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, 2010
 
 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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   Yes o     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   No




As of November 9, 2010, 344,659,562 shares of the issuer's common stock, par value $0.0001 per share, were outstanding.  The common stock is the issuer's only class of stock currently outstanding.




Table of Contest





Telanetix, Inc.


Quarterly Report on Form 10-Q


For the Period Ended September 30, 2010




TABLEOF CONTENTS




PageFORWARD LOOKING STATEMENTS
3PART I - FINANCIAL INFORMATIONItem 1.
FINANCIAL STATEMENTS
4Item 2.
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
22Item 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
34Item 4.
CONTROLS AND PROCEDURES
34PART II - OTHER INFORMATIONItem 1.
LEGAL PROCEEDINGS
35Item 1A.
RISK FACTORS
35Item 2.
UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
49Item 3.
DEFAULTS UPON SENIOR SECURITIES
49Item 4.
(REMOVED AND RESERVED)
49Item 5.
OTHER INFORMATION
49Item 6.
EXHIBITS
49SIGNATURES
50EXHIBIT INDEX
51





Table of Contest




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.




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."  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.  Statements in this report that are forward looking statements include statements regarding:




•
expectations concerning our future revenues and operating costs;




•
the timing of any future product launch and expectations concerning customer acceptance or adoption of our products;




•
our ability to successfully obtain a diverse customer base;




•
expected actions by our competitors and the entrance of new competitors;




•
the timing of the introduction of new technologies and their impact on competition;




•
anticipated changes in the regulatory framework in which our industry operates; and




•
anticipated acquisitions, business combinations, strategic partnerships, divestures, and other significant transactions.




The forward-looking statements in this report are based upon management's current expectations and belief, which management believes are reasonable.  However, 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.




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




3
 Table of Contest




PART I - FINANCIAL INFORMATION




Item1.  FINANCIAL STATEMENTS




TELANETIX, INC.


CondensedConsolidated Balance Sheets


September 30, 2010


December 31, 2009(Unaudited)ASSETSCurrent assetsCash

$
2,272,480


$
493,413Accounts receivable, net


1,719,468



1,888,393Inventory


182,819



253,563Prepaid expenses and other current assets


561,885



465,348Total current assets


4,736,652



3,100,717Property and equipment, net


2,967,993



3,733,120Goodwill


7,044,864



7,044,864Purchased intangibles, net


11,728,337



13,378,337Other assets


554,156



870,476Total assets

$
27,032,002


$
28,127,514LIABILITIES AND STOCKHOLDERS' DEFICITCurrent liabilitiesAccounts payable

$
1,498,201


$
1,614,382Accrued liabilities


2,740,516



3,141,315Deferred revenue


1,014,169



897,453Current portion of capital lease obligations


470,660



683,249Current portion of long-term debt


600,000



-Beneficial conversion feature liabilities


-



4,052,071Total current liabilities


6,323,546



10,388,470Non-current liabilitiesAccrued Interest


-



2,477,021Deferred revenue, net of current portion


263,066



264,271Capital lease obligations, net of current portion


215,063



421,782Long-term debt, net of current portion


5,085,063



-Convertible debentures


-



18,518,487Total non-current liabilities


5,563,192



21,681,561Total liabilities


11,886,738



32,070,031Stockholders' equity (deficit)Common stock, $.0001 par value; Authorized: 600,000,000 shares;Issued and outstanding: 344,569,652 and 31,768,320 at September 30, 2010 and December 31, 2009, respectively


34,457



3,177Additional paid in capital


43,519,786



34,848,164Warrants


56,953



1,551,802Accumulated deficit


(28,465,932
)


(40,345,660
)Total stockholders' equity (deficit)


15,145,264



(3,942,517
)Total liabilities and stockholders' equity (deficit)

$
27,032,002


$
28,127,514
 The accompanying notes are an integral part of these condensed consolidated financial statements.




4
 Table of Contest





TELANETIX, INC.


CondensedConsolidated Statements of Operations


(Unaudited)


Three months ended September 30,


Nine months ended September 30,2010


2009


2010


2009Revenues

$
6,873,268


$
7,165,500


$
21,819,576


$
21,094,655Cost of revenues


3,070,391



2,968,096



9,266,342



8,808,963Gross profit


3,802,877



4,197,404



12,553,234



12,285,692Operating expensesSelling and marketing


1,838,702



1,714,966



5,221,806



4,833,687General and administrative


1,957,668



1,935,171



5,810,206



6,059,744Research, development and engineering


636,800



680,937



2,070,512



2,142,398Depreciation


153,152



236,468



443,704



706,737Amortization of purchased intangibles


550,000



550,000



1,650,000



1,650,000Total operating expenses


5,136,322



5,117,542



15,196,228



15,392,566Operating loss


(1,333,445
)


(920,138
)


(2,642,994
)


(3,106,874
)Other income (expense)Interest income


260



67



523



296Interest expense


(895,908
)


(799,688
)


(2,472,069
)


(3,289,653
)Gain/(loss) on debt extinguishment


16,510,854



-



16,510,854



-Change in fair market value of derivative liabilities


-



3,755,578



790,648



224,883Total other income (expense)


15,615,206



2,955,957



14,829,956



(3,064,474
)Income (loss) from continuing operations before taxes


14,281,761



2,035,819



12,186,962



(6,171,348
)Income tax expense


37,500



-



37,500



-Income (loss) from continuing operations


14,244,261



2,035,819



12,149,462



(6,171,348
)Loss from discontinued operations


-



(1,957,412
)


(269,733
)


(3,042,298
)Net income (loss)

$
14,244,261


$
78,407


$
11,879,729


$
(9,213,646
)Net income (loss) per share – basic and dilutedContinuing operations

$
0.05


$
0.06


$
0.10


$
(0.19
)Discontinued operations


-



(0.06
)


-



(0.10
)Net income (loss) per share

$
0.05


$
(0.00
)

$
0.10


$
(0.29
)Weighted average shares outstanding – basic and diluted


287,687,512



31,667,906



117,701,263



31,265,379


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




5
 Table of Contest





TELANETIX, INC.


Condensed Consolidated Statements of Cash Flows


(Unaudited)


Nine months ended September 30,2010


2009Cash flows from operating activities:Net Income (loss)

$
11,879,729


$
(9,213,646
)Adjustments to reconcile net loss to cash provided by operating activities:Provision for doubtful accounts


(111,168
)


(103,257
)Depreciation


1,328,830



1,527,135Gain on debt extinguishment


(16,510,854
)


-Loss from discontinued operations


269,733



3,042,298(Gain) loss on disposal of fixed assets


165,570



2,218Amortization of deferred financing costs


66,823



86,225Amortization of intangible assets


1,650,000



1,650,000Stock based compensation


974,773



825,647Amortization of note discounts


1,888,228



1,575,627Non-cash interest expense


211,403



-Change in fair value of warrant and beneficial conversion feature liabilities


(790,648
)


(224,883
)Changes in assets and liabilities:Accounts receivable


280,093



(26,739
)Inventory


70,744



(135,291
)Prepaid expenses and other assets


(71,862
)


(12,713
)Accounts payable and accrued expenses


(173,442
)


1,107,971Accrued interest


218,930



1,500,592Deferred revenue


115,511



147,515Deferred compensation


-



(90,547
)Net cash provided by operating activities


1,462,393



1,658,152Cash flows from investing activities:Purchase of property and equipment


(586,259
)


(411,218
)Proceeds from disposal of fixed assets


26,503



43,750Net cash used by investing activities


(559,756
)


(367,468
)Cash flows from financing activities:Payments on capital leases


(588,825
)


(797,014
)Proceeds from senior secured financing


10,500,000



-Payments on convertible debenture


(7,500,000
)


-Payments of financing fees


(1,408,510
)


-Net cash used by financing activities


1,002,665



(797,014
)Cash flows from discontinued operations:Net cash used by operating activities of discontinued operations


(126,235
)


(453,108
)Net cash used by investing activities of discontinued operations


-



-Net used by discontinued operations


(126,235
)


(453,108
)Net increase in cash


1,779,067



40,562Cash at beginning of the period


493,413



975,137Cash at end of the period

$
2,272,480


$
1,015,699Supplemental disclosures of cash flow information:Interest paid

$
86,246


$
148,488Non-cash investing and financing activities:Property and equipment acquired through capital leases

$
169,517


$
304,528Common stock issued in connection with acquisitions

$
-


$
86,571Warrants reclassed from debt to equity

$
-


$
1,541,802Bonuses paid in stock

$
490,678


$
-


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




6
 Table of Contest





TELANETIX, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)




1 . Description of Business




Telanetix, Inc. (the "Company") is an IP communications company, offering a range of communications solutions including hosted IP voice and conferencing products and hosted VoIP solutions to the small-and-medium business marketplace through its Bellevue, Washington-based subsidiary, AccessLine Holdings Inc. ("AccessLine").




Prior to October 27, 2009, the Company also had two additional subsidiaries: AVS Installation Limited Liability Company and Union Labor Force One Limited Liability Company (together, "AVS").  AVS provided a full range of audio visual solutions to clients and end-users.  On October 27, 2009, the Company entered into a securities purchase agreement pursuant to which it transferred all of the issued and outstanding membership interests of AVS to an individual purchaser.




In December 2009, the Company's board of directors made a decision to conclude efforts to seek strategic alternatives regarding the operations, assets and intellectual property relating to the Company's Digital Presence videoconferencing product line so that the Company could focus on growing the business of its AccessLine subsidiary which has been experiencing year over year revenue growth.  The Digital Presence product line experienced a dramatic sales decline in 2009 as compared to prior years.  In March 2010, the Company terminated its Digital Presence product line and ceased incurring costs related to its development.




As a result of the sale of AVS, and the termination of the Digital Presence product line, the Company has reflected its video segment as discontinued operations in its 2009 condensed consolidated financial statements.  See Note 3—Discontinued Operations.




On July 2, 2010, the Company closed two transactions that recapitalized its outstanding debt evidenced by debentures and generated approximately $1.5 million of cash that will be used for working capital purposes (the "Recapitalization").  See Note 4—Recapitalization.




2. Basis of Presentation




The accompanying unaudited financial statements, consisting of the condensed consolidated balance sheet as of September 30, 2010, the condensed consolidated statements of operations for the three and nine months ended September 30, 2010 and 2009, and the condensed consolidated statements of cash flows for the nine months ended September 30, 2010 and 2009, have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and in accordance with the instructions to Form 10-Q.  Accordingly, these condensed consolidated financial statements do not include all of the information and footnotes typically found in the audited consolidated financial statements and footnotes thereto included in the Company's Annual Report on Form 10-K.  In the opinion of management, all adjustments (primarily consisting of normal recurring adjustments) considered necessary for a fair statement have been included.




The condensed consolidated balance sheet at December 31, 2009, has been derived from the audited consolidated financial statements as of that date but does not include all of the information and footnotes included in the Company's Annual Report on Form 10-K for the year ended December 31, 2009.  For further information, refer to the consolidated financial statements and footnotes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2009.




7
 Table of Contest




The preparation of the condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities and equity and disclosure of contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Significant estimates include those related to the allowance for doubtful accounts; valuation of inventories; valuation of goodwill, intangible assets and property and equipment; valuation of stock based compensation expense; the valuation of 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, 2010, are not necessarily indicative of the results that may be expected for the full fiscal year ending December 31, 2010.




Liquidity:




The Company's cash balance as of September 30, 2010 was $2.3 million.  At that time, it had accounts receivable of $1.7 million and a working capital deficit of $1.6 million.  However, current liabilities include certain items that will likely settle without future cash payments or otherwise not require significant expenditures by the Company including: deferred revenue of $1.3 million (primarily deferred up front customer activation fees), deferred rent of $0.2 million and accrued vacation of $0.5 million.  The aforementioned items represent $2.0 million of total current liabilities as of September 30, 2010.




As part of the Recapitalization, the Company received approximately $1.5 million of cash.  See Note 4—Recapitalization.




If the Company continues to generate revenue and gross profit consistent with the growth it experienced during the nine months ended September 30, 2010 and during fiscal 2009, and maintains control of its variable operating expenses, it believes that its existing capital, together with anticipated cash flows from operations, will be sufficient to finance its operations through at least September 30, 2011.




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.




Recent Accounting Pronouncements:




In September 2009, the FASB ratified guidance regarding Multiple-Deliverable Revenue Arrangements. When vendor specific objective evidence or third party evidence for deliverables in a multiple-element arrangement cannot be determined, the Company will be required to develop a best estimate of the selling price for separate deliverables and allocate arrangement consideration using the relative selling price method. The guidance is effective for revenue arrangements entered into or materially modified beginning January 1, 2011, with earlier application permitted. The Company is currently evaluating the impact of adoption on its consolidated financial statements.





In January 2010, the FASB issued guidance which requires reporting entities to make new disclosures about recurring or nonrecurring fair-value measurements including significant transfers into and out of Level 1 and Level 2 fair-value measurements and information on purchases, sales, issuances, and settlements on a gross basis in the reconciliation of Level 3 fair-value measurements.  See Note 8—Fair Value Measurement for a discussion regarding Level 1, 2 and 3 fair-value measurements.  The guidance is effective for annual reporting periods beginning after December 15, 2009, except for Level 3 reconciliation disclosures which are effective for annual periods beginning after December 15, 2010.  The adoption of this guidance did not have a material impact on the Company's consolidated financial statements.




8
 Table of Contest




3. Discontinued Operation




In October 2009, the Company transferred all of the issued and outstanding membership interests of AVS to an individual purchaser.  AVS operated the system integration, design, build-out and installation aspects of the Company's video solutions business.  The purchaser was an employee of AVS.  The transfer related solely to the Company's video integration business, and not the Company's Digital Presence video product business.  The Company did not transfer any assets or intellectual property relating to its Digital Presence product line.




The membership interests were transferred for nominal consideration.  In connection with the transfer, all underlying assets and liabilities were retained by AVS.  The Company determined that the total amount of consideration it received represented fair value for the membership interests.  The Company completed the disposition of the membership interests, and consequently the assets used in and liabilities arising from the business operations of AVS, in October 2009.  The Company no longer holds any ownership interest in AVS.




In December 2009, the Company's board of directors made a decision to conclude efforts to seek strategic alternatives regarding the operations, assets and intellectual property relating to the Company's Digital Presence videoconferencing product line so that the Company could focus on growing the business of its AccessLine subsidiary which has been experiencing year over year revenue growth.  The Digital Presence product line experienced a dramatic sales decline in 2009 as compared to prior years.  In March 2010, the Company terminated its Digital Presence product line and ceased incurring costs related to its development.




