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 1934







For the quarterly period ended March
31,
2009




or




r    
Transition Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934







For the transition period from
to





Commission
file number 000-51995





TELANETIX,
INC.


(Exact
name of registrant as specified in its charter)





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





(206)
621-3500


(Registrant's
telephone number, including area code)




Indicate
by check mark whether the registrant (1)  has filed all reports required to
be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days.


Yesx    Noo





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





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





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





As of May
8, 2009, 31,366,662 shares of the issuer's common stock, par value $0.0001 per
share, were outstanding.  The common stock is the issuer's only class
of stock currently outstanding.








Table of Contents




Telanetix,
Inc.




Quarterly
Report on Form 10-Q


For
the Three Months Ended March 31, 2009







TABLEOF
CONTENTS





PageFORWARD
      LOOKING STATEMENTSPART
      I - FINANCIAL INFORMATIONItem
      1.
              FINANCIAL STATEMENTS
              4Item
      2.
              MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
      RESULTS OF OPERATIONS
              21Item
      3.
              QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
      RISK
              33Item
      4.
              CONTROLS AND PROCEDURES
              33PART
      II - OTHER INFORMATIONItem
      1.
              LEGAL PROCEEDINGS
              34Item
      1A.
              RISK FACTORS
              34Item
      2.
              UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF
      PROCEEDS
              34Item
      3.
              DEFAULTS UPON SENIOR SECURITIES
              34Item
      4.
              SUBMISSION OF MATTERS TO A VOTE OF SECURITY
      HOLDERS
              34Item
      5.
              OTHER INFORMATION
              34Item
      6.
              EXHIBITS
              34SIGNATURES
              35EXHIBIT INDEX
              36








Table of Contents




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




FORWARD
LOOKING STATEMENTS




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




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




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




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


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


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


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


·
            our
      ability to successfully obtain a diverse customer
  base;


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


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


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


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


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


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




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




3
 Table of Contents





PARTI--FINANCIAL INFORMATION





Item1. FINANCIAL STATEMENTS





TELANETIX,
INC.


Condensed
Consolidated Balance Sheets





March
      31, 2009
                                                          
                                                          December
      31, 2008(Unaudited)ASSETSCurrent
      assetsCash
                                                          $
                                                          1,266,912
                                                          
                                                          $
                                                          975,137Accounts
      receivable, net
                                                          
                                                          2,653,081
                                                          
                                                          
                                                          3,591,859Inventory
                                                          
                                                          508,407
                                                          
                                                          
                                                          556,321Prepaid
      expenses and other current assets
                                                          
                                                          613,036
                                                          
                                                          
                                                          568,242Total
      current assets
                                                          
                                                          5,041,436
                                                          
                                                          
                                                          5,691,559Property
      and equipment, net
                                                          
                                                          5,051,265
                                                          
                                                          
                                                          5,178,194Goodwill
                                                          
                                                          7,868,134
                                                          
                                                          
                                                          7,821,728Purchased
      intangibles, net
                                                          
                                                          15,648,337
                                                          
                                                          
                                                          16,233,337Other
      assets
                                                          
                                                          995,850
                                                          
                                                          
                                                          983,098Total
      assets
                                                          $
                                                          34,605,022
                                                          
                                                          $
                                                          35,907,916LIABILITIES
      AND STOCKHOLDERS' EQUITYCurrent
      liabilitiesAccounts
      payable
                                                          $
                                                          2,431,316
                                                          
                                                          $
                                                          2,456,706Accrued
      liabilities
                                                          
                                                          3,270,264
                                                          
                                                          
                                                          2,954,312Accrued
      interest
                                                          
                                                          1,813,232
                                                          
                                                          
                                                          888,242Deferred
      revenue
                                                          
                                                          986,342
                                                          
                                                          
                                                          1,021,389Current
      portion of capital lease obligations
                                                          
                                                          874,670
                                                          
                                                          
                                                          939,603Warrant
      and beneficial conversion feature liabilities
                                                          
                                                          4,493,352
                                                          
                                                          
                                                          5,398,724Total
      current liabilities
                                                          
                                                          13,869,176
                                                          
                                                          
                                                          13,658,976Non-current
      liabilitiesCapital
      lease obligations, net of current portion
                                                          
                                                          782,201
                                                          
                                                          
                                                          814,052Deferred
      revenue
                                                          
                                                          212,586
                                                          
                                                          
                                                          188,134Convertible
      debentures, less current portion
                                                          
                                                          20,727,288
                                                          
                                                          
                                                          20,302,430Total
      non-current liabilities
                                                          
                                                          21,722,075
                                                          
                                                          
                                                          21,304,616Total
      liabilities
                                                          
                                                          35,591,251
                                                          
                                                          
                                                          34,963,592Stockholders'
      equity (deficit)Common
      stock, $.0001 par value; Authorized: 200,000,000 shares;Issued
      and outstanding: 31,366,662 at March 31, 2009 and 31,384,374  at
      December 31, 2008
                                                          3,137
                                                          
                                                          
                                                          3,139Additional
      paid in capital
                                                          
                                                          33,538,023
                                                          
                                                          
                                                          33,211,274Warrants
                                                          
                                                          10,000
                                                          
                                                          
                                                          10,000Accumulated
      deficit
                                                          
                                                          (34,537,389
                                                          )
                                                          
                                                          (32,280,089)
                                                          )Total
      stockholders' equity (deficit)
                                                          
                                                          (986,229
                                                          )
                                                          
                                                          944,324Total
      liabilities and stockholders' equity
                                                          $
                                                          34,605,022
                                                          
                                                          $
                                                          35,907,916





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








4
 Table of Contents




TELANETIX, INC.


Condensed
Consolidated Statements of Operations


(Unaudited)








Three
      months ended March 31,2009
                        
                        
                        2008Revenues
                        
                        $
                        8,559,564
                        
                        
                        $
                        7,656,761Cost
      of revenues
                        
                        
                        4,267,593
                        
                        
                        
                        4,242,999Gross
      profit
                        
                        
                        4,291,971
                        
                        
                        
                        3,413,762Operating
      expensesSelling
      and marketing
                        
                        
                        1,669,902
                        
                        
                        
                        1,647,813General
      and administrative
                        
                        
                        2,287,389
                        
                        
                        
                        2,868,329Research,
      development and engineering
                        
                        
                        1,191,525
                        
                        
                        
                        1,262,805Depreciation
                        
                        
                        282,238
                        
                        
                        
                        193,419Amortization
      of purchased intangibles
                        
                        
                        585,000
                        
                        
                        
                        585,000Total
      operating expenses
                        
                        
                        6,016,054
                        
                        
                        
                        6,557,366Operating
      loss
                        
                        
                        (1,724,083
                        )
                        
                        
                        (3,143,604
                        )Other
      income (expense)Interest
      income
                        
                        
                        153
                        
                        
                        
                        7,540Interest
      expense
                        
                        
                        (1,438,742
                        )
                        
                        
                        (1,265,595
                        )Change
      in fair market value of warrant and beneficial conversion feature
      liabilities
                        
                        
                        905,372
                        
                        
                        
                        (2,208,492
                        )Total
      other income (expense)
                        
                        
                        (533,217
                        )
                        
                        
                        (3,466,547
                        )Net
      loss
                        
                        
                        (2,257,300
                        )
                        
                        
                        (6,610,151
                        )Series
      A preferred stock dividends and accretion
                        
                        
                        —
                        
                        
                        
                        (2,554,242
                        )Net
      loss applicable to common stockholders
                        
                        $
                        (2,257,300
                        )
                        
                        $
                        (9,164,393
                        )Net
      loss per share - basic and diluted
                        
                        $
                        (0.07
                        )
                        
                        $
                        (0.39
                        )Weighted
      average shares outstanding - basic and diluted
                        
                        
                        31,162,972
                        
                        
                        
                        23,237,715





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





5
 Table of Contents




TELANETIX, INC.


