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,
      2008





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.     Yes x  
   No o





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, 2008, 31,740,206 shares of the issuer's common stock, par value
$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 Months Ended September 30, 2008







TABLE OFCONTENTS





PageEXPLANATORY NOTE ABOUT RESTATEMENT
              3FORWARD LOOKING STATEMENTS
              3PART
      I - FINANCIAL INFORMATIONItem
      1.
              Financial
      Statements
              4Item
      2.
              ManagementsDiscussion
      andAnalysis ofFinancialCondition andResults ofOperations
              26Item
      3.
              Quantitative andQualitative DisclosuresAboutMarketRisk
              42Item
      4.
              Controls andProcedures
              42PARTII-OTHER
      INFORMATIONItem
      1.
              Legal Proceedings
              44Item
      1A
              Risk Factors
              44Item
      2.
              Unregistered Sales of Equity
      Securities andUse of Proceeds
              46Item
      3.
              Defaults Upon Senior
      Securities
              46Item
      4.
              Submission ofMattersTo aVote ofSecurity Holders
              46Item
      5.
              Other Information
              46Item
      6.
              Exhibits
              46SIGNATURES
              47EXHIBIT INDEX
              48








Table of Contents




EXPLANATORY NOTE ABOUT RESTATEMENT




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.




We have
restated herein our condensed consolidated financial statements for the three
and nine months ended September 30, 2007 to correct errors in such condensed
consolidated financial statements and financial information.  These
errors were attributable to errors in the valuation of warrants issued in
connection with our financings in December 2006, February 2007, and August
2007.  More information regarding the impact of the restatements on
our condensed consolidated financial statements for the three and nine months
ended September 30, 2007 is disclosed in "Note 3– Restatement" to our
financial statements included in this Report.




FORWARDLOOKING 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."  These forward-looking statements are subject to certain
risks and uncertainties that could cause actual results to differ materially
from historical results or anticipated results, including those set forth under
the heading "Risk Factors" and elsewhere in, or incorporated by reference into,
this report.




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.  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:




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


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


·
            our
      ability to obtain future financing or funds when
  needed;


·
            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 and retain a qualified employee
  base;


·
            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, as market acceptance
and market demand for our products and services, pricing, the changing
regulatory environment, the effect of our accounting policies, potential
seasonality, industry trends, adequacy of our financial resources to execute our
business plan, our ability to attract, retain and motivate key technical,
marketing and management personnel, 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. FinancialStatements





TELANETIX,
INC.


Condensed
Consolidated Balance Sheets






September
      30, 2008
              
              December
      31, 2007(Unaudited)ASSETSCurrent
      assetsCash
              $
              1,406,399
              
              $
              3,779,821Accounts
      receivable, net
              
              2,825,746
              
              
              2,406,885Inventory
              
              559,208
              
              
              230,590Prepaid
      expenses and other current assets
              
              673,101
              
              
              455,577Total
      current assets
              
              5,464,454
              
              
              6,872,873Property
      and equipment, net
              
              5,483,346
              
              
              5,844,421Goodwill
              
              7,821,728
              
              
              6,934,304Purchased
      intangibles, net
              
              19,198,336
              
              
              20,953,333Other
      assets
              
              1,105,919
              
              
              738,024Total
      assets
              $
              39,073,783
              
              $
              41,342,955LIABILITIES
      AND STOCKHOLDERS' EQUITYCurrent
      liabilitiesAccounts
      payable
              $
              2,655,513
              
              $
              1,897,165Accrued
      liabilities
              
              2,820,299
              
              
              2,618,305Line
      of credit
              
              -
              
              
              503,590Deferred
      revenue
              
              1,000,498
              
              
              1,018,515Deferred
      compensation, current portion
              
              130,834
              
              
              445,389Current
      portion of capital lease obligations
              
              993,618
              
              
              1,200,989Convertible
      debentures, current portion
              
              -
              
              
              3,670,734Warrant
      and beneficial conversion feature liabilities
              
              4,702,811
              
              
              9,103,923Total
      current liabilities
              
              12,303,573
              
              
              20,458,610Non-current
      liabilitiesCapital
      lease obligations, net of current portion
              
              1,026,582
              
              
              1,433,694Deferred
      revenue
              
              166,215
              
              
              69,700Convertible
      debentures, less current portion
              
              18,600,929
              
              
              1,003,178Total
      non-current liabilities
              
              19,793,726
              
              
              2,506,572Total
      liabilities
              
              32,097,299
              
              
              22,965,182Stockholders'
      equityPreferred
      stock, $.0001; Authorized:10,000,000;Issued
      and outstanding: None at September 30, 2008 and 13,000 at December 31,
      2007
              
              -
              
              
              1Common
      stock, $.0001 par value; Authorized: 200,000,000 shares;Issued and outstanding: 29,364,292 at September 30, 2008 and 23,079,576 at
      December 31, 2007
              
              2,937
              
              
              2,308Additional
      paid in capital
              
              32,361,364
              
              
              39,011,923Warrants
              
              10,000
              
              
              10,000Accumulated
      deficit
              
              (25,397,817)
              
              
              (20,646,459)Total
      stockholders' equity
              
              6,976,484
              
              
              18,377,773Total
      liabilities and stockholders' equity
              $
              39,073,783
              
              $
              41,342,955




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 30,2008
            
            
            2007
            
            
            2008
            
            
            2007(Restated)
            
            
            
            
            
            (Restated)RevenuesProduct
      revenues
            $
            1,654,038
            
            
            $
            1,185,941
            
            
            $
            4,460,756
            
            
            $
            3,589,929Service
      revenues
            
            6,843,547
            
            
            
            1,075,774
            
            
            
            19,692,125
            
            
            
            1,179,366Total
      revenues
            
            8,497,585
            
            
            
            2,261,715
            
            
            
            24,152,881
            
            
            
            4,769,295Cost
      of revenuesCost
      of product revenues
            
            1,122,393
            
            
            
            1,158,750
            
            
            
            3,507,050
            
            
            
            2,684,818Cost
      of service revenues
            
            2,836,558
            
            
            
            575,274
            
            
            
            8,925,787
            
            
            
            663,772Total
      cost of revenues
            
            3,958,951
            
            
            
            1,734,024
            
            
            
            12,432,837
            
            
            
            3,348,590Gross
      profit
            
            4,538,634
            
            
            
            527,691
            
            
            
            11,720,044
            
            
            
            1,420,705Operating
      expensesSelling,
      general and administrative
            
            4,435,280
            
            
            
            1,927,957
            
            
            
            14,940,248
            
            
            
            4,651,221Research,
      development and engineering
            
            1,266,947
            
            
            
            473,444
            
            
            
            4,311,154
            
            
            
            832,551Depreciation
            
            230,733
            
            
            
            134,966
            
            
            
            635,930
            
            
            
            171,710Amortization
      of purchased intangibles
            
            584,999
            
            
            
            108,333
            
            
            
            1,754,997
            
            
            
            108,333Total
      operating expenses
            
            6,517,959
            
            
            
            2,644,700
            
            
            
            21,642,329
            
            
            
            5,763,815Operating
      loss
            
            (1,979,325
            )
            
            
            (2,117,009
            )
            
            
            (9,922,285
            )
            
            
            (4,343,110
            )Other
      income (expense)Interest
      income
            
            283
            
            
            
            47,500
            
            
            
            17,076
            
            
            
            70,144Interest
      expense
            
            (1,480,689
            )
            
            
            (3,080,358
            )
            
            
            (4,469,134
            )
            
            
            (4,607,409
            )Change
      in fair market value of warrant and beneficial conversion feature
      liabilities
            
            2,840,233
            
            
            
            2,686,252
            
            
            
            11,572,985
            
            
            
            (524,532
            )Gain
      on disposal of fixed assets
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            4,339Total
      other income (expense)
            
            1,359,827
            
            
            
            (346,606
            )
            
            
            7,120,927
            
            
            
            (5,057,458
            )Net
      loss
            
            (619,498
            )
            
            
            (2,463,615
            )
            
            
            (2,801,358
            )
            
            
            (9,400,568
            )Series
      A preferred stock dividends, accretion and increase in stated
      value
            
            -
            
            
            
            (8,716,480
            )
            
            
            (3,178,003
            )
            
            
            (8,716,480
            )Net
      loss applicable to common stockholders
            $
            (619,498
            )
            
            $
            (11,180,095
            )
            
            $
            (5,979,361
            )
            
            $
            (18,117,048
            )Net
      loss per share – basic and diluted
            $
            (0.02
            )
            
            $
            (0.59
            )
            
            $
            (0.24
            )
            
            $
            (1.07
            )Weighted
      average shares outstanding – basic and diluted
            
            27,854,837
            
            
            
            18,970,142
            
            
            
            25,266,459
            
            
            
            16,926,615





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





5
 Table of Contents





TELANETIX,
INC.


Condensed
Consolidated Statements of Cash Flows


(Unaudited)


Nine
      months ended September 30,2008
            
            
            2007(Restated)Cash
      flows from operating activities:Net
      loss
            
            $
            (2,801,358
            )
            
            $
            (9,400,568
            )Adjustments
      to reconcile net loss to cash used by operating
activities:Provision
      for doubtful accounts
            
            
            187,082
            
            
            
            -Reserve
      for excess and obsolete inventory
            
            
            18,595
            
            
            
            97,725Depreciation
            
            
            1,360,644
            
            
            
            171,710Loss
      on disposal of fixed assets
            
            
            -
            
            
            
            (4,339
            )Amortization
      of deferred financing costs
            
            
            236,120
            
            
            
            244,508Amortization
      of intangible assets
            
            
            1,754,997
            
            
            
            108,333Amortization
      of fair value of stock options
            
            
            2,494,930
            
            
            
            499,059Amortization
      of note discounts
            
            
            2,613,957
            
            
            
            3,287,824Exercise
      of stock options in lieu of cash severance payments
            
            
            404,582
            
            
            
            -Accrued interest converted into debentures
            
            
            358,018
            
            
            
            -Common
      stock issued for services
            
            
            509,400
            
            
            
            -Common
      stock issued for accrued interest
            
            
            544,675
            
            
            
            61,405Common
      stock issued for non-registration penalty
            
            
            -
            
            
            
            5,043Common
      stock to induce early conversion of debentures
            
            
            -
            
            
            
            804,587Value
      of warrant issued for finance program agreement
            
            
            -
            
            
            
            596,275Value
      of warrants issued as compensation
            
            
            227,113
            
            
            
            -Change
      in fair value of warrant and beneficial conversion
    liabilities
            
            
            (11,572,985
            )
            
            
            524,532Changes
      in assets and liabilities:Accounts
      receivable
            
            
            (605,943
            )
            
            
            318,053Inventory
            
            
            (347,213
            )
            
            
            (5,545
            )Prepaid
      expenses and other assets
            
            
            (354,449
            )
            
            
            44,916Accounts
      payable and accrued expenses
            
            
            1,116,592
            
            
            
            (636,507
            )Deferred
      revenue
            
            
            78,498
            
            
            
            12,099Deferred
      compensation
            
            
            (207,305
            )
            
            
            (396,540
            )Net
      cash used by operating activities
            
            
            (3,984,050
            )
            
            
            (3,667,430
            )Cash
      flows from investing activities:Purchase
      of property and equipment
            
            
            (657,243
            )
            
            
            (64,615
            )Proceeds
      from disposal of fixed assets
            
            
            -
            
            
            
            4,900Cash
      acquired in acquisition of AVS
            
            
            -
            
            
            
            64,253Acquisition
      of AccessLine, including acquisition costs of $1,990,516
            
            
            
            
            
            
            (13,726,464
            )Net
      cash used by investing activities
            
            
            (657,243
            )
            
            
            (13,721,926
            )Cash
      flows from financing activities:Proceeds
      from preferred stock
            
            
            -
            
            
            
            12,122,500Proceeds
      from sale of convertible debentures
            
            
            5,000,000
            
            
            
            8,351,875Deferred
      financing costs
            
            
            (175,025
            )
            
            
            (554,445
            )Proceeds
      from exercise of  warrants
            
            
            125,000
            
            
            
            1,614,775Proceeds
      from exercise of  stock options
            
            
            -
            
            
            
            5,000Payments
      on capital leases
            
            
            (956,809
            )
            
            
            -Payment
      of notes payable issued to a shareholder
            
            
            -
            
            
            
            (1,300,000
            )Payment
      of convertible debentures
            
            
            (1,225,295
            )
            
            
            -Payments
      on line-of-credit
            
            
            (500,000
            )
            
            
            (419,758
            )Net
      cash provided by financing activities
            
            
            2,267,871
            
            
            
            19,819,947Net
      (decrease) increase in cash
            
            
            (2,373,422
            )
            
            
            2,430,591Cash
      at beginning of the period
            
            
            3,779,821
            
            
            
            3,198,200Cash
      at end of the period
            
            $
            1,406,399
            
            
            $
            5,628,791Supplemental
      disclosures of cash flow information:Interest
      paid
            
            $
            403,732
            
            
            $
            265,785Non-cash
      investing and financing activities:Property
      and equipment acquired through capital leases
            
            $
            342,326
            
            
            $
            -Convertible
      debentures converted into common stock
            
            $
            1,216,796
            
            
            $
            3,251,334Accrued
      dividends on Series A stock
            
            $
            394,675
            
            
            $
            -Preferred
      stock and accrued dividends converted into debentures
            
            $
            15,344,675
            
            
            $
            -Convertible
      debentures converted into debentures
            
            $
            10,654,659
            
            
            $
            -Warrant
      liabilities and beneficial conversion features
            
            $
            7,171,872
            
            
            $
            10,423,534Common
      stock issued in connection with acquisitions
            
            $
            887,424
            
            
            $
            15,435,434Liabilities
      assumed in acquisition of subsidiaries
            
            $
            -
            
            
            $
            7,299,361





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


6
 Table of Contents





TELANETIX,
INC.


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





1.
            Basis of Presentation and Going
      Concern





The
accompanying unaudited financial statements, consisting of the condensed
consolidated balance sheet as of September 30, 2008, the condensed consolidated
statements of operations for the three and nine months ended September 30, 2008
and 2007, and the condensed consolidated statements of cash flows for the nine
months ended September 30, 2008 and 2007, 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 our 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, 2007 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-KSB for the year ended December 31, 2007. As of December 31,
2007, 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, 2008. For further information, refer to
the consolidated financial statements and footnotes thereto included in the
Company's Annual Report on Form 10-KSB for the year ended December 31,
2007.




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 under Statement of Financial Accounting
Standards No. 123R, “Share Based Payments”; 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, 2008 are not necessarily
indicative of the results that may be expected for the full fiscal year ending
December 31, 2008.




We remain
dependent on outside sources of funding until our results of operations provide
positive cash flows.  Our independent registered auditors issued a
going concern uncertainty in their report dated April 14, 2008 since there is
substantial doubt about our ability to continue as a going concern.




During
the years ended December 31, 2007 and 2006, we were unable to generate cash
flows sufficient to support our operations and were dependent on debt and equity
raised from qualified individual investors.  We experienced negative
financial results as follows:




2007
              
              
              2006Net
      loss
              
              $
              (10,633,026
              )
              
              $
              (3,119,056
              )Negative
      cash flow from operating activities
              
              
              (5,582,487
              )
              
              
              (1,827,261
              )Working
      capital deficit
              
              
              (13,585,737
              )
              
              
              (134,726
              )Stockholders’
      equity (deficit)
              
              
              18,377,773
              
              
              
              (1,130,778
              )


These
factors raise substantial doubt about our 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 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.




