result of the uncertainty as to our available working capital over the
upcoming months, we may be required to delay or cancel certain of the projected
capital expenditures, some of the planned marketing expenditures, or other
planned expenses. In addition, it is possible that we will need to seek
additional capital through equity and/or debt financing.  If we raise
additional capital through the issuance of debt, this will result in increased
interest expense. If we raise additional funds through the issuance of equity or
convertible debt securities, the percentage ownership of our company held by
existing shareholders will be reduced and those shareholders may experience
significant dilution.




32




There can
be no assurance that acceptable financing, if needed to fund our ongoing
operations, can be obtained on suitable terms, if at all. Our ability to
continue our existing operations and/or to continue to implement our growth
strategy could suffer if we are unable to raise additional funds on acceptable
terms, which will have an adverse impact on our financial condition and results
of operations.





Cash
provided by operating activities was approximately $69,000 for the fiscal year
ended September 30, 2008, as compared to approximately $2.3 million used by
operations for the prior fiscal year. The $69,000 reflects our net loss of
approximately $6.6 million, reduced by approximately $6.2 million of non-cash
expenses included in that loss as well as by approximately $414,000 arising from
a net decrease in non-cash working capital items during the period. The decrease
in non-cash working capital items for the fiscal year months ended September 30,
2008 is primarily due to an approximately $477,000 increase in accounts payable
and an approximately $87,000 decrease in deferred revenue. This compares to a
net increase in non-cash working capital items of approximately $363,000 for the
prior fiscal year. The primary non-cash expenses included in our loss for the
fiscal year ended September 30, 2008 were approximately $4.2 million of
depreciation and amortization, approximately $1.1 million of amortization of
deferred professional fee expenses paid for by issuing stock and options and
approximately $882,000 of employee compensation expense arising from the
issuance of stock and options. The primary sources of cash inflows from
operations are from receivables collected from sales to
customers.  Future cash inflows from sales are subject to our pricing
and ability to procure business at existing market conditions.





Cash used
in investing activities was approximately $1.4 million for the fiscal year ended
September 30, 2008 as compared to approximately $16.1 million for the prior
fiscal year. Current period investing activities related to acquisition of
property and equipment and while prior fiscal year investing activities included
the acquisition of property and equipment, they were primarily related to the
Infinite Conferencing acquisition.





Cash
provided by financing activities was approximately $1.5 million for the fiscal
year ended September 30, 2008 as compared to approximately $18.7 million for the
prior fiscal year. Current fiscal year financing activities primarily related to
net proceeds from convertible debentures loans as well as proceeds from notes
payable, net of repayments, while the prior fiscal year financing activities
were primarily related to approximately $17.1 million net proceeds from the sale
of common shares, including shares issued in a private financing arranged to
partially fund the Infinite Conferencing acquisition and shares issued upon
exercise of previously issued common stock warrants and options.





Critical
Accounting Policies and Estimates





Our
consolidated financial statements have been prepared in accordance with United
States generally accepted accounting principles (“GAAP”) and our significant
accounting policies are described in Note 1 to those statements.  The
preparation of financial statements in accordance with GAAP requires that we
make estimates and assumptions that affect the amounts reported in the
consolidated financial statements and accompanying footnotes.  Our
assumptions are based on historical experiences and changes in the business
environment.  However, actual results may differ from estimates under
different conditions, sometimes materially.  Critical accounting
policies and estimates are defined as those that are both most important to the
management’s most subjective judgments.  Our most critical accounting
policies and estimates are described as follows.





Our prior
acquisitions of several businesses, including the Onstream Merger and the
Infinite Merger, have resulted in significant increases in goodwill and other
intangible assets. Goodwill and other unamortized intangible assets, which
include acquired customer lists, were approximately $25.4 million at September
30, 2008, representing approximately 75% of our total assets and 91% of the book
value of shareholder equity. In addition, property and equipment as of September
30, 2008 includes approximately $1.4 million (net of depreciation) related to
the DMSP.




33




In
accordance with GAAP, we periodically test these assets for potential
impairment.  As part of our testing, we rely on both historical
operating performance as well as anticipated future operating performance of the
entities that have generated these intangibles.  Factors that could
indicate potential impairment include a significant change in projected
operating results and cash flow, a new technology developed and other external
market factors that may affect our customer base.  We will continue to
monitor our intangible assets and our overall business environment. If there is
a material change in our business operations, the value of our intangible
assets, including the DMSP, could decrease significantly. In the event that it
is determined that we will be unable to successfully market or sell the DMSP, an
impairment charge to our statement of operations could result. Any future
determination requiring the write-off of a significant portion of unamortized
intangible assets, although not requiring any additional cash outlay, could have
a material adverse effect on our financial condition and results of
operations.


ITEM
      7.
              FINANCIAL
      STATEMENTS
 
 Our financial statements are contained
in pages F-1 through F-58, which appear at the end of this annual
report.


ITEM
      8.
              CHANGES
      IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
      DISCLOSURE


None.


ITEM
      8A.
              CONTROLS
      AND PROCEDURES





Management’s report on
disclosure controls and procedures:





As
required by Rule 13a-15 under the Securities Exchange Act of 1934, as of the end
of the period covered by the annual report, being September 30, 2008, we have
carried out an evaluation of the effectiveness of the design and operation of
our company's disclosure controls and procedures. This evaluation was carried
out under the supervision and with the participation of our company's
management, including our company's President along with our company's Chief
Financial Officer. Based upon that evaluation, our company's President along
with our company's Chief Financial Officer concluded that our company's
disclosure controls and procedures are effective. Based upon that evaluation, no
change in our company's internal controls over financial reporting has occurred
during the quarter then ended, which has materially affected, or is reasonably
likely to materially affect, our internal control over financial
reporting.


Disclosure controls and procedures and
other procedures that are designed to ensure that information required to be
disclosed in our reports filed or submitted under the Securities Exchange Act of
1934 is recorded, processed, summarized and reported, within the time period
specified in the Securities and Exchange Commission's rules and forms.
Disclosure controls and procedures include, without limitation, controls and
procedures designed to ensure that information required to be disclosed in our
reports filed under the Securities Exchange Act of 1934 is accumulated and
communicated to management including our President and Chief Financial Officer
as appropriate, to allow timely decisions regarding required
disclosure.
 
 34
 
 Management’s report on
internal control over financial reporting:
 
 We are responsible for establishing and
maintaining adequate internal control over financial reporting. Internal control
over financial reporting is a process designed to provide reasonable assurance
regarding the reliability of financial reporting and the preparation of external
financial statements in accordance with generally accepted accounting
principles. However, all internal control systems, no matter how well designed,
have inherent limitations. Therefore, even those systems determined to be
effective can provide only reasonable assurance with respect to financial
statement preparation and presentation. Because of inherent limitations,
internal control over financial reporting may not prevent or detect
misstatements. Also, projections of any evaluation of effectiveness to future
periods are subject to the risk that controls may become inadequate because of
changes in conditions, or that the degree of compliance with the policies or
procedures may deteriorate.





As
required by Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of
1934, as of the end of the period covered by the annual report, being September
30, 2008, we have carried out an evaluation of the effectiveness of the design
and operation of our company's internal control over financial reporting. This
evaluation was carried out under the supervision and with the participation of
our company's management, including our company's President along with our
company's Chief Financial Officer and was based on the criteria set forth in
“Internal Control – Integrated Framework”, issued by the Committee of Sponsoring
Organizations of the Treadway Commission (‘COSO”). This evaluation included
review of the documentation of controls, evaluation of the design effectiveness
of controls and testing of the operating effectiveness of controls. Based upon
that evaluation, our company's President along with our company's Chief
Financial Officer concluded that our company's internal control over financial
reporting is effective. Based upon that evaluation, no change in our company's
internal controls over financial reporting has occurred during the quarter then
ended, which has materially affected, or is reasonably likely to materially
affect, our internal control over financial reporting.





This
annual report does not include an attestation report of the company’s registered
public accounting firm regarding internal control over financial reporting.
Management’s report was not subject to attestation by the company’s registered
public accounting firm, pursuant to temporary rules of the Securities and
Exchange Commission that permit the company to provide only management’s report
in this annual report.


ITEM
      8B.
                OTHER
      INFORMATION


None.


35
  PART
III





ITEM
      9.
              DIRECTORS,
      EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS AND CORPORATE
      GOVERNANCE; COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE
    ACT


Executive
Officers and Directors
 
 Our
executive officers and directors, and their ages are as
follows:





Name
              
              Age
              
              PositionRandy
      S. Selman
              
              52
              
              Chairman
      of the Board, President and Chief Executive OfficerClifford
      Friedland
              
              57
              
              Vice
      Chairman of the Board, Senior Vice President Business
      DevelopmentAlan
      M. Saperstein
              
              49
              
              Director,
      Chief Operating Officer and TreasurerDavid
      Glassman
              
              57
              
              Senior
      Vice President and Chief Marketing OfficerRobert
      E. Tomlinson
              
              51
              
              Senior
      Vice President and Chief Financial OfficerRobert
      J. Wussler  (1)(2)(3)(4)
              
              72
              
              DirectorCharles
      C. Johnston  (1)(2)(3)
              
              73
              
              DirectorCarl
      L. Silva (1)(2)(3)(4)
              
              45
              
              DirectorLeon
      Nowalsky (2)(3)
              
              47
              
              Director





(1)
              Member
      of the Audit Committee.
 (2)
              Member
      of the Compensation
Committee.


(3)
              Member
      of the Governance and Nominating
Committee.
 (4)
              Member
      of the Finance Committee.


Randy S.
Selman.  Since our inception in May 1993, Mr. Selman has served
as our Chief Executive Officer, President, and a director and, from September
1996 through June 1999 and from August 1, 2004 through December 15, 2004, as our
Chief Financial Officer.  From March 1985 through May 1993, Mr. Selman
was Chairman of the Board, President and Chief Executive Officer of SK
Technologies Corporation (NASDAQ:SKTC), a software development company. SKTC
developed and marketed software for point-of-sale with complete back office
functions such as inventory, sales analysis and communications.  Mr.
Selman founded SKTC in 1985 and was involved in their initial public offering in
1989.  Mr. Selman's responsibilities included management of SKTC,
public and investor relations, finance, high level sales and general overall
administration.


Clifford
Friedland. Mr. Friedland has been a member of our Board of Directors
since December 2004.  From June 2001 until the closing of the Onstream
Merger in December 2004 he had served as Chairman, CEO and co-founder of
privately held Onstream Media Corporation. Mr. Friedland was Vice President of
Business Development and co-founder of TelePlace, Inc., a developer and owner of
internet data centers and central offices from December 1999 to May 2001. Mr.
Friedland was co-founder, Chairman and co-CEO of Long Distance International,
Inc., one of the first competitive European telephone operators from May 1993 to
December 1999. Mr. Friedland was President of Clifford Friedland Inc., a
technology consulting firm, from January 1991 to April 1993. Mr. Friedland was a
Director and co-founder of Action Pay-Per-View, a pay per view cable channel
from January 1988 to December 1990. Mr. Friedland was President and co-founder
of Long Distance America, one of the first competitive long distance operators
after the breakup of AT&T from June 1984 to December 1987. Mr. Friedland was
Vice President and co-founder of United States Satellite Systems, Inc., an FCC
licensed builder and operator of geosynchronous communications satellites from
April 1981 until December 1983. Mr. Friedland was Director and co-founder of
United Satellite Communications, Inc., the world’s first direct-to-home
satellite network from April 1981 until May 1984. Mr. Friedland received a
B.B.A. cum laude, from City University of New York.


36
  Alan M.
Saperstein.  Mr. Saperstein has served as our Executive Vice
President, Treasurer and a director since our inception in May 1993, and has
been our Chief Operating Officer since December 2004. From March 1989 until May
1993, Mr. Saperstein was a free-lance producer of video film
projects.  Mr. Saperstein has provided consulting services for
corporations that have set up their own sales and training video
departments.  From 1983 through 1989, Mr. Saperstein was the Executive
Director/Entertainment Division of NFL Films where he was responsible for
supervision of all projects, budgets, screenings and
staffing.





David
Glassman. Mr.
Glassman has served as our Chief Marketing Officer since December 2004. He
served as Vice Chairman, President and co-founder of Acquired Onstream from June
2001 until joining our company. Mr. Glassman was Vice President of Marketing and
co-founder of TelePlace, Inc., a developer and owner of internet data centers
and central offices from December 1999 to May 2001. Mr. Glassman was co-founder,
Vice Chairman and Co-CEO of Long Distance International, Inc., one of the first
competitive European telephone operators from May 1993 to December 1999. Mr.
Glassman was an independent technology consultant from January 1988 to April
1993. Clients included Action Pay Per View. Mr. Glassman was President and
co-founder of Long Distance America, one of the first competitive long distance
operators after the breakup of AT&T from January 1984 to December 1987. Mr.
Glassman was a communications consultant from January 1981 to January 1984
providing services to United States Satellite Systems Inc. and United Satellite
Communications Inc. Mr. Glassman was co-founder and director of All American
Hero, Inc., from January 1981 until December 1986. Mr. Glassman received a B.S.
in Business Management from Florida International University.


Robert E.
Tomlinson.On December 15, 2004 Mr. Tomlinson was appointed our Chief
Financial Officer.  Mr. Tomlinson joined us as Vice President-Finance
in September 2004. Mr. Tomlinson started his financial and accounting career in
1977 with the international accounting firm of Price Waterhouse. In 1982 he left
that firm to join Embraer, an international aircraft manufacturing and support
firm, at their U.S. subsidiary in Fort Lauderdale, Florida, where he managed all
financial functions and eventually was named Senior Vice President-Finance and a
member of the U.S. firm’s Board of Directors. Mr. Tomlinson left Embraer in 1994
and joined staffing and human resource firm OutSource International, serving as
its Chief Financial Officer and helping to take the company public in 1997. Mr.
Tomlinson's areas of responsibility at OutSource International included
corporate accounting, treasury and risk management. From when he left OutSource
International in February 2000 until 2002 he worked as an independent certified
public accountant, focusing on accounting and tax services to corporations. From
2002 until joining us, Mr. Tomlinson served as CFO for Total Travel and Tickets,
a Fort Lauderdale based ticket broker.  Mr. Tomlinson has held an
active Certified Public Accountant license since 1978.
 
 Robert J.
Wussler.  Mr. Wussler has been a member of our Board of
Directors since July 1999 and serves on our Audit, Compensation, Governance and
Nominating and Finance Committees. Mr. Wussler is currently the Chairman of the
Wussler Group, a global entity in the telecommunication business. Mr. Wussler
has been the President of Ted Turner Pictures LLC and Chairman of the Board of
Directors of Team Sports Entertainment, Inc., a publicly-traded company (OTC
Bulletin Board:TSPT) that is in the closed-wheel auto racing business. Prior to
that, he served as Chairman, Chief Executive Officer and President of U.S.
Digital Communications, Inc., a global satellite communications firm. From June
1995 to May 1998, Mr. Wussler was President and Chief Executive Officer of
Affiliate Enterprises, Inc., a company formed by ABC Television affiliates to
pursue new business opportunities. From 1989 to 1992, he was President and Chief
Executive Officer of COMSAT Video Enterprises. From 1980 to 1990, he was Senior
Vice President and Chief Operating Officer of Turner Broadcasting System. Mr.
Wussler spent 21 years at CBS in various capacities, starting in the mailroom,
and served as President of CBS Television and Sports from 1975 to
1978.
  37


Charles C.
Johnston. Mr. Johnston has been a member of our Board of Directors since
April 2003 and serves on our Audit (as Chairman), Compensation and Governance
and Nominating Committees. Mr. Johnston has been the Chairman of Ventex
Technology, Inc., a privately-held neon light transformer company, since July
1993. Mr. Johnston has also served as Chairman of Inshore Technologies, a
private company, since 1994 and J&C Resources, a private company, since
1987. Mr. Johnston is a member of the board of directors of AuthentiDate Holding
Company (Nasdaq National Market: ADAT), Internet Commerce Corporation (Nasdaq
National Market: ICCA) and McData Corporation (Nasdaq National Market: MCDT).
Mr. Johnston serves as a Trustee of Worcester Polytechnic Institute and earned
his B.S. degree from WPI in 1957.





Carl
Silva.  Mr. Silva, who has been a member of our Board of
Directors since July 2006, serves on our Audit, Compensation (as Chairman),
Governance and Nominating and Finance Committees. Mr. Silva has over 20 years of
experience in the telecommunications and high tech industry, and he has held a
variety of positions in business development, sales, marketing, software
engineering, and systems engineering during this time. In May 2003, Mr. Silva
started Anza Borrego Partners (ABP) as a management consulting firm designed to
support entrepreneurs in the growth of their businesses.  Mr. Silva is
currently president and CEO or Cognigen Business Systems, Inc., a joint venture
of ABP and Cognigen Networks, Inc. (NASDAQ: CNGW) formed for the purpose of
providing broadband services to the quick service retail industry. Mr. Silva is
also Chief Scientist of Nexaira, a company involved in the distribution and
support of 3G mobile broadband and Router solutions.  Mr. Silva was
Senior Vice-President for SAIC’s Converged Network Professional services
organization from July 1998 to May 2003.  From September 1994 to June
1998, he was with Telcordia Technologies (formerly Bell Communications Research,
or Bellcore), where he implemented the first VoIP softswitch in the cable
industry.





Leon
Nowalsky.  Mr. Nowalsky was appointed a member of our Board of
Directors in December 2007 and serves on our Compensation and Governance and
Nominating (as Chairman) Committees. Mr. Nowalsky, a partner in the New
Orleans-based law firm of Nowalsky, Bronston & Gothard APLLC (NBG),
possesses over 20 years experience in the field of telecommunications law and
regulation. Mr. Nowalsky presently is a founder and board member of Thermo
Credit, LLC, a specialty finance company for the telecommunications industry and
J.C. Dupont, Inc., a Louisiana based oil and gas concern. Mr. Nowalsky has been
general counsel for Telemarketing Communications of America, Inc., (“TMC”), as
well as lead counsel in TMC’s mergers and acquisitions program, and following
TMC’s acquisition by a wholly owned subsidiary of Advanced Telecommunications
Corporation, Mr. Nowalsky served as ATC’s chief regulatory counsel as well as
interim general counsel.  In 1990, Mr. Nowalsky left ATC to set up a
private law practice specializing in telecommunications regulatory matters,
mergers and acquisitions and corporate law, which later expanded to become NBG.
Mr. Nowalsky has previously served as a director of the following companies:
Network Long Distance, Inc., a long distance company which was acquired by IXC
Communications; RFC Capital Corp., a specialty finance company dedicated
exclusively to the telecommunications industry which was purchased in 1999 by
TFC Financial Corp., a division of Textron (NYSE:TXT); and New South
Communications, a facilities-based competitive local exchange carrier which
merged to form NUVOX; W2Com, LLC, a video conferencing and distance learning
provider which was acquired by Arel Communications & Software, Ltd. (NASDAQ:
ARLC).





There is no family relationship between
any of the executive officers and directors.  Each director is elected
at our annual meeting of shareholders and holds office until the next annual
meeting of shareholders, or until his successor is elected and
qualified.  At present, our bylaws provide for not less than two
directors.  The bylaws permit the board of directors to fill any
vacancy and such director may serve until the next annual meeting of
shareholders or until his successor is elected and qualified.  The
board of directors elects officers annually and their terms of office are at the
discretion of the Board. Our officers devote full time to our
business.
  38
  Rule 4350(c) of the NASDAQ Marketplace
Rules to which we are subject requires that a majority of the members of our
board of directors are independent as defined in Rule 4200 of the NASDAQ
Marketplace Rules. Our independent directors are Messrs. Wussler, Johnston,
Silva and Nowalsky.
 
 Expansion
of our Board of Directors


Our
bylaws provide that the number of directors shall be no less than one and no
more than nine. Under the terms of the purchase and sale agreement for our
Series A-10 Convertible Preferred Stock the purchasers have the right to
designate one individual to join our Board of Directors.  As of the
date hereof, no individual has been designated and all remaining outstanding
shares of Series A-10 Convertible Preferred Stock will automatically convert to
common shares as of December 31, 2008.  There are seven directors
currently on the board.  As contemplated by the terms of the
Narrowstep merger agreement, David C. McCourt is expected to become a new member
of our board of directors following the merger. Immediately following completion
of the merger, we expect that our board will consist of eight
directors.





Director
Compensation Table


The following table presents director
compensation (excluding directors who are Named Executive Officers) for the year
ended September 30, 2008:


CHANGE INPENSION VALUEFEES EARNED
                
                
                
                
                
                
                
                
                NON-EQUITY
                
                
                AND NONQUALIFIEDOR PAID IN
                
                
                STOCK
                
                
                OPTION
                
                
                INCENTIVE PLAN
                
                
                DEFERRED
                
                
                ALL OTHER
                
                
                TOTALCASH
                
                
                AWARDS
                
                
                AWARDS
                
                
                COMPENSATION
                
                
                COMPENSATION
                
                
                COMPENSATION
                
                
                COMPENSATIONNAME
                
                ($)
      (1)
                
                
                ($)
      (3)
                
                
                ($)
      (4)
                
                
                ($)
                
                
                EARNINGS
      ($)
                
                
                ($)
                
                
                ($)Robert
      J. Wussler
                
                $
                15,000
                
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-
                
                
                $
                15,000Charles
      C. Johnston
                
                $
                15,000
                
                
                $
                43,250
                
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-
                
                
                $
                58,250Carl
      L. Silva
                
                $
                15,000
                
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-
                
                
                $
                15,000Benjamin
      Swirsky
                
                $
                2,750
                (2)
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-
                
                
                $
                2,750Leon
      Nowalsky
                
                $
                12,250
                (2)
                
                
                -0-
                
                
                $
                27,325
                
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-
                
                
                $
                39,575





1)
              Directors
      who are not our employees received $3,750 per quarter as compensation for
      serving on the Board of Directors, as well as reimbursement of reasonable
      out-of-pocket expenses incurred in connection with their attendance at
      Board of Directors meetings.


2)
              On
      December 6, 2007 Mr. Benjamin Swirsky resigned from his post on the Board
      of Directors, for health-related reasons. On the same day, the remaining
      members of the Board appointed Mr. Leon Nowalsky as Mr. Swirsky’s
      replacement. Therefore, the director’s compensation for the quarter ended
      December 31, 2007 was paid on a pro-rated basis to Mr. Swirsky and Mr.
      Nowalsky.
 3)
              From
      time to time we issue the members of our Board of Directors shares of our
      common stock as compensation for their services as directors. In December
      2007, pursuant to approval by Onstream's Compensation Committee and
      Onstream's Board of Directors, Onstream issued 25,000 restricted Plan
      shares of Onstream common stock to Mr. Charles Johnston as compensation
      for services to be rendered by him for the fiscal year ended September 30,
      2008, in connection with his then recent appointment as Chairman of
      Onstream's Audit Committee. These shares were valued at $1.73 per share,
      the fair market value at the date of the approval. No other shares were
      issued to the directors who were not also Named Executive Officers during
      the year ended September 30,
2008.


4)
              From
      time to time we issue the members of our Board of Directors options to
      purchase shares of our common stock as compensation for their services as
      directors. At September 30, 2008 members of our Board of Directors
      (excluding those who are Named Executive Officers) held outstanding
      options and warrants to purchase an aggregate of 629,620 shares of our
      common stock at prices ranging from $0.71 to $3.376 per
    share.




39




In
December 2004, and in connection with the Onstream Merger, Messrs. Wussler and
Johnston each received immediately exercisable five-year options to purchase
100,000 shares of our common stock with an exercise price of $1.57 per share
(fair market value on the date of issuance). These options were issued outside
of our 1996 Stock Option Plan and are still outstanding. In July 2005 Messrs.
Wussler and Johnston each received immediately exercisable five-year Plan
options to purchase 100,000 shares of our common stock with an exercise price of
$1.12 per share (fair market value on the date of issuance), which are still
outstanding. In July 2006 we issued immediately exercisable four-year Plan
options to purchase 50,000 shares of our common stock with an exercise price of
$0.88 per share (fair market value on the date of issuance) granted to Mr. Carl
L. Silva upon his initial appointment to our board of directors, which are still
outstanding. In September 2006 Messrs. Wussler and Johnston each received
immediately exercisable five-year Plan options to purchase 50,000 shares of our
common stock with an exercise price of $0.71 per share (above fair market value
on the date of issuance), which are still outstanding.




Messrs.
Wussler and Silva also each hold warrants to purchase 14,810 ONSM common shares
at $3.376 per share, issued at the time of the Onstream Merger in exchange for
warrants issued to them by Acquired Onstream.





In
December 2007 we issued immediately exercisable four-year Plan options to
purchase 50,000 shares of our common stock with an exercise price of $1.00 per
share (above fair market value on the date of issuance) granted to Mr. Leon
Nowalsky upon his initial appointment to our board of directors. The
compensation value indicated for this option in the above table is the related
expense recognized on our financial statements for the period, based on the
Black Scholes method. No other options were issued to the directors who were not
also Named Executive Officers during the year ended September 30,
2008.





Board
of Directors Meetings and Committees





The Board
of Directors meets regularly (in-person and/or by telephone conference) during
the year to review matters affecting us and to act on matters requiring Board
approval. It also holds special meetings whenever circumstances require and may
act by majority written consent. During the fiscal year ended September 30,
2008, there were six meetings of the Board, and the Board took action eight
times by written consent. The Board of Directors has four standing committees as
discussed below and may, from time to time, establish additional
committees.





Audit
Committee





The Audit
Committee of the Board of Directors is responsible for the engagement of our
independent public accountants, approves services rendered by our accountants,
reviews the activities and recommendations of our internal audit department, and
reviews and evaluates our accounting systems, financial controls and financial
personnel. The Board has previously adopted a charter for the Audit Committee.
Pursuant to the requirements of the Securities and Exchange Commission which
requires that we provide our shareholders with a copy of the Audit Charter at
least once every three years, we have included a copy of the Audit Charter as
Appendix B to our proxy statement for our 2007 Annual Meeting filed with the SEC
on July 31, 2007.





The Audit
Committee is presently composed of Messrs. Johnston (chairman), Wussler and
Silva. Each member of the Audit Committee is independent, as independence for
audit committee members is defined in the listing standards of the NASDAQ Stock
Market and they are “audit committee financial experts” within the meaning of
the applicable regulations of the Securities and Exchange Commission promulgated
pursuant to the Sarbanes-Oxley Act of 2002. The Audit Committee met (in-person
and/or by telephone conference) five times in fiscal 2008.




40




Compensation
Committee





The Compensation Committee establishes
and administers our executive compensation practices and policies, reviews the
individual elements of total compensation for elected officers and recommends
salary adjustments to the board of directors.  In addition, the
Compensation Committee administers our 1996 Stock Option Plan and our 2007
Equity Incentive Plan and determines the number of performance shares and other
equity incentives awarded to elected officers and the terms and conditions of
which they are granted, amends compensation plans within the scope of the
Compensation Committee's authority and recommends plans and plan amendments to
the board, sets company policy for employee benefit programs and plans and
oversees administration of employee retirement plans and various other benefit
plans as we may establish from time to time. The Compensation Committee is
presently composed of Messrs. Silva (chairman), Wussler, Johnston and Nowalsky.
The Compensation Committee met (in-person and/or by telephone conference) two
times in fiscal 2008.





Finance
Committee





The Finance Committee reviews and makes
recommendations concerning:




·
            proposed
      dividend actions, stock splits and
repurchases,




·
            current
      and projected capital requirements,




·
            issuance
      of debt or equity securities,




·
            strategic
      plans and transactions, including mergers, acquisitions, divestitures,
      joint ventures and other equity
investments,




·
            customer
      financing activities, business and related customer finance business and
      funding plans,




·
            overall
      company risk management program and major insurance programs,
      and




·
            investment
      policies, administration and performance of the trust investments of our
      employee benefit plans.





Messrs. Wussler and Silva are the
members of the Finance Committee. The Finance Committee met in fiscal 2008 in
conjunction with meetings of the full Board of Directors.





Governance
and Nominating Committee





While we
have not adopted a formal charter for the Governance and Nominating Committee,
in June 2003 our Board of Directors adopted Corporate Governance and Nominating
Committee Principles.  A copy of our Corporate Governance and
Nominating Committee Principles was included as Exhibit C to the proxy statement
for our 2005 Annual Meeting filed with the SEC on August 1, 2005, which was
updated by the version included as Appendix L to the preliminary combined proxy
statement/Form S-4/A filed with the SEC on November 6, 2008, but not yet
declared effective.





The Governance and Nominating Committee
reviews and makes recommendations to the board of directors with respect
to:




·
            the
      responsibilities and functions of the Board and Board committees and with
      respect to Board compensation,




·
            the
      composition and governance of the Board, including recommending candidates
      to fill vacancies on, or to be elected or re-elected to, the
      Board,




·
            candidates
      for election as Chief Executive Officer and other corporate officers,
      and




·
            monitoring
      the performance of the Chief Executive Officer and our plans for senior
      management succession.




41





The
procedures for identifying candidates include a review of Onstream's current
directors; soliciting input from existing directors and executive officers, and
a review of submissions from stockholders, if any. Onstream’s management
believes that the Board should be composed of:





·
            directors
      chosen with a view to bringing to the Board a variety of experiences and
      backgrounds,




·
            directors
      who have high level managerial experience or are accustomed to dealing
      with complex problems,




·
            directors
      who will represent the balanced, best interests of the stockholders as a
      whole rather than special interest groups or constituencies, while also
      taking into consideration the overall composition and needs of the Board,
      and




·
            a
      majority of the Board's directors must be independent directors under the
      criteria for independence required by the Securities and Exchange
      Commission and the NASDAQ Stock
Market.




In
considering possible candidates for election as an outside director, the
Governance and Nominating Committee and other directors should be guided by the
foregoing general guidelines and by the following criteria:





·
            Each
      director should be an individual of the highest character and integrity,
      have experience at or demonstrated understanding of
      strategy/policy-setting and a reputation for working constructively with
      others.




·
            Each
      director should have sufficient time available to devote to our affairs in
      order to carry out the responsibilities of a
  director.




·
            Each
      director should be free of any conflict of interest, which would interfere
      with the proper performance of the responsibilities of a
      director.




·
            The
      Chief Executive Officer is expected to be a director. Other members of
      senior management may be considered, but Board membership is not necessary
      or a prerequisite to a higher management
  position.




The Governance and Nominating Committee
is presently composed of Messrs. Nowalsky (chairman), Johnston, Wussler and
Silva, who are each "independent" as independence for nominating committee
members is defined within the NASDAQ Marketplace Rules. The Governance and
Nominating Committee met (in-person and/or by telephone conference) one time in
fiscal 2008, as well as in conjunction with meetings of the full Board of
Directors.





Code
of Business Conduct and Ethics


Effective December 18, 2003, our Board
of Directors adopted a Code of Business Conduct and Ethics that applies to,
among other persons, our President (being our principal executive officer) and
our Chief Financial Officer (being our principal financial and accounting
officer), as well as persons performing similar functions. As adopted, our Code
of Business Conduct and Ethics sets forth written standards that are designed to
deter wrongdoing and to promote:


·
              honest
      and ethical conduct, including the ethical handling of actual or apparent
      conflicts of interest between personal and professional
      relationships,
  42


·
              full,
      fair, accurate, timely, and understandable disclosure in reports and
      documents that we file with, or submit to, the Securities and Exchange
      Commission and in other public communications made by
  us,
  ·
              compliance
      with applicable governmental laws, rules and
  regulations,
  ·
              the
      prompt internal reporting of violations of the Code of Business Conduct
      and Ethics to an appropriate person or persons identified in the Code of
      Business Conduct and Ethics, and


·
              accountability
      for adherence to the Code of Business Conduct and
  Ethics.