Condensed
Consolidated Statement of Stockholders' Equity


(Unaudited)











AdditionalCommon
      Stock
                  
                  Paid-In
                  
                  
                  
                  
                  
                  AccumulatedShares
                  
                  
                  Amount
                  
                  
                  Capital
                  
                  
                  Warrants
                  
                  
                  Deficit
                  
                  
                  TotalBalance,
      December 31, 2008
                  
                  
                  31,384,374
                  
                  
                  $
                  3,139
                  
                  
                  $
                  33,211,274
                  
                  
                  $
                  10,000
                  
                  
                  $
                  (32,280,089
                  )
                  
                  $
                  944,324Repurchase
      of common stock
                  
                  
                  (533,334
                  )
                  
                  
                  (53
                  )
                  
                  
                  53
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  —Stock
      based compensation
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  280,341
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  280,341Common
      stock issued for earn out
                  
                  
                  515,622
                  
                  
                  
                  51
                  
                  
                  
                  46,355
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  46,406Net
      loss
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (2,257,300
                  )
                  
                  
                  (2,257,300
                  )Balance,
      March 31, 2009
                  
                  
                  31,366,662
                  
                  
                  $
                  3,137
                  
                  
                  $
                  33,538,023
                  
                  
                  $
                  10,000
                  
                  
                  $
                  (34,537,389
                  )
                  
                  $
                  (986,229
                  )





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








6
 Table of Contents





TELANETIX, INC.


Condensed
Consolidated Statements of Cash Flows


(Unaudited)








Three
      months ended March 31,2009
                        
                        
                        2008Cash
      flows from operating activities:Net
      loss
                        
                        $
                        (2,257,300
                        )
                        
                        $
                        (6,610,151
                        )Adjustments
      to reconcile net loss to cash provided (used) by operating
      activities:Provision
      for doubtful accounts
                        
                        
                        111,938
                        
                        
                        
                        85,992Depreciation
                        
                        
                        540,572
                        
                        
                        
                        426,824Loss
      on disposal of fixed assets
                        
                        
                        2,383
                        
                        
                        
                        —Amortization
      of deferred financing costs
                        
                        
                        28,742
                        
                        
                        
                        86,895Amortization
      of intangible assets
                        
                        
                        585,000
                        
                        
                        
                        585,000Stock
      based compensation
                        
                        
                        280,341
                        
                        
                        
                        324,653Amortization
      of note discounts
                        
                        
                        424,858
                        
                        
                        
                        935,523Common
      stock issued for accrued interest
                        
                        
                        —
                        
                        
                        
                        82,035Value
      of warrant issued as compensation
                        
                        
                        —
                        
                        
                        
                        117,740Change
      in fair value of warrant and beneficial conversion feature
      liabilities
                        
                        
                        (905,372
                        )
                        
                        
                        2,208,492Changes
      in assets and liabilities:Accounts
      receivable
                        
                        
                        826,840
                        
                        
                        
                        86,613Inventory
                        
                        
                        47,914
                        
                        
                        
                        (23,882
                        )Prepaid
      expenses and other assets
                        
                        
                        (86,288
                        )
                        
                        
                        (154,146
                        )Accounts
      payable and accrued expenses
                        
                        
                        290,562
                        
                        
                        
                        1,052,758Accrued
      interest
                        
                        
                        946,268
                        
                        
                        
                        —Deferred
      revenue
                        
                        
                        (10,595
                        )
                        
                        
                        (125,908
                        )Net
      cash provided (used) by operating activities
                        
                        
                        825,863
                        
                        
                        
                        (921,562
                        )Cash
      flows from investing activities:Purchase
      of property and equipment
                        
                        
                        (235,420
                        )
                        
                        
                        (269,108
                        )Net
      cash used by investing activities
                        
                        
                        (235,420
                        )
                        
                        
                        (269,108
                        )Cash
      flows from financing activities:Proceeds
      from sale of convertible debentures
                        
                        
                        —
                        
                        
                        
                        3,000,000Deferred
      financing costs
                        
                        
                        —
                        
                        
                        
                        (175,025
                        )Proceeds
      from exercise of warrants
                        
                        
                        —
                        
                        
                        
                        125,000Payments
      on capital leases
                        
                        
                        (298,668
                        )
                        
                        
                        (353,306
                        )Payment
      of convertible debentures
                        
                        
                        —
                        
                        
                        
                        (889,000
                        )Payments
      on lines of credit
                        
                        
                        —
                        
                        
                        
                        (500,000
                        )Net
      cash (used) provided by financing activities
                        
                        
                        (298,668
                        )
                        
                        
                        1,207,669Net
      increase in cash
                        
                        
                        291,775
                        
                        
                        
                        16,999Cash
      at beginning of the period
                        
                        
                        975,137
                        
                        
                        
                        3,779,821Cash
      at end of the period
                        
                        $
                        1,266,912
                        
                        
                        $
                        3,796,820Supplemental
      disclosures of cash flow information:Interest
      paid
                        
                        $
                        60,153
                        
                        
                        $
                        73,343Non-cash
      investing and financing activities:Property
      and equipment acquired through capital leases
                        
                        $
                        220,218
                        
                        
                        $
                        55,327Convertible
      debentures converted into common stock
                        
                        $
                        —
                        
                        
                        $
                        565,736Accrued
      dividends on Series A stock
                        
                        $
                        —
                        
                        
                        $
                        185,250Warrant
      liabilities and beneficial conversion features
                        
                        $
                        —
                        
                        
                        $
                        2,427,115Common
      stock issued in connection with acquisitions
                        
                        $
                        46,406
                        
                        
                        $
                        —





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





7
 Table of Contents





TELANETIX, INC.


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





1. Basis of Presentation and Going
Concern





The
accompanying unaudited financial statements, consisting of the condensed
consolidated balance sheet as of March 31, 2009, the condensed consolidated
statements of operations for the three months ended March 31, 2009 and
2008, and the condensed consolidated statements of cash flows for the three
months ended March 31, 2009 and 2008, have been prepared in accordance with
accounting principles generally accepted in the United States of America for
interim financial information and in accordance with the instructions to Form
10-Q. Accordingly, these condensed consolidated financial statements do not
include all of the information and footnotes typically found in the audited
consolidated financial statements and footnotes thereto included in the
Company’s Annual Report on Form 10-K. In the opinion of management, all
adjustments (primarily consisting of normal recurring adjustments) considered
necessary for a fair statement have been included.




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




The
preparation of the condensed consolidated financial statements in conformity
with accounting principles generally accepted in the United States requires
management to make estimates and assumptions that affect the reported amounts of
assets, liabilities and equity and disclosure of contingent liabilities at the
date of the financial statements and the reported amounts of revenues and
expenses during the reporting period.  Significant estimates include
those related to the allowance for doubtful accounts; valuation of inventories;
valuation of goodwill, intangible assets and property and equipment; valuation
of stock based compensation expense under Statement of Financial Accounting
Standards No. 123R, “Share Based Payments”; the valuation of warrants and
conversion features; and other contingencies.  On an on-going basis,
the Company evaluates its estimates.  The Company bases its estimates
on historical experience and on various other assumptions that are believed to
be reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying value of assets and liabilities that are not
readily apparent from other sources.  Actual results could differ from
those estimates under different assumptions or conditions. Operating results for
the three months ended March 31, 2009, are not necessarily indicative of the
results that may be expected for the full fiscal year ending December 31,
2009.