The Company's offerings were organized along two product categories: Video Solutions and Voice and Network Solutions, which were considered segments for reporting purposes.  The segments were determined in accordance with how management views and evaluates the Company's business.  The Company's Video Solutions segment included both telepresence solutions and other supporting audio-visual applications.  As a result of the sale of AVS on October 27, 2009 and the termination of the Digital Presence product line, the Company has reflected its video segment as discontinued operations in its 2009 consolidated financial statements.




As of December 31, 2009, all of the assets and liabilities related to the Video Solutions segment had been disposed of, written off or collected.




The following table summarizes certain operating data for discontinued operations for the three and nine months ended September 30, 2009:




Three months ended


Nine months endedSeptember 30, 2009


September 30, 2009Revenues

$
929,424


$
3,152,142Cost of revenues


(845,311
)


(2,608,041
)Other expenses


(2,041,525
)


(3,586,399
)Loss from discontinued operations

$
(1,957,412
)

$
(3,042,298
)





During the three and nine months ended September 30, 2010 there was no expense related to the wind down of the Company’s video telepresence product line.


9
 Table of Contest




4. Recapitalization




On July 2, 2010, the Company closed two transactions that recapitalized its outstanding debt evidenced by debentures and generated approximately $1.5 million of cash that it will use for working capital purposes.




Debenture Repurchase




On June 30, 2010, the Company entered into a securities purchase agreement with the holders of its outstanding debentures in the principal amount of $29.6 million. Under the terms of the agreement, the Company repurchased all of its outstanding debentures in exchange for payment of $7.5 million in cash, the holders of the Company's debentures exchanged all outstanding warrants they held for shares of the Company's common stock and the Company issued to such holders an additional number of shares of common stock, such that the holders collectively beneficially owned approximately 16.6 million shares of common stock immediately following the completion of the transactions contemplated by the agreement. The Company paid the $7.5 million from the proceeds of its senior secured note private placement described below.




After giving effect to the transactions contemplated by the debenture repurchase described above and the transactions contemplated by the senior secured note private placement described below, the Company currently has $10.5 million of senior secured notes outstanding and all of its previously issued debentures, which had a principal amount of $29.6 million, were cancelled.  Upon completion of the rights offering described below, the Company expects that $3 million of the $10.5 million of principal amount of senior secured notes will be either redeemed or exchanged for shares of the Company's common stock, which would leave the Company with approximately $7.5 million of senior secured notes outstanding.




Senior Secured Note Private Placement




On June 30, 2010, the Company entered into a securities purchase agreement (the "Hale Securities Purchase Agreement") with affiliates of Hale Capital Management, LP (collectively, "Hale"), pursuant to which in exchange for $10.5 million, the Company agreed to issue to Hale $10.5 million of senior secured notes (the "2010 notes"), and 287,501,703 unregistered shares of its common stock.  A summary of the material terms of the 2010 notes is set forth in Note 5—2010 Notes, below.




Under the terms of the Hale Securities Purchase Agreement, the Company agreed to conduct a rights offering.  In connection with the rights offering, depending on the amount of capital it raises, the Company and Hale agreed that the Company would either redeem up to $3.0 million of principal of the 2010 notes or that Hale would exchange up to $3.0 million of principal of the 2010 notes for shares of the Company's common stock.  See "Rights Offering," below.




The Company agreed to a number of provisions in the Hale Securities Purchase Agreement that protect Hale's investment, including:




Most Favored Nation.  For so long as the 2010 notes are outstanding and until Hale ceases to own at least 10% of the Company's outstanding common stock, if the Company (i) issues debt on terms that are more favorable than the terms of the 2010 notes, or (ii) issues common stock, preferred stock, equivalents or any other equity security on terms more favorable than those set out in the Hale Securities Purchase Agreement, then the terms of the 2010 notes and/or the Hale Securities Purchase Agreement shall automatically be amended such that Hale receives the benefit of the more favorable terms.




Right of First Refusal.  For so long as the 2010 notes are outstanding and until Hale ceases to own at least ten percent of the Company's outstanding common stock, Hale shall have a right of first refusal on any subsequent placement that the Company makes of common stock or common stock equivalents or any securities convertible into or exchangeable or exercisable for shares of its common stock.




10
 Table of Contest




Fundamental Transactions.  For so long as the 2010 notes are outstanding and thereafter for as long as any of the Hale purchasers continue to own at least 20% of the common stock that they purchased under the Hale Securities Purchase Agreement, the Company cannot effect a transaction in which it consolidates or merges with another entity, conveys all or substantially all of its assets, permit another person or group to acquire more than 50% of its voting stock, or reorganize or reclassify its common stock without the consent of a majority in interest of the Hale purchasers.  Additionally, the Company cannot effect such a transaction without obtaining the foregoing requisite consent if such transaction would trigger the most favored nation provision in the Hale Securities Purchase Agreement described above or if such transaction would otherwise involve the issuance of any equity securities or the incurrence of debt at a price that is less than the price paid in connection with the transaction consummated pursuant under the Hale Securities Purchase Agreement.




Post Closing Adjustment Shares.  If at any time prior to July 2, 2012, the Company is required to make payment on certain identified contingent liabilities up to an aggregate amount of $769,539, then it will issue additional shares of common stock to Hale, such that the total percentage ownership of its fully diluted common stock immediately after the payment of such liabilities will equal the same percentage ownership that Hale would have had if the contingent payable had been paid prior to the closing under the Hale Securities Purchase Agreement.




Registration Rights Agreement




In connection with the Hale Securities Purchase Agreement, the Company entered into a registration rights agreement with Hale pursuant to which the Company agreed to file a registration statement with the SEC for the resale of the shares issued and issuable to Hale under the Hale Securities Purchase Agreement.  The Company filed the registration statement with the SEC on September 30, 2010. The registration rights agreement contains penalty provisions in the event that the Company fails to secure the effectiveness of the registration statement by November 29, 2010, fails to file other registration statements the Company is required to file under the terms of the registration rights agreement in a timely manner or if the Company fails to maintain the effectiveness of any registration statement it is required to file under the terms of the registration rights agreement until the shares issued to Hale are sold or can be sold under Rule 144 without restriction or limitation (including volume restrictions) and without the requirement that the Company be in compliance with Rule 144(c)(1).  In the event of any such failure, and in addition to other remedies available to Hale, the Company agreed to pay Hale as liquidated damages an amount equal to 1% of the purchase price for the shares to be registered in such registration statement. Such payments are due on the date we fail to comply with our obligation and every 30th day thereafter (pro rated for periods totaling less than 30 days) until such failure is cured.




Impact of Debenture Repurchase and Senior Secured Note Private Placement




In connection with the Hale Securities Purchase Agreement, on July 2, 2010, the Company received gross proceeds of $10.5 million.  The Company incurred, or expects to incur, expenses of approximately $1.5 million in connection with the transactions contemplated by the Hale Securities Purchase Agreement, resulting in net proceeds of approximately $9.0 million.  The Company used $7.5 million of these proceeds to repurchase its outstanding debentures and will use the remaining $1.5 million for working capital purposes, including advertising and distribution programs for its Digital Phone Service products.




Merriman Curhan Ford acted as the Company's financial advisor in the transaction and was paid a fee of $682,500 in connection with the transaction.  The Company also issued to Merriman Curhan Ford warrants to purchase 2,336,431 shares of its common stock.  The warrants are exercisable at $0.03852 per share for a period of 5 years.




Stock Award Agreements




As a condition to the completion of the transactions contemplated by the Hale Securities Purchase Agreement, on July 2, 2010, the Company entered into stock award agreements with its employees who had earned compensation under its senior management incentive plans that had yet to be paid.  The stock award agreements were entered into to eliminate all accrued and unpaid incentive compensation owed to those employees.  Under the terms of the stock award agreements, each employee received 30% of his or her accrued incentive compensation in cash, which amounts are being withheld to pay applicable withholding taxes, and the balance in unregistered shares of the Company's common stock, calculated on the basis of one share being issued for every $0.03852 of incentive compensation owed.  In the aggregate, the Company paid $147,230 in cash and issued 8,918,421 shares of its common stock to employees in cancellation of $490,768 of earned and unpaid incentive compensation.




11
 Table of Contest




Rights Offering




Under the terms of the Hale Securities Purchase Agreement, the Company agreed to conduct a rights offering pursuant to which the Company would distribute at no charge to holders of its common stock non-transferable subscription rights to purchase up to an aggregate of 77,881,027 shares of common stock at a subscription price of $0.0385202935 per share. Under the terms of the 2010 notes, the Company agreed to use the gross proceeds of the rights offering to redeem an aggregate of up to $3 million of principal amount of such notes. To the extent the gross proceeds of the rights offering are less than $3 million, the Company and Hale agreed that Hale would exchange the principal amount to be redeemed (up to $3 million) for shares of the Company's common stock at an exchange price equal to the subscription price of the subscription rights.  The Company paid Hale an aggregate of $60,000 in consideration of the foregoing. In addition, the Company agreed to pay Hale upon completion of the rights offering an amount of cash equal to the accrued and unpaid interest in respect of the principal amount of the senior secured notes redeemed or exchanged for shares of common stock in connection with the rights offering




Tax Impact of the Recapitalization




During the quarter ended September 30, 2010, the Company recorded a one-time tax gain related to the Recapitalization.  The provision relates to state income taxes resulting from the tax gain on debt restructure.  For Federal purposes, we expect the net operating loss carryforwards to fully offset the debt restructure gain, resulting in no tax expense for Federal income tax purposes.  Excluding the debt restructure gain, we continue to incur losses from operations.  Accordingly, we expect to continue to record a full valuation allowance against our remaining net deferred tax assets until we sustain an appropriate level of taxable income through improved operations.   In October 2010, the State of California revised its laws to suspend the use of net operating loss carryovers for the 2010 and 2011 tax years.  The estimated impact of this law change will result in a California state income tax expense of approximately $225,000.  The impact of this state tax expense will be recorded in the fourth quarter of 2010.


5. The 2010 Notes




In connection with the Recapitalization, on July 2, 2010, the Company issued $10.5 million in principal amount of 2010 notes.  The following summarizes the terms of the 2010 notes:




Term.  The 2010 notes are due and payable on July 2, 2014.




Interest.  Interest accrues at a rate equal to the prime rate as published in The Wall Street Journal as of the first business day of each interest period plus 4.75% per annum and is payable at the end of each month, with the first payment due on July 31, 2010.  Through June 30, 2011, the Company has the option to defer the monthly interest payments otherwise due and have the amount of interest deferred added to the principal balance of the 2010 notes.




Principal Payment.  In July 2011 and continuing for the 11 months thereafter, principal payments of $200,000 per month are due on the last day of each month.  Thereafter, the Company is required to pay principal in a monthly amount equal to the sum of (a) $316,667 and (b) the quotient determined by dividing the (i) aggregate amount of interest added to the principal amount by (ii) 24.  Any remaining principal amount, if not paid earlier, is due and payable on July 2, 2014.




Early Redemption.  As discussed in more detail below under the heading entitled, "Rights Offering," the Company has the right to redeem up to $3 million of the 2010 notes prior to maturity.  See "Rights Offering," below.


No Conversion Rights.  The 2010 notes are not convertible other than in connection with the rights offering.  See "Rights Offering," below.


12
 Table of Contest




Security.  The 2010 notes are secured by all of the Company's assets under the terms of a pledge and security agreement that the Company and its subsidiaries entered into with Hale.  Each of the Company's subsidiaries also entered into guarantees in favor of Hale, pursuant to which each subsidiary guaranteed the complete payment and performance by the Company of its obligations under the 2010 notes and related agreements.




Covenants.  The 2010 notes impose certain covenants on the Company, including: restrictions against incurring additional indebtedness, creating any liens on our property, entering into a change in control transaction, redeeming or paying dividends on shares of its outstanding common stock, entering into certain related party transactions, changing the nature of its business, making or investing in a joint venture, disposing of any of its assets outside of the ordinary course of business, effecting any subsequent offering of debt or equity, amending its articles of incorporation or bylaws, limiting its ability to enter into lease arrangements.




Events of Default.  The 2010 notes define certain events of default, including: failure to make a payment obligation under the 2010 notes, failure to pay other indebtedness when due if the amount exceeds $250,000, bankruptcy, entry of a judgment against the Company in excess of $250,000 which are not discharged or covered by insurance,  failure to observe other covenants of the 2010 notes or related agreements (subject to applicable cure periods), breach of representation or warranty, failure of Hale's security documents to be binding and enforceable, and casualty loss of any of the Company's assets that would have a material adverse effect on its business, and failure to meet 80% of quarterly financial targets from its annual operating budget, including cash, revenues and EBITDA.  In the event of default, additional default interest of 4% will accrue on the outstanding balance.  In addition, in the event of default, the Company may be required to redeem all or any portion of the 2010 notes at a price equal to 125% of the sum of the principal amount that such holder requests that it redeems plus accrued but unpaid interest on such principal amount plus any accrued and unpaid late charges with respect to such principal and interest.




Change of Control.  The Company is required to obtain the consent of the holders of the 2010 notes representing at least a majority of the aggregate principal amount of the 2010 notes then outstanding in order to enter into a change of control transaction.  If such consent is obtained, the holders of the 2010 notes may require the Company to redeem all or any portion of such notes at a price equal to 125% of the sum of the principal amount that such holder requests that it redeems plus accrued but unpaid interest on such principal amount plus any accrued and unpaid late charges with respect to such principal and interest.




Rights Offering




Under the terms of the Hale Securities Purchase Agreement, we agreed to conduct a rights offering pursuant to which we would distribute at no charge to holders of our common stock non-transferable subscription rights to purchase up to an aggregate of 77,881,027 shares of our common stock at a subscription price of $0.0385202935 per share. Under the terms of the 2010 notes, we agreed to use the gross proceeds of the rights offering to redeem an aggregate of up to $3 million of principal amount of such notes. To the extent the gross proceeds of the rights offering are less than $3 million, we and Hale agreed that Hale would exchange the principal amount to be redeemed (up to $3 million) for shares of our common stock at an exchange price equal to the subscription price of the subscription rights.  We paid Hale an aggregate of $60,000 in consideration of the foregoing. In addition, we agreed to pay Hale upon completion of the rights offering an amount of cash equal to the accrued and unpaid interest in respect of the principal amount of the senior secured notes redeemed or exchanged for shares of common stock in connection with the rights offering.  The discount on the 2010 Notes resulted in a potential beneficial conversion feature on the portion of the notes subject to the rights offering.  The amount of beneficial conversion feature will depend solely on the proceeds from the rights offering and, as a result, could result in a one-time charge to interest expense of $0 to approximately $1.0 million upon completion of the offering.