Our Code of Business Conduct and Ethics
requires, among other things, that all of our company's personnel shall be
accorded full access to our President and Chief Financial Officer with respect
to any matter that may arise relating to the Code of Business Conduct and
Ethics. Further, all of ourcompany's personnel are
to be accorded full access to our company's board of directors if any such
matter involves an alleged breach of the Code of Business Conduct and Ethics by
our President or Chief Financial Officer.
 
 In addition, our Code of Business
Conduct and Ethics emphasizes that all employees, and particularly managers
and/or supervisors, have a responsibility for maintaining financial integrity
within our company, consistent with generally accepted accounting principles,
and federal, provincial and state securities laws.  Any employee who
becomes aware of any incidents involving financial or accounting manipulation or
other irregularities, whether by witnessing the incident or being told of it,
must report it to his or her immediate supervisor or to our company's President
or Chief Financial Officer.  If the incident involves an alleged
breach of the Code of Business Conduct and Ethics by the President or Chief
Financial Officer, the incident must be reported to any member of our Board of
Directors.  Any failure to report such inappropriate or irregular
conduct of others is to be treated as a severe disciplinary matter. It is
against our company policy to retaliate against any individual who reports in
good faith the violation or potential violation of our company's Code of
Business Conduct and Ethics by another.
 
 Our Code of Business Conduct and Ethics
is included as Exhibit 14.1 to this annual report. We will provide a copy of the
Code of Business Conduct and Ethics to any person without charge, upon request.
Requests can be sent to: Onstream Media Corporation, 1291 SW 29 Avenue, Pompano
Beach, Florida  33069.


COMPLIANCE
WITH SECTION 16(a) OF THE EXCHANGE ACT





Based
solely upon a review of Forms 3 and 4 and amendments thereto furnished to us
under Rule 16a-3(d) of the Securities Exchange Act of 1934, as amended, during
the fiscal year ended September 30, 2008 and Forms 5 and amendments thereto
furnished to us with respect to the fiscal year ended September 30, 2008, as
well as any written representation from a reporting person that no Form 5 is
required, we are not aware of any person that failed to file on a timely basis,
as disclosed in the aforementioned Forms, reports required by Section 16(a) of
the Securities Exchange Act of 1934 during the fiscal year ended September 30,
2008, other than indicated below.





Randy
Selman, our CEO and Chairman of the Board, Alan Saperstein, our COO and one of
our directors and Clifford Friedland, our Senior VP-Business Development and one
of our directors, have not filed a Form 4 on a timely basis related to 620,000
options granted each of them on September 27, 2007. Mr. Selman, Mr. Saperstein
and Mr. Friedland have represented to us that they will file these forms as soon
as practicable.





Robert
Tomlinson, our CFO, and David Glassman, our Senior VP-Marketing have not filed a
Form 4 on a timely basis related to 620,000 options granted each of them on
September 27, 2007. Mr. Tomlinson and Mr. Glassman Friedland have represented to
us that they will file these forms as soon as practicable.




43




Charles
Johnston, one of our directors, has not filed a Form 3 or Form 4 on a timely
basis related to 25,000 shares issued to him on December 5, 2007. Mr. Johnston
has represented to us that he will file this form as soon as
practicable.





Leon
Nowalsky, one of our directors, has not filed a Form 3 or Form 4 on a timely
basis related to 50,000 options granted to him on December 6, 2007. Mr. Nowalsky
has represented to us that he will file this form as soon as
practicable.





ITEM
      10.
            EXECUTIVE
      COMPENSATION





Summary
Compensation Table


The following table sets forth certain
information relating to the compensation of (i) our Chief Executive Officer; and
(ii) each of our executive officers who earned more than $100,000 in total
compensation during the most recent fiscal year (collectively, the “Named
Executive Officers”):





STOCK
                                                            
                                                            
                                                            OPTION
                                                            
                                                            
                                                            SECURITIES
                                                            
                                                            ALL OTHER
                                                            
                                                            TOTALNAME
      AND
                                                            
                                                            FISCAL
                                                            
                                                            
                                                            
                                                            
                                                            BONUS
                                                            
                                                            
                                                            AWARDS
                                                            
                                                            
                                                            AWARDS
                                                            
                                                            
                                                            UNDERLYING
                                                            
                                                            COMPENSATION
                                                            
                                                            COMPENSATIONPRINCIPAL
      POSITION
                                                            
                                                            YEAR
                                                            
                                                            SALARY ($)
                                                            
                                                            
                                                            ($)
                                                            
                                                            
                                                            ($)
                                                            
                                                            
                                                            ($)
                                                            
                                                            
                                                            OPTIONS (#)
                                                            
                                                            ($)
      (12)
                                                            
                                                            ($)(13)Randy
      S. Selman
                                                            
                                                            2008
                                                            
                                                            $
                                                            263,695
                                                            
                                                            
                                                            
                                                            -0-
                                                            
                                                            
                                                            
                                                            -0-
                                                            
                                                            
                                                            $
                                                            141,417
                                                            (11)
                                                            
                                                            
                                                            -0-
                                                            
                                                            
                                                            $
                                                            51,502
                                                            (1)
                                                            
                                                            $
                                                            456,614President,
      Chief
                                                            
                                                            2007
                                                            
                                                            $
                                                            224,272
                                                            
                                                            
                                                            
                                                            -0-
                                                            
                                                            
                                                            
                                                            -0-
                                                            
                                                            
                                                            
                                                            -0-
                                                            (11)
                                                            
                                                            
                                                            620,000
                                                            (11)
                                                            
                                                            $
                                                            48,679
                                                            (2)
                                                            
                                                            $
                                                            272,951Executive
      Officerand
      DirectorAlan
      Saperstein
                                                            
                                                            2008
                                                            
                                                            $
                                                            238,695
                                                            
                                                            
                                                            
                                                            -0-
                                                            
                                                            
                                                            
                                                            -0-
                                                            
                                                            
                                                            $
                                                            141,417
                                                            (11)
                                                            
                                                            
                                                            -0-
                                                            
                                                            
                                                            $
                                                            56,942
                                                            (3)
                                                            
                                                            $
                                                            437,054Chief
      Operating
                                                            
                                                            2007
                                                            
                                                            $
                                                            206,689
                                                            
                                                            
                                                            
                                                            -0-
                                                            
                                                            
                                                            
                                                            -0-
                                                            
                                                            
                                                            
                                                            -0-
                                                            (11)
                                                            
                                                            
                                                            620,000
                                                            (11)
                                                            
                                                            $
                                                            54,901
                                                            (4)
                                                            
                                                            $
                                                            261,590Officer,
      Treasurerand
      DirectorClifford
      Friedland
                                                            
                                                            2008
                                                            
                                                            $
                                                            212,358
                                                            
                                                            
                                                            
                                                            -0-
                                                            
                                                            
                                                            
                                                            -0-
                                                            
                                                            
                                                            $
                                                            141,417
                                                            (11)
                                                            
                                                            
                                                            -0-
                                                            
                                                            
                                                            $
                                                            59,050
                                                            (5)
                                                            
                                                            $
                                                            412,825Senior
      VP - Busi-
                                                            
                                                            2007
                                                            
                                                            $
                                                            192,940
                                                            
                                                            
                                                            
                                                            -0-
                                                            
                                                            
                                                            
                                                            -0-
                                                            
                                                            
                                                            
                                                            -0-
                                                            (11)
                                                            
                                                            
                                                            620,000
                                                            (11)
                                                            
                                                            $
                                                            58,263
                                                            (6)
                                                            
                                                            $
                                                            251,203ness
      Developmentand
      DirectorDavid
      Glassman
                                                            
                                                            2008
                                                            
                                                            $
                                                            212,358
                                                            
                                                            
                                                            
                                                            -0-
                                                            
                                                            
                                                            
                                                            -0-
                                                            
                                                            
                                                            $
                                                            141,417
                                                            (11)
                                                            
                                                            
                                                            -0-
                                                            
                                                            
                                                            $
                                                            52,155
                                                            (7)
                                                            
                                                            $
                                                            405,930Senior
      VP -
                                                            
                                                            2007
                                                            
                                                            $
                                                            192,940
                                                            
                                                            
                                                            
                                                            -0-
                                                            
                                                            
                                                            
                                                            -0-
                                                            
                                                            
                                                            
                                                            -0-
                                                            (11)
                                                            
                                                            
                                                            620,000
                                                            (11)
                                                            
                                                            $
                                                            51,629
                                                            (8)
                                                            
                                                            $
                                                            244,569MarketingRobert
      Tomlinson
                                                            
                                                            2008
                                                            
                                                            $
                                                            223,125
                                                            
                                                            
                                                            
                                                            -0-
                                                            
                                                            
                                                            
                                                            -0-
                                                            
                                                            
                                                            $
                                                            141,417
                                                            (11)
                                                            
                                                            
                                                            -0-
                                                            
                                                            
                                                            $
                                                            63,742
                                                            (9)
                                                            
                                                            $
                                                            428,284Chief
      Financial
                                                            
                                                            2007
                                                            
                                                            $
                                                            191,134
                                                            
                                                            
                                                            
                                                            -0-
                                                            
                                                            
                                                            
                                                            -0-
                                                            
                                                            
                                                            
                                                            -0-
                                                            (11)
                                                            
                                                            
                                                            620,000
                                                            (11)
                                                            
                                                            $
                                                            51,950
                                                            (10)
                                                            
                                                            $
                                                            243,084Officer





(1)
              Includes
      $15,046 for medical and other insurance; $12,000 automobile allowance;
      $5,000 dues allowance and $19,456 deferred compensation and 401(k)
      match.
 (2)
              Includes
      $13,679 for medical and other insurance; $12,000 automobile allowance;
      $5,000 dues allowance and $18,000 deferred
  compensation.
 (3)
              Includes
      $21,942 for medical and other insurance; $12,000 automobile allowance;
      $5,000 dues allowance and $18,000 deferred
  compensation.
 (4)
              Includes
      $19,901 for medical and other insurance; $12,000 automobile allowance;
      $5,000 dues allowance and $18,000 deferred
  compensation.
 (5)
              Includes
      $21,939 for medical and other insurance; $12,000 automobile allowance;
      $5,000 dues allowance and $20,111 deferred compensation and 401(k)
      match.
  44
  (6)
              Includes
      $19,897 for medical and other insurance; $12,000 automobile allowance;
      $5,000 dues allowance and $21,366 deferred compensation and 401(k) match.
      Table excludes amounts paid to Mr. Friedland during fiscal 2007 related to
      compensation accrued prior to the Onstream
  Merger.
 (7)
              Includes
      $15,044 for medical and other insurance; $12,000 automobile allowance;
      $5,000 dues allowance and $20,111 deferred compensation and 401(k)
      match.
 (8)
              Includes
      $13,263 for medical and other insurance; $12,000 automobile allowance;
      $5,000 dues allowance and $21,366 deferred compensation and 401(k) match.
      Table excludes amounts paid to Mr. Glassman during fiscal 2007 related to
      compensation accrued prior to the Onstream
  Merger.
 (9)
              Includes
      $21,941 for medical and other insurance; $12,000 automobile allowance;
      $8,125 dues allowance and $21,676 deferred compensation and 401(k)
      match.
 (10)
              Includes
      $19,871 for medical and other insurance; $10,875 automobile allowance and
      $21,204 deferred compensation and 401(k)
match.
 (11)
              During
      the year ended September 30, 2007, each of the Named Executive Officers
      was issued options to purchase 620,000 common shares at $1.73 per share,
      which was the fair value at date of grant. The fair value was $0.30 per
      share as of September 30, 2008. 220,000 of those options vest based on
      performance over the two year period from October 1, 2007 through
      September 30, 2009 and since that service period starts after September
      30, 2007, there was no related compensation expense for the year then
      ended. The remaining 400,000 of those options vest based on service over a
      four year period that starts on September 27, 2007.  The four
      days from the vesting period start date through September 30, 2007
      represent approximately one quarter of one percent of an approximately
      1,460 day total service period, which is considered immaterial for
      inclusion of compensation expense for the year ended September 30, 2007.
      The entire non-cash compensation expense for these options will be
      recognized over the two years starting October 1, 2007, using the
      Black-Scholes model.


We have
determined that the performance objectives (as set forth in Employment
Agreements below) were met for the quarter ended December 31, 2007, but that
they were not met for the remaining three quarters of fiscal 2008 nor were they
met for the year ended September 30, 2008. Therefore, 13,750 options out of a
potential 110,000 performance options vested for each executive during fiscal
2008. An additional 100,000 service options vested during fiscal 2008, for total
vested options of 113,750 for each of the Named Executive Officers during fiscal
2008.


(12)
              The
      Named Executive Officers did not receive non-equity incentive plan
      compensation or compensation from changes in pension value and
      nonqualified deferred compensation earnings during the periods covered by
      the above table.
 (13)
              Total
      compensation includes cash and non-cash elements. The most significant
      non-cash element is the options, which as discussed in footnote 11 above
      had a strike price that exceeded the fair value by $1.43 per share of
      September 30, 2008 and thus at that date were what is commonly described
      as “under water”. Below is a table that presents the cash and non-cash
      elements of compensation for the year ended September 30,
      2008:


Cash
                    Compensation
                  
                  
                  Non-Cash
                    Compensation
                  
                  
                  Total
                    CompensationRandy
      S. Selman
                  
                  $
                  315,197
                  
                  
                  $
                  141,417
                  
                  
                  $
                  456,614Alan
      Saperstein
                  
                  $
                  295,637
                  
                  
                  $
                  141,417
                  
                  
                  $
                  437,054Clifford
      Friedland
                  
                  $
                  271,408
                  
                  
                  $
                  141,417
                  
                  
                  $
                  412,825David Glassman
                  
                  $
                  264,513
                  
                  
                  $
                  141,417
                  
                  
                  $
                  405,930Robert
      Tomlinson
                  
                  $
                  286,867
                  
                  
                  $
                  141,417
                  
                  
                  $
                  428,284


45





Employment
Agreements





On
September 27, 2007, our Compensation Committee and our Board of Directors
approved three-year employment agreements with Messrs. Randy Selman (President
and CEO), Alan Saperstein (COO and Treasurer), Robert Tomlinson (Chief Financial
Officer), Clifford Friedland (Senior Vice President Business Development) and
David Glassman (Senior Vice President Marketing), collectively referred to as
“the Executives”. Other than the extended term of the new agreements, the
following salary, raise and benefit payments are substantially the same as the
Executives would have received under the employment agreements previously in
place that would have expired December 27, 2008. The new agreements provide
annual base salaries of $253,000 for Mr. Selman, $230,000 for Mr. Saperstein,
$207,230 for Mr. Tomlinson and $197,230 for Messrs. Friedland and Glassman, and
allow for 10% annual increases through December 27, 2008 and 5% per year
thereafter. In addition, each of the Executives receives an auto allowance
payment of $1,000 per month, a “retirement savings” payment of $1,500 per month,
and an annual $5,000 allowance for the reimbursement of dues or charitable
donations.  We also pay insurance premiums for the Executives,
including medical, life and disability coverage.





As part
of the above employment agreements, and in accordance with the terms of the
“2007 Equity Incentive Plan” approved by our shareholders in their September 18,
2007 annual meeting, we granted each of the Executives options (“Plan Options”)
to purchase an aggregate of 400,000 shares of our common stock at an exercise
price of $1.73 per share, the fair market value at the date of the grant, which
shall be exercisable for a period of four (4) years from the date of vesting.
The options vest in installments of 100,000 per year, starting on September 27,
2008, and they automatically vest upon the happening of the following events on
a date more than six (6) months after the date of the agreement: (i) change of
control (ii) constructive termination, and (iii) termination other than for
cause, each as defined in the employment agreements. Unvested options
automatically terminate upon (i) termination for cause or (ii) voluntary
termination.  In the event the agreement is not renewed or the
Executive is terminated other than for cause, the Executives shall be entitled
to require us to register the options.





The
Executives will be eligible for a performance bonus, based on meeting revenue
and cash flow objectives. In connection with this bonus program, we granted each
of the Executives Plan Options to purchase an aggregate of 220,000 shares of our
common stock at an exercise price of $1.73 per share, the fair market value at
the date of the grant, which shall be exercisable for a period of four (4) years
from the date of vesting. Up to one-half of these shares will be eligible for
vesting on a quarterly basis and the rest annually, with the total grant
allocated over a two-year period starting October 1, 2007. Vesting of the
quarterly portion is subject to achievement of increased revenues over the prior
quarter as well as positive and increased net cash flow per share (defined as
cash provided by operating activities per the Company’s statement of cash flow,
measured before changes in working capital components and not including
investing or financing activities) for that quarter. Vesting of the annual
portion is subject to meeting the above cash flow requirements on a
year-over-year basis, plus a revenue growth rate of at least 30% for the fiscal
year over the prior year. In the event of quarter to quarter decreases in
revenues and or cash flow, the options shall not vest for that quarter but the
unvested quarterly options shall be added to the available options for the year,
vested subject to achievement of the applicable annual goal. In the event
options do not vest based on the quarterly or annual goals, they shall
immediately expire. In the event the agreement is not renewed or the Executive
is terminated other than for cause, the Executives shall be entitled to require
us to register the vested options. We have agreed that this bonus program will
continue after the initial two-year period, with the specific bonus parameters
to be negotiated in good faith between the parties at least ninety (90) days
before the expiration of the program then in place.





We have
determined that the above performance objectives were met for the quarter ended
December 31, 2007, but that they were not met for the remaining three quarters
of fiscal 2008 nor were they met for the year ended September 30, 2008.
Therefore, 13,750 options out of a potential 110,000 performance options vested
for each executive during fiscal 2008.




46




Under the
terms of the agreements, upon a termination subsequent to a change of control,
termination without cause or constructive termination, each as defined in the
agreements, we would be obligated to pay each of the Executives an amount equal
to three times the Executive’s base salary plus full benefits for a period of
the lesser of (i) three years from the date of termination or (ii) the date of
termination until a date one year after the end of the initial employment
contract term. We may defer the payment of all or part of this obligation for up
to six months, to the extent required by Internal Revenue Code Section 409A. In
addition, if the five day average closing price of the common stock is greater
than or equal to $2.50 per share on the date of any termination or change in
control, all options previously granted the Executive(s) will be cancelled, with
all underlying shares (vested or unvested) issued to the executive, and we will
pay all taxes for the Executive(s).  If the five-day average closing
price of the common stock is less than $2.50 per share on the date of any
termination or change in control, the options will remain exercisable under the
original term.





As
part of the above employment agreements, and in consideration for the provision
in the new employment agreements that change of control benefits would not be
paid related to any merger and any related financing occurring within eighteen
months of entering into the new agreements, we agreed to grant each of the
Executives fully vested four-year options for shares equivalent to one percent
(1%) of the total number of shares issued in connection with any such merger
and/or any related financing including any contingent shares, once earned. If we
enter into a definitive merger agreement during that eighteen month period, the
number of options will be determined and granted at the time of closing that
merger and will have an exercise price equal to the fair value at the date of
grant (but no less than $1.00). We agreed to register these and all other shares
or options held by the Executives with or simultaneously to any shares
registered in connection with such a merger and/or any related financing. See
Note 9 to the Consolidated Financial Statements for a discussion of the proposed
Narrowstep Merger, which would result in the issuance of options to the
Executives in accordance with the above provision.





Under the terms of the agreements, we
may terminate an Executive’s employment upon his death or disability or with or
without cause. To the extent that an Executive is terminated for cause, no
severance benefits are due him. If an employment agreement is terminated as a
result of the Executive’s death, his estate will receive one year base salary
plus any bonus or other compensation amount or benefit then payable or that
would have been otherwise considered vested or earned under the agreement during
the one-year period subsequent to the time of his death. If an employment
agreement is terminated as a result of the Executive’s disability, as defined in
the agreement, he is entitled to compensation in accordance with our disability
compensation for senior executives to include compensation for at least 180
days, plus any bonus or other compensation amount or benefit then payable or
that would have been otherwise considered vested or earned under the agreement
during the one-year period subsequent to the time of his disability. These
employment agreements contain certain non-disclosure and non-competition
provisions and we have agreed to indemnify the Executives in certain
circumstances.





As part
of the above employment agreements, we agreed that in the event the Company is
sold for a Company Sale Price in excess of the Current Capitalization during the
term of the agreements, both terms as defined below, and the Company Sale Price
represents at least $2.50 per share (adjusted for recapitalization including but
not limited to splits and reverse splits), the Executives and certain other
employees, will receive, as a group, cash compensation of twelve and one-half
percent (12.5%) of the excess of the Company Sale Price over the Current
Capitalization, payable in immediately available funds at the time of closing
such transaction. The Current Capitalization is defined as the sum of (i) the
number of common shares issued and outstanding, (ii) the common stock equivalent
shares related to paid for but not converted preferred shares and (iii) the
number of common shares underlying “in-the-money” warrants and options, such sum
multiplied by the market price per share and then reduced by the proceeds
payable upon exercise of the “in-the-money” warrants and options, all determined
as of the date of this new agreement but the market price per share used for
this purpose to be no less than $2.00. The Company Sale Price is defined as the
number of common shares outstanding at the time the Company is sold multiplied
by the price per share paid in such Company Sale transaction. The 12.5% was
allocated in the new employment agreements as two and one-half percent (2.5%)
each to Messrs. Selman, Saperstein, Friedland and Glassman and one and one-half
percent (1.5%) to Mr. Tomlinson. The remaining one percent (1.0%) will be
allocated by the Board and our management at a later date, which will be
primarily to compensate our other executives not having employment contracts,
but may also include additional allocation to some or all of these five senior
Executives.




47




The above
description is qualified in its entirety by the terms and conditions of the
employment agreements.





Outstanding
Equity Awards at Fiscal Year-End Table





The following table sets forth certain
information regarding stock options held as of September 30, 2008 by the Named
Executive Officers. There were no outstanding stock awards held by them as of
that date:





NUMBER OF SECURITIES
                                                                          UNDERLYING UNEXERCISED
                                                                          OPTIONS (#)
                                                                        
                                                                        EQUITY
                                                                          INCENTIVE
                                                                          PLAN

                                                                            AWARDS:
                                                                            NUMBER OF
                                                                            SECURITIES
                                                                            UNDERLYING
                                                                            UNEXERCISED
                                                                            UNEARNED
                                                                        
                                                                        OPTION
                                                                          EXERCISE
                                                                        
                                                                        OPTION EXPIRATIONNAME
                                                                        
                                                                        EXERCISABLE
                                                                        
                                                                        UNEXERCISABLE
                                                                        
                                                                        OPTIONS (#)
                                                                        
                                                                        PRICE ($)
                                                                        
                                                                        DATERandy
      Selman (3)
                                                                        
                                                                        
                                                                        100,000
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        $
                                                                        0.71
                                                                        
                                                                        9/29/2011450,000
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        $
                                                                        1.12
                                                                        
                                                                        7/6/2010450,000
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        $
                                                                        1.57
                                                                        
                                                                        12/27/09400,000
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        $
                                                                        2.50
                                                                        
                                                                        9/30/09100,000
                                                                        (1)
                                                                        
                                                                        
                                                                        300,000
                                                                        (1)
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        $
                                                                        1.73
                                                                        
                                                                        9/28/2012–
      9/28/201513,750
                                                                        (2)
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        206,250
                                                                        (2)
                                                                        
                                                                        $
                                                                        1.73
                                                                        
                                                                        12/31/2011–9/28/2013Alan
      Saperstein (3)
                                                                        
                                                                        
                                                                        100,000
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        $
                                                                        0.71
                                                                        
                                                                        9/29/2011450,000
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        $
                                                                        1.12
                                                                        
                                                                        7/6/2010450,000
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        $
                                                                        1.57
                                                                        
                                                                        12/27/09400,000
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        $
                                                                        2.50
                                                                        
                                                                        9/30/09100,000
                                                                        (1)
                                                                        
                                                                        
                                                                        300,000
                                                                        (1)
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        $
                                                                        1.73
                                                                        
                                                                        9/28/2012–
      9/28/201513,750
                                                                        (2)
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        206,250
                                                                        (2)
                                                                        
                                                                        $
                                                                        1.73
                                                                        
                                                                        12/31/2011–9/28/2013Cliff
      Friedland (3)
                                                                        
                                                                        
                                                                        100,000
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        $
                                                                        0.71
                                                                        
                                                                        9/29/201188,860
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        $
                                                                        3.376
                                                                        
                                                                        7/1/2012100,000
                                                                        (1)
                                                                        
                                                                        
                                                                        300,000
                                                                        (1)
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        $
                                                                        1.73
                                                                        
                                                                        9/28/2012–
      9/28/201513,750
                                                                        (2)
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        206,250
                                                                        (2)
                                                                        
                                                                        $
                                                                        1.73
                                                                        
                                                                        12/31/2011–9/28/2013David
      Glassman (3)
                                                                        
                                                                        
                                                                        100,000
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        $
                                                                        0.71
                                                                        
                                                                        9/29/201188,860
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        $
                                                                        3.376
                                                                        
                                                                        7/1/2012100,000
                                                                        (1)
                                                                        
                                                                        
                                                                        300,000
                                                                        (1)
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        $
                                                                        1.73
                                                                        
                                                                        9/28/2012–
      9/28/201513,750
                                                                        (2)
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        206,250
                                                                        (2)
                                                                        
                                                                        $
                                                                        1.73
                                                                        
                                                                        12/31/2011–9/28/2013Robert
      Tomlinson (3)
                                                                        
                                                                        
                                                                        100,000
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        $
                                                                        0.71
                                                                        
                                                                        9/29/2011100,000
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        $
                                                                        1.12
                                                                        
                                                                        7/6/2010150,000
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        $
                                                                        1.21
                                                                        
                                                                        7/6/2009100,000
                                                                        (1)
                                                                        
                                                                        
                                                                        300,000
                                                                        (1)
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        $
                                                                        1.73
                                                                        
                                                                        9/28/2012–
      9/28/201513,750
                                                                        (2)
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        206,250
                                                                        (2)
                                                                        
                                                                        $
                                                                        1.73
                                                                        
                                                                        12/31/2011–9/28/2013


48




(1)
                Vesting
      of the options to purchase 400,000 shares is based on years of service.
      These vesting conditions are discussed in detail under “Employment
      Agreements” above.
 (2)
                Vesting
      of the options to purchase 220,000 shares is based on achieving certain
      financial objectives, respectively. These vesting conditions are discussed
      in detail under “Employment Agreements” above. 96,250 of the 206,250
      shares unvested as of September 30, 2008 will never vest based on meeting
      those certain objectives, since the applicable financial periods have
      already passed, but they may vest under the conditions noted in footnote 3
      to this table, below.
 (3)
                The
      executive’s employment agreement provides that under certain
      circumstances, all options previously granted the executive will be
      cancelled, with all underlying shares (vested or unvested) issued to the
      executive, and we will pay all taxes for the executive. These conditions
      are discussed in detail under “Employment Agreements”
    above.





1996
Stock Option Plan and 2007 Equity Incentive Plan


On February 9, 1997, the board of
directors and a majority of our shareholders adopted our 1996 Stock Option Plan
(the "Plan").  Pursuant to an amendment to the Plan ratified by
shareholders on September 13, 2005, we have reserved an aggregate of 4,500,000
shares of common stock for issuance pursuant to options granted under the Plan
("Plan Options") and 2,000,000 shares for restricted stock grants (“Stock
Grants”) made under the Plan.  At September 30, 2008, there were
unexercised options to purchase 4,043,000 shares of our common stock outstanding
under the Plan.  Such options were issued to our directors, employees
and consultants at exercise prices ranging from $0.71 to $2.98 per share. As
discussed in the following paragraph, the Company may no longer issue additional
options or stock grants under the Plan
 
 On September 18, 2007, the Company’s
Board of Directors and a majority of our shareholders adopted the 2007 Equity
Incentive Plan (the “2007 Plan”), which authorized the issuance of up to
6,000,000 shares of ONSM common stock pursuant to stock options, stock purchase
rights, stock appreciation rights and/or stock awards for employees, directors
and consultants. The options and stock grants authorized for issuance under the
2007 Plan were in addition to those already issued under the Plan, although we
may no longer issue additional options or stock grants under the Plan. At
September 30, 2008, there were unexercised options to purchase 4,060,000 shares
of our common stock outstanding under the 2007 Plan.  Such options
were issued to our directors, employees and consultants at exercise prices
ranging from $1.00 to $1.73 per share.


The
stated purpose of the Plan and the 2007 Plan is to increase our employees',
advisors', consultants' and non-employee directors' proprietary interest in the
company, and to align more closely their interests with the interests of our
shareholders, as well as to enable us to attract and retain the services of
experienced and highly qualified employees and non-employee directors. The Plan
and the 2007 Plan is administered by the Compensation Committee of our Board of
Directors (“the Committee"). The Committee determines, from time to time, those
of our officers, directors, employees and consultants to whom Stock Grants and
Plan Options will be granted, the terms and provisions of the respective Grants
and Plan Options, the dates such Plan Options will become exercisable, the
number of shares subject to each Plan Option, the purchase price of such shares
and the form of payment of such purchase price. Stock Grants may be issued by
the Committee at up to a 10% discount to market at the time of grant. All other
questions relating to the administration of the Plan and the 2007 Plan, and the
interpretation of the provisions thereof are to be resolved at the sole
discretion of the Board of Directors or the Committee.


Plan Options granted under the Plan or
the 2007 Plan may either be options qualifying as incentive stock options
("Incentive Options") under Section 422 of the Internal Revenue Code of 1986, as
amended (the "Code"), or options that do not so qualify ("Non-Qualified
Options").  In addition, the Plan also allowed for the inclusion of a
reload option provision ("Reload Option"), which permits an eligible person to
pay the exercise price of the Plan Option with shares of common stock owned by
the eligible person and to receive a new Plan Option to purchase shares of
common stock equal in number to the tendered shares.  Any Incentive
Option granted under the Plan must provide for an exercise price of not less
than 100% of the fair market value of the underlying shares on the date of such
grant, but the exercise price of any Incentive Option granted to an eligible
employee owning more than 10% of our common stock must be at least 110% of such
fair market value as determined on the date of the grant.
  49
  The term of each Plan Option and the
manner in which it may be exercised is determined by the Board of Directors or
the Committee, provided that no Plan Option may be exercisable more than 10
years after the date of its grant and, in the case of an Incentive Option
granted to an eligible employee owning more than 10% of our common stock, no
more than five years after the date of the grant.  In any case, the
exercise price of any stock option granted under the Plan or the 2007 Plan will
not be less than 85% of the fair market value of the common stock on the date of
grant.  The exercise price of Non-Qualified Options is determined by
the Committee.
 
 The per share purchase price of shares
subject to Plan Options granted under the Plan or the 2007 Plan may be adjusted
in the event of certain changes in our capitalization, but any such adjustment
shall not change the total purchase price payable upon the exercise in full of
Plan Options granted under the Plan.  Officers, directors and
employees of and consultants to us and our subsidiaries are eligible to receive
Non-Qualified Options under the Plan or the 2007 Plan.  Only such
individuals who are employed by us or by any of our subsidiaries thereof are
eligible to receive Incentive Options.
 