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




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





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





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




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




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




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




Reclassifications:




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




8
 Table of Contents


2.
Recent Accounting Pronouncements




In May
2008, the Financial Accounting Standards Board (“FASB”) issued Accounting
Principles Board (“APB”) 14-1, “Accounting for Convertible Debt Instruments That
May Be Settled in Cash upon Conversion (Including Partial Cash Settlement)”
(“FSP APB 14-1”). FSP APB 14-1 requires the issuer of certain convertible
debt instruments that may be settled in cash (or other assets) on conversion to
separately account for the liability (debt) and equity (conversion option)
components of the instrument in a manner that reflects the issuer’s
non-convertible debt borrowing rate. FSP APB 14-1 is effective for fiscal years
beginning after December 15, 2008 on a retroactive basis and was adopted by the
Company in the first quarter of fiscal 2009. The adoption of the provisions of
FSP APB 14-1 did not materially impact the Company’s condensed consolidated
financial position and results of operations.




In June
2008, the FASB ratified EITF 07-5,Determining Whether an Instrument
(or Embedded Feature) is Indexed to an Entity’s Own
Stock  (EITF 07-5). EITF 07-5 provides that an entity should
use a two-step approach to evaluate whether an equity-linked financial
instrument (or embedded feature) is indexed to its own stock, including
evaluating the instrument’s contingent exercise and settlement provisions. The
adoption of this pronouncement effective January 1, 2009, required the Company
to perform additional analyses on both its freestanding equity derivatives and
embedded equity derivative features. The adoption of EITF 07-05 did not have a
material effect on the Company’s condensed consolidated financial
statements during the first quarter of 2009.




In
September 2006, the FASB issued SFAS No. 157,Fair Value Measurements,
(SFAS No. 157). SFAS No. 157 provides enhanced guidance for using fair
value to measure assets and liabilities. In February 2008, the FASB issued
FSP No. 157-2, which deferred the effective date of SFAS No. 157 for
one year relative to certain nonfinancial assets and liabilities. On
January 1, 2009, the beginning of the Company’s fiscal 2009, the Company
adopted the requirements of SFAS No. 157 that had been deferred under FSP
157-2,Effective
Date of FASB Statement No. 157 . The adoption did not have a
material impact on the Company’s condensed consolidated financial statements
during the first quarter of 2009.




In
October 2008, the FASB issued FSP No. FAS 157-3, Determining the Fair Value of a
Financial Asset When the Market for that Asset is Not Active (FSP
FAS 157-3), which clarifies the application of SFAS 157 in a market
that is not active. Additional guidance is provided regarding how the reporting
entity’s own assumptions should be considered when relevant observable inputs do
not exist, how available observable inputs in a market that is not active should
be considered when measuring fair value, and how the use of market quotes should
be considered when assessing the relevance of inputs available to measure fair
value. FSP FAS 157-3 became effective immediately upon issuance. Its
adoption did not have a material impact on the Company’s condensed consolidated
financial statements in the first quarter of 2009.




In April
2009 the FASB issued FSP No. FAS 157-4, Determining Fair Value When the
Volume and Level of Activity for the Asset or Liability Have Significantly
Decreased and Identifying Transactions That Are Not Orderly (FSP
FAS 157-4), which clarifies the application of SFAS 157 when there is
no active market or where the price inputs being used represent distressed
sales. Additional guidance is provided regarding estimating the fair value of an
asset or liability (financial and nonfinancial) when the volume and level of
activity for the asset or liability have significantly decreased and identifying
transactions that are not orderly. FSP FAS 157-4 will be effective for interim
and annual periods ending after June 15, 2009. The Company does not
anticipate that adoption in fiscal 2009 will have a material impact on the
Company’s results of operations or financial condition.





3.
Securities Exchange Agreement




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





In May
2009, the Company again restructured the terms of its outstanding debentures and
all of the Company’s outstanding debenture related warrants. See Note 12 –
Subsequent Event.





9
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4.
Fair Value Measurements




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





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





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





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




At March
31, 2009, the Company recorded liabilities related to its warrants (See Note 6 –
Warrants and Warrant Liabilities) and the beneficial conversion feature of its
convertible debentures (See Note 5 – Convertible Debentures) at their fair
market values as provided by SFAS No. 157.




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





Fair
      Value Measurements at Reporting Date Using Significant Unobservable Inputs
      (Level 3)Description
                    
                    March
      31, 2009Warrant
      liabilities
                    
                    $
                    490,696Beneficial
      conversion feature liabilities
                    
                    
                    4,002,656$
                    4,493,352





The
following table provides a reconciliation of the beginning and ending balances
of the warrant and beneficial conversion feature liabilities. There were no
purchases, sales, issuances or settlements related to the warrant and beneficial
conversion feature liabilities during the three months ended March 31,
2009.  The change in fair market value of the warrant and beneficial
conversion feature liabilities is included in Other Income (Expense) in the
Condensed Consolidated Statements of Operations.





Warrant
      liability
                  
                  
                  Beneficial
      conversion feature liability
                  
                  
                  TotalBeginning
      balance January 1, 2009
                  
                  $
                  580,712
                  
                  
                  $
                  4,818,012
                  
                  
                  $
                  5,398,724Change
      in fair market value of warrant and beneficial conversion
      liabilities
                  
                  
                  (90,016
                  )
                  
                  
                  (815,356
                  )
                  
                  
                  (905,372
                  )Ending
      balance March 31, 2009
                  
                  $
                  490,696
                  
                  
                  $
                  4,002,656
                  
                  
                  $
                  4,493,352




Certain
financial instruments are carried at cost on the consolidated balance sheets,
which approximates fair value due to their short-term, highly liquid nature.
These instruments include cash and cash equivalents, accounts receivable,
accounts payable and accrued expenses, other short-term liabilities, and capital
lease obligations. In addition, as the Company entered into its debentures
during 2008, it believes that the carrying amount of its debentures approximates
their fair value as of March 31, 2009.






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5.
Convertible Debentures




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




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




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




As of
March 31, 2009, the Company had reserved 74,123,251 shares of common stock for
the conversion of the outstanding debentures issued in June 2008, August 2008
and December 2008, all of which are discussed below.




June2008




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




In
December 2008, the Company amended certain terms of the debentures issued in
June 2008 which are discussed below under the heading “December
2008.”  And, in May 2009, the Company again restructured the terms of
its outstanding debentures which are discussed in Note 12 – Subsequent
Event.




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




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




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




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




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




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




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




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




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Covenants. The debentures
impose certain covenants on the Company, including restrictions against
incurring additional indebtedness, creating any liens on the Company’s property,
amending its certificate of incorporation or bylaws, redeeming or paying
dividends on shares of its outstanding common stock, and entering into certain
related party transactions. The debentures define certain events of default,
including without limitation failure to make a payment obligation, failure to
observe other covenants of the debenture or related agreements (subject to
applicable cure periods), breach of representation or warranty, bankruptcy,
default under another significant contract or credit obligation, delisting of
the Company's common stock, a change in control, failure to be
in compliance with Rule 144(c)(1) for more than 20 consecutive days, or
more than an aggregate of 45 days in any 12 month period, or if any other
conditions exist for such a period of time that the holder is unable to sell the
shares issuable upon conversion of the debenture pursuant to Rule 144
without volume or manner of sale restrictions, or failure to deliver share
certificates in a timely manner. In the event of default, the holders of the
debentures have the right to accelerate all amounts outstanding under the
debenture and demand payment of a mandatory default amount equal to 130% of the
amount outstanding plus accrued interest and expenses.  As
of  March 31, 2009, the Company is in compliance with the covenants
described above.