The following table summarizes information relative to the 2010 Notes at September 30, 2010:




September 30, 2010Face value of debt

$
10,500,000Plus: accreted interest


211,403Less: unamortized debt discounts


(5,026,340
)2010 Notes, net of discounts


5,685,063Less current portion


(600,000
)2010 Notes, long term portion

$
5,085,063




The value assigned to the debt and related discount and equity associated with issuance of the Recapitalization were calculated by an independent valuation using relative fair values.




13
 Table of Contest




6. Convertible Debentures




In May 2009, pursuant to the terms of an Amendment Agreement dated May 8, 2009 (the "Amendment Agreement"), the Company restructured the terms of the then-outstanding debentures it issued in June 2008, August 2008 and December 2008 and all of the Company's then-outstanding warrants issued in December 2006, February 2007, August 2007, March 2008, August 2008 and December 2008.  In connection with the Recapitalization which occurred on July 2, 2010, the Company repurchased all of the debentures that were subject of the Amendment Agreement and all of the Company's warrants that were subject of the Amendment Agreement were cancelled. See "Debenture Repurchase," below.




The following summarizes the terms of the debentures, as amended, as in effect prior to the repurchase thereof in connection with the Recapitalization:




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




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




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




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




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




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




Forced Conversion.  Subject to compliance with certain equity conditions, the Company had the right to force conversion if the volume weighted average price for its common stock exceeded 200% of the then effective conversion price for 20 trading days out of a consecutive 30 trading day period.  Any forced conversion was subject to the Company meeting certain equity conditions and was 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.




14
 Table of Contest




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




Under the terms of the Amendment Agreement, the Company also agreed to add certain covenants to the debentures, including a requirement to maintain at least $300,000 in cash at all times while the debentures were outstanding, to sustain a level of gross revenue each quarter equal to at least 80% of the average gross revenue for the trailing two quarters, and commencing with the period ended June 30, 2009, to maintain a positive adjusted EBITDA in each rolling two quarter period.  For example, ending June 30, 2010, the sum of the three-month adjusted EBITDA of the three months ended March 31, 2010 and the three months ended June 30, 2010 must be at least $0.00 or greater.  Adjusted EBITDA is calculated by taking the Company's net income for the applicable period, and adding to that amount the sum of the following:  (i) any provision for (or less any benefit from) income taxes, plus (ii) any deduction for interest expense, net of interest income, plus (iii) depreciation and amortization expense, plus (iv) non-cash expenses (such as stock-based compensation and warrant compensation), plus (v) expenses related to changes in fair market value of warrant and beneficial conversion features, plus (vi) expenses related to impairment of tangible and intangible assets.  The Company was in compliance with all covenants at June 30, 2010, the final quarter-end before the debentures were repurchased and cancelled in connection with the Recapitalization.




Security.  The debentures were secured by all of the Company's assets.  Each of the Company's subsidiaries also entered into guarantees, pursuant to which each subsidiary guaranteed the complete payment and performance by the Company of its obligations under the debentures and related agreements.




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




As discussed above under the caption "interest", when originally issued, interest accrued at the rate of 12.0% per annum and was payable monthly, commencing on August 1, 2008.  In December 2008, the parties agreed to amend the interest payment provisions to eliminate monthly interest payments and to provide that interest was payable quarterly at the rate of (i) 0% per annum from October 1, 2008 until September 30, 2009, (ii) 13.5% per annum from October 1, 2009 until September 30, 2012 and (iii) 18% per annum from October 1, 2012 until maturity.  In May 2009, the parties again agreed to amend the interest payment provisions to reduce the interest rate to 0% through June 30, 2011 and then to 5% per annum thereafter.  The Company has recorded interest expense for the three months ended September 30, 2010, at the effective interest rate of the debentures during that period.




All of the Company's debentures were repurchased and cancelled as of July 2, 2010, and the beneficial conversion feature derivative liability was eliminated.




15
 Table of Contest




The following table summarizes information relative to the outstanding debentures at September 30, 2010 and December 31, 2009:




September 30, 2010


December 31, 2009Convertible debentures

$
-


$
29,649,300Less unamortized discounts:Original issue discount


-



(4,190,903
)Detachable warrants discount


-



(2,100,996
)Beneficial conversion feature discount


-



(4,838,914
)Convertible debentures, net of discounts


-



18,518,487Less current portion


-



-Convertible debentures, long term portion

$
-


$
18,518,487





For each reporting period that these convertible debentures were outstanding, the Company assessed the value of our convertible debentures which were accounted for as derivative financial instruments indexed to and potentially settled in its own stock.




At December 31, 2009, the Company determined that the beneficial conversion feature in the 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 could be adjusted if the Company subsequently issued common stock at a lower price and it was deemed possible the Company could have to net cash settle the contract if there were not enough authorized shares to issue upon conversion.




The convertible debentures contain embedded derivative features, which are accounted for at fair value as a compound embedded derivative at December 31, 2009 and through June 30, 2010.  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 December 31, 2009, the Company recorded beneficial conversion liabilities of $4.1 million.  For the three months ended September 30, 2009, the Company recognized other income of $3.8 million related to the change in fair market value of the beneficial conversion liabilities.  For the nine months ended September 30, 2010 and 2009, the Company recognized other income of $0.8 million and other expense of $1.2 million, respectively, related to the change in fair market value of the beneficial conversion liabilities.




7. Warrants and Warrant Liabilities




In connection with its various financings through December 2008, the Company issued warrants to purchase shares of common stock in conjunction with the sale of its convertible debentures.  The Company issued such warrants in December 2006, February 2007, August 2007, March 2008, August 2008 and December 2008.  In May 2009, the Company restructured the terms of the then-outstanding debentures and all of the Company's then-outstanding warrants issued in connection with the debentures pursuant to the terms of the Amendment Agreement.  In connection with the Recapitalization, the Company repurchased all of its then-outstanding debentures and cancelled substantially all of its then-outstanding warrants. See Note 6—Convertible Debentures.




16
 Table of Contest




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




The fair value of the warrants was estimated at their various issuance dates and revalued at May 8, 2009, using the Monte Carlo model discussed in Note 6—Convertible Debentures.  Effective with the reclassification of the warrants to equity on May 8, 2009, the Company no longer reports a warrant liability and no longer recognizes other income or expense related to the warrants.  During the three and nine months ended September 30, 2009, the Company recognized other expense of $0.0 million and $1.0 million, respectively, related to the change in fair market value of the warrants.




On July 2, 2010, in connection with the Recapitalization, the Company eliminated all of the warrants it issued in connection with debentures and none of those warrants were outstanding as of September 30, 2010.  See Note 6—Convertible Debentures.




At September 30, 2010 and December 31, 2009, 2,749,556 and 12,695,718 shares, respectively, were subject to outstanding warrants at a weighted average exercise price of $0.30 and $0.45, respectively.  The following table summarizes information about warrants outstanding at September 30, 2010.




Exercise Prices

Number of Shares Subject to Outstanding Warrants and Exercisable

Weighted Average Remaining Contractual Life (years)$
0.03852

2,336,431

2.26$
1.25

105,000

2.67$
1.73

200,000

2.49$
1.92

78,125

2.49$
4.00

30,000

2.382,749,556





8. Fair Value Measurements




Fair value is defined as an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.  As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability.  As a basis for considering such assumptions, the authoritative guidance establishes a three-tier value hierarchy, which prioritizes the inputs used in measuring fair value as follows:  (Level 1) observable inputs such as quoted prices in active markets; (Level 2) inputs other than the quoted prices in active markets that are observable either directly or indirectly; and (Level 3) unobservable inputs in which there is little or no market data, which require us to develop our own assumptions.  This hierarchy requires companies to use observable market data, when available, and to minimize the use of unobservable inputs when determining fair value.  The Company measures certain financial assets and liabilities at fair value including the 2010 Securities Purchase Agreement.




Certain financial instruments are carried at cost on the consolidated balance sheets, which approximates fair value due to their short-term, highly liquid nature.  These instruments include cash and cash equivalents, accounts receivable, accounts payable and accrued expenses, other short-term liabilities, and capital lease obligations.




17
 Table of Contest




On July 2, 2010, in connection with the Recapitalization, the Company repurchased all of its then-outstanding debentures and converted all of its then-outstanding warrants that were issued in connection with such debentures. As a result, the Company eliminated the beneficial conversion feature derivative liability. Prior to the Recapitalization the Company recorded a liability related beneficial conversion feature, which was revalued at fair value at the end of each quarter with the gain or loss being recognized in the consolidated statement of operations. See Note 6—Convertible Debentures.




The following table provides a reconciliation of the beginning and ending balances of the beneficial conversion feature derivative liability as of September 30, 2010:




Beginning balance January 1, 2010

$
4,052,071Change in fair market value of derivative liabilities


(790,648
)Elimination due to Recapitalization


(3,261,423
)Ending balance September 30, 2010

$
-




9. Business Risks and Credit Concentration




The Company's cash is maintained with a limited number of commercial banks, and are invested in the form of demand deposit accounts.  Deposits in these institutions may exceed the amount of FDIC insurance provided on such deposits.




The Company markets its products to resellers and end-users primarily in the United States.  Management performs ongoing credit evaluations of the Company's customers and maintains an allowance for potential credit losses.  There can be no assurance that the Company's credit loss experience will remain at or near historic levels.  One customer accounted for 12% of gross accounts receivable at September 30, 2010.  At December 31, 2009, one customer accounted for 11% of gross accounts receivable.




During the three and nine months ended September 30, 2010, no customer accounted for revenues of 10% or more.  However during the three and nine months ended September 30, 2009, one customer accounted for 11% and 12%, respectively of the Company's revenue.




During the first quarter of 2010, the Company received notice from two of its customers that they would be terminating service during the course of 2010.  This service is an older product offering that had been in place with these customers for several years.  The Company had known for some time that the customers would move away from the service eventually and the revenue generated by these customers had been declining over recent years.  Revenue received from these customers accounted for approximately 2% and 9% of revenue during the three and nine months ended September 30, 2010, respectively, as compared to 16% and 18% of revenue during the three and nine months ended September 30, 2009, respectively.




10. Commitments and Contingencies




Leases




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




18
 Table of Contest




Minimum Third Party Network Service Provider Commitments




The Company has a contract with a third party network service provider that facilitates interconnects with a number of third party network service providers.  The contract contains a minimum usage guarantee of $0.2 million per monthly billing cycle and expires in July 2011.  The cancellation terms are a 90 day written notice prior to the extended term expiring.




Litigation




From time to time and in the course of business, the Company 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 management, there are no legal claims currently pending or threatened against the Company that would be likely to have a material adverse effect on its financial position, results of operations or cash flows.




11. Stock Based Compensation




Equity Incentive Plans




The Company maintains two equity incentive plans: the 2005 Equity Incentive Plan (the "2005 Plan") and the 2010 Stock Incentive Plan (the "2010 Plan").




The 2005 Plan, which was approved by the Company's stockholders 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.  On December 11, 2008, the Board of Directors approved an amendment to the 2005 Plan to increase the number of shares of common stock available for grant to 15.5 million shares.




Option awards are generally granted with an exercise price that equals the market price of the Company's stock at the date of grant; these option awards generally vest based on 3 years of continuous service and have 10-year contractual terms.




The 2010 Plan, which was approved by the Company's stockholders in July 2010, permits the Company to grant options to purchase, and other stock-based awards covering, in the aggregate up to 89,189,859 shares of the Company's common stock to the Company's employees, directors or consultants.    As of September 30, 2010, no awards have been granted under the 2010 Plan.





A summary of option activity under the 2005 Plan as of September 30, 2010, and changes during the nine months then ended is presented below:




Shares


Weighted-Average Exercise PriceOutstanding at December 31, 2009


10,873,043


$
0.19Granted


-



-Exercised


-



-Forfeited or expired


(721,973
)


0.24Outstanding at September 30, 2010


10,151,070


$
0.19





19
 Table of Contest




The options outstanding and currently exercisable by exercise price at September 30, 2010 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$
0.06 to 0.10

9,411,111

7.30

$
0.07

8,578,937

7.16

$
0.07$
0.11 to 2.55

564,959

8.85

$
1.10

553,234

8.87

$
1.30$
3.50 to 3.50

175,000

7.75

$
3.50

175,000

7.75

$
3.5010,151,070

7.39

$
0.19

9,307,171

7.28

$
0.20





As of September 30, 2010 and December 31, 2009, 9,307,171 and 5,416,533 outstanding options were exercisable at an aggregate average exercise price of $0.20 and $0.43, respectively.  The aggregate intrinsic value of stock options outstanding and stock options exercisable at September 30, 2010 was less than $0.1 million.




As of September 30, 2010, total compensation cost related to nonvested stock options not yet recognized was $0.2 million, which is expected to be recognized over the next 1.37 years on a weighted-average basis.




Valuation and Expense Information




The Company measures and recognizes 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 for the three months ended September 30, 2010 and 2009, and its allocation within the Condensed Consolidated Statements of Operations:




Three months ended September 30,


Nine months ended September 30,2010


2009


2010


2009Selling and marketing

$
148,458


$
31,246


$
210,950


$
93,741General and administrative


407,964



68,948



548,032



207,346Research and development


127,189



43,391



215,791



134,911Stock based compensation included in continuing operations


683,611



143,585



974,773



435,998Stock based compensation in discontinued operations


-



125,447



143,498



389,649Total stock-based compensation expense related to employee equity awards

$
683,611


$
269,032


$
1,118,271


$
825,647




20
 Table of Contest




Valuation Assumptions:




The Company uses the Black Scholes option pricing model in determining its option expense.  The fair value of each option is estimated on the date of grant using the Black Scholes option pricing model and is recognized as expense using the straight-line method over the requisite service period.  There were no options granted during either of the nine months ended September 30, 2010 and September 30, 2009, respectively.


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 estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.




12. Computation of Net Loss Per Share




Basic net loss per share is based upon the weighted average number of common shares 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 common shares 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, 2010 and 2009, which were excluded from the net loss per share calculation because their effect is anti-dilutive.




September 30,2010


2009Convertible Debentures


-



98,831,000Stock Options


10,151,070



9,922,543Warrants


2,749,556



12,695,718Total


12,900,626



121,449,261




21
 Table of Contest




Item2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS




The following discussion of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and the related notes and other financial information appearing elsewhere in this report.  Readers are also urged to carefully review and consider the various disclosures made by us which attempt to advise interested parties of the factors which affect our business, including without limitation, the disclosures made under "Item 1A. Risk Factors" included in Part II of this report and in our audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2009, 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 products and services.  Our subsidiary, AccessLine, offers the following hosted VoIP services: Digital Phone Service, SIP Trunking Service and individual phone services.




