UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
DC 20549







FORM
10-Q








x
            Quarterly
      Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act
      of 1934For
      the quarterly period ended September 30,
      2009




or





o
            Transition
      Report Pursuant to Section 13 or 15(d) of the
      Securities Exchange Act of 1934For
      the transition period from
      to





Commission
file number 000-51995





TELANETIX,
INC.


(Exact
name of registrant as specified in its charter)





Delaware
            77-0622733(State
      or other jurisdiction of incorporation or organization)
            (I.R.S.
      Employer Identification No.)11201
      SE 8th
      Street, Suite 200
              Bellevue,
      Washington
            98004(Address
      of principal executive offices)
            (Zip
      Code)





(206)
621-3500


(Registrant's
telephone number, including area code)





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





Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding
12 months (or for such shorter period that the registrant was required to submit
and post such files).    Yes  ̈    No  ̈





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
the definitions of "large accelerated filer", "accelerated filer" and "smaller
reporting company" in Rule 12b-2 of the Exchange Act. (Check
one):





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





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





As of
November
6, 2009,  31,768,320 shares of the issuer's common stock, par
value $0.0001 per share, were outstanding.  The common stock is the
issuer's only class of stock currently outstanding.




Table of Contents




Telanetix,
Inc.




Quarterly
Report on Form 10-Q




For
the Three and Nine months Ended September 30, 2009







TABLE OF
CONTENTS





PageFORWARD
      LOOKING STATEMENTSPART
      I - FINANCIAL INFORMATIONItem
      1.
            FINANCIAL STATEMENTS
            4Item
      2.
            MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
      RESULTS OF OPERATIONS
            20Item
      3.
            QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
      RISK
            34Item
      4.
            CONTROLS AND PROCEDURES
            34PART
      II - OTHER INFORMATIONItem
      1.
            LEGAL PROCEEDINGS
            35Item
      1A.
            RISK FACTORS
            35Item
      2.
            UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF
      PROCEEDS
            35Item
      3.
            DEFAULTS UPON SENIOR SECURITIES
            35Item
      4.
            SUBMISSION OF MATTERS TO A VOTE OF SECURITY
      HOLDERS
            35Item
      5.
            OTHER INFORMATION
            35Item
      6.
            EXHIBITS
            35SIGNATURES
            36EXHIBIT INDEX
            37





Table of Contents




In this
report, unless the context indicates otherwise, the terms "Telanetix," "Company," "we," "us," and "our" refer to Telanetix, Inc.,
a Delaware corporation, and its wholly-owned subsidiaries.




FORWARD
LOOKING STATEMENTS




This
Quarterly Report on Form 10-Q contains forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933, or the "Securities Act," and Section
21E of the Securities Exchange Act of 1934 or the "Exchange Act."  In
some cases, you can identify forward looking statements by terms such as "may,"
"intend," "might," "will," "should," "could," "would," "expect," "believe,"
"anticipate," "estimate," "predict," "potential," or the negative of these
terms.  These terms and similar expressions are intended to identify
forward-looking statements.  Such statements are subject to certain
risks and uncertainties, which could cause actual results to differ materially
from those projected, including those set forth under "Item 1A. Risk Factors" in
"Part II—Other Information" and elsewhere in, or incorporated by reference into,
this report.




The
forward-looking statements in this report are based upon management's current
expectations and belief, which management believes are reasonable.  In
addition, we cannot assess the impact of each factor on our business or the
extent to which any factor or combination of factors, or factors we are aware
of, may cause actual results to differ materially from those contained in any
forward looking statements.  You are cautioned not to place undue
reliance on any forward-looking statements.  These statements
represent our estimates and assumptions only as of the date of this Quarterly
Report on Form 10-Q.  Except to the extent required by federal
securities laws, we undertake no obligation to update any forward-looking
statement to reflect events or circumstances after the date hereof or to reflect
the occurrence of unanticipated events.




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




·
            market
      acceptance and market demand for our products and
  services;


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


·
            the
      adequacy of our financial resources to execute our business
      plan;


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


·
            our
      ability to successfully obtain a diverse customer
  base;


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


·
            our
      ability to attract, retain and motivate key technical, marketing and
      management personnel;


·
            our
      ability to respond to new developments in technology and new applications
      of existing technology before our
competitors;


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


·
            our
      ability to maintain and execute a successful business strategy;
      and


·
            we
      face other risks described from time to time in periodic and current
      reports we file with the United States Securities and Exchange Commission,
      or the "SEC."




Other
risks and uncertainties include such factors, among others, pricing, the
changing regulatory environment, the effect of our accounting policies,
potential seasonality, industry trends, possible disruption in commercial
activities occasioned by terrorist activity and armed conflict, and other risk
factors detailed in this report and our other SEC filings.  You should
consider carefully the statements under "Item 1A. Risk Factors" in "Part
II—Other Information" and other sections of this report, which address
additional factors that could cause our actual results to differ from those set
forth in the forward-looking statements and could materially and adversely
affect our business, operating results and financial condition.  All
subsequent written and oral forward-looking statements attributable to us or
persons acting on our behalf are expressly qualified in their entirety by the
applicable cautionary statements.




3
 Table of Contents




PART
I--FINANCIAL INFORMATION


Item 1. FINANCIAL STATEMENTS


TELANETIX,
INC.
 Condensed
Consolidated Balance Sheets
 
 September
      30, 2009
                  
                  
                  December
      31, 2008(Unaudited)ASSETSCurrent
      assetsCash
                  
                  $
                  1,015,699
                  
                  
                  $
                  975,137Accounts
      receivable, net
                  
                  
                  2,172,990
                  
                  
                  
                  3,591,859Inventory
                  
                  
                  681,265
                  
                  
                  
                  556,321Prepaid
      expenses and other current assets
                  
                  
                  573,417
                  
                  
                  
                  568,242Total
      current assets
                  
                  
                  4,443,371
                  
                  
                  
                  5,691,559Property
      and equipment, net
                  
                  
                  4,185,309
                  
                  
                  
                  5,178,194Goodwill
                  
                  
                  7,044,864
                  
                  
                  
                  7,821,728Purchased
      intangibles, net
                  
                  
                  13,928,337
                  
                  
                  
                  16,233,337Other
      assets
                  
                  
                  947,250
                  
                  
                  
                  983,098Total
      assets
                  
                  $
                  30,549,131
                  
                  
                  $
                  35,907,916LIABILITIES
      AND STOCKHOLDERS' EQUITY (DEFICIT)Current
      liabilitiesAccounts
      payable
                  
                  $
                  2,896,173
                  
                  
                  $
                  2,456,706Accrued
      liabilities
                  
                  
                  2,985,597
                  
                  
                  
                  2,954,312Accrued
      interest
                  
                  
                  —
                  
                  
                  
                  888,242Deferred
      revenue
                  
                  
                  1,130,546
                  
                  
                  
                  1,021,389Current
      portion of capital lease obligations
                  
                  
                  714,118
                  
                  
                  
                  939,603Warrant
      and beneficial conversion feature liabilities
                  
                  
                  7,609,987
                  
                  
                  
                  5,398,724Total
      current liabilities
                  
                  
                  15,336,421
                  
                  
                  
                  13,658,976Non-current
      liabilitiesAccrued
      interest
                  
                  
                  2,367,556
                  
                  
                  
                  —Capital
      lease obligations, net of current portion
                  
                  
                  528,718
                  
                  
                  
                  814,052Deferred
      revenue
                  
                  
                  231,629
                  
                  
                  
                  188,134Convertible
      debentures, less current portion
                  
                  
                  17,900,109
                  
                  
                  
                  20,302,430Total
      non-current liabilities
                  
                  
                  21,028,012
                  
                  
                  
                  21,304,616Total
      liabilities
                  
                  
                  36,364,433
                  
                  
                  
                  34,963,592Stockholders'
      equity (deficit)Common
      stock, $.0001 par value; Authorized: 300,000,000 shares;Issued
      and outstanding: 31,768,320 at September 30, 2009 and 31,384,374 at
      December 31, 2008
                  
                  
                  3,177
                  
                  
                  
                  3,139Additional
      paid in capital
                  
                  
                  34,123,454
                  
                  
                  
                  33,211,274Warrants
                  
                  
                  1,551,802
                  
                  
                  
                  10,000Accumulated
      deficit
                  
                  
                  (41,493,735
                  )
                  
                  
                  (32,280,089
                  )Total
      stockholders' equity (deficit)
                  
                  
                  (5,815,302
                  )
                  
                  
                  944,324Total
      liabilities and stockholders' equity (deficit)
                  
                  $
                  30,549,131
                  
                  
                  $
                  35,907,916
 The
accompanying notes are an integral part of these condensed consolidated
financial statements.
 
 4
 Table of Contents
 
 TELANETIX,
INC.
 Condensed
Consolidated Statements of Operations
 (Unaudited)
 
 Three
      months ended September 30,
                
                Nine
      months ended September 30,2009
                
                2008
                
                2009
                
                2008Revenues
                
                $
                8,094,924
                
                
                $
                8,497,585
                
                
                $
                24,246,797
                
                
                $
                24,152,881Cost
      of revenues
                
                
                3,813,407
                
                
                
                3,981,703
                
                
                
                11,417,004
                
                
                
                12,502,054Gross
      profit
                
                
                4,281,517
                
                
                
                4,515,882
                
                
                
                12,829,793
                
                
                
                11,650,827Operating
      expensesSelling
      and marketing
                
                
                1,786,170
                
                
                
                1,723,483
                
                
                
                5,181,554
                
                
                
                5,188,653General
      and administrative
                
                
                2,030,313
                
                
                
                2,689,045
                
                
                
                6,453,861
                
                
                
                9,682,377Research,
      development and engineering
                
                
                1,068,511
                
                
                
                1,266,947
                
                
                
                3,349,200
                
                
                
                4,311,155Depreciation
                
                
                275,638
                
                
                
                230,733
                
                
                
                826,141
                
                
                
                635,930Amortization
      of purchased intangibles
                
                
                585,000
                
                
                
                584,999
                
                
                
                1,755,000
                
                
                
                1,754,997Impairment
      of intangibles
                
                
                1,413,435
                
                
                
                —
                
                
                
                1,413,435
                
                
                
                —Total
      operating expenses
                
                
                7,159,067
                
                
                
                6,495,207
                
                
                
                18,979,191
                
                
                
                21,573,112Operating
      loss
                
                
                (2,877,550
                )
                
                
                (1,979,325
                )
                
                
                (6,149,398
                )
                
                
                (9,922,285
                )Other
      income (expense)Interest
      income
                
                
                67
                
                
                
                283
                
                
                
                523
                
                
                
                17,076Interest
      expense
                
                
                (799,688
                )
                
                
                (1,480,689
                )
                
                
                (3,289,654
                )
                
                
                (4,469,134
                )Change
      in fair market value of derivative liabilities
                
                
                3,755,578
                
                
                
                2,840,233
                
                
                
                224,883
                
                
                
                11,572,985Total
      other income (expense)
                
                
                2,955,957
                
                
                
                1,359,827
                
                
                
                (3,064,248
                )
                
                
                7,120,927Net
      income (loss)
                
                
                78,407
                
                
                
                (619,498
                )
                
                
                (9,213,646
                )
                
                
                (2,801,358
                )Series
      A preferred stock dividends, accretion and increase in stated
      value
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                (3,178,003
                )Net
      income (loss) applicable to common stockholders
                
                $
                78,407
                
                
                $
                (619,498
                )
                
                $
                (9,213,646
                )
                
                $
                (5,979,361
                )Net
      income (loss) per share - basic
                
                $
                0.00
                
                
                $
                (0.02
                )
                
                $
                (0.29
                )
                
                $
                (0.24
                )Net
      income (loss) per share – diluted
                
                $
                0.00
                
                
                $
                (0.02
                )
                
                $
                (0.29
                )
                
                $
                (0.24
                )Weighted
      average shares outstanding – basic
                
                
                31,667,906
                
                
                
                27,854,837
                
                
                
                31,402,501
                
                
                
                25,266,459Weighted
      average shares outstanding - diluted
                
                
                31,667,906
                
                
                
                27,854,837
                
                
                
                31,402,501
                
                
                
                25,266,459
 
 
 The
accompanying notes are an integral part of these condensed consolidated
financial statements.
 
 5
 Table of Contents
 TELANETIX,
INC.
 Condensed Consolidated Statement of Stockholders'
Equity (Deficit)
 (Unaudited)
 
 
 AdditionalCommon
      Stock
                
                Paid-In
                
                
                
                
                
                AccumulatedShares
                
                
                Amount
                
                
                Capital
                
                
                Warrants
                
                
                Deficit
                
                
                TotalBalance,
      December 31, 2008
                
                
                31,384,374
                
                
                $
                3,139
                
                
                $
                33,211,274
                
                
                $
                10,000
                
                
                $
                (32,280,089
                )
                
                $
                944,324Repurchase
      of common stock
                
                
                (533,334
                )
                
                
                (53
                )
                
                
                53
                
                
                
                
                
                
                
                
                
                
                
                —Stock
      based compensation
                
                
                
                
                
                
                
                
                
                
                825,647
                
                
                
                
                
                
                
                
                
                
                
                825,647Common
      stock issued for earn out
                
                
                917,280
                
                
                
                91
                
                
                
                86,480
                
                
                
                
                
                
                
                
                
                
                
                86,571Warrants
      reclassed from debt to equity
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                1,541,802
                
                
                
                
                
                
                
                1,541,802Net
      loss
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                (9,213,646
                )
                
                
                (9,213,646
                )Balance,
      September 30, 2009
                
                
                31,768,320
                
                
                $
                3,177
                
                
                $
                34,123,454
                
                
                $
                1,551,802
                
                
                $
                (41,493,735
                )
                
                $
                (5,815,302
                )
 
 
 The
accompanying notes are an integral part of these condensed consolidated
financial statements.
 
 
 6
 Table of Contents
 
 TELANETIX,
INC.
 Condensed
Consolidated Statements of Cash Flows
 (Unaudited)
  Nine
      months ended September 30,2009
                  
                  
                  2008Cash
      flows from operating activities:Net
      loss
                  
                  $
                  (9,213,646
                  )
                  
                  $
                  (2,801,358
                  )Adjustments
      to reconcile net loss to cash provided (used) by operating
      activities:Provision
      for doubtful accounts
                  
                  
                  (159,458
                  )
                  
                  
                  187,082Depreciation
                  
                  
                  1,646,537
                  
                  
                  
                  1,360,644Loss
      on disposal of fixed assets
                  
                  
                  2,218
                  
                  
                  
                  —Reserve
      for excess and obsolete inventory
                  
                  
                  —
                  
                  
                  
                  18,595Amortization
      of deferred financing costs
                  
                  
                  86,225
                  
                  
                  
                  236,120Impairment
      of intangible assets
                  
                  
                  1,413,435
                  
                  
                  
                  —Amortization
      of intangible assets
                  
                  
                  1,755,000
                  
                  
                  
                  1,754,997Stock
      based compensation
                  
                  
                  825,647
                  
                  
                  
                  2,494,930Amortization
      of note discounts
                  
                  
                  1,575,627
                  
                  
                  
                  2,613,957Common
      stock issued for accrued interest
                  
                  
                  —
                  
                  
                  
                  544,675Value
      of warrant issued as compensation
                  
                  
                  —
                  
                  
                  
                  227,113Exercise
      of stock options in lieu of cash severance payments
                  
                  
                  —
                  
                  
                  
                  404,582Accrued
      interest converted into debentures
                  
                  
                  —
                  
                  
                  
                  358,018Common
      stock issued for services
                  
                  
                  —
                  
                  
                  
                  509,400Change
      in fair value of warrant and beneficial conversion feature
      liabilities
                  
                  
                  (224,883
                  )
                  
                  
                  (11,572,985
                  )Changes
      in assets and liabilities:Accounts
      receivable
                  
                  
                  1,578,327
                  
                  
                  
                  (605,943
                  )Inventory
                  
                  
                  (124,944
                  )
                  
                  
                  (347,213
                  )Prepaid
      expenses and other assets
                  
                  
                  (55,552
                  )
                  
                  
                  (354,449
                  )Accounts
      payable and accrued expenses
                  
                  
                  470,752
                  
                  
                  
                  909,287Accrued
      interest
                  
                  
                  1,500,592
                  
                  
                  
                  —Deferred
      revenue
                  
                  
                  152,652
                  
                  
                  
                  78,498Net
      cash provided (used) by operating activities
                  
                  
                  1,228,529
                  
                  
                  
                  (3,984,050
                  )Cash
      flows from investing activities:Purchase
      of property and equipment
                  
                  
                  (434,703
                  )
                  
                  
                  (657,243
                  )Proceeds
      from disposal of fixed assets
                  
                  
                  43,750
                  
                  
                  
                  —Net
      cash used by investing activities
                  
                  
                  (390,953
                  )
                  
                  
                  (657,243
                  )Cash
      flows from financing activities:Proceeds
      from sale of convertible debentures
                  
                  
                  —
                  
                  
                  
                  5,000,000Deferred
      financing costs
                  
                  
                  —
                  
                  
                  
                  (175,025
                  )Proceeds
      from exercise of warrants
                  
                  
                  —
                  
                  
                  
                  125,000Payments
      on capital leases
                  
                  
                  (797,014
                  )
                  
                  
                  (956,809
                  )Payment
      of convertible debentures
                  
                  
                  —
                  
                  
                  
                  (1,225,295
                  )Payments
      on lines of credit
                  
                  
                  —
                  
                  
                  
                  (500,000
                  )Net
      cash (used) provided by financing activities
                  
                  
                  (797,014
                  )
                  
                  
                  2,267,871Net
      increase (decrease) in cash
                  
                  
                  40,562
                  
                  
                  
                  (2,373,422
                  )Cash
      at beginning of the period
                  
                  
                  975,137
                  
                  
                  
                  3,779,821Cash
      at end of the period
                  
                  $
                  1,015,699
                  
                  
                  $
                  1,406,399Supplemental
      disclosures of cash flow information:Interest
      paid
                  
                  $
                  148,488
                  
                  
                  $
                  403,732Non-cash
      investing and financing activities:Property
      and equipment acquired through capital leases
                  
                  $
                  304,528
                  
                  
                  $
                  342,326Convertible
      debentures converted into common stock
                  
                  $
                  —
                  
                  
                  $
                  1,216,796Accrued
      dividends on Series A Preferred stock
                  
                  $
                  —
                  
                  
                  $
                  394,675Preferred
      stock and accrued dividends converted into debentures
                  
                  $
                  —
                  
                  
                  $
                  15,344,675Convertible
      debentures and accrued interest converted into debentures
                  
                  $
                  —
                  
                  
                  $
                  10,654,659Warrant
      liabilities and beneficial conversion features
                  
                  $
                  —
                  
                  
                  $
                  7,171,872Common
      stock issued in connection with the acquisition of
      subsidiaries
                  
                  $
                  86,571
                  
                  
                  $
                  887,424Warrants
      reclassed from debt to equity
                  
                  $
                  1,541,802
                  
                  
                  $
                  —
 
 The
accompanying notes are an integral part of these condensed consolidated
financial statements.
  7
 Table of Contents





TELANETIX,
INC.