 All Plan Options are nonassignable and
nontransferable, except by will or by the laws of descent and distribution and,
during the lifetime of the optionee, may be exercised only by such
optionee.  If an optionee's employment is terminated for any reason,
other than his death or disability or termination for cause, or if an optionee
is not our employee but is a member of our Board of Directors and his service as
a Director is terminated for any reason, other than death or disability, the
Plan Option granted may be exercised on the earlier of the expiration date or 90
days following the date of termination.  If the optionee dies during
the term of his employment, the Plan Option granted to him shall lapse to the
extent unexercised on the earlier of the expiration date of the Plan Option or
the date one year following the date of the optionee's death.  If the
optionee is permanently and totally disabled within the meaning of Section
22(c)(3) of the Code, the Plan Option granted to him lapses to the extent
unexercised on the earlier of the expiration date of the option or one year
following the date of such disability.
 
 The Board of Directors may amend,
suspend or terminate the Plan or the 2007 Plan at any time, except that no
amendment shall be made which (i) increases the total number of shares subject
to the Plan or the 2007 Plan or changes the minimum purchase price therefore
(except in either case in the event of adjustments due to changes in our
capitalization) without the consent of our shareholders, (ii) affects
outstanding Plan Options or any exercise right thereunder, (iii) extends the
term of any Plan Option beyond ten years, or (iv) extends the termination date
of the Plan or the 2007 Plan.
 
 Unless the Plan or 2007 Plan has been
earlier suspended or terminated by the Board of Directors, the Plan or the 2007
Plan shall terminate 10 years from the date of the Plan's or the 2007 Plan’s
adoption.  Any such termination of the Plan or the 2007 Plan shall not
affect the validity of any Plan Options previously granted
thereunder.


The
potential benefit to be received from a Plan Option is dependent on increases in
the market price of the common stock. The ultimate dollar value of the Plan
Options that have been or may be granted under the Plan or the 2007 Plan are
therefore not ascertainable. On December 5, 2008, the closing price of our
common stock as reported on the NASDAQ Capital Market was $0.30 per
share.


50


ITEM
      11.
                SECURITY
      OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
      STOCKHOLDER MATTERS





The following table contains
information regarding beneficial ownership of our common stock as of December 5,
2008 held by:





·
            persons
      who own beneficially more than 5% of our outstanding common
      stock,


·
            our
      directors,


·
            named
      executive officers, and


·
            all
      of our directors and officers as a
group.





Unless otherwise indicated, the address
of each of the listed beneficial owners identified is c/o Onstream Media
Corporation, 1291 Southwest 29th Avenue,
Pompano Beach, Florida 33069. Unless otherwise noted, we believe that all
persons named in the table have sole voting and investment power with respect to
all shares of our common stock beneficially owned by them.  A person
is deemed to be the beneficial owner of securities that can be acquired by such
a person within 60 days from December 5, 2008 upon exercise of options, warrants
or convertible securities. Each beneficial owner's percentage of ownership is
determined by assuming that options, warrants and convertible securities that
are held by such a person (but not those held by any other person) and are
exercisable within 60 days from the date hereof (unless otherwise indicated
below) have been exercised. All information is based upon a record list of
stockholders as of December 5, 2008. At that date, approximately 71% of the
Company's outstanding shares were held by CEDE & Co., which is accounted for
as a single shareholder of record for multiple beneficial owners. CEDE & Co.
is a nominee of the Depository Trust Company (DTC), with respect to securities
deposited by participants with DTC, e.g., mutual funds, brokerage firms, banks,
and other financial organizations.  Shares held by Cede & Co. are
not reflected in the following table,except with
regard to shares held by Messrs. Lewis, Berman and Tuccio, since that
information was provided to us in connection with their execution of Voting
Agreements in connection with the proposed Narrowstep merger.





Shares
      of Common Stock Beneficially OwnedName
      and Address of Beneficial Owner
                          
                          Number
                          
                          
                          PercentageRandy
      S. Selman (1)
                          
                          
                          1,537,452
                          
                          
                          
                          3.5
                          %Alan
      M. Saperstein (2)
                          
                          
                          1,539,320
                          
                          
                          
                          3.5
                          %Robert
      Wussler (3)
                          
                          
                          265,426
                          
                          
                          
                          0.6
                          %Charles
      C. Johnston (4)
                          
                          
                          744,828
                          
                          
                          
                          1.7
                          %Clifford
      Friedland (5)
                          
                          
                          1,059,776
                          
                          
                          
                          2.5
                          %David
      Glassman (6)
                          
                          
                          1,059,609
                          
                          
                          
                          2.5
                          %Carl
      L. Silva (7)
                          
                          
                          64,810
                          
                          
                          
                          0.2
                          %Leon
      Nowalsky (8)
                          
                          
                          50,000
                          
                          
                          
                          0.1
                          %Robert
      E. Tomlinson (9)
                          
                          
                          477,500
                          
                          
                          
                          1.1
                          %All
      directors and officers as a group (nine persons) (10)
                          
                          
                          6,798,721
                          
                          
                          
                          14.3
                          %Fred
      DeLuca (11)
                          
                          
                          4,043,849
                          
                          
                          
                          9.4
                          %Austin
      Lewis (12)
                          
                          
                          3,414,893
                          
                          
                          
                          8.0
                          %Neil
      Berman (13)
                          
                          
                          2,690,100
                          
                          
                          
                          6.3
                          %Edward
      Tuccio (14)
                          
                          
                          2,212,000
                          
                          
                          
                          5.2
                          %





(1)           Includes
9,952 shares of our common stock presently outstanding, options to acquire
100,000 common shares at $0.71 per share, options to acquire 450,000 common
shares at $1.12 per share, options to acquire 450,000 common shares at $1.57 per
share, options to acquire 113,750 common shares at $1.73 per share and options
to acquire 400,000 common shares at $2.50 per share. Also includes unvested
options to acquire 13,750 common shares at $1.73 per share, which could
potentially vest within 60 days after December 5, 2008, subject to the
achievement of certain performance objectives. Options to acquire another
492,500 common shares at $1.73 per share are excluded from the ownership table,
as they are not expected to vest within that time frame, although they could
vest under certain circumstances such as (i) change of control, (ii)
constructive termination or (iii) termination other than for
cause.  See Item 10 – Executive Compensation.


51




(2)           Includes
11,820 shares of our common stock presently outstanding, options to acquire
100,000 common shares at $0.71 per share, options to acquire 450,000 common
shares at $1.12 per share, options to acquire 450,000 common shares at $1.57 per
share, options to acquire 113,750 common shares at $1.73 per share and options
to acquire 400,000 common shares at $2.50 per share. Also includes unvested
options to acquire 13,750 common shares at $1.73 per share, which could
potentially vest within 60 days after December 5, 2008, subject to the
achievement of certain performance objectives.  Options to acquire
another 492,500 common shares at $1.73 per share are excluded from the ownership
table, as they are not expected to vest within that time frame, although they
could vest under certain circumstances such as (i) change of control, (ii)
constructive termination or (iii) termination other than for cause. See Item 10
– Executive Compensation.





(3)           Includes
616 shares of our common stock presently outstanding, options to acquire 50,000
ONSM common shares at $0.71 per share, options to acquire 100,000 ONSM common
shares at $1.12 per share, options to acquire 100,000 ONSM common shares at
$1.57 per share and warrants to purchase 14,810 ONSM common shares at $3.376 per
share.





(4)           Includes
25,000 restricted shares of our common stock presently outstanding, 460,214
shares of our common stock held by J&C Resources, LLC, 9,614 shares of our
common stock held by Asset Factoring, Ltd., options to acquire 50,000 ONSM
common shares at $0.71 per share, options to acquire 100,000 ONSM common shares
at $1.12 per share and options to acquire 100,000 ONSM common shares at $1.57
per share.  Mr. Johnston is the control person of J&C Resources,
LLC and Asset Factoring, Ltd. and exercises sole voting and dispositive powers
over these shares.  Mr. Johnston's holdings exclude our securities
owned by CCJ Trust. CCJ Trust is a trust for Mr. Johnston's adult children and
he disclaims any beneficial ownership interest in CCJ Trust.





(5)           Includes
447,216 shares of our common stock presently outstanding, 148,100 shares of our
common stock held by Titan Trust, 148,100 shares of our common stock held by
Dorado Trust, options to acquire 100,000 common shares at $0.71 per share,
options to acquire 113,750 common shares at $1.73 per share and options to
acquire 88,860 common shares at $3.376 per share. Also includes unvested options
to acquire 13,750 common shares at $1.73 per share, which could potentially vest
within 60 days after December 5, 2008, subject to the achievement of certain
performance objectives. Options to acquire another 492,500 common shares at
$1.73 per share are excluded from the ownership table, as they are not expected
to vest within that time frame, although they could vest under certain
circumstances such as (i) change of control, (ii) constructive termination or
(iii) termination other than for cause. See Item 10 – Executive Compensation.
Mr. Friedland is the control person and beneficial owner of both Titan Trust and
Dorado Trust and exercises sole voting and dispositive powers over these shares.
Mr. Friedland executed a Voting Agreement with respect to the 743,416
outstanding shares of common stock included above.





(6)           Includes
447,049 shares of our common stock presently outstanding, 148,100 shares of our
common stock held by JMI Trust, 148,100 shares of our common stock held by
Europa Trust, options to acquire 100,000 common shares at $0.71 per share,
options to acquire 113,750 common shares at $1.73 per share and options to
acquire 88,860 common shares at $3.376 per share. Also includes unvested options
to acquire 13,750 common shares at $1.73 per share, which could potentially vest
within 60 days after December 5, 2008, subject to the achievement of certain
performance objectives. Options to acquire another 492,500 common shares at
$1.73 per share are excluded from the ownership table, as they are not expected
to vest within that time frame, although they could vest under certain
circumstances such as (i) change of control, (ii) constructive termination or
(iii) termination other than for cause. See Item 10 – Executive Compensation.
Mr. Glassman is the control person and beneficial owner of both JMI Trust and
Europa Trust and exercises sole voting and dispositive powers over these shares.
Mr. Glassman executed a Voting Agreement with respect to the 743,249 outstanding
shares of common stock included above.


52




(7)           Includes
options to acquire 50,000 ONSM common shares at $0.88 per share and warrants to
purchase 14,810 ONSM common shares at $3.376 per share.





(8)           Includes
options to acquire 50,000 ONSM common shares at $1.00 per share.





(9)           Includes
options to acquire 100,000 common shares at $0.71 per share, options to acquire
100,000 common shares at $1.12 per share, options to acquire
150,000  common shares at $1.21 per share and options to acquire
113,750 common shares at $1.73 per share. Also includes unvested options to
acquire 13,750 common shares at $1.73 per share, which could potentially vest
within 60 days after December 5, 2008, subject to the achievement of certain
performance objectives.  Options to acquire another 492,500 common
shares at $1.73 per share are excluded from the ownership table, as they are not
expected to vest within that time frame, although they could vest under certain
circumstances such as (i) change of control, (ii) constructive termination or
(iii) termination other than for cause.  See Item 10 – Executive
Compensation.





(10)           See
footnotes (1) through (9) above.





(11)           Includes
3,839,304 shares of our common stock presently outstanding, warrants to acquire
21,212 ONSM common shares at $1.65 per share, warrants to acquire 83,333 ONSM
common shares at $1.50 per share and options to acquire 100,000 ONSM common
shares at $2.46 per share. Mr. DeLuca executed a Voting Agreement with respect
to the 3,839,304 outstanding shares of common stock included above.





(12)           Includes
3,388,643 shares of our common stock presently outstanding and warrants to
acquire 26,250 common shares at $1.50 per share. These items are held in the
name of Lewis Asset Management, LAM Opportunity Fund, Ltd and/or Lewis
Opportunity Fund, LP. Mr. Lewis is the control person and beneficial owner of
these entities and exercises sole voting and dispositive powers over these
shares. Mr. Lewis executed a Voting Agreement with respect to the 3,388,643
outstanding shares of common stock included above. See Item 1 – Risk
Factors.





(13)           Includes
2,312,600 shares of our common stock presently outstanding, 240,000 common
shares issuable under an April 1, 2008 consulting agreement for financial public
relations services to be received over a two year term from Mr. Berman, warrants
to acquire 87,500 common shares at $1.50 per share and options to acquire 50,000
common shares at $1.00 per share. Mr. Berman executed a Voting Agreement with
respect to the 2,312,600 outstanding shares of common stock included above. Mr.
Berman disclaims ownership with regards to shares owned or controlled by David
Berman, Corey Berman or Robyn Berman. See Item 12 – Certain Relationships and
Related Transactions.





(14)           Includes
2,087,000 shares of our common stock presently outstanding and options to
acquire 125,000 common shares at $1.00 per share. Mr. Tuccio executed a Voting
Agreement with respect to the 2,087,000 outstanding shares of common stock
included above.





Securities Authorized for Issuance
Under Equity Compensation Plans -See Item 5 - Market For Common Equity
And Related Stockholder Matters And Small Business Issuer Purchases Of Equity
Securities.


53





ITEM
      12.
            CERTAIN
      RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
      INDEPENDENCE





Certain
relationships and related transactions





In April 2008, we entered into a
two-year consulting agreement (for services starting January 1, 2008) with Mr.
Neil Berman, a major shareholder, calling for the issuance of 240,000 restricted
common shares.





In
November 2006, we entered into a three-year consulting contract with the
principal and beneficial owner of SBV Capital Corporation, for the provision of
international business development and financial advice. The contract, which was
cancellable upon thirty days notice after the first year, called for the
issuance of 60,000 restricted common shares in advance every six months. The
first two tranches under this contract (60,000 shares each) were issued in
January and May 2007. This contract was amended in July 2007 for some additional
short-term services, resulting in issuance of an additional 15,000 shares plus
$22,425 for cash reimbursement of related travel expenses. This contract was
amended again in October 2007, which resulted in the issuance of the remaining
240,000 restricted common shares, in exchange for the extension of the remaining
term of the contract from two years to three years.





In
December 2007, we entered into a line of credit arrangement with a financial
institution under which we could borrow up to an aggregate of $1.0 million for
working capital, collateralized by our accounts receivable. This arrangement was
amended in August 2008 to allow maximum borrowings on $1.6 million. As of
December 5, 2008, we have received $1.55 million funding under this arrangement.
The outstanding balance bears interest at prime plus 11% per annum, payable
monthly in arrears, and may be repaid at any time, but no later than two (2)
years after the date of the agreement, which term may be extended by us for an
extra year, subject to compliance with all loan terms, including no material
adverse change. The outstanding principal is due on demand in the event a
payment default is uncured five (5) days after written notice. The loan is also
subject to us maintaining an adequate level of receivables, based on certain
formulas, as well as our compliance with debt service coverage and minimum
tangible net worth covenants. We received waivers from the lender with respect
to lack of compliance with the tangible net worth covenant as of March 31, 2008,
waivers with respect to the tangible net worth and debt service to cash flow
covenants as of June 30, 2008 and for the quarter then ended and waivers with
respect to the tangible net worth and debt service to cash flow covenants as of
September 30, 2008 and for the quarter then ended.  Mr. Leon Nowalsky,
a member of our Board of Directors, is also a founder and board member of the
lender.





Director
independence





Rule 4350(c) of the NASDAQ Marketplace
Rules to which we are subject requires that a majority of the members of our
board of directors are independent as defined in Rule 4200 of the NASDAQ
Marketplace Rules. Our independent directors are Messrs. Wussler, Johnston,
Silva and Nowalsky.


54


PART
IV


ITEM
13.                      EXHIBITS


The
following documents are filed as a part of this report or are incorporated by
reference to previous filings, if so indicated:





Number
              
              Description2.1
              
              Agreement
      and Plan of Merger dated as of October 22, 2003 by and between Visual Data
      Corporation, OSM, Inc., a subsidiary of Visual Data Corporation, and
      Onstream Media Corporation (11)2.2
              
              Amendment
      #1 to Agreement and Plan of Merger dated as of October 15, 2004 by and
      between Visual Data Corporation, OSM, Inc., a subsidiary of Visual Data
      Corporation, and Onstream Media Corporation (13)2.3
              
              Agreement
      and Plan of Merger dated June 4, 2001 among Entertainment Digital Network,
      Inc., Visual Data Corporation and Visual Data San Francisco, Inc.
      (6)2.4
              
              Agreement
      and Plan of Reorganization between Visual Data Corporation, Media on
      Demand, Inc. and Charles Saracino (7)2.5
              
              Voting
      Agreement (7)2.6.1
              
              Infinite
      Conferencing Merger Agreement dated March 26, 2007 (22)2.6.2
              
              Infinite
      Conferencing Merger - Form of Registration Rights Agreement
      (22)2.6.3
              
              Infinite
      Conferencing Merger - Form of Lock-Up Agreement (22)2.7.1
              
              Narrowstep
      Merger Agreement dated May 29, 2008 (26)2.7.2
              
              First
      Amendment to Narrowstep Merger Agreement dated May 29, 2008
      (28)2.7.2
              
              Second
      Amendment to Narrowstep Merger Agreement dated May 29, 2008
      (29)3.1.1
              
              Articles
      of Incorporation (1)3.1.2
              
              Articles
      of Amendment dated July 26, 1993 (1)3.1.3
              
              Articles
      of Amendment dated January 17, 1994 (1)3.1.4
              
              Articles
      of Amendment dated October 11, 1994 (1)3.1.5
              
              Articles
      of Amendment dated March 25, 1995 (1)3.1.6
              
              Articles
      of Amendment dated October 31, 1995 (1)3.1.7
              
              Articles
      of Amendment dated May 23, 1996 (1)3.1.8
              
              Articles
      of Amendment dated May 5, 1998 (5)3.1.9
              
              Articles
      of Amendment dated August 11, 1998 (2)3.1.10
              
              Articles
      of Amendment dated June 13, 2000 (4)3.1.11
              
              Articles
      of Amendment dated April 11, 2002 (8)3.1.12
              
              Articles
      of Amendment dated June 24, 2003, with regard to Series A-9 Convertible
      Preferred Stock (9)3.1.13
              
              Articles
      of Amendment dated June 20, 2003, with regard to reverse stock split
      (10)3.1.14
              
              Articles
      of Amendment dated December 23, 2004, with regard to the designations for
      Series A-10 Convertible Preferred Stock (16)3.1.15
              
              Articles
      of Amendment dated December 30, 2004, with regard to corporate name change
      (15)3.1.16
              
              Articles
      of Amendment dated February 7, 2005 with regard to the designations for
      Series A-10 Convertible Preferred Stock (17)3.2
              
              By-laws
      (1)4.1
              
              Specimen
      Common Stock Certificate (1)4.2
              
              Form
      of 8% Senior Secured Convertible Notes (16)4.3
              
              Form
      of $1.65 Warrant (16)4.4
              
              Form
      of $1.50 Warrant (16)4.5
              
              Form
      of $1.00 Warrant (20)4.6
              
              Form
      of $1.65 Warrant issuable upon exercise of $1.00 Warrant
    (20)


55





4.7
              
              Form
      of Subordinated Secured Convertible Note (21)4.8
              
              Form
      of $1.50 Warrant for Subordinated Secured Convertible Notes
      (21)4.9
              
              Form
      of 12% Convertible Secured Note (27)10.1
              
              Form
      of 1996 Stock Option Plan and Amendment thereto (1)(3)10.2
              
              Form
      of 2007 Equity Incentive Plan (24)10.3
              
              Employment
      Agreement (Amended) dated May 15, 2008 between Onstream Media Corporation
      and Randy S. Selman (25)10.4
              
              Employment
      Agreement (Amended) dated May 15, 2008 between Onstream Media Corporation
      and Alan Saperstein (25)10.5
              
              Employment
      Agreement (Amended) dated May 15, 2008 between Onstream Media Corporation
      and Clifford Friedland (25)10.6
              
              Employment
      Agreement (Amended) dated May 15, 2008 between Onstream Media Corporation
      and David Glassman (25)10.7
              
              Employment
      Agreement (Amended) dated May 15, 2008 between Onstream Media Corporation
      and Robert Tomlinson (25)10.8
              
              Form
      of Subscription Agreement used for sale of $11.0 million common shares -
      March 2007 (22)10.9
              
              Form
      of Securities Purchase Agreement for 8% Senior Secured Convertible Notes
      (16)10.10
              
              Form
      of Additional Investment Right (16)10.11
              
              Form
      of Pledge Agreement (16)10.12
              
              Form
      of Security Agreement (16)10.13
              
              Form
      of Letter Agreement with Additional Investment Right holders
      (18)10.14
              
              Deposit
      Control Agreement dated October 2004 (14)10.15
              
              Form
      of Subscription Agreement for Subordinated Secured Convertible Notes
      (21)10.16
              
              Form
      of Subordination Agreement for Subordinated Secured Convertible Notes
      (21)10.17
              
              Form
      of Security Agreement for Subordinated Secured Convertible Notes
      (21)10.18
              
              Amendment
      and Waiver Agreement, dated as of May 29, 2008, among Narrowstep Inc. and
      the investors party thereto (26)10.19
              
              Form
      of Narrowstep Voting Agreement, dated as of May 29, 2008
    (26)10.20
              
              Form
      of Onstream Voting Agreement, dated as of May 29, 2008
  (26)10.21
              
              Form
      of Subscription Agreement, dated as of May 29, 2008, by and between
      Narrowstep Inc. and the investors party thereto (26)10.22
              
              Form
      of Subscription Agreement, dated as of August 13, 2008, by and between
      Narrowstep Inc. and the investors party thereto (28)10.23
              
              Form
      of Subscription Agreement for 12% Convertible Secured Notes
      (27)10.24
              
              Form
      of Security Agreement for 12% Convertible Secured Notes
    (27)14.1
              
              Code
      of Business Conduct and Ethics (12)14.2
              
              Corporate
      Governance and Nominating Committee Principles (30)14.3
              
              Audit
      Committee Charter (24)21.1
              
              Subsidiaries
      of the registrant21.2
              
              Financial
      statements of Acquired Onstream for the years ended December 31, 2003 and
      2002 and for the three and six months ended June 30, 2004 and 2003
      (19)21.3.1
              
              Infinite
      Conferencing, LLC - Audited December 31, 2006 and 2005 Financial
      Statements (23)21.3.2
              
              Infinite
      Conferencing, LLC - Reviewed March 31, 2007 and 2006 Financial Statements
      (23)23.1
              
              Consent
      of Independent Registered Public Accounting Firm31.1
              
              Rule
      13a-14(a)/15d-14(a) Certification of Chief Executive
    Officer31.2
              
              Rule
      13a-14(a)/15d-14(a) Certification of Chief Financial
    Officer32.1
              
              Section
      906 Certification of Chief Executive Officer32.2
              
              Section
      906 Certification of Chief Financial
Officer





(1)
            Incorporated
      by reference to the exhibit of the same number filed with the registrant's
      registration statement on Form SB-2, registration number 333-18819, as
      amended and declared effective by the SEC on July 30,
  1997.


56





(2)
            Incorporated
      by reference to the registrant's current report on Form 8-K dated August
      21, 1998.


(3)
            Incorporated
      by reference to the registrant's Proxy Statement for the year ended
      September 30, 1998.


(4)
            Incorporated
      by reference to the registrant's Quarterly Report on Form 10-QSB for the
      period ended June 30, 2000.


(5)
            Incorporated
      by reference to the registrant’s Annual Report on Form 10-KSB for the year
      ended September 30, 2000.


(6)
            Incorporated
      by reference to the registrant’s current report on Form 8-K filed on June
      12, 2001.


(7)
            Incorporated
      by reference to the registrant’s current report on Form 8-K filed on
      February 5, 2002.


(8)
            Incorporated
      by reference to exhibit 3.1 to the registrant's registration statement on
      Form S-3, file number 333-89042, declared effective on June 7,
      2002.


(9)
            Incorporated
      by reference to the registrant's current report on Form 8-K filed July 2,
      2003.


(10)
            Incorporated
      by reference to the registrant's Quarterly Report on Form 10-QSB for the
      period ended June 30, 2003.


(11)
            Incorporated
      by reference to the registrant's current report on Form 8-K filed October
      28, 2003.


(12)
            Incorporated
      by reference to the registrant’s Annual Report on Form 10-KSB for the year
      ended September 30, 2003.


(13)
            Incorporated
      by reference to the registrant’s Annual Report on Form 10-KSB for the year
      ended September 30, 2004.


(14)
            Incorporated
      by reference to the registrant's current report on Form 8-K filed November
      4, 2004.


(15)
            Incorporated
      by reference to the registrant’s current report on Form 8-K filed on
      January 4, 2005.


(16)
            Incorporated
      by reference to the registrant’s current report on Form 8-K/A filed on
      January 4, 2005.


(17)
            Incorporated
      by reference to the registrant's current report on Form 8-K filed February
      11, 2005.


(18)
            Incorporated
      by reference to the registrant's current report on Form 8-K filed February
      17, 2005.


(19)
            Incorporated
      by reference to the registrant's current report on Form 8-K/A filed March
      8, 2005.


(20)
            Incorporated
      by reference to the registrant's Proxy Statement for the 2005 Annual
      Shareholder’s Meeting filed on August 1,
2005.


(21)
            Incorporated
      by reference to the registrant's current report on Form 8-K/A filed April
      3, 2006.


(22)
            Incorporated
      by reference to the registrant's current report on Form 8-K filed March
      28, 2007.


(23)
            Incorporated
      by reference to the registrant's current report on Form 8-K/A filed July
      11, 2007.


(24)
            Incorporated
      by reference to the registrant’s proxy statement for the 2007 Annual
      Meeting filed with the SEC on July 31,
2007.


(25)
            Incorporated
      by reference to the registrant's Quarterly Report on Form 10-QSB filed May
      15, 2008.


(26)
            Incorporated
      by reference to the registrant's current report on Form 8-K filed June 2,
      2008.


(27)
            Incorporated
      by reference to the registrant's current report on Form 8-K filed June 6,
      2008.


(28)
            Incorporated
      by reference to the registrant's current report on Form 8-K filed August
      15, 2008.


(29)
            Incorporated
      by reference to the registrant's current report on Form 8-K/A filed
      September 19, 2008.


(30)
            Incorporated
      by reference to the registrant's Proxy Statement for the 2005 Annual
      Shareholder’s Meeting filed on August 1, 2005, which was updated by the
      version included as Appendix L to the preliminary combined proxy
      statement/Form S-4/A filed with the SEC on November 6, 2008, but not yet
      declared effective.




ITEM
14.                      PRINCIPAL
ACCOUNTANT FEES AND SERVICES


Audit
Fees





The
aggregate audit fees billed to us by Goldstein Lewin & Co. for professional
services rendered during the fiscal year ended September 30, 2008 were $240,632,
for the audit of our annual financial statements included in our Annual Report
on Form 10-KSB for the fiscal year ended September 30, 2007 and for the review
of our quarterly financial statements included in our quarterly reports on Form
10-QSB for the quarters ended December 31, 2007, and March 31 and June 30,
2008.


57





The aggregate audit fees billed to us
by Goldstein Lewin & Co. for professional services rendered during the
fiscal year ended September 30, 2007 were $231,000, for the audit of our annual
financial statements included in our Annual Report on Form 10-KSB for the fiscal
year ended September 30, 2006 and for the review of our quarterly financial
statements included in our quarterly reports on Form 10-QSB for the quarters
ended December 31, 2006, and March 31 and June 30, 2007.





Audit
Related Fees





The
aggregate fees billed to us by Goldstein, Lewin & Co. for assurance and
related services relating to the performance of the audit of our financial
statements which are not reported under the caption "Audit Fees" above were
$85,757 and $46,214 for the fiscal years ended September 30, 2008 and 2007,
respectively. The $85,757 for fiscal 2008 includes $71,104 for their services
rendered in connection with our joint Proxy/Form S-4 first filed with the SEC on
September 23, 2008, and subsequently amended by us, but not yet declared
effective.





Tax
Fees





The
aggregate tax fees billed to us by Goldstein Lewin & Co. were $15,737 and
$14,582 for the fiscal years ended September 30, 2008 and 2007, respectively.
Tax fees include the preparation of federal and state corporate income tax
returns as well as tax compliance, tax advice and tax planning.





All
Other Fees





Other than fees relating to the
services described above under “Audit Fees,” “Audit-Related Fees” and “Tax
Fees,” there were no additional fees billed to us by Goldstein Lewin & Co.
for services rendered for the fiscal years ended September 30, 2008 or
2007.





Audit
Committee Policies


Effective May 6, 2003, the Securities
and Exchange Commission adopted rules that require that before our independent
auditor is engaged by us to render any auditing or permitted non-audit related
service, the engagement be:





·
              approved
      by our audit committee; or
 ·
              entered
      into pursuant to pre-approval policies and procedures established by the
      audit committee, provided the policies and procedures are detailed as to
      the particular service, the audit committee is informed of each service,
      and such policies and procedures do not include delegation of the audit
      committee's responsibilities to
management.


The audit committee pre-approves all
services provided by our independent auditors, including those set forth
above.  The audit committee has considered the nature and amount of
fees billed by Goldstein Lewin & Co. and believes that the provision of
services for activities unrelated to the audit is compatible with maintaining
Goldstein Lewin & Co.’s independence.


58


SIGNATURES


In accordance with Section 13 or 15(d)
of the Exchange Act, the registrant caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.


Onstream
      Media CorporationBy:
              /s/ Randy S. SelmanRandy
      S. Selman, President, ChiefExecutive
      OfficerBy:
              /s/ Robert E. TomlinsonRobert
      E. Tomlinson, Chief Financial
Officer





In
accordance with the Exchange Act, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and on the
dates indicated.


Signature
                                              
                                              Title
                                              
                                              Date/s/ Randy S. Selman
                                              
                                              Director,
      President,
                                              
                                              December
      29, 2008Randy
      S. Selman
                                              
                                              Chief
      Executive Officer/s/
      Robert E. Tomlinson
                                              
                                              Chief
      Financial Officer andRobert
      E. Tomlinson
                                              
                                              Principal
      Accounting Officer
                                              
                                              December
      29, 2008/s/ Clifford Friedland
                                              
                                              Director
      and Senior VP
                                              
                                              December
      29, 2008Clifford
      Friedland
                                              
                                              Business
      Development/s/ Alan Saperstein
                                              
                                              Director
      and Chief
                                              
                                              December
      29, 2008Alan
      Saperstein
                                              
                                              Operating
      Officer/s/ Robert J. Wussler
                                              
                                              Director
                                              
                                              December
      29, 2008Robert
      J. Wussler/s/ Charles C. Johnston
                                              
                                              Director
                                              
                                              December
      29, 2008Charles
      C. Johnston/s/ Carl Silva
                                              
                                              Director
                                              
                                              December
      29, 2008Carl
      Silva/s/ Leon Nowalsky
                                              
                                              Director
                                              
                                              December
      29, 2008Leon
      Nowalsky


59





REPORT OF INDEPENDENT
REGISTERED PUBLIC ACCOUNTING FIRM





To the
Shareholders of Onstream Media Corporation


Pompano
Beach, Florida





We have
audited the accompanying consolidated balance sheets of Onstream Media
Corporation and subsidiaries as of September 30, 2008 and 2007, and the related
consolidated statements of operations, stockholders' equity and cash flows for
the years then ended.  These financial statements are the
responsibility of the Company's management.  Our responsibility is to
express an opinion on these financial statements based on our
audits.