Digital Phone Service replaces a customer's existing telephone lines with a VoIP alternative.  It is sold as a complete solution where we bundle our software applications and hosted network services with business-class phone equipment which is manufactured by third parties.  The service is designed to be easy to install, set-up and use, and at a lower cost than traditional phone service. This service is targeted at small businesses looking for a fully integrated solution that does not require expert assistance to install; the customer has the ability to select the number of phone stations (from 2 to 20), number of phone lines (from 2 to 8) and types of phone numbers.




SIP Trunking Service is for larger businesses that already have their own PBX equipment and is targeted at those businesses with large calling volumes looking for cost effective alternatives to traditional carrier offerings.  SIP Trunking Service does not include user equipment such as business phones.  The service involves routing phone calls over internet data networks to avoid tariffs and reduce expenses for larger enterprises.  This service can support businesses with hundreds of employees




As part of its individual phone service product offerings, AccessLine offers a variety 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.




Our revenues principally consist of: monthly recurring charges, activation, and usage fees from communication solutions, which include mobility solutions, PBX enhancements, single number solutions and unified messaging, voice messaging, paging, and bundled solutions of phone equipment and service.




We differentiate our VoIP services on the basis of the quality of our service, the comprehensiveness of our solutions and the quality of our customer support.  Our engineers have refined our network infrastructure and our software to provide robust, scalable, and reliable solutions.  Our engineers have written substantially all of the software used in our network and applications.  As a result, we have greater visibility into the software, a greater understanding of its function, and believe that we can respond more quickly in the development of new features and functions or to customize an application to meet customer demand.  This level of understanding has allowed us to simplify the user experience for our customers, such as our Digital Phone System which can be self-installed by the customer.  Our network architecture is designed to provide redundancy, with multiple failover layers, and scalability.  Finally, we have also written tools that augment and enhance our customer support functions, providing greater access to information and accelerating our call response rates.




22
 Table of Contest




Recent Developments




Our overriding objective is to grow revenue while achieving operating profitability and generating cash from operations.




We experienced growth in revenue and gross profit for both the nine months ended September 30, 2010 and fiscal 2009.  We increased revenue through, in part, more efficiency in our advertising and also through our success in selling our SIP Trunking Service through direct and agent channels.  Our Digital Phone Service continues to grow month over month.




On July 2, 2010, we closed two transactions that recapitalized our outstanding debt and generated approximately $1.5 million of cash that we will use for working capital purposes.  These transactions resulted in the cancellation of $29.6 million of debentures due June 30, 2014 in exchange for the issuance of $10.5 million of senior secured notes due July 2, 2014 and approximately 300 million shares of common stock.  Upon completion of the rights offering described below, we expect that $3.0 million of the $10.5 million of principal amount of senior secured notes will be either redeemed or exchanged for an additional 77,881,027 shares of our common stock, which would leave us with approximately $7.5 million of senior secured notes outstanding. See "Recent Financings" below.  The recapitalization substantially reduced our future interest expense to be more in line with the scale of our business.  Moreover, except for the rights offering (which is at a fixed price) the senior secured notes are not convertible into shares of our common stock.




Prior to October 27, 2009, we had two additional subsidiaries: AVS Installation Limited Liability Company and Union Labor Force One Limited Liability Company (together, "AVS").  AVS provided a full range of audio visual solutions to clients and end-users.  On October 27, 2009, we entered into a securities purchase agreement pursuant to which we transferred all of the issued and outstanding membership interests of AVS to an individual purchaser.




In December 2009, our board of directors made a decision to conclude efforts to seek strategic alternatives regarding the operations, assets and intellectual property relating to our Digital Presence product line so that we could focus on growing the business of our AccessLine subsidiary which has been experiencing year over year revenue growth.  The Digital Presence product line experienced a dramatic sales decline in 2009 as compared to prior years.  In March 2010, we terminated our Digital Presence product line and ceased incurring costs related to its development.




As a result of the sale of AVS, and the termination of the Digital Presence product line, we have reflected the results of their operations as discontinued operations in our condensed consolidated financial statements.




Outlook




Over the past two years we have introduced unique new product offerings such as our Digital Phone Service.  We have also worked aggressively to cut expenses and have significantly reduced our net loss.  2009 was a year of mixed results.  We experienced strong initial traction with our Digital Phone Services.  We also experienced strong growth in our SIP trunking business.  The results of our video segment were disappointing.  In addition, subsequent to the end of the year, we received notice from two of our significant customers that they would be terminating our Legacy service during the course of 2010.  These two customers made up 16% of our revenues in the third quarter of 2009 compared to 2% of revenues in the third quarter of 2010.  The Legacy revenue decay rate has flattened out in the third quarter of 2010 and we do not expect further significant declines in our Legacy revenues.  During 2010 our focus has been on driving our core business of next generation VOIP services.  Our network infrastructure is scalable and capable of supporting significant additional services, without substantial capital expenditure.  As we generate additional revenues, we can distribute the fixed costs elements of our business over a greater revenue base, and increase gross profit.  The recent financing transactions provided working capital to support additional marketing for our new products.  The repurchase of our outstanding debentures also substantially reduced our future cash interest expense and eliminated dilutive conversion rights.




23
 Table of Contest




Over the course of the third quarter 2010, we reduced headcount, or did not replace headcount, amounting to approximately 15 employees.  As a result, starting in the fourth quarter we will see lower operating expenses, totaling about $212,000 per quarter.  In addition, we have taken cost savings measures we expect will improve our gross margins in the coming quarters closer to the high 50% range as in quarters prior to the third quarter 2010.




If we can continue to generate revenue and gross profit in our Digital Phone Service and SIP Trunking Service products consistent with our growth in 2009 and we maintain control of our operating expenses, we believe that our existing capital, taking into account the effect of the two transactions that recapitalized our debt described below, will be sufficient to finance our operations through at least the next 12 months.  However, the uncertainties related to the global economic slowdown and the disruption in the financial markets has impacted our visibility on our business outlook.  Weakening economic conditions may result in decreased demand for our products.  In addition, we have limited financial resources.  Significant unforeseen decreases in revenues or increases in operating costs could impact our ability to fund our operations.  We do not currently have any sources of credit available to us.  See "Liquidity and Capital Resources" below.




Recent Financings




Debenture Repurchase




On June 30, 2010, we entered into a securities purchase agreement with the holders of our outstanding debentures in the principal amount of $29.6 million. Under the terms of the agreement, we repurchased all of our outstanding debentures in exchange for payment of $7.5 million in cash, the holders of our debentures exchanged all outstanding warrants they held for shares of our common stock and we issued to such holders an additional number of shares of our common stock, such that the holders collectively beneficially owned approximately 16.6 million shares of our common stock immediately following the completion of the transactions contemplated by the agreement. We paid the $7.5 million from the proceeds of our senior secured note private placement described below.




After giving effect to the transactions contemplated by the debenture repurchase described above and the transactions contemplated by the senior secured note private placement described below, we currently have $10.5 million of senior secured notes outstanding and all of our previously issued debentures, which had a principal amount of $29.6 million, were cancelled.  Upon completion of the rights offering described below, we expect that $3 million of the $10.5 million of principal amount of senior secured notes will be either redeemed or exchanged for shares of our common stock, which would leave us with approximately $7.5 million of senior secured notes outstanding.




Senior Secured Note Private Placement




On June 30, 2010, we entered into a securities purchase agreement, which we refer to as the "Hale Securities Purchase Agreement" in this report, with affiliates of Hale Capital Management, LP, whom we refer to collectively as "Hale" in this report, pursuant to which in exchange for $10.5 million, we issued to Hale $10.5 million of senior secured notes, which we refer to as the "2010 notes" in this report, and 287,501,703 unregistered shares of our common stock. For a summary of the material terms of the 2010 notes, see "Commitments and Contingencies" below.




We agreed to a number of provisions in the Hale Securities Purchase Agreement that protect Hale's investment, including:




Most Favored Nation.  For so long as the 2010 notes are outstanding and until Hale ceases to own ten percent of our outstanding common stock, if we (i) issue debt on terms that are more favorable than the terms of the 2010 notes, or (ii) issue common stock, preferred stock, equivalents or any other equity security on terms more favorable than those set out in the Hale Securities Purchase Agreement, then the terms of the 2010 notes and/or the Hale Securities Purchase Agreement shall automatically be amended such that Hale receives the benefit of the more favorable terms.




24
 Table of Contest




Right of First Refusal.  For so long as the 2010 notes are outstanding and until Hale ceases to own ten percent of our outstanding common stock, Hale shall have a right of first refusal on any subsequent placement that we make of common stock or common stock equivalents or any securities convertible into or exchangeable or exercisable for shares of our common stock.




Fundamental Transactions.  For so long as the 2010 notes are outstanding and thereafter for as long as any of the Hale purchasers continue to own 20% of the common stock that they purchased under the Hale Securities Purchase Agreement, we cannot effect a transaction in which we consolidate or merge with another entity, convey all or substantially all of our assets, permit another person or group to acquire more than 50% of our voting stock, or reorganize or reclassify our common stock without the consent of a majority in interest of the Hale purchasers. Additionally, we cannot effect such a transaction without obtaining the foregoing requisite consent if such transaction would trigger the most favored nation provision in the Hale Securities Purchase Agreement described above or if such transaction would otherwise involve the issuance of any equity securities or the incurrence of debt at a price that is less than the price paid in connection with the transaction consummated pursuant under the Hale Securities Purchase Agreement.




Post Closing Adjustment Shares.  If at any time prior to July 2, 2012, we are required to make payment on certain identified contingent liabilities up to an aggregate amount of $769,539, then we will issue additional shares of common stock to Hale, such that the total percentage ownership of our fully diluted common stock immediately after the payment of such liabilities will equal the same percentage ownership that Hale would have had if the contingent payable had been paid prior to the closing under the Hale Securities Purchase Agreement.




Registration Rights Agreement




In connection with the Hale Securities Purchase Agreement, we entered into a registration rights agreement with Hale pursuant to which we have agreed to file a registration statement with the SEC for the resale of the shares issued and issuable to Hale under the Hale Securities Purchase Agreement.  We filed that registration statement on September 30, 2010. The registration rights agreement contains penalty provisions in the event that we fail to secure the effectiveness of that registration statement by November 29, 2010, fail to file other registration statements we are required to file under the terms of the registration rights agreement in a timely manner or if we fail to maintain the effectiveness of any registration statement we are required to file under the terms of the registration rights agreement until the shares issued to Hale are sold or can be sold under Rule 144 without restriction or limitation (including volume restrictions) and without the requirement that our company be in compliance with Rule 144(c)(1).  In the event of any such failure, and in addition to other remedies available to Hale, we agreed to pay Hale as liquidated damages an amount equal to 1% of the purchase price for the shares to be registered in such registration statement. Such payments are due on the date we fail to comply with our obligation and every 30th day thereafter (pro rated for periods totaling less than 30 days) until such failure is cured.




Impact of Debenture Repurchase and Senior Secured Note Private Placement




In connection with the Hale Securities Purchase Agreement we received gross proceeds of $10.5 million.  We incurred, or expect to incur, expenses of approximately $1.5 million in connection with the transactions contemplated by the Hale Securities Purchase Agreement, resulting in net proceeds of approximately $9.0 million.  We used $7.5 million of these proceeds to repurchase our outstanding debentures.  We will use the remaining $1.5 million for working capital purposes, including advertising and distribution programs for our Digital Phone Service products.




Merriman Curhan Ford acted as our financial advisor in the transaction and we paid them a fee of $682,500 in connection with the transaction.  We also issued to Merriman Curhan Ford warrants to purchase 2,336,431 shares of our common stock.  The warrants are exercisable at $0.03852 per share for a period of 5 years.




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 Table of Contest




Stock Award Agreements




As a condition to the completion of the transactions contemplated by the Hale Securities Purchase Agreement, on July 2, 2010, we entered into stock award agreements with our employees who had earned compensation under our senior management incentive plans that had yet to be paid.  The stock award agreements were entered into to eliminate all accrued and unpaid incentive compensation owed to those employees.  Under the terms of the stock award agreements, each employee received 30% of his or her accrued incentive compensation in cash, which amounts are being withheld to pay applicable withholding taxes, and the balance in unregistered shares of our common stock, calculated on the basis of one share being issued for every $0.03852 of incentive compensation owed.  In the aggregate, we paid $147,230 in cash and we issued 8,918,421 shares of our common stock to employees in cancellation of $490,768 of earned and unpaid incentive compensation.




Rights Offering




Under the terms of the Hale Securities Purchase Agreement, we agreed to conduct a rights offering pursuant to which we would distribute at no charge to holders of our common stock non-transferable subscription rights to purchase up to an aggregate of 77,881,027 shares of our common stock at a subscription price of $0.0385202935 per share. Under the terms of the 2010 notes, we agreed to use the gross proceeds of the rights offering to redeem an aggregate of up to $3 million of principal amount of such notes. To the extent the gross proceeds of the rights offering are less than $3 million, we and Hale agreed that Hale would exchange the principal amount to be redeemed (up to $3 million) for shares of our common stock at an exchange price equal to the subscription price of the subscription rights.  We paid Hale an aggregate of $60,000 in consideration of the foregoing. In addition, we agreed to pay Hale upon completion of the rights offering an amount of cash equal to the accrued and unpaid interest in respect of the principal amount of the senior secured notes redeemed or exchanged for shares of common stock in connection with the rights offering. The discount on the 2010 Notes resulted in a potential beneficial conversion feature on the portion of the notes subject to the rights offering.  The amount of beneficial conversion feature will depend solely on the proceeds from the rights offering and, as a result, could result in a one-time charge to interest expense of $0 to approximately $1.0 million upon completion of the offering.