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




August2008




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




December2008




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




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





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





The
Company refers to the debenture issued in this December 2008 financing, together
with the debentures issued in June 2008 and August 2008, as the "PIPE Debentures." The Company
refers to the warrant issued in this December 2008 financing, together with the
other warrants it issued in December 2006, February 2007, March 2008 and August
2008, as the "PIPE Warrants."





May 2009




In May
2009, the Company again restructured the terms of its outstanding debentures.
See Note 12 – Subsequent Event.





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 Table of Contents




General




The
unamortized discounts on the debentures issued in December 2006, August 2007 and
March 2008 were carried forward as discounts on the debentures issued in June
2008, and will be amortized to interest expense through June 30,
2014.  See Note 3 – Securities Exchange Agreement.  The
discounts on the debentures issued in August 2008 and December 2008 will be
amortized to interest expense through June 30, 2014.




The
amendment in December 2008, provides for 0% interest until September, 30,
2009.  However, the Company has recorded interest expense for the
three months ended March 31, 2009, at the debt’s effective interest
rate.




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





March
      31, 2009
                
                
                December
      31, 2008Convertible
      debentures
                $
                29,649,300
                
                
                $
                29,649,300Less
      unamortized discounts:Original
      issue discount
                
                (825,451
                )
                
                
                (864,758
                )Detachable
      warrants discount
                
                (2,451,162
                )
                
                
                (2,567,884
                )Beneficial
      conversion feature discount
                
                (5,645,399
                )
                
                
                (5,914,228
                )Convertible
      debentures, net of discounts
                
                20,727,288
                
                
                
                20,302,430Less
      current portion
                
                —
                
                
                
                —Convertible
      debentures, long term portion
                $
                20,727,288
                
                
                $
                20,302,430





The
convertible debentures outstanding at March 31, 2009 are due June 30,
2014.





At each
reporting period the Company assesses the convertible debentures under SFAS No.
133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS No.
133”) and EITF No. 00-19, “Accounting for Derivative Financial Instruments
Indexed to and Potentially Settled in, a Company's Own Stock”, and at March 31,
2009 and December 31, 2008, the Company determined that the beneficial
conversion feature in the convertible debentures represented an embedded
derivative liability.  Accordingly, the Company bifurcated the
embedded conversion feature and accounted for it as a derivative liability
because the conversion price and ultimate number of shares can be adjusted if
the Company subsequently issues common stock at a lower price and it was deemed
possible the Company could have to net cash settle the contract if there were
not enough authorized shares to issue upon conversion.




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




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




At March
31, 2009 and December 31, 2008, the Company recorded beneficial conversion
liabilities of $4.0 million and $4.8 million, respectively.  For the
three months ended March 31, 2009 and 2008, the Company recognized other income
of $0.8 million and other expense of  less than $0.1 million,
respectively, related to the change in fair market value of the beneficial
conversion liabilities.




6.
Warrants and Warrant Liabilities




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




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




13
 Table of Contents




On
December 11, 2008, the Company issued warrants to purchase 456,000 shares of
common stock at $0.40 per share in conjunction with the sale of its
debentures.  In addition, the exercise price of all previously issued
warrants was reduced to $0.40.  However, under the terms of the
December 11, 2008 amendment, the parties agreed to waive the adjustment
provision of the PIPE Warrants that would have increased the number of shares
subject to the PIPE Warrants as a result of the issuance of the debentures and
warrants in the December 2008 financing. Pursuant to SFAS No. 133 and EITF No.
00-19, the fair value of the warrants at the issuance was recorded as a warrant
liability because the exercise price of the warrants can adjust if the Company
subsequently issues common stock at a lower price and it is possible for the
Company to not have enough authorized shares to settle the warrants and
therefore would have to settle the warrants with cash.




The fair
value of the warrants was estimated at their various issuance dates and
revalued at March 31, 2009, using the Monte Carlo model discussed in Note 5 –
Convertible Debentures, above.  At March 31, 2009 and December 31,
2008, the Company recorded warrant liabilities of $0.5 million and $0.6 million,
respectively.  For the three months ended March 31, 2009 and 2008, the
Company recognized other income of $0.1 million and other expense of $2.2
million, respectively, related to the change in fair market value of the
warrants.




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




The
following table summarizes warrant activity for the three months ended March 31,
2009:





Number
      of Shares Subject to Warrants
                
                Weighted
      Average Exercise PriceBalance
      - December 31, 2008
                12,695,718
                
                $
                0.45Issued
                —
                
                
                —Exercised
                —
                
                
                —Expired
                —
                
                
                —Balance
      – March 31, 2009
                12,695,718
                
                $
                0.45





The
following table summarizes information about warrants outstanding at March 31,
2009:





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





As of
March 31, 2009, the Company had reserved 12,695,718 shares of common stock for
the exercise of the outstanding warrants.




In May
2009, the Company restructured the terms of the PIPE Warrants. See Note 12 –
Subsequent Event.





14
 Table of Contents




7.
Commitments and Contingencies




Leases




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




Minimum Third Party Network
Service Provider Commitments




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




Litigation




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




Communications Assistance
for Law Enforcement Act




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




Universal Service
Fund




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




Sales and additional
taxes




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




Other




In
connection with its acquisition of AccessLine, the Company was required to pay
up to an additional $9.0 million in the form of 2,500,000 shares
of  the Company’s restricted common stock upon the achievement of
certain future financial objectives, the value of which would increase the
amount of goodwill recorded in the transaction.  The first earn out
period ended December 31, 2007.  In April 2008, when the contingency
related to the first earn out period was resolved, the Company issued 599,130
shares valued at $0.6 million, resulting in increases to goodwill and
equity.  The second earn out period ended June 30, 2008, and the
Company issued 529,252 shares valued at $0.3 million in July 2008 when the
contingency was resolved.  The increase in goodwill and equity were
recorded in the third fiscal quarter of 2008.  The third earn out
period ended December 31, 2008, and the Company issued 515,622 shares valued at
$0.04 million in February 2009.  The increase in goodwill and equity
was recorded in the first quarter of fiscal 2009. There is one additional earn
out period which will terminate on June 30, 2009.  The Company may be
required to pay up to 625,000 additional shares of common stock upon
AccessLine's achievement of certain future financial objectives during that
period.




15
 Table of Contents




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




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




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




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




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




8.
Preferred Stock and Dividends




Pursuant
to terms of the Company’s Series A preferred stock (the “Series A Stock”),
effective April 1, 2008, the stated value of such stock increased by 15%, or
$2.0 million, because the Company’s common stock was not listed on an exchange
other than the OTC Bulletin Board by March 31, 2008. The Company recorded a
dividend of $2.0 million during the three months ended March 31, 2008, related
to the increase in stated value of the Series A Stock.




Pursuant
to the Securities Exchange Agreement the Company entered into on June 30, 2008,
all shares of the Series A Stock, which had a stated value of $14.9 million, and
accrued dividends of $0.4 million were converted into the debentures issued on
June 30, 2008.  See Note 3 – Securities Exchange Agreement. As of
March 31, 2009, the Company has no shares of preferred stock issued or
outstanding.