We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement.  An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements.  An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement
presentation.  We believe that our audits provide a reasonable basis
for our opinion.





In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of Onstream Media Corporation
and subsidiaries as of September 30, 2008 and 2007, and the results of their
operations and their cash flows for the years then ended in conformity with
generally accepted accounting principles in the United States of
America.




/s/ Goldstein Lewin & Co.GOLDSTEIN
      LEWIN & CO.Certified
      Public AccountantsBoca
      Raton, FloridaDecember 29,
2008





F-1




ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


CONSOLIDATED
BALANCE SHEETS





September30,
                                  2008
                              
                              
                              September30,
                                  2007ASSETSCURRENT
      ASSETS:Cash and cash
      equivalents
                              
                              $
                              674,492
                              
                              
                              $
                              560,230Accounts receivable,
      net of allowance fordoubtful
      accounts of $30,492 and $65,254, respectively
                              
                              
                              2,545,450
                              
                              
                              
                              2,620,177Prepaid
      expenses
                              
                              
                              328,090
                              
                              
                              
                              565,649Inventories
                              
                              
                              94,689
                              
                              
                              
                              85,459Other current
      assets
                              
                              
                              77,422
                              
                              
                              
                              137,632Total
      current assets
                              
                              
                              3,720,143
                              
                              
                              
                              3,969,147PROPERTY
      AND EQUIPMENT, net
                              
                              
                              4,056,770
                              
                              
                              
                              5,551,026INTANGIBLE
      ASSETS, net
                              
                              
                              3,731,586
                              
                              
                              
                              5,108,604GOODWILL,
      net
                              
                              
                              21,696,948
                              
                              
                              
                              21,696,948OTHER
      NON-CURRENT ASSETS
                              
                              
                              639,101
                              
                              
                              
                              157,931Total
      assets
                              
                              $
                              33,844,548
                              
                              
                              $
                              36,483,656LIABILITIES
      AND STOCKHOLDERS' EQUITYCURRENT
      LIABILITIES:Accounts payable and
      accrued liabilities
                              
                              $
                              3,059,376
                              
                              
                              $
                              2,266,134Amounts due to
      shareholders and officers
                              
                              
                              109,419
                              
                              
                              
                              109,419Deferred
      revenue
                              
                              
                              128,715
                              
                              
                              
                              215,400Notes and leases
      payable –  current portion, net of
      discount
                              
                              
                              1,774,264
                              
                              
                              
                              138,629Total
      current liabilities
                              
                              
                              5,071,774
                              
                              
                              
                              2,729,582Notes
      and leases payable, net of current portion
                              
                              
                              109,151
                              
                              
                              
                              255,329Convertible
      debentures, net of discount
                              
                              
                              795,931
                              
                              
                              
                              -Total
      liabilities
                              
                              
                              5,976,856
                              
                              
                              
                              2,984,911COMMITMENTS
      AND CONTINGENCIESSTOCKHOLDERS'
      EQUITY:Series
      A-10 Convertible Preferred stock, par value $.0001 per share,authorized
      700,000
      shares,
                                74,841
      and 69,196 issued and outstanding, respectively
                              
                              
                              8
                              
                              
                              
                              7Common
      stock, par value $.0001 per share; authorized 75,000,000 shares, 42,625,627
      and
                                41,880,707
      issued and outstanding, respectively
                              
                              
                              4,262
                              
                              
                              
                              4,188Additional
      paid-in capital
                              
                              
                              130,078,354
                              
                              
                              
                              129,090,403Unamortized
      discount
                              
                              
                              (20,292
                              )
                              
                              
                              (98,491
                              )Accumulated
      deficit
                              
                              
                              (102,194,640
                              )
                              
                              
                              (95,497,362
                              )Total
      stockholders’ equity
                              
                              
                              27,867,692
                              
                              
                              
                              33,498,745Total
      liabilities and stockholders’ equity
                              
                              $
                              33,844,548
                              
                              
                              $
                              36,483,656





The
accompanying notes are an integral part of these consolidated financial
statements




F-2





ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES
 CONSOLIDATED
STATEMENTS OF OPERATIONS
 
 Years
      Ended
                    September 30,2008
                
                
                2007REVENUE:DMSP
      and hosting
                
                $
                1,440,584
                
                
                $
                778,385Network
      usage
                
                
                2,235,078
                
                
                
                2,105,477Webcasting
                
                
                5,924,507
                
                
                
                4,769,053Audio
      and web conferencing
                
                
                7,262,685
                
                
                
                3,198,818Other
                
                
                724,369
                
                
                
                1,263,312Total
      revenue
                
                
                17,587,223
                
                
                
                12,115,045COSTS
      OF REVENUE:DMSP
      and hosting
                
                
                606,947
                
                
                
                348,228Network
      usage
                
                
                938,487
                
                
                
                895,573Webcasting
                
                
                2,134,765
                
                
                
                1,722,901Audio
      and web conferencing
                
                
                1,476,575
                
                
                
                545,615Other
                
                
                654,251
                
                
                
                806,768Total
      costs of revenue
                
                
                5,811,025
                
                
                
                4,319,085GROSS
      MARGIN
                
                
                11,776,198
                
                
                
                7,795,960OPERATING
      EXPENSES:General
      and administrative:Compensation
                
                
                9,257,629
                
                
                
                6,679,964Professional
      fees
                
                
                1,970,007
                
                
                
                3,344,615Other
                
                
                2,735,816
                
                
                
                2,183,298Depreciation
      and amortization
                
                
                4,215,669
                
                
                
                3,099,940Total
      operating expenses
                
                
                18,179,121
                
                
                
                15,307,817Loss
      from operations
                
                
                (6,402,923
                )
                
                
                (7,511,857
                )OTHER
      EXPENSE, NET:Interest
      income
                
                
                1,781
                
                
                
                69,487Interest
      expense
                
                
                (244,678
                )
                
                
                (7,464,897
                )Debt
      extinguishment loss
                
                
                -
                
                
                
                (135,000
                )Other
      income, net
                
                
                84,362
                
                
                
                284,214Total
      other expense, net
                
                
                (158,535
                )
                
                
                (7,246,196
                )Net
      loss
                
                $
                (6,561,458
                )
                
                $
                (14,758,053
                )Loss
      per share – basic and diluted:Net
      loss per share
                
                $
                (0.16
                )
                
                $
                (0.48
                )Weighted
      average shares of common stock outstanding – basic and
    diluted
                
                
                42,329,391
                
                
                
                30,636,669
 
 The
accompanying notes are an integral part of these consolidated financial
statements
  F-3




ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


CONSOLIDATED
STATEMENT OF STOCKHOLDERS' EQUITY


YEARS
ENDED SEPTEMBER 30, 2007 AND 2008




Series A- 10
                                Preferred Stock
                              
                              
                              Common Stock
                              
                              
                              Additional Paid-in Capital
                              
                              
                              AccumulatedShares
                              
                              
                              Amount
                              
                              
                              Shares
                              
                              
                              Amount
                              
                              
                              Gross
                              
                              
                              Discount
                              
                              
                              Deficit
                              
                              
                              TotalBalance,
      September 30, 2006
                              
                              
                              430,983
                              
                              
                              $
                              43
                              
                              
                              
                              15,127,253
                              
                              
                              $
                              1,513
                              
                              
                              $
                              87,699,908
                              
                              
                              $
                              (1,369,617
                              )
                              
                              $
                              (77,945,696
                              )
                              
                              $
                              8,386,151Cumulative
      effect of change in accounting principle - adoption of  FSP EITF
      00-19-2
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              2,416,891
                              
                              
                              
                              -
                              
                              
                              
                              ( 1,300,957
                              )
                              
                              
                              1,115,934Conversion
      of 8% Convertible Debentures to common shares
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              5,299,153
                              
                              
                              
                              530
                              
                              
                              
                              5,298,624
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              5,299,154Conversion
      of Series A-10 preferred shares to common shares
                              
                              
                              (393,368
                              )
                              
                              
                              (39
                              )
                              
                              
                              3,933,680
                              
                              
                              
                              393
                              
                              
                              
                              (354
                              )
                              
                              
                              966,124
                              
                              
                              
                              (966,124
                              )
                              
                              
                              -Conversion
      of Notes Payable to common shares
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              3,045,902
                              
                              
                              
                              305
                              
                              
                              
                              3,099,695
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              3,100,000Issuance
      of shares, warrants and options for equipment and services
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              910,608
                              
                              
                              
                              91
                              
                              
                              
                              2,509,790
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              2,509,881Common
      shares and options issued for  interest and fees on 8%
      Convertible Debentures and Notes Payable
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              2,279,156
                              
                              
                              
                              228
                              
                              
                              
                              5,028,803
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              5,029,031Common
      shares issued upon exercise of warrants and options
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              4,552,154
                              
                              
                              
                              455
                              
                              
                              
                              6,879,882
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              6,880,337Sale
      of common shares, net of issuance costs
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              4,888,889
                              
                              
                              
                              489
                              
                              
                              
                              10,206,537
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              10,207,026Common
      shares issued for Infinite Conferencing and Auction Video
      acquisitions
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              1,843,912
                              
                              
                              
                              184
                              
                              
                              
                              5,499,816
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              5,500,000Dividends
      accrued or paid on Series A-10 preferred
                              
                              
                              31,581
                              
                              
                              
                              3
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              315,811
                              
                              
                              
                              305,002
                              
                              
                              
                              (526,532
                              )
                              
                              
                              94,284Beneficial
      conversion included in J&C Resources note
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              135,000
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              135,000Net
      loss
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              (14,758,053
                              )
                              
                              
                              (14,758,053
                              )Balance,
      September 30, 2007
                              
                              
                              69,196
                              
                              
                              $
                              7
                              
                              
                              
                              41,880,707
                              
                              
                              $
                              4,188
                              
                              
                              $
                              129,090,403
                              
                              
                              $
                              (98,491
                              )
                              
                              $
                              (95,497,362
                              )
                              
                              $
                              33,498,745




(Continued)


F-4




ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


CONSOLIDATED
STATEMENT OF STOCKHOLDERS' EQUITY


YEARS
ENDED SEPTEMBER 30, 2007 AND 2008





(Continued)





Series
      A- 10
                  Preferred
      Stock
                
                
                Common
      Stock
                
                
                Additional
      Paid-in Capital
                
                
                AccumulatedShares
                
                
                Amount
                
                
                Shares
                
                
                Amount
                
                
                Gross
                
                
                Discount
                
                
                Deficit
                
                
                TotalBalance,
      September 30, 2007
                
                
                69,196
                
                
                $
                7
                
                
                
                41,880,707
                
                
                $
                4,188
                
                
                $
                129,090,403
                
                
                $
                (98,491
                )
                
                $
                (95,497,362
                )
                
                $
                33,498,745Issuance
      of shares, warrants and options for consultant services
                
                
                -
                
                
                
                -
                
                
                
                543,670
                
                
                
                54
                
                
                
                821,151
                
                
                
                -
                
                
                
                -
                
                
                
                821,205Issuance
      of shares and options for employee services
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                882,242
                
                
                
                -
                
                
                
                -
                
                
                
                882,242Common
      shares issued for interest and fees on convertible
    debentures
                
                
                -
                
                
                
                -
                
                
                
                201,250
                
                
                
                20
                
                
                
                186,492
                
                
                
                -
                
                
                
                -
                
                
                
                186,512Obligation
      for shortfall in proceeds from sales of common shares issued for
      acquisition of Infinite Conferencing
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (958,399
                )
                
                
                -
                
                
                
                -
                
                
                
                (958,399
                )Dividends
      accrued or paid on Series A-10 preferred
                
                
                5,645
                
                
                
                1
                
                
                
                -
                
                
                
                -
                
                
                
                56,465
                
                
                
                78,199
                
                
                
                (135,820
                )
                
                
                (1,155
                )Net
      loss
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (6,561,458
                )
                
                
                (6,561,458
                )Balance,
      September 30, 2008
                
                
                74,841
                
                
                $
                8
                
                
                
                42,625,627
                
                
                $
                4,262
                
                
                $
                130,078,354
                
                
                $
                (20,292
                )
                
                $
                (102,194,640
                )
                
                $
                27,867,692





The
accompanying notes are an integral part of these consolidated financial
statements.




F-5





ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF CASH FLOWS





Years Ended
                  September 30,2008
              
              
              2007CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      loss
              
              $
              (6,561,458
              )
              
              $
              (14,758,053
              )Adjustments
      to reconcile net loss to net cashprovided
      by (used in) operating activities:Depreciation
      and amortization
              
              
              4,215,669
              
              
              
              3,099,940Amortization
      of deferred professional fee expenses paid with equity
              
              
              1,079,073
              
              
              
              2,323,215Compensation
      expenses paid with equity
              
              
              882,242
              
              
              
              -Amortization
      of discount on convertible debentures
              
              
              23,104
              
              
              
              2,290,995Amortization
      of discount on notes payable
              
              
              15,227
              
              
              
              5,015,103Interest
      expense paid in common shares and options
              
              
              -
              
              
              
              108,754Debt
      extinguishment loss
              
              
              -
              
              
              
              135,000Bad
      debt expense
              
              
              16,843
              
              
              
              37,022Gain
      from settlements of obligations and sales of equipment
              
              
              (16,199
              )
              
              
              (193,403
              )Net
      cash (used in) operating activities, before changes incurrent
      assets and liabilities
              
              
              (345,499
              )
              
              
              (1,941,427
              )Changes
      in current assets and liabilities, net of effect of
      acquisitions:Decrease
      (Increase)  in accounts receivable
              
              
              57,884
              
              
              
              (169,479
              )(Increase)
      Decrease in prepaid expenses
              
              
              (22,208
              )
              
              
              79,319(Increase)
      in other current assets
              
              
              (2,290
              )
              
              
              (67,517
              )(Increase)
      in inventories
              
              
              (9,230
              )
              
              
              (18,652
              )Increase
      (Decrease) in accounts payable and accrued liabilities
              
              
              476,777
              
              
              
              (133,980
              )(Decrease)
      in deferred revenue
              
              
              (86,686
              )
              
              
              (52,837
              )Net
      cash provided by (used in) operating activities
              
              
              68,748
              
              
              
              (2,304,573
              )CASH
      FLOWS FROM INVESTING ACTIVITIES:Acquisition
      of property and equipment
              
              
              (1,429,656
              )
              
              
              (1,260,191
              )Payments
      in connection with the acquisition of Infinite Conferencing,net
      of cash acquired
              
              
              -
              
              
              
              (14,201,668
              )Payments
      in connection with the acquisition of Auction Video
              
              
              -
              
              
              
              (523,066
              )Payment
      of accounts payable and accrued liabilities assumedat
      time of Onstream Merger
              
              
              -
              
              
              
              (100,718
              )Net
      cash (used in) investing activities
              
              
              (1,429,656
              )
              
              
              (16,085,643
              )





(Continued)




F-6


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF CASH FLOWS





(Continued)


Years
      Ended
                  September 30,2008
              
              
              2007CASH
      FLOWS FROM FINANCING ACTIVITIES:Proceeds
      from loans and notes payable, net of expenses
              
              $
              1,160,980
              
              
              $
              2,050,000Proceeds
      from convertible debentures, net of expenses
              
              
              959,339
              
              
              
              -Proceeds
      from sale of common shares, net of expenses
              
              
              -
              
              
              
              17,087,363Repayment
      of loans, notes and leases payable
              
              
              (645,149
              )
              
              
              (409,880
              )Net
      cash provided by financing activities
              
              
              1,475,170
              
              
              
              18,727,483NET
      INCREASE IN CASH AND CASH EQUIVALENTS
              
              
              114,262
              
              
              
              337,267CASH
      AND CASH EQUIVALENTS, beginning of period
              
              
              560,230
              
              
              
              222,963CASH
      AND CASH EQUIVALENTS, end of period
              
              $
              674,492
              
              
              $
              560,230SUPPLEMENTAL
      DISCLOSURES OF CASH FLOW INFORMATION:Cash
      payments for interest
              
              $
              225,481
              
              
              $
              94,568SUPPLEMENTAL
      SCHEDULE OF NON-CASH INVESTING AND FINANCING
      ACTIVITIES:Obligation
      arising for shortfall in proceeds from sales of common shares issued for
      acquisition of Infinite Conferencing – see note 2 for assets acquired and
      liabilities assumed
              
              $
              958,399
              
              
              $
              -Issuance
      of shares for acquisition of Infinite Conferencing – see note 2for
      assets acquired and liabilities assumed
              
              $
              -
              
              
              $
              4,000,000Issuance
      of shares, warrants and options for consultant services
              
              $
              821,205
              
              
              $
              2,
      382,481Issuance
      of shares and options for employee services
              
              $
              882,242
              
              
              $
              -Issuance
      of A-10 preferred shares for dividends
              
              $
              56,466
              
              
              $
              315,814Issuance
      of warrants to placement agent for sale of common shares
              
              $
              -
              
              
              $
              518,445Issuance
      of common shares and options for interest
              
              $
              186,512
              
              
              $
              5,029,031Issuance
      of shares for payment of accounts payable
              
              $
              -
              
              
              $
              127,400Issuance
      of shares for acquisition of Auction Video – see note 2 for assets
      acquired and liabilities assumed
              
              $
              -
              
              
              $
              1,500,000Conversion
      of Series A-10 convertible preferred to common shares
              
              $
              -
              
              
              $
              3,933,680Conversion
      of 8% Convertible Debentures to common shares
              
              $
              -
              
              
              $
              5,299,153Conversion
      of notes payable to common shares
              
              $
              -
              
              
              $
              3,100,000Purchase
      of equipment under capital lease
              
              $
              -
              
              
              $
              339,483Purchase
      of software and equipment with payment to vendor deferred past established
      trade terms
              
              $
              315,000
              
              
              $
              187,500Cumulative
      effect of change in accounting principle – adoption of FSP EITF 00-19-2,
      resulting in reversal of previous reclassifications from equity to
      liability
              
              $
              -
              
              
              $
              2,416,891





The
accompanying notes are an integral part of these consolidated financial
statements.




F-7


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE 1:
NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES





Nature of
Business





Onstream
Media Corporation (the "Company" or "Onstream" or "ONSM"), organized in 1993, is
a leading online service provider of live and on-demand Internet video,
corporate web communications and content management applications, including
digital media services and webcasting services. Digital media services are
provided primarily to entertainment, advertising and financial industry
customers. Webcasting services are provided primarily to corporate, education,
government and travel industry customers.





The
Company’s Digital Media Services Group consists of its Webcasting division, its
DMSP (“Digital Media Services Platform”) division, its UGC (“User Generated
Content”) division, its Smart Encoding division and its travel
division.


The
Webcasting division, which operates primarily from facilities in Pompano Beach,
Florida, provides an array of web-based media services to the corporate market
including live audio and video webcasting, packaged corporate announcements, and
rich media information storage and distribution for any business entity. The
Webcasting division generates revenue through production and distribution
fees.


The DMSP
division, which operates primarily from facilities in San Francisco, California,
provides an online, subscription based service that includes access to enabling
technologies and features for the Company’s clients to acquire, store, index,
secure, manage, distribute and transform these digital assets into saleable
commodities.The UGC division, which
operates primarily from facilities in San Francisco, California and also
operates as Auction Video – see note 2, provides a video ingestion and flash
encoder that can be used by the Company’s clients on a stand-alone basis or in
conjunction with the DMSP.
 
 The Smart
Encoding division, which operates primarily from facilities in San Francisco,
California, provides both automated and manual encoding and editorial services
for processing digital media, using a set of coordinated technologies and
processes that allow the quick and efficient online search, retrieval, and
streaming of this media, which can include photos, videos, audio, engineering
specs, architectural plans, web pages, and many other pieces of business
collateral. This division also provides hosting, storage and streaming services
for digital media, which are provided via the DMSP.


The
Travel division, which operates primarily from facilities in Pompano Beach,
Florida, produces Internet-based multi-media streaming videos related to hotels,
resorts, time-shares, golf facilities, and other travel destinations. The
Company warehouses this travel content on its own online travel portal –
www.travelago.com ("Travelago"). The Travel division generates revenue through
production and distribution fees.





On May
29, 2008, the Company entered into an Agreement and Plan of Merger (the “Merger
Agreement”) to acquire Narrowstep, Inc., a publicly held Delaware corporation
(“Narrowstep”) with most of its employees and facilities located in the United
Kingdom. As of December 5, 2008, this merger was not consummated. Narrowstep is
a provider of Internet TV services supporting content providers, broadcasters,
telecommunications companies and corporations worldwide and will be part of the
Company’s Digital Media Services Group. See Note 9.





F-8





ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008




NOTE 1:
NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES (Continued)





The
Company’s Audio and Web Conferencing Services Group consists of its Infinite
Conferencing (“Infinite”) division and its EDNet division.





The
Company’s Infinite division, which operates primarily from facilities in the New
York City metropolitan area, generates revenues from usage charges and fees for
other services provided in connection with “reservationless” and
operator-assisted audio and web conferencing services – see note 2.





The EDNet
division, which operates primarily from facilities in San Francisco, California,
provides connectivity within the entertainment and advertising industries
through its managed network, which encompasses production and post-production
companies, advertisers, producers, directors, and talent. The global network,
with approximately 500 active clients in cities throughout the United States,
Canada, Mexico, Europe, and the Pacific Rim, enables high-speed exchange of high
quality audio, compressed video and multimedia data communications, utilizing
long distance carriers, regional phone companies, satellite operators, and major
internet service providers. EDNet also provides systems integration and
engineering services, application-specific technical advice, audio equipment,
proprietary and off-the-shelf codecs, teleconferencing equipment, and other
innovative products to facilitate the Company's broadcast and production
applications. EDNet generates revenues from network usage, the sale, rental and
installation of equipment, and other related fees.





Liquidity





The
consolidated financial statements have been presented on the basis that the
Company is an ongoing concern, which contemplates the realization of assets and
the satisfaction of liabilities in the normal course of business. The Company
has incurred losses since its inception, and has an accumulated deficit of
approximately $102.2 million as of September 30, 2008. The Company's operations
have been financed primarily through the issuance of equity and debt. For the
year ended September 30, 2008, ONSM had a net loss of approximately $6.6
million, although cash provided by operations for that period was approximately
$69,000. Although the Company had cash of approximately $674,000 at September
30, 2008, working capital was a deficit of approximately $1.4 million at that
date.





The
Company is constantly evaluating its cash needs, in order to make appropriate
adjustments to operating expenses. Depending on its actual future cash needs,
the Company may need to raise additional debt or equity capital to provide
funding for ongoing future operations, or to refinance existing indebtedness. No
assurances can be given that the Company will be successful in obtaining
additional capital, or that such capital will be available on terms acceptable
to the Company. The Company's continued existence is dependent upon its ability
to raise capital and to market and sell its services successfully. The financial
statements do not include any adjustments to reflect future effects on the
recoverability and classification of assets or amounts and classification of
liabilities that may result if the Company is unsuccessful.





As of
December 5, 2008, the Company has estimated that, absent any reduction in its
current and planned expenditure levels, it would require an approximately 13.8%
increase in its consolidated revenues, as well as approximately $832,000
incremental receivable and equipment financing proceeds (or other financing), in
order to adequately fund those expenditures (including debt service and
anticipated capital expenditures) through September 30, 2009. The
Company has implemented specific actions, including hiring additional sales
personnel, developing new products and initiating new marketing programs, geared
towards achieving the above revenue increases. However, in the event the Company
is unable to achieve these revenue increases within the required time frames, or
is unable to obtain the financing as described above, it has identified
decreases in its current level of expenditures that it would implement and that
it believes would be sufficient to allow the Company to operate through
September 30, 2009.




F-9


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE 1:
NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES (Continued)





Basis of
Consolidation





The
accompanying consolidated financial statements include the accounts of Onstream
Media Corporation and its subsidiaries - Entertainment Digital Network, Inc.,
Media On Demand, Inc., HotelView Corporation, OSM Acquisition, Inc., AV
Acquisition, Inc., Auction Video Japan, Inc. and Infinite Conferencing, Inc. All
significant intercompany accounts and transactions have been eliminated in
consolidation.





Accounting
Estimates





The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States, requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenue and expenses during the reporting
period. Estimates are used when accounting for allowances for doubtful accounts,
revenue reserves, inventory reserves, depreciation and amortization, taxes,
contingencies and impairment allowances. Such estimates are reviewed on an
on-going basis and actual results could materially differ from those
estimates.





Cash and
cash equivalents





Cash and
cash equivalents consists of all highly liquid investments with original
maturities of three months or less.





Fair
Value of Financial Instruments





The
carrying amounts of cash and cash equivalents, accounts receivable, accounts
payable and accrued expenses approximate fair value due to the short maturity of
the instruments. The carrying amounts of notes payable approximate fair value
due to the short maturity of the instruments, as well as the market value
interest rates they carry. The carrying amounts of convertible debentures
approximate fair value due to the market value interest rates they carry as well
as the debt discount recorded as a deduction of the face value of such
instruments.





Bad Debt
Reserves





The
Company evaluates the collectibility of its accounts receivable based on a
combination of factors. In cases where the Company is aware of circumstances
that may impair a specific customer's ability to meet its financial obligations
to the Company, the Company records a specific allowance against amounts due to
us, and thereby reduce the net recognized receivable to the amount the Company
reasonably believes will be collected. For all other customers, the Company
recognizes allowances for doubtful accounts based on the length of time the
receivables are past due, the current business environment and historical
experience. Bad debt reserves were approximately $30,000 and $65,000, at
September 30, 2008 and 2007, respectively.
  F-10


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE 1:
NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES (Continued)





Concentration
of Credit Risk





The
Company at times has cash in banks in excess of FDIC insurance limits and places
its temporary cash investments with high credit quality financial institutions.
The Company performs ongoing credit evaluations of its customers' financial
condition and does not require collateral from them. Reserves for credit losses
are maintained at levels considered adequate by management.





Inventories




Inventories
are stated at the lower of cost (first-in, first-out method) or market by
analyzing market conditions, current sales prices, inventory costs, and
inventory balances.  The Company evaluates inventory balances for
excess quantities and obsolescence on a regular basis by analyzing backlog,
estimated demand, inventory on hand, sales levels and other information. Based
on that analysis, the Company’s management estimates the amount of provisions
made for obsolete or slow moving inventory.





Property
and Equipment





Property
and equipment are recorded at cost, less accumulated
depreciation.  Property and equipment under capital leases are stated
at the lower of the present value of the minimum lease payments at the beginning
of the lease term or the fair value at the inception of the lease. Depreciation
is computed using the straight-line method over the estimated useful lives of
the related assets. Amortization expense on assets acquired under capital leases
is included in depreciation expense. The costs of leasehold improvements are
amortized over the lesser of the lease term or the life of the
improvement.





Software


Included
in property and equipment is computer software developed for internal use,
including the Digital Media Services Platform (“DMSP”) – see notes 2 and
3.  Such amounts have been accounted for in accordance with Statement
of Position 98-1 “Accounting for the Costs of Computer Software Developed or
Obtained for Internal Use” and Emerging Issues Task Force pronouncement
(“EITF”) 00–2 “Accounting for Web Site Development Costs”.  Such
costs are amortized on a straight-line basis over three to five years,
commencing when the related asset has been substantially placed in
service.




F-11


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE 1:
NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES (Continued)





Goodwill
and other intangible assets





In
accordance with Statement of Financial Accounting Standards (“SFAS”) 142,
“Goodwill and Other Intangible Assets”, goodwill is reviewed annually (or more
frequently if impairment indicators arise) for impairment. Other intangible
assets, such as customer lists, are amortized to expense over their estimated
useful lives, although they are still subject to review and adjustment for
impairment.





The
Company reviews its long-lived assets for impairment whenever events or changes
in circumstances indicate that the carrying amount of an asset may not be
recoverable. The Company assesses the recoverability of such assets by comparing
the estimated undiscounted cash flows associated with the related asset or group
of assets against their respective carrying amounts. The impairment amount, if
any, is calculated based on the excess of the carrying amount over the fair
value of those assets.





See Note
2 – Goodwill and other Acquisition-Related Intangible Assets.





Revenue
Recognition





Revenues
from sales of goods and services are recognized when (i) persuasive evidence of
an arrangement between the Company and the customer exists, (ii) the good or
service has been provided to the customer, (iii) the price to the customer is
fixed or determinable and (iv) collectibility of the sales prices is reasonably
assured.





The
Webcasting division of the Digital Media Services Group recognizes revenue from
live and on-demand webcasts at the time an event is accessible for streaming
over the Internet.  Webcasting services are provided to customers
using the Company’s proprietary streaming media software, tools and processes.
Customer billings are typically based on (i) the volume of data streamed at
rates agreed upon in the customer contract or (ii) a set monthly fee. Since the
primary deliverable for the webcasting group is a webcast, returns are
inapplicable.  If the Company has difficulty in producing the webcast,
it may reduce the fee charged to the customer.  Historically these
reductions have been immaterial, and are recorded in the month the event
occurs.





Services
for live webcast events are usually sold for a single price that includes
on-demand webcasting services in which the Company hosts an archive of the
webcast event for future access on an on-demand basis for periods ranging from
one month to one year. However, on-demand webcasting services are sometimes sold
separately without the live event component and the Company has referred to
these separately billed transactions as verifiable and objective evidence of the
amount of its revenues related to on-demand services.  In addition,
the Company has determined that the material portion of all views of archived
webcasts take place within the first ten days after the live
webcast.





Based on
its review of the above data, the Company has determined that the material
portion of its revenues for on-demand webcasting services are recognized during
the period in which those services are provided, which complies with the
provisions of Staff Accounting Bulletin (“SAB”) 101 and SAB 104, “Revenue
Recognition”, and EITF 00-21, “Accounting for Revenue Arrangements with Multiple
Elements”. Furthermore, the Company has determined that the maximum potentially
deferrable revenue from on-demand webcasting services charged for but not
provided as of September 30, 2007 and 2008 is immaterial in relation to the
Company’s recorded liabilities.




F-12





ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE 1:
NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES (Continued)





The
Travel division of the Digital Media Services Group recognizes a portion of its
contract revenue at the time of completion of video production services with the
remaining revenue recognized over the term of the contract. Per hit charges are
recognized when users watch a video on the Internet.  Fixed monthly
fees are recognized on a monthly basis consistent with the terms of the
contract.  Commissions on bookings are recognized when the stays are
completed.





The
Company includes the DMSP and UGC divisions’ revenues, along with the Smart
Encoding division’s revenues from hosting, storage and streaming, in the DMSP
and hosting revenue caption. The Company includes the Travel division revenues,
the EDNet division’s revenues from equipment sales and rentals and the Smart
Encoding division’s revenues from encoding and editorial services in the Other
Revenue caption.





The DMSP,
UGC and Smart Encoding divisions of the Digital Media Services Group recognizes
revenues from the acquisition, editing, transcoding, indexing, storage and
distribution of its customers’ digital media. Charges to customers by the Smart
Encoding and UGC divisions are generally based on the activity or volumes of
such media, expressed in megabytes or similar terms, and are recognized at the
time the service is performed. Charges to customers by the DMSP division are
generally based on a monthly subscription fee, as well as charges for hosting,
storage and professional services. Fees charged to customers for customized
applications or set-up are recognized as revenue at the time the application or
set-up is completed.