Results of Operations




Three and Nine Months Ended September 30, 2010 Compared to Three and Nine Months Ended September 30, 2009




Revenues, Cost of Revenues and Gross Profit




Increase2010

2009

Dollars

PercentThree Months Ended September 30:Revenues

$
6,873,268



7,165,500


$
(292,232)



(4.1%
)Cost of revenues


3,070,391



2,968,096



102,295



3.4%Gross profit


3,802,877



4,197,404



(394,527
)


(9.4%
)Gross profit percentage


55.3%



58.6%Nine Months Ended September 30:Revenues

$
21,819,576


$
21,094,655


$
724,921



3.4%Cost of revenues


9,266,342



8,808,963



457,379



5.2%Gross profit


12,553,234



12,285,692



267,542



2.2%Gross profit percentage


57.5%



58.2%




26
 Table of Contest




Net revenues for the three months ended September 30, 2010 were $6.9 million, a decrease of $0.3 million, or 4.1%, over the same period in 2009.  Net revenues for the nine months ended September 30, 2010 were $21.2 million, an increase of $0.7 million, or 3.4%, over the same period in 2009.  The decrease in the three months ended September 30, 2010 revenue is directly related to the reduction in revenue from two significant customers who are terminating their Legacy service.  The increase in the nine months ended September 30, 2010 revenue is due to strong growth in our Digital Phone Service products and to increased success in selling SIP Trunking Service through direct and agent channels.  We expect revenue growth in Digital Phone Service and SIP Trunking Service to continue to be strong throughout 2010.




The increase in these revenues was partially offset by a decline in our Legacy revenue.  During the first quarter of 2010, we received notice from two of our significant Legacy customers that they would be terminating our service during the course of 2010.  This service is an older product offering, that had been in place with these customers for several years.  We had known for some time that the customers would move away from the service eventually and the revenue generated by these customers had been declining over recent years.  Revenue received from these customers accounted for approximately 2% and 9% of revenue during the three and nine months ended September 30, 2010, respectively, as compared to 16% and 18% of revenue during the three and nine months ended September 30, 2009, respectively.
 
 Cost of revenues for the three months ended September 30, 2010 were $3.1 million, an increase of $0.1 million, or 3.4%, over the same period in 2009.  Cost of revenues for the nine months ended September 30, 2010 were $9.3 million, an increase of $0.5 million, or 5.2%, over the same period in 2009.  Cost of revenues increased as a result of the increased revenues, partially offset by a shift in product mix from our higher margin legacy products to our Digital Phone Service and SIP Trunking Service product lines and several cost saving measures that we began implementing during 2009.
 
 Gross profit for the three months ended September 30, 2010 was $3.8 million, a decrease of $0.4 million, or 9.4%, over the same period in 2009.  Gross profit percentage was 55.3% for the three months ended September 30, 2010 as compared to 58.6% in the same period in 2009.  Gross profit for the nine months ended September 30, 2010 was $12.6 million, an increase of $0.3 million, or 2.2%, over the same period in 2009.  Gross profit percentage was 57.5% for the nine months ended September 30, 2010 as compared to 58.2% in the same period in 2009.
 
 The decrease in gross profit percentage for the three months ended September 30, 2010 as compared to the prior year is due to the shift in revenue to our Digital Phone Service and SIP Trunking Service product lines, both of which have somewhat lower margins than our individual services and legacy products (see net revenue discussion above).  The shift in revenue occurred primarily in the third quarter, which is reflected in the fact that the gross profit percentage for the nine months ended September 30, 2010 is 0.7% points lower than the same period in 2009.  We expect gross profit to be in the mid to high 50 percent range throughout 2010.
 
 Selling and Marketing Expenses
 
 Selling and marketing expenses for the three months ended September 30, 2010 were $1.8 million, an increase of $0.1 million or 7.2%, over the same period in 2009.  Selling and marketing expenses for the nine months ended September 30, 2010 were $5.2 million, an increase of $0.4 million or 8.0%, over the same period in 2009.  The increase in both periods was primarily due to an increase in advertising, sales commission, and higher stock compensation expense.  We anticipate that selling and marketing expenses for 2010 will be higher than those incurred in 2009 as we increase our advertising expense in our effort to increase market share and to promote our Digital Phone Service product line.
 
 General and Administrative Expenses
 
 General and administrative expenses were $1.9 million for both the three months ended September 30, 2010 and September 30, 2009.  General and administrative expenses for the nine months ended September 30, 2010 were $5.8 million, a decrease of $0.2 million or 4.1%, over the same period in 2009.  The decrease in the nine months ending September 30, 2010 is primarily a result of lower bad debt expense as a result of improved internal processes around our collection efforts, lower personnel costs, lower outside service fees, offset by write-off of two fixed assets and higher stock compensation expense.


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 Table of Contest




Research, Development and Engineering Expenses




Research, development and engineering expenses were $0.6 million for both the three months ended September 30, 2010 and September 30, 2009.  Research, development and engineering expenses were $2.1 million for both the three months ended September 30, 2010 and September 30, 2009.




Depreciation Expense




Depreciation expense for the three months ended September 30, 2010 was $0.1 million, a decrease of $0.1 million or 35.2%, over the same period in 2009.  Depreciation expense for the nine months ended September 30, 2010 was $0.4 million, a decrease of $0.3 million or 37.2%, over the same period in 2009.  The decrease is primarily attributable to assets becoming fully depreciated in the latter half of 2009, partially offset by additions to fixed assets during the preceding twelve months.




Amortization of Purchased Intangibles




We recorded amortization expense of $0.6 million for both the three months, and $1.7 million for both the nine months, ended September 30, 2010 and 2009, related to the amortization of intangible assets acquired in the AccessLine acquisition.




Interest Expense




Interest expense for the three months ended September 30, 2010 was $0.9 million, a increase of $0.1 million or 12.5%, from the same period in 2009.  Interest expense for the nine months ended September 30, 2010 was $2.5 million, a decrease of $0.8 million or 24.2%, from the same period in 2009.




Interest expense includes stated interest, amortization of note discounts, amortization of deferred financing costs, and interest on capital leases.  Interest expense decreased in 2010 primarily as a result of the restructure of our convertible debentures as discussed below under the caption "Convertible debentures." Following the December 2008 amendment, interest was payable quarterly at the rate of (i) 0% per annum from October 1, 2008 until September 30, 2009, (ii) 13.5% per annum from October 1, 2009 until September 30, 2012 and (iii) 18% per annum from October 1, 2012 until maturity.  In May 2009, the parties agreed to amend the interest payment provisions to reduce the interest rate to 0% through September 30, 2011 and then to 5% per annum thereafter.  We recorded interest expense for the three and nine months ended September 30, 2010 and 2009, at the effective interest rate of the convertible debentures during the respective periods.




On June 30, 2010, we entered into a securities purchase agreement with the holders of our outstanding debentures in the principal amount of $29.6 million. Under the terms of the agreement, we repurchased all of our outstanding debentures in exchange for payment of $7.5 million in cash, the holders of our debentures exchanged all outstanding warrants they held for shares of our common stock and we issued to such holders an additional number of shares of our common stock, such that the holders collectively beneficially owned approximately 16.6 million shares of our common stock immediately following the completion of the transactions contemplated by the agreement.




In connection with the securities purchase agreement interest accrues at a rate equal to the prime rate as published in The Wall Street Journal as of the first business day of each interest period plus 4.75% per annum and is payable at the end of each month, with the first payment due on July 31, 2010.  Through June 30, 2011, the Company has the option to defer the monthly interest payments otherwise due and have the amount of interest deferred added to the principal balance of the 2010 notes.




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 Table of Contest




Change in Fair Value of Warrant and Beneficial Conversion Liabilities




We initially recorded the fair value of the warrants issued in connection with our various financings at the issuance dates as a warrant liability because the exercise price of the warrants could be adjusted if we subsequently issued common stock at a lower price and it was 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 each reporting date.  However, as a result of the Amendment Agreement (see "Convertible Debentures", below), the price-based anti-dilution protection feature of these warrants was removed, which eliminates the potential for future price-based dilution from these warrants.  Accordingly, these warrants are no longer a derivative liability and their value as of May 8, 2009, was reclassed to equity. Accordingly, the change in fair value of warrants during the nine months ended September 30, 2009 resulted in non-operating expense $1.0 million.




In connection with the Recapitalization, on July 2, 2010, all of the Company’s convertible debentures were repurchased and the related conversion feature was eliminated.  At each reporting period that these convertible debentures were outstanding, the Company assessed the value of these convertible debentures that were accounted for as a derivative financial instrument indexed to and potentially settled in the Company’s stock.  At December 31, 2001 and through June 30, 2010, the Company determined that the beneficial conversion feature in the 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 share could be adjusted if the Company subsequently issued common stock at a lower price and it was deemed possible the Company could have to net cash settle the contract if there were not enough authorized shares to issue upon conversion.
  The 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.




In connection with the Recapitalization, on July 2, 2010, all of the Company’s convertible debentures were repurchased and the related conversion feature was eliminated.  Accordingly at September 30, 2010 there is no beneficial conversion feature liability and there is no income or expense related to fair market value changes for the three months ended September 30, 2010.  At December 31, 2009, the Company recorded beneficial conversion liabilities of $4.1 million.  For the three months ended September 30, 2009, the Company recognized other income of $3.8 million related to the change in fair market value of the beneficial conversion liabilities.  For the nine months ended September 30, 2010 and 2009, the Company recognized other income of $0.8 and $1.2 million, respectively related to the change in fair market value of the beneficial conversion liabilities.




Discontinued Operations




As a result of the sale of AVS in October 2009, and the termination of the Digital Presence product line (see "Recent Developments" above), we have reported our video segment results as discontinued operations in both 2010 and 2009.  The $0.3 million of expenses incurred during the nine months ended September 30, 2010, relate to the wind down of our Digital Presence product line.  The $1.9 million and $3.0 million of expense incurred during the three and nine months ended September 30, 2009, respectively, primarily related to operating losses incurred by AVS during that period.




Provision for Income Taxes


Provision for income taxes for the quarter ended September 30, 2010 and 2009 was an expense of $37,500 and $0, respectively.  During the quarter ended September 30, 2010, the company incurred a one-time tax gain related to the Recapitalization.  The provision relates to state income taxes resulting from the tax gain on debt restructure.  For Federal purposes, we expect the net operating loss carryforwards to fully offset the debt restructure gain, resulting in no tax expense for Federal income tax purposes.  Excluding the debt restructure gain, we continue to incur losses from operations.  Accordingly, we expect to continue to record a full valuation allowance against our remaining net deferred tax assets until we sustain an appropriate level of taxable income through improved operations.   In October 2010, the State of California revised its laws to suspend the use of net operating loss carryovers for the 2010 and 2011 tax years.  The estimated impact of this law change will result in a California state income tax expense of approximately $225,000.  The impact of this state tax expense will be recorded in the fourth quarter of 2010.


29
 Table of Contest




Liquidity and Capital Resources




Our cash balance as of September 30, 2010 was $2.3 million.  At that time, we had accounts receivable of $1.7 million and a working capital deficit of $1.6 million.  However, current liabilities include certain items that will likely settle without future cash payments or otherwise not require significant expenditures by the Company including: deferred revenue of $1.3 million (primarily deferred up front customer activation fees), deferred rent of $0.2 million and accrued vacation of $0.5 million.  The aforementioned items represent $2.0 million of total current liabilities as of September 30, 2010.




Cash generated by continuing operations during the nine months ended September 30, 2010 was $1.5 million.  This was primarily the result of income generated from operations of $11.9 million and non-cash charges including: amortization of note discounts of $1.9 million; amortization of intangible assets of $1.7 million; depreciation expense of $1.3 million (which includes depreciation expense of $0.9 million in cost of sales); and stock compensation expense of $1.0 million. This was offset by the gain on the recapitalization of $16.5 million.  The remaining $0.2 million of cash was generated by the change in working capital..




Net cash used by investing activities during the nine months ended September 30, 2010 was $0.6 million, which consisted primarily of purchases of property and equipment.




Net cash generated by financing activities was $1.0 million during the nine months ended September 30, 2010, $10.5 million was related to proceeds from the 2010 Notes, $7.5 million went to pay down the then outstanding convertible debentures, $1.4 was related to payments of financing fees, and $0.6 million was used for payments on our capital leases. As discussed in "—Recent Financings," above, on July 2, 2010, we received gross proceeds of $10.5 million in exchange for the issuance of the 2010 notes and shares of our common stock.  We incurred, or expect to incur, expenses of approximately $1.5 million in connection with that transaction, resulting in net proceeds of approximately $9.5 million.  We used $7.5 million of such proceeds to repurchase our outstanding debentures in the principal amount of $29.6 million.  We will use the remaining $1.5 million for working capital purposes, including advertising and distribution programs for our Digital Phone Service products.  Upon completion of the rights offering, we expect that $3.0 million of the $10.5 million of principal amount of 2010 notes will be either redeemed or exchanged for shares of our common stock, which would leave us with approximately $7.5 million of principal amount of indebtedness under the 2010 notes.


Over the course of the third quarter 2010, we reduced headcount, or did not replace headcount, amounting to approximately 15 employees.  As a result, starting in the fourth quarter, we will see lower operating expenses, totaling about $212,000 per quarter.  In addition, we have taken cost savings measures we expect will improve our gross margin in coming quarters closer to the high 50% range as in quarter prior to the third quarter 2010.




The Legacy revenue decay has flattened out in the third quarter 2010 and we do not expect further significant declines in our Legacy revenues.




If we can continue to generate non-Legacy revenue and gross profit in our Digital Phone Service and SIP Trunking Service products consistent with our growth in 2009, and we maintain control of our variable operating expenses, we believe that our existing capital, together with anticipated cash flows from operations, will be sufficient to finance our operations through at least September 30, 2011.




We do not currently have any unused credit arrangement or open credit facility available to us.  The 2010 notes are secured by a lien on all of our assets, and the terms of those notes restrict our ability to borrow funds, pledge our assets as security for any borrowing or raise additional capital by selling shares of capital stock or other equity or debt securities, without the consent of the holders of the 2010 notes.




Commitments and Contingencies




Leases




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




30
 Table of Contest




At September 30, 2010, future minimum rental payments required under non-cancelable operating and capital leases are as follows for the years ending December 31:




Operating Leases


Capital Leases2010

$
340,670


$
174,0872011


1,413,246



437,8862012


1,321,702



102,8602013


252,920



18,242Total minimum lease payments

$
3,258,538



733,075Less amount representing interest






(47,352
)Present value of minimum lease payments






685,723Less current portion






(470,660
)$
215,063





The 2010 Notes




In connection with the Recapitalization, on July 2, 2010, the Company issued $10.5 million in principal amount of 2010 notes.  The following summarizes the terms of the 2010 notes:




Term.  The 2010 notes are due and payable on July 2, 2014.




Interest.  Interest accrues at a rate equal to the prime rate as published in The Wall Street Journal as of the first business day of each interest period plus 4.75% per annum and is payable at the end of each month, with the first payment due on July 31, 2010.  Through June 30, 2011, we have the option to defer the monthly interest payments otherwise due and have the amount of interest deferred added to the principal balance of the 2010 notes.