7
 Table of Contents




We have
supported current operations by raising additional operating cash through the
private sale of our convertible debentures.  This has provided us with
the cash to continue our business plan, but has not resulted in significant
improvement in our financial position.  We are considering
alternatives to address our cash situation that include: (1) raising capital
through additional sale of our common stock and/or debentures and (2) reducing
cash operating expenses to levels that are in line with current
revenues.




The first
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 raise additional working capital or that
we can achieve positive cash flows from operations.  Our long-term
viability as a going concern is dependent upon our ability to:





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





Reclassifications:




Certain
previously reported amounts have been reclassified to conform to the current
year’s presentation.  The reclassifications had no effect on
previously reported net losses.




2.
            Recent
      Accounting Pronouncements




In May
2008, the Financial Accounting Standards Board (“FASB”) issued Accounting
Principles Board (“APB”) 14-1, “Accounting for Convertible Debt Instruments That
May Be Settled in Cash upon Conversion (Including Partial Cash Settlement)”
(“FSP APB 14-1”). FSP APB 14-1 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. FSP APB 14-1 is effective for fiscal years
beginning after December 15, 2008 on a retroactive basis and will be adopted by
the Company in the first quarter of fiscal 2009. The Company is currently
evaluating the impact that FSP APB 14-1 will have on its consolidated financial
statements.




In May
2008, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No.
162, “The Hierarchy of Generally Accepted Accounting Principles” (“SFAS No.
162”). SFAS No. 162 identifies the sources of accounting principles and the
framework for selecting the principles used in the preparation of financial
statements of nongovernmental entities that are presented in conformity with
generally accepted accounting principles (the GAAP hierarchy). SFAS No. 162 will
become effective sixty days following the Securities and Exchange Commission’s
approval of the Public Company Accounting Oversight Board amendments to AU
Section 411, “The Meaning of Present Fairly in Conformity With Generally
Accepted Accounting Principles.” The adoption of the provisions of SFAS No. 162
is not anticipated to materially impact our consolidated financial position and
results of operations.




In March
2008, the FASB released SFAS No. 161, “Disclosures about Derivative Instruments
and Hedging Activities” (“SFAS No. 161”), which requires qualitative disclosures
about objectives and strategies for using derivatives, quantitative disclosures
about fair value amounts of and gains and losses on derivative instruments, and
disclosures about credit-risk-related contingent features in derivative
agreements. The application of SFAS No. 161 is required for fiscal years
beginning after November 15, 2008 and interim periods within those fiscal
years.  We have not yet determined the impact, if any, that the
implementation of SFAS No. 161 will have on our financial
statements.




In
December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in
Consolidated Financial Statements—an amendment of ARB No. 51” (“SFAS No.
160”).  SFAS No. 160 requires (i) that noncontrolling (minority)
interests be reported as a component of shareholders’ equity, (ii) that net
income attributable to the parent and to the noncontrolling interest be
separately identified in the Consolidated Statement of Operations, (iii) that
changes in a parent’s ownership interest while the parent retains its
controlling interest be accounted for as equity transactions, (iv) that any
retained noncontrolling equity investment upon the deconsolidation of a
subsidiary be initially measured at fair value, and (v) that sufficient
disclosures are provided that clearly identify and distinguish between the
interests of the parent and the interests of the noncontrolling
owners.  SFAS No. 160 is effective for annual periods beginning after
December 15, 2008 and should be applied prospectively.  However, the
presentation and disclosure requirements of the statement shall be applied
retrospectively for all periods presented.  The adoption of the
provisions of SFAS No. 160 is not anticipated to materially impact our
consolidated financial position and results of operations.




In
December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business
Combinations” (“SFAS No. 141(R)”). SFAS No. 141(R) changes the requirements for
an acquirer’s recognition and measurement of the assets acquired and the
liabilities assumed in a business combination.  SFAS No. 141(R) is
effective for annual periods beginning after December 15, 2008 and will be
applied prospectively for all business combinations entered into after the date
of adoption.




8
 Table of Contents




In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
Financial Assets and Financial Liabilities—Including an Amendment of FASB
Statement No. 115” (“SFAS No. 159”) which is effective for fiscal years
beginning after November 15, 2007.  This statement permits an entity
to choose to measure many financial instruments and certain other items at fair
value at specified election dates.  Subsequent unrealized gains and
losses on items for which the fair value option has been elected will be
reported in earnings.  The adoption of the provisions of SFAS No. 159
did not materially impact our consolidated financial position and results of
operations.




In
September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS
No. 157”). SFAS No. 157 defines fair value, establishes a framework for
measuring fair value using generally accepted accounting principles, and expands
disclosures related to fair value measurements.  SFAS No. 157 applies
to other accounting pronouncements that require or permit fair value
measurements. Accordingly, SFAS No.157 does not require any new fair value
measurements.  However, for some entities, the application of SFAS No.
157 changes current practice.  SFAS No. 157 became effective for us on
January 1, 2008.  Subsequent to the issuance of SFAS No. 157, the FASB
issued FASB Staff Position 157-2 (“FSP 157-2”).  FSP 157-2 delays the
effective date of the application of SFAS No. 157 to fiscal years beginning
after November 15, 2008 for all nonfinancial assets and nonfinancial liabilities
that are recognized or disclosed at fair value in the financial statements on a
nonrecurring basis.  We adopted all of the provisions of SFAS No. 157
on January 1, 2008 with the exception of the application to nonfinancial assets
and liabilities.


3.
              Restatement


The
Company has restated herein its condensed consolidated financial statements for
the three and nine months ended September 30, 2007, in accordance with SEC Staff
Accounting Bulletin No. 108 to correct errors in the 2007 condensed consolidated
financial statements that would have a material effect on the financial
statements for the current year if not corrected.  The effects of
restatement are shown below.


Restated
Condensed Consolidated Balance Sheet





September
      30, 2007Convertible
      debentures, net, current portion (1)
            
            $
            (1,354,319
            )Warrant
      liabilities (2)
            
            
            3,416,558Convertible
      debentures, net, less current portion (1)
            
            
            (1,010,453
            )Additional
      paid in capital (1) (2)
            
            
            (1,472,923
            )Accumulated
      deficit (1) (2)
            
            
            421,137Total
            
            $
            —





Restated
Condensed Consolidated Statements of Operations




Three
      months ended September 30, 2007
            
            
            Nine
      months endedSeptember 30, 2007Interest
      expense (1) (2)
            $
            (587,677
            )
            
            $
            (1,025,460
            )Change
      in fair value of warrant liabilities (2)
            
            1,289,252
            
            
            
            1,446,597Series
      A preferred stock dividends and accretion (3)
            
            (8,589,810
            )
            
            
            (8,589,810
            )Total
            $
            (7,888,235
            )
            
            $
            (8,168,673
            )




9
 Table of Contents




Restated
Condensed Consolidated Statement of Cash Flows




Nine
      months endedSeptember
      30, 2007Change
      in net loss for period (1) (2)
            
            $
            421,137Amortization
      of note discounts (1)
            
            
            1,025,460Change
      in fair value of warrant liabilities (2)
            
            
            (1,446,597
            )Total
            
            $
            —





(1)
            To
      reflect an increase in note discounts resulting from the change in value
      of the warrants issued in connection with the sale of the related
      debentures.(2)
            To
      reflect an increase in warrant liabilities resulting from the change in
      value of the warrants issued in connection with the sale of the related
      debentures.(3)
            To
      reflect an increase in Series A preferred stock accretion resulting from
      the change in value of the warrants issued in connection with the sale of
      the Series A preferred stock.





4.
            Securities
      Exchange Agreement




On June
30, 2008, the Company entered into a Securities Exchange Agreement with the
investors in its previous debenture and preferred stock financings under which
the Company issued six-year, interest only debentures due June 30, 2014 in
exchange for all of the then outstanding debentures and shares of preferred
stock of the Company.  The debentures issued amend and restate the
terms of the previously outstanding debentures.  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.  Also in
conjunction with the 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.





The
Company, with the help of an independent valuation firm, determined that a
concession was not granted by the creditors pursuant to Emerging Issues Task
Force (“EITF”) No. 02-4, “Determining Whether a Debtor’s Modifications or
Exchange of Debt Instruments is within the Scope of FASB Statement No.
15.”  The Company determined that the newly issued debentures were not
substantially different from the then outstanding debentures in accordance with
EITF 96-19, “Debtor’s Accounting for a Modification or Exchange of Debt
Instruments”, and accounted for the transaction as a modification of the then
outstanding debentures.





See Note
7 – Convertible Debentures, Note 8 – Warrants and Warrant Liabilities, and Note
10 – Preferred Stock, Common Stock and Dividends.





5.
            Business
      Combinations




Effective
September 14, 2007, the Company acquired AccessLine Holdings, Inc., a Delaware
corporation (“AccessLine”), and effective April 1, 2007, the Company acquired
all of the stock of two corporations which own all of the membership interests
in AVS Installation Limited Liability Company and Union Labor Force One Limited
Liability Company (together, “AVS”).





AccessLine




Effective
September 14, 2007, the Company acquired AccessLine, a Bellevue,
Washington-based provider of hosted VoIP solutions to the small-and-medium
business marketplace.  The consideration paid by the Company for
AccessLine consisted of 3,939,565 shares of the Company's common stock valued at
$14.2 million, $11.7 million in cash, and $2.0 million in acquisition costs for
a total of $27.9 million.  Pursuant to the earn out provisions of the
acquisition agreement, the Company was required to pay up to an additional $9.0
million in the form of 2,500,000 shares of 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 fiscal quarter of 2008.  There are two
additional earn out periods which will terminate on December 31, 2008 and June
30, 2009.  The Company may be required to pay up to 1,250,000
additional shares of common stock upon AccessLine's achievement of certain
future financial objectives during those periods.




10
 Table of Contents




AVS




Effective
April 1, 2007, the Company acquired AVS, which at the time of acquisition was
one of the Company’s channel partners.  AVS provides a full range of
audio visual solutions to clients and end-users as the single point of contact
during design and project implementation.  The consideration paid by
the Company for the membership interests of AVS consisted of 248,119 shares of
the Company's common stock valued at $1.3 million and acquisition costs of less
than $0.1 million for a total of $1.3 million.  The purchase price was
allocated to the assets acquired and liabilities assumed based on their
estimated fair values on the acquisition date with the assistance of an
independent appraisal.  The Company recorded approximately $0.9
million of goodwill, $0.9 million of identifiable intangible assets, and $0.5
million of net tangible liabilities in connection with this
acquisition.  The primary reason for the acquisition and the factors
that contributed to the recognition of goodwill relate to AVS' expertise in the
audio visual field and their client base, that when combined with the Company's
existing product offerings, allow the Company with the ability to provide
solutions required for videoconferencing and audio visual needs.




Pro-Forma
Information




AccessLine’s
and AVS' results are included in the Company's results of operations from the
acquisition dates.  The unaudited financial information table below
summarizes the combined results of operations of the Company, AccessLine and
AVS, on a pro forma basis, as if the acquisitions had occurred at January 1,
2007.  The unaudited pro forma financial information combines the
historical results of operations of the Company, AccessLine and AVS for the
three and nine months ended September 30, 2007, has been prepared for
comparative purposes only and does not purport to be indicative of the actual
operating results that would have been recorded had the acquisitions actually
taken place on January 1, 2007, and should not be taken as indicative of future
consolidated operating results.





Three
      months ended
            
            Nine
      months endedSeptember
      30, 2007
            
            September
      30, 2007Net
      revenue
            $
            7,567,292
            
            $
            23,510,522Net
      loss applicable to common stockholders
            $
            (13,506,597
            )
            $
            (28,020,892
            )Net
      loss per share - basic and diluted
            $
            (0.61
            )
            $
            (1.35
            )




6.
              Fair Value Measurements


The
Company adopted SFAS No. 157 as of January 1, 2008. SFAS
No. 157 applies to certain assets and liabilities that are being measured
and reported on a fair value basis. SFAS No. 157 defines fair value,
establishes a framework for measuring fair value in accordance with generally
accepted accounting principles, and expands disclosure about fair value
measurements.  SFAS No. 157 enables the reader of the financial
statements to assess the inputs used to develop those measurements by
establishing a hierarchy for ranking the quality and reliability of the
information used to determine fair values. SFAS No. 157 requires that assets and
liabilities carried at fair value will be classified and disclosed in one of the
following three categories:





Level 1:
Quoted market prices in active markets for identical assets or
liabilities.





Level 2:
Observable market based inputs or unobservable inputs that are corroborated by
market data.





Level 3:
Unobservable inputs that are not corroborated by market data.




11
 Table of Contents




At
September 30, 2008, the Company recorded liabilities related to its warrants
(See Note 8 – Warrants and Warrant Liabilities) and the beneficial conversion
feature of its convertible debentures (See Note 7 – Convertible Debentures) at
their fair market values as provided by SFAS No. 157.




The
following table provides fair market measurements of the warrant and beneficial
conversion feature liabilities:





Fair
      Value Measurements at Reporting Date Using Significant Unobservable Inputs
      (Level 3)Description
            
            
            September
      30, 2008Warrant
      liabilities
            
            
            $
            1,093,776Beneficial
      conversion feature liabilities
            
            
            
            3,609,035$
            4,702,811





The
following table provides a reconciliation of the beginning and ending balances
of the warrant and beneficial conversion feature liabilities. The change in fair
market value of the warrant and beneficial conversion feature liabilities is
included in Other Income (Expense) in the Condensed Consolidated Statements of
Operations.





Warrant
      liability
            
            
            Beneficial
      conversion feature liability
            
            
            TotalBeginning
      balance January 1, 2008
            
            $
            7,410,515
            
            
            $
            1,693,408
            
            
            $
            9,103,923Purchases,
      sales, issuances and settlements
            
            
            1,804,803
            
            
            
            5,367,070
            
            
            
            7,171,873Change
      in fair market value of warrant and beneficial conversion
      liabilities
            
            
            (8,121,543
            )
            
            
            (3,451,442
            )
            
            
            (11,572,985
            )Ending
      balance September 30, 2008
            
            $
            1,093,775
            
            
            $
            3,609,036
            
            
            $
            4,702,811





Carrying
amounts of certain of the Company’s financial instruments, including cash and
cash equivalents, accounts receivable, accounts payable, other accrued
liabilities and convertible debentures approximate fair value due to their short
maturities.




7.
              Convertible Debentures


As
discussed in Note 4 – Securities Exchange Agreement, 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 principal
balances of the 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 which are
discussed below under the heading “August 2008.”




As of
September 30, 2008, the Company had reserved 22,556,384 shares of common stock
for the conversion of the outstanding debentures issued in June 2008 and August
2008.




December 2006 and February
2007




On
December 28, 2006, the Company issued original issue discount 6% unsecured
convertible debentures and common stock purchase warrants to four unaffiliated
institutional investors.  The Company issued an aggregate of $3.7
million principal amount of debentures at an original issue discount of 12.5%
and warrants to purchase an aggregate of 949,907 shares of common
stock.  Net proceeds to the Company were $3.0 million after deducting
legal fees and transaction expenses totaling $0.2 million, which were
capitalized as deferred financing costs.