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)


1. Description of Business, Basis of Presentation and Going
Concern




Description
of Business:




The
Company is an IP communications company, offering a range of communications
solutions from hosted IP voice and conferencing products, to text and data
collaboration, to telepresence videoconferencing products. The Company’s
subsidiary, AccessLine Holdings Inc. ("AccessLine"), is a Bellevue,
Washington-based provider of hosted VoIP solutions to the small-and-medium
business marketplace. The Company’s subsidiaries, AVS Installation Limited
Liability Company and Union Labor Force One Limited Liability Company (together,
"AVS") provide a full range of audio visual solutions to clients and end-users
as the single point of contact during design and project implementation. The
Company’s Digital PresenceTM
product line provides its customers with a complete system for telepresence
video conferencing.




Subsequent
to September 30, 2009, the Company entered into a securities purchase agreement
pursuant to which it transferred all of the issued and outstanding membership
interests of two of its subsidiaries: AVS and ULF, to an individual purchaser.
The purchaser was an employee of AVS. The transfer related solely to our video
integration business, and not the Company’s video product
business.  The Company did not transfer any assets or intellectual
property relating to its Digital Presence product line.  See Note 11 –
Subsequent Event.




Basis
of Presentation:




The
accompanying unaudited financial statements, consisting of the condensed
consolidated balance sheet as of September 30, 2009, the condensed consolidated
statements of operations for the three and nine months ended September 30, 2009
and 2008, and the condensed consolidated statements of cash flows for the nine
months ended September 30, 2009 and 2008, have been prepared in accordance with
accounting principles generally accepted in the United States of America for
interim financial information and in accordance with the instructions to Form
10-Q. Accordingly, these condensed consolidated financial statements do not
include all of the information and footnotes typically found in the audited
consolidated financial statements and footnotes thereto included in the
Company’s Annual Report on Form 10-K. In the opinion of management, all
adjustments (primarily consisting of normal recurring adjustments) considered
necessary for a fair statement have been included.




The
condensed consolidated balance sheet at December 31, 2008, has been derived from
the audited consolidated financial statements as of that date but does not
include all of the information and footnotes included in the Company’s Annual
Report on Form 10-K for the year ended December 31, 2008. As of December 31,
2008, the Company’s independent registered auditors concluded that there was
substantial doubt about the Company’s ability to continue as a going concern,
and this condition remains as of September 30, 2009. For further information,
refer to the consolidated financial statements and footnotes thereto included in
the Company’s Annual Report on Form 10-K for the year ended December 31,
2008.




The
preparation of the condensed consolidated 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, liabilities and equity and disclosure of contingent liabilities at the
date of the financial statements and the reported amounts of revenues and
expenses during the reporting period.  Significant estimates include
those related to the allowance for doubtful accounts; valuation of inventories;
valuation of goodwill, intangible assets and property and equipment; valuation
of stock based compensation expense; the valuation of warrants and conversion
features; and other contingencies.  On an on-going basis, the Company
evaluates its estimates.  The Company bases its estimates on
historical experience and on various other assumptions that are believed to be
reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying value of assets and liabilities that are not
readily apparent from other sources.  Actual results could differ from
those estimates under different assumptions or conditions. Operating results for
the three and nine months ended September 30, 2009, are not necessarily
indicative of the results that may be expected for the full fiscal year ending
December 31, 2009.




During
the three months ended September 30, 2009, management determined that due to the
decline in performance of the Company’s Video Solutions segment, that
goodwill and intangible assets related to that segment were 100% impaired as of
September 30, 2009.  This impairment resulted in a charge of $1.4
million of impairment expense in the three months ended September 30,
2009.  There was no impairment of assets during the three months ended
September 30, 2008.




Going
Concern:




The
Company remains dependent on outside sources of funding until its results of
operations provide positive cash flows.  The Company’s previous
independent registered auditors issued a going concern uncertainty in their
report dated March 27, 2009, because there is substantial doubt about the
Company’s ability to continue as a going concern.




8
 Table of Contents





During
the years ended December 31, 2008 and 2007, the Company was unable to generate
cash flows sufficient to support its operations and was dependent on debt and
equity raised from qualified individual investors.  The Company
experienced negative financial results as follows:





2008
            
            
            2007Net
      loss
            $
            (9,683,630
            )
            
            $
            (10,633,026
            )Negative
      cash flow from operating activities
            
            (5,447,148
            )
            
            
            (5,582,487
            )Working
      capital deficit
            
            (7,967,417
            )
            
            
            (13,585,737
            )Stockholders’
      equity
            
            944,324
            
            
            
            18,377,773





These
factors raise substantial doubt about the Company’s ability to continue as a
going concern.  The financial statements contained herein do not
include any adjustments relating to the recoverability and classification of
recorded asset amounts or amounts and classification of liabilities that might
be necessary should the Company be unable to continue in
existence.  The Company’s ability to continue as a going concern is
dependent upon the Company’s ability to generate sufficient cash flows to meet
its obligations on a timely basis, to obtain additional financing as may be
required, and ultimately to attain profitable operations.  However,
there is no assurance that profitable operations or sufficient cash flows will
occur in the future.




The
Company has supported current operations by raising additional operating cash
through the private sale of its preferred stock and convertible
debentures.  This has provided it with the cash flows to continue its
business plan, but has not resulted in significant improvement in its financial
position.  The Company is considering alternatives to address its cash
situation that include: (1) reducing cash operating expenses to levels that are
in line with current revenues and (2) raising capital through additional sale of
its common stock and/or debentures. The second alternative could result in
substantial dilution of existing stockholders.  There can be no
assurance that the Company’s current financial position can be improved, that it
can achieve positive cash flows from operations or that it can raise additional
working capital.




The
Company’s long-term viability as a going concern is dependent upon its ability
to:




•
            achieve
      profitability and ultimately generate sufficient cash flow from operations
      to sustain its continuing operations; and•
            locate
      sources of debt or equity funding to meet current commitments and
      near-term future requirements.





Reclassifications:




Certain
previously reported amounts have been reclassified to conform to the current
year’s presentation.  The reclassifications had no impact on net loss
or stockholders’ equity amounts previously reported.


2.
Recent Accounting Pronouncements




In May
2008, the Financial Accounting Standards Board (“FASB”) issued guidance on
accounting for convertible debt instruments that may be settled in cash upon
conversion (including partial cash settlement. The guidance requires the issuer
of certain convertible debt instruments that may be settled in cash (or other
assets) on conversion to separately account for the liability (debt) and equity
(conversion option) components of the instrument in a manner that reflects the
issuer’s non-convertible debt borrowing rate. The guidance is effective for
fiscal years beginning after December 15, 2008 on a retroactive basis and was
adopted by the Company in the first quarter of fiscal 2009. The adoption of this
guidance did not materially impact the Company’s consolidated financial position
and results of operations.




In June
2008, the FASB approved guidance on determining whether an instrument (or
embedded feature) is indexed to an entity’s own stock. The guidance instructs an
entity to use a two-step approach to evaluate whether an equity-linked financial
instrument (or embedded feature) is indexed to its own stock, including
evaluating the instrument’s contingent exercise and settlement provisions. The
adoption of this guidance on January 1, 2009, required the Company to perform
additional analyses on both its freestanding equity derivatives and embedded
equity derivative features. The adoption of this guidance did not have a
material effect on the Company’s consolidated financial statements in
2009.




In
September 2006, the FASB provided enhanced guidance for using fair value to
measure assets and liabilities, with further clarification of how to measure
certain nonfinancial assets and liabilities in February 2008.  This
guidance became effective at the beginning of the Company’s fiscal 2009. The
adoption of this guidance did not have a material impact on the Company’s
consolidated financial statements in 2009.




In
October 2008, the FASB issued guidance which clarifies how to determine the fair
value of a financial asset when the market that is not active. Additional
guidance is provided regarding how the reporting entity’s own assumptions should
be considered when relevant observable inputs do not exist, how available
observable inputs in a market that is not active should be considered when
measuring fair value, and how the use of market quotes should be considered when
assessing the relevance of inputs available to measure fair value. The adoption
of this guidance did not have a material impact on the Company’s consolidated
financial statements in 2009.





9
 Table of Contents





In April
2009, the FASB issued guidance on how to determine the fair value of assets and
liabilities when the volume and level of activity for the asset/liability has
significantly decreased and on identifying circumstances that indicate a
transaction is not orderly. In addition, the guidance requires disclosure in
interim and annual periods of the inputs and valuation techniques used to
measure fair value and a discussion of changes in valuation techniques. The
adoption of the guidance did not have a material impact on our consolidated
financial statements.





In May
2009, the FASB issued guidance establishing general standards for accounting and
disclosure of events that occur after the balance sheet date but before
financial statements are available to be issued. More specifically, the guidance
sets forth the period after the balance sheet date during which management of a
reporting entity should evaluate events or transactions that may occur for
potential recognition in the financial statements, identifies the circumstances
under which an entity should recognize events or transactions occurring after
the balance sheet date in its financial statements and the disclosures that
should be made about events or transactions that occur after the balance sheet
date. The adoption of the guidance did not have a material impact on our
consolidated financial statements.





In June
2009, the FASB issued guidance to establish a single source of authoritative
nongovernmental Generally Accepted Accounting Principles (“GAAP”) in the United
States. The guidance is effective for interim and annual periods ending after
September 15, 2009, or as of July 1, 2009 for the Company.  Adoption
of the guidance did not have an impact on our consolidated financial
statements.





In
September 2009, FASB’s Emerging Issues Task Force (“EITF”) issued authoritative
guidance addressing certain revenue arrangements with multiple deliverables.
This guidance states that tangible products with hardware and software
components that work together to deliver the product functionality are
considered non-software products, and the accounting guidance under the revenue
arrangements with multiple deliverables is to be followed. This guidance is
effective for the Company’s future interim reporting period ending on September
30, 2010. The Company is currently evaluating the impact of the implementation
of this guidance on its financial position, results of operations and cash
flows.


3.
Securities Exchange and Amendment Agreements




On June
30, 2008, the Company entered into a Securities Exchange Agreement with the
investors in its previous debenture and preferred stock
financings.  Under this Securities Exchange Agreement the Company
issued six-year, interest only debentures due June 30, 2014 in exchange for all
of the outstanding debentures the Company issued in December 2006, August 2007
and March 2008 and shares of preferred stock the Company issued in August
2007.  The debentures issued in this transaction amend and restate the
terms of the debentures issued in December 2006, August 2007 and March
2008.  The debentures issued in this transaction (an aggregate
principal amount of $26.1 million) were exchanged for all of the then
outstanding debentures held by the investors (an aggregate principal amount of
$10.7 million), accrued interest on the outstanding debentures of $0.1 million,
all of the then outstanding shares of preferred stock held by the investors
(stated value of $14.9 million), and accrued dividends on such preferred stock
of $0.4 million.  In connection with this transaction, the exercise
prices of the outstanding warrants issued in the previous debenture and
preferred stock financings were reduced from $1.25 per share to $1.00 per
share.  The number of common shares underlying these warrants was not
adjusted in connection with this change in exercise price. See Note 5 –
Convertible Debentures, Note 6 – Warrants and Warrant Liabilities and Note 8 –
Preferred Stock and Dividends.





In May
2009, the Company restructured the terms of its outstanding debentures issued in
June 2008, August 2008 and December 2008 (collectively, the  "PIPE Debentures") and all of
the Company’s outstanding warrants issued in December 2006, February 2007,
August 2007, March 2008, August 2008 and December 2008 (the "PIPE Warrants") pursuant to
the terms of an Amendment Agreement dated May 8, 2009 entered into between the
Company and the holders of the outstanding PIPE Debentures and PIPE Warrants
(the "Amendment
Agreement").  See Note 5 – Convertible Debentures.




4. Fair Value
Measurements





Fair
value is defined as an exit price, representing the amount that would be
received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants. As such, fair value is a market-based
measurement that should be determined based on assumptions that market
participants would use in pricing an asset or liability. As a basis for
considering such assumptions, the authoritative guidance establishes a
three-tier value hierarchy, which prioritizes the inputs used in measuring fair
value as follows: (Level 1) observable inputs such as quoted prices in active
markets; (Level 2) inputs other than the quoted prices in active markets that
are observable either directly or indirectly; and (Level 3) unobservable inputs
in which there is little or no market data, which require us to develop our own
assumptions. This hierarchy requires companies to use observable market data,
when available, and to minimize the use of unobservable inputs when determining
fair value. On a recurring basis, we measure certain financial assets and
liabilities at fair value, including our marketable securities.





At
September 30, 2009, the Company recorded a liability related to the beneficial
conversion feature of its convertible debentures (See Note 5 – Convertible
Debentures) at its fair market value of $7.6 million utilizing unobservable
inputs (Level 3).  The change in fair market value of the beneficial
conversion feature liability is included in Other Income (Expense) in the
Condensed Consolidated Statements of Operations.




10
 Table of Contents





The
change in the fair market value of the beneficial conversion feature liability
as a result of the decrease the conversion price of the PIPE Debentures from
$0.40 to $0.30 per the Amendment Agreement (see Note 3 - Securities Exchange and
Amendment Agreements) was recorded as additional debt discount of $4.0 million
on May 8, 2009. In addition, as a result of the Amendment Agreement (see Note 3
- Securities Exchange and Amendment Agreements), the anti-dilution protection
under the PIPE Warrants was removed, which eliminates the potential for future
dilution from the PIPE Warrants.  Accordingly, the PIPE Warrants,
previously reported as a derivative liability, are no longer a derivative
liability and their value as of May 8, 2009, was reclassed to
equity





The
following table provides a reconciliation of the beginning and ending balances
of the derivative liabilities as of September 30, 2009:





Warrant
      liability
            
            
            Beneficial
      conversion feature liability
            
            
            TotalBeginning
      balance January 1, 2009
            
            $
            580,712
            
            
            $
            4,818,012
            
            
            $
            5,398,724Change
      in fair market value of beneficial conversion liabilities due to change in
      conversion factor
            
            
            —
            
            
            
            3,977,948
            
            
            
            3,977,948Conversion
      of warrants to equity
            
            
            (1,541,802
            )
            
            
            —
            
            
            
            (1,541,802
            )Change
      in fair market value of warrant and beneficial conversion
      liabilities
            
            
            961,090
            
            
            
            (1,185,973
            )
            
            
            (224,883
            )Ending
      balance September 30, 2009
            
            $
            —
            
            
            $
            7,609,987
            
            
            $
            7,609,987




Certain
financial instruments are carried at cost on the consolidated balance sheets,
which approximates fair value due to their short-term, highly liquid nature.
These instruments include cash and cash equivalents, accounts receivable,
accounts payable and accrued expenses, other short-term liabilities, and capital
lease obligations. In addition, as the Company amended its debentures in May
2009, it believes that the carrying amount of its debentures approximates their
fair value as of September 30, 2009.