Principal Payment.  In July 2011 and continuing for the 11 months thereafter, principal payments of $200,000 per month are due on the last day of each month.  Thereafter, we are required to pay principal in a monthly amount equal to the sum of (a) $316,667 and (b) the quotient determined by dividing the (i) aggregate amount of interest added to the principal amount by (ii) 24.  Any remaining principal amount, if not paid earlier, is due and payable on July 2, 2014.




Early Redemption.  We have the right to redeem up to $3 million of the 2010 notes prior to maturity in connection with the rights offering.




No Conversion Rights.  The 2010 notes are not convertible other than in connection with the rights offering.




Security.  The 2010 notes are secured by all of our assets under the terms of a pledge and security agreement that we and our subsidiaries entered into with Hale.  Each of our subsidiaries also entered into guarantees in favor of Hale, pursuant to which each subsidiary guaranteed the complete payment and performance by us of our obligations under the 2010 notes and related agreements.




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 Table of Contest




Covenants.  The 2010 notes impose certain covenants on us, including: restrictions against incurring additional indebtedness, creating any liens on our property, entering into a change in control transaction, redeeming or paying dividends on shares of our outstanding common stock, entering into certain related party transactions, changing the nature of our business, making or investing in a joint venture, disposing of any of our assets outside of the ordinary course of business, effecting any subsequent offering of debt or equity, amending our articles of incorporation or bylaws, limiting our ability to enter into lease arrangements.




Events of Default.  The 2010 notes define certain events of default, including: failure to make a payment obligation under the 2010 notes, failure to pay other indebtedness when due if the amount exceeds $250,000, bankruptcy, entry of a judgment against us in excess of $250,000 which are not discharged or covered by insurance,  failure to observe other covenants of the 2010 notes or related agreements (subject to applicable cure periods), breach of representation or warranty, failure of Hale's security documents to be binding and enforceable, and casualty loss of any of our assets that would have a material adverse effect on our business, and failure to meet 80% of quarterly financial targets from our annual operating budget, including cash, revenues and EBITDA.  In the event of default, additional default interest of 4% will accrue on the outstanding balance.  In addition, in the event of default, we may be required to redeem all or any portion of the 2010 notes at a price equal to 125% of the sum of the principal amount that such holder requests that we redeem plus accrued but unpaid interest on such principal amount plus any accrued and unpaid late charges with respect to such principal and interest.




Change of Control.  We are required to obtain the consent of the holders of the 2010 notes representing at least a majority of the aggregate principal amount of the 2010 notes then outstanding in order to enter into a change of control transaction. If such consent is obtained, the holders of the 2010 notes may require us to redeem all or any portion of such notes at a price equal to 125% of the sum of the principal amount that such holder requests that we redeem plus accrued but unpaid interest on such principal amount plus any accrued and unpaid late charges with respect to such principal and interest.




Minimum Third Party Network Service Provider Commitments




We have a contract with a third party network service provider that facilitates interconnectivity with a number of third party network service providers. The contract contains a minimum usage guarantee of $0.2 million per monthly billing cycle and expires in July 2011. The cancellation terms are a 90 day written notice prior to the then current term expiring.




Critical Accounting Policies Involving Management Estimates and Assumptions




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




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




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 Table of Contest





Goodwill




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




Impairment of Long-Lived Assets




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




Revenue Recognition




Revenues from continuing operations 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




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




Derivative Financial Instruments




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




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




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 Table of Contest




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 non-operating income or expense.  When the convertible debt or equity instruments contain embedded derivative instruments that are to be bifurcated and accounted for as liabilities, the total proceeds allocated to the convertible host instruments are first allocated to the fair value of all the bifurcated derivative instruments.  The remaining proceeds, if any, are then allocated to the convertible instruments themselves, usually resulting in those instruments being recorded at a discount from their face amount.




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




Stock Based Compensation




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




Recent Accounting Pronouncements




See "Note 2 - Basis of Presentation" of the Notes to the 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.




Item3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK




Under the rules and regulations of the Securities and Exchange Commission, as a smaller reporting company we are not required to provide the information required by this Item..




Item4.  CONTROLS AND PROCEDURES




Evaluation of Disclosure Controls and Procedures




Our disclosure controls and procedures are designed to provide reasonable assurances that material information related to our company is recorded, processed, summarized and reported within the time periods specified in the SEC rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.  Our Chief Executive Officer and Chief Financial Officer have determined that as of September 30, 2010, our disclosure controls were effective at that "reasonable assurance" level.




Changes In Internal Controls over Financial Reporting.




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




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 Table of Contest








PART II  - OTHER INFORMATION




Item1.  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.




Item1A.  RISK FACTORS




Investing in our common stock involves risk.  Before making an investment in our common stock, you should carefully consider the risks described below, together with the other information included in this prospectus, and the risks we have highlighted in other sections of this prospectus.  The risks described below are those which we believe are the material risks we face.  Any of the risks described below could significantly and adversely affect our business, prospects, financial condition and results of operations.  As a result, the trading price of our common stock could decline and you may lose part or all of your investment.  Additional risks and uncertainties not presently known to us or not currently believed by us to be material may also impact us.  The risks discussed below include forward-looking statements, and our actual results may differ substantially from those discussed in these forward-looking statements.




Risks Related To Our Financial Condition




The impact of the current economic climate and tight financing markets may impact consumer demand for our products and services.




Many of our existing and target customers are in the small and medium business sector.  Although we believe our products and services are less costly than traditional telephone services, these businesses are more likely to be significantly affected by economic downturns than larger, more established businesses.  Additionally, these customers often have limited discretionary funds, which they may choose to spend on items other than our products and services.  If small and medium businesses experience economic hardship, it could negatively affect the overall demand for our products and services, could cause delay and lengthen sales cycles and could cause our revenue to decline.




Although we maintain allowances for returns and doubtful accounts for estimated losses resulting from product returns and the inability of our customers to make required payments, and such losses have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience the same return and bad debt rates that we have in the past, especially given the current economic conditions.




We have experienced significant losses to date and may require additional capital to fund our operations.  The current financial climate may make it more difficult to secure financing, if we need it.  If our business model is not successful, or if we are unable to generate sufficient revenue to offset our expenditures, we may not become profitable, and the value of your investment may decline.




We incurred a net loss of $8.1 million for the year ended December 31, 2009, and $9.7 million for the year ended December 31, 2008.  We have an accumulated deficit of $28.5 million at September 30, 2010.  Furthermore, we are experiencing the costs and uncertainties of a young operating company, including unforeseen costs and difficulties.  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.




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 Table of Contest




We believe our cash balance, together with anticipated cash flows from operations, is sufficient to fund our operations for at least the next 12 months.  However, if we are unable to generate sufficient revenues to pay our expenses, we will need to raise additional funds to continue our operations.  We have historically financed our operations through private equity and debt financings.  Recent economic turmoil and severe lack of liquidity in the debt capital markets together with volatility and rapidly falling prices in the equity capital markets have severely and adversely affected capital raising opportunities.  In addition, the terms of the 2010 notes restrict our ability to borrow funds, pledge our assets as security for any borrowing or raise additional capital by selling shares of capital stock or other equity or debt securities, without the consent of the holders of the 2010 notes.  We do not have any commitments for financing at this time, and financing may not be available to us on favorable terms, if at all.  If we are unable to obtain debt or equity financing in amounts sufficient to fund our operations, if necessary, we will be forced to suspend or curtail our operations.




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 recently completed private placements, in the aggregate, we issued a total of 312,801,332 shares of our common stock.  We are required to file one or more registration statements covering the resale of the shares of common stock sold to Hale in our recent private placement transaction.  If and when such registration statements are declared effective, the holders of those shares will be able to sell. In addition, generally, the holders of the shares of our common stock acquired in private placements will be able to sell such shares in accordance with Rule 144 adopted under the Securities Act of 1933.  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.




We have significant indebtedness and agreed to certain restrictions on our operations.




We currently owe, in the aggregate, $10.5 million in principal on the 2010 notes.  The 2010 notes, all of which are held by one investor and its affiliates, contain covenants that impose significant restrictions on us, including restrictions on our ability to issue debt or equity securities, 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.




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 2010 notes, permitting the holder to accelerate the maturity of the 2010 notes and demand repayment in full, which could impair our ability to operate our business or cause us to seek bankruptcy protection.




All of the 2010 notes are held by one investor and its affiliates, and that investor will be able to control any waivers or amendments to the terms of the 2010 notes and exercise rights and remedies with respect to the 2010 notes.




One investor and its affiliates holds all of the 2010 notes.  Under the terms of the purchase agreement entered into in connection with the 2010 notes, certain amendments or waivers must be approved by the holders of a majority of the outstanding principal amount of the 2010 notes.  Consequently, one investor and its affiliates, will have sole authority to approve or not approve any amendment or waiver.  In addition, the one investor and its affiliates will have the sole authority to exercise any rights or remedies available to it under the terms of the 2010 notes.




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 Table of Contest




Our failure to repay the 2010 notes could result in substantial penalties against us, and legal action which could substantially impair our operations.




The 2010 notes accrue interest at a rate equal to the prime rate plus 4.75% per annum and is payable at the end of each month, with the first payment due on July 31, 2010.  Through June 30, 2011, we have the option to defer the monthly interest payments otherwise due and have the amount of interest deferred added to the principal balance.  It will be an event of default under the 2010 notes if we are unable to make payments thereunder when and as required.  Other events of default under the 2010 notes include: failure to pay other indebtedness when due if the amount exceeds $250,000, bankruptcy, entry of a judgment against us in excess of $250,000 which is not discharged or covered by insurance, failure to observe other covenants of the 2010 notes or related agreements (subject to applicable cure periods), breach of representation or warranty, failure of security documents entered into in connection with the issuance of the 2010 notes to be binding and enforceable, and casualty loss of any of our assets that would have a material adverse effect on our business, and failure to meet 80% of quarterly financial targets from our annual operating budget, including cash, revenues and earnings before interest, taxes, depreciation and amortization, or EBITDA.  In the event of default, additional default interest of 4% will accrue on the outstanding balance of the 2010 notes.  In addition, in the event of default, we may be required to redeem all or any portion of the 2010 notes at a price equal to 125% of the sum of the principal amount that such holder requests that we redeem plus accrued but unpaid interest on such principal amount plus any accrued and unpaid late charges with respect to such principal and interest.  If we were unable to repay the default amount when and as 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.




Our failure to secure registration of the common stock and to maintain such registration could result in monetary damages.




Under the terms of the registration rights agreements we entered into in connection with our 2010 note private placement, we agreed to file registration statements covering the resale of the shares of common stock we sold in such private placement by specified deadlines, to have such registration statements declared effective by specified deadlines, and to maintain the effectiveness of such registration statements to permit the resale of all of the shares of common stock we agreed to register for resale.  The registration rights agreement contains penalty provisions in the event that we fail to comply with the foregoing. For example, if we did not file the registration statement that we filed on September 30, 2010 by September 30, 2010, or if such registration statement is not declared effective by November 29, 2010, or if we fail to file other registration statements we are required to file under the terms of the registration rights agreement in a timely manner or if we fail to maintain the effectiveness of any registration statement we file under the registration rights agreement until the shares issued in our 2010 note private placement are sold or can be sold under Rule 144 without restriction or limitation (including volume restrictions) and without the requirement that our company be in compliance with Rule 144(c)(1), then, as partial relief for the damages to any holder of registrable securities by reason of any such delay in or reduction of its ability to sell the shares of common stock, and in addition to any other remedies available to such holder, we agreed to pay liquidated damages in an amount of 1% of the aggregate purchase price of such holder's registrable securities included in such registration statement that are then owned by such holder. Such payments are due on the date we fail to comply with our obligation and every 30th day thereafter (pro rated for periods totaling less than 30 days) until such failure is cured.




Our ability to use our net operating loss carryforwards may be limited.




As of December 31, 2009, we had net operating loss carryforwards of approximately $46 million, some of which, if not utilized, will begin expiring in 2010.  Our ability to utilize the net operating loss carryforwards is dependent upon generating taxable income.  We have recorded a corresponding valuation allowance to offset the deferred tax assets as it is more likely than not that the deferred tax assets will not be realized.  Section 382 of the U.S. Internal Revenue Code of 1986, as amended, generally imposes an annual limitation on the amount of net operating loss carryforwards that may be used to offset taxable income when a corporation has undergone significant changes in stock ownership.  For tax purposes, we have not yet determined whether our recently completed private placement in which we issued the 2010 notes and shares of common stock will result in any  limitations on our ability to use our net operating loss carryforwards.  In addition, it is possible that the rights offering we intend to effect, either on a standalone basis or when combined with past or future transactions (including, but not limited to, significant increases during the applicable testing period in the percentage of our stock owned directly or constructively by (i) any stockholder who owns 5% or more of our stock or (ii) some or all of the group of stockholders who individually own less than 5% of our stock), will cause us to undergo one or more ownership changes.  In that event, our ability to use our net operating loss carryforwards could be adversely affected.  To the extent our use of net operating loss carryforwards is significantly limited under the rules of Section 382 (as a result of this offering or otherwise), our income could be subject to U.S. corporate income tax earlier than it would if we were able to use net operating loss carryforwards, which could result in lower profits.




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 Table of Contest




Risks Related to Our Business




We face competition from much larger and well-established companies.




We face competition from much larger and well-established companies.  In addition, our competition is not only from other independent VoIP providers, but also from traditional telephone companies, wireless companies, cable companies, competitive local exchange carriers and alternative voice communication providers.  Some of our competitors have or may have greater financial resources, production, sales, marketing, engineering and other capabilities with which to develop, manufacture, market and sell their products, and more experience in research and development than we have.  As a result, our competitors may have greater credibility with our existing and potential customers.  Further, because most of our target market is already purchasing communications services from one or more of our competitors, our success is dependent upon our ability to attract customers away from their existing providers.




In addition, other established or new companies may develop or market technologies or products competitive with, or superior to, ours.  We cannot assure you that our competitors will not succeed in developing or marketing technologies or products that are more effective or commercially attractive than ours or that would render our products and services obsolete.  Our success will depend in large part on our ability to maintain a competitive position with our products and services.




Lower than expected market acceptance of our products or services would negatively impact our business.




We continue to develop and introduce new products and our ability to increase revenues is partially dependent on our successful introduction of new products.  End-users will not begin to use our products or services unless they determine that our products and services are reliable, reasonably priced and an effective means of communication.  These and other factors may affect the rate and level of market acceptance of our products and services, including:




•
our price relative to competing products or services or alternative means of communication;




•
effectiveness of our sales and marketing efforts;




•
perception by our targeted end-users of our systems' reliability, efficacy and benefits compared to competing technologies;




•
willingness of our targeted end-users to adopt new technologies; and




•
development of new products and technologies by our competitors.