9.
Stock Based Compensation




Stock Option
Plan




The 2005
Equity Incentive Plan (the “2005 Plan”), which was approved by the shareholders
in August 2006, permits the Company to grant shares of common stock and options
to purchase shares of common stock to the Company’s employees for up to 5
million shares of common stock.  The Company believes that such awards
better align the interests of its employees with those of its
shareholders.  Option awards are generally granted with an exercise
price that approximates the market price of the Company's stock at the date of
grant; these option awards generally vest based on 4 years of continuous service
and have 10-year contractual terms.  On November 8, 2007, the Board of
Directors approved an amendment to the 2005 Plan to increase the number of
shares of common stock available for grant to 8.5 million shares. On December
11, 2008, the Board of Directors approved an additional amendment to the 2005
Plan to increase the number of shares of common stock available for grant to
15.5 million shares.




16
 Table of Contents




A summary
of option activity under the 2005 Plan as of March 31, 2009, and changes during
the three months then ended is presented below:





Shares
                    
                    
                    Weighted-Average
      Exercise PriceOutstanding
      at December 31, 2008
                    
                    
                    11,486,293
                    
                    
                    $
                    0.28Granted
                    
                    
                    —
                    
                    
                    
                    —Exercised
                    
                    
                    —
                    
                    
                    
                    —Forfeited
      or expired
                    
                    
                    (6,500
                    )
                    
                    
                    1.22Outstanding
      at March 31, 2009
                    
                    
                    11,479,793
                    
                    
                    $
                    0.28




The
options outstanding and currently exercisable by exercise price at March 31,
2009 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$
                    0.07
      to 0.20
                    
                    10,724,834
                    
                    8.56
                    
                    $
                    0.09
                    
                    2,626,751
                    
                    5.74
                    
                    $
                    0.13$
                    2.15
      to 3.50
                    
                    754,959
                    
                    6.67
                    
                    $
                    2.99
                    
                    667,459
                    
                    7.04
                    
                    $
                    2.9211,479,793
                    
                    8.43
                    
                    $
                    0.28
                    
                    3,294,210
                    
                    6.00
                    
                    $
                    0.69





As of
March 31, 2009 and December 31, 2008, 3,294,210 and 2,999,335 outstanding
options were exercisable at an aggregate average exercise price of $0.69 and
$0.75, respectively.  The aggregate intrinsic value of stock options
outstanding and stock options exercisable at March 31, 2009 was
nil.




As of
March 31, 2009, total compensation cost related to nonvested stock options not
yet recognized was $2.5 million, which is expected to be recognized over the
next 2.7 years on a weighted-average basis.




Valuation and Expense
Information Under SFASNo.123(R)




On
January 1, 2006, the Company adopted SFAS No. 123(R), “Share Based Payments”
(“SFAS No. 123(R)”), which requires the measurement and recognition of
compensation expense for all share-based payment awards made to employees and
directors based upon estimated fair values.  The following table
summarizes stock-based compensation expense recorded under SFAS No. 123(R) for
the three months ended March 31, 2009 and 2008, and its allocation within the
Condensed Consolidated Statements of Operations:





March
      31,2009
                
                
                2008Cost
      of product revenues
                
                $
                12,191
                
                
                $
                17,725Selling,
      general and administrative
                
                
                197,088
                
                
                
                239,559Research
      and development
                
                
                71,062
                
                
                
                67,369Stock
      based compensation included in operating expenses
                
                
                268,150
                
                
                
                306,928Stock-based
      compensation expense related to employee equity awards
                
                $
                280,341
                
                
                $
                324,653





Stock-based
compensation expense for the three months ended March 31, 2009 includes less
than $0.1 million of expense related to option modifications.




17
 Table of Contents




Valuation
Assumptions:




Prior to
January 1, 2008, the Company estimated the fair value of stock options using the
Black Scholes option pricing model, and through June 30, 2008, the Company
estimated the fair value of stock options using a binomial lattice model; since
July 1, 2008, the company is again using the Black Scholes option pricing model,
all consistent with the provisions of SFAS No. 123(R) and SEC Staff Accounting
Bulletin No. 107.  The weighted-average estimated fair value of
employee stock options granted during the three months ended March 31, 2008 was
$1.17 per share.  No options were granted during the three months
ended March 31, 2009.  The fair value of each option is estimated on
the date of grant using the valuation models discussed above and is recognized
as expense using the straight-line method over the requisite service
period:





March
      31,2009
                    
                    
                    2008Expected
      volatility
                    
                    
                    —
                    
                    
                    
                    65.50
                    %Risk-free
      interest rate
                    
                    
                    —
                    
                    
                    
                    3.45
                    %Expected
      dividends
                    
                    
                    —
                    
                    
                    
                    —Expected
      life (yrs)
                    
                    
                    —
                    
                    
                    
                    9.3





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




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




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




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




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




10.
Computation of Net Loss Per Share




Net loss
per share is calculated in accordance with the SFAS No. 128, “Earnings Per
Share.”  Basic net loss per share is based upon the weighted average
number of shares of common stock outstanding.  Diluted net loss per
share is based on the assumption that all potential common stock equivalents
(convertible preferred stock, convertible debentures, stock options, and
warrants) are converted or exercised.  The calculation of diluted net
loss per share excludes potential common stock equivalents if the effect is
anti-dilutive.  The Company's weighted average shares of common stock
outstanding for basic and dilutive are the same because the effect of the
potential common stock equivalents is anti-dilutive.




The
Company has the following dilutive common stock equivalents as of March 31, 2009
and 2008, which were excluded from the net loss per share calculation because
their effect is anti-dilutive.





March
      31,2009
                
                
                2008Convertible
      Debentures
                
                
                74,123,251
                
                
                
                7,454,640Preferred
      Stock
                
                
                —
                
                
                
                8,441,558Stock
      Options
                
                
                11,479,793
                
                
                
                6,217,222Warrants
                
                
                12,695,718
                
                
                
                9,415,602Total
                
                
                98,298,762
                
                
                
                31,529,022






18
 Table of Contents




11.
Business Segment Information




Telanetix
is an IP communications company, offering a range of communications solutions
from hosted IP voice and conferencing products, to text and data collaboration,
to telepresence videoconferencing products.  The Company’s offerings
are organized along two product categories: Voice and Network Solutions and
Video Solutions, which are considered segments for reporting
purposes.  The segments are determined in accordance with how
management views and evaluates the Company’s business and based on the criteria
as outlined in SFAS No. 131, “Disclosures about Segments of an Enterprise and
Related Information.”.




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




Financial
information for each reportable segment is as follows as of the fiscal quarters
ended March 31, 2009 and 2008:





Voice
      and Network Solutions
                
                Video
      Solutions
                
                Total2009Revenues
                
                $
                7,024,192
                
                
                $
                1,535,372
                
                
                $
                8,559,564Gross
      profit
                
                $
                3,897,421
                
                
                $
                394,550
                
                
                $
                4,291,971Gross
      profit %
                
                
                55.5%
                
                
                
                25.7%
                
                
                
                50.1%Operating
      loss
                
                $
                (843,082)
                
                
                $
                (881,001)
                
                
                $
                (1,724,083)Total
      assets
                
                $
                30,405,269
                
                
                $
                4,199,753
                
                
                $
                34,605,0222008Revenues
                
                $
                6,248,858
                
                
                $
                1,407,903
                
                
                $
                7,656,761Gross
      profit
                
                $
                3,294,422
                
                
                $
                119,340
                
                
                $
                3,413,762Gross
      profit %
                
                
                52.7%
                
                
                
                8.5%
                
                
                
                44.6%Operating
      loss
                
                $
                (1,120,609)
                
                
                $
                (2,022,995)
                
                
                $
                (3,143,604)Total
      assets
                
                $
                33,371,630
                
                
                $
                7,462,222
                
                
                $
                40,833,852





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




For the
three months ended March 31, 2009, one customer accounted for 13% of the
Company’s Voice and Network Solutions segment net revenues and two customers
accounted for 53% of its Video Solutions segment net revenues. For the three
months ended March 31, 2008, one customer accounted for 16% of the Voice and
Network Solutions segment net revenues and no one customer accounted for more
than 10% of the Video Solutions segment net revenues.