5. Convertible
Debentures




As
discussed in Note 3 – Securities Exchange and Amendment Agreements, pursuant to
the terms of the Securities Exchange Agreement the Company entered into with
certain investors on June 30, 2008, the Company exchanged the outstanding
debentures it issued in December 2006, August 2007 and March 2008 for newly
issued debentures, the terms of which are discussed below under the heading
“June 2008.”  Prior to entering into the Securities Exchange
Agreement, the conversion prices on the December 2006, August 2007 and March
2008 debentures were reduced to $1.25 per share pursuant to the anti-dilution
provisions of such debentures.




In August
2008, the Company issued $2.0 million principal amount of debentures, the terms
of which are discussed below under the heading “August 2008.”




In
December 2008, the Company issued $1.5 million principal amount of debentures
and amended certain terms of the debentures issued in June 2008 and August 2008.
See the discussion below under the heading “December 2008.”




In May
2009, the Company restructured the terms of its outstanding PIPE Debentures and
all of the Company’s outstanding PIPE Warrants pursuant to the terms of the
Amendment Agreement.  See the discussion below under the heading “May
2009.”




As of
September 30, 2009, the Company had reserved 98,831,000 shares of common stock
for the conversion of the outstanding PIPE Debentures.




June
2008




On June
30, 2008, the Company entered into a Securities Exchange Agreement with the
holders of all of the then outstanding debentures and shares of preferred stock
of the Company, pursuant to which the Company issued six-year, interest only
debentures due June 30, 2014 in exchange for all of the outstanding debentures
the Company issued in December 2006, August 2007 and March 2008 and shares of
preferred stock the Company issued in August 2007. See Note 3 – Securities
Exchange Agreement. The debentures issued in this transaction amended and
restated the terms of the previously outstanding debentures held by the
investors.




In
December 2008, the Company amended certain terms of the debentures issued in
June 2008, the terms of which are discussed below under the heading “December
2008.”  And, in May 2009, the Company restructured the terms of all of
its outstanding debentures, the terms of which are discussed below under the
heading “May 2009.”




The
following summarizes the terms of the debentures issued in June 2008, as amended
in December 2008 and May 2009:




Term. The debentures are due
and payable on June 30, 2014.




11
 Table of Contents





Interest. When originally
issued, interest accrued at the rate of 12.0% per annum and was payable monthly,
commencing on August 1, 2008.  In December 2008, the parties agreed to
amend the interest payment provisions to eliminate monthly interest payments at
the rate of 12% per annum.  Following this amendment, interest was
payable quarterly at the rate of (i) 0% per annum from October 1, 2008 until
September 30, 2009, (ii) 13.5% per annum from October 1, 2009 until September
30, 2012 and (iii) 18% per annum from October 1, 2012 until
maturity.  In May 2009, the parties again agreed to amend the interest
payment provisions to reduce the interest rate to 0% through June 30, 2011 and
then to 5% per annum thereafter.




Principal Payment. The
principal amount of the debenture, if not paid earlier, is due and payable on
June 30, 2014.




Payments of Interest.
Interest payments, as amended in May 2009, are due quarterly on January 1, April
1, July 1 and October 1, commencing on October 1, 2011. Interest payments are
required to be paid in cash.




Early Redemption. The Company
has the right to redeem the debentures before their maturity by payment in cash
of the then outstanding principal amount plus (i) accrued but unpaid interest,
(ii) an amount equal to all interest that would have accrued if the principal
amount subject to such redemption had remained outstanding through the maturity
date and (iii) all liquidated damages and other amounts due in respect of the
debenture. To redeem the debentures the Company must meet certain equity
conditions. The payment of the debentures would occur on the 10th day following
the date the Company gave the holders notice of the Company's intent to redeem
the debentures. The Company agreed to honor any notices of conversion received
from a holder before the pay off date of the debentures.




Voluntary Conversion by
Holder. When originally issued, the debentures were convertible at
anytime at the discretion of the holder at a conversion price per share of
$1.25, subject to adjustment including full-ratchet, anti-dilution protection.
The conversion price was reduced to $0.40 with the December 2008 amendment and
further reduced to $0.30 with the May 2009 amendment.




Forced Conversion. Subject to
compliance with certain equity conditions, the Company also has the right to
force conversion if the VWAP for its common stock exceeds 200% of the then
effective conversion price for 20 trading days out of a consecutive 30 trading
day period. Any forced conversion is subject the Company meeting certain equity
conditions and is subject to a 4.99% cap on the beneficial ownership of the
Company’s shares of common stock by the holder and its affiliates following such
conversion.




Covenants. The debentures
impose certain covenants on the Company, including restrictions against
incurring additional indebtedness, creating any liens on the Company’s property,
amending its certificate of incorporation or bylaws, redeeming or paying
dividends on shares of its outstanding common stock, and entering into certain
related party transactions. The debentures define certain events of default,
including without limitation failure to make a payment obligation, failure to
observe other covenants of the debenture or related agreements (subject to
applicable cure periods), breach of representation or warranty, bankruptcy,
default under another significant contract or credit obligation, delisting of
the Company's common stock, a change in control, failure to be
in compliance with Rule 144(c)(1) for more than 20 consecutive days, or
more than an aggregate of 45 days in any 12 month period, or if any other
conditions exist for such a period of time that the holder is unable to sell the
shares issuable upon conversion of the debenture pursuant to Rule 144
without volume or manner of sale restrictions, or failure to deliver share
certificates in a timely manner. In the event of default, the holders of the
debentures have the right to accelerate all amounts outstanding under the
debenture and demand payment of a mandatory default amount equal to 130% of the
amount outstanding plus accrued interest and expenses.  As of
September 30, 2009, the Company is in compliance with the covenants described
above.




Under the
terms of the Amendment Agreement entered into in May 2009, the Company also
agreed to additional financial performance covenants, including a requirement to
maintain at least $300,000 in cash at all times while the PIPE Debentures are
outstanding, to sustain a level of gross revenue each quarter equal to at least
80% of the average gross revenue for the trailing two quarters, and commencing
with the period ended September 30, 2009, to maintain a positive adjusted EBITDA
in each rolling two quarter period.  For example, ending September 30,
2009, the sum of the three-month adjusted EBITDA of the three months ended June
30 and September 30 must be at least $0.00 or greater.  Adjusted
EBITDA is calculated by taking the Company’s net income for the applicable
period, and adding to that amount the sum of the following: (i) any provision
for (or less any benefit from) income taxes, plus (ii) any deduction for
interest expense, net of interest income, plus (iii) depreciation and
amortization expense, plus (iv) non-cash expenses (such as stock-based
compensation and warrant compensation), plus (v) expenses related to changes in
fair market value of warrant and beneficial conversion features, plus (vi)
expenses related to impairment of tangible and intangible assets.




Security. The debentures the
Company issued are secured by all of the Company's assets under the terms of the
amended and restated security agreement the Company and its subsidiaries entered
into with the holders of the June 2008 debentures, which amends and restates the
security agreement the Company and the holders entered into in connection with
the Company's August 2007 financing. Each of the Company's subsidiaries also
entered into guarantees in favor of the investors, pursuant to which each
subsidiary guaranteed the complete payment and performance by the Company of its
obligations under the debentures and related agreements.




August
2008




On August
13, 2008, the Companyentered into a debenture
and warrant purchase agreement with one of the institutional investors that
invested in theprevious private
placements.  Under the terms of this purchase agreement, the
Companyissued a
senior secured convertible debenture with a principal amount of $2.0 million,
along with five year warrants to purchase 608,000shares of common stock at
a price of $1.00 per share, subject to adjustment, including full-ratchet
anti-dilution protection.  The rights and obligations of the investor
and of the Company with respect to the debenture and the underlying common
shares are identical to the debentures and underlying common shares issued
pursuant to the Securities Exchange Agreement dated June 30, 2008, as
amended.  The rights and obligations of the investor and of the
Company with respect to the warrant and the underlying common shares are
identical to the warrants and underlying common shares issued pursuant to the
Securities Purchase Agreement dated March 27, 2008 among the Company and the
purchasers’ signatory thereto.




12
 Table of Contents





December
2008




On
December 11, 2008, the Company entered into an amendment agreement with the
holders of the debentures issued in June 2008 and August 2008, and the warrants
the Company issued in December 2006, February 2007, March 2008 and August 2008.
With respect to the debentures, the parties agreed to amend the interest rate
and interest payment provisions, which had called for monthly interest payments
at the rate of 12% per annum.  As amended in December 2008, interest
is payable quarterly at the rate of (i) 0% per annum from October 1, 2008 until
September 30, 2009, (ii) 13.5% per annum from October 1, 2009 until September
30, 2012 and (iii) 18% per annum from October 1, 2012 until maturity. In May
2009, the parties again agreed to amend the interest payment provisions to
reduce the interest rate to 0% through June 30, 2011 and then to 5% per annum
thereafter.





On the
same date, the Company entered into a debenture and warrant purchase agreement
with an institutional investor and a holder of the Company's other outstanding
debentures and warrants pursuant to which the Company issued a senior secured
convertible debenture in the principal amount of $1.5 million, along with a
warrant to purchase 456,000 shares of the Company's common stock with an
exercise price of $0.40 per share.  The terms of the debenture issued
in December 2008 are substantially similar to the terms of the debentures issued
in June 2008 and August 2008, as amended.





As a
result of the issuance of the debenture and warrant in December 2008, the
conversion price and exercise price, respectively, of the debentures issued in
June 2008 and August 2008 and the warrants issued in December 2006, February
2007, March 2008 and August 2008 was reduced to $0.40.  However, under
the December 2008 amendment agreement, the parties agreed to waive the
adjustment provision of such warrants that would have increased the number of
shares subject to such warrants as a result of the issuance of the debentures
and warrants in the December 2008 financing.





May 2009




In May
2009, the Company restructured the terms of its outstanding PIPE Debentures and
all of the Company’s outstanding PIPE Warrants pursuant to the terms of the
Amendment Agreement.  The Amendment Agreement revised the terms of the
PIPE Debentures to:




·
            decrease
      the conversion price from $0.40 to
$0.30;




·
            require
      that all future interest payments be made in
  cash;




·
            defer
      interest payments until October 1,
2011;




·
            reduce
      the interest rate to 0% through June 30, 2011 and then to 5% per annum
      thereafter;




·
            eliminate
      the requirement that, at the time of any conversion of principal, the
      Company pay the holders an amount in cash equal to the interest that would
      have accrued on such principal had such principal remained outstanding
      through the full term of the PIPE Debentures;
  and




·
            eliminate
      the 20% premium for voluntary
prepayment.




In
addition, under the terms of the Amendment Agreement, the holders of the PIPE
Warrants were granted the right to exchange their outstanding PIPE Warrants for
shares of the Company’s common stock at the rate of 1.063 shares of common stock
underlying the PIPE Warrants for one share of common stock, subject to
adjustment for stock splits and dividends.  In exchange, the
anti-dilution protection under the PIPE Warrants was
eliminated.  Previously the exercise price of the PIPE Warrants would
decrease, and the number of shares issuable upon exercise would increase,
generally, each time the Company issued common stock or common stock equivalents
at a price less than the exercise price of the PIPE Warrants.  The
Amendment Agreement eliminates the potential for future dilution from the PIPE
Warrants.





Under the
terms of the Amendment Agreement, the Company also agreed to add certain
covenants to the PIPE Debentures, including a requirement to maintain at least
$300,000 in cash at all times while the PIPE Debentures are outstanding, to
sustain a level of gross revenue each quarter equal to at least 80% of the
average gross revenue for the trailing two quarters, and commencing with the
period ended June 30, 2009, to maintain a positive adjusted EBITDA in each
rolling two quarter period.  For example, ending September 30, 2009,
the sum of the three-month adjusted EBITDA of the three months ended June 30 and
September 30 must be at least $0.00 or greater.  Adjusted EBITDA is
calculated by taking the Company’s net income for the applicable period, and
adding to that amount the sum of the following: (i) any provision for (or less
any benefit from) income taxes, plus (ii) any deduction for interest expense,
net of interest income, plus (iii) depreciation and amortization expense, plus
(iv) non-cash expenses (such as stock-based compensation and warrant
compensation), plus (v) expenses related to changes in fair market value of
warrant and beneficial conversion features, plus (vi) expenses related to
impairment of tangible and intangible assets. .   The Company did
not achieve the adjusted EBITDA target for the quarterly period ending September
30, 2009. The Company received waivers from the holders of all of its debentures
waiving any right to declare a default under the debentures for not achieving
the adjusted EBITDA target.





13
 Table of Contents





General




The
unamortized discounts on the debentures issued in December 2006, August 2007 and
March 2008 were carried forward as discounts on the debentures issued in June
2008, and will be amortized to interest expense through June 30,
2014.  The discounts on the debentures issued in August 2008 and
December 2008 will be amortized to interest expense through June 30, 2014. The
change in the fair market value of the beneficial conversion feature liability
as a result of the decrease of the conversion price of the debentures from $0.40
to $0.30 per the Amendment Agreement was recorded as additional debt discount of
$4.0 million on May 8, 2009. See Note 3 – Securities Exchange and Amendment
Agreements.




The
amendment agreement entered into in December 2008, provided for 0% interest
until September, 30, 2009.  The Amendment Agreement entered into in
May 2009, provided for a further deferral of interest payments until October 1,
2011 and a reduction in the interest rate to 0% through June 30, 2011 and then
to 5% per annum thereafter.  However, the Company has recorded
interest expense for the three and nine months ended September 30, 2009, at the
effective interest rate of the debentures during those periods.




The
following table summarizes information relative to the outstanding debentures at
September 30, 2009 and December 31, 2008:





September
      30, 2009
            
            
            December
      31, 2008Convertible
      debentures
            $
            29,649,300
            
            
            $
            29,649,300Less
      unamortized discounts:Original
      issue discount
            
            (4,423,731
            )
            
            
            (864,758
            )Detachable
      warrants discount
            
            (2,217,718
            )
            
            
            (2,567,884
            )Beneficial
      conversion feature discount
            
            (5,107,742
            )
            
            
            (5,914,228
            )Convertible
      debentures, net of discounts
            
            17,900,109
            
            
            
            20,302,430Less
      current portion
            
            —
            
            
            
            —Convertible
      debentures, long term portion
            $
            17,900,109
            
            
            $
            20,302,430





The
convertible debentures outstanding at September 30, 2009 are due June 30,
2014.





At each
reporting period the Company assesses the value of its convertible debentures
that are accounted for as derivative financial instruments indexed to and
potentially settled in its own stock. At September 30, 2009 and December 31,
2008, the Company determined that the beneficial conversion feature in the
convertible debentures represented an embedded derivative
liability.  Accordingly, the Company bifurcated the embedded
conversion feature and accounted for it as a derivative liability because the
conversion price and ultimate number of shares can be adjusted if the Company
subsequently issues common stock at a lower price and it was deemed possible the
Company could have to net cash settle the contract if there were not enough
authorized shares to issue upon conversion.




The
convertible debentures contain embedded derivative features, which are accounted
for at fair value as a compound embedded derivative at September 30, 2009 and
December 31, 2008.  This compound embedded derivative includes the
following material features: (1) the standard conversion feature of the
debentures; (2) a reset of the conversion price condition for subsequent equity
sales; (3) the Company’s ability to pay interest in cash or shares of its common
stock; (4) optional redemption at the Company’s election; (5) forced conversion;
(6) holder’s restriction on conversion; and (7) a default put.




The
Company, with the assistance of an independent valuation firm, calculated the
fair value of the compound embedded derivative associated with the convertible
debentures utilizing a complex, customized Monte Carlo simulation model suitable
to value path dependant American options.  The model uses the risk
neutral methodology adapted to value corporate securities.  This model
utilized subjective and theoretical assumptions that can materially affect fair
values from period to period.




At
September 30, 2009 and December 31, 2008, the Company recorded beneficial
conversion liabilities of $7.6 million and $4.8 million,
respectively.  The Company recognized other income of $3.8 million and
other expense of $1.2 million for the three and nine months ended September 30,
2009, respectively and recognized other income of $1.4 million and $3.5 million
for the three and nine months ended September 30, 2008, respectively, related to
the change in fair market value of the beneficial conversion
liabilities.


6.
Warrants and Warrant Liabilities




In
connection with its various financings through June 30, 2008, the Company issued
warrants to purchase shares of common stock in conjunction with the sale of its
debentures. Prior to the Securities Exchange Agreement executed on June 30,
2008, the exercise prices of the warrants were reduced to $1.25 per share,
resulting in an increase in the number of aggregate shares of common stock
underlying the warrants to 11,205,809. On June 30, 2008 in connection with the
Securities Exchange Agreement, the exercise prices of the warrants discussed
above were further reduced to $1.00 per share.  The number of shares
of common stock underlying the warrants remained at 11,205,809.  The
Company recorded $0.2 million of deferred financing costs related to the change
in exercise price discussed above.  See Note 3 – Securities Exchange
and Amendment Agreements.




