**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

----

**FORM 10-K**

**FOR ANNUAL AND TRANSITIONREPORTS**

**PURSUANT TO SECTIONS 13 OR15(d) OF THE**

**SECURITIESEXCHANGE ACT OF 1934**

| **(Mark One)**                                                                                                                         | ** ** | ** **                                                                                                                 |
|----------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------|
| x                                                                                                                                      | ** ** | **ANNUAL REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                        |
| **For the fiscal year ended: December 31,  2005**                                                                                 |
| **OR**                                                                                                                                 |
| o                                                                                                                                      | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE  REQUIRED]** |
| **For the transition period from                  to** |

**CommissionFile Number 0-22871**

----

**OMTOOL, LTD.**

(Exact Name of Registrantas Specified in Its Charter)

| **Delaware**                              |   | **02-0447481**                           |
|-------------------------------------------|--------|------------------------------------------|
| (State or Other  Jurisdiction of          |   | (I.R.S. Employer  Identification Number) |
| Incorporation or  Organization)           |   | ** **                               |
| **8A Industrial Way, Salem, NH**          |   | **03079**                                |
| (Address of  Principal Executive Offices) |   | (Zip Code)                               |

Registrant’s telephone number, including area code: **(603) 898-8900**

Securities registeredpursuant to Section 12(b) of the Act: **None**

Securities registered pursuant to Section 12(g) ofthe Act:

**Common Stock, $.01 par value**

(Title of Class)

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act. Yes o  No x

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or15(d) of the Exchange Act. Yes o  No x

Indicate by check markwhether the registrant: (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports) and (2) has been subject to such filing requirementsfor the past 90 days. Yes x  No o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K isnot contained herein and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K. x

Indicate by check markwhether the Registrant is a large accelerated filer, an accelerated filer or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o                                Acceleratedfiler o                                  Non-accelerated filer x

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

As ofJune 30, 2005, the aggregate market value of the registrant’s common stockheld by non-affiliates of the registrant was $18,343,016.12 based on theaverage bid and asked price as reported on the National Association of Securities Dealers AutomatedQuotation System National Market System.

The number of sharesoutstanding of the registrant’s common stock as of March 24, 2006 was 3,976,786.

**DOCUMENTS INCORPORATED BYREFERENCE**

Theregistrant intends to file a definitive proxy statement pursuant to Regulation 14Awithin 120 days of the end of the fiscal year ended December 31,2005. Portions of such proxy statement are incorporated by reference into Part IIIof this report.

 

----

Except for the historicalinformation contained herein, this Report contains forward-lookingstatements within the meaning of Section 27A of the Securities Act of 1933and Section 21E of the Securities Exchange Act of 1934, includingstatements regarding, among other items: our growth strategies; anticipatedtrends in our business; our ability to expand our product and serviceofferings; and the Company’s ability to satisfy working-capital requirements.These forward-looking statements are based largely on the Company’sexpectations and are subject to a number of risks and uncertainties, certain ofwhich are beyond the Company’s control. In addition, we may face additionalrisks and uncertainties not presently known to us or that we presently deem tobe immaterial. If any of those known or unknown risk or uncertainties wereactually to occur, our actual results could differ materially from theseforward-looking statements. Further, our actual results could materiallydiffer from those forward-looking statements as a result of a number of factorsincluding, but not limited to, those factors described in Item 1A. RiskFactors.

**PART I**

**Item 1.**                        Business

We provide document routing solutions and servicesthat enable organizations to manage the capture, processing and distribution of“mixed-mode” documents (i.e., documents that contain both paper and electroniccomponents) to electronic information systems such as enterprise contentmanagement systems, document management systems, records management systems,e-mail systems and document-archiving systems, leveraging applicationinterfaces with which users are already familiar. Our enterprise-class productsare used by organizations that manage paper-based documents as part of theirstandard business processes and/or have stringent compliance requirements forsecure document handling, storage, integration and tracking of a variety ofdocuments to or from corporate information systems.

We help companies manage document routing byleveraging existing information technology (“IT”) infrastructures andintegrating our products with industry-leading electronic information systems. Weadd secure document management and routing functions along with high-volume faxfunctionality to a company’s existing communication infrastructure. Since paperremains integral to many business processes, we also provide technology thatincorporates electronic delivery, security and billing functionality intoindustry-leading multi-function and scanning devices.

AccuRoute®, our flagship product, is a softwareplatform for simplified, simultaneous and secure document distribution.AccuRoute allows companies to control the integration and distribution ofmixed-mode documents into ever-changing corporate information systems andprocesses. Similar in concept to a network router, our AccuRoute product is thedocument routing hub, transforming between both paper and electronic-baseddocuments and routing the information within and outside an organization.

Working with virtually all multi-function devices andelectronic information systems (whether enterprise content management systems,document management systems, records management systems and archival systems aswell as fax and e-mail systems), our AccuRoute product provides adevice-independent, personalized solution so users can distribute documentsfrom a multi-function device (“MFD”) panel or right from their desktop computerusing a familiar and comfortable interface. In addition, our AccuRoute productsupports the movement of electronic documents and information, enablingcompanies to increase employee productivity by quickly capturing hardcopydocuments, distributing them in electronic form and complying with privacyregulations related to health, financial or other confidential information.