At March
31, 2009 no one customer accounted for more than 10% of gross accounts
receivable in the Voice and Network Solutions segment and one customer accounted
for 19% of gross accounts receivable in the Video Solutions segment. At March
31, 2008 one customer accounted for 37% of gross accounts receivable in the
Voice and Network Solutions segment and two customers accounted for 38% of gross
accounts receivable in the Video Solutions segment.






19
 Table of Contents




12.
Subsequent Event




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




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




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




·
            defer
      interest payments until October 1,
2011;




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




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




·
            eliminate
      the 20% premium for voluntary
prepayment.




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




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






20
 Table of Contents




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, 2008, previously
filed with the SEC.




Overview




Business




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




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




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




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




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




History




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




21
 Table of Contents




Recent
Financings




June 2008Financing




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




In
December 2008, we amended certain terms of the debentures issued in June 2008
which are discussed below under the heading “December 2008 Amendment of
Outstanding Debentures and Warrants.”  And, in May 2009, the Company
again restructured the terms of its outstanding debentures which are discussed
below under the heading “May 2009 Amendment of Outstanding Debentures and
Warrants.”




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




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




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




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




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




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




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




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




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




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




22
 Table of Contents




August 2008Financing




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




December 2008
Financing




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




The terms
of the debenture we issued in December 2008 are substantially similar to the
terms of the debentures we issued in June 2008 and August 2008, except as
follows: interest is payable quarterly at the rate of (i) 0% per annum from the
original issue date until the one year anniversary of the original issue date,
(ii) 12% per annum from the one year anniversary of the original issue date
until the four year anniversary of the original issue date, and (iii) 18% per
annum from the four year anniversary of the original issue date until the
maturity date. The terms of the debenture were amended by the terms of the
amendment agreement we entered into in May 2009. See "May 2009 Amendment of
Outstanding Debentures and Warrants," below.




December 2008Amendment of Outstanding
Debentures and Warrants




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




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





May 2009Amendment of Outstanding
Debentures and Warrants




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




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




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




·
            defer
      interest payments until October 1,
2011;




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




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




·
            eliminate
      the 20% premium for voluntary
prepayment.




23
 Table of Contents




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




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




Outlook





We
entered 2009 with a solid product line of both voice and video solutions,
including our Digital Phone Service.  We experienced growth in
revenues and gross margins for each of our Voice and Network Solutions and our
Video Solutions segments in 2008 and during the three months ended March 31,
2009. Currently, our overriding objective is to achieve operating
profitability.  To that end, during the first quarter of our current
fiscal year, we have worked to increase sales by spending more in advertising
than we spent in the fourth quarter of 2008.  In addition, we have
undertaken initiatives to reduce operating expenses, including optimizing our
network configuration and reducing our staffing levels.




If we can
continue to generate revenue and gross margin improvements consistent with our
growth in 2008 and during the three months ended March 31, 2009, and maintain
control of our operating expenses, we believe that our existing capital will be
sufficient to finance our operations for 2009. However, the uncertainties
related to the global economic slowdown and the disruption in the financial
markets has impacted our visibility on our business outlook. Weakening economic
conditions may result in decreased demand for our products.  We have
witnessed some slow down on our Video Solutions segment.  In addition,
we have limited financial resources.  Unforeseen decreases in
revenues, or increases in operating costs could impact our ability to fund our
operations.  We do not currently have any sources of credit available
to us.  See “Liquidity and Capital Resources” below.





Based on
currently available information, management believes 2009 revenues will show
double digit increases in growth over 2008 numbers.  We are committed
to achieving positive cash flow.




Going
Concern




We remain
dependent on outside sources of funding until our results of operations provide
positive cash flows. As of December 31, 2008, our independent registered
auditors concluded that there was substantial doubt about the Company’s ability
to continue as a going concern, and this condition remains as of March 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, 2008.




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





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




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




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




24
 Table of Contents




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




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




Results
of Operations




First
Quarter of Fiscal 2009 Compared to First Quarter of Fiscal 2008




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




Revenues,
Cost of Revenues and Gross Profit





Three
      months ended March 31, 2009
                                      
                                      
                                      Three
      months ended March 31, 2008
                                      
                                      
                                      Increase
      (decrease)Voice
      and Network Solutions
                                      
                                      
                                      Video
                                        Solutions
                                      
                                      
                                      Total
                                      
                                      
                                      Voice
      and Network Solutions
                                      
                                      
                                      Video
                                        Solutions
                                      
                                      
                                      Total
                                      
                                      
                                      Voice
      and Network Solutions
                                      
                                      
                                      Video
                                        Solutions
                                      
                                      
                                      TotalNet
      revenues:
                                      
                                      $
                                      7,024,192
                                      
                                      
                                      $
                                      1,535,372
                                      
                                      
                                      $
                                      8,559,564
                                      
                                      
                                      $
                                      6,248,858
                                      
                                      
                                      $
                                      1,407,903
                                      
                                      
                                      $
                                      7,656,761
                                      
                                      
                                      $
                                      775,334
                                      
                                      
                                      $
                                      127,469
                                      
                                      
                                      $
                                      902,803Cost
      of revenues:
                                      
                                      
                                      3,126,771
                                      
                                      
                                      
                                      1,140,822
                                      
                                      
                                      
                                      4,267,593
                                      
                                      
                                      
                                      2,954,436
                                      
                                      
                                      
                                      1,288,563
                                      
                                      
                                      
                                      4,242,999
                                      
                                      
                                      
                                      172,335
                                      
                                      
                                      
                                      (147,741
                                      )
                                      
                                      
                                      24,594Gross
      profit:
                                      
                                      $
                                      3,897,421
                                      
                                      
                                      $
                                      394,550
                                      
                                      
                                      $
                                      4,291,971
                                      
                                      
                                      $
                                      3,294,422
                                      
                                      
                                      $
                                      119,340
                                      
                                      
                                      $
                                      3,413,762
                                      
                                      
                                      $
                                      602,999
                                      
                                      
                                      $
                                      275,210
                                      
                                      
                                      $
                                      878,209Gross
      profit %
                                      
                                      
                                      55.5
                                      %
                                      
                                      
                                      25.7
                                      %
                                      
                                      
                                      50.1
                                      %
                                      
                                      
                                      52.7
                                      %
                                      
                                      
                                      8.5
                                      %
                                      
                                      
                                      44.
      6
                                      %





Net
revenues for the three months ended March 31, 2009 were $8.6 million, an
increase of $0.9 million, or 11.8%, over the same period in 2008.  Net
revenues in our Voice and Network Solutions segment increased $0.8 million. Net
revenues in our Video Solutions segment increased $0.1 million.  The
increase in Voice and Network Solutions revenues is due in part to organic
growth of existing products and services as a result of the increase in
advertising year over year and to the success of our Digital Phone Service
product which was launched in mid-2008.




For the
three months ended March 31, 2009, one customer accounted for 13% of our Voice
and Network Solutions segment net revenues and two customers accounted for 53%
of our Video Solutions segment net revenues. For the three months ended March
31, 2008, one customer accounted for 16% of our Voice and Network Solutions
segment net revenues and no single customer accounted for more than 10% of our
Video Solutions segment net revenues.