14
 Table of Contents





On August
13, 2008, the Company issued warrants to purchase 608,000 shares of common stock
at $1.00 per share in conjunction with the sale of its
debentures.  The warrant is immediately exercisable and expires five
years from the date of issuance.




On
December 11, 2008, the Company issued warrants to purchase 456,000 shares of
common stock at $0.40 per share in conjunction with the sale of its
debentures.  In addition, the exercise price of all previously issued
warrants was reduced to $0.40.  However, under the terms of the
December 11, 2008 amendment, the parties agreed to waive the adjustment
provision of the PIPE Warrants that would have increased the number of shares
subject to the PIPE Warrants as a result of the issuance of the debentures and
warrants in the December 2008 financing. Pursuant to FASB guidance, the fair
value of the warrants at the issuance was recorded as a warrant liability
because the exercise price of the warrants can adjust if the Company
subsequently issues common stock at a lower price and it is possible for the
Company to not have enough authorized shares to settle the warrants and
therefore would have to settle the warrants with cash.




In
addition, the Company issued an additional 425,909 warrants to various entities
as compensation for services provided to the Company during 2007 and
2008.




In May
2009, under the terms of the Amendment Agreement, the holders of the PIPE
Warrants were granted the right to exchange their outstanding PIPE Warrants for
shares of the Company’s common stock at the rate of 1.063 shares of common stock
underlying the PIPE Warrants for one share of common stock, subject to
adjustment for stock splits and dividends.  In exchange, the
anti-dilution protection under the PIPE Warrants was
eliminated.  Previously the exercise price of the PIPE Warrants would
decrease, and the number of shares issuable upon exercise would increase,
generally, each time the Company issued common stock or common stock equivalents
at a price less than the exercise price of the PIPE Warrants.  The
Amendment Agreement eliminates the potential for future dilution from the PIPE
Warrants. Accordingly, the warrants are no longer a derivative liability and
their value as of May 8, 2009, was reclassed to equity.





The fair
value of the warrants was estimated at their various issuance dates and revalued
at May 8, 2009, using the Monte Carlo model discussed in Note 5 – Convertible
Debentures, above.  As a result of the reclass of the warrants to
equity on May 8, 2009, the Company recorded no warrant liabilities at September
30, 2009.  At December 31, 2008, the Company recorded warrant
liabilities of $0.6 million.  As a result of the reclass of the
warrants to equity in May 2009, the Company recorded no expense related to the
change in fair market value of the warrants during the three months ended
September 30, 2009. For the nine months ended September 30, 2009, the Company
recognized other expense of $1.0 million related to the change in fair market
value of the warrants. For the three months and nine months ended September 30,
2008, the Company recognized other income of $1.5 million and $8.1 million,
respectively, related to the change in fair market value of the
warrants.




There
were 12,695,718 shares subject to warrants at a weighted average exercise price
of $0.45 at September 30, 2009 and December 31, 2008.





The
following table summarizes information about warrants outstanding at September
30, 2009:






Exercise
      Prices
            
            
            Number
      of Shares Subject to Outstanding Warrants and Exercisable
            
            
            Weighted
      Average
              Remaining
      Contractual Life (years)$
            0.40
            
            
            
            12,269,809
            
            
            
            3.33$
            1.25
            
            
            
            105,000
            
            
            
            4.17$
            1.73
            
            
            
            200,000
            
            
            
            3.99$
            1.92
            
            
            
            78,125
            
            
            
            3.99$
            3.52
            
            
            
            12,784
            
            
            
            1.36$
            4.00
            
            
            
            30,000
            
            
            
            3.8812,695,718




As of
September 30, 2009, the Company had reserved 12,695,718 shares of common stock
for the exercise of outstanding warrants.




7. Commitments and
Contingencies




Leases




The
Company has non-cancelable operating and capital leases for corporate facilities
and equipment.




15
 Table of Contents





Minimum Third Party Network
Service Provider Commitments




The
Company has a contract with a third party network service provider that
facilitates interconnects with a number of third party network service
providers.  The contract contains a minimum usage guarantee of $0.2
million per monthly billing cycle.  The contract commenced on October
16, 2003 with an initial 24 month term.  The contract was extended in
July 2005 for a 3 year term that expired in July 2008.  On October 24,
2008, the contract was extended for another 3 year term.  The
cancellation terms are a 90 day written notice prior to the extended term
expiring.




Litigation




From time
to time, the Company may be involved in litigation relating to claims arising
out of its operations in the normal course of business, including claims of
alleged infringement, misuse or misappropriation of intellectual property rights
of third parties. As of the date of this report, the Company is not a party to
any litigation which it believes would have a material adverse effect on the
Company’s business operations or financial condition.




Communications Assistance
for Law Enforcement Act




On August
5, 2005, the Federal Communications Commission, or FCC, unanimously adopted an
order requiring VoIP providers to comply with the Communications Assistance for
Law Enforcement Act, or CALEA. CALEA requires covered providers to assist law
enforcement agencies in conducting lawfully authorized electronic
surveillance.  Under the FCC order, all VoIP providers were to become
fully CALEA compliant by May 14, 2007.  The Company engaged a third
party to help it develop a solution to be CALEA compliant.  In
February 2007, the Company notified the FCC that it did not expect to have a
CALEA compliant solution completed by May 14, 2007, but that it instead expected
to have the development complete by September 1, 2007.  The Company’s
formal CALEA compliance testing with the third party was completed on September
28, 2007.  Currently, the Company’s CALEA solution is fully deployed
in its network.  However, the Company could be subject to an
enforcement action by the FCC or law enforcement agencies for any delays related
to meeting, or if the Company fails to comply with, any current or future CALEA
obligations.




Universal Service
Fund




In June
2006, the FCC concluded that VoIP providers must contribute to the Universal
Service Fund, or USF.  The FCC established a contribution safe harbor
percentage of 64.9% of total VoIP service revenue.  Alternatively,
VoIP providers are permitted to calculate their contribution based on FCC
pre-approved traffic studies.  The Company began contributing to the
USF on October 1, 2006 using the 64.9% safe harbor.  In the meantime,
the FCC continues to evaluate alternative methods for assessing USF charges,
including imposing an assessment on telephone numbers.  The outcome of
these proceedings cannot be determined at this time nor can the Company
determine the potential financial impact as the details of an alternative method
of USF contribution have not been determined at this time.  There is
also a risk that state USF funds may attempt to impose state USF contribution
obligations and other state and local charges.




Sales and additional
taxes




Based
upon a new Internal Revenue Service ruling, the Company ceased collecting
federal excise tax on August 1, 2006 on long-distance or bundled
services.  The Company has not collected or accrued liabilities for
E911 taxes for VoIP services prior to July 1, 2006, and it is possible that
substantial claims for back taxes may be asserted against the
Company.  Also, the Company is currently working to obtain Inter
Exchange Carrier (IXC) certification in Alaska, Maryland and
Mississippi.  The Company’s current certification status in these
three states may leave it liable for fees and penalties that could decrease its
ability to compete with traditional telephone companies.  In addition,
future expansion of the Company’s service, along with other aspects of its
evolving business, may result in additional sales and other tax
obligations.  One or more taxing authorities may seek to impose sales,
use or other tax collection obligations on the Company.  The Company
has received inquiries or demands from numerous state authorities and may be
subjected to audit at any time.  A successful assertion by one or more
taxing authorities that the Company should collect sales, use or other taxes on
the sale of its services could result in substantial tax liabilities for past
sales.




Other




In
connection with its acquisition of AccessLine, the Company was required to pay
up to an additional $9.0 million in the form of 2,500,000 shares
of  the Company’s restricted common stock upon the achievement of
certain future financial objectives, the value of which would increase the
amount of goodwill recorded in the transaction.  The first earn out
period ended December 31, 2007.  In April 2008, when the contingency
related to the first earn out period was resolved, the Company issued 599,130
shares valued at $0.6 million, resulting in increases to goodwill and
equity.  The second earn out period ended June 30, 2008, and the
Company issued 529,252 shares valued at $0.3 million in July 2008 when the
contingency was resolved.  The increase in goodwill and equity was
recorded in the third quarter of 2008.  The third earn out period
ended December 31, 2008, and the Company issued 515,622 shares valued at $0.04
million in February 2009.  The increase in goodwill and equity was
recorded in the first quarter of 2009. The final earn out period ended on June
30, 2009 and the Company issued 401,658 shares valued at $0.04 million in July
2009.  The increase in goodwill and equity was recorded in the third
quarter of 2009.




16
 Table of Contents





On April
18, 2007, the FCC released a Notice of Proposed Rulemaking tentatively
concluding that VoIP providers should pay regulatory fees.  According
to the notice, the FCC would like to begin collection of such fees in the August
to September 2007 timeframe.  The FCC is considering calculating
contribution obligations for VoIP providers based on either revenues or
telephone numbers used.  The Company cannot predict the outcome of
this proceeding.  On June 8, 2007, the FCC released an order
implementing various recommendations from its Independent Panel Reviewing the
Impact of Hurricane Katrina on Communications Networks Panel, including a
requirement that certain VoIP providers submit reports regarding the reliability
and resiliency of their 911 systems.  At this time, the Company is not
subject to these reporting requirements but may become subject in future
years.




On June
8, 2007, the FCC released an order implementing various recommendations from its
Independent Panel Reviewing the Impact of Hurricane Katrina on Communications
Networks Panel, including a requirement that certain VoIP providers submit
reports regarding the reliability and resiliency of their 911
systems.  At this time, the Company is not subject to these reporting
requirements but may become subject in future years.




On June
15, 2007, the FCC extended the disability access requirements of Sections 225
and 255 of the Communications Act, which applied to traditional phone services,
to providers of VoIP services and to manufacturers of specially designed
equipment used to provide those services.  Section 255 of the
Communications Act requires service providers to ensure that its equipment and
service is accessible to and usable by individuals with disabilities, if readily
achievable, including requiring service providers to ensure that information and
documentation provided in connection with equipment or services be accessible to
people with disabilities, where readily achievable and that employee training
account for accessibility requirements.  In addition, the FCC said
that VoIP providers were subject to the requirements of Section 225, including
contributing to the Telecommunications Relay Services, or TRS, fund and that
they must offer 711 abbreviated dialing for access to relay
services.  Although the Company contributes to the TRS fund as
required, it has not yet implemented a solution for the 711 abbreviated dialing
requirement.  The Company may be subject to enforcement actions
including, but not limited to, fines, cease and desist orders, or other
penalties if it does not comply with these obligations.




In the
latter half of 2007, the FCC released two Report and Orders that increase the
costs of doing business.  One of them, released on August 6, 2007,
concerns the collection of regulatory fees for fiscal year 2007, which, for the
first time, mandates the collection of such fees from VoIP
providers.  This order, which became effective in November 2007,
requires that VoIP providers pay regulatory fees based on reported interstate
and international revenues.  Regulatory fees for the FCC's fiscal year
2007 were due in 2008.  Fiscal year 2008 fees were paid in 2008 during
the normal regulatory fee payment window.  The assessment of
regulatory fees on the Company’s VoIP service offering will increase its costs
and reduce its profitability or cause the Company to increase the retail price
of its VoIP service offerings.




The other
order, released on November 8, 2007, imposes local number portability and
related obligations on VoIP providers, such as requiring VoIP providers to
contribute to shared numbering administration costs on a competitively neutral
basis.  The assessment of local number portability fees to the
Company’s VoIP service will increase its costs and reduce its profitability or
cause the Company to increase the price of its VoIP service
offerings.




8. Preferred Stock and
Dividends




Pursuant
to terms of the Company’s Series A preferred stock (the “Series A Stock”),
effective April 1, 2008, the stated value of such stock increased by 15%, or
$2.0 million, because the Company’s common stock was not listed on an exchange
other than the OTC Bulletin Board by June 30, 2008. The Company recorded
dividends of $3.2 million during the nine months ended September 30, 2008 (none
were issued during the three months ended September, 30, 2008), related to the
increase in stated value of the Series A Stock.




Pursuant
to the Securities Exchange Agreement the Company entered into on June 30, 2008,
all shares of the Series A Stock, which had a stated value of $14.9 million, and
accrued dividends of $0.4 million were converted into the debentures issued on
June 30, 2008.  See Note 3 – Securities Exchange and Amendment
Agreements. As of September 30, 2009, the Company has no shares of preferred
stock issued or outstanding.




9. Computation of Net Income (Loss)
Per Share




The
Company calculates basic net income (loss) per share by dividing its net income
(loss) by the weighted average number of shares of common stock
outstanding.  Diluted net loss per share is based on the assumption
that all potential common stock equivalents (convertible preferred stock,
convertible debentures, stock options, and warrants) are converted or
exercised.  The calculation of diluted net loss per share excludes
potential common stock equivalents if the effect is
anti-dilutive.  The Company's weighted average shares of common stock
outstanding for basic and dilutive are the same because the effect of the
potential common stock equivalents is anti-dilutive.




The
Company has the following dilutive common stock equivalents which were excluded
from the net loss per share calculation because their effect is anti-dilutive
for the three and nine months ended September 30, 2009 and for the nine months
ended September 30, 2008:





September
      30,2009
            
            
            2008Convertible
      Debentures
            
            
            98,831,000
            
            
            
            22,556,384Stock
      Options
            
            
            9,922,543
            
            
            
            5,759,127Warrants
            
            
            12,695,718
            
            
            
            12,239,718Total
            
            
            121,449,261
            
            
            
            40,555,229





17
 Table of Contents




10. Business
Segment Information





Telanetix
is an IP communications company, offering a range of communications solutions
from hosted IP voice and conferencing products, to text and data collaboration,
to telepresence videoconferencing products.  The Company’s offerings
are organized along two product categories: Voice and Network Solutions and
Video Solutions, which are considered segments for reporting
purposes.  The segments are determined in accordance with how
management views and evaluates the Company’s business. The Voice and Network
Solutions segment includes the Company’s VoIP communications offerings which
include a variety of voice and messaging solutions services. The Video Solutions
segment includes the Company’s telepresence solutions and other supporting
audio-visual applications.




Subsequent
to September 30, 2009, the Company entered into a securities purchase agreement
pursuant to which it transferred all of the issued and outstanding membership
interests of two of its subsidiaries: AVS and ULF, to an individual purchaser.
The purchaser was an employee of AVS. The transfer related solely to our video
integration business, and not the Company’s video product
business.  The Company did not transfer any assets or intellectual
property relating to its Digital Presence product line. The sale of AVS and ULF
represents the majority of operations under table caption: Video Solutions. See
Note 11 – Subsequent Event.




Financial
information for each reportable segment is as follows as of the three months
ended September 30, 2009 and 2008:





Voice
      and Network Solutions
            
            Video
      Solutions
            
            Total2009Revenues
            
            $
            7,165,501
            
            
            $
            929,423
            
            
            $
            8,094,924Gross
      profit
            
            $
            4,197,404
            
            
            $
            84,113
            
            
            $
            4,281,517Gross
      profit %
            
            
            58.6
            %
            
            
            9.1
            %
            
            
            52.9
            %Operating
      loss
            
            $
            (611,252
            )
            
            $
            (2,266,298
            )
            
            $
            (2,877,550
            )Total
      assets
            
            $
            28,805,847
            
            
            $
            1,743,284
            
            
            $
            30,549,1312008Revenues
            
            $
            6,786,712
            
            
            $
            1,710,873
            
            
            $
            8,497,585Gross
      profit
            
            $
            4,027,465
            
            
            $
            488,417
            
            
            $
            4,515,882Gross
      profit %
            
            
            59.3
            %
            
            
            28.5
            %
            
            
            53.1
            %Operating
      loss
            
            $
            (625,801
            )
            
            $
            (1,353,524
            )
            
            $
            (1,979,325
            )Total
      assets
            
            $
            34,188,530
            
            
            $
            4,885,253
            
            
            $
            39,073,783





Financial
information for each reportable segment is as follows as of the nine months
ended September 30, 2009 and 2008:





Voice
      and Network Solutions
            
            Video
      Solutions
            
            Total2009Revenues
            
            $
            21,094,655
            
            
            $
            3,152,142
            
            
            $
            24,246,797Gross
      profit
            
            $
            12,285,692
            
            
            $
            544,101
            
            
            $
            12,829,793Gross
      profit %
            
            
            58.2
            %
            
            
            17.3
            %
            
            
            52.9
            %Operating
      loss
            
            $
            (2,010,265
            )
            
            $
            (4,139,133
            )
            
            $
            (6,149,398
            )Total
      assets
            
            $
            28,805,847
            
            
            $
            1,743,284
            
            
            $
            30,549,1312008Revenues
            
            $
            19,388,090
            
            
            $
            4,764,791
            
            
            $
            24,152,881Gross
      profit
            
            $
            10,734,245
            
            
            $
            916,582
            
            
            $
            11,650,827Gross
      profit %
            
            
            55.4
            %
            
            
            19.2%
            
            
            
            48.2
            %Operating
      loss
            
            $
            (2,902,131
            )
            
            $
            (7,020,154
            )
            
            $
            (9,922,285
            )Total
      assets
            
            $
            34,188,530
            
            
            $
            4,885,253
            
            
            $
            39,073,783




18
 Table of Contents




Segment
revenues consist of sales to external customers in the United
States.  Segment gross margin includes all segment revenues less the
related cost of sales.  Margin is used, in part, to evaluate the
performance of, and allocate resources to, each of the segments.