12
 Table of Contents




On
February 12, 2007, the Company issued original issue discount 6% unsecured
convertible debentures and common stock purchase warrants to the same four
unaffiliated institutional investors in the December 2006 private
placement.  The Company issued an aggregate of $1.5 million principal
amount of debentures at an original issue discount of 12.5% and warrants to
purchase an aggregate of 401,040 shares of common stock.  Net proceeds
to the Company were $1.3 million after deducting legal fees and transaction
expenses of $0.1 million, which were capitalized as deferred financing
costs.




The
debentures issued in both private placements were due December 31,
2008.  Interest on the debentures accrued at the rate of 6% per annum
and was payable quarterly on April 1, July 1, October 1, and December 1,
commencing on April 1, 2007, and on each monthly redemption payment
date.  Monthly redemption payments equaled 1/18th of the principal
amount due under each debenture beginning July 1, 2007 and would have continued
through December 31, 2008.  Monthly redemption payments also included
any accrued interest on the portion of the debentures being
redeemed.  The Company had the right to pay interest and monthly
redemption payments in cash, or upon notice to the holders and compliance with
certain equity conditions set forth in the debentures, the Company could have
paid all or a portion of any such payment in common stock valued at the price
equal to the lesser of the then effective conversion price or 85% of the average
of the volume weighted average price ("VWAP") per share for the Company's common
stock for the ten trading days prior to the payment date or the date that the
shares were delivered.  The Company had the option, subject to
compliance with certain equity conditions, to redeem the debentures before their
maturity by payment in cash of 120% of the then outstanding principal amount of
the debenture plus accrued interest and other charges.




The
debentures were convertible at any time 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 Company also had the
right, subject to compliance with certain equity conditions and certain
limitations on the holder’s beneficial ownership of common stock, to force
conversion if the average of the VWAP for the Company's common stock exceeded
200% of the then effective conversion price for 20 trading days out of a
consecutive 30 day trading period.




The
debentures imposed certain covenants on the Company, including restrictions
against incurring additional indebtedness (other than permitted indebtedness as
defined in the debenture), creating any liens on its property (other than
permitted liens as defined in the debenture), 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 defined 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 secure and maintain
an effective registration statement covering the resale of the common stock
underlying the debentures and the warrants, or failure to deliver share
certificates in a timely manner.  On the occurrence of an event of
default, the holders of the debentures had the right to accelerate all amounts
outstanding under the debentures and demand payment of a mandatory default
amount equal to 130% of the amount outstanding under the debenture, plus accrued
interest and expenses.




The
Company also entered into registration rights agreements with the institutional
investors in both the December and February private placements, pursuant to
which the Company agreed to file a registration statement covering the resale of
the shares of common stock that were issuable to investors upon the conversion
of the debentures, payment in kind, and the exercise of the warrants, and to
maintain the effectiveness of that registration statement (subject to certain
limitations) for a period of time until the holders can sell the underlying
common stock without volume restrictions under Rule 144.  The Company
filed the required registration statements, and they were declared effective in
accordance with terms of the registration rights agreement.  Because
the holders could have sold the underlying stock without volume restrictions
under Rule 144, the Company’s registration obligation had
terminated.




Prior to
the Securities Exchange Agreement, (i) the holders of the debentures issued in
December 2006 converted $1.8 million of principal value into 1,187,382 shares of
common stock at the original conversion price of $1.54 per share; and (ii)
the holders of the debentures issued in February 2007 converted the entire
principal balance of $1.5 million into 1,002,598 shares of common stock at the
original conversion price of $1.54 per share.




The
holders of the debentures issued in December 2006 converted $1.7 million of
principal value into the debentures issued in June 2008.




August
2007




On August
30, 2007, the Company issued original issue discount 6% unsecured convertible
debentures and common stock purchase warrants to five unaffiliated institutional
investors.  The Company issued an aggregate of $8.0 million principal
amount of debentures at an original issue discount of 12.5%, and warrants to
purchase an aggregate of 826,190 shares of common stock.  Net proceeds
to the Company were $6.5 million after deducting legal fees and transaction
expenses of $0.5 million, which were capitalized as deferred financing
costs.




13
 Table of Contents




The terms
of debentures issued in August 2007 were substantially similar to the terms of
the debentures issued in December 2006 and February 2007, except as follows: (i)
the maturity date of the August 2007 debentures was June 30, 2009; (ii) interest
payments commenced on October 1, 2007; and (iii) monthly redemption payments
began December 1, 2007 and were to continue through May 1, 2009.




The
Company also entered into registration rights agreements with the institutional
investors, pursuant to which the Company agreed to file a registration statement
covering the resale of the shares of common stock that would have been issuable
to investors upon the conversion of the debentures, payment in kind, and the
exercise of the warrants, and to maintain the effectiveness of that registration
statement (subject to certain limitations) for a period of time until the
holders could have sold the underlying common stock without volume restrictions
under Rule 144.  As a result of the changes made to Rule 144, which
were effective February 15, 2008, the Company's obligations under these
registration rights agreements terminated as of February 29,
2008.  However, if the Company failed to satisfy the public
information requirement under Rule 144 and the underlying shares could not be
sold because of such failure, the Company, as partial relief for damages to the
investors by reason of such inability to sell, agreed to pay the investors cash
damages, payable on the date of such failure and on every 30th day thereafter,
equal to one percent of the aggregate purchase price paid by such investor under
the terms of the August 2007 financing documents.




The
holders of the debentures issued in August 2007 converted $5.5 million of
principal value into the debentures issued in June 2008.




March
2008




On March
27, 2008, the Company entered into a separate securities purchase agreement with
two of the institutional investors that invested in the previous private
placements, pursuant to which the Company issued original issue discount 6.0%
senior secured convertible debentures in the aggregate principal amount of $3.4
million (issued at an original issue discount of 12.5%), along with five year
warrants to purchase 814,285 shares of common stock at a price of $1.92 per
share, subject to adjustment, including full-ratchet anti-dilution
protection.  The Company refers to this transaction as the March 2008
Private Placement.  The March 2008 Private Placement resulted in net
proceeds of $2.8 million, after deducting fees and expenses of $0.2 million
which were capitalized as deferred financing costs.  In addition to
the fees and expenses related to the transaction, the Company issued its
investment banking firm a warrant to purchase 78,125 shares of common stock at
$1.92 per share.  The warrant is exercisable immediately and expires
in March 2013.  The value of the warrant, $67,734, was capitalized as
deferred financing costs.




The terms
of debentures issued in March 2008 were substantially similar to the terms of
the debentures issued in August 2007, except as follows: (i) the maturity date
of the March 2008 debentures was April 30, 2010; and (ii) monthly redemption
payments began October 1, 2008 and were to continue through March 1,
2010.




The
holders of the debentures issued in March 2008 converted $3.4 million of
principal value into the debentures issued in June 2008.




June2008




On June
30, 2008, the Company entered into a Securities Exchange Agreement, see Note 4 –
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 currently outstanding debentures and shares of preferred stock of
the Company. The debentures issued amend and restate the terms of the previously
outstanding debentures held by the investors.




The
following summarizes the terms of the debentures issued in June
2008:




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




Interest. Interest accrues at
the rate of 12.0% per annum and is payable monthly, commencing on August 1,
2008.




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




Payments of Interest. The
Company has the right to make interest payments in cash, or upon notice to the
holders and compliance with certain equity conditions, the Company can pay all
or a portion of any such payment in common stock valued at a price equal to the
lesser of the then effective conversion price (initially $1.25) or 85% of the
average of the VWAP per share of the common stock for the 10 consecutive trading
days immediately prior to the applicable payment date.




14
 Table of Contents




Early Redemption. The Company
has the right to redeem the debentures before their maturity by payment in cash
of 120% 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 the Company 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. 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. The debentures are 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.




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 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 secure and maintain an effective
registration statement covering the resale of the common stock underlying the
debentures and the warrants, 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 the date of this report,
the Company is in compliance with the covenants described above.




Security. The debentures the
Company 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.




August2008




On August
13, 2008, the Companyentered into a separate
debenture and warrant purchase agreement with one of the institutional investors
that invested in theprevious private
placements, pursuant to which 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.  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.




The
Company refers to this transaction as the August 2008 Private Placement, which
resulted in net proceeds of $2.0 million.




15
 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.  See Note 4 – Securities Exchange Agreement.  The
discounts on the debentures issued in August 2008 will be amortized to interest
expense through June 30, 2014.




The
following table summarizes information relative to the outstanding debentures at
September 30, 2008 and December 31, 2007:




September
      30, 2008
              
              
              December
      31, 2007Convertible
      debentures
              
              $
              28,195,480
              
              
              $
              9,506,307Less
      unamortized discounts:Original
      issue discount
              
              
              (915,026
              )
              
              
              (930,127
              )Detachable
      warrants discount
              
              
              (2,685,509
              )
              
              
              (2,251,931
              )Beneficial
      conversion feature discount
              
              
              (5,994,016
              )
              
              
              (1,650,337
              )Convertible
      debentures, net of discounts
              
              
              18,600,929
              
              
              
              4,673,912Less
      current portion
              
              
              —
              
              
              
              (3,670,734
              )Convertible
      debentures, long term portion
              
              $
              18,600,929
              
              
              $
              1,003,178


The
convertible debentures outstanding at September 30, 2008 are due June 30,
2014.





The
Company determined that the convertible debentures issued in February 2007 had a
non-cash beneficial conversion feature of $0.5 million.  The
beneficial conversion feature was determined based on the difference between the
calculated conversion value after the allocation of the full fair value of the
warrants issued in connection with such debentures of $0.8 million to the debt
discount and the fair value of the Company's common stock of $2.49 per
share.  After the allocation of proceeds between the debentures and
warrants were made, a conversion price of $1.583 was calculated based on the
allocated amount to debentures divided by the total number of shares into which
the debentures are convertible.  The calculated amount of $0.907, the
difference of the fair value of the common stock of $2.49 and the effective
conversion price of $1.583, represented the beneficial value per
share.  This beneficial value was applied to the total shares into
which the debentures were convertible to calculate the beneficial conversion
feature.  Through June 30, 2008, the discounts on account of the
beneficial conversion feature and fair value of the warrants were recognized as
additional interest expense over the term of the related
debentures.  As of July 1, 2008, the unamortized discounts on an
account of the beneficial conversion feature and fair value of the warrants will
be recognized as additional interest expense over the term of debentures issued
in June 2008, or through June 30, 2014.




The
Company determined that the convertible debentures issued in August 2007 had a
non-cash beneficial conversion feature of $1.8 million.  The
beneficial conversion feature was determined based on the difference between the
calculated conversion value after the allocation of the full fair value of the
warrants issued in connection with such debentures of $2.4 million to the debt
discount and the fair value of the Company's common stock of $3.60 per
share.  After the allocation of proceeds between the debentures and
warrants were made, a conversion price of $2.692 was calculated based on the
allocated amount to debentures divided by the total number of shares into which
the debentures are convertible.  The calculated amount of $0.908, the
difference of the fair value of the common stock of $3.60 and the effective
conversion price of $2.692, represented the beneficial value per
share.  This beneficial value was applied to the total shares into
which the debentures were convertible to calculate the beneficial conversion
feature.  Through June 30, 2008, the discounts on account of the
beneficial conversion feature and fair value of the warrants are recognized as
additional interest expense over the term of the related
debentures.  As of July 1, 2008, the unamortized discounts on an
account of the beneficial conversion feature and fair value of the warrants will
be recognized as additional interest expense over the term of debentures issued
in June 2008, or through June 30, 2014.




The
Company determined that the convertible debentures issued in March 2008 had a
non-cash beneficial conversion feature of $1.1 million.  The
beneficial conversion feature was determined based on the fair value of the
embedded conversion feature ($0.53 per share) at the issuance
date.  Through June 30, 2008, the discounts on account of the
beneficial conversion feature and fair value of the warrants were recognized as
additional interest expense over the term of the related
debentures.  As of July 1, 2008, the unamortized discounts on an
account of the beneficial conversion feature and fair value of the warrants will
be recognized as additional interest expense over the term of debentures issued
in June 2008, or through June 30, 2014.




16
 Table of Contents




The
Company determined that the convertible debentures issued in June 2008 had a
non-cash beneficial conversion feature of $4.0 million.  The
beneficial conversion feature was determined based on the fair value of the
embedded conversion feature ($0.19 per share) at the issuance
date.  In connection with the Securities Exchange Agreement, the
Company reduced the beneficial conversion feature discount on the debentures
issued in June 2008 by $0.8 million to reclassify the remaining beneficial
conversion liabilities related to the previously issued
debentures.  The discounts on account of the beneficial conversion
feature will be recognized as additional interest expense over the term of the
related debentures, or through June 30, 2014.




The
Company determined that the convertible debenture issued in August 2008 had a
non-cash beneficial conversion feature of $1.0 million.  The
beneficial conversion feature was determined based on the fair value of the
embedded conversion feature ($0.63 per share) at the issuance
date.  The discounts on account of the beneficial conversion feature
and fair value of the warrants will be recognized as additional interest expense
over the term of the related debentures, or through June 30, 2014.




At each
reporting period the Company assesses the convertible debentures under SFAS No.
133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS No.
133”) and EITF No. 00-19, “Accounting for Derivative Financial Instruments
Indexed to and Potentially Settled in, a Company's Own Stock”, and at September
30, 2008 and December 31, 2007, 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.  At December
31, 2006 and each of the quarterly reporting periods in 2007, the Company
determined the conversion feature was not an embedded derivative that needed to
be bifurcated based on the factors existing for each respective reporting
period.  The Company’s conclusion changed at December 31, 2007 due to
the decline in the stock price and the Company’s need to raise additional funds
to continue operations.




The
convertible debentures contain embedded derivative features, which are accounted
for at fair value as a compound embedded derivative at September 30, 2008 and
December 31, 2007.  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, 2008 and December 31, 2007, the Company recorded beneficial
conversion liabilities of $3.6 million and $1.7 million,
respectively.  For the three months and nine months ended September
30, 2008, the Company recognized other income in the Consolidated Statements of
Operations of $1.4 million and $3.5 million, respectively, related to the change
in fair market value of the beneficial conversion liabilities.




8.
            Warrants
      and Warrant Liabilities




On
December 28, 2006, the Company issued warrants to purchase 949,907 shares of
common stock at $1.69 per share in conjunction with the sale of its
debentures.  On February 12, 2007, the Company issued warrants to
purchase 401,040 shares of common stock at $1.69 per share in conjunction with
the sale of its debentures.  On August 30, 2007, the Company issued
warrants to purchase 1,758,008 shares of common stock at $4.20 per share in
conjunction with the sale of its Series A preferred stock and issued warrants to
purchase 826,190 shares of common stock at $4.20 per share in conjunction with
the sale of its debentures.  On March 27, 2008, the Company issued
warrants to purchase 814,285 shares of common stock at $1.92 per share in
conjunction with the sale of its debentures.  Each of these warrants
is immediately exercisable and expires five years from the issue
date.




Prior to
the Securities Exchange Agreement executed on June 30, 2008, the exercise prices
of the warrants discussed above 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 4 – Securities Exchange
Agreement.