The
Infinite Conferencing division of the Audio and Web Conferencing Services Group
generates revenues from audio conferencing and web conferencing services, plus
recording and other ancillary services.  Infinite owns telephone
switches used for audio conference calls by its customers, which are generally
charged for those calls based on a per-minute usage rate. Infinite provides
online webconferencing services to its customers, charging either a per-minute
rate or a monthly subscription fee allowing a certain level of usage. Audio
conferencing and web conferencing revenue is recognized based on the timing of
the customer’s use of those services.





The EDNet
division of the Audio and Web Conferencing Services Group generates revenues
from customer usage of digital telephone connections controlled by EDNet, as
well as bridging services and the sale of equipment.  EDNet purchases
digital phone lines from telephone companies and sells access to the lines, as
well as separate per-minute usage charges. Network usage and bridging revenue is
recognized based on the timing of the customer’s use of those
services.





EDNet
sells various audio codecs and video transport systems, equipment which enables
its customers to collaborate with other companies or with other
locations.  As such, revenue is recognized for the sale of equipment
when the equipment is installed or upon signing of a contract after the
equipment is installed and successfully operating.  All sales are
final and there are no refund rights or rights of return. EDNet leases some
equipment to customers under terms that are accounted for as operating
leases.  Rental revenue from leases is recognized ratably over the
life of the lease and the related equipment is depreciated over its estimated
useful life.  All leases of the related equipment contain fixed
terms.




F-13





ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE 1:
NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES (Continued)





Revenue
Recognition (Continued)





Deferred
revenue represents amounts billed to customers for webcasting, EDNet, smart
encoding or DMSP services to be provided in future accounting
periods.  As projects or events are completed and/or the services
provided, the revenue is recognized. The Company received $135,000 in
non-refundable smart encoding fees during the year ended September 30, 2006 that
were not included in the revenue reported for that period. Based on applicable
accounting literature, including SAB 104, “Revenue Recognition”, the Company
recognized this amount as revenue during the year ended September 30, 2007.
Deferred revenue included $50,000 at September 30, 2007, which in addition to
another $50,000 the Company received in November 2007 were payments received
from ASPA-Japan Co., Ltd. (“ASPA”) in connection with an exclusive sales agency
agreement which was terminated in January 2008. The Company recognized these
payments, net of $18,750 commissions paid to the former Auction Video
shareholders, as other income for the year ended September 30, 2008 – see note
5.





Comprehensive
Income or Loss





The
Company has no components of other comprehensive income or loss, and
accordingly, net loss equals comprehensive loss for all periods
presented.


Advertising
and marketing





Advertising
and marketing costs, which are charged to operations as incurred and included in
Other General and Administrative Operating Expenses, were approximately $554,000
and $340,000 for the years ended September 30, 2008 and 2007,
respectively.





Income
Taxes





As part
of the process of preparing our consolidated financial statements, the Company
is required to estimate its income taxes in each of the jurisdictions in which
it operates. This process involves estimating current tax exposure together with
assessing temporary differences resulting from differing treatment of items for
tax and accounting purposes. These differences result in deferred tax assets and
liabilities, which are included within the Company’s consolidated balance sheet.
The Company then assesses the likelihood that the deferred tax assets will be
recovered from future taxable income and to the extent it believes that recovery
is not likely, it establishes a valuation allowance. To the extent the Company
establishes a valuation allowance or changes this allowance in a period, it
includes an expense or a benefit within the tax provision in the Company’s
statement of operations.





The
Company has approximately $82.0 million in Federal net operating loss
carryforwards as of September 30, 2008, which expire in 2010 through
2028.  The utilization of approximately $16.0 million of the net
operating loss carryforward, acquired from the 2001 acquisition of EDNET and the
2002 acquisition of MOD and included in this total, against future taxable
income may be limited as a result of ownership changes and other
limitations.




F-14





ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE 1:
NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES (Continued)





Income
Taxes (Continued)





Significant
judgment is required in determining the Company’s provision for income taxes,
its deferred tax assets and liabilities and any valuation allowance recorded
against those deferred tax assets. The Company had a deferred tax asset of
approximately $30.9 million as of September 30, 2008, primarily resulting from
net operating loss carryforwards. A full valuation allowance has been recorded
related to the deferred tax asset due to the uncertainty of realizing the
benefits of certain net operating loss carryforwards before they expire.
Management will continue to assess the likelihood that the deferred tax asset
will be realizable and the valuation allowance will be adjusted
accordingly.





Accordingly,
no income tax benefit has been recorded in the accompanying consolidated
statement of operations as a result of the net tax losses for the years ended
September 30, 2008 and 2007, respectively.  The primary differences
between the net loss for book and tax purposes are the following items expensed
for book purposes but not deductible for tax purposes – amortization of loan
discount, amortization of customer lists, inventory and receivable reserves, and
expenses for stock options and shares issued in payment for consultant and
employee services but not exercised by the recipients, or in the case of shares,
not registered for or eligible for resale.





In June
2006, the FASB issued FASB Interpretation (“FIN”) No. 48 “Accounting for
Uncertainty in Income Taxes”, which clarifies SFAS 109, “Accounting for Income
Taxes” by prescribing a recognition threshold and measurement attribute for the
financial statement recognition and measurement of a tax position taken or
expected to be taken in a tax return. The Company adopted FIN 48 as of the
beginning of its fiscal year beginning October 1, 2007. However, as of the date
of such adoption and as of September 30, 2008, the Company has not taken, nor
recognized the financial statement impact of, any material tax positions, as
defined by FIN 48. The Company’s policy is to recognize as non-operating expense
interest or penalties related to income tax matters at the time such payments
become probable, although it had not recognized any such material items in its
statement of operations for the years ended September 30, 2008 or 2007. The tax
years ending September 30, 2005 and thereafter remain subject to examination by
Federal and various state tax jurisdictions.





The
Company has been assessed state income taxes, plus penalties and interest, for
the years ending September 30, 2004 and 2005, in an aggregate amount of
approximately $89,000. It has contested these assessments with the state taxing
authorities and believes the ultimate resolution will not have a material impact
on the Company’s financial position or results of operations - see note
5.





Net Loss
Per Share





For the
years ended September 30, 2008 and 2007, net loss per share is based on the net
loss divided by the weighted average number of shares of common stock
outstanding.  Since the effect of common stock equivalents was
anti-dilutive, all such equivalents were excluded from the calculation of
weighted average shares outstanding. The total outstanding options and warrants,
which have been excluded from the calculation of weighted average shares
outstanding, were 15,155,731 and 14,636,231 at September 30, 2008 and 2007,
respectively.
  F-15





ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE 1:
NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES (Continued)





Net Loss
Per Share (Continued)





In
addition, the potential dilutive effects of the following convertible securities
outstanding at September 30, 2008 have been excluded from the calculation of
weighted average shares outstanding: (i) 74,841 shares of Series A-10
Convertible Preferred Stock (“Series A-10”) which could potentially convert into
748,410 shares of ONSM common stock and (ii) $1,000,000 of convertible notes
which in aggregate could potentially convert into up to 1,250,000 shares of ONSM
common stock (excluding interest). The potential dilutive effects of the
following convertible securities previously outstanding at September 30, 2007
were excluded from the calculation of weighted average shares outstanding:
69,196 shares of Series A-10 which could have potentially converted into 691,960
shares of ONSM common stock.





Equity
Compensation to Employees and Consultants





The
Company has a stock based compensation plan for its employees (the “Plan”). In
December 2004, the FASB issued SFAS 123R,“Share-Based Payments”,
which requires all companies to measure compensation cost for all share-based
payments, including employee stock options, at fair value, which the Company
adopted as of October 1, 2006 (the required date) and first applied during the
year ended September 30, 2007, using the modified-prospective-transition method.
Under this method, compensation cost recognized for the years ended September
30, 2008 and 2007 includes compensation cost for all share-based payments
granted subsequent to September 30, 2006, based on the grant-date fair value
estimated in accordance with the provisions of SFAS 123(R). As of October 1,
2006, there were no outstanding share-based payments granted prior to that date,
but not yet vested. The fair value of each Plan option first expensed during the
year ended September 30, 2008 was estimated on the date of grant using the
Black-Scholes model with the following assumptions: expected volatility rates
from 77% to 81%, risk-free interest rates of 2.92% to 6.25%, expected dividends
of $0 and expected terms of 4 to 6.5 years, the full term of the related
options. For Plan options first expensed during the year ended September 30,
2007, the expected volatility rate was 81%, the risk-free interest rate was
6.25%, expected dividends were $0 and the expected term was 5
years.





The
Company has granted Non-Plan Options to consultants and other third parties.
These options have been accounted for under SFAS 123, under which the fair value
of the options at the time of their issuance is reflected in the Company’s
consolidated financial statements and expensed as professional fees at the time
the services contemplated by the options are provided to the Company. The fair
value of each Non-Plan option first expensed during the year ended September 30,
2008 was estimated on the date of grant using the Black-Scholes model with the
following assumptions: expected volatility rate of 79%, risk-free interest rate
of 6.25%, expected dividends of $0 and expected term of 4 years, the full term
of the related options. For Non-Plan options first expensed during the year
ended September 30, 2007, the expected volatility rates were from 56% to 112%%,
the risk-free interest rate was 6.25%, expected dividends were $0 and the
expected terms were 2 to 4 years.





See Note
8 for additional information related to all stock option issuances.




F-16




ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE 1:
NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES (Continued)





Compensation
and related expenses





Compensation
costs for employees considered to be direct labor are included as part of
webcasting and smart encoding costs of revenue. Certain compensation costs for
employees involved in development of software for internal use, as discussed
under Software above, are capitalized. Accounts payable and accrued liabilities
includes approximately $555,000 and $578,000 as of September 30, 2008 and 2007
respectively, related to salaries, commissions, taxes, vacation and other
benefits earned but not paid as of those dates.
 
 Employee
401(k) plan


The
Company’s 401(k) plan, the Onstream Media Corporation 401(k) Retirement Plan and
Trust (the “Plan”), is available to all full-time employees and provides them
with tax deferred salary reductions and alternative investment options (directly
solely by the employees).  Employees may contribute a portion of their
salary, subject to certain limitations, including an annual maximum established
by the Internal Revenue Code.  The Company matches employees’
contributions to the Plan, up to the first 8% of eligible compensation, at a 25%
rate.  The Company’s matching contribution was approximately $46,000
and $40,000 for the years ended September 30, 2008 and 2007, respectively. The
Company expensed approximately $41,000 and $40,000 in those fiscal years,
respectively, with the remaining amount of $5,000 in fiscal 2008 satisfied by
amounts previously funded by the Company and expensed but forfeited by
terminated employees. The Company’s contributions to the Plan vest over five
years, based on the employee’s initial date of service and without regard to the
date of the contribution. Therefore, the unvested portion of the Company’s
previous contributions was not material as of September 30, 2008.





Reclassifications


Certain
prior year amounts have been reclassified to conform to the current year
presentation, including revenue and cost of revenues classifications, property
and equipment classifications and segment revenue and operating income (loss)
classifications.





Effects
of Recent Accounting Pronouncements





In
September 2006, the FASB issued SFAS 157, "Fair Value Measurements". SFAS 157
does not expand the use of fair value measures in financial statements, but
standardizes its definition and guidance by defining fair value as used in
numerous accounting pronouncements, establishes a framework for measuring fair
value and expands disclosure related to the use of fair value measures. SFAS 157
will be effective for the Company’s fiscal year beginning October 1, 2008 and
the Company is currently evaluating the impact SFAS 157 may have on its
financial statements.


F-17


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE 1:
NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES (Continued)





Effects
of Recent Accounting Pronouncements (Continued)





In
February 2007, the FASB issued SFAS 159, "The Fair Value Option for
Financial Assets and Financial Liabilities". Under SFAS 159, the Company
may elect to report most financial instruments and certain other items at fair
value on an instrument-by-instrument basis with changes in fair value reported
in earnings. After the initial adoption, the election is made at the acquisition
of an eligible financial asset, financial liability, or firm commitment or when
certain specified reconsideration events occur. The fair value election may not
be revoked once an election is made. SFAS 159 will be effective for the
Company’s fiscal year beginning October 1, 2008 and the Company is currently
evaluating the impact SFAS 159 may have on its financial
statements.





In
December 2007, the FASB issued SFAS 141R, “Business Combinations”, which
establishes principles and requirements for how an acquirer recognizes and
measures in its financial statements the identifiable assets acquired, the
liabilities assumed, and any noncontrolling interest in an acquiree, including
the recognition and measurement of goodwill acquired in a business
combination.  The requirements of SFAS 141R will be effective for
the Company’s fiscal year beginning October 1, 2009 and early adoption is
prohibited. The Company is currently evaluating the impact SFAS 141R may
have on its financial statements.





In April
2008, the FASB issued FSP No. FAS 142-3, “Determination of the Useful Life of
Intangible Assets”, which amends the factors that should be considered in
developing renewal or extension assumptions used to determine the useful life of
a recognized intangible asset under SFAS No. 142, “Goodwill and Other
Intangible Assets”. The objective of FSP No. 142-3 is to improve the
consistency between the useful life of a recognized intangible asset under SFAS
No. 142 and the period of expected cash flows used to measure the fair
value of the asset under SFAS No. 141 “Business Combinations” and other
U.S. GAAP. FSP No. 142-3 shall be effective for the Company’s fiscal year
beginning October 1, 2009 and early adoption is prohibited. FSP No. 142-3
applies to all intangible assets, whether acquired in a business combination or
otherwise, and should be applied prospectively to intangible assets acquired
after the effective date. The Company is currently evaluating the impact FSP
No. 142-3 may have on its financial statements.





In May
2008, the FASB issued FASB Staff Position (“FSP”) APB 14-1, “Accounting for
Convertible Debt Instruments That May Be Settled in Cash upon Conversion
(Including Partial Cash Settlement”. Among other items, FSP APB 14-1 specifies
that issuers of convertible debt instruments that may be settled in cash upon
conversion (including partial cash settlement) should separately account for the
liability and equity components in a manner that will reflect the entity’s
nonconvertible debt borrowing rate when interest cost is recognized in
subsequent periods. The requirements of FSP APB 14-1 will be effective for the
Company’s fiscal year beginning October 1, 2009, including interim periods
within that fiscal year. The Company is currently evaluating the impact FSP
APB 14-1 may have on its financial statements.





In May
2008, the FASB issued SFAS 162, "The Hierarchy of Generally Accepted Accounting
Principles". Under SFAS 162, the Generally Accepted Accounting Principles (GAAP)
hierarchy will now reside in the accounting literature established by the FASB.
SFAS 162 identifies the sources of accounting principles and the framework for
selecting the principles used in the preparation of financial statements in
conformity with GAAP. SFAS 162 is effective 60 days following the SEC's approval
of the Public Company Accounting Oversight Board Auditing amendments to AU
Section 411, "The Meaning of Present Fairly in Conformity with Generally
Accepted Accounting Principles." The Company believes that the adoption of this
standard on its effective date will not have a material effect on its
consolidated financial statements.


F-18


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE 2:
GOODWILL AND OTHER ACQUISITION-RELATED INTANGIBLE ASSETS





Information
regarding the Company’s goodwill and other acquisition-related intangible assets
is as follows:





September 30,
      2008
              
              
              September
      30, 2007Gross
                Carrying
                Amount
              
              
              Accumulated
                Amortization
              
              
              Net
      Book
                Value
              
              
              Gross
                Carrying
                Amount
              
              
              Accumulated
                Amortization
              
              
              Net
      Book
                ValueGoodwill:Infinite
      Conferencing
              
              $
              12,000,887
              
              
              $
              -
              
              
              $
              12,000,887
              
              
              $
              12,000,887
              
              
              $
              -
              
              
              $
              12,000,887Acquired
      Onstream
              
              
              8,421,401
              
              
              
              -
              
              
              
              8,421,401
              
              
              
              8,421,401
              
              
              
              -
              
              
              
              8,421,401EDNet
              
              
              1,271,444
              
              
              
              -
              
              
              
              1,271,444
              
              
              
              1,271,444
              
              
              
              -
              
              
              
              1,271,444Auction
      Video
              
              
              3,216
              
              
              
              -
              
              
              
              3,216
              
              
              
              3,216
              
              
              
              -
              
              
              
              3,216Total
      goodwill
              
              
              21,696,948
              
              
              
              -
              
              
              
              21,696,948
              
              
              
              21,696,948
              
              
              
              -
              
              
              
              21,696,948Acquisition-related
      intangible assets:Infinite  Conferencing  -
                customer
      lists,  trademarks,
                URLs,
      supplier terms and
                consulting/non-
      competes
              
              
              4,583,604
              
              
              
              ( 1,275,000
              )
              
              
              3,308,604
              
              
              
              4,583,604
              
              
              
              ( 375,000
              )
              
              
              4,208,604Auction
      Video - customer
                lists,
      patent pending  and
                consulting/non-
      competes
              
              
              1,174,827
              
              
              
              ( 751,845
              )
              
              
              422,982
              
              
              
              1,150,000
              
              
              
              ( 250,000
              )
              
              
              900,000Total
      intangible assets
              
              
              5,758,431
              
              
              
              ( 2,026,845
              )
              
              
              3,731,586
              
              
              
              5,733,604
              
              
              
              ( 625,000
              )
              
              
              5,108,604Total
      goodwill and other acquisition-related intangible assets
              
              $
              27,455,379
              
              
              $
              (2,026,845
              )
              
              $
              25,428,534
              
              
              $
              27,430,552
              
              
              $
              ( 625,000
              )
              
              $
              26,805,552





Infinite Conferencing –
April 27, 2007





On April
27, 2007 the Company completed the acquisition of Infinite Conferencing LLC
(“Infinite”), a Georgia limited liability company. The transaction, by which the
Company acquired 100% of the membership interests of Infinite, was structured as
a merger by and between Infinite and the Company’s wholly-owned subsidiary,
Infinite Conferencing, Inc. (the “Infinite Merger”). The primary assets
acquired, in addition to Infinite’s ongoing audio and web conferencing business
operations, were accounts receivable, equipment, internally developed software,
customer lists, trademarks, URLs (internet domain names), favorable supplier
terms and employment and non-compete agreements. The operations of Infinite are
part of the Audio and Web Conferencing Services Group.





The
consideration for the Infinite Merger was a combination of $14 million in cash
and 1,376,622 shares of Onstream Media restricted common stock (valued at
approximately $4.0 million, or $2.906 per share), for an aggregate purchase
price of approximately $18 million, before transaction costs. Onstream arranged
a private equity financing for net proceeds totaling approximately $10.2
million, to partially fund the cash portion of the
transaction.


F-19


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE 2:
GOODWILL AND OTHER ACQUISITION-RELATED INTANGIBLE ASSETS
(Continued)





Infinite Conferencing –
April 27, 2007 (Continued)





The use
of $2.906 per share, the average share price for the thirty days prior to the
announcement of the definite merger agreement, to value the portion of the
purchase price paid in shares, was in accordance with the merger agreement.
However, EITF No. 99-12 indicates that securities given in a business
combination should be measured during a period only up to "a few days before and
after” the measurement date. In cases where there is a formula, the measurement
date is when the number of shares first becomes fixed, which in this case was
March 26, 2007, when the March 23, 2007 signing of the definitive merger
agreement was publicly announced. The ONSM market price was $2.73 per share on
March 21, 2007, $2.78 per share on March 26, 2007 and $2.64 per share on March
27, 2007. Although the $2.906 price used to value the shares was outside the
high end of the range indicated by these prices, the Company’s management
believes that it was not materially different (particularly when considering
that the equity portion was only approximately 22% of the total purchase price)
and so is acceptable as reasonably indicative of fair value as of the date of
the Infinite Merger.





At the
closing of the Infinite Merger, the Company entered into a lock-up agreement
with the former Infinite shareholders that limits the number of shares that they
may sell, to 25% per quarter and/or weekly sales of 30,000 shares, commencing
with the June 15, 2007 registration of such shares with the SEC and which
percentage and weekly limitation may be increased at our option. The lock-up
agreement also provides that in the event that the accumulated gross proceeds of
the sale of first 50% of the 1,376,622 shares issued to them is less than $2.0
million, the Company, at its sole option but provided that all securities to be
issued in connection with the merger agreement and any related financing or
other transactions do not exceed 19.99% of ONSM outstanding common stock at the
measurement date, would pay the difference in registrable ONSM common shares, or
cash to the extent required by the 19.99% restriction. On December 27, 2007, the
former Infinite shareholders notified the Company that the first 688,311 shares
had been sold by them for $1,041,601, which would require an additional payment
by the Company in cash or shares of approximately $958,399. In accordance with
SFAS 141, contingent consideration should only be recorded once the contingency
is resolved and the additional consideration is issued or becomes issuable. The
Company concluded that these conditions were substantively met as of December
31, 2007, and accordingly recorded the liability on its financial statements as
of that date, which was offset by a reduction in additional paid in capital.
Furthermore, on March 12, 2008, the Company executed collateralized promissory
notes payable to the former Infinite shareholders in final settlement of this
obligation – see note 4.





In
connection with the merger agreement, the Company entered into two employment
contracts and one consulting contract with three key Infinite executives. The
employment contracts include five-year option grants for the purchase of up to
200,000 common shares with an exercise price of $2.50 per share (fair market
value at the date of closing) and vesting over two years – see Note 8. As a
result of the April 2008 expiration and non-renewal of one of the employment
contracts, 50,000 of these options were forfeited. The employment and consulting
contracts contain non-compete provisions with a minimum term of three years from
the merger closing.


F-20


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE 2:
GOODWILL AND OTHER ACQUISITION-RELATED INTANGIBLE ASSETS
(Continued)





Infinite Conferencing –
April 27, 2007 (Continued)


The
summarized balance sheet of Infinite as of the April 27, 2007 closing of the
Infinite Merger is as follows, showing the fair values assigned by the Company
to Infinite’s assets and liabilities in accordance with SFAS 141 and recorded by
the Company at that time.





Accounts receivable
                  
                  $
                  893,228Property
      and equipment
                  
                  
                  894,388Other
      tangible assets (includes $14,861 cash)
                  
                  
                  48,817Identifiable
      intangible assets
                  
                  
                  4,583,604Total
      assets
                  
                  $
                  6,420,037Accounts
      payable and accrued liabilities
                  
                  $
                  204,395Shareholder’s equity
                  
                  
                  6,215,642Total
      liabilities and shareholder’s equity
                  
                  $
                  6,420,037





Infinite’s
accounts receivable, net of reserves, were considered to be reasonably
collectible and were generally due within thirty days of the closing of the
Infinite Merger and therefore their book carrying value as of the date of
acquisition was considered to be a reasonable estimate of their fair
value.





Infinite’s
management estimated the fair value of their property and equipment, primarily
phone switch equipment and related internally developed billing and management
reporting software, based on information regarding third-party sales of similar
equipment and the estimated cost to recreate the customized
software.  The Company is amortizing these assets over useful lives
ranging from 3 to 5 years.





The fair
value of certain intangible assets (internally developed software, customer
lists, trademarks, URLs (internet domain names), favorable contractual terms and
employment and non-compete agreements) acquired as part of the Infinite Merger
was determined by Company management at the time of the merger. This fair value
was primarily based on the discounted projected cash flows related to these
assets for the next three to six years immediately following the merger, as
projected by the Company’s and Infinite’s management on a stand-alone basis
without regard to the Infinite Merger. The discount rate utilized considered
equity risk factors (including small stock risk) as well as risks associated
with profitability and working capital, competition, and intellectual property.
The projections were adjusted for charges related to fixed assets, working
capital and workforce retraining. The Company is amortizing these assets over
useful lives ranging from 3 to 6 years.





Infinite’s
accounts payable and accrued liabilities were generally due within thirty days
of the closing of the Infinite Merger and therefore their book carrying value as
of the date of acquisition was considered to be a reasonable estimate of their
fair value.


F-21


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE 2:
GOODWILL AND OTHER ACQUISITION-RELATED INTANGIBLE ASSETS
(Continued)





Infinite Conferencing –
April 27, 2007 (Continued)





The
Company purchased Infinite for $18,216,529 in cash and stock. In conjunction
with the acquisition, liabilities were assumed as follows:





Identifiable
      tangible and intangible assets
                  
                  $
                  6,420,037Goodwill
                  
                  
                  12,000,887Acquired
      assets (at fair value)
                  
                  
                  18,420,924Less:
      Cash paid for non-cash assets
                  
                  
                  (14,201,668
                  )Less:
      Cash acquired for cash
                  
                  
                  (14,861
                  )Less:
      Shares issued for non-cash assets
                  
                  
                  ( 4,000,000
                  )Assumed
      liabilities
                  
                  $
                  204,395





The
$12,000,887 excess included in the $18,216,529 paid by the Company for 100% of
Infinite over $6,215,642 (the fair values assigned to the tangible and
intangible assets, net of liabilities at fair value) was recorded by the Company
as goodwill, subject to regular future valuations and adjustments as required by
SFAS 142. The other intangible assets are being amortized to expense over their
estimated useful lives, although the unamortized balances are still subject to
review and adjustment for impairment. Annual reviews for impairment in future
periods may result in future periodic write-downs.  Tests for
impairment between annual tests may be required if events occur or circumstances
change that would more likely than not reduce the fair value of the net carrying
amount.





The
following table sets forth the unaudited pro-forma consolidated results of
operations for the year ended September 30, 2007, giving effect to the Infinite
Merger as if the acquisition had occurred as of the beginning of the
period:





Revenues
                  
                  $
                  16,121,548Net
      loss
                  
                  $
                  (13,910,074
                  )Net
      loss per share
                  
                  $
                  (0.40
                  )




The above
pro-forma net loss per share is based on a weighted average number of shares of
common stock which includes (i) the shares issued in connection with the
Infinite Merger, (ii) the shares issued for approximately $10.2 million net
proceeds in the private equity financing discussed above, since that financing
was integral to and directly associated with the Infinite Merger and (iii)
shares issued as a result of the exercise of options and warrants, to the extent
necessary to fund the portion of the Infinite purchase price not satisfied by
the first two items.  Since the effect of common stock equivalents was
anti-dilutive, all such equivalents are excluded from the calculation of the pro
forma weighted average number of shares and the pro forma net loss per
share.


F-22


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE 2:
GOODWILL AND OTHER ACQUISITION-RELATED INTANGIBLE ASSETS
(Continued)





Auction Video – March 27,
2007





On March
27, 2007 the Company completed the acquisition of the assets, technology and
patents pending of privately owned Auction Video, Inc., a Utah corporation, and
Auction Video Japan, Inc., a Tokyo-Japan corporation (collectively, “Auction
Video”). The Auction Video, Inc. transaction was structured as a purchase of
assets and the assumption of certain identified liabilities by the Company’s
wholly-owned U.S. subsidiary, AV Acquisition, Inc. The Auction Video Japan, Inc.
transaction was structured as a purchase of 100% of the issued and outstanding
capital stock of Auction Video Japan, Inc. The acquisitions were made with a
combination of 467,290 shares of restricted ONSM common stock (valued at
approximately $1.5 million, or $3.21 per share) issued to the stockholders of
Auction Video Japan, Inc. and $500,000 cash paid to certain stockholders and
creditors of Auction Video, Inc., for an aggregate purchase price of
approximately $2.0 million, before transaction costs.  The Company has
determined that these transactions do not meet the requirements established by
the Securities and Exchange Commission for a “significant acquisition”, and
therefore no pro-forma or other financial information related to the periods
prior to the acquisition is being presented. The operations of Auction Video are
part of the Digital Media Services Group.





On
December 5, 2008 the Company entered into an agreement whereby one of the former
owners of Auction Video Japan, Inc. agreed to shut down the Japan office of
Auction Video as well as assume all of the Company’s outstanding assets and
liabilities connected with that operation -  see Note 10.





The
Company allocated $2,046,996 of the Auction Video purchase price to the
identifiable tangible and intangible assets acquired, based on a determination
of their reasonable fair value as of the date of the acquisition. $600,000 was
assigned as the value of the video ingestion and flash transcoder, which was
already integrated into the Company’s DMSP as of the date of the acquisition and
was added to that asset’s carrying cost for financial statement
purposes,  with depreciation over a three-year life commencing April
2007 – see Note 3. Future cost savings for Auction Video services to be provided
to Onstream Media customers existing prior to the acquisition were valued at
$250,000 and are reflected in other current and non-current assets as of
September 30, 2007 and in other current assets as of September 30, 2008, being
amortized to cost of sales over a two-year period commencing April 2007. The
technology and patent pending related to the video ingestion and flash
transcoder, the Auction Video customer lists and the consulting and non-compete
agreements entered into with the former executives and owners of Auction Video
were valued in aggregate at $1,150,000 and are being amortized over various
lives between two to five years commencing April 2007. Other tangible assets
acquired were valued at $46,996.





The
Company purchased Auction Video for $2,023,963 in cash and stock. In conjunction
with the acquisition, liabilities were assumed as follows:





Identifiable
      tangible and intangible assets
                  
                  $
                  2,046,996Goodwill
                  
                  
                  3,216Acquired
      assets (at fair value)
                  
                  
                  2,050,212Less:
      Cash paid for non-cash assets
                  
                  
                  (
      523,066
                  )Less:
      Cash acquired for cash
                  
                  
                  (897
                  )Less:
      Shares issued for non-cash assets
                  
                  
                  ( 1,500,000
                  )Assumed
      liabilities
                  
                  $
                  26,249


F-23


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE 2:
GOODWILL AND OTHER ACQUISITION-RELATED INTANGIBLE ASSETS
(Continued)





Auction Video – March 27,
2007 (Continued)





In
connection with the acquisition, the Company entered into three consulting
contracts with three key Auction Video employees, two of which expired as of
February 28, 2008. Starting with such expiration to date, the Company has
continued paying one of these two employees on a month to month basis. The third
such contract included a two-year option grant to one of the consultants for the
purchase of up to 35,000 common shares with an exercise price of $2.98 per share
(fair market value at the date of closing) and vesting over two years – see Note
8. The consulting contracts contain non-compete provisions with a minimum term
of two years from the acquisition closing.





Acquired Onstream – December
23, 2004





On
October 22, 2003 the Company executed an agreement and plan of merger agreement
with privately held Onstream Media Corporation (“Acquired Onstream”) to acquire
the remaining 74% of Acquired Onstream not already owned by the Company. On
December 23, 2004, after approval by a majority of the Company’s shareholders in
a duly constituted meeting, Acquired Onstream was merged with and into OSM
Acquisition Inc., a Delaware corporation and the Company’s wholly owned
subsidiary (the “Onstream Merger”). At that time, all outstanding shares of
Acquired Onstream capital stock and options not already owned by the Company
were converted into 2,207,966 shares of the ONSM restricted common stock and
463,554 options and warrants to purchase ONSM common stock at an exercise price
of $3.376 per share. The Company also issued common stock options to directors
and management as additional compensation at the time of and for the Onstream
Merger, which was accounted for in accordance with APB 25.





Acquired
Onstream was a development stage company founded in 2001 that began the
development of a feature rich digital asset management service, offered on an
application service provider (“ASP”) basis, to allow corporations to better
manage their digital rich media without the major capital expense for the
hardware, software and additional staff necessary to build their own digital
asset management solution. This new product (the “Digital Media Services
Platform” or “DMSP”) was initially designed and managed by Science Applications
International Corporation (“SAIC”), one of the country's foremost IT security
firms, providing services to all branches of the federal government as well as
leading corporations.