If our products and services do not achieve market acceptance, our ability to achieve any level of profitability would be harmed and our stock price would decline.




Price competition would negatively impact our business.




Our profitability could be negatively affected as a result of competitive price pressures in the sale of unified communications products, which could cause us to reduce the price of our products or services.  Any such reduction could have an adverse impact on our margins and profitability.  Our competitors may also offer bundled service arrangements offering a more complete product despite the technical merits or advantages of our products.  Moreover, our competitors' financial resources may allow them to offer services at prices below cost or even for free to maintain and gain market share or otherwise improve their competitive positions.  Any of these competitive factors could make it more difficult for us to attract and retain customers, cause us to lower our prices in order to compete resulting in lower gross profit and lower profitability.




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 Table of Contest




We depend on contract manufacturers to manufacture substantially all of our products, and any delay or interruption in manufacturing by these contract manufacturers would result in delayed or reduced shipments to our customers and may harm our business.




We bundle certain of our services with telephone and network hardware that we acquire from third parties.  We do not have long-term purchase agreements with our contract manufacturers and we depend on a concentrated group of contract manufacturers for a substantial portion of manufacturing our products.  There can be no assurance that our contract manufacturers will be able or willing to reliably manufacture our products, in volumes, on a cost-effective basis or in a timely manner.  If we cannot compete effectively for the business of these contract manufacturers, or if any of the contract manufacturers experience financial or other difficulties in their businesses, our revenue and our business could be adversely affected.  In particular, if one of our contract manufacturers decides to cease doing business with us or becomes subject to bankruptcy proceedings, we may not be able to obtain any of our products made by the contract manufacturer, which could be detrimental to our business




We could be liable for breaches of security on our web site, fraudulent activities of our users, or the failure of third-party vendors to deliver credit card transaction processing services.




A fundamental requirement for operating an Internet-based, worldwide voice communications service and electronically billing our customers is the secure transmission of confidential information and media over public networks.  Although we have developed systems and processes that are designed to protect consumer information and prevent fraudulent credit card transactions and other security breaches, failure to mitigate such fraud or breaches may adversely affect our operating results.  The law relating to the liability of providers of online payment services is currently unsettled and states may enact their own rules with which we may not comply.  We rely on third party providers to process and guarantee payments made by our subscribers up to certain limits, and we may be unable to prevent our customers from fraudulently receiving goods and services.  Our liability risk will increase if a larger fraction of our transactions involve fraudulent or disputed credit card transactions.  Any costs we incur as a result of fraudulent or disputed transactions could harm our business.  In addition, the functionality of our current billing system relies on certain third-party vendors delivering services.  If these vendors are unable or unwilling to provide services, we will not be able to charge for our services in a timely or scalable fashion, which could significantly decrease our revenue and have a material adverse effect on our business, financial condition and operating results.




We have historically experienced losses due to subscriber fraud and theft of service and may again in the future.




In the past, subscribers have obtained access to our service without paying for monthly service and international toll calls by unlawfully using our authorization codes or by submitting fraudulent credit card information.  To date, such losses from unauthorized credit card transactions and theft of service have not been significant.  We have implemented anti-fraud procedures in order to control losses relating to these practices, but these procedures may not be adequate to effectively limit all of our exposure in the future from fraud.  If our procedures are not effective, consumer fraud and theft of service could significantly decrease our revenue and have a material adverse effect on our business, financial condition and operating results.




System disruptions could cause delays or interruptions of our service, which could cause us to lose customers or incur additional expenses.




Our success depends on our ability to provide reliable service.  Although we have designed our network service to minimize the possibility of service disruptions or other outages, our service may be disrupted by problems on our system, such as malfunctions in our software or other facilities, overloading of our network and problems with the systems of competitors with which we interconnect, such as physical damage to telephone lines and power surges and outages.  Although we have experienced isolated power disruptions and other outages for short time periods, we have not had system-wide disruptions of a sufficient duration or magnitude that had a significant impact on our customers or our business.  Any significant disruption in our ability to provide reliable service could cause us to lose customers and incur additional expenses.




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 Table of Contest




Business disruptions, including disruptions caused by security breaches, extreme weather, terrorism or other disasters, could harm our future operating results.




The day-to-day operation of our business is highly dependent on the integrity of our communications and information technology systems, and on our ability to protect those systems from damage or interruptions by events beyond our control.  Sabotage, computer viruses or other infiltration by third parties could damage our systems.  Such events could disrupt our service, damage our facilities, damage our reputation, and cause us to lose customers, among other things, and could harm our results of operations.  In addition, a catastrophic event could materially harm our operating results and financial condition.  Catastrophic events could include a terrorist attack on the United States, or major natural disasters, extreme weather, earthquake, fire, or similar event that affects our central offices, corporate headquarters, network operations center or network equipment.  We believe that communications infrastructures, such as the one on which we rely, may be vulnerable in the case of such an event, and our markets, which are metropolitan markets, or Tier 1 markets, may be more likely to be the targets of terrorist activity.




Our future operating results may vary substantially from period to period and may be difficult to predict.




On an annual and a quarterly basis, there are a number of factors that may affect our operating results, many of which are outside our control.  These include, but are not limited to:




•
changes in market demand;


•
customer cancellations;


•
competitive market conditions;


•
new product introductions by us or our competitors;


•
market acceptance of new or existing products;


•
cost and availability of components;


•
timing and level of expenditures associated with new product development activities;


•
mix of our customer base and sales channels;


•
mix of products sold;


•
continued compliance with industry standards and regulatory requirements; and


•
general economic conditions.




These factors are difficult to forecast and may contribute to substantial fluctuations in our quarterly revenues and substantial variation from our projections.  Any failure to meet investor expectations regarding our operating results may cause our stock price to decline.




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 Table of Contest




We may experience delays in introducing products or services to the market and our products or services may contain defects which could seriously harm our results of operations.




We may experience delays in introducing new or enhanced products or services to the market.  Such delays, whether caused by factors such as unforeseen technology issues or otherwise, could negatively impact our sales revenue in the relevant period.  In addition, we may terminate new product, service or enhancement development efforts prior to any introduction of a new product, service or enhancement.  Any delays for new offerings currently under development or any product defect issues or product recalls could adversely affect the market acceptance of our products or services, our ability to compete effectively in the market, and our reputation, and therefore, could lead to decreased sales and could seriously harm our results of operations.




It may be difficult for us to identify the source of the problem when there is a network problem.




We must successfully integrate our service with products from third party vendors and carriers.  When network problems occur, it may be difficult for us to identify its source.  This may result in the loss of market acceptance of our products and we may incur expenses in connection with any necessary corrections.




Decreasing telecommunications rates may diminish or eliminate our competitive pricing advantage in the VoIP business.




Telecommunications rates in the markets in which we do business have and may continue to decrease, which may eliminate the competitive pricing advantage of our services.  Customers who use our services to benefit from our current pricing advantage may switch to other providers if such pricing advantage diminishes.  Further, continued rate decreases by our competitors may require us to lower our rates, which will reduce or possibly eliminate any gross profit from our services.




We rely on third party network service providers for certain aspects of our VoIP business.




Rather than deploying our own network, we leverage the infrastructure of third party service providers to provide telephone numbers, public switched telephone network, or PSTN, call termination and origination services, and local number portability for our customers.  Though this has lowered our operating costs in the short term, it has also reduced our operating flexibility and ability to make timely service changes.  If any of the third party service providers stop providing the services on which we depend, the delay in switching the underlying services to another service provider, if available, and qualifying this new service could adversely affect our business.




While we believe that we have good relationships with our current service providers, we can give no assurance that they will continue to supply cost-effective services to us in the future or that we will be successful in signing up alternative or additional providers.  Although we believe we could replace our current providers, if necessary, our ability to provide service to our customers would be impacted during this timeframe, which could adversely affect our business.




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 Table of Contest




Our growth may be limited by certain aspects of our VoIP service.




Our VoIP services are not the same in all respects as those provided by traditional telephone service providers.  For example:




•
In some cases, we utilize a data circuit rather than traditional wireline voice circuits to interconnect to existing customer equipment.  This requires the additional use of a modem and gateway on the customer's premises, which is an unfamiliar concept for many of our customers.


•
Our emergency calling service is different.


•
Our customers may experience higher dropped-call rates and other call quality issues because our services depend on data networks rather than traditional voice networks and these services have more single points of failure than traditional wireline networks.


•
Our customers cannot accept collect calls.


•
Our services are interrupted in the event of a power outage or if Internet access is interrupted.




Because our continued growth depends on our target market adopting our services, our ability to adequately address significant differences through our technology, customer services, marketing and sales efforts is important.  If potential customers do not accept the differences between our service and traditional telephone service, they may not subscribe to our VoIP services and our business would be adversely affected.




Our growth in the VoIP business may be negatively affected if we are unable to improve our process for local number portability provisioning.




Local number portability, which is considered an important feature by many customers, allows a customer to retain their existing telephone numbers when subscribing to our services.  The customer must maintain their existing telephone service during the number transfer process.  Although we are taking steps to reduce how long the process takes, currently the process of transferring numbers can take 20 business days or longer.  By comparison, generally, transferring wireless telephone numbers among wireless service providers takes several hours, and transferring wireline telephone numbers among traditional wireline service providers takes a few days.  The additional time our process takes is due to our reliance on third party carriers to transfer the numbers and any delay by the existing telephone service provider may contribute to the process.  If we fail to reduce the amount of time the process takes, our ability to acquire new customers or retain existing customers may suffer.




Our success in the VoIP business also depends on our ability to handle a large number of simultaneous calls.




We expect the volume of simultaneous calls to increase significantly as our customer base grows.  Our network hardware and software may not be able to accommodate this additional volume.  This could result in a decreased level of operating performance, disruption of service and a loss of customers, any of which could adversely affect our business.




A higher rate of customer terminations would reduce our revenue or require us to spend more money to grow our customer base in the VoIP business.




We must acquire new customers on an ongoing basis to maintain our existing level of customers and revenues due to customers that terminate our service.  As a result, marketing expense is an ongoing requirement of our business.  If our churn rate increases, we will have to acquire even more new customers to maintain our existing revenues.  We incur significant costs to acquire new customers, and those costs are an important factor in  achieving future profitability.  Therefore, if we are unsuccessful in retaining customers or are required to spend significant amounts to acquire new customers, our revenue could decrease and our net losses could increase.




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 Table of Contest




Our success also depends on third parties in our distribution channels.




We currently sell our products both directly to customers and through resellers.  We may not be successful in developing additional distribution relationships.  Agreements with distribution partners generally provide for one-time or recurring commissions based on our list prices, and do not require minimum purchases or restrict development or distribution of competitive products.  Therefore, entities that distribute our products may compete with us.  In addition, distributors and resellers may not dedicate sufficient resources or give sufficient priority to selling our products.  Our failure to develop new distribution channels, the loss of a distribution relationship or a decline in the efforts of a reseller or distributor could adversely affect our business.




We need to retain key personnel to support our products and ongoing operations.




The development and marketing of our products will continue to place a significant strain on our limited personnel, management, and other resources.  Our future success depends upon the continued services of our executive officers and other key employees who have critical industry experience and relationships that we rely on to implement our business plan.  None of our officers or key employees are bound by employment agreements for any specific term.  The loss of the services of any of our officers or key employees could delay the development and introduction of, and negatively impact our ability to sell our products which could adversely affect our financial results and impair our growth.  We currently do not maintain key person life insurance policies on any of our employees.




Risks Relating to Our Industry




We face risks associated with our products and services and their development, including new product or service introductions and transitions.




The communications market is going through a period of rapid technological changes and frequent introduction of new and enhanced products, which may result in products or services that are superior to ours.  To compete successfully in this market, we must continue to design, develop, manufacture, and sell new and enhanced products and services that provide increasingly higher levels of performance and reliability at lower cost and respond to customer expectations.  Our success in designing, developing, manufacturing, and selling such products and services will depend on a variety of factors, including:




•
our ability to timely identify new technologies and implement product design and development;


•
the scalability of our software products; and


•
our ability to successfully implement service features mandated by federal and state law.




If we are unable to anticipate or keep pace with changes in the marketplace and the direction of technological innovation and customer demands, our products or services may become less useful or obsolete and our operating results will suffer.  Additionally, properly addressing the complexities associated with compatibility issues, sales force training, and technical and sales support are also factors that may affect our success.




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 Table of Contest




Because the communications industry is characterized by competing intellectual property, we may be sued for violating the intellectual property rights of others.




The communications industry is susceptible to litigation over patent and other intellectual property rights.  Determining whether a product infringes a patent involves complex legal and factual issues, and the outcome of patent litigation actions is often uncertain.  We have not conducted an extensive search of patents issued to third parties, and no assurance can be given that third party patents containing claims covering our products, parts of our products, technology or methods do not exist, have not been filed, or could not be filed or issued.




From time to time, we have received, and may continue to receive in the future, notices of claims of infringement, or potential infringement, of other parties' proprietary rights.  If we become subject to a patent infringement or other intellectual property lawsuit and if the relevant patents or other intellectual property were upheld as valid and enforceable and we were found to infringe or violate the terms of a license to which we are a party, we could be prevented from selling our products unless we could obtain a license or were able to redesign the product to avoid infringement.  If we were unable to obtain a license or successfully redesign our products, we might be prevented from selling our products.  If there is an allegation or determination that we have infringed the intellectual property rights of a third party, we may be required to pay damages, or a settlement or ongoing royalties.  In these circumstances, we may be unable to sell our products at competitive prices or at all, our business and operating results could be harmed and our stock price may decline.




Inability to protect our proprietary technology would disrupt our business.




We rely in part on patent, trademark, copyright, and trade secret law, and nondisclosure agreements to protect our intellectual property in the United States and abroad.  As of September 30, 2010, we had two patents and one patent pending relating to telecommunications and security.  We cannot provide any assurance that these patents or any patents that we may secure in the future will be sufficient to provide commercial advantage for our products.  We may not be able to protect our proprietary rights in the United States or abroad, and competitors may independently develop technologies that are similar or superior to our technology, duplicate our technology or design around any patent of ours.  Moreover, litigation may be necessary in the future to enforce our intellectual property rights.  Such litigation could result in substantial costs and diversion of management time and resources and could adversely affect our business.




Our VoIP products must comply with industry standards, which are evolving.