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.  The number of common shares
underlying the warrants and the exercise price of the warrants issued in
connection with the Series A preferred stock and all of the debentures are
subject to adjustment, including full ratchet, anti-dilution
protection.




17
 Table of Contents




Through
September 30, 2008, 410,000 of the warrants issued in December 2006 have been
exercised for cash at $1.69 per share. None of the other warrants discussed
above have been exercised as of September 30, 2008.




Pursuant
to SFAS No. 133 and EITF No. 00-19, 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.




The fair
value of the warrants was estimated at the issuance dates and revalued at
September 30, 2008, using the Monte Carlo model discussed in Note 7 –
Convertible Debentures, above.  At September 30, 2008 and December 31,
2007, the Company recorded warrant liabilities of $1.1 million and $7.4 million
at September 30, 2008 and December 31, 2007, respectively.  The change
in fair value of the warrants for the three months and nine months ended
September 30, 2008 of $1.5 million and $8.1 million, respectively, were reported
as other income in the Condensed Consolidated Statement of
Operations.




On March
6, 2007, the Company issued an immediately exercisable warrant to purchase
250,000 shares of common stock at $2.00 per share in connection with its
agreement with Aequitas Capital Management, Inc., to provide the Company's
prospective customers with a leasing alternative for the Company's telepresence
videoconferencing systems.  The warrant had a three year term, and was
accounted for as an equity issuance in the financial statements.  The
warrant was exercised in 2007.  The fair value of the warrant issued
to Aequitas Capital at the issue date was calculated using the Black Scholes
option pricing model with the following assumptions: a risk free interest rate
of 4.75%, volatility factor of 42.90%, contractual term and expected term of 3
years.  The fair value of the warrant of $0.6 million was included in
selling, general and administrative expenses in the Condensed Consolidated
Statement of Operations for the three months ended March 31, 2007.




On August
8, 2007, the Company issued an immediately exercisable warrant to purchase
12,784 shares of common stock at $3.52 per share in connection with its Loan and
Security Agreement with Bridge Bank.  The warrant has a three year
term, and was accounted for as an equity issuance in the financial
statements.  The fair value of the warrant issued to Bridge Bank at
the issue date was calculated using the Black Scholes option pricing model with
the following assumptions: a risk free interest rate of 4.77%, volatility factor
of 32.18%, contractual term and expected term of 3 years.  The fair
value of the warrant was less than $0.1 million and was included in
selling, general and administrative expenses in the Condensed Consolidated
Statement of Operations for the three months ended September 30,
2007.




On
February 15, 2008, the Company issued an immediately exercisable warrant to
purchase 30,000 shares of common stock at $4.00 per share pursuant to a
consulting agreement.  The warrant has a five year term, and was
accounted for as an equity issuance in the financial statements.  The
fair value of the warrant at the issue date was calculated using the Black
Scholes option pricing model with the following assumptions: a risk free
interest rate of 2.76%, volatility factor of 65.5%, contractual term and
expected term of 5 years.  The fair value of the warrant was less than
$0.1 million and was included in selling, general and administrative expenses in
the Condensed Consolidated Statement of Operations for the three months ended
March 31, 2008.




On March
26, 2008, the Company issued a warrant to purchase 200,000 shares of common
stock at $1.73 per share to a financial and marketing consulting firm in
connection with a client service agreement.  The warrant has a five
year term, 50% of the shares are immediately exercisable, and the remaining 50%
are exercisable in June 2008.  The fair value of the warrant at the
issue date was calculated using the Black Scholes option pricing model with the
following assumptions: a risk free interest rate of 2.61%, volatility factor of
65.5%, contractual term and expected term of 5 years.  The fair value
of the warrant was $0.2 million, the Company recognized $0.1 million as expense
during the three months ended March 31, 2008, and recognized the remaining $0.1
million during the three months ended June 30, 2008.  The expense
related to the warrant is included in selling, general and administrative
expenses in the Condensed Consolidated Statement of Operations.




On March
27, 2008, the Company issued an immediately exercisable warrant to purchase
78,125 shares of common stock at $1.92 per share to its investment bankers in
connection with the March 2008 financing transaction.  The warrant has
a five year term, and was accounted for as an equity issuance in the financial
statements.  The fair value of the warrant at the issue date was
calculated using the Black Scholes option pricing model with the following
assumptions: a risk free interest rate of 2.61%, volatility factor of 65.5%,
contractual term and expected term of 5 years.  The fair value of the
warrant was $0.1 million, and was capitalized to deferred financing costs and is
being amortized to interest expense over the life of the related debentures
using the effective interest method.




18
 Table of Contents




On May
31, 2008, the Company issued an immediately exercisable warrant to purchase
105,000 shares of common stock at $1.25 per share to a public relations
consultant.  The warrant has a five year term, and was accounted for
as an equity issuance in the financial statements.  The fair value of
the warrant at the issue date was calculated using the Black Scholes option
pricing model with the following assumptions: a risk free interest rate of 3.4%,
volatility factor of 63.9%, contractual term and expected term of 5
years.  The fair value of the warrant was less than $0.1 million, and
was included in selling, general and administrative expenses in the Condensed
Consolidated Statement of Operations for the three months ended June 30,
2008.




The
following table summarizes warrant activity for the nine months ended September
30, 2008:




Number
      of Shares Subject to Warrants
              
              
              Weighted
      Average Exercise PriceBalance
      - December 31, 2007
              
              
              3,837,929
              
              
              $
              3.38Issued
              
              
              8,701,789
              
              
              
              1.32Exercised
              
              
              (100,000
              )
              
              
              1.25Expired
              
              
              (200,000
              )
              
              
              1.80Balance
      – September 30, 2008
              
              
              12,239,718
              
              
              $
              1.03


The
following table summarizes information about warrants outstanding at September
30, 2008:





Exercise
      Prices
            
            Number
      of Shares Subject to Outstanding
              Warrants
      and Exercisable
            
            Weighted
      Average Remaining
              Contractual
      Life (years)$
            1.00
            
            11,813,809
            
            3.96$
            1.25
            
            105,000
            
            4.67$
            1.73
            
            200,000
            
            4.49$
            1.92
            
            78,125
            
            4.49$
            3.52
            
            12,784
            
            1.85$
            4.00
            
            30,000
            
            4.3812,239,718





As of
September 30, 2008, the Company had reserved 12,239,718 shares of common stock
for the exercise of the outstanding warrants.


9.
              Commitments and
      Contingencies


Leases




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




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 3rd party
network service providers.  The contract containsa 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 ninety (90) day
written notice prior to the extended term expiring.




19
 Table of Contents




Litigation
Settlement




From time
to time and in the course of business, we may become involved in various legal
proceedings seeking monetary damages and other relief.  The amount of
the ultimate liability, if any, from such claims cannot be
determined.  However, in the opinion of our management, there are no
legal claims currently pending or threatened against us that would be likely to
have a material adverse effect on our financial position, results of operations
or cash flows.




In
January 2008, the Company issued 72,000 shares of its common stock valued at
$0.2 million in settlement of compensation claims made by a former sales
representative.  The settlement amount was accrued at December 31,
2007, and was included in selling, general and administrative expenses in the
Condensed Consolidated Statement of Operations for the year ended December 31,
2007.  Pursuant to the terms of the settlement, the Company was
required to issue additional shares of its common stock should the Company’s
stock price decline during the six month period subsequent to the date of the
settlement.  In July 2008, pursuant to terms of the settlement reached
in January 2008, the Company issued an additional 60,000 shares of its common
stock valued at less than $0.1 million, which is included in selling, general
and administrative expenses in the Condensed Consolidated Statement of
Operations for the three and nine months ended September 30, 2008.




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.




20
 Table of Contents




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 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, 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 were recorded in the
third fiscal quarter of 2008.  There are two additional earn out
periods which will terminate on December 31, 2008 and June 30,
2009.  The Company may be required to pay up to 1,250,000 additional
shares of common stock upon AccessLine's achievement of certain future financial
objectives during those periods.




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, 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.




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 will be due in 2008.  Fiscal year 2008 fees will also be 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 our 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 our VoIP service offerings.


10.
              Preferred Stock,
      Common 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
$1.95 million, because the Company’s common stock was not listed on an exchange
other than the OTC Bulletin Board by March 31, 2008. The Company recorded a
dividend of $1.95 million during the nine 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 $14.95 million,
and accrued dividends of $0.4 million were converted into the debentures issued
on June 30, 2008.  See Note 4 – Securities Exchange Agreement. As of
September 30, 2008, the Company has no shares of preferred stock issued or
outstanding.




Pursuant
to the terms of a consultant agreement dated July 23, 2008, the Company issued
1.2 million shares of its common stock, valued at $0.5 million,  to a
consultant in exchange for services during the three months ended September 30,
2008.


21
 Table of Contents


11.
              Stock Based
      Compensation


Stock Option
Plan




The 2005
Equity Incentive Plan (the “2005 Plan”), which was approved by the shareholders
in August 2006, permits the Company to grant shares of common stock and options
to purchase shares of common stock to the Company’s employees for up to 5
million shares of common stock.  The Company believes that such awards
better align the interests of its employees with those of its
shareholders.  Option awards are generally granted with an exercise
price that approximates the market price of the Company's stock at the date of
grant; these option awards generally vest based on 4 years of continuous service
and have 10-year contractual terms.  On November 8, 2007, the Board of
Directors approved an amendment to the 2005 Plan to increase the number of
shares of common stock available for grant to 8.5 million shares.




A summary
of option activity under the 2005 Plan as of September 30, 2008, and changes
during the nine months then ended is presented below:





Shares
            
            
            Weighted-Average
      Exercise PriceOutstanding
      at December 31, 2007
            
            
            6,206,222
            
            
            $
            1.83Granted
            
            
            1,375,500
            
            
            
            0.81Exercised
            
            
            (1,712,095
            )
            
            
            0.30Forfeited
      or expired
            
            
            (110,500
            )
            
            
            3.31Outstanding
      at September 30, 2008
            
            
            5,759,127
            
            
            $
            1.59





The
options outstanding and currently exercisable by exercise price at September 30,
2008 are as follows:





Stock
      options outstanding
            
            Stock
      Options ExercisableRange
      of Exercise Prices
            
            Number
      Outstanding
            
            Weighted-Average
      Remaining Contractual Term (Years)
            
            Weighted-Average
      Exercise Price
            
            Number
      Exercisable
            
            Weighted-Average
      Remaining Contractual Term (Years)
            
            Weighted-Average
      Exercise Price$
            0.20
      to 1.12
            
            3,141,668
            
            7.19
            
            $
            0.55
            
            1,508,564
            
            4.73
            
            $
            0.37$
            2.15
      to 2.55
            
            1,981,459
            
            8.34
            
            $
            2.54
            
            780,959
            
            7.09
            
            $
            2.55$
            3.50
            
            535,000
            
            5.76
            
            $
            3.50
            
            528,958
            
            5.73
            
            $
            3.50$
            5.05
      to 5.17
            
            101,000
            
            8.57
            
            $
            5.10
            
            66,000
            
            8.61
            
            $
            5.135,759,127
            
            7.47
            
            $
            1.59
            
            2,884,481
            
            5.64
            
            $
            1.65





As of
September 30, 2008 and December 31, 2007, 2,884,481 and 2,968,055 outstanding
options were exercisable at an aggregate average exercise price of $1.65 and
$0.38, respectively.  The aggregate intrinsic value of stock options
outstanding and stock options exercisable at September 30, 2008 was
nil.




As of
September 30, 2008, total compensation cost related to nonvested stock options
not yet recognized was $2.8 million, which is expected to be recognized over the
next 3.02 years on a weighted-average basis.




22
 Table of Contents




Valuation and Expense
Information Under SFASNo.123(R)




On
January 1, 2006, the Company adopted SFAS No. 123(R), “Share Based Payments”
(“SFAS No. 123(R)”), which requires the measurement and recognition of
compensation expense for all share-based payment awards made to employees and
directors based upon estimated fair values.  The following table
summarizes stock-based compensation expense recorded under SFAS No. 123(R) for
the three months and nine months ended September 30, 2008 and 2007, and its
allocation within the Condensed Consolidated Statements of
Operations:





Three
      months ended September 30,
            
            
            Nine
      months ended September 30,2008
            
            
            2007
            
            
            2008
            
            
            2007Cost
      of product revenues
            
            $
            22,483
            
            
            $
            20,644
            
            
            $
            58,995
            
            
            $
            41,064Selling,
      general and administrative
            
            
            206,494
            
            
            
            175,223
            
            
            
            1,911,505
            
            
            
            353,105Research
      and development
            
            
            36,914
            
            
            
            65,773
            
            
            
            524,430
            
            
            
            104,890Stock
      based compensation included in operating expenses
            
            
            243,408
            
            
            
            240,996
            
            
            
            2,435,935
            
            
            
            457,995Stock-based
      compensation expense related to employee equity awards
            
            $
            265,891
            
            
            $
            261,640
            
            
            $
            2,494,930
            
            
            $
            499,059





Stock-based
compensation expense for the nine months ended September 30, 2008 includes $1.4
million of expense related to accelerated vesting and option modifications for
former officers of the Company.




Valuation
Assumptions:




Prior to
January 1, 2008, the Company estimated the fair value of stock options using the
Black Scholes option pricing model, and through June 30, 2008, the Company
estimated the fair value of stock options using a binomial lattice model; since
July 1, 2008, the company is again using the Black Scholes option pricing model,
all consistent with the provisions of SFAS No. 123(R) and SEC Staff Accounting
Bulletin No. 107.  The weighted-average estimated fair value of
employee stock options granted during the nine months ended September 30, 2008
and 2007 was $0.49 per share and $2.36 per share, respectively.  The
fair value of each option is estimated on the date of grant using the valuation
models discussed above and is recognized as expense using the straight-line
method over the requisite service period:





September
      30,2008
            
            
            2007Expected
      volatility
            
            63.9%
      to 92.1%
            
            
            58.8%
      to 60.7 %Risk-free
      interest rate
            
            3.3%
      to 3.9%
            
            
            4.5%
      to 4.7%%Expected
      dividends
            
            
            —
            
            
            
            —Expected
      life (yrs)
            
            6.1
      to 9.3
            
            
            6.08





The
expected volatility is based on the weighted average of the historical
volatility of publicly traded surrogates in the Company’s peer
group.




The
risk-free interest rate assumption is based upon published interest rates
appropriate for the expected life of the Company’s employee stock
options.




The
dividend yield assumption is based on the Company’s history of not paying
dividends and no future expectations of dividend payouts.




The
expected life of employee stock options represents the weighted-average period
that the stock options are expected to remain outstanding and was determined
based on historical experience of similar awards, giving consideration to the
contractual terms of the stock-based awards, vesting schedules and expectations
of future employee behavior as influenced by changes to the terms of its
stock-based awards.




As the
stock-based compensation expense recognized in the Condensed Consolidated
Statements of Operations is based on awards ultimately expected to vest, such
amounts have been reduced for estimated forfeitures. SFAS 123(R) requires
forfeitures to be estimated at the time of grant and revised, if necessary, in
subsequent periods if actual forfeitures differ from those
estimates.




23
 Table of Contents


12.
              Computation of Net
      Loss Per Share


Net loss
per share is calculated in accordance with the SFAS No. 128, “Earnings Per
Share.”  Basic net loss per share is based upon 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 as of September 30,
2008 and 2007 which were excluded from the nine month calculation because their
effect is anti-dilutive.