For the
three months ended September 30, 2009, one customer accounted for 11% of the
Company’s Voice and Network Solutions segment net revenues and three customers
accounted for 45% of its Video Solutions segment net revenues. For the three
months ended September 30, 2008, one customer accounted for 14% of the Voice and
Network Solutions segment net revenues and two customers accounted for 23% of
the Video Solutions segment net revenues.




For the
nine months ended September 30, 2009, one customer accounted for 12% of the
Company’s Voice and Network Solutions segment net revenues and three customers
accounted for 35% of its Video Solutions segment net revenues. For the three
months ended September 30, 2008, one customer accounted for 15% of the Voice and
Network Solutions segment net revenues and no one customer accounted for more
than 10% of the Video Solutions segment net revenues.




At
September 30, 2009, no one customer accounted for more than 10% of gross
accounts receivable in the Voice and Network Solutions segment and four
customers accounted for 67% of gross accounts receivable in the Video Solutions
segment. At September 30, 2008, two customers accounted for 23% of gross
accounts receivable in the Voice and Network Solutions segment and one customer
accounted for 10% of gross accounts receivable in the Video Solutions segment.




11. Subsequent Event




On
October 27, 2009, the Company entered into a securities purchase agreement
pursuant to which it transferred all of the issued and outstanding membership
interests of two of its subsidiaries: AVS Installation Limited Liability
Company, or AVS, and Union Labor Force One Limited Liability Company, or ULF, to
an individual purchaser.  AVS and ULF operated the system integration,
design, build-out and installation aspects of the Company’s video solutions
business. The purchaser was an employee of AVS. The transfer related solely to
our video integration business, and not the Company’s video product
business.  The Company did not transfer any assets or intellectual
property relating to its Digital Presence product line.




The
membership interests were transferred for nominal consideration.  In
connection with the transfer, all underlying assets and liabilities were
retained by AVS and ULF.  The Company determined that the total amount
of consideration it received, along with strengthening of its balance sheet that
it will recognize by the transfer of the liabilities of AVS and ULF to the
purchaser as a result of the transfer of the membership interests, represented
fair value for the membership interests.   The Company completed
the disposition of the membership interests, and consequently the assets used in
and liabilities arising from the business operations of AVS and ULF, on October
27, 2009. The Company no longer holds any ownership interest in either of AVS or
ULF.


19
 Table of Contents


Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.




The
following discussion of our financial condition and results of operations should
be read in conjunction with our condensed consolidated financial statements and
the related notes and other financial information appearing elsewhere in this
report. Readers are also urged to carefully review and consider the various
disclosures made by us which attempt to advise interested parties of the factors
which affect our business, including without limitation, the disclosures made
under "Item 1A. Risk Factors" included in Part II of this report and in our
audited consolidated financial statements and related notes included in our
Annual Report on Form 10-K for the year ended December 31, 2008, previously
filed with the SEC.




Overview




Business




We are an
IP communications company, offering a range of communications solutions from
hosted IP voice and conferencing products, to text and data collaboration, to
telepresence videoconferencing products.




Our
subsidiary, AccessLine, Inc., provides customers with a range of business phone
services and applications. At the core of AccessLine's business phone services
are their software components, all of which are developed internally and loaded
on standard commercial grade servers. AccessLine's phone service can be
delivered with a variety of hosted features configured to meet the application
needs of the customer. By delivering business phone service to the market in
this manner, AccessLine offers flexibility to customers and can serve a variety
of business sizes.




AccessLine
offers two business dialtone products: SmartVoiceTM and
Digital Phone Service. SmartVoiceTM
replaces a customer's existing telephone lines with a VoIP alternative, but
allows the customer to keep using its current phone equipment. This product is
targeted at the mid-size business market. The customer has the ability to select
the number of office locations, number of phone lines and types of phone
numbers. Digital Phone Service is a combined package of a digital phone system
and accompanying service, geared for small companies with 20 or fewer employees
at a single location. The customer selects how many phone lines and how many
stations, and selects optional features such as Automated Attendant, conference
calling or fax numbers. AccessLine then preconfigures the phone system to the
customer’s specifications, and ships it directly to the customer.




In
addition, AccessLine offers a host of other phone services, including,
conferencing calling services, toll-free service plans, a virtual phone system
with after hours answering service that routes calls based on specific business
needs, find-me and follow-me services, a full featured voice mail system that
instantly contacts a customer via an email or cell phone text message the moment
such customer receives a new voice mail or fax, and the ability to manage faxes
from virtually anywhere.




Through
our Digital PresenceTM
product line we provide our customers with a complete system for telepresence
video conferencing. The core of our system is our software components—video and
audio encoder and decoders, call signaling and bandwidth management—all of which
are developed internally and pre-loaded on a standard Linux server. Our
telepresence solutions are based on next generation IP standards. A Digital
PresenceTM system also includes the monitors, cameras and audio components to
optimize the user experience, as well as the equipment necessary to enable a
"hotspot" in the conference room for the wireless operation of the system
controls and data-sharing. Our Digital PresenceTM
systems can be matched with a wide range of off-the-shelf monitors, cameras and
audio components to meet certain room configuration or performance requirements.
Our channel act as the system integrators to design, build-out and install the
complete telepresence system including components and peripheral equipment to
meet the application needs of the customer. By delivering Digital PresenceTM to
the market in this manner, we offer flexibility to customers and can support
conference rooms for both small and large audiences.




Recent
Developments & Outlook





Our
overriding objective in 2009 has been, and remains, to grow revenue while
achieving operating profitability and generating cash from
operations.




We
experienced growth in revenue and gross margin for our Voice and Network
Solutions segment in 2008 and during the nine months ended September 30, 2009.
We increased revenue during the nine months ended September 30, 2009 through, in
part, spending more per quarter in advertising than we spent during the same
period for 2008. Our Digital Phone Service continues to grow rapidly month over
month.  We increased our year-to-date gross margin through our
continued progress in optimizing our network configuration. Additionally, we
have reduced operating expenses, in part, through reducing our staffing
levels.




Our Video
Solutions segment has been severely impacted by the down economy during the nine
months ended September 30, 2009, resulting in a substantial decline in revenue.
It is unclear when, if ever, our Video Solutions segment will generate
consistent growth in revenue and gross margins.  In addition, our
Video Solutions segment continues to generate negative earnings and was in a
negative working capital position at September 30, 2009. As a result, due to our
commitment to grow profitability and to avoid seeking additional capital, on
October 27, 2009 we entered into a securities purchase agreement pursuant to
which we transferred all of our ownership interest in two of our subsidiaries
operating in our Video Solutions segment – AVS Installation Limited Liability
Company, or AVS, and Union Labor Force One Limited Liability Company, or
ULF.  Our ownership interests were transferred for nominal
consideration.  In connection with the transfer, all underlying assets
and liabilities were retained by AVS and ULF.  We determined that the
total amount of consideration we received, along with strengthening of our
balance sheet that we will recognize by the transfer of the liabilities of AVS
and ULF to the purchaser as a result of the transfer of our ownership interests,
represented fair value for our ownership interests.  The transfer
related solely to our video integration business, and not our video product
business.  We did not transfer any assets or intellectual property
relating to our Digital Presence product line.  However, we believe
that it is in the best interest of our shareholders to evaluate strategic
alternatives to maximize shareholder value for this product line and we continue
to explore such strategic alternatives with respect to it.




20
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If we can
continue to generate Voice and Network Solution revenue and gross margin
improvements consistent with our growth in 2008 and during the nine months ended
September 30, 2009, maintain control of our operating expenses and execute a
successful strategic alternative for our Digital Presence product line, we
believe that our existing capital will be sufficient to finance our operations
through the end of 2009. However, the uncertainties related to the global
economic slowdown and the disruption in the financial markets has impacted our
visibility on our business outlook. Weakening economic conditions may result in
decreased demand for our products.  In addition, we have limited
financial resources.  Unforeseen decreases in revenues or increases in
operating costs could impact our ability to fund our operations.  We
do not currently have any sources of credit available to us.  See
“Liquidity and Capital Resources” below.




Recent
Financings





June 2008
Financing




On June
30, 2008, we entered into a securities exchange agreement with the investors in
our previous debenture and preferred stock financings and issued six-year,
interest only debentures due June 30, 2014 in exchange for all of the then
outstanding debentures we issued in December 2006, August 2007 and March 2008
and shares of our preferred stock we issued in August 2007.  The
debentures issued in June 2008 amend and restate the terms of the debentures we
issued December 2006, August 2007 and March 2008.  The debentures
issued in this transaction (an aggregate principal amount of $26.1 million) were
exchanged for all of the then outstanding debentures held by the investors (an
aggregate principal amount of $10.7 million), accrued interest on the
outstanding debentures of $0.1 million, all of the then outstanding shares of
preferred stock held by the investors (stated value of $14.9 million), and
accrued dividends on such preferred stock of $0.4 million.  In
connection with this transaction, the exercise prices of the outstanding
warrants issued in the previous debenture and preferred stock financings were
reduced from $1.25 per share to $1.00, which was subsequently reduced to $0.40
per share in connection with our December 2008 financing, discussed
below.  The number of common shares underlying these warrants was not
adjusted in connection with this change in exercise price.




In
December 2008, we amended certain terms of the debentures issued in June 2008
which are discussed below under the heading “December 2008 Amendment of
Outstanding Debentures and Warrants.”  And, in May 2009, we further
restructured the terms of our outstanding debentures issued in June 2008, August
2008 and December 2008 (collectively, the  "PIPE Debentures") and all of
our outstanding warrants issued in December 2006, February 2007, August 2007,
March 2008, August 2008 and December 2008 (the "PIPE
Warrants").  See “May 2009 Amendment of Outstanding Debentures
and Warrants,” below.




The
following summarizes the terms of the debentures issued in June 2008, as amended
in December 2008 and May 2009:




Term. The debentures are due
and payable on June 30, 2014.




Interest. When originally
issued, interest accrued at the rate of 12.0% per annum and was payable monthly,
commencing on August 1, 2008.  In December 2008, the parties agreed to
amend the interest payment provisions to eliminate monthly interest payments at
the rate of 12% per annum.  Following this amendment, interest was
payable quarterly at the rate of (i) 0% per annum from October 1, 2008 until
September 30, 2009, (ii) 13.5% per annum from October 1, 2009 until September
30, 2012 and (iii) 18% per annum from October 1, 2012 until
maturity.  In May 2009, the parties again agreed to amend the interest
payment provisions to reduce the interest rate to 0% through June 30, 2011 and
then to 5% per annum thereafter.




Principal Payment. The
principal amount of the debenture, if not paid earlier, is due and payable on
June 30, 2014.




Payments of Interest.
Interest payments, as amended in May 2009,  are due quarterly on
January 1, April 1, July 1 and October 1, commencing on October 1, 2011.
Interest payments are required to be paid in cash.




Early Redemption. We have the
right to redeem the debentures before their maturity by payment in cash of the
then outstanding principal amount plus (i) accrued but unpaid interest, (ii) an
amount equal to all interest that would have accrued if the principal amount
subject to such redemption had remained outstanding through the maturity date
and (iv) all liquidated damages and other amounts due in respect of the
debenture. To redeem the debentures we must meet certain equity conditions. The
payment of the debentures would occur on the 10th day following the date we gave
the holders notice of our intent to redeem the debentures. We agreed to honor
any notices of conversion received from a holder before the pay off date of the
debentures.




Voluntary Conversion by
Holder. When originally issued, the debentures were convertible at
anytime at the discretion of the holder at a conversion price per share of
$1.25, subject to adjustment including full-ratchet, anti-dilution protection.
The conversion price was reduced to $0.40 with the December 2008 amendment and
further reduced to $0.30 with the May 2009 amendment.




Forced Conversion. Subject to
compliance with certain equity conditions, we also have the right to force
conversion if the VWAP for its common stock exceeds 200% of the then effective
conversion price for 20 trading days out of a consecutive 30 trading day period.
Any forced conversion is subject to our meeting certain equity conditions and is
subject to a 4.99% cap on the beneficial ownership of our common stock by the
holder and its affiliates following such conversion, which cap may increase to
9.99% by the holder upon not less than 61 days notice.




21
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Covenants. The debentures
impose certain covenants on us, including restrictions against incurring
additional indebtedness, creating any liens on our property, amending our
certificate of incorporation or bylaws, redeeming or paying dividends on shares
of our outstanding common stock, and entering into certain related party
transactions. The debentures define certain events of default, including without
limitation failure to make a payment obligation, failure to observe other
covenants of the debenture or related agreements (subject to applicable cure
periods), breach of representation or warranty, bankruptcy, default under
another significant contract or credit obligation, delisting of our common
stock, a change in control, failure to be in compliance with Rule 144(c)(1)
for more than 20 consecutive days, or more than an aggregate of 45 days in any
12 month period, or if any other conditions exist for such a period of time that
the holder is unable to sell the shares issuable upon conversion of the
debenture pursuant to Rule 144 without volume or manner of sale
restrictions, or failure to deliver share certificates in a timely manner. In
the event of default, the holders of the debentures have the right to accelerate
all amounts outstanding under the debenture and demand payment of a mandatory
default amount equal to 130% of the amount outstanding plus accrued interest and
expenses.




Under the
terms of the Amendment Agreement entered into in May 2009, we also agreed to
additional financial performance covenants, including a requirement to maintain
at least $300,000 in cash at all times while the PIPE Debentures are
outstanding, to sustain a level of gross revenue each quarter equal to at least
80% of the average gross revenue for the trailing two quarters, and commencing
with the period ended September 30, 2009, to maintain a positive adjusted EBITDA
in each rolling two quarter period.  For example, ending September 30,
2009, the sum of the three-month adjusted EBITDA of the three months ended June
30 and September 30 must be at least $0.00 or greater.  Adjusted
EBITDA is calculated by taking the Company’s net income for the applicable
period, and adding to that amount the sum of the following: (i) any provision
for (or less any benefit from) income taxes, plus (ii) any deduction for
interest expense, net of interest income, plus (iii) depreciation and
amortization expense, plus (iv) non-cash expenses (such as stock-based
compensation and warrant compensation), plus (v) expenses related to changes in
fair market value of warrant and beneficial conversion features, plus (vi)
expenses related to impairment of tangible and intangible assets.




Security. The debentures we
issued are secured by all of our assets under the terms of the amended and
restated security agreement we and our subsidiaries entered into with the
holders of the June 2008 debentures, which amends and restates the security
agreement we and the holders entered into in connection with our August 2007
financing. Each of our subsidiaries also entered into guarantees in favor of the
Investors, pursuant to which each subsidiary guaranteed the complete payment and
performance by us of our obligations under the debentures and related
agreements.




August 2008
Financing




On August
13, 2008, we entered into a debenture and warrant purchase agreement with one of
the institutional investors that invested in the previous private
placements.  Under the terms of this purchase agreement we issued a
senior secured convertible debenture in the principal amount of $2.0 million,
along with a five year warrant to purchase 608,000 shares of our common stock at
an exercise price of $1.00 per share, subject to adjustment, including
full-ratchet anti-dilution protection.  The terms of the debentures we
issued in this financing were also amended by the terms of the amendment
agreement we entered into in December 2008 and were further amended by the terms
of the amendment agreement we entered into in May 2009. See "December 2008
Amendment of Outstanding Debentures and Warrants," and "May 2009 Amendment of
Outstanding Debentures and Warrants," below.  Our rights and
obligations, as well as those of the investor, with respect to the debenture we
issued in this financing are identical to the rights and obligations of the
debentures we issued in June 2008, as amended.




December 2008
Financing




On
December 11, 2008, we entered into a debenture and warrant purchase agreement
with an institutional investor and a holder of the debentures we issued in June
2008 and August 2008.  Under the terms of this purchase agreement we
issued a senior secured convertible debenture in the principal amount of $1.5
million, along with a warrant to purchase 456,000 shares of our common stock
with an exercise price of $0.40 per share. This financing transaction resulted
in net proceeds to us of $1.5 million. We may refer to this financing as our
December 2008 financing in this report.




The terms
of the debenture we issued in December 2008 are substantially similar to the
terms of the debentures we issued in June 2008, as amended.