The
summarized balance sheet of Acquired Onstream as of the December 23, 2004
Onstream Merger is as follows, showing the fair values assigned by the Company
to Acquired Onstream’s assets and liabilities in accordance with SFAS 141 and
recorded by the Company at that time.





Cash
      and other current assets
                  
                  $
                  36,059Property
      and equipment
                  
                  
                  2,667,417Total
      assets
                  
                  $
                  2,703,476Accounts
      payable and accrued liabilities
                  
                  $
                  814,739Notes
      payable and capitalized lease
                  
                  
                  335,179Total
      liabilities
                  
                  
                  1,149,918Shareholder’s
      equity
                  
                  
                  1,553,558Total
      liabilities and shareholder’s equity
                  
                  $
                  2,703,476


F-24


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE 2:
GOODWILL AND OTHER ACQUISITION-RELATED INTANGIBLE ASSETS
(Continued)


Acquired Onstream – December
23, 2004 (Continued)


Property
and equipment in the above table represents the partially (at the time)
completed DMSP, primarily Acquired Onstream’s payments to its vendors SAIC,
Virage, North Plains and Nine Systems. This was the primary asset included in
the purchase of Acquired Onstream, and was recorded at fair value as of the
December 23, 2004 closing, in accordance with SFAS 141 – see Note 3. The fair
value was primarily based on the discounted projected cash flows related to this
asset for the next five years immediately following the acquisition, as
projected at the time of the acquisition by the Company’s and Acquired
Onstream’s management on a stand-alone basis without regard to the Onstream
Merger. The discount rate utilized considered equity risk factors (including
small stock risk and bridge/IPO stage risk) as well as risks associated with
profitability and working capital, competition, and intellectual property. The
projections were adjusted for charges related to fixed assets, working capital
and workforce retraining.





The
$8,421,401 excess included in the $9,974,959 paid by the Company for 100% of
Acquired Onstream over $1,553,558 (the fair values assigned to the tangible and
intangible assets, net of liabilities at fair value) was recorded by the Company
as goodwill, subject to regular future valuations and adjustments as required by
SFAS 142.


SFAS 142,
Goodwill and Other Intangible Assets, which addresses the financial accounting
and reporting standards for goodwill and other intangible assets subsequent to
their acquisition, requires that goodwill be tested for impairment on a periodic
basis. The Company performed impairment tests on Acquired Onstream as of
December 31, 2007 and on Infinite Conferencing as of April 27,
2008.  The Company assessed the fair value of the net assets of these
reporting units by considering the projected cash flows and by analysis of
comparable companies, including such factors as the relationship of the
comparable companies’ revenues to their respective market
values.  Based on these factors, the Company concluded that (i) there
was no impairment of Acquired Onstream’s net assets (which include the DMSP) as
of December 31, 2007 and (ii) there was no impairment of Infinite Conferencing’s
net assets as of April 27, 2008.





SFAS 142
allows the carryforward of a previous detail valuation, provided certain
criteria are met, including no significant changes in assets and liabilities of
the reporting unit since the previous valuation, a substantial margin between
the previous valuation and the carrying value at the time and a determination
that a current year impairment would be remote based on an analysis of past
events and changes in circumstances since the previous valuation. The Company
determined that these criteria were met as of September 30, 2008 and 2007 and
based on this, as well as its internal valuation calculations and review for
impairment performed on a basis consistent with the September 30, 2006 detail
valuation, determined that an independent valuation of EDNet’s unamortized
goodwill was not necessary, and that no impairment existed, as of September 30,
2008 and 2007.


F-25


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE 2:
GOODWILL AND OTHER ACQUISITION-RELATED INTANGIBLE ASSETS
(Continued)





The
valuations of EDNet, Acquired Onstream and Infinite Conferencing incorporate
management’s estimates of future sales and operating income, which estimates in
the case of Acquired Onstream are dependent on a product (the DMSP) from which
significant sales increases may be required to support that
valuation.





The
Company is required to perform reviews for impairment in future periods, at
least annually, that may result in future periodic write-downs.  Tests
for impairment between annual tests may be required if events occur or
circumstances change that would more likely than not reduce the fair value of
the net carrying amount.





NOTE
3:  PROPERTY AND EQUIPMENT





Property
and equipment, including equipment acquired under capital leases, consists
of:





September
      30,
              
              
              September
      30,
              
              
              Useful
      Lives2008
              
              
              2007
              
              
              (Years)Equipment
      and software
              
              $
              10,096,433
              
              
              $
              9,466,448
              
              
              
              1-5DMSP
              
              
              5,256,575
              
              
              
              4,784,875
              
              
              
              3-5Travel
      video library
              
              
              1,368,112
              
              
              
              1,368,112
              
              
              
              2Capitalized
      internal use software
              
              
              771,485
              
              
              
              558,485
              
              
              
              3-5Furniture,
      fixtures and leasehold improvements
              
              
              475,857
              
              
              
              475,857
              
              
              
              2-717,968,462
              
              
              
              16,653,777Less:
      Accumulated depreciation and amortization
              
              
              (13,911,692
              )
              
              
              (11,102,751
              )Net
      book value
              
              $
              4,056,770
              
              
              $
              5,551,026





Depreciation
and amortization expense for property and equipment was approximately $2,816,000
and $2,285,000 for the years ended September 30, 2008 and 2007, respectively.
The travel video library was fully depreciated as of September 30, 2008 and
furniture, fixtures and leasehold improvements represented an aggregate of
$51,000 remaining net book value as of that date.





The DMSP
is comprised of four separate “products”, only two of which were available on an
individual basis at the time of the December 2004 Onstream Merger – see Note 2.
The four separate products are transcoding, storage, search and retrieval and
distribution. A limited version of the DMSP, which included three of the four
products, was first placed in service with third-party customers in November
2005, at which time depreciation of 75% (for three of the four products in
service, based on guidance in SFAS 86, “Accounting for the Costs of Computer
Software to be Sold, Leased or Otherwise Marketed”) of the DMSP’s carrying cost
began and continued until the fourth product was placed in service during
October 2006, at which time the Company began to depreciate 100% of the DMSP’s
carrying cost.  This initial version of the DMSP offered by the
Company for sale to the general public since October 2006 is known as the “Store
and Stream” version. In connection with the development of a second version of
the DMSP with additional functionality and known as “Streaming Publisher”, the
Company has capitalized as part of the DMSP’s carrying cost approximately
$146,000 of employee compensation and related costs during the year ended
September 30, 2008.


F-26


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE
3:  PROPERTY AND EQUIPMENT (Continued)





On March
27, 2007 the Company completed the acquisition of Auction Video – see Note 2.
The assets acquired included a video ingestion and flash transcoder, which was
already integrated into the Company’s DMSP as of the date of the acquisition.
Based on the Company’s determination of the fair value of that transcoder at the
date of the acquisition, $600,000 was added to the DMSP’s carrying cost as
reflected above, which additional cost is being depreciated over a three-year
life commencing April 2007.





On March
31, 2008 the Company agreed to pay $300,000 for a perpetual license for certain
digital asset management software, which it currently utilizes to provide its
automatic meta-tagging services, in addition to and in accordance with a limited
term license that it purchased in 2007 for $281,250 - see Note 5 for additional
terms of this license. Although the Company continues to use this software to
provide its automatic meta-tagging services, the Company recently expanded its
use of this software in providing its core DMSP services.
Therefore,  the Company recorded a portion of this 2008 purchase, as
well as a portion of the remaining unamortized amount of the 2007 purchase, as
an aggregate $243,750 increase in the DMSP’s carrying cost as reflected above,
which additional cost is being depreciated over a five-year life commencing
April 2008.





The net
book value of the DMSP was approximately $1.4 million as of September 30,
2008.





As part
of the Onstream Merger, the Company became obligated under a Basic Ordering
Agreement for Professional Solutions ("BOA") with SAIC, under which SAIC would
build an outsourced solution for customers allowing for management and use of
digital rich media and offering flexible applications, including collaboration
and re-purposing (the “DMSP”). SAIC agreed (i) to design the DMSP to allow for
the addition and customization of applications to fit the specific needs of
customers, (ii) to provide certain hosting and back-office services directly to
the Company and in support of the Company’s customers and (iii) to bill its
services under the BOA at a discount to its regular rates throughout the term of
the BOA. The original term of the BOA ran from June 12, 2003 through December
31, 2006. As part of a November 2006 agreement between the Company and SAIC, all
previous contractual extension options were rescinded in exchange for a single
18-month extension and the contract terminated on June 30, 2008. Cancellation of
the contract among other things releases SAIC to offer the Onstream Media
Solution directly or indirectly to third parties, which right Onstream’s
management does not expect to result in a material adverse impact on future DMSP
sales.




Capitalized
internal use software includes approximately $213,000 of employee compensation
and related costs capitalized during the year ended September 30, 2008 and
related to the development of iEncode webcasting software.


F-27


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE 4:
CONVERTIBLE DEBENTURES AND NOTES PAYABLE





Convertible
Debentures





In
December 2007, the Company entered into an equipment financing line of credit
arrangement with several individuals under which it could borrow up to an
aggregate of $1.5 million for equipment purchases, including purchases made and
paid for by the Company during the twelve (12) months prior to the date of the
agreement. As of April 3, 2008, the Company had not drawn any funds under this
arrangement and accordingly the Company notified the individuals that it was
canceling the line of credit arrangement as of that date so that it might put
together an alternative financing structure for the same purpose.





During
the period from June 3, 2008 through July 8, 2008 the Company received an
aggregate of $1.0 million from seven accredited individuals and other entities
(the “Lenders”), under a software and equipment financing arrangement. The
Company issued Notes to those Lenders, which are collateralized by specifically
designated software and equipment owned by the Company with a cost basis of
approximately $1.5 million, as well as a subordinated lien on certain other
Company assets to the extent that the designated software and equipment, or
other software and equipment added to the collateral at a later date, is not
considered sufficient security for the loan. Under this arrangement, the Lenders
received 10,000 restricted ONSM common shares for each $100,000 lent to the
Company, and will also receive interest at 12% per annum. Interest is payable
every 6 months in cash or, at the Company’s option, in restricted ONSM common
shares, based on a conversion price equal to seventy-five percent (75%) of the
average ONSM closing price for the thirty (30) trading days prior to the date
the applicable payment is due. The first interest payment date was October 31,
2008 – see Note 10 – Subsequent Events.





The
Company may prepay the Notes, which have a three (3) year maturity date, at any
time upon ten (10) days' prior written notice to the Lenders during which time
the Lender may choose to convert the Note.  In the event of such
repayment, all interest accrued and due for the remaining unexpired loan period
is due and payable and may be paid in cash or restricted ONSM common shares in
accordance with the above formula.





The
outstanding principal is due on demand in the event a payment default is uncured
ten (10) business days after written notice. Lenders holding in excess of 50% of
the outstanding principal amount of the Notes may declare a default and may take
steps to amend or otherwise modify the terms of the Notes and related security
agreement.





The Notes
may be converted to restricted ONSM common shares at any time six (6) months
after issuance and prior to their three (3) year maturity date, at the Lender’s
option, based on a conversion price equal to seventy-five percent (75%) of the
average ONSM closing price for the thirty (30) trading days prior to the date of
conversion, but in no event may the conversion price be less than $0.80 per
share. In the event the Notes are converted prior to maturity, interest on the
Notes for the remaining unexpired loan period will be due and payable in
additional restricted ONSM common shares in accordance with the same formula.
Notwithstanding the above, the Company has the right in its sole discretion to
allow the Lender to convert the Note into restricted ONSM common shares during
the first six months after issuance for any reason.


F-28


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE 4:
CONVERTIBLE DEBENTURES AND NOTES PAYABLE (Continued)





Convertible
Debentures (Continued)





Fees were
paid to placement agents and finders for their services in connection with the
Notes in aggregate of 101,250 restricted ONSM common shares and $31,500 paid in
cash. The 101,250 shares plus the 100,000 shares issued to the investors
discussed above had a fair market value of approximately $186,513. The value of
these 201,250 shares, plus the $31,500 cash fees and $9,160 paid for legal fees
and other issuance costs related to the Notes, were reflected as a $227,173
discount against the Notes and are being amortized as interest expense over the
three year term of the Notes. The effective interest rate of the Notes is
approximately 19.5% per annum, excluding the potential effect of a premium to
market prices if payment is made in common shares instead of cash.





Although
the minimum conversion price was established in the Notes at $0.80 per ONSM
share, the quoted market price was approximately $0.93 per ONSM share at the
time the material portion of the proceeds ($950,000 out of $1 million total)
were received by the Company (including releases of funds previously placed in
escrow) and the related Notes were issued (June 3-5, 2008). However, the quoted
market price per ONSM share was $0.81 on April 30, 2008, $0.84 on May 20, 2008
and back to $0.80 by June 27, 2008, less than one month after the issuance of
the related Notes. Therefore, the Company has determined that the $0.80 per
share conversion price in the Notes was materially equivalent to fair value at
the date of issuance, which was the intent of all parties when the deal was
originally discussed between them in late April and early May 2008. Accordingly,
the Company determined that there was not a beneficial conversion feature
included in the Notes and did not record additional discount in that
respect.





Notes
Payable





Notes
payable consist of the following as of September 30, 2008 and 2007:





September 30,
                  2008
              
              
              September 30,
                  2007Note
      payable to a financial institution, collateralized by
      accounts    receivable, interest at prime plus 8%
      (prime plus 11% from December 2008), payable monthly.  Revolving
      line of credit expiring December 2009.
              
              $
              1,200,000
              
              
              $
              -Notes
      payable to former Infinite shareholders, collateralized by subordinated
      liens on all assets other than accounts receivable, principal payable in
      monthly installments through July 2009, interest at 12% per annum payable
      at maturity
              
              
              458,399
              
              
              
              -Capitalized
      software and equipment leases
              
              
              248,809
              
              
              
              393,958Total
      notes payable
              
              
              1,907,208
              
              
              
              393,958Less:
      discount on notes payable
              
              
              (23,793
              )
              
              
              -Notes
      payable, net of discount
              
              
              1,883,415
              
              
              
              393,958Less:
      current portion, net of discount
              
              
              ( 1,774,264
              )
              
              
              ( 138,629
              )Long
      term notes payable, net of current portion
              
              $
              109,151
              
              
              $
              255,329


F-29


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE 4:
CONVERTIBLE DEBENTURES AND NOTES PAYABLE (Continued)


In
December 2007, the Company entered into a line of credit arrangement with a
financial institution under which it could borrow up to an aggregate of $1.0
million for working capital, collateralized by its accounts receivable. In
August 2008 the maximum allowable borrowing amount was increased to $1.6 million
and the Company has received $1.2 million funding under this arrangement as of
September 30, 2008 and $1.55 million funding under this arrangement as of
December 5, 2008. The outstanding balance bears interest at prime plus 8% per
annum (prime plus 11% from December 2, 2008), payable monthly in arrears. The
Company paid initial origination and commitment fees aggregating $20,015 and a
commitment fee of $10,000 will be due for the second and any subsequent year. In
August 2008, the Company paid an additional commitment fee of $6,000 related to
the increase in the lending limit and a commitment fee of $6,000 will be due one
year thereafter. The outstanding principal may be repaid at any time, but no
later than two (2) years after the date of the agreement, which term may be
extended by the Company for an extra year, subject to compliance with all loan
terms, including no material adverse change. The outstanding principal is due on
demand in the event a payment default is uncured five (5) days after written
notice. The loan is also subject to the Company maintaining an adequate level of
receivables, based on certain formulas, as well as its compliance with debt
service coverage and minimum tangible net worth covenants. The Company received
waivers from the lender with respect to lack of compliance with the tangible net
worth covenant as of March 31, 2008, with respect to the tangible net worth and
debt service to cash flow covenants as of June 30, 2008 and for the quarter then
ended, and with respect to the tangible net worth and debt service to cash flow
covenants as of September 30, 2008 and for the quarter then ended. Mr. Leon
Nowalsky, a member of the Company’s Board of Directors, is also a founder and
board member of the lender.





At the
time of the April 27, 2007 Infinite Merger (see note 2), the Company entered
into a lock-up agreement with the former Infinite shareholders (the "Infinite
Shareholders") that provided that in the event the accumulated gross proceeds of
the sale of certain shares issued to them in connection with that merger were
less than a contractually defined amount, the Company would pay the
difference.  On December 27, 2007, the Infinite Shareholders notified
the Company that those shares had been sold by them for proceeds which under the
lock-up agreement would require the Company to pay an additional $958,399. The
Company recorded this amount as a liability as of December 31, 2007, which was
offset by a reduction in additional paid in capital and on February 14, 2008,
the Company paid $100,000 against this obligation.


F-30


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE 4:
CONVERTIBLE DEBENTURES AND NOTES PAYABLE (Continued)





On March
12, 2008, the Company executed promissory notes (the “Infinite Notes”) payable
to the Infinite Shareholders for the remaining aggregate balance due of $858,399
plus interest accruing at 12% per annum on the outstanding balance from February
15, 2008 until the July 10, 2009 maturity. Note payments of (i) $100,000 (one
hundred thousand dollars) were paid on March 15, 2008 and (ii) $50,000 (fifty
thousand dollars) were paid monthly from April through November 2008. Additional
payments of (iii) $50,000 (fifty thousand dollars) will be due on the 10th of
the following seven months and (iv) the final payment of $8,399 plus accrued
interest will be due on July 10, 2009. The Infinite Notes are collateralized by
all of the Company’s assets other than accounts receivable and are subordinated
to the first $4.0 million of Company debt outstanding from time to time. The
Company also agreed to pay in aggregate up to $7,500 of the Infinite
Shareholders' legal expenses incurred in connection with negotiating this
matter, which the Company, along with its own legal expenses in the matter,
recorded as a note discount to be amortized as interest expense over the
remaining term of the Infinite Notes.  The Infinite Notes may be
prepaid without penalty and all principal and interest thereunder, as well as
the legal expenses, is payable in cash.  The Infinite Notes provide
that if any of certain identified events of default occur, which includes a
scheduled payment not made and remaining unpaid after five days notice from the
Infinite Shareholders, then or at any time during the continuance of the event
of default, the Infinite Shareholders, at their option, may accelerate the
maturity of the Infinite Notes and require all accrued interest and other
amounts to become immediately due and payable.





The terms
of the Series A-10 shares provide that the Company may not incur additional
indebtedness greater than $1.5 million in aggregate, and excluding trade and
purchase money payables, without the consent of the holders of at least 50% of
the outstanding Series A-10 shares – see Note 6. In December 2007, the Company
obtained consent from the single majority holder of the Series A-10 for a
working capital line of up to $1.5 million and equipment financing of up to $1.5
million. Although the working capital line currently has a $1.6 million limit,
the equipment financing (which took the form of convertible debentures) is only
$1.0 million. In March 2008, the consent was updated to cover the Infinite
Notes, as discussed above.





As part
of the Onstream Merger, the Company assumed a capital lease for software, which
had an outstanding principal balance of $26,121 as of September 30, 2008. The
balance is payable in equal monthly payments of $3,366 through May 2009, which
includes interest at approximately 7% per annum. Accounts payable at September
30, 2008 includes $79,692 of past due payments related to this lease. See Note
2.





During
July 2007, the Company entered into a capital lease for audio conferencing
equipment, which had an outstanding principal balance of $222,688 as of
September 30, 2008. The balance is payable in equal monthly payments of $10,172
through August 2010, which includes interest at approximately 5% per annum, plus
an optional final payment based on fair value, but not to exceed
$16,974.


F-31


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE 4:
CONVERTIBLE DEBENTURES AND NOTES PAYABLE (Continued)





In
accordance with APB 26, “Early Extinguishment of Debt”, and EITF 96-19,
“Debtor’s Accounting for a Modification or Exchange of Debt Instruments”, new
debt instruments are to be recorded at fair value at the date of modification
and that fair value is to be compared to the carrying value of the previous debt
instrument in order to determine the debt extinguishment gain or loss, if
any.  A J&C Resources note executed by the Company following Board
of Director approval of the modified terms on December 20, 2006, was recorded at
a gross amount of $435,000, equivalent to the market value of the 245,902 shares
that would be received upon its conversion. This value was based on the market
value of $1.77 per ONSM share, which was the most recent daily closing price as
of the date of Board approval of the terms of the new note, although the $1.22
conversion rate was based on negotiations that occurred with J&C only two
weeks earlier when the market value was approximately $1.20 per ONSM share. The
valuation based on the date of Board approval resulted in a debt extinguishment
loss of $135,000, the difference between the $435,000 fair value and the
$300,000 face value of the note, and such non-cash loss was reflected in the
Company’s results of operations for the year ended September 30, 2007. The gross
carrying value of the new note was offset by the $135,000 value of the
conversion feature, which was reflected by an increase to additional paid-in
capital and resulted in the net carrying value of the note, prior to its
conversion to common stock in March 2007, being equal to its $300,000 face
value.  There was no material difference between the effective
interest rates of the old and new J&C notes.





NOTE
5:  COMMITMENTS AND CONTINGENCIES





Narrowstep
acquisition – On May 29, 2008, the Company entered into an Agreement and
Plan of Merger (the “Merger Agreement”) to acquire Narrowstep, which merger has
not been consummated as of December 5, 2008. The Company may recognize certain
expenses or incur certain liabilities in the event this merger is not
consummated, including (i) the write-off of $418,058 of acquisition-related
costs included in other non-current assets on its balance sheet as of September
30, 2008 and (ii) satisfaction of certain compensation agreements entered into
by the Company in contemplation of this merger. See Note 9.





NASDAQ letters regarding
share price and annual meeting listing requirements – The Company
received a letter from NASDAQ dated January 4, 2008 indicating that it had 180
calendar days, or until July 2, 2008, to regain compliance with Marketplace Rule
4310(c)(4) (the “Rule”), which is necessary in order to be eligible for
continued listing on the NASDAQ Capital Market. The NASDAQ letter indicated that
the Company’s non-compliance with the Rule was as a result of the bid price of
ONSM common stock closing below $1.00 per share for the preceding thirty
consecutive business days.  On July 3, 2008, the Company received a
letter from NASDAQ stating that the Company was not considered compliant with
the Rule as of that date, but because the Company met all other initial listing
criteria for the NASDAQ Capital Market, it was granted an additional 180
calendar days, or until December 30, 2008, to regain compliance with the Rule.
On October 22, 2008, the Company received a letter from NASDAQ stating that
NASDAQ had recently suspended enforcement of the bid price listing requirement
through January 19, 2009, which on December 19, 2008 was extended to April 20,
2009.  As a result, all companies presently in a bid price compliance
period will remain at the same stage of the process they were when the NASDAQ
announced the suspension and will not be subject to delisting for that concern,
and accordingly the Company will have until at least July 6, 2009 to regain
compliance with this requirement. The Company might be considered compliant with
the Rule, subject to the NASDAQ staff’s discretion, if ONSM common stock closes
at $1.00 per share or more for a minimum of ten consecutive business days before
the July 6, 2009 deadline.  The closing ONSM share price was $0.30 per
share on December 5, 2008.


F-32


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE
5:  COMMITMENTS AND CONTINGENCIES (Continued)





On
October 1, 2008 the Company received a letter from NASDAQ stating that its
common stock is subject to delisting since it failed to hold the required annual
shareholder meeting by September 30, 2008, the end of the Company’s fiscal year.
Company representatives attended a hearing with the NASDAQ Listing
Qualifications Panel on November 20, 2008, at which time they appealed the
deficiency and sought an extension of the annual meeting date requirement. On
December 22, 2008 the Company received a letter from NASDAQ stating that the
NASDAQ Listing Qualifications Panel had granted the Company’s request that its
securities continue to be listed on NASDAQ, provided that it hold its annual
shareholder meeting on or before February 28, 2009.  Notwithstanding
the Panel’s decision to continue the Company’s common stock’s listing on the
NASDAQ Capital Market, the Panel issued the Company a public reprimand for its
failure to hold an annual meeting for the prior fiscal year in a timely manner.
The Company’s management believes that this listing requirement would be met by
the shareholder meeting contemplated in the joint proxy statement/S-4 prospectus
now filed with the SEC but not yet declared effective.


The terms
of the 8% Senior Convertible Debentures and the 8% Subordinated Convertible
Debentures (and the related warrants) issued by the Company at various times
from December 2004 through April 2006, as well as the common shares issued in
connection with the April 2007 Infinite Merger, contain penalty clauses in the
event the Company’s common stock is not traded on NASDAQ or a similar national
exchange – See further discussion below.
 
 Registration payment
arrangements – The Company included the 8% Subordinated Convertible
Debentures and related $1.50 warrants on a registration statement which was
declared effective by the Securities and Exchange Commission (“SEC”) on July 26,
2006. The Company is only required to expend commercially reasonable efforts to
keep the registration statement continuously effective. However, in the event
the registration statement or the ability to sell shares thereunder lapses for
any reason for 30 or more consecutive days in any 12 month period or more than
twice in any 12 month period, the purchasers of the 8% Subordinated Convertible
Debentures may require the Company to redeem any shares obtained from the
conversion of those notes and still held, for 115% of the market value for the
previous five days. The same penalty provisions apply if the Company’s common
stock is not listed or quoted, or is suspended from trading on an eligible
market for a period of 20 or more trading days (which need not be consecutive).
Due to the fact that that there is no established mechanism for reporting to the
Company changes in the ownership of these shares after  they are
originally issued, the Company is unable to quantify how many of these shares
are still held by the original recipient and thus subject to the above
provisions. Regardless of the above, the Company believes that the applicability
of these provisions would be limited by equity and/or by statute to a certain
timeframe after the original security purchase. All of these debentures were
converted to common shares on or before March 31, 2007.





The
Company included the common shares underlying the 8% Senior Convertible
Debentures, including the Additional 8% Convertible Debentures (AIR), and the
related $1.65 warrants, on a registration statement declared effective by the
SEC on June 29, 2005. These debentures provide cash penalties of 1% of the
original purchase price for each month that (a) the Company’s common shares are
not listed on the NASDAQ Capital Market for a period of 3 trading days (which
need not be consecutive) or (b) the common shares underlying those securities
and the related warrants are not saleable subject to an S-3 or other
registration statement then effective with the SEC. The latter penalty only
applies for a five-year period beginning with the June 29, 2005 registration
statement effective date and does not apply to shares saleable under Rule
144(k).


F-33


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE
5:  COMMITMENTS AND CONTINGENCIES (Continued)


The $1.65
warrants provide that if the shares are not subject to an effective registration
statement on the date required in relation to the initial and/or subsequent
issuance of shares under these transactions and at the time of warrant exercise,
the holder could elect a “cashless exercise” whereby the Company would issue
shares based on the excess of the market price at the time of the exercise over
the warrant exercise price. Regardless of the above, the Company believes that
the applicability of these provisions would be limited by equity and/or by
statute to a certain timeframe after the original security purchase. All of
these debentures were converted to common shares on or before March 31, 2007,
although 1,128,530 of the warrants are still outstanding as of September 30,
2008 – see Note 8.
 
 During
March and April 2007, the Company sold an aggregate of 4,888,889 restricted
common shares at $2.25 per share for total gross proceeds of approximately $11.0
million. This private equity financing was arranged by the Company to partially
fund the Infinite Merger – see Note 2. These shares were included in a
registration statement declared effective by the SEC on June 15,
2007.  The Company is required to maintain the effectiveness of this
registration statement until the earlier of the date that (i) all of the shares
have been sold, (ii) all the shares have been transferred to persons who may
trade such shares without restriction or (iii) all of the shares may be sold at
any time, without volume or manner of sale limitations pursuant to Rule 144(k)
or any similar provision. In the event such effectiveness is not maintained or
trading in the shares is suspended or if the shares are delisted for more than
five (5) consecutive trading days then the Company is liable for a compensatory
payment (pro rated on a daily basis) of one and one-half percent (1.5%) per
month until the situation is cured, such payment based on the purchase price of
the shares still held and provided that such payments may not exceed ten percent
(10%) of the initial purchase price of the shares with respect to any one
purchaser. Regardless of the above, the Company believes that the applicability
of these provisions would be limited by equity and/or by statute to a certain
timeframe after the original security purchase.





Effective
within the year ended September 30, 2007, the Company elected early adoption of
FASB Staff Position (“FSP”) EITF 00-19-2, “Accounting for Registration
Payment Arrangements”, which was issued on December 21, 2006 and establishes
that contingent obligations under registration payment arrangements, as defined
in FSP EITF 00-19-2, shall be recognized and measured separately in accordance
with Statement of Financial Accounting Standard  (“SFAS”) No. 5,
“Accounting for Contingencies” and FASB Interpretation (“FIN”) No. 14,
“Reasonable Estimation of the Amount of a Loss”, and not under EITF 00-19. The
Company has concluded that (i) the terms discussed in the three preceding
paragraphs above are registration payment arrangements as defined in the
applicable accounting pronouncements, (ii) based on its satisfactory recent
history of maintaining the effectiveness of its registration statements and its
NASDAQ listing, as well as stockholders’ equity in excess of the NASDAQ listing
standards as of September 30, 2008, that material payments under these
registration payment arrangements are not probable, and (iii) therefore no
accrual related to them is necessary with respect to SFAS 5 and FIN 14 as of
that date. However, the Company’s share price was below $1.00 as of December 5,
2008, and the Company had also failed to hold the required annual shareholder
meeting as of that date, which conditions could eventually affect its NASDAQ
listing status, as discussed above.


F-34


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE
5:  COMMITMENTS AND CONTINGENCIES (Continued)


Registration rights -
The Company has granted a major shareholder demand registration rights,
effective six months from the January 2007 modification date of a certain
convertible note, for any unregistered common shares issuable thereunder. Upon
such demand, the Company will have 60 days to file a registration statement and
shall use its best efforts to obtain promptly the effectiveness of such
registration statement. 784,592 of the 2,789,592 shares issued in March 2007
were included in a registration statement declared effective by the SEC on June
15, 2007 and as of December 5, 2008 the Company has not received any demand for
the registration of the balance. As the note does not provide for damages or
penalties in the event the Company does not comply with these registration
rights, the Company has concluded that these rights do not constitute
registration payment arrangements under FSP EITF 00-19-2. In any event, the
Company has determined that material payments in relation to these rights are
not probable and therefore no accrual related to them is necessary with respect
to SFAS 5 and FIN 14.
 
 The
Company has granted demand registration rights, effective six months from the
date of a certain October 2006 convertible note, for any unregistered common
shares issuable thereunder. Upon such demand, the Company will have 60 days to
file a registration statement and shall use its best efforts to obtain promptly
the effectiveness of such registration statement. 1,000,000 of the 1,694,495
total principal and interest shares were included in a registration statement
declared effective by the SEC on June 15, 2007 and as of December 5, 2008 the
Company has not received any demand for the registration of the
balance.  As the note does not provide for damages or penalties in the
event the Company does not comply with these registration rights, the Company
has concluded that these rights do not constitute registration payment
arrangements under FSP EITF 00-19-2. Furthermore, the unregistered shares were
originally issued in November and December 2006 and may be saleable, in whole or
in part, under Rule 144. In any event, the Company has determined that material
payments in relation to these rights are not probable and therefore no accrual
related to them is necessary with respect to SFAS 5 and FIN 14. See Note 6
regarding a consulting contract entered into by the Company with the principal
and beneficial owner of the lending entity.