Cost of
revenues for the three months ended March 31, 2009 was $4.3 million, an increase
of $24,594, or 0.6%, over the same period in 2008. Cost of revenues in our Voice
and Network Solutions segment increased $0.2 million consistent with the
increase in revenues.  Cost of revenues in our Video Solutions segment
decreased by $0.1 million due primarily to an improved mix of product and
services sold.




Gross
profit for the three months ended March 31, 2009 was $4.3 million, an increase
of $0.9 million, or 25.7%, over the same period in 2008.  Gross profit
in our Voice and Network Solutions segment increased $0.6 million consistent
with the increase in revenues. Gross profit in our Video Solutions segment
increased $0.3 million primarily as a result of increased margin on product
sales during the period.




Gross
profit percentage was 50.1% for the three months ended March 31, 2009 compared
to 44.6% in the same period in 2008.  Gross profit percentage for our
Voice and Network Solutions segment was 55.5% for the three months ended March
31, 2009 compared to 52.7% in the same period in 2008, and the increase is a
result of improved purchasing power from network infrastructure providers
allowing us to purchase network access at lower rates. Gross profit percentage
for our Video Solutions segment was 25.7% for the three months ended March 31,
2009 compared to 8.5% in the same period in 2008, and the increase is a result
of a more profitable mix of products sold.




25
 Table of Contents




Selling
and Marketing Expenses




Selling
and marketing expenses for the three months ended March 31, 2009 were $1.7
million, an increase of less than $0.1 million or 1.3%, over the same period in
2008.  We anticipate that selling and marketing expenses for future
quarters of 2009 will be higher than those incurred in 2008 as we increase our
advertising expense in order to increase market share and to promote our Digital
Phone Service product line.  This will be partially offset by a
reduction in our video selling staff in late February 2009.




General
and Administrative Expenses




General
and administrative expenses for the three months ended March 31, 2009 were $2.3
million, a decrease of $0.6 million or 20.3%, over the same period in
2008.  Approximately, 70% of the decrease is attributable to lower
accounting costs in 2009 as compared to 2008, which included costs associated
with the first time consolidation of the activity of our Accessline and AVS
subsidiaries that were acquired during 2007.  The remaining 30% of the
decrease is primarily attributable to lower consulting fees in 2009 as compared
to 2008, which included costs associated with various valuations as a result of
our acquisitions and various debt restructurings in 2007 and 2008.




Research,
Development and Engineering Expenses




Research,
development and engineering expenses for the three months ended March 31, 2009
were $1.2 million, a decrease of $0.1 million or 5.6%, over the same period in
2008.  Research, development and engineering expenses decreased in
2009 as compared to 2008 primarily as a result of a decrease in research and
development staffing.




Depreciation
Expense




Depreciation
expense for the three months ended March 31, 2009 was $0.3 million, an increase
of $0.1 million or 45.9%, over the same period in 2008.  The increase
is primarily attributable to additions to fixed assets during the preceding
twelve months.




Amortization
of Purchased Intangibles




We
recorded $0.6 million of amortization expense for the three months ended March
31, 2009 and 2008, related to the intangible assets acquired in the AVS and
AccessLine acquisition transactions.




Interest
Expense




Interest
expense for the three months ended March 31, 2009 was $1.4 million, an increase
of $0.2 million or 13.7%, from the same period in 2008.  Interest
expense includes stated interest, amortization of note discounts, amortization
of deferred financing costs, and interest on capital leases.  Interest
expense increased in 2009 primarily as a result of the higher interest rate on
our debentures from 6% to 12%, which is discussed in more detail
below.




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




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




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




In
December, 2008, we issued a debenture with a face value of $1.5 million that
bears interest at a rate of (i) 0% per annum from the original issue date until
the one year anniversary of the original issue date, (ii) 12% per annum from the
one year anniversary of the original issue date until the four year anniversary
of the original issue date, and (iii) 18% per annum from the four year
anniversary of the original issue date until June 2014.




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




In May
2009, following the end of the period covered by this report, under the
Amendment Agreement, we restructured the terms of our PIPE Debentures to: (i)
defer interest payments until October 1, 2011; (ii) reduce the interest rate to
0% through June 30, 2011 and then to 5% per annum thereafter; and (iii) require
that all future interest payments be made in cash. See "Recent Financings,"
above.




26
 Table of Contents




Change
in Fair Value of Warrant and Beneficial Conversion Liabilities




Pursuant
to SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”
and EITF No. 00-19, “Accounting for Derivative Financial Instruments Indexed to
and Potentially Settled in, a Company's Own Stock”, we recorded the fair value
of the warrants issued in connection with our various financings at the issuance
dates as a warrant liability because the exercise price of the warrants can be
adjusted if we subsequently issue common stock at a lower price and it is
possible for us to not have enough authorized shares to settle the warrants and
therefore would have to settle the warrants with cash.




The fair
value of the then outstanding warrants was estimated at December 31, 2008 and
again at each subsequent reporting date.  For the three months ended
March 31, 2009, we recorded non-operating income of $0.1 million in the
Consolidated Statement of Operations for the decrease in the fair values of the
warrants, which is primarily attributable to the decrease in the market price of
our common stock.




At
December 31, 2008 and again at each subsequent reporting date, we assessed the
then outstanding convertible debentures under SFAS No. 133, and we determined
that the beneficial conversion feature represented an embedded derivative
liability.  Accordingly, we bifurcated the embedded beneficial
conversion feature and accounted for it as a derivative liability because the
conversion price of the debentures could be adjusted if we subsequently issue
common stock at a lower price and due to recent events it became possible that
we could have to net cash settle the contract if there were not enough
authorized shares to issue upon conversion.




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




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




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




For the
three months ended March 31, 2009, we recorded non-operating income of $0.8
million in the Consolidated Statement of Operations for the decrease in the fair
market values of the embedded derivative features, which is primarily
attributable to the decrease in the market price of our common
stock.




In May
2009, following the end of the period covered by this report, under the
Amendment Agreement, we amended the terms of our PIPE Warrants to allow the
holder's to exchange the PIPE Warrants directly for shares of our outstanding
common stock at ratio of 1.063 shares of common stock underlying the PIPE
Warrants for one share of common stock.  The exchange ratio is subject
to adjustment in the event of stock split or dividend.  However, the
provision in the PIPE Warrants relating to adjusting the exercise price on the
issuance of future equity securities has been eliminated.   See
"Recent Financings," above.




Provision
for income taxes




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




We
adopted the provisions of FASB Interpretation No. 48, “Accounting for
Uncertainty in Income Taxes,” on January 1, 2007.  We did not have any
unrecognized tax benefits which would require an adjustment to the January 1,
2007 beginning balance of retained earnings. We did not have any unrecognized
tax benefits at December 31, 2007 or at December 31, 2008.  We
recognize interest accrued and penalties related to unrecognized tax benefits in
tax expense. During the years ended December 31, 2008 and 2007, we recognized no
interest and penalties.





27
 Table of Contents




Liquidity
and Capital Resources




Our cash
balance as of March 31, 2009 was $1.3 million.  At that time, we had
accounts receivable of $2.7 million and a working capital deficit of $8.8
million, which includes warrant and beneficial conversion liabilities of $4.5
million and accrued interest on debentures of $1.8 million.