December 2008 Amendment of
Outstanding Debentures and Warrants




In
connection with our December 2008 financing, we entered into an amendment
agreement with the holders of the debentures we issued in June 2008 and August
2008, and the warrants we issued in December 2006, February 2007, March 2008 and
August 2008. With respect to the debentures, the parties agreed to amend the
interest rate and interest payment provisions, which had called for monthly
interest payments at the rate of 12% per annum.  As amended in
December 2008, interest is payable quarterly at the rate of (i) 0% per annum
from October 1, 2008 until September 30, 2009, (ii) 13.5% per annum from October
1, 2009 until September 30, 2012 and (iii) 18% per annum from October 1, 2012
until maturity.  In May 2009, the parties further agreed to amend the
interest payment provisions to reduce the interest rate to 0% through June 30,
2011 and then to 5% per annum thereafter.




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As a
result of the issuance of the debenture and warrant in the December 2008
financing discussed above, the conversion price and exercise price,
respectively, of the debentures issued in June 2008 and August 2008 and the
warrants issued in December 2006, February 2007, March 2008 and August 2008 was
reduced to $0.40.  However, under the amendment agreement, the parties
agreed to waive the adjustment provision of such warrants that would have
increased the number of shares subject to such warrants as a result of the
issuance of the debentures and warrants in the December 2008
financing.





May 2009 Amendment of
Outstanding Debentures and Warrants




In May
2009, we restructured the terms of our PIPE Debentures and all of PIPE Warrants
pursuant to the terms of an Amendment Agreement dated May 8, 2009 entered into
between the Company and the holders of the outstanding PIPE Debentures and PIPE
Warrants (the "Amendment
Agreement").  The Amendment Agreement revised the terms of the
PIPE Debentures to:




·
            decrease
      the conversion price from $0.40 to
$0.30;




·
            require
      that all future interest payments be made in
  cash;




·
            defer
      interest payments until October 1,
2011;




·
            reduce
      the interest rate to 0% through June 30, 2011 and then to 5% per annum
      thereafter;




·
            eliminate
      the requirement that, at the time of any conversion of principal, we pay
      the holders an amount in cash equal to the interest that would have
      accrued on such principal had such principal remained outstanding through
      the full term of the PIPE Debentures;
and




·
            eliminate
      the 20% premium for voluntary
prepayment.




Under the
terms of the Amendment Agreement, the holders of the PIPE Warrants were granted
the right to exchange their outstanding PIPE Warrants for shares of our common
stock at the rate of 1.063 shares of common stock underlying the PIPE Warrants
for one share of common stock, subject to adjustment for stock splits and
dividends.  In exchange, the anti-dilution protection under the PIPE
Warrants was eliminated.  Previously the exercise price of the PIPE
Warrants would decrease, and the number of shares issuable upon exercise would
increase, generally, each time we issued common stock or common stock
equivalents at a price less than the exercise price of the PIPE
Warrants.  The Amendment Agreement eliminates the potential for future
dilution from the PIPE Warrants.




In
addition, under the terms of the Amendment Agreement, we also agreed to add
certain covenants to the PIPE Debentures, including a requirement to maintain at
least $300,000 in cash at all times while the PIPE Debentures are outstanding,
to sustain a level of gross revenue each quarter equal to at least 80% of the
average gross revenue for the trailing two quarters, and commencing with the
period ended June 30, 2009, to maintain a positive adjusted EBITDA in each
rolling two quarter period.  For example, ending September 30, 2009,
the sum of the three-month adjusted EBITDA of the three months ended June 30 and
September 30 must be at least $0.00 or greater.  Adjusted EBITDA is
calculated by taking the our net income for the applicable period, and adding to
that amount the sum of the following: (i) any provision for (or less any benefit
from) income taxes, plus (ii) any deduction for interest expense, net of
interest income, plus (iii) depreciation and amortization expense, plus (iv)
non-cash expenses (such as stock-based compensation and warrant compensation),
plus (v) expenses related to changes in fair market value of warrant and
beneficial conversion features, plus (vi) expenses related to impairment of
tangible and intangible assets. We did not achieve the adjusted EBITDA target
for the quarterly period ending September 30, 2009. We received waivers from the
holders of all of our debentures waiving any right to declare a default under
the debentures for not achieving the adjusted EBITDA target.




Going
Concern




We remain
dependent on outside sources of funding until our results of operations provide
positive cash flows. As of December 31, 2008, our independent registered
auditors concluded that there was substantial doubt about the Company’s ability
to continue as a going concern, and this condition remains as of September 30,
2009. For further information, refer to the consolidated financial statements
and footnotes thereto included in the Company's Annual Report on Form 10-K for
the year ended December 31, 2008.




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 Table of Contents





During
the years ended December 31, 2008 and 2007, we were unable to generate cash
flows sufficient to support our operations and have been dependent on debt and
equity raised from qualified individual investors.  We experienced
negative financial results as follows:





2008
            
            
            2007Net
      loss
            $
            (9,683,630
            )
            
            $
            (10,633,026
            )Negative
      cash flow from operating activities
            
            (5,447,148
            )
            
            
            (5,582,487
            )Working
      capital deficit
            
            (7,967,417
            )
            
            
            (13,585,737
            )Stockholders’
      equity
            
            944,324
            
            
            
            18,377,773







These
factors raise substantial doubt about our ability to continue as a going
concern.  The financial statements contained in this report do not
include any adjustments relating to the recoverability and classification of
recorded asset amounts or amounts and classification of liabilities that might
be necessary should we be unable to continue in existence.  Our
ability to continue as a going concern is dependent upon our ability to generate
sufficient cash flows to meet our obligations on a timely basis, to obtain
additional financing as may be required, and ultimately to attain profitable
operations.  However, there is no assurance that profitable operations
or sufficient cash flows will occur in the future.




We have
supported current operations by raising additional operating cash through the
private sale of our preferred stock and convertible debentures.  This
has provided us with the cash flows to continue our business plan, but have not
resulted in significant improvement in our financial position.  We are
considering alternatives to address our cash situation that include: (1)
reducing cash operating expenses to levels that are in line with current
revenues and (2) raising capital through additional sale of our common stock
and/or debentures. The second alternative could result in substantial dilution
of existing stockholders.  There can be no assurance that our current
financial position can be improved, that we can achieve positive cash flows from
operations or that we can raise additional working capital.




Our
long-term viability as a going concern is dependent upon our ability
to:




•
            achieve
      profitability and ultimately generate sufficient cash flow from operations
      to sustain our continuing operations; and•
            locate
      sources of debt or equity funding to meet current commitments and
      near-term future requirements.







Results
of Operations




Three
months ended September 30, 2009 Compared to Three months ended September 30,
2008




Our
business operates in two segments: Voice and Network Solutions and Video
Solutions.  Our Voice and Network Solutions segment includes our
SmartVoiceTM and Digital Phone Service and other VoIP communications offerings
including a variety of voice and messaging solutions. Our Video Solutions
segment includes our Digital PresenceTM
telepresence solutions and other supporting audio-visual applications and
services.




Revenues,
Cost of Revenues and Gross Profit





Three
      months ended September 30, 2009
            
            Three
      months ended September 30, 2008
            
            Increase
      (decrease)Voice
      and Network Solutions
            
            Video
              Solutions
            
            Total
            
            Voice
      and Network Solutions
            
            Video
              Solutions
            
            Total
            
            Voice
      and Network Solutions
            
            Video
              Solutions
            
            TotalNet
      revenues:
            
            $
            7,165,501
            
            
            $
            929,423
            
            
            $
            8,094,924
            
            
            $
            6,786,712
            
            
            $
            1,710,873
            
            
            $
            8,497,585
            
            
            $
            378,789
            
            
            $
            (781,450
            )
            
            $
            (402,661
            )Cost
      of revenues:
            
            
            2,968,097
            
            
            
            845,310
            
            
            
            3,813,407
            
            
            
            2,759,247
            
            
            
            1,222,456
            
            
            
            3,981,703
            
            
            
            208,850
            
            
            
            (377,146
            )
            
            
            (168,296
            )Gross
      profit:
            
            $
            4,197,404
            
            
            $
            84,113
            
            
            $
            4,281,517
            
            
            $
            4,027,465
            
            
            $
            488,417
            
            
            $
            4,515,882
            
            
            $
            169,939
            
            
            $
            (404,304
            )
            
            $
            (234,365
            )Gross
      profit %
            
            
            58.6
            %
            
            
            9.1
            %
            
            
            52.9
            %
            
            
            59.3%
            
            
            
            28.5%
            
            
            
            53.1%





24
 Table of Contents





Net
revenues for the three months ended September 30, 2009 were $8.1 million, a
decrease of $0.4 million, or 4.7%, over the same period in 2008.  Net
revenues in our Voice and Network Solutions segment increased $0.4 million. Net
revenues in our Video Solutions segment decreased $0.8 million.  The
increase in Voice and Network Solutions revenues is due in part to organic
growth of existing products and services as a result of the increase in
advertising year over year and to the success of our Session Initiation Protocol
(SIP) Trunking and Digital Phone Service (DPS) products which were launched in
mid-2008.  The decrease in Video Solutions revenues was primarily due
to the impact of the economy which has many potential customers avoiding
spending on big ticket items such as our Telepresence systems and other video
equipment.




For the
three months ended September 30, 2009, one customer accounted for 11% of our
Voice and Network Solutions segment net revenues and three customers accounted
for 45% of our Video Solutions segment net revenues. For the three months ended
September 30, 2008, one customer accounted for 14% of our Voice and Network
Solutions segment net revenues and two customers accounted for 23% of our Video
Solutions segment net revenues.




Cost of
revenues for the three months ended September 30, 2009 was $3.8 million, a
decrease of $0.2 million, or 4.2%, over the same period in 2008. Cost of
revenues in our Voice and Network Solutions segment increased $0.2 million as a
result of the increased revenues, partially offset by several cost saving
measures that we began implementing during 2009.  Cost of revenues in
our Video Solutions segment decreased by $0.4 million due primarily to the
decrease in revenues.




Gross
profit for the three months ended September 30, 2009 was $4.3 million, a
decrease of $0.2 million, or 5.2%, over the same period in
2008.  Gross profit in our Voice and Network Solutions segment
increased $0.2 million as a result of the increase in revenues. Gross profit in
our Video Solutions segment decreased $0.4 million primarily as a result of the
decrease in revenues as compared to the same period in the prior
year.




Gross
profit percentage was 52.9% for the three months ended September 30, 2009
compared to 53.1% in the same period in 2008.  Gross profit percentage
for our Voice and Network Solutions segment was 58.6% for the three months ended
September 30, 2009 compared to 59.3% in the same period in 2008.  The
decrease is a result of a shift in revenue to our DPS and SIP Trunking product
lines, both of which have somewhat lower margins than our individual services
and legacy products.  This decrease was partially offset by improved
purchasing power from network infrastructure providers allowing us to purchase
network access at lower rates, combined with cost saving measures implemented
during the period. Gross profit percentage for our Video Solutions segment was
9.1% for the three months ended September 30, 2009 compared to 28.5% in the same
period in 2008, primarily due to a less profitable mix of products
sold.




Selling
and Marketing Expenses




Selling
and marketing expenses for the three months ended September 30, 2009 were $1.8
million, an increase of $0.1 million or 3.6%, over the same period in
2008.  The increase was primarily due to an increase in advertising
and sales commission expense in our Voice and Network solutions segment,
partially offset by a reduction in our Video Solutions selling staff in late
February 2009. We anticipate that selling and marketing expenses for the fourth
quarter of 2009 will be higher than those incurred in 2008 as we increase our
advertising expense in order to increase market share and to promote our Digital
Phone Service product line.




General
and Administrative Expenses




General
and administrative expenses for the three months ended September 30, 2009 were
$2.0 million, a decrease of $0.7 million or 24.5%, over the same period in
2008.  Approximately, 73% of the decrease is attributable costs
associated with common stock issued for investor relations services provided
during the three months ended September 30, 2008.  No similar costs
were incurred for the same period in 2009.




Research,
Development and Engineering Expenses




Research,
development and engineering expenses for the three months ended September 30,
2009 were $1.1 million, a decrease of $0.2 million or 15.7%, over the same
period in 2008.  Research, development and engineering expenses
decreased in 2009 as compared to 2008 primarily as a result of a decrease in
research and development staffing.




Depreciation
Expense




Depreciation
expense for the three months ended September 30, 2009 was $0.3 million, an
increase of $0.1 million or 19.5%, over the same period in 2008.  The
increase is primarily attributable to additions to fixed assets during the
preceding twelve months.




Amortization
of Purchased Intangibles




We
recorded $0.6 million of amortization expense for the three months ended
September 30, 2009 and 2008, related to the intangible assets acquired in the
AVS and AccessLine acquisition transactions.




Impairment
of Intangibles




We do not
amortize goodwill and intangible assets with indefinite useful
lives.  However, we do review these assets for impairment at least
annually. We test goodwill for impairment using a two-step process. The first
step is a screen for potential impairment, while the second step measures the
amount of the impairment, if any.




25
 Table of Contents





Other
intangible assets with finite useful lives consist primarily of developed
technology and customer relationships. These intangibles are amortized on the
straight-line basis over the expected period of benefit which range from five to
ten years.




Long-lived
assets, including developed technology and customer relationships, are reviewed
for impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable.  Recoverability of
assets to be held and used is measured by comparing of the carrying amount of
the asset to future undiscounted net cash flows expected to be generated by the
asset.  If an asset is considered to be impaired, the impairment to be
recognized is measured by the amount by which the carrying amount of that asset
exceeds the fair value of that asset.  Assets to be disposed of are
reported at the lower of the carrying amount or fair value less costs to
sell.




We
determined that the goodwill, intangible assets and other long-lived assets for
our Voice and Network Solutions segment were not impaired as of September 30,
2009.  However, due to the decline in performance of our Video
Solutions segment, we determined that goodwill and intangible assets related to
that segment were 100% impaired as of September 30, 2009.  This
impairment resulted in a charge of $1.4 million of impairment expense in the
three months ended September 30, 2009.  There was no impairment of
assets during the three months ended September 30, 2008.




Interest
Expense




Interest
expense for the three months ended September 30, 2009 was $0.8 million, a
decrease of $0.7 million or 46.0%, from the same period in
2008.  Interest expense includes stated interest, amortization of note
discounts, amortization of deferred financing costs, and interest on capital
leases.  Interest expense decreased in 2009 primarily as a result of
the reduced interest rate on our debentures pursuant to the May 2009 Amendment
Agreement, which is discussed in more detail below.




The
debentures we issued prior to June 2008 had an interest rate of 6%, and we
recorded discounts to the debentures for the beneficial conversion feature and
for the value of the warrants granted in connection with those
debentures.  We also recorded deferred financing costs related to the
private placements in which such debentures were issued.




On June
30, 2008, we exchanged our then outstanding debentures for new debentures with
an aggregate face value of $26.1 million that have a six year term and, when
originally issued, bore interest at 12%.  As discussed in greater
detail below, the interest rate on these debentures was amended in December 2008
and again in May 2009.  During the second half of 2008, a portion of
these debentures were converted into shares of our common stock.  We
recorded deferred financing costs of $0.2 million related to the issuance of the
new debentures in June 2008.  The unamortized discounts and deferred
financing costs at June 30, 2008 related to the prior financing transactions
will be amortized to interest expense in future periods over the term of the
newly issued debentures, or through June 30, 2014.




In
August, 2008, we issued a debenture with a face value of $2.0 million that, when
originally issued, bore interest at 12% per annum.  As discussed in
greater detail below, the interest rate on this debenture was amended in
December 2008 and again in May 2009.  We recorded discounts
aggregating to $1.3 million which will be amortized to interest expense in
future periods over the term of the debenture, or through June 30,
2014.




In
December, 2008, we issued a debenture with a face value of $1.5 million that,
when originally issued, bore interest at a rate of (i) 0% per annum from the
original issue date until the one year anniversary of the original issue date,
(ii) 12% per annum from the one year anniversary of the original issue date
until the four year anniversary of the original issue date, and (iii) 18% per
annum from the four year anniversary of the original issue date until June
2014.  The interest rate on this debenture was amended in May
2009.




In
addition, in December 2008, with respect to the debentures we issued in June
2008 and August 2008, the parties agreed to amend the interest rate and interest
payment provisions, which had called for monthly interest payments at the rate
of 12% per annum.  As amended in December 2008, interest is payable
quarterly at the rate of (i) 0% per annum from October 1, 2008 until September
30, 2009, (ii) 13.5% per annum from October 1, 2009 until September 30, 2012 and
(iii) 18% per annum from October 1, 2012 until maturity.




In May
2009, with respect to the debentures we issued in June 2008, August 2008 and
December 2008, the parties agreed to amend the terms of such debentures to: (i)
defer interest payments until October 1, 2011; (ii) reduce the interest rate to
0% through June 30, 2011 and then to 5% per annum thereafter; and (iii) require
that all future interest payments be made in cash. This change in terms resulted
in an effective interest rate for the period subsequent to May 8, 2009 of
1.5%.   See "Recent Financings," above.