September
      30,2008
            
            
            2007Convertible
      Debentures
            
            
            22,556,384
            
            
            
            3,440,295Preferred
      Stock
            
            
            -
            
            
            
            4,626,335Stock
      Options
            
            
            5,759,127
            
            
            
            4,481,056Warrants
            
            
            12,239,718
            
            
            
            3,837,929Total
            
            
            40,555,229
            
            
            
            16,385,615




13.
              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: Video Solutions and Voice and
Network Solutions, which are considered segments for reporting
purposes.  The segments are determined in accordance with how
management views and evaluates the Company’s business and based on the criteria
as outlined in SFAS No. 131, “Disclosures about Segments of an Enterprise and
Related Information.”.




The Video
Solutions segment includes the Company’s telepresence solutions and other
supporting audio-visual applications.  The Voice and Network Solutions
segment includes the Company’s VoIP communications offerings which include a
variety of voice and messaging solutions and telepresence network
services.




Segment
Data




Financial
information for each reportable segment is as follows as of the fiscal quarters
ended September 30, 2008 and 2007:





Video
      Solutions
            
            Voice
      and Network Solutions
            
            Total2008Revenues
            
            $
            1,710,873
            
            
            $
            6,786,712
            
            
            $
            8,497,585Gross
      profit
            
            $
            511,169
            
            
            $
            4,027,465
            
            
            $
            4,538,634Gross
      profit %
            
            
            29.88
            %
            
            
            59.34
            %
            
            
            53.41
            %Operating
      loss
            
            $
            (1,353,524
            )
            
            $
            (625,801
            )
            
            $
            (1,979,325
            )Total
      assets
            
            $
            4,885,253
            
            
            $
            34,188,530
            
            
            $
            39,073,7832007Revenues
            
            $
            1,226,691
            
            
            $
            1,035,024
            
            
            $
            2,261,715Gross
      profit
            
            $
            (1,220
            )
            
            $
            528,911
            
            
            $
            527,691Gross
      profit %
            
            
            -0.10
            %
            
            
            51.10
            %
            
            
            23.33
            %Operating
      loss
            
            $
            (1,794,612
            )
            
            $
            (322,397
            )
            
            $
            (2,117,009
            )Total
      assets
            
            $
            8,840,201
            
            
            $
            33,878,683
            
            
            $
            42,718,884




24
 Table of Contents





Financial
information for each reportable segment is as follows as of the nine months
ended September 30, 2008 and 2007:





Video
      Solutions
            
            Voice
      and Network Solutions
            
            Total2008Revenues
            
            $
            4,764,791
            
            
            $
            19,388,090
            
            
            $
            24,152,881Gross
      profit
            
            $
            985,799
            
            
            $
            10,734,245
            
            
            $
            11,720,044Gross
      profit %
            
            
            20.69
            %
            
            
            55.37
            %
            
            
            48.52
            %Operating
      income (loss)
            
            $
            (7,020,154
            )
            
            $
            (2,902,131
            )
            
            $
            (9,922,285
            )Total
      assets
            
            $
            4,885,253
            
            
            $
            34,188,530
            
            
            $
            39,073,7832007Revenues
            
            $
            3,734,271
            
            
            $
            1,035,024
            
            
            $
            4,769,295Gross
      profit
            
            $
            891,794
            
            
            $
            528,911
            
            
            $
            1,420,705Gross
      profit %
            
            
            23.88
            %
            
            
            51.10
            %
            
            
            29.79
            %Operating
      loss
            
            $
            (4,020,713
            )
            
            $
            (322,397
            )
            
            $
            (4,343,110
            )Total
      assets
            
            $
            8,840,201
            
            
            $
            33,878,683
            
            
            $
            42,718,884





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 and nine months ended September 30, 2008, two customers accounted
for 23% and 0% of the Video Solutions segment net revenues, respectively, and
one customer accounted for 14% and 15% of the Voice and Network Solutions
segment net revenues, respectively.  For the three and nine months
ended September 30, 2007, three customers accounted for 61% and  four
customers accounted for 59% of the Video Solutions segment net revenues,
respectively.




At
September 30, 2008, one customer accounted for 10% of gross accounts receivable
in the Video Solutions segment and two customers accounted for 23% of gross
accounts receivable in the Voice and Network Solutions segment.  At
September 30, 2007, two customers accounted for 60% of gross accounts receivable
in the Video Solutions segment and one customer accounted for 17% of gross
accounts receivable in the Voice and Network Solutions segment.


14.
              Related party
      transactions


In March
2007, the Company entered into an agreement with Aequitas Capital Management,
Inc. (“Aequitas Capital”), in order to provide prospective customers with a
leasing alternative for the Company’s telepresence videoconferencing
systems.  At the time the parties entered into this agreement,
Aequitas Capital beneficially owned five percent or more of the Company’s then
outstanding common stock, but currently does not.  In connection with
this agreement, the Company issued Aequitas Capital an immediately exercisable
warrant to purchase 250,000 shares of the Company’s common stock at an exercise
price of $2.00 per share.  Under the terms of the agreement with
Aequitas Capital, qualifying customers will be able to lease one of the
Company’s telepresence videoconferencing systems through private label leasing
provided by Aequitas Capital.  Once the qualifying customer accepts
the terms and conditions of the approved leasing arrangement and executes the
documents, the Company will sell the telepresence videoconferencing system to
Aequitas Capital who in turn will lease it to the customer on the terms and
conditions agreed to by Aequitas Capital and the customer.  The
Company agreed to provide Aequitas Capital with a right of first refusal for
providing prospective customers with this type of the leasing
arrangement.




Also,
during the nine months ended September 30, 2007, the Company sold an aggregate
of eight Digital Presence Systems to Aequitas Commercial Finance, an affiliate
of Aequitas Capital, for $0.3 million.  There were no sales to this
company in 2008.







25
 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-KSB for the year ended December 31, 2007, 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 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 partners and our subsidiary, AVS, 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.




26
 Table of Contents




History




We were a
development stage company through 2005 working on our Digital PresenceTM product
line.  We completed the development of our initial telepresence
solution and commenced sales of that product in 2005.  In 2006 we
focused our business efforts on developing our channel partner relationships and
we secured our first significant telepresence customer accounts. In April 2007,
we acquired AVS, which at the time was one of our channel partners who
distributed our telepresence systems and related solutions in New York, New
Jersey and nearby regions of the United States.  With this
acquisition, we expanded our business to provide integration, consultation and
implementation solutions for customers desiring telepresence and audio-visual
systems and products.  We entered the VOIP voice and network services
market in September 2007, with our acquisition of AccessLine, Inc.




Recent
Developments




Currently,
our overriding objective is to achieve operating profitability.  To
that end, during the second and third quarters of our current fiscal year, we
undertook substantial initiatives to increase sales, increase market share with
new product offerings, reduce operating expenses, secure additional working
capital, and recapitalize our short term debt.  These initiatives
included the following:





·
            Retained
      former Accord Networks executive to manage telepresence sales and
      distribution and added three veteran telepresence sales leaders to our
      sales team·
            Launched
      a new upgrade program, dubbed “Represence,” to layer full telepresence
      functionality into existing video conferencing rooms regardless of
      existing hardware solutions·
            Partnered
      with Costco Wholesale® (a national and international operator of
      membership warehouses) to provide new Digital Phone and service to small
      office/home office (SOHO) customers·
            Established
      Anew Communication Technology as telepresence distributor in 12 western
      states·
            Consolidated
      business units and reduced operating expenses·
            Secured
      $4.8 million of additional working capital through two financings in March
      2008 and August 2008.·
            Restructured
      short term debt and preferred stock to six year interest only convertible
      debenture.





Business
Developments




Mr. J.D.
Vaughn, a senior telepresence industry executive, joined us recently as our Vice
President of Worldwide Video Sales. Prior to joining us, Mr. Vaughn served in
leadership roles at companies including Accord Networks, Polycom, AT&T, and
PictureTel.  Also recently joining our video sales team were Brice
Drogosch, Steve Parrish and Linda Bickelman, each of whom previously worked with
Mr. Vaughn at Accord Networks.




Mr.
Drogosch, our Western Region Vice President of Video Sales, has more than 18
years of industry experience, and previously served as Vice President of Sales
at Radvision and was a Sales Director responsible for Western Region Sales at
Accord Networks and Polycom.




Mr.
Parrish, our Eastern Region Vice President of Video Sales, has more than 20
years of industry experience, and previously held positions as Vice President
for Channels for Polycom and as Regional Vice President for Accord Networks and
ViewTech that is now WireOne.




Ms.
Bickelman, our Director of Channel Development—Video, has actively supported
videoconferencing channels for over 18 years. She began her career at Rolm and
was instrumental in helping build and support channels at PictureTel, Viewcast,
Accord Networks, Trapeze Networks and Polycom.




27
 Table of Contents




In
September 2008, we launched a new upgrade program to layer full telepresence
functionality into existing video conferencing rooms regardless of existing
hardware solution.  Dubbed "Represence", the program includes HD
telepresence codecs, dual monitor support, five-way multi-point with continuous
presence, one button touch panel control and can be upgraded to include the
multipoint immersive gateway (MIG) which allows interoperability to legacy video
conferencing systems. The program will extend the life expectancy and reduce the
overall expense for a company wishing to deploy full telepresence solutions to
replace narrower bandwidth videoconferencing systems in integrated meeting
rooms.  Represence allows companies to extend and upgrade their
videoconferencing rooms without investing another $300,000.




In
September 2008, we appointed Douglas N. Johnson, our chief executive officer, as
chairman of our board of directors.  Mr. Johnson succeeded Thomas A.
Szabo in this role, who resigned from our board of directors on September 5,
2008.




During
the second quarter of our current fiscal year, we partnered with Costco
Wholesale®, a national and international operator of membership warehouses, to
launch a new VOIP product. Under this arrangement we are offering a combined
business phone service and business phone system package to Costco's Membership,
targeted at members running small businesses with five or fewer employees. This
segment represents over 60% of all registered businesses in the U.S. To simplify
the purchase process for Costco Members, AccessLine Digital Phone Service is a
complete package; it comes with a cutting-edge phone system, complete with all
necessary phones, bundled with the phone service itself. The package is packed
with features that make the whole purchase and installation process easy for the
Costco business member, such as an equipment installment purchase plan rather
than a large upfront charge, one point of contact rather than dealing with a
service provider and an equipment provider, plug and play installation, and
service quality monitoring.




Also
during the second quarter, we entered into an agreement with Anew Communications
Technology, Inc., a sales and marketing manufacturer representative firm
concentrating on the Commercial Audio Visual Market and Digital Signage
Applications. Under the terms of the agreement, Anew will provide sales
representation for our telepresence video products in California, Oregon,
Washington, Arizona, Nevada, New Mexico, Colorado, Wyoming, Utah, Montana, Idaho
and Alaska.




We are
aggressively evaluating and reducing our operating expenses at all levels of the
organization. We've consolidated certain of our business units and reduced
headcount throughout our organization, including executive and mid level
management. We incurred $1.8 million in severance and termination expenses
during the second quarter associated with these reductions.




Financing
Developments




In August
2008, we sold senior secured convertible debentures in the aggregate principal
amount of $2.0 million, along with a warrant to purchase 608,000 shares of our
common stock with an exercise price of $1.00 per share, resulting in net
proceeds to us of $2.0 million.  See "Recent Financings,"
below.




In June
2008, we restructured all $10.8 million of our outstanding convertible
promissory notes and all $15.3 million of our preferred stock into six year,
interest only, non-amortizing debentures in an aggregate principal amount of
$26.1 million. The restructure significantly lowers debt service requirements
for the next six years, by extending the term for payment, securing a fixed
interest rate, and removing the ratchet provision for monthly payments made in
common stock. See "Recent Financings," below.




In March
2008, we completed a convertible debenture financing transaction that resulted
in net proceeds to us of $2.8 million.




28
 Table of Contents




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 under SFAS No. 123(R), 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.




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.  The Company records 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 the Company’s 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, 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.




29
 Table of Contents




Revenue
Recognition:




Video Solutions
Revenue




The
Company recognizes 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,
the Company recognizes extended service revenue on our hardware and software
products ratably over the service period, generally one year.




The
Company’s telepresence products are integrated with software that is essential
to the functionality of the equipment.  Additionally, the Company
provides unspecified software upgrades and enhancements related to most of
these products through maintenance contracts.  Accordingly, the
Company accounts for revenue for these products in accordance with Statement of
Position (“SOP”) No. 97-2, “Software Revenue Recognition,” and all related
interpretations.




The
Company generally recognizes revenue generated by AVS for integration,
consultation and implementation solutions on a percentage completion basis based
on direct labor costs in accordance with SOP No. 81-1,Accounting for Performance of
Construction Type and Certain Production Type Contracts.




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.




Income
Taxes:




The
Company accounts 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.




On
January 1, 2007, the Company adopted the provisions of FASB Interpretation No.
48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB
Statement No. 109” (“FIN 48”), which clarifies the accounting for uncertainty in
income tax positions.  This interpretation requires the Company to
recognize in the consolidated financial statements only those tax positions
determined to be more likely than not of being sustained.




Derivative
Financial Instruments




The
Company does not use derivative instruments to hedge exposures to cash flow,
market or foreign currency risks.




The
Company reviews 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, the Company 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.




30
 Table of Contents




Stock
Based Compensation:




On
January 1, 2006, the Company adopted SFAS No. 123(R) “Share-Based Payments”,
which requires the Company to measure the cost of employee services received in
exchange for an award of equity instruments based on the grant-date fair value
of the award.  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.




Limited
Operating History




We have
limited historical financial information upon which to base an evaluation of our
future performance. We cannot guarantee that we will be successful in our
business. We are subject to risks inherent to a company in our stage of
development, including limited capital resources, possible delays in product
development and manufacturing, and possible cost overruns due to price and cost
increases. There is no assurance that future financing will be available to our
company on acceptable terms.  Additional equity financing will likely
result in substantial dilution to existing stockholders.




Results
of Operations




Third
Quarter of Fiscal 2008 Compared to Third Quarter of Fiscal 2007




Our
business operates in two segments: Video Solutions and Voice and Network
Solutions.  Our Video Solutions segment includes our Digital
PresenceTM
telepresence solutions and other supporting audio-visual applications and
services.  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 as well as telepresence
network services.