Market acceptance of VoIP is, in part, dependent upon the adoption of industry standards so that products from various manufacturers can interoperate.  Currently, industry leaders do not agree on which standards should be used for a particular application, and the standards continue to change.  Our VoIP telephony products rely significantly on communication standards (e.g., SIP and MGCP) and network standards (e.g., TCP/IP and UDP) to interoperate with equipment of other vendors.  As standards change, we may have to incur substantial expense to modify our existing products or develop and support new versions of our products.  The failure of our products and services to comply, or delays in compliance, with industry standards could delay or interrupt production of our VoIP products or harm the perception and adoption rates of our service, any of which would adversely affect our business.




Future regulation of VoIP services could limit our growth.




The VoIP industry may be subject to increased regulation.  In addition, established telecommunication companies may devote substantial lobbying efforts to influence the regulation of the VoIP industry in a manner that is contrary to our interests.  Increased regulation and additional regulatory funding obligations at the federal and state level could require us to either increase the retail price for our VoIP services, which would make us less competitive, or absorb such costs, which would decrease our profit margins.




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 Table of Contest




Our emergency and 911 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 911 service, where offered, operates in a similar manner.  However, the only location information that our 911 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.




The operation of our 911 service may vary depending on the specific location of the customer.  In some areas, emergency calls are delivered with the caller's address or callback number.  In other areas the emergency call may be delivered without 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 "New and Emerging Technologies 911 Improvement Act of 2008" was enacted.  This 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 911 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 911 services and, unlike traditional wireline and wireless telephone providers, with the exception of the 2008 Act mentioned above, we know of no other  state or federal provisions that currently indemnify or limit our liability for connecting and carrying emergency 911 phone calls over IP networks.




If we fail to comply with FCC regulations requiring us to provide E911 services, we may be subject to significant fines or penalties in the VoIP business.




In May 2005, the FCC required VoIP providers that interconnect with the PSTN to provide E911 service.  On November 7, 2005, the Enforcement Bureau of the FCC issued a notice stating the information required to be submitted to the FCC in E911 compliance letters due by November 28, 2005.  In this notice, the Enforcement Bureau stated that, although it would not require providers that had not achieved full E911 compliance by November 28, 2005 to discontinue the provision of VoIP services to any existing customers, it did expect that such providers would discontinue marketing VoIP services, and accepting new customers for their services, in all areas where they are not transmitting 911 calls to the appropriate PSAP in full compliance with the FCC's rules.  On November 28, 2005, we filed our E911 compliance report.  On March 12, 2007, we received a letter from the Enforcement Bureau requesting that we file an updated E911 Status Report no later than April 11, 2007.  On April 11, 2007, we responded to the FCC and indicated that (i) 95.4% of our VoIP subscribers receive 911 service in full compliance with the FCC's rules, (ii) we do not accept new VoIP customers in areas where it is not possible to provide 911 service in compliance with the FCC rules, (iii) we currently serve only a very small number of existing subscribers in areas where we have not yet deployed a 911 network solution that is fully compliant with the FCC's regulations and were provisioned with new service after November 28, 2005, and (iv) we have procedures in place to ensure that no new subscribers are being provisioned in non-compliant areas.




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 Table of Contest




The FCC may determine that services we may offer based on nomadic emergency calling do not satisfy the requirements of its VoIP E911 order because, in some instances, a nomadic emergency calling solution may require that we route an emergency call to a national emergency call center instead of connecting subscribers directly to a local PSAP through a dedicated connection and through the appropriate selective router.  The FCC may issue further guidance on compliance requirements in the future that might require us to disconnect those subscribers not receiving access to emergency services in a manner consistent with the VoIP E911 order.  The effect of such disconnections, monetary penalties, cease and desist orders or other enforcement actions initiated by the FCC or other agency or task force against us could have a material adverse effect on our financial position, results of operations, cash flows or business reputation.  On June 1, 2007, the FCC released a Notice of Proposed Rulemaking in which they tentatively conclude that all VoIP service providers that allow customers to use their service in more than one location (nomadic VoIP service providers) must utilize an automatic location technology that meets the same accuracy standards which apply to providers of commercial mobile radio services (mobile phone service providers).  The outcome of this proceeding cannot be determined at this time and we may or may not be able to comply with any such obligations that may be adopted.  At present, we currently have no means to automatically confirm the physical location of a subscriber if the service is such that the subscriber is connected via the Internet.  The FCC's VoIP E911 order has increased our cost of doing business and may adversely affect our ability to deliver our service to new and existing customers in all geographic regions or to nomadic customers who move to a location where emergency calling services compliant with the FCC's mandates are unavailable.  We cannot guarantee that emergency calling service consistent with the VoIP E911 order will be available to all of our subscribers.  The FCC's current VoIP E911 order, follow-on orders or clarifications, or their impact on our customers due to service price increases or other factors, could have a material adverse affect on our business, financial position and results of operations.




Our inability to comply with the requirements of federal law enforcement agencies could adversely affect our VoIP business.




Broadband Internet access services and VoIP services are subject to CALEA.  Currently, our CALEA solution is fully deployed in our network.  However, we could be subject to an enforcement action by the FCC or law enforcement agencies for any delays related to meeting, or if we fail to comply with, any current or future CALEA obligations.  Such enforcement actions could subject us to fines, cease and desist orders, or other penalties, any of which could adversely affect our business.




Our inability to comply with the requirements of federal and other regulations related to customer proprietary network information could adversely affect our VoIP business.




We are subject to the customer proprietary network information, or CPNI, rules.  CPNI includes information such as the phone numbers called by a consumer; the frequency, duration, and timing of such calls; and services purchased by the consumer, such as call waiting, call forwarding, and caller ID.  Under the current rules, generally, except in connection with providing existing services to a customer, carriers may not use CPNI without customer consent.  We do not currently use our customer's CPNI in a manner which would require us to obtain consent, but if we do in the future, we will be required to adhere to specific CPNI rules.  If we fail to comply with any current or future CPNI rules, we could be subject to enforcement action or other penalties, any of which could adversely affect our business.




Our VoIP business may suffer if we fail to comply with funding requirements of state or federal funds, or if our customers cancel service due to the impact of these price increases to their service.




Currently, VoIP providers must contribute to the federal USF.  There is a risk that states may attempt to assert state USF contribution requirements and other state and local charges.  In addition, VoIP providers are subject to Section 225 of the Communications Act, which requires contribution to the TRS fund and requires VoIP providers to offer 711 abbreviated dialing for access to relay services.  Although we contribute to the TRS fund, we have not yet implemented a solution for the 711 abbreviated dialing requirement.  We cannot predict the impact of these types of obligations on our business or our ability to comply with them.  We will likely pass these additional costs on to our customers and the impact of this price increase or our inability to recoup our costs or liabilities or other factors could adversely affect our business.  We may be subject to enforcement actions if we are not able to comply with these new requirements.




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 Table of Contest




We may be subject to liabilities for past telecom taxes, sales taxes, surcharges and fees.




We collect telecom taxes, sales taxes, surcharges and fees from our customers.  The amounts collected from our customers are remitted to the proper authorities.  While we believe we have collected and remitted appropriately, it is possible that substantial claims for back taxes may be asserted against us, which could adversely affect our business financial condition or operating results.  In addition, future expansion of our service, along with other aspects of our evolving business, may result in additional tax obligations.  One or more taxing authorities may seek to impose sales, use or other tax collection obligations on us.  We have received inquiries or demands from numerous state authorities and may be subjected to audit at any time.  A successful assertion by one or more taxing authorities that we should collect sales, use or other taxes on the sale of our services could result in substantial tax liabilities for past sales, could decrease our ability to compete with traditional telephone companies, and could adversely affect our business.




Our ability to offer new VoIP services outside the United States is subject to the local regulatory environment.




The regulations and laws applicable to the VoIP market outside the United States are various and often complicated and uncertain.  Because of our relationship with certain resellers, some countries may assert that we are required to register as a provider in their country.  The failure by us, our customers or our resellers to comply with applicable laws and regulations could adversely affect our business.




Risks Related to the Market for Our Common Stock




Our board of directors has the right to issue additional shares of common stock or preferred stock, without stockholder consent, which could have the effect of creating substantial dilution or impeding or discouraging a takeover transaction.




Pursuant to our certificate of incorporation, our board of directors may issue additional shares of common or preferred stock.  Any additional issuance of common stock or the issuance of preferred stock could have the effect of impeding or discouraging the acquisition of control of us by means of a merger, tender offer, proxy contest or otherwise, including a transaction in which our stockholders would receive a premium over the market price for their shares, thereby protecting the continuity of our management.  Specifically, if in the due exercise of its fiduciary obligations, our board of directors was to determine that a takeover proposal was not in the best interest of the Company or our stockholders, shares could be issued by our board of directors without stockholder approval in one or more transactions that might prevent or render more difficult or costly the completion of the takeover by:




•
diluting the voting or other rights of the proposed acquirer or insurgent stockholder group;


•
putting a substantial voting block in institutional or other hands that might undertake to support the incumbent board of directors; or


•
effecting an acquisition that might complicate or preclude the takeover




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 Table of Contest




Hale owns a substantial amount of our stock and has the right to appoint a majority of our directors, which ownership and board control gives them significant influence over our business.




Hale currently owns approximately 83% of our outstanding common stock.  Accordingly, Hale has significant influence over the outcome of matters submitted to our stockholders for approval, including the election of directors.  Hale's significant ownership also could affect the market price of our common stock by, for example, delaying, deferring or preventing a change in corporate control, impeding a merger, consolidation, takeover or other business combination involving us, or discouraging a potential acquirer from making a tender offer or otherwise attempting to obtain control of us.  In addition, Hale has the right to appoint three members to our five member board of directors.




An investment in our company may be diluted in the future as a result of the issuance of additional securities, or the exercise of options or warrants.




To raise additional capital to fund our business plan, we may, although we currently do not intend to, issue additional shares of common stock or securities convertible, exchangeable or exercisable into common stock from time to time, which could result in substantial dilution to current stockholders.  The issuance of additional debt securities would result in increased expenses and could result in covenants that would restrict our operations.  No arrangements for any such offering exist, and no assurance can be given concerning the terms of any future offering or that we will be successful in issuing common stock or other securities at all.  If adequate funds are not available, we may not be able to continue our operations or implement our planned additional research and development activities, any of which would adversely affect our results of operations and financial condition.




We may be the subject of securities class action litigation due to future stock price volatility.




In the past, when the market price of a stock has been volatile, holders of that stock have often instituted securities class action litigation against the company that issued the stock.  If any of our stockholders brought a lawsuit against us, we could incur substantial costs defending the lawsuit.  The lawsuit could also divert the time and attention of our management.




We have never paid dividends on our common stock, and we do not anticipate paying any dividends in the foreseeable future.




We have paid no cash dividends on our common stock to date.  In addition, we are currently restricted from paying any dividends on our common stock under the terms of the 2010 notes.  Even absent such restriction, we currently intend to retain our future earnings, if any, to fund the development and growth of our business.  In addition, the terms of any future debt or credit facility, if any, may preclude us from paying dividends.  As a result, capital appreciation, if any, of our common stock will be our stockholders' sole source of gain for the foreseeable future.




Our common stock is quoted on the OTC Bulletin Board, which may be detrimental to investors.




Our common stock is currently quoted on the OTC Bulletin Board.  Stocks quoted on the OTC Bulletin Board generally have limited trading volume and exhibit a wide spread between the bid/ask quotation.  Accordingly, you may not be able to sell your shares quickly or at the market price if trading in our stock is not active.




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 Table of Contest




Our common stock is subject to penny stock rules.




Our common stock is subject to Rule 15g-1 through 15g-9 under the Exchange Act, which imposes certain sales practice requirements on broker-dealers who sell our common stock to persons other than established customers and "accredited investors" (generally, individuals with a net worth in excess of $1,000,000 or annual incomes exceeding $200,000 (or $300,000 together with their spouse)).  For transactions covered by this rule, a broker-dealer must make a special suitability determination for the purchaser and have received the purchaser's written consent to the transaction prior to the sale.  This rule adversely affects the ability of broker-dealers to sell our common stock and purchasers of our common stock to sell their shares of such common stock.  Additionally, our common stock is subject to the SEC regulations for "penny stock."  Penny stock includes any non-NASDAQ equity security that has a market price of less than $5.00 per share, subject to certain exceptions.  The regulations require that prior to any non-exempt buy/sell transaction in a penny stock, a disclosure schedule set forth by the SEC relating to the penny stock market must be delivered to the purchaser of such penny stock.  This disclosure must include the amount of commissions payable to both the broker-dealer and the registered representative and current price quotations for the common stock.  The regulations also require that monthly statements be sent to holders of penny stock which disclose recent price information for the penny stock and information of the limited market for penny stocks.  These requirements adversely affect the market liquidity of our common stock.




Item2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS




None.




Item3.  DEFAULTS UPON SENIOR SECURITIES




None.




Item4.  (REMOVED AND RESERVED)






Item5.  OTHER INFORMATION




None.




Item6.  EXHIBITS




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




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 Table of Contest





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.Date:  November 10, 2010
By:  /s/ J. Paul QuinnJ. Paul Quinn,Chief Financial Officer(Duly Authorized Officer and Principal Financial Officer)





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 Table of Contest





EXHIBITINDEX




Exhibit No.

Description4.1

Form of senior secured notes issued on July 2, 2010 (1)10.1

Securities Purchase Agreement dated June 30, 2010, by and among Telanetix, Inc., a Delaware corporation, and the holders of debentures identified therein (1)10.2

Securities Purchase Agreement dated June 30, 2010, by and among Telanetix, Inc., a Delaware corporation, and the purchasers identified therein (1)10.3

Registration Rights agreement dated July 2, 2010, by and among Telanetix, Inc., a Delaware corporation, and the purchasers identified therein (1)10.4

Pledge and Security Agreement dated July 2, 2010, by and among Telanetix, Inc., a Delaware corporation, all of its subsidiaries and the holders of the senior secured notes issued on July 2, 2010 (1)10.5

Guaranty dated July 2, 2010, issued by the subsidiaries of Telanetix, Inc., a Delaware corporation (1)10.6

Stock Award Agreement between Telanetix, Inc., a Delaware corporation, and Douglas N. Johnson (1)10.7

Stock Award Agreement between Telanetix, Inc., a Delaware corporation, and J. Paul Quinn (1)10.8

Telanetix, Inc. 2010 Stock Incentive Plan (1)10.9

Form of Nonqualified Stock Option Agreement issued under the Telanetix, Inc. 2010 Stock Incentive Plan (1)10.10

Form of Letter Agreement dated July 1, 2010, between Telanetix, Inc., a Delaware corporation, and each of David A. Rane and James R. Everline (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(1)      Incorporated herein by reference to the registrant's Form 8-K filed on July 7, 2010*      Filed with this report