Change
in Fair Value of Warrant and Beneficial Conversion Liabilities




We
recorded the fair value of the warrants issued in connection with our various
financings at the issuance dates as a warrant liability because the exercise
price of the warrants can be adjusted if we subsequently issue common stock at a
lower price and it is possible for us to not have enough authorized shares to
settle the warrants and therefore would have to settle the warrants with
cash.




The fair
value of the then outstanding warrants was estimated at December 31, 2008 and
again at each subsequent reporting date.  However, as a result of the
Amendment Agreement (see Recent Financings above), the anti-dilution protection
under the PIPE Warrants was removed, which eliminates the potential for future
dilution from the PIPE Warrants.  Accordingly, the PIPE Warrants are
no longer a derivative liability and their value as of May 8, 2009, was
reclassed to equity.  Accordingly, for the three months ended
September 30, 2009, there was no related expense.




26
 Table of Contents




At
December 31, 2008 and again at each subsequent reporting date, we assessed the
then outstanding convertible debentures and determined that the beneficial
conversion feature represented an embedded derivative
liability.  Accordingly, we bifurcated the embedded beneficial
conversion feature and accounted for it as a derivative liability because the
conversion price of the debentures could be adjusted if we subsequently issue
common stock at a lower price and due to recent events it became possible that
we could have to net cash settle the contract if there were not enough
authorized shares to issue upon conversion.




The
debentures we issued in December 2006, February 2007, August 2007 and March 2008
contained embedded derivative features which were accounted for at fair value as
a compound embedded derivative up to June 30, 2008, the date we exchanged those
debentures for debentures with a six year term and 12% interest
rate.  This compound embedded derivative included the following
material features: (1) the standard conversion feature of the debentures; (2) a
reset of the conversion price condition for subsequent equity sales; (3) our
ability to pay interest in cash or shares of our common stock; (4) monthly
redemption payments as per the debenture agreements; (5) optional redemption at
our election; (6) forced conversion; (7) holder’s restriction on conversion; and
(8) a default put.




The
debentures we issued in June 2008, August 2008 and December 2008 contain
embedded derivative features, which were accounted for at fair value as a
compound embedded derivative at the issuance dates and at each subsequent
reporting date.  This compound embedded derivative included the
following material features: (1) the standard conversion feature of the
debentures; (2) a reset of the conversion price condition for subsequent equity
sales; (3) our ability to pay interest in cash or shares of our common stock;
(4) optional redemption at our election; (5) forced conversion; (6) holder’s
restriction on conversion; and (7) a default put.




The
change in the fair market value of the beneficial conversion feature liability
on May 8, 2009 as a result of the decrease the conversion price of all of our
debentures from $0.40 to $0.30 per the Amendment Agreement (see Recent
Financings above) was recorded as additional debt discount of $4.0
million.




We, with
the assistance of an independent valuation firm, calculated the fair value of
the compound embedded derivative associated with the convertible debentures
utilizing a complex, customized Monte Carlo simulation model suitable to value
path dependant American options.  The model uses the risk neutral
methodology adapted to value corporate securities.  This model
utilized subjective and theoretical assumptions that can materially affect fair
values from period to period.




For the
three months ended September 30, 2009, we recorded non-operating income of $3.8
million in the Consolidated Statement of Operations for the increase in the fair
market values of the embedded derivative features, which is primarily
attributable to the decrease in the market price of our common
stock.




Provision
for Income Taxes




No
provision for income taxes has been recorded because we have experienced net
losses from inception through September 30, 2009. As of December 31, 2008, we
had net operating loss carryforwards (“NOL’s”) of approximately $42.0 million,
some of which, if not utilized, will begin expiring in the current year.
 Our ability to utilize the NOL carryforwards is dependent upon generating
taxable income.  We have recorded a corresponding valuation allowance to
offset the deferred tax assets as it is more likely than not that the deferred
tax assets will not be realized. We recognize interest accrued and penalties
related to unrecognized tax benefits in tax expense. During the years ended
December 31, 2008 and 2007, we recognized no interest and
penalties.




Nine
months ended September 30, 2009 Compared to Nine months ended September 30,
2008




Revenues,
Cost of Revenues and Gross Profit





Nine
      months ended September 30, 2009
            
            Nine
      months ended September 30, 2008
            
            Increase
      (decrease)Voice
      and Network Solutions
            
            Video
              Solutions
            
            Total
            
            Voice
      and Network Solutions
            
            Video
              Solutions
            
            Total
            
            Voice
      and Network Solutions
            
            Video
              Solutions
            
            TotalNet
      revenues:
            
            $
            21,094,655
            
            
            $
            3,152,142
            
            
            $
            24,246,797
            
            
            $
            19,388,090
            
            
            $
            4,764,791
            
            
            $
            24,152,881
            
            
            $
            1,706,565
            
            
            $
            (1,612,649
            )
            
            $
            93,916Cost
      of revenues:
            
            
            8,808,963
            
            
            
            2,608,041
            
            
            
            11,417,004
            
            
            
            8,653,845
            
            
            
            3,848,209
            
            
            
            12,502,054
            
            
            
            155,118
            
            
            
            (1,240,168
            )
            
            
            (1,085,050
            )Gross
      profit:
            
            $
            12,285,692
            
            
            $
            544,101
            
            
            $
            12,829,793
            
            
            $
            10,734,245
            
            
            $
            916,582
            
            
            $
            11,650,827
            
            
            $
            1,551,447
            
            
            $
            (372,481
            )
            
            $
            1,178,966Gross
      profit %
            
            
            58.2
            %
            
            
            17.3
            %
            
            
            52.9
            %
            
            
            55.4%
            
            
            
            19.2%
            
            
            
            48.2%





Net
revenues for the nine months ended September 30, 2009 were $24.2 million, an
increase of $0.1 million, or 0.4%, over the same period in 2008.  Net
revenues in our Voice and Network Solutions segment increased $1.7 million. Net
revenues in our Video Solutions segment decreased $1.6 million.  The
increase in Voice and Network Solutions revenues is due in part to organic
growth of existing products and services as a result of the increase in
advertising year over year and to the success of our SIP Trunking and Digital
Phone Service products which were launched in mid-2008. The decrease in Video
Solutions revenues was primarily due to the impact of the economy which has many
potential customers avoiding spending on big ticket items such as video
equipment.




27
 Table of Contents




For the
nine months ended September 30, 2009, one customer accounted for 12% of our
Voice and Network Solutions segment net revenues and three customers accounted
for 35% of our Video Solutions segment net revenues. For the nine months ended
September 30, 2008, one customer accounted for 15% of the Voice and Network
Solutions segment net revenues and no one customer accounted for more than 10%
of the Video Solutions segment net revenues.




Cost of
revenues for the nine months ended September 30, 2009 were $11.4 million, a
decrease of $1.1 million, or 8.7%, over the same period in 2008. Cost of
revenues in our Voice and Network Solutions segment increased $0.2 million as a
result of the increased revenues, partially offset by several cost saving
measures that we began implementing during 2009.  Cost of revenues in
our Video Solutions segment decreased by $1.2 million due to the decrease in
revenues.




Gross
profit for the nine months ended September 30, 2009 was $12.8 million, an
increase of $1.2 million, or 10.1%, over the same period in
2008.  Gross profit in our Voice and Network Solutions segment
increased $1.6 million consistent with the increase in revenues. Gross profit in
our Video Solutions segment decreased $0.4 million primarily as a result of the
decrease in revenues as compared to the same period in the prior
year.




Gross
profit percentage was 52.9% for the nine months ended September 30, 2009
compared to 48.2% in the same period in 2008.  Gross profit percentage
for our Voice and Network Solutions segment was 58.2% for the nine months ended
September 30, 2009 compared to 55.4% in the same period in 2008.  The
increase is a result of improved purchasing power from network infrastructure
providers allowing us to purchase network access at lower rates as well as
several cost saving measures that the Company began implementing during 2009,
which more than offset the shift in revenue to our DPS and SIP Trunking product
lines, both of which have somewhat lower margins than our individual services
and legacy products. Gross profit percentage for our Video Solutions segment was
17.3% for the nine months ended September 30, 2009 compared to 19.2% in the same
period in 2008, and the decrease is primarily due to a less profitable mix of
products sold.




Selling
and Marketing Expenses




Selling
and marketing expenses for the nine months ended September 30, 2009 were $5.2
million, equal to expenses in the same period in 2008.  This lack of
change in expense is due to a reduction in our Video Solutions selling staff in
late February 2009, offset by increased advertising and sales commission expense
in our Voice and Network solutions segment. We anticipate that selling and
marketing expenses for the fourth quarter of 2009 will be higher than those
incurred in 2008 as we increase our advertising expense in order to increase
market share and to promote our Digital Phone Service product line.




General
and Administrative Expenses




General
and administrative expenses for the nine months ended September 30, 2009 were
$6.5 million, a decrease of $3.2 million or 33.3%, over the same period in
2008.  Approximately, 70% of the decrease is attributable to lower
payroll and stock compensation expense as a result of a decrease in management
staff and the impact of related severance costs in 2008. Approximately, 13% of
the decrease is attributable to lower accounting costs in 2009 as compared to
2008, which included costs associated with the first time consolidation of the
activity of our Accessline and AVS subsidiaries that were acquired during
2007.  Another 13% of the decrease is attributable to lower investor
relations costs in 2009 as our contract with an investor relations firm for
payment in stock ended in 2008.  There was no such related expense in
2009.  The remaining decrease is primarily attributable to lower
consulting fees in 2009 as compared to 2008, which included costs associated
with various valuations as a result of our acquisitions and various debt
restructurings in 2007 and 2008.




Research,
Development and Engineering Expenses




Research,
development and engineering expenses for the nine months ended September 30,
2009 were $3.3 million, a decrease of $1.0 million or 22.3%, over the same
period in 2008.  Research, development and engineering expenses
decreased in 2009 as compared to 2008 primarily as a result of a decrease in
research and development staffing and the impact of related severance costs in
2008.




Depreciation
Expense




Depreciation
expense for the nine months ended September 30, 2009 was $0.8 million, an
increase of $0.2 million or 29.9%, over the same period in 2008.  The
increase is primarily attributable to additions to fixed assets during the
preceding twelve months.




Amortization
of Purchased Intangibles




We
recorded $1.8 million of amortization expense for the nine months ended
September 30, 2009 and 2008, related to the intangible assets acquired in the
AVS and AccessLine acquisition transactions.




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 Table of Contents





Impairment
of Intangibles




We
determined that the goodwill, intangible assets and other long-lived assets for
the Voice and Network Solutions segment were not impaired as of September 30,
2009.  However, due to the decline in performance of our Video
Solutions segment, we determined that goodwill and intangible assets related to
that segment were 100% impaired at September 30, 2009.  This
impairment resulted in a charge of $1.4 million of impairment expense in the
nine months ended September 30, 2009.  There was no impairment of
assets during the nine months ended September 30, 2008.




See also
"—Three months ended September 30, 2009 Compared to Three months ended September
30, 2008—Impairment of Intangibles," above.




Interest
Expense




Interest
expense for the nine months ended September 30, 2009 was $3.3 million, a
decrease of $1.2 million or 26.4%, from the same period in
2008.  Interest expense includes stated interest, amortization of note
discounts, amortization of deferred financing costs, and interest on capital
leases. Interest expense decreased in 2009 primarily as a result of the reduced
interest rate on our debentures pursuant to the May 2009 Amendment Agreement.
See also "—Three months ended September 30, 2009 Compared to Three months ended
September 30, 2008—Interest Expense," above.




Change
in Fair Value of Warrant and Beneficial Conversion Liabilities




For the
nine months ended September 30, 2009, we recorded non-operating income from the
change in fair value of warrant and beneficial conversion liabilities of $0.2
million, comprised of non-operating expense of $1.0 million for the decrease in
the fair values of the warrants from the period from January 1, 2009, through
May 8, 2009 and non-operating income of $1.2 million for the increase in the
fair market values of the beneficial conversion feature liability.




See also
"—Three months ended September 30, 2009 Compared to Three months ended September
30, 2008—Change in Fair Value of Warrant and Beneficial Conversion Liabilities,"
above.




Provision
for Income Taxes




No
provision for income taxes has been recorded because we have experienced net
losses from inception through September 30, 2009. See also "—Three months ended
September 30, 2009 Compared to Three months ended September 30, 2008—Provision
for Income Taxes,” above.




Liquidity
and Capital Resources




Our cash
balance as of September 30, 2009 was $1.0 million.  At that time, we
had accounts receivable of $2.2 million and a working capital deficit of $10.9
million, which includes beneficial conversion liabilities of $7.6
million.




Cash
generated by operations during the nine months ended September 30, 2009 was $1.2
million. This was primarily the result of the receipt of $1.6 million of
accounts receivable and an increase in accounts payable and accrued expenses of
$0.5 million, partially offset by the net loss. The net loss of $9.2 million was
almost entirely offset by the following non-cash charges: amortization of
intangible assets of $1.8 million; depreciation expense of $1.6 million (which
includes depreciation expense of $0.8 million in cost of sales); amortization of
note discounts of $1.6 million; the change in accrued interest of $1.5 million;
impairment of intangible assets of $1.4 million, and stock compensation expense
of $0.8 million.




Net cash
used by investing activities during the nine months ended September 30, 2009 was
$0.4 million, which consisted of purchases of property and
equipment.




Net cash
used by financing activities was $0.8 million during the nine months ended
September 30, 2009, all of which was used for payments on our capital
leases.




If we can
continue to generate Voice and Network Solution revenue and gross margin
improvements consistent with our growth in 2008 and during the nine months ended
September 30, 2009, maintain control of our operating expenses and execute a
successful strategic alternative for our Digital Presence product line, we
believe that our existing capital will be sufficient to finance our operations
through the end of 2009. We do not currently have any unused credit arrangement
or open credit facility available to us.  Our PIPE Debentures are
secured by a lien on all of our assets, and the terms of those debentures
restrict our ability to borrow funds and pledge our assets as security for any
such borrowing, without the consent of the holders of the PIPE
Debentures.





If our
cash reserves prove insufficient to sustain operations, we plan to raise
additional capital by selling shares of capital stock or other equity or debt
securities.  However, there are no commitments or arrangements for
future financings in place at this time, and we can give no assurance that such
capital will be available on favorable terms or at all.  We may need
additional financing thereafter until we can achieve
profitability.  If we cannot, we will be forced to curtail our
operations or possibly be forced to evaluate a sale or liquidation of our
assets.  Any future financing may involve substantial dilution to
existing investors.




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 Table of Contents




Commitments
and Contingencies





Debentures





As of
September 30, 2009, the principal balance we owe on our outstanding debentures
is $29.6 million, all of which is due June 30, 2014.  In May 2009, the
terms of our debentures were amended to defer interest payments until October 1,
2011.  All interest payments must be paid in cash.  In
addition, at any time, the holders of the debentures have the right to convert
the debentures into common stock at the then effective conversion price
(currently $0.30). See "Recent Financings," above.




If our
cash flows from operations are not sufficient to make interest payments in cash,
we will evaluate other equity financing opportunities, the proceeds of which
could be used to repay the debentures.




If we are
unable to make the payments due on our outstanding debentures, we would be in
default under those securities. The holders of our debentures would be entitled
to demand that all amounts due thereunder be immediately paid in cash, and the
holders would have the right to demand that we pay 130% of the outstanding
principal amount and the interest rate accrues at a rate equal to the lesser of
18% per annum or the maximum rate permitted under applicable law. In addition,
the holders would have the right to foreclose on all of our assets pursuant to
the terms of the security agreement we entered into with such holders and they
would have the right to take possession of our assets and operate our
business.




Leases




We have
non-cancelable operating and capital leases for corporate facilities and
equipment.




Future
minimum rental payments required under non-cancelable operating and capital
leases are as follows for the years ending December 31:





Operating
              Leases
            
            
            Capital
              Leases2009
            
            $
            398,330
            
            
            $
            264,7172010
            
            
            1,418,485
            
            
            
            733,9772011
            
            
            1,273,228
            
            
            
            318,1922012
            
            
            1,269,119
            
            
            
            63,0302013
            
            
            184,920
            
            
            
            14,139Thereafter
            
            
            —
            
            
            
            —Total
      minimum lease payments
            
            $
            4,544,082
            
            
            
            1,394,055Less
      amount representing interest
            
            
            
            
            
            
            (151,219
            )Present
      value of minimum lease payments
            
            
            
            
            
            
            1,242,836Less
      current portion
            
            
            
            
            
            
            (714,118
            )Total
      long term portion
            
            
            
            
            
            $
            528,718




Minimum Third Party Network
Service Provider Commitments




We have a
contract with a third party network service provider that facilitates
interconnectivity with a number of third party network service
providers.  The contract contains a minimum usage guarantee of $0.2
million per monthly billing cycle.  The contract commenced on October
16, 2003 with an initial 24 month term.  The contract was extended in
July 2005 for a three year term that expired in July 2008.  On October
24, 2008, the contract was extended for another three year term.  The
cancellation terms are a 90 day written notice prior to the then current term
expiring.