Revenues,
Cost of Revenues and Gross Profit





Three
      months ended September 30, 2008
            
            Three
      months ended September 30, 2007
            
            Increase
      (decrease)Video
      Solutions
            
            Voice
      and Network Solutions
            
            Total
            
            Video
      Solutions
            
            Voice
      and Network Solutions
            
            Total
            
            Video
      Solutions
            
            Voice
      and Network Solutions
            
            TotalNet
      revenues:Product
            
            $
            1,654,038
            
            
            $
            -
            
            
            $
            1,654,038
            
            
            $
            1,185,941
            
            
            $
            -
            
            
            $
            1,185,941
            
            
            $
            468,097
            
            
            $
            -
            
            
            $
            468,097Services
            
            
            56,835
            
            
            
            6,786,712
            
            
            
            6,843,547
            
            
            
            40,750
            
            
            
            1,035,024
            
            
            
            1,075,774
            
            
            
            16,085
            
            
            
            5,751,688
            
            
            
            5,767,7731,710,873
            
            
            
            6,786,712
            
            
            
            8,497,585
            
            
            
            1,226,691
            
            
            
            1,035,024
            
            
            
            2,261,715
            
            
            
            484,182
            
            
            
            5,751,688
            
            
            
            6,235,870Cost
      of revenues:Product
            
            
            1,122,393
            
            
            
            -
            
            
            
            1,122,393
            
            
            
            1,158,750
            
            
            
            -
            
            
            
            1,158,750
            
            
            
            (36,357)
            
            
            
            -
            
            
            
            (36,357)Services
            
            
            77,311
            
            
            
            2,759,247
            
            
            
            2,836,558
            
            
            
            69,161
            
            
            
            506,113
            
            
            
            575,274
            
            
            
            8,150
            
            
            
            2,253,134
            
            
            
            2,261,2841,199,704
            
            
            
            2,759,247
            
            
            
            3,958,951
            
            
            
            1,227,911
            
            
            
            506,113
            
            
            
            1,734,024
            
            
            
            (28,207)
            
            
            
            2,253,134
            
            
            
            2,224,927Gross
      profit
            
            $
            511,169
            
            
            $
            4,027,465
            
            
            $
            4,538,634
            
            
            $
            (1,220)
            
            
            $
            528,911
            
            
            $
            527,691
            
            
            $
            512,389
            
            
            $
            3,498,554
            
            
            $
            4,010,943Gross
      profit %
            
            
            29.88
            %
            
            
            59.34
            %
            
            
            53.41
            %
            
            
            (0.10%)
            
            
            
            51.10%
            
            
            
            23.33%




31
 Table of Contents




Net
revenues for the three months ended September 30, 2008 were $8.5 million, an
increase of $6.2 million, or 276%, over the same period in 2007.  Net
revenues in our Video Solutions segment increased $0.5 million.  Net
revenues in our Voice and Network Solutions segment increased $5.8 million. The
increase in Voice and Network Solutions revenue is attributable to the fact that
we acquired AccessLine on September 14, 2007 and its results are included in our
results of operations only from the date of acquisition, or approximately half
of a month for the three months ended September 30, 2007, as compared to all
three months for the three months ended September 30, 2008.




For the
three months ended September 30, 2008, two customers accounted for 23% of our
Video Solutions segment net revenues, and one customer accounted for 14% of our
Voice and Network Solutions segment net revenues.  For the three
months ended September 30, 2007, three customers accounted for 61% of our Video
Solutions segment net revenues.




Cost of
revenues for the three months ended September 30, 2008 were $4.0 million, an
increase of $2.2 million, or 128%, over the same period in 2007.  Cost
of revenues in our Video Solutions segment decreased by less than $0.1 million
due primarily to an improved mix of product and services sold.  Cost
of revenues in our Voice and Network Solutions segment increased $2.3 million
consistent with the increase in revenues attributable to the operation of our
Accessline subsidiary for a full quarter.




Gross
profit for the three months ended September 30, 2008 was $4.5 million, an
increase of $4.0 million, or 760%, over the same period in
2007.  Gross profit in our Video Solutions segment increased $0.5
million primarily as a result of increased margin on product sales during the
period.  Gross profit in our Voice and Network Solutions segment
increased $3.5 million consistent with the increase in revenues attributable to
the operation of our Accessline subsidiary for a full quarter.




Gross
profit percentage was 53.41% for the three months ended September 30, 2008
compared to 23.33% in the same period in 2007.  Gross profit
percentage for our Video Solutions segment was 29.88% for the three months ended
September 30, 2008 compared to nil in the same period in 2007, and the increase
is a result of a more profitable mix of products sold.  Gross profit
percentage for our Voice and Network Solutions segment was 59.34% for the three
months ended September 30, 2008 compared to 51.10% in the same period in 2007,
and the increase is a result of improved purchasing power from network
infrastructure providers allowing us to purchase network access at lower
rates.




Selling,
General and Administrative Expenses




Selling,
general and administrative expenses for the three months ended September 30,
2008 were $4.4 million, an increase of $2.5 million or 130%, over the same
period in 2007.  More than 95%, or $2.4 million, of the increase in
selling, general and administrative expenses for the three months ended
September 30, 2008 was a result of the expenses associated with operations
brought to us through our acquisition of AccessLine in September
2007.




Research,
Development and Engineering Expenses




Research,
development and engineering expenses for the three months ended September 30,
2008 were $1.3 million, an increase of $0.8 million or 168%, over the same
period in 2007.  Research, development and engineering expenses
increased as a result of our acquisition of AccessLine in September
2007.




Depreciation
Expense




Depreciation
expense for the three months ended September 30, 2008 was $0.2 million, an
increase of $0.1 million or 71%, over the same period in 2007.  We
acquired fixed assets valued at $5.1 million in our acquisition of AccessLine in
September 2007, and depreciation expense increased primarily as a result of
recording depreciation expense on those assets.




Amortization
of Purchased Intangibles




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




32
 Table of Contents




Interest
Expense




Interest
expense for the three months ended September 30, 2008 was $1.5 million, a
decrease of $1.6 million or 52%, from the same period in
2007.  Interest expense includes stated interest, amortization of note
discounts, amortization of deferred financing costs, and interest on capital
leases.  Interest expense decreased in 2008 primarily as a result of
the lower discount amortization, resulting from the extension of the terms of
our debentures from two years to six years that occurred in June 2008, and which
is discussed in more detail below.




The
debentures we issued in December 2006 and February 2007 had an original face
value aggregating $5.2 million.  The debentures we issued in August
2007 had an original face value aggregating $8.0 million. The debentures we
issued in March 2008 had an original face value aggregating $3.4 million. Each
of these debentures had a two year term. The interest rate on such debentures
was 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 the outstanding debentures we issued in December 2006,
August 2007 and March 2008 for new debentures with an aggregate face value of
$26.1 million that bear interest at 12% and have a six year term.  We
recorded deferred financing costs of $0.2 million related to the issuance of the
new debentures.  The unamortized discounts and deferred financing
costs at June 30, 2008 related to the financing transactions in December 2006,
August 2007 and March 2008 will be amortized to interest expense in future
periods over the term of the newly issued debentures, or through June 30,
2014.




On August
13, 2008, we issued a new debenture with a face value of $2.0 million that bears
interest at 12%.  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.




Assuming
the aggregate debenture balance of $28.2 million is not prepaid before maturity
and interest payments are made in cash, subsequent to September 30, 2008, we
anticipate paying an additional $19.8 million in interest expense on these
debentures through maturity in June 2014.  In lieu of making such
interest payments in cash, we have the option of paying the interest in shares
of our common stock, subject to, among other things, meeting certain equity
conditions, including having a certain volume of trading in our common
stock.  We can also force the holders of these debentures to convert
the outstanding principal and accrued interest into common stock subject to
compliance with certain equity conditions and subject to the applicable cap on
the beneficial ownership of our shares of common stock by the holder and its
affiliates following such conversion contained in the debenture being
converted.  See "Recent Financings," below.




Change
in Fair Value of Warrant and Beneficial Conversion Liabilities




Pursuant
to SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”
and EITF No. 00-19, “Accounting for Derivative Financial Instruments Indexed to
and Potentially Settled in, a Company's Own Stock”, we recorded the fair value
of the warrants issued in connection with our financings in December 2006,
February 2007, August 2007, March 2008 and August 2008 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, 2007 and
again at each subsequent reporting date. For the three months ended
September 30, 2008, we recorded non-operating income of $1.5 million in our
Condensed Consolidated Statement of Operations for the decrease in the fair
values of the warrants, which is primarily attributable to the decrease in the
market price of our common stock.




At
December 31, 2007 and again at each subsequent reporting date, we assessed the
then outstanding convertible debentures under SFAS No. 133, and we 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
convertible debentures 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, and at December 31, 2007.  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.




33
 Table of Contents




The
convertible debentures issued in June 2008 and August 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 its common stock; (4) optional
redemption at our election; (5) forced conversion; (6) holder’s restriction on
conversion; and (7) a default put.




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, 2008, we recorded non-operating income of $1.4
million in our Condensed Consolidated Statement of Operations for the decrease
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.




First
Nine Months of Fiscal 2008 Compared to First Nine Months of Fiscal
2007




Revenues,
Cost of Revenues and Gross Profit





Nine
      months ended September 30, 2008
            
            Nine
      months ended September 30, 2007
            
            Increase
      (decrease)Video
      Solutions
            
            Voice
      and Network Solutions
            
            Total
            
            Video
      Solutions
            
            Voice
      and Network Solutions
            
            Total
            
            Video
      Solutions
            
            Voice
      and Network Solutions
            
            TotalNet
      revenues:Product
            
            $
            4,460,756
            
            
            $
            -
            
            
            $
            4,460,756
            
            
            $
            3,589,929
            
            
            $
            -
            
            
            $
            3,589,929
            
            
            $
            870,827
            
            
            $
            -
            
            
            $
            870,827Services
            
            
            304,035
            
            
            
            19,388,090
            
            
            
            19,692,125
            
            
            
            144,342
            
            
            
            1,035,024
            
            
            
            1,179,366
            
            
            
            159,693
            
            
            
            18,353,066
            
            
            
            18,512,7594,764,791
            
            
            
            19,388,090
            
            
            
            24,152,881
            
            
            
            3,734,271
            
            
            
            1,035,024
            
            
            
            4,769,295
            
            
            
            1,030,520
            
            
            
            18,353,066
            
            
            
            19,383,586Cost
      of revenues:Product
            
            
            3,507,050
            
            
            
            -
            
            
            
            3,507,050
            
            
            
            2,684,818
            
            
            
            -
            
            
            
            2,684,818
            
            
            
            822,232
            
            
            
            -
            
            
            
            822,232Services
            
            
            271,942
            
            
            
            8,653,845
            
            
            
            8,925,787
            
            
            
            157,659
            
            
            
            506,113
            
            
            
            663,772
            
            
            
            114,283
            
            
            
            8,147,732
            
            
            
            8,262,0153,778,992
            
            
            
            8,653,845
            
            
            
            12,432,837
            
            
            
            2,842,477
            
            
            
            506,113
            
            
            
            3,348,590
            
            
            
            936,515
            
            
            
            8,147,732
            
            
            
            9,084,247Gross
      profit
            
            $
            985,799
            
            
            $
            10,734,245
            
            
            $
            11,720,044
            
            
            $
            891,794
            
            
            $
            528,911
            
            
            $
            1,420,705
            
            
            $
            94,005
            
            
            $
            10,205,334
            
            
            $
            10,299,339Gross
      profit %
            
            
            20.69%
            
            
            
            55.37%
            
            
            
            48.52%
            
            
            
            23.88%
            
            
            
            51.10%
            
            
            
            29.79%





Net
revenues for the nine months ended September 30, 2008 were $24.2 million, an
increase of $19.4 million, or 406%, over the same period in 2007.  Net
revenues in our Video Solutions segment increased $1.0 million primarily as a
result of our acquisition of AVS in April 2007.  Net revenues in our
Voice and Network Solutions segment increased $18.4 million. This increase is
attributable to the fact that we acquired AccessLine on September 14, 2007 and
its results are included in our results of operations only from the date of
acquisition, or approximately half of a month for the nine months ended
September 30, 2007, as compared to all nine months for the nine months ended
September 30, 2008.




For the
nine months ended September 30, 2008, no single customer accounted for more than
10% of our Video Solutions segment net revenues, and one customer accounted for
15% of our Voice and Network Solutions segment net revenues.  For the
nine months ended September 30, 2007, four customers accounted for 59% of our
Video Solutions segment net revenues.




34
 Table of Contents




Cost of
revenues for the nine months ended September 30, 2008 were $12.4 million, an
increase of $9.1 million, or 271%, over the same period in 2007.  Cost
of revenues in our Video Solutions segment increased $0.9 million primarily as a
result of our acquisition of AVS in April 2007.  Cost of revenues in
our Voice and Network Solutions segment increased $8.2 million consistent with
the increase in revenues as a result of our operating the Accessline business
for a full nine months.




Gross
profit for the nine months ended September 30, 2008 was $11.7 million, an
increase of $10.3 million, or 725%, over the same period in
2007.  Gross profit in our Video Solutions segment increased $0.1
million primarily as a result of our product mix during the
period.  Gross profit in our Voice and Network Solutions segment
increased $10.2 million consistent with the increase in revenues as a result of
our operating the Accessline business for a full nine months.




Gross
profit percentage was 48.52% for the nine months ended September 30, 2008
compared to 29.79% in the same period in 2007.  Gross profit
percentage for our Video Solutions segment was 20.69% for the nine months ended
September 30, 2008 compared to 23.88% in the same period in 2007, and the
decrease is a result of the lower gross margins on our product mix during the
period.  Gross profit percentage for our Voice and Network Solutions
segment was 55.37% for the nine months ended September 30. 2007 compared to
51.10% in the same period in 2007, and the increase is a result of improved
purchasing power from network infrastructure providers allowing us to purchase
network access at lower rates.




Selling,
General and Administrative Expenses




Selling,
general and administrative expenses for the nine months ended September 30, 2008
were $14.9 million, an increase of $10.3 million or 221%, over the same period
in 2007.  Selling, general and administrative expenses increased
approximately $0.2million as a result of our acquisition of AVS in April 2007
and approximately $7.8 million as a result of our acquisition of AccessLine in
September 2007.  The additional $2.3 million increase in selling,
general and administrative expenses for the nine months ended September 30, 2008
was primarily due to $1.3 million in severance costs, $0.5 million for stock
based compensation related to our stock option grants, $0.5 million for legal
and accounting fees related to our corporate filings, and $0.7 million for
investor relations services and $0.2 million for warrant compensation to
consultants.  These increases were partially offset by $0.6 million in
expense recorded in 2007 related to the issuance of a warrant related to our
lease financing program and a $0.3 million reduction in payroll expense in the
three months ended September 30, 2008.


Research,
Development and Engineering Expenses




Research,
development and engineering expenses for the nine months ended September 30,
2008 were $4.3 million, an increase of $3.5 million or 418%, over the same
period in 2007.  Research, development and engineering expenses
increased $3.2 million as a result of our acquisition of AccessLine in September
2007.  Specific additional increases in research, development and
engineering expenses for the nine months ended September 30, 2008 is related to
severance costs and headcount adjustments.




Depreciation
Expense




Depreciation
expense for the nine months ended September 30, 2008 was $0.6 million, an
increase of $0.5 million or 270%, over the same period in 2007.  We
acquired fixed assets valued at $5.1 million in our acquisition of AccessLine in
September 2007, and depreciation expense increased primarily as a result of
recording depreciation expense on those assets.




Amortization
of Purchased Intangibles




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




Interest
Expense




Interest
expense for the nine months ended September 30, 2008 was $4.5 million, a
decrease of $0.1 million or 3%, from 2007.  Interest expense includes
stated interest, amortization of note discounts, amortization of deferred
financing costs, and interest on capital leases.  Interest expense
decreased in 2008 primarily as a result of the lower discount amortization
resulting from the extension of the terms of our debentures from two years to
six years that occurred in June 2008.  For a more detailed discussion
regarding the interest expense related to our debentures, please see "--Third
Quarter of Fiscal 2008 Compared to Third Quarter of Fiscal 2007--Interest
Expense," above.