255,000
options and 100,000 shares issued to consultants prior to June 15, 2007 were
granted with piggyback registration rights but were not included on the
registration statement declared effective by the SEC on June 15, 2007. As these
options and shares do not provide for damages or penalties in the event the
Company does not comply with these registration rights, the Company has
concluded that these rights do not constitute registration payment arrangements
under FSP EITF 00-19-2. In any event, the Company has determined that material
payments in relation to these rights are not probable and therefore no accrual
related to them is necessary with respect to SFAS 5 and FIN 14.
 
 Consultant contract -
The Company has entered into an agreement requiring the future issuance of
approximately 150,000 unregistered shares for financial consulting and advisory
services. The services are being provided over a 15 month period, and will
result in a professional fees expense of approximately $45,000 over that service
period, based on the current market value of an ONSM common share. None of these
shares will be issued to Company directors or officers.


F-35


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE
5:  COMMITMENTS AND CONTINGENCIES (Continued)





Employment Contracts and
Severance – On September 27, 2007, the Company’s Compensation Committee
and Board of Directors approved three-year employment agreements with Messrs.
Randy Selman (President and CEO), Alan Saperstein (COO and Treasurer), Robert
Tomlinson (Chief Financial Officer), Clifford Friedland (Senior Vice President
Business Development) and David Glassman (Senior Vice President Marketing),
collectively referred to as “the Executives”. Other than the extended term of
the new agreements, the following salary, raise and benefit payments are
substantially the same as the Executives would have received under the
employment agreements previously in place that would have expired December 27,
2008. The new agreements provide annual base salaries of $253,000 for Mr.
Selman, $230,000 for Mr. Saperstein, $207,230 for Mr. Tomlinson and $197,230 for
Messrs. Friedland and Glassman, and allow for 10% annual increases through
December 27, 2008 and 5% per year thereafter. In addition, each of the
Executives receives an auto allowance payment of $1,000 per month, a “retirement
savings” payment of $1,500 per month, and an annual $5,000 allowance for the
reimbursement of dues or charitable donations.  The Company also pays
insurance premiums for the Executives, including medical, life and disability
coverage.





As part
of the above employment agreements, and in accordance with the terms of the
“2007 Equity Incentive Plan” approved by the Company’s  shareholders
in their September 18, 2007 annual meeting, the Company’s Compensation Committee
and Board of Directors granted each of the Executives options (“Plan Options”)
to purchase an aggregate of 400,000 shares of ONSM common stock at an exercise
price of $1.73 per share, the fair market value at the date of the grant, which
shall be exercisable for a period of four (4) years from the date of vesting.
The options vest in installments of 100,000 per year, starting on September 27,
2008, and they automatically vest upon the happening of the following events on
a date more than six (6) months after the date of the agreement: (i) change of
control (ii) constructive termination, and (iii) termination other than for
cause, each as defined in the employment agreements. Unvested options
automatically terminate upon (i) termination for cause or (ii) voluntary
termination.  In the event the agreement is not renewed or the
Executive is terminated other than for cause, the Executives shall be entitled
to require the Company to register the options.





As part
of the above employment agreements, the Executives are eligible for a
performance bonus, based on meeting revenue and cash flow objectives. In
connection with this bonus program, the Company’s Compensation Committee and
Board of Directors granted each of the Executives Plan Options to purchase an
aggregate of 220,000 shares of ONSM common stock at an exercise price of $1.73
per share, the fair market value at the date of the grant, which shall be
exercisable for a period of four (4) years from the date of vesting. Up to
one-half of these shares will be eligible for vesting on a quarterly basis and
the rest annually, with the total grant allocated over a two-year period
starting October 1, 2007. Vesting of the quarterly portion is subject to
achievement of increased revenues over the prior quarter as well as positive and
increased net cash flow per share (defined as cash provided by operating
activities per the Company’s statement of cash flow, measured before changes in
working capital components and not including investing or financing activities)
for that quarter. Vesting of the annual portion is subject to meeting the above
cash flow requirements on a year-over-year basis, plus a revenue growth rate of
at least 30% for the fiscal year over the prior year.


F-36


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE
5:  COMMITMENTS AND CONTINGENCIES (Continued)





In the
event of quarter to quarter decreases in revenues and or cash flow, the options
shall not vest for that quarter but the unvested quarterly options shall be
added to the available options for the year, vested subject to achievement of
the applicable annual goal. In the event options do not vest based on the
quarterly or annual goals, they shall immediately expire. In the event the
agreement is not renewed or the Executive is terminated other than for cause,
the Executives shall be entitled to require the Company to register the vested
options. The Company has also agreed that this bonus program will continue after
the initial two-year period, with the specific bonus parameters to be negotiated
in good faith between the parties at least ninety (90) days before the
expiration of the program then in place.





The
Company has determined that the performance objectives were met for the quarter
ended December 31, 2007 but that they were not met for the remaining three
quarters of fiscal 2008 nor were they met for the year ended September 30, 2008.
Therefore, 13,750 options out of a potential 110,000 performance options vested
for each executive during fiscal 2008 and as a result the Company recognized
compensation expense of approximately $80,000 for the year ended September 30,
2008, related to the vested quarterly portion of these options.





Under the
terms of the above employment agreements, upon a termination subsequent to a
change of control, termination without cause or constructive termination, each
as defined in the agreements, the Company would be obligated to pay each of the
Executives an amount equal to three times the Executive’s base salary plus full
benefits for a period of the lesser of (i) three years from the date of
termination or (ii) the date of termination until a date one year after the end
of the initial employment contract term. The Company may defer the payment of
all or part of this obligation for up to six months, to the extent required by
Internal Revenue Code Section 409A. In addition, if the five day average closing
price of the common stock is greater than or equal to $2.50 per share on the
date of any termination or change in control, all options previously granted the
Executive(s) will be cancelled, with all underlying shares (vested or unvested)
issued to the executive, and the Company will pay all taxes for the
Executive(s).  If the five-day average closing price of the common
stock is less than $2.50 per share on the date of any termination or change in
control, the options will remain exercisable under the original
terms.





As part
of the above employment agreements, and in consideration for the provision in
the new employment agreements that change of control benefits would not be paid
related to any merger and any related financing occurring within eighteen months
of entering into the new agreements, the Company’s Compensation Committee and
Board of Directors agreed that the Company would grant each of the Executives
fully vested four-year options for shares equivalent to one percent (1%) of the
total number of shares issued in connection with any such merger and/or any
related financing including any contingent shares, once earned. If the Company
enters into a definitive merger agreement during that eighteen month period, the
number of options will be determined and granted at the time of closing that
merger and will have an exercise price equal to the fair value at the date of
grant, but no less than $1.00. The Company agreed to register these and all
other shares or options held by the Executives with or simultaneously to any
shares registered in connection with such a merger and/or any related financing.
See Note 9 for a discussion of the proposed Narrowstep Merger, which would
result in the issuance of options to the Executives in accordance with the above
provision.


F-37


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE
5:  COMMITMENTS AND CONTINGENCIES (Continued)


Under the
terms of the above employment agreements, the Company may terminate an
Executive’s employment upon his death or disability or with or without cause. To
the extent that an Executive is terminated for cause, no severance benefits are
due him. If an employment agreement is terminated as a result of the Executive’s
death, his estate will receive one year base salary plus any bonus or other
compensation amount or benefit then payable or that would have been otherwise
considered vested or earned under the agreement during the one-year period
subsequent to the time of his death. If an employment agreement is terminated as
a result of the Executive’s disability, as defined in the agreement, he is
entitled to compensation in accordance with the Company’s disability
compensation for senior executives to include compensation for at least 180
days, plus any bonus or other compensation amount or benefit then payable or
that would have been otherwise considered vested or earned under the agreement
during the one-year period subsequent to the time of his disability. These
employment agreements contain certain non-disclosure and non-competition
provisions and the Company has agreed to indemnify the Executives in certain
circumstances.


As part
of the above employment agreements, the Company’s Compensation Committee and
Board of Directors agreed that in the event the Company is sold for a Company
Sale Price in excess of the Current Capitalization during the term of the
agreements, both terms as defined below, and the Company Sale Price represents
at least $2.50 per share (adjusted for recapitalization including but not
limited to splits and reverse splits), the Executives and certain other
employees, will receive, as a group, cash compensation of twelve and one-half
percent (12.5%) of the excess of the Company Sale Price over the Current
Capitalization, payable in immediately available funds at the time of closing
such transaction. The Current Capitalization is defined as the sum of (i) the
number of common shares issued and outstanding, (ii) the common stock equivalent
shares related to paid for but not converted preferred shares and (iii) the
number of common shares underlying “in-the-money” warrants and options, such sum
multiplied by the market price per share and then reduced by the proceeds
payable upon exercise of the “in-the-money” warrants and options, all determined
as of the date of the above employment agreements but the market price per share
used for this purpose to be no less than $2.00. The Company Sale Price is
defined as the number of common shares outstanding at the time the Company is
sold multiplied by the price per share paid in such Company Sale transaction.
The 12.5% was allocated in the new employment agreements as two and one-half
percent (2.5%) each to Messrs. Selman, Saperstein, Friedland and Glassman and
one and one-half percent (1.5%) to Mr. Tomlinson. The remaining one percent
(1.0%) will be allocated by the Board and the Company’s management at a later
date, which will be primarily to compensate other Company executives not having
employment contracts, but may also include additional allocation to some or all
of these five senior Executives.


F-38


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008


NOTE
5:  COMMITMENTS AND CONTINGENCIES (Continued)





The form
of an agreement containing the above terms was approved by the Company’s
Compensation Committee and Board in their September 27, 2007 meeting, subject
only to changes to be made to comply with IRS Section 409A. These changes were
made and the agreements were executed and filed as exhibits to a Form 8-K/A the
Company filed with the SEC on December 22, 2007. It was determined in a
subsequent review by corporate counsel that the provision allowing payment of
severance as a lump sum was inadvertently deleted as part of the Section 409A
modifications, but such deletion was not necessary in order to comply with
Section 409A.  Accordingly, on May 15, 2008 the Compensation Committee
and Board approved the correction of those agreements to reinstate the lump sum
provision, since deletion of that provision was not their intention at the time
they originally approved the form of agreement. In their May 15, 2008 meeting,
the Compensation Committee and Board also extended the time period for the 1%
option grant (discussed above) from 6 months to 18 months, modified the grant
date to merger closing versus merger agreement date and specified the exercise
price to be no less than $1.00. Those amended and corrected agreements were
immediately executed and filed as exhibits to the Form 10-QSB the Company filed
with the SEC on that same day.





Long Distance Purchase
Commitment - Effective January 15, 2006, EDNet entered into a two-year
long distance telephone rate agreement with a national telecommunications
company, which included a telephone services purchase commitment of
approximately $120,000 per year. On September 13, 2007, this agreement was
extended to add another two years, for a total term of four years. The Company
is in compliance with this agreement.
 
 Bandwidth Purchase
Commitments - Effective July 1, 2008, the Company entered into a two-year
long distance bandwidth rate agreement with a national CDN (content delivery
network) company, which includes a minimum purchase commitment of approximately
$200,000 per year. The Company is in compliance with this
agreement.
 
 The
Company has entered into various agreements with a national co-location
facilities company, for an aggregate minimum purchase commitment of
approximately $27,000 per month, expiring at various times through September
2009.





Lease Commitments -
The Company is obligated under operating leases for its four offices (one each
in Pompano Beach, Florida and San Francisco, California and two in the New York
City area), which call for monthly payments totaling approximately $52,800. The
leases, with expiration dates ranging from 2009 to 2010, provide for renewal
options and annual increases.  Future minimum lease payments required
under these non-cancelable leases as of September 30, 2008, excluding the
capital lease obligations discussed in Note 4, total approximately
$823,000.





The
Company’s three-year operating lease for its principal executive offices in
Pompano Beach, Florida expires September 15, 2010. The monthly base rental is
currently approximately $21,400 (including the Company's share of property taxes
and common area expenses) with annual five percent (5%) increases. The lease
provides for one two-year renewal option with 5% annual
increases.


F-39


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008


NOTE
5:  COMMITMENTS AND CONTINGENCIES (Continued)





The
Company’s five-year operating lease for office space in San Francisco expires
April 30, 2009.  The lease provides for one five-year renewal option
at 95% of fair market value.   The monthly base rental (including
month-to-month parking) is approximately $18,000 with annual increases up to
five percent (5%).


The
Company’s annual operating lease for office space in New York City expires
December 31, 2009.   The monthly base rental is approximately
$6,600.
 
 The lease
for the Company’s Infinite Conferencing location in New Jersey expires July 31,
2009. The monthly base rental is approximately $6,800.


Future
minimum lease payments required under the non-cancelable leases, plus the
capital leases included in Notes Payable and more fully discussed in Note 4, are
as follows:


Operating
                
                
                Capital
                
                
                AllYear
      Ending September 30:
                
                Leases
                
                
                Leases
                
                
                Leases2009
                
                $
                533,300
                
                
                $
                148,989
                
                
                $
                682,2892010
                
                
                289,998
                
                
                
                111,888
                
                
                
                401,886Total
      minimum lease payments
                
                $
                823,298
                
                
                $
                260,877
                
                
                $
                1,084,175Less:
      amount representing interest
                
                
                
                
                
                
                12,068Present
      value of net minimum lease payments
                
                
                
                
                
                $
                248,809Less:
      current portion
                
                
                
                
                
                
                144,134Long-term
      portion
                
                
                
                
                
                $
                104,675





Total
rental expense for all operating leases was approximately $776,000 and $636,000
for the years ended September 30, 2008 and 2007,
respectively.





Software purchase and
royalty commitment – On March 31, 2008 the Company agreed to pay $300,000
(plus a $37,500 annual support fee) for a perpetual license for certain digital
asset management software, which it currently utilizes to provide its automatic
meta-tagging and other DMSP services. The initial $56,250 payment due under this
perpetual license agreement was paid in July 2008 and the remaining obligation
of $281,250, included in accounts payable at September 30, 2008, is due on or
before December 31, 2008. In connection with this license, the Company also
agreed to pay a 1% royalty on revenues arising from the use, licensing or
offering of the functionality of this software to its customers, to the extent
such revenue exceeds certain levels, subject to a minimum amount per transaction
and only to the extent the calculated royalty exceeds the perpetual license
payment.





Exclusive sales
territories – During 2007, the Company received $100,000 from ASPA-Japan
Co., Ltd. (“ASPA”), as partial payment of the amount due in connection with an
exclusive sales agency agreement. As part of the January 2008 termination of
this agreement, which allowed the Company to retain the $100,000 which it
recognized as other income (net of commissions) upon such termination, the
Company agreed to reinstate the exclusive five year agreement, provided ASPA
pays the remaining $900,000 due within one year of termination and the
territories (certain Middle Eastern countries) are still available at the time
of such payment. The Company is continuing to pursue several direct sales
opportunities in certain Middle Eastern countries.


F-40


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE
5:  COMMITMENTS AND CONTINGENCIES (Continued)





State income taxes -
The Company has been assessed state income taxes, plus penalties and interest,
for the years ending September 30, 2004 and 2005, in an aggregate amount of
approximately $89,000. The basis of the assessment is an attempt by the state to
disallow certain net operating loss carryforwards to the years in question. The
Company has contested these assessments with the state taxing authorities and
believes the ultimate resolution will not have a material impact on the
Company’s financial position or results of operations.





Legal Proceedings –
The Company is involved in litigation and regulatory investigations arising in
the ordinary course of business. While the ultimate outcome of these matters is
not presently determinable, it is the opinion of management that the resolution
of these outstanding claims will not have a material adverse effect on the
Company’s financial position or results of operations.





NOTE
6:  CAPITAL STOCK





Common
Stock





During
the year ended September 30, 2007, the Company issued an aggregate of 9,232,833
registered common shares as a result of conversions by several investors of 8%
Senior and Subordinated Convertible Debentures and Series A-10 Preferred, as
follows:





(i)
            3,042,472
      ONSM common shares for the conversion of $3.0 million of 8% Senior
      Convertible Debentures, plus accrued
interest,





(ii)
            2,256,681
      ONSM common shares for the conversion of $2.225 million of 8% Subordinated
      Convertible Debentures, plus accrued
interest,





(iii)
            3,933,680
      ONSM common shares for the conversion of 393,368 shares of Series A-10
      Preferred, including accrued
dividends.





During
the year ended September 30, 2007, the Company received approximately $6.9
million from the exercise of previously issued warrants and options, resulting
in its issuance of 4,547,154 registered and 5,000 unregistered common shares.
These warrants and options had exercise prices ranging from $0.71 to $2.50 per
share.
 
 During
March and April 2007, the Company sold an aggregate of 4,888,889 restricted
common shares at $2.25 per share for total gross proceeds of approximately $11.0
million. This private equity financing was arranged by the Company to partially
fund the Infinite Merger – see Note 2. The Company paid $770,000 as the cash
portion of the finders and/or placement fees, equal to 7% of the gross proceeds
related to the above sale, which was reflected as a reduction of paid-in
capital. After deducting these fees, as well as legal fees and other issuance
costs, the net proceeds to the Company were $10,207,026. As additional placement
fees related to this sale, the Company issued 342,222 five-year warrants
exercisable at $2.70 per share, which it valued at $518,445 using Black-Scholes
methodology – see Note 8. These shares and warrants were included in a
registration statement declared effective by the SEC on June 15, 2007. The
Company is subject to penalties if the effectiveness of this registration
statement is not maintained for a certain time period – See Note
5.


F-41


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE
6:  CAPITAL STOCK (Continued)





Common Stock
(Continued)


During
April 2007, the Company issued 1,376,622 restricted common shares to certain of
the Infinite sellers - see Note 2.
 
 During
March 2007, the Company issued 467,290 restricted common shares as in exchange
for 100% of the issued and outstanding capital stock of Auction Video Japan,
Inc. – see Note 2. There were no registration rights associated with this
transaction and as of December 5, 2008 the related shares have not been included
in a registration statement.
 
 During
the year ended September 30, 2007, the Company issued 910,608 shares of common
stock for consulting, financial, advisory and other services, as
follows:


790,993
unregistered shares valued at approximately $1,530,000 and recognized as
professional fees expense for financial consulting and advisory services over
various service periods of up to 21 months. None of these shares were issued to
Company directors or officers.





59,615
unregistered shares of common stock to SAIC as payment for services previously
capitalized by the Company at $62,000 during the year ended September 30,
2006.
 
 60,000
unregistered shares of common stock as payment for equipment purchased and
capitalized for approximately $65,000 by the Company during the year ended
September 30, 2007.





During
the year ended September 30, 2007, the Company issued options to purchase its
common shares, in exchange for financial consulting and advisory services, such
options valued at approximately $852,000.





During
the year ended September 30, 2007, the Company issued (i) 3,045,902 restricted
common shares as the result of the conversion of four promissory notes having an
aggregate face value of $3.1 million and (ii) 2,258,185 restricted common shares
for payment of interest and fees incurred in connection with those promissory
notes. See Note 5.


During
the year ended September 30, 2007, the Company issued 95,125 common shares in
lieu of the $112,686 interest accrued and due on the 8% Convertible Debentures
and the 8% Subordinated Convertible Debentures (which included 74,154 shares
issued for $74,154 interest due on conversions during that period).
 
 During
the year ended September 30, 2008, the Company issued 543,670 unregistered
shares valued at approximately $611,000 (including the 240,000 shares issued in
connection with a three-year consulting contract entered into in November 2006
and discussed below) and recognized as professional fees expense for financial
consulting and advisory services over various service periods of up to 36
months. Except for 25,000 shares issued to Mr. Charles Johnston, director, as
compensation for services to be rendered by him for fiscal year 2008 in
connection with his appointment as audit committee chairman, none of the other
shares were issued to Company directors or officers.


F-42


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE
6:  CAPITAL STOCK (Continued)





Common Stock
(Continued)


In
November 2006, the Company entered into a three-year consulting contract with
the principal and beneficial owner of an entity which loaned the Company funds
under a convertible note in October 2006, as discussed in Note 5. The contract,
for the provision of international business development and financial advice, is
cancellable upon thirty days notice and originally called for the issuance of
60,000 restricted common shares in advance every six months. The first two
tranches under this contract (60,000 shares each) were issued in January and May
2007, valued based on fair market value as of the date of issuance and expensed
under SFAS 123 as professional fees expense. This contract was amended in July
2007 for some additional short-term services, resulting in issuance of an
additional 15,000 shares plus $22,425 for cash reimbursement of related travel
expenses. This contract was amended again in October 2007, which resulted in the
issuance of the remaining 240,000 restricted common shares, in exchange for the
extension of the remaining term of the contract from two years to three years.
These shares were valued based on fair market value as of the date of issuance
and will be expensed under SFAS 123 ratably over the contract term as
professional fees expense.





During
the year ended September 30, 2008, the Company issued options to purchase its
common shares, in exchange for financial consulting and advisory services, such
options valued at approximately $210,000. Except for options to purchase 50,000
shares issued to Mr. Leon Nowalsky, director, as compensation for services to be
rendered by him in connection with his appointment to the board, none of the
other options were issued to Company directors or officers. Professional fee
expenses arising from these and prior issuances of shares and options for
financial consulting and advisory services were approximately $1,079,000 and
$2,323,000 for the years ended September 30, 2008 and 2007, respectively. As a
result of previously issued shares and options for financial consulting and
advisory services, the Company has approximately $251,000 in deferred equity
compensation expense at September 30, 2008, to be amortized over the remaining
periods of service of up to 25 months. The deferred equity compensation expense
is included in the balance sheet captions prepaid expenses and other non-current
assets.





During
the year ended September 30, 2008, the Company recognized compensation expense
(and a corresponding increase in additional paid in capital) of approximately
$882,000 in connection with options issued to its employees to purchase its
common shares. See Note 5 (employment contracts and severance) and Note
8.





During
the year ended September 30, 2008, the Company issued 201,250 shares in
connection with the Notes – 101,250 shares issued as fees to placement agents
and finders and 100,000 shares issued to the investors. See Note
4.


F-43


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE
6:  CAPITAL STOCK (Continued)





Preferred
Stock





Series
A-10 Convertible Preferred Stock





As of
September 30, 2008 and 2007, the only preferred stock outstanding is Series A-10
Convertible Preferred Stock (“Series A-10”).  The Series A-10 has a
coupon of 8% per annum, payable annually in cash (or semi-annually at the
Company’s option in cash or in additional shares of Series A-10), has a stated
value of $10.00 per preferred share and has a conversion rate of $1.00 per
common share. Series A-10 dividends are cumulative and must be fully paid by the
Company prior to the payment of any dividend on its common shares. The Series
A-10 is not redeemable by the Company and any shares of Series A-10 that are
still outstanding as of December 31, 2008 will automatically convert into common
shares. Series A-10 is senior to all other preferred share classes that may be
issued by the Company and the Company may not incur any additional indebtedness
greater than $1.5 million in aggregate, and excluding trade and purchase money
payables, without the consent of the holders of at least 50% of the outstanding
Series A-10 shares – see Note 4. The Series A-10 holders have the right to
designate one member of the Company’s board of directors. Except as explicitly
required by applicable law, the holders of Series A-10 shall not be entitled to
vote on any matters as to which holders of the Company’s common shares are
entitled to vote. In February 2005, the board of directors and the holders of a
majority of the issued and outstanding shares of Series A-10 voted to approve an
increase in the authorized number of Series A-10 from 500,000 shares to 700,000
shares to provide for the possible issuance of shares of Series A-10 as
dividends on Series A-10 presently outstanding.





On
December 23, 2004, the Company sold 215,000 shares of Series A-10 Convertible
Preferred Stock for $2.15 million to sixteen accredited investors, plus 100,000
shares of Series A-10 for $1.0 million of previously outstanding debt to a
single accredited investor. In December 2004, a single shareholder converted all
232,750 shares of Series A-8 Preferred held by him into 139,650 shares of Series
A-10.





The
Company’s Board declared a dividend payable on November 15, 2007 to Series A-10
shareholders of record as of November 10, 2007 of 2,767 Series A-10 preferred
shares, in lieu of a $27,679 cash payment. The Company’s Board declared a
dividend payable on May 15, 2008 to Series A-10 shareholders of record as of May
10, 2008 of 2,878 Series A-10 preferred shares, in lieu of a $28,786 cash
payment. Including these two dividends, the Company has issued 88,549 Series
A-10 preferred shares, in lieu of $885,515 in cash payments due for regular
interest and dividends, from the Company’s initial issuance of Series A-10
shares through September 30, 2008. See Note 10 with respect to dividends paid
after September 30, 2008.


As of
September 30, 2008, the Company had issued 4,742,110 ONSM common shares as a
result of several investors converting a total of 474,211 shares of Series A-10
preferred shares, which included 5,853 Series A-10 shares issued for accrued
dividends through the respective conversion dates.


F-44


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE
6:  CAPITAL STOCK (Continued)





Preferred Stock
(Continued)





The above
transactions are summarized as follows through September 30, 2008:





Initial
      number of Series A-10 shares issued
                  
                  
                  454,650Plus:
      A-10 shares issued for regular interest and dividends
                  
                  
                  88,549Plus:
      A-10 shares issued for conversion dividends
                  
                  
                  5,853Less:
      A-10 shares converted to common shares
                  
                  
                  (474,211
                  )Number
      of Series A-10 shares outstanding
                  
                  
                  74,841





The
315,000 shares of Series A-10 sold in December 2004, as discussed above,
included five-year warrants to purchase 1,575,000 ONSM common shares, plus
five-year warrants for 215,000 ONSM shares issued to the placement agents, all
exercisable for $1.50 per share. The estimated fair value of these warrants
given in connection with the Series A-10, plus the Series A-10’s beneficial
conversion feature, was $2,755,951, which, in accordance with EITF 98-05 and
EITF 00-27, was allocated to additional paid in capital and discount. The
Company’s management calculated the discount primarily based on its estimate of
the fair value of the warrants as a percentage of the face value of the
convertible securities. The estimate was based on the closing price of the stock
at the date of the agreement and the relationship to the conversion price of the
instrument and the exercise price of the warrants. The discount, which totals
$2,928,041 after inclusion of other direct costs associated with the financing,
is being amortized as a dividend over the four-year term of the Series A-10. In
addition, the unamortized portion of the discount related to converted
securities is expensed as an additional dividend at the time of the
conversion.





909,083
of these warrants remain outstanding as of September 30, 2008 – see Note
8.


F-45


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE
7:  SEGMENT INFORMATION


The
Company's operations are currently comprised of two groups, Digital Media
Services and Audio and Web Conferencing Services. The primary operating
activities of the DMSP, UGC and Smart Encoding divisions of the Digital Media
Services Group as well as the EDNet division of the Audio and Web Conferencing
Services Group are in San Francisco, California. The primary operating
activities of the Infinite division of the Audio and Web Conferencing Services
Group are in the New York City, New York area. The primary operating activities
of the Webcasting and Travel divisions of the Digital Media Services Group, as
well as the Company’s headquarters, are in Pompano Beach, Florida. All material
Company sales, as well as the location of the Company’s property and equipment,
are within the United States.





The above
structure reflects changes made by the Company during the fiscal year ending
September 30, 2008, as follows: the Webcasting and Travel divisions were
included in the already existing Digital Media Services Group, the Infinite
division and the EDNet division were combined in a newly created Audio and Web
Conferencing Group and the previously existing Web Communications Services
Group, which contained the Webcasting, Infinite and Travel divisions, was
discontinued. Detailed below are the results of operations by segment for the
years ended September 30, 2008 and 2007, and total assets by segment as of
September 30, 2008 and 2007. All numbers reflect the current corporate structure
outlined above.
  For the years ended
                          September 30,2008
                        
                        
                        2007Revenue:Digital
      Media Services Group
                        
                        $
                        7,851,243
                        
                        
                        $
                        6,621,338Audio
      and Web Conferencing Services Group
                        
                        
                        9,735,980
                        
                        
                        
                        5,493,707Total
      consolidated revenue
                        
                        $
                        17,587,223
                        
                        
                        $
                        12,115,045Segment
      operating income (loss):Digital
      Media Services Group
                        
                        
                        (82,455
                        )
                        
                        
                        (372,090
                        )Audio
      and Web Conferencing Services Group
                        
                        
                        3,675,654
                        
                        
                        
                        2,052,506Total
      segment operating income
                        
                        
                        3,593,199
                        
                        
                        
                        1,680,416Depreciation
      and amortization
                        
                        
                        (4,215,669
                        )
                        
                        
                        (3,099,940
                        )Corporate
      and unallocated shared expenses
                        
                        
                        (5,780,453
                        )
                        
                        
                        (6,092,333
                        )Other
      (expense), net
                        
                        
                        (158,535
                        )
                        
                        
                        (7,246,196
                        )Net
      loss
                        
                        $
                        (6,561,458
                        )
                        
                        $
                        (14,758,053
                        )September30,2008
                        
                        
                        September30,2007Assets:Digital
      Media Services Group
                        
                        $
                        13,215,981
                        
                        
                        $
                        14,835,414Audio
      and Web Conferencing Services Group
                        
                        
                        18,986,117
                        
                        
                        
                        20,314,254Corporate
      and unallocated
                        
                        
                        1,642,450
                        
                        
                        
                        1,333,988Total
      assets
                        
                        $
                        33,844,548
                        
                        
                        $
                        36,483,656


Depreciation
and amortization are not utilized by the Company’s primary decision makers for
making decisions with regard to resource allocation or performance
evaluation.


F-46


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE
8:  STOCK OPTIONS AND WARRANTS


As of
September 30, 2008, the Company had issued and outstanding options and warrants
to purchase up to 15,155,731 ONSM common shares, including 8,103,000 Plan
Options; 2,420,284 Non-Plan Options to employees and directors; 1,848,962
Non-Plan Options to financial consultants; and 2,783,485 warrants issued in
connection with various financings and other transactions.
 
 On
February 9, 1997, the Board of Directors and a majority of the Company's
shareholders adopted the 1996 Stock Option Plan (the "1996 Plan"), which,
including the effect of subsequent amendments to the Plan, authorized up to
4,500,000 shares available for issuance as options and up to another 2,000,000
shares available for stock grants. On September 18, 2007, the Company’s Board of
Directors and a majority of the Company's shareholders adopted the 2007 Equity
Incentive Plan (the “2007 Plan”), which authorized the issuance of up to
6,000,000 shares of ONSM common stock pursuant to stock options, stock purchase
rights, stock appreciation rights and/or stock awards for employees, directors
and consultants. The options and stock grants authorized for issuance under the
2007 Plan were in addition to those already issued under the 1996 Plan, although
the Company may no longer issue additional options or stock grants under the
1996 Plan.
 
 As of
September 30, 2008 there are 8,103,000 outstanding options granted to
management, employees and directors under the 1996 Plan and the 2007 Plan, which
all have exercise prices equal to or greater than the fair market value at the
date of grant. The initial terms of these options were generally four to five
years and they were fully vested as of September 30, 2008, except 2,648,750 of
these options issued in fiscal 2007 and 910,000 of these options issued in
fiscal 2008 and detailed later in this note.


In
December 2004 the Company issued four-year Plan options to purchase 50,000
common shares to General Ronald Yates upon his initial appointment to the
Company's Board of Directors, immediately exercisable at an exercise price of
$1.57 per share. In December 2004, the Company's Board of Directors
granted 150,000 four-year Plan options exercisable at an exercise price of
$1.21 per share to a single senior executive. The Board later accelerated the
vesting of these options, as discussed below.