30
 Table of Contents




Communications Assistance
for Law Enforcement Act




On August
5, 2005, the Federal Communications Commission, or FCC, unanimously adopted an
order requiring VoIP providers to comply with the Communications Assistance for
Law Enforcement Act, or CALEA. CALEA requires covered providers to assist law
enforcement agencies in conducting lawfully authorized electronic
surveillance.  Under the FCC order, all VoIP providers were to become
fully CALEA compliant by May 14, 2007.  We engaged a third party to
help it develop a solution to be CALEA compliant.  In February 2007,
we notified the FCC that it did not expect to have a CALEA compliant solution
completed by May 14, 2007, but that it instead expected to have the development
complete by September 1, 2007.  Our formal CALEA compliance testing
with the third party was completed on September 28, 2007.  Currently,
our CALEA solution is fully deployed in its network.  However, we
could be subject to an enforcement action by the FCC or law enforcement agencies
for any delays related to meeting, or if we fail to comply with, any current or
future CALEA obligations.




Universal Service
Fund




In June
2006, the FCC concluded that VoIP providers must contribute to the Universal
Service Fund, or USF.  The FCC established a contribution safe harbor
percentage of 64.9% of total VoIP service revenue.  Alternatively,
VoIP providers are permitted to calculate their contribution based on FCC
pre-approved traffic studies.  We began contributing to the USF on
October 1, 2006 using the 64.9% safe harbor.  In the meantime, the FCC
continues to evaluate alternative methods for assessing USF charges, including
imposing an assessment on telephone numbers.  The outcome of these
proceedings cannot be determined at this time nor can we determine the potential
financial impact as the details of an alternative method of USF contribution
have not been determined at this time.  There is also a risk that
state USF funds may attempt to impose state USF contribution obligations and
other state and local charges.




Sales and Additional
Taxes




Based
upon a new Internal Revenue Service ruling, we ceased collecting federal excise
tax on August 1, 2006 on long-distance or bundled services.  We had
not collected or accrued liabilities for E911 taxes for VoIP services prior to
July 1, 2006, and it is possible that substantial claims for back taxes may be
asserted against us.  Also, we are currently working to obtain Inter
Exchange Carrier (IXC) certification in Alaska, Maryland and
Mississippi.  Our current certification status in these three states
may leave it liable for fees and penalties that could decrease its ability to
compete with traditional telephone companies.  In addition, future
expansion of our service, along with other aspects of its evolving business, may
result in additional sales and other tax obligations.  One or more
taxing authorities may seek to impose sales, use or other tax collection
obligations on us.  We have received inquiries or demands from
numerous state authorities and may be subjected to audit at any
time.  A successful assertion by one or more taxing authorities that
we should collect sales, use or other taxes on the sale of its services could
result in substantial tax liabilities for past sales.




Other




In
connection with our acquisition of AccessLine, we were required to pay up to an
additional $9.0 million in the form of 2,500,000 shares of our restricted common
stock upon the achievement of certain future financial objectives, the value of
which would increase the amount of goodwill recorded in the
transaction.  The first earn out period ended December 31,
2007.  In April 2008, when the contingency related to the first earn
out period was resolved, we issued 599,130 shares valued at $0.6 million,
resulting in increases to goodwill and equity.  The second earn out
period ended June 30, 2008, and we issued 529,252 shares valued at $0.3 million
in July 2008.  The increase in goodwill and equity was recorded in the
third quarter of 2008.  The third earn out period ended December 31,
2008, and we issued 515,622 shares valued at less than $0.1 million in February
2009.  The increase in goodwill and equity was recorded in the first
quarter of 2009.  The final earn out period ended on June 30, 2009 and
we issued 401,658 shares valued at $0.04 million in July 2009.  The
increase in goodwill and equity was recorded in the third quarter of
2009.




On April
18, 2007, the FCC released a Notice of Proposed Rulemaking tentatively
concluding that VoIP providers should pay regulatory fees.  According
to the notice, the FCC would like to begin collection of such fees in the August
to September 2007 timeframe.  The FCC is considering calculating
contribution obligations for VoIP providers based on either revenues or
telephone numbers used.  We cannot predict the outcome of this
proceeding.  On June 8, 2007, the FCC released an order implementing
various recommendations from its Independent Panel Reviewing the Impact of
Hurricane Katrina on Communications Networks Panel, including a requirement that
certain VoIP providers submit reports regarding the reliability and resiliency
of their 911 systems.  At this time, the Company is not subject to
these reporting requirements but may become subject in future
years.




On June
8, 2007, the FCC released an order implementing various recommendations from its
Independent Panel Reviewing the Impact of Hurricane Katrina on Communications
Networks Panel, including a requirement that certain VoIP providers submit
reports regarding the reliability and resiliency of their 911
systems.  At this time, we are not subject to these reporting
requirements but may become subject in future years.




On June
15, 2007, the FCC extended the disability access requirements of Sections 225
and 255 of the Communications Act, which applied to traditional phone services,
to providers of VoIP services and to manufacturers of specially designed
equipment used to provide those services.  Section 255 of the
Communications Act requires service providers to ensure that its equipment and
service is accessible to and usable by individuals with disabilities, if readily
achievable, including requiring service providers to ensure that information and
documentation provided in connection with equipment or services be accessible to
people with disabilities, where readily achievable and that employee training
account for accessibility requirements.  In addition, the FCC said
that VoIP providers were subject to the requirements of Section 225, including
contributing to the Telecommunications Relay Services, or TRS, fund and that
they must offer 711 abbreviated dialing for access to relay
services.  Although we contribute to the TRS fund as required, we have
not yet implemented a solution for the 711 abbreviated dialing
requirement.  We may be subject to enforcement actions including, but
not limited to, fines, cease and desist orders, or other penalties if we do not
comply with these obligations.




31
 Table of Contents





In the
latter half of 2007, the FCC released two Report and Orders that increase the
costs of doing business.  One of them, released on August 6, 2007,
concerns the collection of regulatory fees for fiscal year 2007, which, for the
first time, mandates the collection of such fees from VoIP
providers.  This order, which became effective in November 2007,
requires that VoIP providers pay regulatory fees based on reported interstate
and international revenues.  Regulatory fees for the FCC's fiscal year
2007 were due in 2008.  Fiscal year 2008 fees were paid in 2008 during
the normal regulatory fee payment window.  The assessment of
regulatory fees on our VoIP service offering will increase our costs and reduce
our profitability or cause us to increase the retail price of its VoIP service
offerings.




The other
order, released on November 8, 2007, imposes local number portability and
related obligations on VoIP providers, such as requiring VoIP providers to
contribute to shared numbering administration costs on a competitively neutral
basis.  The assessment of local number portability fees to our VoIP
service will increase our costs and reduce our profitability or cause us to
increase the price of its VoIP service offerings.




Critical
Accounting Policies Involving Management Estimates and Assumptions




Our
discussion and analysis of our financial condition and results of operations is
based on our consolidated financial statements.  The preparation of
the consolidated 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, liabilities and
equity and disclosure of contingent liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period.  Significant estimates include those related to the
allowance for doubtful accounts; valuation of inventories; valuation of
goodwill, intangible assets and property and equipment; valuation of stock based
compensation expense, the valuation of warrants and conversion features; and
other contingencies.  On an on-going basis, we evaluate our
estimates.  We base our estimates on historical experience and on
various other assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying value of assets and liabilities that are not readily apparent from
other sources.  Actual results could differ from those estimates under
different assumptions or conditions.




The
following is a discussion of certain of the accounting policies that require
management to make estimates and assumptions where the impact of those estimates
and assumptions may have a substantial impact on our financial position and
results of operations.




Inventories:




Inventories,
which consist primarily of finished goods, are valued at the lower of cost or
market with cost computed on a first-in, first-out (FIFO)
basis.  Consideration is given to obsolescence, excessive levels,
deterioration and other factors in evaluating net realizable
value.  We record write downs for excess and obsolete inventory equal
to the difference between the cost of inventory and the estimated fair value
based upon assumptions about future product life-cycles, product demand and
market conditions.




Property
and Equipment:




Property
and equipment are stated at cost less accumulated depreciation and
amortization.  Depreciation is provided using the straight-line method
over the estimated useful lives of the assets.  Estimated useful lives
are two to seven years.  Amortization of leasehold improvements is
computed using the straight-line method over the shorter of the remaining lease
term or the estimated useful lives of the assets.  Disposals of
capital equipment are recorded by removing the costs and accumulated
depreciation from the accounts and gains or losses on disposals are included in
operating expenses in the Consolidated Statement of Operations.




Goodwill:




Goodwill
is not amortized but is regularly reviewed for potential
impairment.  The identification and measurement of goodwill impairment
involves the estimation of the fair value of our reporting units.  The
estimates of fair value of reporting units are based on the best information
available as of the date of the assessment, which primarily incorporate
management assumptions about expected future cash flows.  Future cash
flows can be affected by changes in industry or market conditions or the rate
and extent to which anticipated synergies or cost savings are realized with
newly acquired entities.




Impairment
of Long-Lived Assets:




Purchased
intangible assets with finite lives are amortized using the straight-line method
over the estimated economic lives of the assets, which range from five to ten
years.  Purchased intangible assets determined to have indefinite
useful lives are not amortized.  Long-lived assets, including
intangible assets with finite lives, are reviewed for impairment whenever events
or changes in circumstances indicate that the carrying amount of such assets may
not be recoverable.  Determination of recoverability is based on an
estimate of undiscounted future cash flows resulting from the use of the asset
and its eventual disposition.  Measurement of an impairment loss for
long-lived assets that management expects to hold and use is based on the fair
value of the asset.  Long-lived assets to be disposed of are reported
at the lower of carrying amount or fair value less costs to sell.




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Revenue
Recognition:




Voice and Network Solutions
Revenue




Voice and
network revenues are derived primarily from monthly recurring fees, which are
recognized over the month the service is provided, activation fees, which are
deferred and recognized over the estimated life of the customer relationship,
and fees from usage which are recognized as the service is
provided.




Video Solutions
Revenue




We
recognize revenue when persuasive evidence of an arrangement exists, title has
transferred, product payment is not contingent upon performance of installation
or service obligations, the price is fixed or determinable, and collectability
is reasonably assured.  In instances where final acceptance of the
product or service is specified by the customer, revenue is deferred until all
acceptance criteria have been met.  Additionally, we recognize
extended service revenue on our hardware and software products ratably over the
service period, generally one year.




Our
telepresence products are integrated with software that is essential to the
functionality of the equipment.  Additionally, we provide unspecified
software upgrades and enhancements related to most of these products
through maintenance contracts.  We generally recognize revenue
generated by integration, consultation and implementation solutions on a
percentage completion basis based on direct labor costs.




Income
Taxes:




We
account for income taxes under the liability method, which recognizes deferred
tax assets and liabilities determined based on the difference between the
financial statement and tax basis of assets and liabilities using enacted tax
rates in effect for the year in which the differences are expected to affect
taxable income.  Valuation allowances are established to reduce
deferred tax assets when, based on available objective evidence, it is more
likely than not that the benefit of such assets will not be
realized.  In addition, FASB guidance requires us to recognize in the
consolidated financial statements only those tax positions determined to be more
likely than not of being sustained.




Derivative
Financial Instruments




We do not
use derivative instruments to hedge exposures to cash flow, market or foreign
currency risks.




We review
the terms of convertible debt and equity instruments it issues to determine
whether there are embedded derivative instruments, including the embedded
conversion option, that are required to be bifurcated and accounted for
separately as a derivative financial instrument.  In circumstances
where the convertible instrument contains more than one embedded derivative
instrument, including the conversion option, that is required to be bifurcated,
the bifurcated derivative instruments are accounted for as a single, compound
derivative instrument.  Also, in connection with the sale of
convertible debt and equity instruments, we may issue freestanding warrants that
may, depending on their terms, be accounted for as derivative instrument
liabilities, rather than as equity.




Bifurcated
embedded derivatives are initially recorded at fair value and are then revalued
at each reporting date with changes in the fair value reported as charges or
credits to income.  When the convertible debt or equity instruments
contain embedded derivative instruments that are to be bifurcated and accounted
for as liabilities, the total proceeds allocated to the convertible host
instruments are first allocated to the fair value of all the bifurcated
derivative instruments.  The remaining proceeds, if any, are then
allocated to the convertible instruments themselves, usually resulting in those
instruments being recorded at a discount from their face amount.




The
discount from the face value of the convertible debt, together with the stated
interest on the instrument, is amortized over the life of the instrument through
periodic charges to income, using the effective interest method.




Stock
Based Compensation:




We
measure the cost of employee services received in exchange for an award of
equity instruments based on the grant-date fair value of the
award.  That cost is recognized in the Consolidated Statement of
Operations over the period during which the employee is required to provide
service in exchange for the award – the requisite service period.  No
compensation cost is recognized for equity instruments for which employees do
not render the requisite service.  The grant-date fair value of
employee share options and similar instruments is estimated using option-pricing
models adjusted for the unique characteristics of those
instruments.




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Recent
Accounting Pronouncements




Please
see “Note 2 - Recent Accounting Pronouncements” of the Notes to Condensed
Consolidated Financial Statements included in "Item 1. Financial Statements" of
Part I of this report.




Off-Balance
Sheet Arrangements




We do not
have any off-balance sheet arrangements, as defined in Item
303(a)(4)(ii) of Regulation S-K promulgated under the Securities
Act.




Item 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK




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




Item 4.
CONTROLS AND PROCEDURES




Evaluation
of Disclosure Controls and Procedures




Our
disclosure controls and procedures are designed to provide reasonable assurances
that material information related to our company is recorded, processed,
summarized and reported within the time periods specified in the SEC rules and
forms, and that such information is accumulated and communicated to our
management, including our Chief Executive Officer and Chief Financial Officer,
as appropriate, to allow timely decisions regarding required disclosure. Our
Chief Executive Officer and Chief Financial Officer have determined that as of
September 30, 2009, our disclosure controls were effective at that "reasonable
assurance" level.




Changes In Internal
Controls over Financial Reporting.




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




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PART
      II – OTHER INFORMATION


Item 1. LEGAL PROCEEDINGS





From time
to time, we may be involved in litigation relating to claims arising out of our
operations in the normal course of business, including claims of alleged
infringement, misuse or misappropriation of intellectual property rights of
third parties. As of the date of this report, we are not a party to any
litigation which we believe would have a material adverse effect on our business
operations or financial condition.




Item
1A. RISK FACTORS





In
addition to the other information set forth in this report, you should carefully
consider the risk factors discussed in "Part I. Item 1A—Risk Factors" in our
Annual Report on Form 10-K for the fiscal year ended December 31, 2008. The
risks and uncertainties described in such risk factors and elsewhere in this
report have the potential to materially affect our business, financial
condition, results of operations, cash flows, projected results and future
prospects. As of the date of this report, we do not believe that there have
been any material changes to the risk factors previously disclosed in our Annual
Report on Form 10-K for the fiscal year ended December 31, 2008.


Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF
PROCEEDS





In July
2009, we issued 401,658 shares of our common stock pursuant to the earn out
provisions of the AccessLine acquisition agreement for the period ending June
30, 2009.




The
issuance described above was exempt from registration under the Securities Act
pursuant to Section 4(2) thereof. The transaction was not conducted in
connection with a public offering, and no public solicitation or advertisement
was made or relied upon by the investor in connection with the
offering.


Item 3. DEFAULTS UPON SENIOR SECURITIES




None.


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




None.


Item 5. OTHER INFORMATION




None.


Item 6. EXHIBITS




See the
exhibit index immediately following the signature page of this
report.




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SIGNATURES




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







TELANETIX,
      INC./s/
      J. Paul
      QuinnDate:
      November 12, 2009
            J.
      Paul Quinn, Chief Financial Officer(Duly
      Authorized Officer and Principal Financial
  Officer)





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EXHIBIT INDEX




Exhibit
      No.
            Description10.1
            Amendment
      No. 1 to Employment Agreement with Douglas N. Johnson dated July 1, 2009
      (1)10.2
            Amendment
      No. 1 to Employment Agreement with J. Paul Quinn dated July 1, 2009
      (1)10.3
            Securities
      Purchase Agreement between Telanetix, Inc. and Mike Venditte dated October
      27, 2009 (2)31.1
            Certification of Principal Executive Officer pursuant to
      Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as
      adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
      *31.2
            Certification of Principal Financial Officer pursuant to
      Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as
      adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
      *32.1
            Certification of Principal Executive Officer pursuant to
      18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002 **32.2
            Certification of Principal Financial Officer pursuant to
      18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002 ***
            Filed
      with this report**
            Furnished
      with this report(1)
            Incorporated
      by reference to the registrant's Current Report on Form 8-K filed on July
      2, 2009(2)
            Incorporated
      by reference to the registrant's Current Report on Form 8-K filed on
      November 2, 2009











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