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Change
in Fair Value of Warrant and Beneficial Conversion Liabilities




Pursuant
to SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”
and EITF No. 00-19, “Accounting for Derivative Financial Instruments Indexed to
and Potentially Settled in, a Company's Own Stock”, we recorded the fair value
of the warrants issued in connection with our financings in December 2006,
February 2007, August 2007, March 2008 and August 2008 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, 2007 and
again at each subsequent reporting date. For the nine months ended
September 30, 2008, we recorded non-operating income of $8.1 million in the
Condensed Consolidated Statement of Operations for the decrease in the fair
values of the warrants, which is primarily attributable to the decrease in the
market price of our common stock.




At
December 31, 2007 and again at each subsequent reporting date, we assessed the
then outstanding convertible debentures under SFAS No. 133, and we 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
convertible debentures 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, and at December 31, 2007.  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
convertible debentures issued in June 2008 and August 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 its common stock; (4) optional
redemption at our election; (5) forced conversion; (6) holder’s restriction on
conversion; and (7) a default put.




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
nine months ended September 30, 2008, we recorded non-operating income of $3.5
million in the Condensed Consolidated Statement of Operations for the decrease
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.




Liquidity
and Capital Resources




Our cash
balance as of September 30, 2008 was $1.4 million.  At that time, we
had accounts receivable of $2.8 million and a working capital deficit of $6.8
million, which includes warrant and beneficial conversion liabilities of $4.7
million.




Cash used
in operations during the nine months ended September 30, 2008 was $4.0 million.
This was primarily the result of a net loss of $2.8 million which was offset by
the following non-cash charges: stock compensation expense of $2.5 million;
amortization of note discounts of $2.6 million; amortization of intangible
assets of $1.8 million; depreciation expense of $1.4 million (which includes
depreciation expense of $0.7 million in cost of sales); stock issued for
services of $0.5 million; non-cash severance payments of $0.4 million; and
expenses related to warrant grants of $0.2 million. The change in fair value of
warrant and beneficial conversion liabilities of $11.6 million decreased our
cash used in operations.




Net cash
used by investing activities during the nine months ended September 30, 2008 was
$0.7 million, which consists of purchases of property and
equipment.




Net cash
provided by financing activities for the nine months ended September 30, 2008
was $2.3 million consisting of the following: (i) aggregate net proceeds from
our March 2008 and August 2008 financings of $4.8 million, and proceeds from the
exercise of warrants of $0.1 million; less (ii) payments we made of $1.2 million
on our debentures, $1.0 million on our capital leases, and $0.5 million to pay
off our line-of-credit balance.  As of the date of this report, we
have no line-of-credit facilities.




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Since
inception we have financed substantially all of our operating capital
requirements from the sale of debt and equity securities.  At
September 30, 2008 we had outstanding debentures in the face amount of $28.2
million.  See "Recent Financings" below.  We do not have any
credit facility or working capital line of credit available to us at this
time.  The debentures are secured by a first priority lien on
substantially all of our assets.  In addition, the debentures impose
substantial restrictions on us, including restrictions that prohibit us from
incurring additional indebtedness or granting additional liens in our assets.




Our
revenues have increased substantially with the AccessLine acquisition, and the
growth of our telepresence business.  For the long term, we are
looking for an increase in positive cash flow from operations, reducing our need
for external capital.




We do not
believe our cash reserves at September 30, 2008 are sufficient to maintain
operations for the long term and we plan to raise additional capital by selling
equity or debt securities. Any future financing may involve substantial dilution
to existing investors. 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 to us on favorable terms or at all. If we are not able to
obtain adequate financing, we will be forced to curtail our operations or
possibly be forced to evaluate a sale or liquidation of our assets. Even if we
are able to secure financing in the short term, we may need additional financing
thereafter until we achieve profitability.




Going
Concern




We remain
dependent on outside sources of funding until our results of operations provide
positive cash flows. As of December 31, 2007, 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,
2008. For further information, refer to the consolidated financial statements
and footnotes thereto included in the Company's Annual Report on Form 10-KSB for
the year ended December 31, 2007.




During
the years ended December 31, 2007 and 2006, we have been 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:





2007
            
            
            2006Net
      Loss
            $
            (10,633,026
            )
            
            $
            (3,119,056
            )Negative
      cash flow from operating activities
            
            (5,582,487
            )
            
            
            (1,827,261
            )Working
      capital deficit
            
            (13,585,737
            )
            
            
            (134,726
            )Stockholders’
      equity (deficit)
            
            18,377,773
            
            
            
            (1,130,778
            )




These
factors raise substantial doubt about our 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 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) raising
capital through additional sale of our common stock and/or debentures and (2)
reducing cash operating expenses to levels that are in line with current
revenues.




The first
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 raise additional working capital or that
we can achieve positive cash flows from operations.  Our long-term
viability as a going concern is dependent upon our ability to:





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




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Recent
Financings




August
2008 Financing




In August
2008, we entered into a debenture and warrant purchase agreement with an
institutional investor pursuant to which we issued a senior secured convertible
debenture in the aggregate principal amount of $2.0 million, along with a
warrant to purchase 608,000 shares of our common stock with an exercise price of
$1.00 per share.




In this
report we may refer to the debenture we issued in August 2008 as our August 2008
debenture. A summary of the terms of our August 2008 debenture is set forth
below. Such summary is qualified by reference to a copy of the August 2008
debenture which is filed as an exhibit to our Form 8-K filed with the SEC on
August 14, 2008.




Term
            Due
      and payable on June 30, 2014.Interest
            Interest
      accrues at the rate of 12.0% per annum and is payable on the first of each
      month.Principal
      Payment
            The
      principal amount, if not paid earlier, is due and payable on June 30,
      2014.Interest
      Payments
            We
      have the right to make interest payments in cash or, upon notice to the
      holders and compliance with certain equity conditions, we can pay all or a
      portion of any such payment in common stock valued at a price equal to the
      lesser of the then effective conversion price (currently $1.25) or 85% of
      the average of the VWAP per share for our common stock for the 10
      consecutive trading days immediately prior to the applicable payment
      date.Early
      Redemption
            We
      have the right to redeem the debenture before maturity by payment in cash
      of 120% 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 debenture we
      must meet certain equity conditions. The payment of the debenture would
      occur on the 10th day following the date we gave the holder notice of our
      intent to redeem the debenture. We agreed to honor any notices of
      conversion that we receive from a holder before the date we pay off the
      debenture.Voluntary
      Conversion by Holder
            The
      debenture is 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.Forced
      Conversion
            Subject
      to compliance with certain equity conditions, we also have the right to
      force conversion if the VWAP for our 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 our meeting certain
      equity conditions and is subject to a 4.99% cap on the beneficial
      ownership of our shares of common stock by the holder and its affiliates
      following such conversion.Covenants
            The
      debenture imposes 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 debenture defines 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 or
      failure to deliver share certificates in a timely manner. In the event of
      default, the debenture holder has 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.Security
            The
      debenture is secured by all of our assets under the terms of the amended
      and restated security agreement we and our subsidiaries entered into with
      the investor in connection with the June 2008 financing discussed
      below.  Each of our subsidiaries also gave guarantees, pursuant
      to which each subsidiary guaranteed the complete payment and performance
      by us of our obligations under the debenture and related
      agreements.




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June
2008 Financing




On June
30, 2008, we entered into a securities exchange agreement with the holders of
all of our then outstanding debentures and shares of preferred stock, pursuant
to which we issued six-year, interest only debentures due June 30, 2014, in
exchange for all of our then currently outstanding debentures and shares of
preferred stock. The debentures issued amend and restate the terms of the
previously outstanding debentures held by the investors.




The terms
of the debentures we issued in June 2008, which we refer to as our June 2008
debentures, are substantially similar to the terms of our August 2008
debentures, a summary of which is set forth above. A copy of the June 2008
debentures is filed as an exhibit to our Form 8-K filed with the SEC on July 1,
2008 and qualifies the summary of the terms of our June 2008 debentures set
forth in this report.




In
connection with the June 2008 transaction described above, the exercise price of
all of the warrants to purchase shares of our common stock held by the investors
was reduced to $1.00 per share.




Commitments
and Contingencies




Debentures




As of
September 30, 2008, the principal balance we owe on our outstanding debentures
is $28.2 million, all of which is due June 30, 2014.  Monthly interest
payments of $0.3 million are payable the first of each month.




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 $1.25). We
have the right to pay interest in cash, or upon notice to the holders and
compliance with certain equity conditions, we can pay all or a portion of any
such interest payment in common stock valued at a price equal to the lesser of
the then effective conversion price (currently $1.25) or 85% of the average of
the VWAP per share for our common stock for the 10 consecutive trading days
immediately prior to the applicable payment date.  One of the equity
conditions we must meet is having a daily dollar trading volume for our common
stock exceed $300,000 for each of the 20 consecutive trading days before the
date in question. We do not currently meet this equity condition and it may
prove difficult for us to meet it in the future.  If we make interest
payments in common stock or the holders voluntarily elect to convert all or a
portion of the debentures into common stock, these actions could result in
substantial dilution to our existing stockholders.




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 pay the interest in
cash, or elect not to do so to preserve working capital, we will make the
payments with our common stock pursuant to the terms of the agreements including
a conversion price based on the lower of the then effective conversion price or
85% of the average of the VWAP per share of our common stock for the 10
consecutive trading days immediately prior to the applicable payment date.
Making interest payments with our common stock requires that we meet certain
equity conditions, one of which is having a daily dollar trading volume for our
common stock exceed $300,000 for each of the 20 consecutive trading days before
the date in question. We currently do not meet this equity condition and will
need the investors to waive this equity condition if we are going to make an
interest payment with stock. The investors are not required to waive this equity
condition, and may require us to pay additional consideration in order to secure
their waiver.




If we are
unable to make payments, whether in cash or stock, 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.




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Capital
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
      Leases2008
            
            $
            415,606
            
            
            $
            369,8942009
            
            
            1,185,667
            
            
            
            1,071,6722010
            
            
            1,211,313
            
            
            
            606,9582011
            
            
            1,218,197
            
            
            
            273,1472012
            
            
            1,223,261
            
            
            
            36,250Thereafter
            
            
            184,920
            
            
            
            —Total
      minimum lease payments
            
            $
            5,438,964
            
            
            $
            2,357,921Less
      amount representing interest
            
            
            
            
            
            
            (337,721
            )Present
      value of minimum lease payments
            
            
            
            
            
            
            2,020,200Less
      current portion
            
            
            
            
            
            
            (993,618
            )$
            1,026,582





Minimum Third Party Network
Service Provider Commitments




We have a contract with a third party
network service provider that
facilitates interconnects with a number of 3rd party
network service providers.  The contract containsa minimum
usage guarantee of $0.2 million per monthly billing cycle.  The
contract commenced in October 2003 and was extended in October 2008 for a 36
month term.  The contract can be terminated by delivery of written
notice of cancellation 90 days prior to the expiration of the extended
term.




Litigation




In
January 2008, we issued 72,000 shares of our common stock valued at $0.2
million in settlement of compensation claims made by a former sales
representative.  The settlement amount was accrued at December 31,
2007, and was included in selling, general and administrative expenses in our
Condensed Consolidated Statement of Operations for the year ended December 31,
2007.  Under the terms of the settlement, we were required to issue
additional shares of our common stock if the  price of our common
stock declined during the six month period subsequent to the date of the
settlement.  In July 2008, because the price of our common stock so
declined, we issued an additional 60,000 shares of our common
stock.  The 60,000 shares we issued, valued at less than $0.1 million,
is included in selling, general and administrative expenses in our Condensed
Consolidated Statement of Operations for the three months ended September 30,
2008.




Communications Assistance
for Law Enforcement Act




On August
5, 2005, the 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.  AccessLine engaged a third party to help it develop a solution
to be CALEA compliant.  In February 2007, AccessLine 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.  AccessLine’s formal CALEA compliance testing with the third
party was completed on September 28, 2007.  Currently, AccessLine’s
CALEA solution is fully deployed in its network.  However, AccessLine
could be subject to an enforcement action by the FCC or law enforcement agencies
for any delays related to meeting, or if AccessLine fails to comply with, any
current or future CALEA obligations.




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Sales and Additional
Taxes.




Based
upon a new Internal Revenue Service ruling, AccessLine ceased collecting federal
excise tax on August 1, 2006 on long-distance or bundled
services.  AccessLine 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
AccessLine.  Also, AccessLine is currently working to obtain Inter
Exchange Carrier (IXC) certification in Alaska, Maryland and
Mississippi.  AccessLine’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 AccessLine’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 AccessLine.  AccessLine 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 AccessLine should collect sales, use or other taxes on
the sale of AccessLine’s services could result in substantial tax liabilities
for past sales.




Other




In
connection with our acquisition of AccessLine, we may be 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 pre determined revenue and gross margin
targets.  The earn out is payable in up to 625,000 shares of our
common stock at the end of each six month period ending December 31, 2007, June
30, 2008, December 31, 2008 and June 30, 2009, based on AccessLine’s achievement
of targeted revenue and gross profit targets for those periods.  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 when the contingency was
resolved.  The increase in goodwill and equity was recorded in our
third fiscal quarter of 2008.  There are two additional earn out
periods, terminating on December 31, 2008 and June 30, 2009.  We may
be required to issue up to an additional 1,250,000 shares of our common stock
upon AccessLine's achievement of the future financial objectives associated with
those periods.




Other
Matters Relating to Future Amortizable Charges




As of
September 30, 2008, we have $9.6 million of debt discount and $0.7 million of
deferred financing costs included in our balance sheet, which will be amortized
to interest expense using the effective interest method over the life of the
related debentures.




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 of
1933.




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Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK




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




Item 4. CONTROLSAND PROCEDURES




Evaluation
of Disclosure Controls and Procedures




As of
September 30, 2008, we conducted an evaluation under the supervision and with
the participation of our management, including our Chief Executive Officer and
Chief Financial Officer, of the effectiveness of the design and operation of our
disclosure controls and procedures. The term “disclosure controls and
procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act,
means controls and other procedures of a company that are designed to ensure
that information required to be disclosed by the company in the reports it files
or submits under the Exchange Act is recorded, processed, summarized and
reported, within the time periods specified in the SEC's rules and forms.
Disclosure controls and procedures also include, without limitation, controls
and procedures designed to ensure that information required to be disclosed by a
company in the reports that it files or submits under the Exchange Act is
accumulated and communicated to the company's management, including its
principal executive and principal financial officers, or persons performing
similar functions, as appropriate, to allow timely decisions regarding required
disclosure. Based on this evaluation, our Chief Executive Officer and Chief
Financial Officer have concluded that our disclosure controls and procedures
were not effective as of September 30, 2008 for the reasons discussed below
related to material weaknesses in our internal control over financial
reporting.