In July
2005 the Company’s Board of Directors granted 2,634,224 five-year Plan options,
exercisable at $1.12 per share. This included 1,500,000 fully vested options to
Company directors and senior management, with the balance issued to other
Company employees and vesting quarterly during the year ended September 30,
2006. At the same time, the Board accelerated the vesting of 150,000 four-year
Plan options previously granted to a senior executive in December 2004, as
discussed above. The options, which were to vest in installments of 50,000
options per year, beginning December 15, 2005, were declared fully vested. At
the same time, the Company issued 26,759 Plan fully paid stock grants to Company
executives.
 
 During
July 2006, the Company issued four-year Plan options to purchase 50,000 common
shares to Mr. Carl L. Silva upon his initial appointment to the Company’s Board
of Directors, immediately exercisable at an exercise price of $0.88 per share.
In September 2006 the Company’s Board of Directors granted 1,500,000 fully
vested five-year Plan options, exercisable at $0.71 per share, with 700,000
issued to Company directors (other than Mr. Silva) and senior management and the
balance issued to other Company employees.


F-47


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE
8:  STOCK OPTIONS AND WARRANTS (Continued)





During
the year ended September 30, 2007, the Company issued 3,360,000 Plan options-
(i) 35,000 two-year options exercisable at $2.98 per share in connection with
the Auction Video acquisition – see note 2, (ii) 200,000 five-year Plan options
exercisable at $2.50 per share in connection with the Infinite Merger, of which
50,000 have been forfeited due to termination of employment - see note 2, (iii)
25,000 four-year Plan Options exercisable at $2.28 per share to a non-executive
employee and (iv) 3,100,000 four-year (from vesting) 2007 Plan options
exercisable at $1.73 per share in connection with executive employment contracts
- see note 4. None of these options, except 17,500 of those exercisable at
$2.98, 50,000 of those exercisable at $2.50, the 25,000 exercisable at $2.28 and
568,750 of the service and performance options issued in connection with
executive employment contracts, were vested as of September 30,
2008.


In
December 2007, the Company issued (i) immediately exercisable four-year 2007
Plan options to purchase 50,000 ONSM common shares at $1.00 per share (above
fair market value on the date of issuance) granted to Mr. Leon Nowalsky upon his
initial appointment to the Company’s Board of Directors and (ii) four-year 2007
Plan options, vesting over three years starting on the grant date, to an
employee to purchase 10,000 ONSM common shares at $1.00 per share. In December
2007, pursuant to approval of the Company’s Compensation Committee and Board of
Directors, the Company issued 25,000 2007 Plan shares of its common stock to Mr.
Charles Johnston, director, as compensation for services to be rendered by him
for fiscal year 2008, in connection with his appointment as audit committee
chairman.





In April
2008, the Company issued four-year Plan options to certain employees to purchase
25,000 ONSM common shares at $1.00 per share (above fair market value on the
date of issuance). These options vest over two and three years. In May 2008, the
Company issued (i) four-year Plan options to purchase 40,000 ONSM common shares
at $1.00 per share (above fair market value on the date of issuance), vesting
over two years and (ii) four-year Plan options to purchase 400,000 ONSM common
shares, as discussed in Note 9.





In August
2008, the Company issued four-year Plan options to certain employees to purchase
435,000 ONSM common shares at $1.00 per share (above fair market value on the
date of issuance). These options vest over two and three years, except for
25,000 options which will vest in less than one year.





The
Company recorded total compensation expense of approximately $962,000 and
$106,000 for the years ended September 30, 2008 and 2007, respectively, related
to Plan Options granted to employees and vesting during those periods. The
unvested portion of Plan Options outstanding as of September 30, 2008 (and
granted on or after the Company’s October 1, 2006 adoption of SFAS 123R)
represents approximately $3,672,000 of potential future compensation expense.
This $3,672,000 includes approximately $559,000 related to unvested performance
options granted to certain Company executives for which the performance
objectives were not met within the required time periods, although they could
vest under certain circumstances such as (i) change of control, (ii)
constructive termination or (iii) termination other than for cause. See Note
5.


F-48


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE
8:  STOCK OPTIONS AND WARRANTS (Continued)


Detail of
Plan Option activity for the year ended September 30, 2008 is as
follows:


Number
      of
                    Shares
                
                
                Weighted
                    Average
                    Exercise
      PriceBalance,
      beginning of period
                
                
                7,471,332
                
                
                $
                1.43Granted
      during the period
                
                
                960,000
                
                
                $
                1.00Expired
      or forfeited during the period
                
                
                ( 328,332
                )
                
                $
                3.37Balance,
      end of the period
                
                
                8,103,000
                
                
                $
                1.31Exercisable
      at end of the period
                
                
                4,544,250
                
                
                $
                1.11





The
Company’s outstanding exercisable Plan Options at September 30, 2008 have a
remaining life of approximately 2.0 years and exercise prices ranging from $0.71
to $2.98 per share.





As of
September 30, 2008, the Company had 2,420,284 outstanding Non Plan options
issued to employees and directors, which were issued during the year ended
September 30, 2005. During that period, the Company issued immediately
exercisable five-year options to certain executives, directors and other
management for the purchase of 1,350,000 shares of ONSM common stock at $1.57
per share (fair market value at date of grant); five-year options to certain
executives, fully-vested as of September 30, 2005, for the purchase of 800,000
shares of ONSM common stock at $2.50 per share (greater than the $1.57 fair
market value at date of grant); and 281,390 immediately exercisable options at
an exercise price of $3.376 per share, issued in conjunction with the Onstream
Merger and of which 11,106 have expired as of September 30,
2008.


F-49


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE
8:  STOCK OPTIONS AND WARRANTS (Continued)


As of
September 30, 2008, the Company had 1,848,962 outstanding and fully vested Non
Plan options issued to financial consultants, as follows:


Issuance period
                
                Number
                    of options
                
                
                Exercise
      price
                    per share
                
                Expiration
                    DateOctober
      2007
                
                
                150,000
                
                
                $
                1.73
                
                Oct
      2011October
      2007
                
                
                100,000
                
                
                $
                1.83
                
                Oct
      2011Year
      ended September 30, 2008
                
                
                250,000October
      - December 2006
                
                
                75,000
                
                
                $
                1.00
                
                Oct
      - Dec 2010December
      2006
                
                
                40,000
                
                
                $
                1.50
                
                December
      2010January
      – December 2007
                
                
                490,000
                
                
                $
                2.46
                
                Oct
      2010 - Dec 2011March
      2007
                
                
                21,184
                
                
                $
                2.48
                
                March
      2012Year
      ended September 30, 2007
                
                
                626,184October
      2005 – August 2006
                
                
                295,000
                
                
                $
                1.00
                
                Oct
      2009 – Aug 2010March
      – September 2006
                
                
                85,750
                
                
                $
                1.05
                
                March
      2011Year
      ended September 30, 2006
                
                
                380,750July
      – September 2005
                
                
                225,000
                
                
                $
                1.10
                
                July
      – Sept 2009January
      – March 2005
                
                
                215,000
                
                
                $
                1.65
                
                Jan
      – Feb 2009January
      2005
                
                
                30,000
                
                
                $
                2.50
                
                January
      2009January
      2005
                
                
                50,000
                
                
                $
                3.50
                
                January
      2009December
      2004
                
                
                37,028
                
                
                $
                3.376
                
                Mar
      2008 – Dec 2009Year
      ended September 30, 2005
                
                
                557,028May
      2004
                
                
                35,000
                
                
                $
                2.25
                
                May
      2009Year
      ended September 30, 2004
                
                
                35,000Total
      Non Plan consultant options
                    as
      of September 30, 2008
                
                
                1,848,962


F-50


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE
8:  STOCK OPTIONS AND WARRANTS (Continued)
 
 As of
September 30, 2008, the Company had outstanding vested warrants, primarily
issued in connection with various financings, to purchase an aggregate of
2,783,485 shares of common stock, as follows:


Description of
      transaction
                
                Number
      of
                    warrants
                
                
                Exercise
      price
                    per share
                
                Expiration
                    DatePlacement
      fees – common share offering –
                    March
      and April 2007
                
                
                342,222
                
                
                $
                2.70
                
                March
      and April
                    20128%
      Subordinated Convertible Debentures –
                    March
      and April 2006
                
                
                403,650
                
                
                $
                1.50
                
                March
      and April
                    2011Additional
      8%  Convertible Debentures -
                    February
      and April 2005
                
                
                391,416
                
                
                $
                1.65
                
                February
      and April
                    20108%
      Convertible Debentures – December 2004
                
                
                737,114
                
                
                $
                1.65
                
                December
      2009Series
      A-10 Preferred – December 2004
                
                
                909,083
                
                
                $
                1.50
                
                December
      2009Total
      warrants as of September 30, 2008
                
                
                2,783,485


In March
and April 2006, in connection with the sale of the 8% Subordinated Convertible
Debentures, the Company issued five year common stock purchase warrants to
purchase an aggregate of 987,500 shares of ONSM common stock, which included
selling agent fees, exercisable starting six months after issuance. These
warrants have an exercise price of $1.50 per share, subject to adjustment in the
event of stock splits, stock dividends, pro rata distributions of equity
securities, evidences of indebtedness, rights or warrants to purchase common
stock or cash or any other asset or mergers or consolidations. These warrants,
of which 403,650 remain outstanding as of September 30, 2008, include a cashless
exercise feature, which provides that, starting one year after issuance, in the
event the shares are not subject to an effective registration statement at the
time of exercise, the holder could elect a “cashless exercise” whereby the
Company would issue shares based on the excess of the market price at the time
of the exercise over the warrant exercise price. The number of shares of ONSM
common stock that can be issued upon the exercise of the warrants is limited to
the extent necessary to ensure that following the exercise the total number of
shares of ONSM common stock beneficially owned by the holder does not exceed
4.999% of the Company’s issued and outstanding common stock.


In
December 2004, in connection with the sale of the 8% Convertible Debentures, the
Company issued five-year warrants to purchase 1,957,500 common shares of ONSM,
which included selling agent fees,  exercisable for $1.65 per share.
737,114 of these warrants remain outstanding as of September 30, 2008. In
February and April 2005, in connection with the sale of the Additional 8%
Convertible Debentures the Company issued five-year warrants to purchase 978,750
common shares of ONSM, which included selling agent fees, exercisable for $1.65
per share. 391,416 of these warrants remain outstanding as of September 30,
2008. The number of shares of ONSM common stock that can be issued upon the
exercise of the $1.65 warrants is limited to the extent necessary to ensure that
following the exercise the total number of shares of ONSM common stock
beneficially owned by the holder does not exceed 9.999% of the Company’s issued
and outstanding common stock.
 
 See Note
6 related to the warrants issued with the Series A-10 Preferred. See Note 5
related to certain registration payment arrangements and related provisions
contained in the above $1.50 and $1.65 warrants.


F-51


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008


NOTE 9:
NARROWSTEP ACQUISITION


On May
29, 2008, the Company entered into an Agreement and Plan of Merger (the “Merger
Agreement”) to acquire Narrowstep, Inc. (“Narrowstep”), a Delaware corporation
with most of its employees and facilities located in the United Kingdom.
Narrowstep is a provider of Internet TV services supporting content providers,
broadcasters, telecommunications companies and corporations worldwide. The
initial Narrowstep Merger Agreement was amended twice (on August 13, 2008 and on
September 15, 2008)  and on September 23, 2008, the Company filed a
combination Proxy/Form S-4 for the transaction with the SEC. As a result of the
SEC’s comments, the Company filed an amended Proxy/Form S-4 on November 6, 2008.
The SEC has provided the Company with comments on this amended Proxy/Form S-4,
which Company management believes will not require a long period of time to
address. However, the Company is unable to file further amendments to the
Proxy/Form S-4 until after the fiscal 2008 audit is completed and the related
Form 10-KSB is filed with the SEC.





Pursuant
to the Merger Agreement, at the effectiveness of the Merger (the “Effective
Time”) which is currently expected to be no sooner than October 2008, each
outstanding share of Narrowstep common stock, par value $0.000001 per share
(“Narrowstep Common Stock”), including shares issued under restricted stock
awards, and other than shares held by stockholders who have perfected their
appraisal rights under Delaware law, cancelled shares and shares held by any
subsidiary of Narrowstep (collectively, the “Shares to be Converted”), will be
converted into (i) shares of Onstream common stock, par value $0.0001 per share
(“Onstream Common Stock”) based on an exchange ratio determined as described
below and (ii) one contingent value right (a “Contingent Value Right”) having
terms and conditions described below. Onstream Common Stock and Contingent Value
Rights issued for Narrowstep Common Stock issued pursuant to certain restricted
stock awards will be subject to any vesting conditions in those
awards.





The
aggregate number of shares of Onstream Common Stock issuable in the Acquisition
in exchange for the Shares to be Converted. will be the greater of (i) the sum
of (A) two (2) times Annualized Narrowstep Revenue (as defined in the Merger
Agreement) and (B) one (1) times the amount of Narrowstep’s cash and cash
equivalents immediately prior to the Effective Time, including any proceeds in
escrow from Series A Preferred Stock as discussed below, and the sum of these
items not exceeding $600,000 and (ii) 8,100,000.  The exchange ratio
will be the amount determined as described in the prior sentence divided by the
Shares to be Converted plus the number of Narrowstep shares held by stockholders
who have perfected their appraisal rights ( the “Exchange Ratio”).





The final
Exchange Ratio will be determined based on Narrowstep’s consolidated revenues
for the quarter ended May 31, 2008 (after adjustments as defined in the Merger
Agreement) and may not be known prior to the Effective
Time.  Accordingly, the Merger Agreement provides that the Shares to
be Converted will receive an aggregate of 8,100,000 shares of Onstream Common
Stock (the “Minimum Exchange Ratio”) upon consummation of the
Merger.  In the event that the final Exchange Ratio exceeds the
Minimum Exchange Ratio, former holders of Shares to be Converted will receive
additional shares of Onstream Common Stock within 30 days after the final
determination of the Exchange Ratio.  No assurance can be given that
the Exchange Ratio will exceed the Minimum Exchange Ratio.





In the
Acquisition, outstanding shares of Narrowstep’s Series A Preferred Stock, par
value $0.000001 per share (the “Series A Preferred Stock”), will be converted
into an aggregate of 2,000,000 shares of Onstream Common Stock.


F-52


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE 9:
NARROWSTEP ACQUISITION (Continued)





In
connection with the Acquisition, the Surviving Corporation will assume
Narrowstep’s obligations under its outstanding Warrants for the purchase of up
to 39,449,939 shares of Narrowstep Common Stock, which includes the 2007
Warrants discussed below.  From and after the Acquisition, except as
summarized below, holders of warrants will have the right to exercise their
warrants for a number of shares of Onstream Common Stock and at exercise prices
appropriately adjusted to give effect to the greater of the Exchange Ratio or
the Minimum Exchange Ratio.  Holders of warrants issued by Narrowstep
in August 2007 to acquire an aggregate of 22,726,400 shares of Narrowstep Common
Stock (the “2007 Warrants”) will have the right to exercise their 2007 Warrants
for cash only for an aggregate of 1,000,000 shares of Onstream Common Stock at
an exercise price of $3.50 per share.  In the event that any of the
warrants are exercised prior to the Final Exercise Date (as defined in the CVR
Agreement referenced below), an exercising holder will also be entitled to
receive Contingent Value Rights in an amount equal to the number of Contingent
Value Rights such holder would have received had its warrants been exercised
immediately prior to the Effective Time.  In connection with the
Merger Agreement, holders of a majority of the 2007 Warrants have entered into
an Amendment and Waiver Agreement with Narrowstep (the “Amendment and Waiver
Agreement”) pursuant to which such holders, on behalf of themselves and all
other holders of the 2007 Warrants, agreed to amend the terms of the 2007
Warrants as provided above and to waive certain antidilution and other
rights.





Narrowstep
has agreed that, for a period of at least fifteen (15) days prior to the
Effective Time, it shall provide each holder of an option (“Narrowstep Option”)
granted by it under the Narrowstep Inc. 2004 Stock Plan or otherwise with the
opportunity to exercise each such Narrowstep Option, regardless of whether such
Narrowstep Option is otherwise vested or exercisable.  To the extent
that any such Narrowstep Option is not exercised prior to the Effective Time,
such Narrowstep Option shall be canceled and be of no further force and
effect.  If any Narrowstep Options are exercised prior to the
Effective Time, any shares of Narrowstep Stock issued as a result thereof will
be included in the total number of Shares to be Converted.





The
Contingent Value Rights will be issued pursuant to the terms of a Contingent
Value Rights Agreement to be entered into among Onstream, the CVR Representative
and the Rights Agent, in the form attached to the Merger Agreement (the “CVR
Agreement”).  Pursuant to the terms and subject to the conditions set
forth in the CVR Agreement, the Contingent Value Rights will be converted into
shares of Onstream Common Stock in the event that the Narrowstep business
reaches certain revenue targets for the 18 month period starting 6 months after
the Acquisition; provided, however, that the maximum number of shares of
Onstream Common Stock issuable in the Acquisition, including those pursuant to
the Contingent Value Rights and the conversion of the Series A Preferred Stock,
will not exceed 20,000,000.  The number of shares of Onstream Common
Stock issuable upon the conversion of each Contingent Value Right will depend on
a number of factors, including the Narrowstep business meeting the revenue
targets set forth in the CVR Agreement and the number of warrants, if any,
exercised prior to the final determination of the consideration, if any, to be
paid pursuant to the CVR Agreement.  The conversion of Contingent
Value Rights into Onstream Common Stock will occur in two stages, shortly
following the final determination of whether the initial 12-month and subsequent
6-month revenue targets within the 18-month revenue measurement period have been
met. The Contingent Value Rights will not be transferable by the holders thereof
except by operation of law in limited circumstances.


F-53


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE 9:
NARROWSTEP ACQUISITION (Continued)





The
Boards of Directors of both Onstream and Narrowstep have unanimously approved
the Merger Agreement and have recommended adoption of the Merger Agreement by
the respective stockholders.





The
Merger is intended to qualify as a tax-free reorganization for Federal income
tax purposes.





The
Merger Agreement contains customary representations and warranties of Narrowstep
and Onstream.  The Merger Agreement also contains customary covenants,
including covenants regarding operation of the business of Narrowstep and its
subsidiaries prior to the closing of the Merger.  In addition,
Narrowstep has agreed to use its commercially reasonable efforts to operate its
business in accordance with a restructuring plan (the “Plan”), attached as an
exhibit to the Merger Agreement, which is designed to significantly reduce or
eliminate substantial costs related to Narrowstep’s facility leases, selling,
general and administrative expenses, public company and headquarters costs, and
other professional fees and services.





The
Acquisition is subject to customary closing conditions, including obtaining the
approval of Narrowstep’s and Onstream’s stockholders.  Each of
Narrowstep and Onstream has agreed, unless the Merger Agreement is terminated
earlier, to cause a stockholders meeting to be held, for the purpose of
considering approval of the Merger and the Merger Agreement, with respect to
Narrowstep’s stockholders and, among other things, for the purpose of
considering approval of the issuance of Onstream’s common stock as provided in
the Merger Agreement, with respect to Onstream’s stockholders. The Merger
Agreement may be terminated under certain specified events, including by either
Onstream or Narrowstep if the Effective Time has not occurred on or prior to
November 30, 2008. Onstream and Narrowstep are currently negotiating to extend
this termination date, which negotiations may result in changes to other terms
of the transaction. If the Merger Agreement is terminated under certain
circumstances specified in the Merger Agreement, Narrowstep may be required to
pay a termination fee of $377,000 to Onstream.  Both Narrowstep and
Onstream have entered into voting agreements (“Voting Agreements”) pursuant to
which several significant stockholders have agreed to vote their shares in favor
of the adoption of the Merger Agreement.  Pursuant to the Voting
Agreements, the holders of approximately 35% of the Narrowstep Common Stock
presently outstanding and approximately 42% of the Onstream Common Stock
presently outstanding have agreed to vote their shares in favor of the adoption
of the Merger Agreement.





In
connection with the original Merger Agreement, as well as its subsequent
amendment, Narrowstep entered into subscription agreements (the “Subscription
Agreements”) with three of Narrowstep’s major stockholders, as well as other
qualified investors.  Under the Subscription Agreements, which contain
a  consent to the Merger, the investors agreed to purchase immediately
prior to the Merger shares of a to-be-established Series A Preferred
Stock.  Holders of the Series A Preferred Stock will be entitled to
such dividends, if any, as may be declared by the Company’s Board of Directors
out of funds legally available therefore (although no such dividends are
provided for in the Plan), will not have any voting rights (except to the extent
required by applicable law), will have no right to convert the Series A
Preferred Stock into Common Stock or any other Narrowstep security and will have
no right to force the redemption or repurchase of the Series A Preferred Stock
by Narrowstep.


F-54


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE 9:
NARROWSTEP ACQUISITION (Continued)





The
following table sets forth the components of the estimated purchase price of
$5.1 million:





Number
      of ONSM common shares issued to sellers
                  
                  
                  10,100,000Number
      of ONSM common shares issued as finders fee
                  
                  
                  200,000Number
      of ONSM common shares issued
                  
                  
                  10,300,000ONSM
      per common share closing price on September 15, 2008
                  
                  $
                  0.42Value
      of ONSM common shares issued
                  
                  $
                  4,326,000Warrants
      assumed – Black Scholes valuation
                  
                  
                  100,000Estimated
      cash transaction costs
                  
                  
                  700,000Total
      purchase price
                  
                  $
                  5,126,000





The 10.1
million ONSM common shares indicated above as issued to the sellers represents
the minimum number issuable on the Effective Date. Although the Merger Agreement
provides that the number of ONSM common shares issued to the sellers on or
shortly after the Effective Date might be greater than 10.1 million depending
on, among other things, Narrowstep’s consolidated revenues for the quarter ended
May 31, 2008 (after adjustments as defined in the Merger Agreement), the
Company’s preliminary calculations indicate that these provisions will not
result in an issuance on or shortly after the Effective Date in excess of the
minimum number indicated above. In the event the Company is required to issue
shares above the minimum, it will be recorded as additional purchase price
included in goodwill and subject to periodic evaluation for
impairment.





EITF No.
99-12 indicates that securities given in a business combination should be
measured during a period only up to "a few days before and after” the
measurement date, which in this case September 15, 2008, the day before the
September 15, 2008 signing of the second amendment to the definitive merger
agreement was publicly announced on September 16, 2008. The ONSM market price
was $0.49 per share on September 10, 2008, $0.42 per share on September 15, 2008
and $0.37 per share on September 18, 2008. The Company believes that the prices
three business days before and three business days after were not materially
different from the price as of the date the second amendment to the definitive
merger agreement was publicly announced and so the value at that date is
acceptable for valuing the ONSM common shares issued in connection with the
Acquisition.





EITF No.
99-12 indicates that if the purchase price (i.e., number of shares or other
consideration) is substantively changed after the initial acquisition agreement
is announced, that the measurement date would be changed to be the date that the
new terms were announced. On September 16, 2008, the Company publicly announced
the September 15, 2008 amendment of the Merger Agreement and related documents,
which amendment resulted in a 1.0 million share decrease in the minimum number
of ONSM shares to be issued to the holders of Narrowstep common shares and no
change in the number of ONSM shares to be issued to the holders of Narrowstep
preferred shares. The terms of this second amendment resulted in an
approximately 9% decrease in the total minimum number of ONSM shares to be
issued in the transaction, from 11.1 million to 10.1 million, which the Company
determined to be a substantive change. Therefore, based on the guidance provided
in EITF 99-12, a change in the measurement date, to the date the second
amendment was announced, was indicated.


F-55


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE 9:
NARROWSTEP ACQUISITION (Continued)





The above
purchase price will be allocated by the Company to assets acquired and
liabilities assumed, based upon its determination of the fair value of those
assets and liabilities on the Effective Date. Based on information currently
available to it, the Company expects the fair value of the assets acquired, net
of assumed liabilities, will be approximately $2.9 million (including intangible
assets such as customer lists, tradenames, URLs (internet domain names) and
employment agreements) and goodwill will be approximately $2.2 million. These
estimates of fair value may change based upon completion of the Company’s final
valuation. In accordance with applicable accounting pronouncements, goodwill is
not amortized but is reviewed annually (or more frequently if impairment
indicators arise) for impairment. Other intangible assets, such as customer
lists, are amortized to expense over their estimated useful lives, although the
unamortized balances are still subject to review and adjustment for impairment.
In the event the Company is required to issue shares or pay cash under the CVR
Agreement, it will be recorded as additional purchase price included in goodwill
and subject to periodic evaluation for impairment as well.





The
shares of Narrowstep Common Stock being exchanged for a portion of the 10.1
million ONSM common shares to be issued in the Merger include restricted shares
subject to vesting conditions established at the time those restricted shares
were issued.  Most of those restricted shares will vest as a result of
termination of the holder’s employment arising from a change in control, the
definition of which is satisfied by the Merger. The remaining restricted shares
will convert on the Effective Date to restricted ONSM common shares, which will
vest under the original conditions, primarily the holder’s continued service as
an employee for a certain period after the Effective Date. Since these
restricted ONSM common shares are considered immaterial to the transaction as a
whole, they are included as part of the Narrowstep purchase price.





In
connection with, and in anticipation of, the Acquisition, the Company entered
into an employment contract with an individual who was employed by Narrowstep as
a consultant upon the signing of the Definitive Agreement and will become an
employee (and the Managing Director) of Narrowstep on the Effective Date,
although the Company’s obligations under the contract are not contingent on the
closing of the merger. The terms of this contract include:





a) Base
fees/salary of $20,000 per month (pro-rated for initial part-time
service),





b) A
recoverable draw of $2,000 per month for the first six months, to be deducted
from future paid commissions if applicable,





c)
Commissions of 1% on Narrowstep’s sales that are 25% above annualized existing
revenue and 2% on sales that are 50% above annualized existing
revenue,





d)
Four-year vested options for the purchase of 15,000 common ONSM shares for every
one million dollars that Narrowstep’s sales are above 125% annualized existing
revenue,  applicable for the first two years of
service,


F-56


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE 9:
NARROWSTEP ACQUISITION (Continued)





e)
Four-year term (from vesting) option grants for the purchase of 400,000 common
ONSM shares, vesting over four years at 100,000 per year, and





f)
Reimbursement of travel and moving expenses up to $16,000.





All
options are exercisable at the fair market value at the date of grant, but no
less than $1.00 per share. The employment contract contains non-compete
provisions and is for a minimum term of one year from the signing of the
Definitive Agreement and provides for 6 months severance in the event of
termination without cause after that one year period. The Company has estimated
the total compensation expense under the above arrangement to be approximately
$302,000 for the initial year, which includes expected salary, expense
reimbursement and minimum commission payments, as well as the fair value of the
400,000 guaranteed options, the latter calculated in accordance with the
provisions of SFAS No. 123R, “Share-Based Payments”, using the Black-Scholes
model with the following assumptions: expected volatility of 79-90%, risk-free
interest rate of 4.5%, expected dividends of $0 and expected term of 6.5 years,
the average term of the related options. This total compensation expense
excludes commissions and options that are contingent on increased
sales.





The Board
of Directors of Narrowstep selected W. Austin Lewis IV to act as the Stockholder
Representative under the merger agreement and as the Contingent Value Rights
Representative under the contingent value rights agreement.  Pursuant
to the terms of the merger agreement and the contingent value rights agreement,
Mr. Lewis is required to perform certain duties on behalf of the former
stockholders of Narrowstep, including confirming or disputing the Company’s
calculation of the exchange ratio under the merger agreement and the amount of
consideration, if any, payable under the contingent value rights
agreement.  Mr. Lewis is the principal owner of Lewis Asset Management
Corp., Lewis Opportunity Fund and LAM Opportunity Fund, and as such the
beneficial owner of approximately 3,414,893 shares of the Company’s common
stock.  In addition, pursuant to the merger agreement, Lewis Asset
Management Corp., Lewis Opportunity Fund and/or LAM Opportunity Fund will
receive in aggregate approximately 1,767,387 additional shares of the Company’s
common stock and 11,506,667 contingent value rights in exchange for the shares
of Narrowstep common and preferred stock beneficially owned by them or expected
to be owned by them on the effective date of the merger.


F-57


ONSTREAM
MEDIA CORPORATION AND SUBSIDIARIES


NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2008





NOTE 9:
NARROWSTEP ACQUISITION (Continued)





In
addition, Lewis Opportunity Fund and LAM Opportunity Fund hold in aggregate
warrants to purchase 26,250 shares of the Company’s common stock at $1.50 per
share and warrants to purchase 2,770,000 shares of Narrowstep common stock, the
latter which will be assumed by the Company upon the merger and converted into
warrants to purchase 132,383 shares of our common stock at prices from $3.50 to
$10.34 per share, with a weighted average price of $5.75 per share and which
will also result in the issuance of up to 2,770,000 contingent value rights in
the event the warrants are exercised within 25 months after the effective date
of the merger. Further, Mr. Lewis executed voting agreements with respect to his
beneficially owned common shares in both Onstream and Narrowstep. Because of his
ownership interest in Onstream, Mr. Lewis may be presented with circumstances
where his duties under the merger agreement and the contingent value rights
agreement conflict with his financial interest in Onstream.  Pursuant
to the terms of the merger agreement and the contingent value rights agreement,
the former Narrowstep stockholders do not have the right to remove Mr. Lewis as
the Stockholder Representative and may only remove Mr. Lewis as the Contingent
Value Rights Representative by action of the holders of a majority of the
contingent value rights.  Mr. Lewis is not required to recuse himself
from any situation where a conflict of interest may exist and will not be liable
to the former Narrowstep stockholders for any act or omission as Stockholder
Representative or Contingent Value Rights Representative except to the extent
such act or omission has been held by a court of competent jurisdiction to
constitute willful misconduct or gross negligence.








NOTE 10:
SUBSEQUENT EVENTS





During
the period from October 1, 2008 through December 5, 2008, the Company issued
5,348 unregistered shares of common stock for financial consulting and advisory
services. The services were provided over a period of one month, and will result
in a professional fees expense of approximately $2,000 over the service period.
None of these shares were or will be issued to Company directors or
officers.





On
November 11, 2008, the Company issued 158,000 unregistered shares of common
stock for interest on $1,000,000 face value convertible debentures (see Note 4)
for the period from June 2008 through October 2008. The shares were in
satisfaction of interest expense of approximately $48,740 recognized over that
period. None of these shares were issued to Company directors or
officers.





The
Company’s Board declared a dividend payable on November 15, 2008 to Series A-10
shareholders of record as of November 10, 2008 of 2,994 Series A-10 preferred
shares, in lieu of a $29,938 cash payment.





On
December 5, 2008 the Company entered into an agreement whereby one of the former
owners of Auction Video Japan, Inc. agreed to shut down the Japan office of
Auction Video as well as assume all of the Company’s outstanding assets and
liabilities connected with that operation, in exchange for non-exclusive rights
to sell Onstream Media products in Japan and be compensated on a commission-only
basis. As a result, the Company will recognize other income of approximately
$45,000 for the three months ended December 31, 2008, which is the difference
between the assumed liabilities of approximately $84,000 and the assumed assets
of approximately $39,000. See Note 2.


F-58