Cash
generated by operations during the three months ended March 31, 2009 was $0.8
million. This was primarily the result of a net loss of $2.3 million which was
offset by the following non-cash charges: stock compensation expense of $0.3
million; amortization of note discounts of $0.4 million; amortization of
intangible assets of $0.6 million; and depreciation expense of $0.5 million
(which includes depreciation expense of $0.2 million in cost of sales). The
change in fair value of warrant and beneficial conversion liabilities of $0.9
million decreased our cash generated by operations.  In addition to
the non-cash charges, the increase in cash generated by operations during the
three months ended March 31, 2009 was primarily attributable to a reduction in
accounts receivable of $0.8 million and an increase in accrued interest of $0.9
million.




Net cash
used by investing activities during the three months ended March 31, 2009 was
$0.2 million, which consisted of purchases of property and
equipment.




Net cash
used by financing activities was $0.3 million during the quarter ended March 31,
2009. All of the cash used by financing activities was used for payments on our
capital leases.




We
believe our cash balance, along with other cost saving initiatives we have
planned for 2009, if implemented successfully, is sufficient to fund our
operations through fiscal 2009.  We do not currently have any unused
credit arrangement or open credit facility available to us.  Our PIPE
Debentures are secured by a lien on all of our assets, and the terms of those
debentures restrict our ability to borrow funds and pledge our assets as
security for any such borrowing, without the consent of the holders of the PIPE
Debentures.




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




Commitments
and Contingencies




Debentures




As of
March 31, 2009, the principal balance we owe on our outstanding debentures is
$29.6 million, all of which is due June 30, 2014.  In May 2009, the
terms of our debentures were amended to defer interest payments until October 1,
2011 at which time interest is to be paid in cash.  In addition, at
any time, the holders of the debentures have the right to convert the debentures
into common stock at the then effective conversion price (currently $0.30). See
"Recent Financings," above.




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




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




Leases




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




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





Operating
                    Leases
                  
                  
                  Capital
                    Leases2009
                  
                  $
                  1,232,526
                  
                  
                  $
                  845,1812010
                  
                  
                  1,418,485
                  
                  
                  
                  687,2232011
                  
                  
                  1,273,228
                  
                  
                  
                  281,9892012
                  
                  
                  1,269,119
                  
                  
                  
                  46,6842013
                  
                  
                  184,920
                  
                  
                  
                  14,139Thereafter
                  
                  
                  —
                  
                  
                  
                  —Total
      minimum lease payments
                  
                  $
                  5,378,278
                  
                  
                  
                  1,875,216Less
      amount representing interest
                  
                  
                  
                  
                  
                  
                  (218,345
                  )Present
      value of minimum lease payments
                  
                  
                  
                  
                  
                  
                  1,656,871Less
      current portion
                  
                  
                  
                  
                  
                  
                  (874,670
                  )Total
      long term portion
                  
                  
                  
                  
                  
                  $
                  782,201





Minimum Third Party Network
Service Provider Commitments




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




Communications Assistance
for Law Enforcement Act




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




Universal Service
Fund




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




Sales and Additional
Taxes




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




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Other




In
connection with our acquisition of AccessLine, we are required to pay up to an
additional $9.0 million in the form of 2,500,000 shares of our restricted common
stock upon the achievement of certain future financial objectives, the value of
which would increase the amount of goodwill recorded in the
transaction.  The first earn out period ended December 31,
2007.  In April 2008, when the contingency related to the first earn
out period was resolved, we issued 599,130 shares valued at $0.6 million,
resulting in increases to goodwill and equity.  The second earn out
period ended June 30, 2008, and we issued 529,252 shares valued at $0.3 million
in July 2008.  The increase in goodwill and equity were recorded in
the third fiscal quarter of 2008.  The third earn out period ended
December 31, 2008, and we issued 515,622 shares valued at less than $0.1 million
in February 2009.  The increase in goodwill and equity was recorded in
the first quarter of fiscal 2009.  There is one additional earn out
period which will terminate on June 30, 2009.  We may be required to
pay up to 625,000 additional shares of common stock upon AccessLine's
achievement of certain future financial objectives during that
period.




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




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




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




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




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




Critical
Accounting Policies Involving Management Estimates and Assumptions




Our
discussion and analysis of our financial condition and results of operations is
based on our consolidated financial statements.  The preparation of
the consolidated financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the reported amounts of assets, liabilities and
equity and disclosure of contingent liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period.  Significant estimates include those related to the
allowance for doubtful accounts; valuation of inventories; valuation of
goodwill, intangible assets and property and equipment; valuation of stock based
compensation expense under SFAS No. 123(R), the valuation of warrants and
conversion features; and other contingencies.  On an on-going basis,
we evaluate our estimates.  We base our estimates on historical
experience and on various other assumptions that are believed to be reasonable
under the circumstances, the results of which form the basis for making
judgments about the carrying value of assets and liabilities that are not
readily apparent from other sources.  Actual results could differ from
those estimates under different assumptions or conditions.




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




Inventories:




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




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Property
and Equipment:




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




Goodwill:




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




Impairment
of Long-Lived Assets:




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




Revenue
Recognition:




Voice and Network Solutions
Revenue




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




Video Solutions
Revenue




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




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




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




Income
Taxes:




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




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




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Derivative
Financial Instruments




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




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




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




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




Stock
Based Compensation:




On
January 1, 2006, we adopted SFAS No. 123(R) “Share-Based Payments”, which
requires us to measure the cost of employee services received in exchange for an
award of equity instruments based on the grant-date fair value of the
award.  That cost is recognized in the Consolidated Statement of
Operations over the period during which the employee is required to provide
service in exchange for the award – the requisite service period.  No
compensation cost is recognized for equity instruments for which employees do
not render the requisite service.  The grant-date fair value of
employee share options and similar instruments is estimated using option-pricing
models adjusted for the unique characteristics of those
instruments.




Recent
Accounting Pronouncements




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




Off-Balance
Sheet Arrangements




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




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Item3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK




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




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
March 31, 2009, our disclosure controls were effective at that "reasonable
assurance" level.




Changes In Internal
Controls over Financial Reporting.




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






33
 Table of Contents




PART
II – OTHER INFORMATION









Item
1. LEGAL PROCEEDINGS .




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




Item1A. RISK FACTORS




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




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




In
February 2009, we issued 515,622 shares of our common stock pursuant to the earn
out provisions of the AccessLine acquisition agreement for the period ending
December 31, 2008.




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




Item
3. DEFAULTS UPON SENIOR SECURITIES




None.




Item4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY
HOLDERS




None.




Item5. OTHER INFORMATION




None.




Item6. EXHIBITS




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






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SIGNATURES




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






TELANETIX,
      INC./s/
      J. Paul
      QuinnDate:
      May 13, 2009
                J.
      Paul Quinn, Chief Financial Officer(Duly
      Authorized Officer and Principal Financial
  Officer)






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EXHIBITINDEX




Exhibit
      No.
              Description3.1
              Bylaws,
      as amended (1)10.1
              Amendment
      to Debenture and Warrant Purchase Agreement dated May 8, 2009
      (2)31.1*
              Certification of Principal Executive Officer pursuant to
      Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as
      adopted pursuant to Section 302 of the Sarbanes-Oxley Act of
      200231.2*
              Certification of Principal Financial Officer pursuant to
      Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as
      adopted pursuant to Section 302 of the Sarbanes-Oxley Act of
      200232.1*
              Certification of Principal Executive Officer pursuant to
      18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
      Sarbanes-Oxley Act of 200232.2*
              Certification of Principal Financial Officer pursuant to
      18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002
   *
              Filed
      with this report(1)
              Incorporated
      by reference to the registrant's Current Report on Form 8-K filed on April
      29, 2009(2)
              Incorporated
      by reference to the registrant's Current Report on Form 8-K filed on May
      11, 2009






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