Identified
Material Weaknesses




A
material weakness is a deficiency, or a combination of deficiencies, in internal
control over financial reporting, such that there is a reasonable possibility
that a material misstatement of a company’s annual or interim financial
statements will not be prevented or detected on a timely basis. Our management
identified the following internal control deficiencies during its assessment of
our internal control over financial reporting as of September 30,
2008:





1.
            We
      did not have formal policies governing certain accounting transactions and
      financial reporting processes in the following areas:•
            Check
      signing policy;•
            Insider
      trading policy;•
            Purchasing
      approval policy;•
            Human
      resources policies; and•
            Fixed
      assets policies.2.
            We
      did not obtain prescribed attestations by all employees and members of our
      board of directors regarding their compliance with our code of ethics or
      their understanding of and compliance with our policies related to their
      employment.3.
            We
      did not perform adequate oversight of certain accounting functions and
      maintained inadequate documentation of management review and approval of
      accounting transactions and financial reporting processes in the following
      areas:•
            Revenue
      recognition;•
            Stock
      compensation; and•
            Warrant
      transaction valuations.4.
            We
      did not have a record retention policy for retention of hard copy
      documents. Cases of inadequate records retention or supporting
      documentation were noted in the accounting department and impacted our
      ability to support and account for
transactions.





In
conclusion, our Chief Executive Officer and Chief Financial Officer concluded
that we did not maintain effective internal control over financial reporting as
of September 30, 2008.




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Management’s
Remediation Initiatives




We are in
the process of evaluating our material weaknesses.




In an
effort to remediate the material weaknesses and other deficiencies that we have
already identified, and to enhance our internal controls, we have initiated, or
plan to initiate, the following series of measures:





1.
            Consolidating
      all accounting functions to our Headquarters in Bellevue and moving to one
      uniform accounting software platform.  These changes will
      address the identified material weaknesses reported in our 2007 annual
      report on form 10-KSB;2.
            Establish
      comprehensive formal general accounting policies and procedures and
      require employees to sign off such policies and procedures as
      documentation of their understanding of and compliance with company
      policies;3.
            Require
      all employees and directors to sign our code of ethics on an annual
      basis;4.
            Implement
      appropriate management oversight and approval activities in the areas of
      vendor bill payments, employee expense reimbursements, customer invoicing,
      and period-end closing processes; and5.
            Establish
      a records retention policy that outlines the requirements and procedures
      for retaining the appropriate supporting documentation for financial
      transactions and plan to implement procedures designed to verify
      compliance with the related policy.





We are
currently implementing the above five initiatives, and to date we have
implemented a check signing policy, insider trading policy, purchasing approval
policy, human resources policies, fixed asset policies and code of ethics. 
We plan to test our updated controls and remediate our material weaknesses by
December 31, 2008.




Conclusion




The above
identified material weaknesses resulted in material audit adjustments to our
2007 financial statements. If the identified material weaknesses are not
remediated, one or more of the identified material weaknesses noted above could
result in a material misstatement in our reported financial statements in a
future interim or annual period.




In light
of the identified material weaknesses, management performed (1) significant
additional substantive review of those areas described above, and (2) additional
analyses, including but not limited to a detailed balance sheet and statement of
operations analytical review that compared changes from the prior period's
financial statements and analyzed all significant differences. These procedures
were completed so management could gain assurance that the financial statements
included in this report fairly present in all material respects our financial
position, results of operations and cash flows for the periods
presented.




Changes
in Internal Control over Financial Reporting




During
the quarter ended September 30, 2008, we implemented the following change that
has materially affected, or is reasonably likely to materially affect, our
internal control over financial reporting, as defined in Rules 13a-15(f) and
15d-15(f) under the Exchange Act: we consolidated all accounting functions to
our headquarters in Bellevue, Washington, utilizing one uniform accounting
software platform.




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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 factors discussed in "Part I. Item 1—Description of Business—Risk
Factors" in our Annual Report on Form 10-KSB for the fiscal year ended December
31, 2007. These risks and uncertainties 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, other than the risk
factors set forth below, we do not believe that there have been any material
changes to the risk factors previously disclosed in our Annual Report on Form
10-KSB for the fiscal year ended December 31, 2007.




Substantially
all of our debentures are held by a single investor, and that investor will be
able to control any waivers or amendments to the terms of our debentures and
exercise rights and remedies with respect to substantially all of our
debentures.




On
October 31, 2008, one investor acquired certain of our debentures and warrants
that had been held by other investors.  As a result of that
acquisition, that one investor, and its affiliates, now holds over 95% of the
principal amount of our outstanding debentures.  Among other things,
the debentures carry covenants that impose significant restrictions on us and
the debentures require us to make payments of interest on a monthly
basis.  If we fail to comply with our covenants under the debentures
or if we are unable to make payments under debentures when required, we would be
in breach or default under the debentures.  See the risk factors
entitled "We have significant indebtedness and agreed to certain restrictions as
a result of our recent private placement of debentures," and "Our failure to
repay the debentures could result in substantial penalties against us, and legal
action which could substantially impair our operations." Under the terms of the
debentures, certain amendments or waivers must be approved by the holders of at
least 90% of the outstanding principal amount of the debentures.  By
virtue of its recent acquisition, the one significant investor, and its
affiliates, will have sole authority to approve or not approve any amendment to
the debentures or waiver of a breach or default under the
debentures.  In addition, the one significant investor, and its
affiliates, without regard to the position or desires of other holders, will
have the sole authority to exercise any rights or remedies available to it under
the terms of the debentures that would affect substantial all of our outstanding
debentures.




We
have a limited operating history, have experienced significant expenditures
related to funding our initial product development, and are currently carrying a
net loss. If our business model is not successful, or if we are unable to
generate sufficient revenue to offset our start-up expenditures, we may not
become profitable, and the value of your investment may decline.




We have a
limited operating history from which to evaluate our business and prospects. We
incurred a net loss of $2.8 million for the nine months ended September 30,
2008, $10.6 million for the year ended December 31, 2007 and $3.1 million for
the year ended December 31, 2006. We have an accumulated deficit of $25.4
million at September 30, 2008. Furthermore, we are experiencing the initial
costs and uncertainties of a young operating company, including start-up
expenditures, unforeseen costs and difficulties, complications, and delays, all
of which must be resolved and/or paid without the benefit of a predictable
revenue stream. We cannot be sure that we will be successful in meeting these
challenges and addressing these risks and uncertainties. If we are unable to do
so, our business will not be successful.




The sale of the
shares of our common stock acquired in private placements could cause the price
of our common stock to decline.




In our
June 2008 and August 2008 private placements, in the aggregate, we issued a
total of $28.1 million principal amount of debentures convertible into our
shares of common stock at a current conversion price of $1.25 per share. As of
September 30, 2008, we had warrants outstanding to purchase 12,239,718 shares of
our common stock. In connection with our acquisition of AccessLine, we issued
3,939,565 shares of our common stock at the time of the closing of the
acquisition, an additional 1,128,382 in the aggregate in connection with the
earn out periods ended December 31, 2007 and June 30, 2008, and may issue up to
an additional 1,250,000 shares in connection with the earn out periods ending
December 31, 2008 and June 30, 2009. Generally, the holders of the securities
convertible or exercisable into our common stock will be able to sell the common
stock issued upon conversion or exercise under Rule 144. As such, you should
expect a significant number of such shares of common stock to be sold. Depending
upon market liquidity at the time our common stock is resold by the holders
thereof, such re-sales could cause the trading price of our common stock to
decline. In addition, the sale of a substantial number of shares of our common
stock, or anticipation of such sales, could make it more difficult for us to
sell equity or equity-related securities in the future at a time and at a price
that we might otherwise wish to effect sales.




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We
have significant indebtedness and agreed to certain restrictions as a result of
our recent private placement of debentures.




We
incurred $28.1 million in principal amount of indebtedness as a result of the
issuance of the debentures in our June 2008 and August 2008 private placements,
the principal balance of which is due June 30, 2014. The debentures carry
covenants that impose significant restrictions 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 also carry substantial covenants that
impose significant requirements on us, including, among others, requirements
that:




·
            we
      pay interest and other charges on the
  debentures;


·
            we
      use the proceeds from the sale of the debentures only for permitted
      purposes;


·
            while
      the debentures are outstanding, if we issue equity or equity linked
      securities at a price lower than the conversion price of the debentures,
      then the conversion price of the debentures will be reduced to the same
      price of the equity or equity linked securities so issued;
    and


·
            we
      may not, directly or indirectly, redeem, purchase or otherwise acquire any
      capital stock or set aside any monies for such redemption, purchase or
      other acquisition.




Our
ability to comply with these provisions may be affected by changes in our
business condition or results of our operations, or other events beyond our
control. The breach of any of these covenants could result in a default under
the debentures, permitting the holders thereof to accelerate the maturity of the
debentures and demand repayment in full. Such actions by such holders could
impair our ability to operate or cause us to seek bankruptcy
protection.




Our
failure to repay the debentures could result in substantial penalties against
us, and legal action which could substantially impair our
operations.




Our
outstanding debentures accrue interest at the rate of 12.0% per annum, payable
on the first of each month.  We have the right to pay interest
payments in cash, or upon notice to the holders and compliance with certain
equity conditions, we can pay all or a portion of any such payment in common
stock valued at a price equal to the lesser of the then effective conversion
price (initially $1.25) or 85% of the average of the VWAP per share for our
common stock for the 10 consecutive trading days immediately prior to the
applicable payment date. One of the equity conditions we must meet is having a
daily dollar trading volume for our common stock exceed $300,000 for each of the
20 consecutive trading days before the date in question. We do not currently
meet this equity condition and it may prove difficult for us to meet it in the
future. If we make interest payments in common stock or the holders voluntarily
elect to convert all or a portion of the debentures into common stock, these
actions could result in substantial dilution to our existing stockholders. To
repay the debentures in cash, we will be required to use our limited working
capital or raise additional funds. If we are unable to make payments under
debentures when required, either in cash or in common stock, we would be in
default under those securities, certain consequences of which are discussed
below. 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. Any such action could impose significant costs on us and
require us to curtail or cease operations.




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, or failure to deliver share certificates in a timely manner. In the
event of default, which is not cured within specified grace periods, the holders
of the debentures have the right to accelerate all amounts outstanding under the
debentures and demand payment of a mandatory default amount equal to 130% of the
amount outstanding under the debenture, plus accrued interest and expenses, and
the interest rate accrues at a rate equal to the lesser of 18% per annum or the
maximum rate permitted under applicable law. If we were unable to repay the
mandatory default amount when required, the holders could commence legal action
against us. Any such action could impose significant costs on us and require us
to curtail or cease operations.




If
we pay interest on the debentures in shares of common stock when our stock price
is low, the holders thereof have the ability to negatively affect our stock
price and to create a greater dilution to our stockholders.




Upon
notice to the holders and compliance with certain equity conditions, we can pay
all or a portion of any interest payment on our debentures in common stock
valued at a price equal to the lesser of the then effective conversion price
(initially $1.25) or 85% of the average of the VWAP per share for our common
stock for the 10 consecutive trading days immediately prior to the applicable
payment date. One of the equity conditions we must meet is having a daily dollar
trading volume for our common stock exceed $300,000 for each of the 20
consecutive trading days before the date in question. We do not currently meet
this equity condition and it may prove difficult for us to meet it in the
future. To the extent that we pay interest in common stock during a period when
our common stock price is low (which we have done in the past), such investor
will receive a larger number of shares of our common stock as a result of the
conversion, which such investor could sell at high volumes to drive the VWAP
downward. Downward pressure on the price of our common stock from consecutive
conversions could result in the investors receiving payment on the debentures at
successively lower conversion rates, thereby causing a successively greater
dilution of our stockholders, and causing a downward spiraling affect on the
price of our stock (a so-called "death spiral").




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Our
emergency and E911 calling services differ from those offered by traditional
telephone service providers and may expose us to significant liability in the
VoIP business.




Traditional
telephone service providers route emergency calls over a dedicated
infrastructure directly to an emergency services dispatcher in the caller's
area. Generally, the dispatcher automatically receives the caller's phone number
and location information. Our E911 service, where offered, operates in a similar
manner. However, the only location information that our E911 service can
transmit to an emergency service dispatcher is the information that our
customers have registered with us. A customer's registered location may be
different from the customer's actual location at the time of the call, and the
customer, in those instances, would have to verbally inform the emergency
services dispatcher of his or her actual location at the time of the
call.




We do not
currently offer E911 service in all areas where our customers are located. In
some areas, emergency calls are delivered with the caller's address or callback
number. In some cases calls may be delivered to a call center that is run by a
third-party provider, and the call center operator will coordinate connecting
the caller to the appropriate Public Safety Answering Point or emergency
services provider and providing the customer's service location and phone number
to those local authorities. In late July 2008, the President signed into law the
"New and Emerging Technologies 911 Improvement Act of 2008." The law provides
public safety, interconnected VoIP providers and others involved in handling 911
calls the same liability protections when handling 911 calls from interconnected
VoIP users as from mobile or wired telephone service users. We do not know what
effect this law will have on our call center solution at this time. Also, we may
be exposed to liability for 911 calls made prior to the adoption of this new law
although we are unaware of any such liability.




Delays
our customers encounter when making emergency services calls and any inability
of the answering point to automatically recognize the caller's location or
telephone number can result in life threatening consequences. In addition, if a
customer experiences an Internet or power outage or network failure, the
customer will not be able to reach an emergency services provider using our
services. Customers may attempt to hold us responsible for any loss, damage,
personal injury or death suffered as a result of any failure of our E911
services and, unlike traditional wireline and wireless telephone providers,
there are no state or federal provisions that currently indemnify or limit our
liability for connecting and carrying emergency 911 phone calls over IP
networks.




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




In
November 2008, we issued an aggregate 385,307 shares of our common stock to pay
the monthly interest payment for the June 2008 Debentures.
  In
November 2008, we issued an aggregate of 908,498 shares of our common stock for
the converted principal and interest of our June 2008 Debentures.
  In
October 2008, we issued an aggregate of 750,009 shares of our common stock for
the converted principal and interest of our June 2008 Debentures.
  In
October 2008, we issued an aggregate 332,100 shares of our common stock to pay
the monthly interest payment for the June 2008 Debentures.
  In
September 2008, we issued an aggregate of 228,047 shares of our common stock for
the converted principal and interest and for the monthly interest payment for
our June 2008 Debentures.
  In August
2008, we issued an aggregate 550,382 shares of our common stock to pay the
monthly interest payment for the June 2008 Debentures.
  In August
2008, we issued 529,252 shares of our common stock pursuant to the earn out
provisions of the AccessLine acquisition agreement for the period ending June
30, 2008.
  In August
2008, we issued an aggregate of 250,067 shares of our common stock for the
converted principal and interest of our June 2008 Debentures.
  In August
2008, we issued 60,000 shares of our common stock per the terms of the January
2008 settlement of a claim by a former independent sales representative for
compensation for services rendered.
  In July
2008, we issued an aggregate of 100,021 shares of our common stock for the
converted principal and interest of our June 2008 Debentures.
  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, 2008
            J.
      Paul Quinn, Chief Financial Officer(Duly
      Authorized Officer and Principal Financial
  Officer)








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EXHIBIT INDEX




Exhibit
      No.
            Description4.1
            Form
      of senior secured convertible debenture issued in connection with the
      August 2008 financing (1)4.2
            Form
      of warrant issued in connection with the August 2008 financing
      (1)10.1
            Debenture
      and Warrant Purchase Agreement dated August 13, 2008
(1)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
      200231.2*
            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
      200232.1*
            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 200232.2*
            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(1)
            Incorporated
      by reference to the registrant's Current Report on Form 8-K filed on
      August 14, 2008






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