GenidocsTM, our secure document-delivery applicationproduct, integrates with existing e-mail systems and provides multiple optionsfor content and attachment encryption, authentication, audit trail, deliveryconfirmation and digital signatures. GenifaxTM, our enterprise fax product,offers a scalable, server-based 

2

----

feature set and shares acommon Microsoft® Windows® server-basedarchitecture with our Genidocs product line.

Our AccuRoute product further unifies the code basesand architecture of our Genidocs and Genifax products. With its routingcapabilities, our AccuRoute product provides a customer-specific software thateasily manages both paper and electronic documents with little or no usertraining required.

Companies can deploy our software products onheterogeneous, multi-platform networks and digital scanning and MFDs and canintegrate them with both desktop and enterprise software applications such ascontent management systems, e-mail systems and groupware systems. To addressour users’ needs, our products are modular and scaleable. Our customers canimplement additional communication capacity through the addition of systemcomponents and connectors to keep pace with growing demand. Our customers canalso add additional Omtool product servers to a configuration to providefailover redundancy, helping to ensure continuous operation. We license ourproducts on a combination server/seat basis and as external hardware devicesbecome increasingly technologically advanced, we will extend a portion of ourlicense fees to a device-based model.

We will continue to focus on those vertical marketswhere industry or governmental regulations or business practices requireconfidentiality, timely electronic delivery and archiving of critical documentsin electronic and paper format. We also expect to maintain our establishedposition in our traditional market – secure electronic document exchange(primarily fax-based business). In addition, we plan to continue the evolutionof our AccuRoute product line; encapsulate the functionality of all ourproducts into a single, configurable platform; expand our integration withcomplementary technologies (such as document and records management tools);andto extend our document capture capabilities to continue to includecompatibility with virtually all MFDs and scanners. In this manner, we willpursue a leadership position in the broader document delivery, routing andmanagement markets that we believe will grow in response to increasinglyregulated communications and stringent privacy requirements.

We were incorporated inNew Hampshire in March 1991 and we reincorporated in Delaware in January 1996.Our principal executive offices are located at 8A Industrial Way, Salem, NewHampshire 03079 and our telephone number is (603) 898-8900. Our Website is at *http:*//*www.omtool.com.*We make available free of charge through our Web site our annualreports on Form 10-K, quarterly reports on Form 10-Q,current reports on Form 8-K and amendments to these reports filed orfurnished pursuant to Section 13(a) or 15(d) of the Exchange Actas soon as reasonably practicable after we electronically file these materialswith the Securities and Exchange Commission.

**Industry Background**

Industry leading companies today are striving toincrease employee productivity so as to remain competitive while complying withemerging government mandates and regulatory frameworks. As a result, companiesmust focus on improving and streamlining the exchange and management ofdocuments within the context of complete enterprise content management. Whilemany enterprises have invested heavily in powerful and reliable ITinfrastructures, these investments address only a portion of the problem. Asignificant percentage of a company’s critical business information remainslocked in the company’s file drawers in the form of paper documents.

As a result, many companies are encounteringcontent-management challenges. According to the Enterprise Strategy Group,unstructured content (including such things as audio, video and unstructured textsuch as the body of an e-mail or word processor document) is growing annuallyat a ninety-two percent compound rate. This growing amount of unstructuredcontent has a direct impact on employee productivity as employees are forced todeal with the growing influx of documents. Studies show that a typical officeworker spends forty percent of his or her time looking for information whileprofessionals spend more than 500 hours annually reviewing and routingdocuments and another 150 hours annually 

3

----

looking for incorrectlyfiled documents.  The cost of this timeis significant.  An industry study foundthat an average organization spends $20 in labor to file each document, whileone out of every 20 documents is lost. We believe companies seeking to remaincompetitive must address this lost productivity and we believe that ourproducts are well-suited to tackle this challenge.

In the wake of confidence-shattering corporate fraudand misrepresentations, new and revised compliance requirements are forcingcompanies to address the way in which they handle their documents (both paperand electronic) and manage their associated information managementinfrastructure. To ensure that they retain required documents for theprescribed periods of time and that retained documents are immediatelyaccessible, enterprises are revisiting their document retention policies basedon specific compliance requirements such as the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”);Section 17(a) of the Securities Exchange Act of 1934, as amended;anti-money laundering statutes; and other similar laws and regulations. At thesame time, consumer privacy continues to be a growing concern. Compliancerequirements in support of privacy – such as the Gramm-Leach Bliley Actand the Health Information Portability and Accountability Act (“HIPAA”) – dictatespecific policies and procedures for capturing, distributing and storingconsumer and patient records and securing their privacy and security.

To remain competitive and comply with these regulatorymandates, companies must improve and streamline the exchange and management ofdocuments both within and beyond their organizations. Further, companies desireenterprise content management strategies that encompass the paper portion oftheir business processes and integrate mixed-mode documents. A comprehensivecontent management strategy dictates how the company will capture, process androute documents. Industry analysts at Gartner, Inc. such as Toby Bellindicate that the enterprise content management market is evolving towarddistributed workgroup enablement and that the office document solutionsprovider that delivers a distributed document routing product and providesenterprise savings by supplementing or replacing centralized scanning solutionswhere appropriate will be positioned for long-term growth. Understanding thismarket potential and the suitability of our products to these challenges, wehave targeted our technology and market focus on just this type of solution.

The paperless office is a myth – paper remains aprimary medium for exchange, collaboration and final delivery of documents.Recognizing the continued prevalence of hardcopy documents and the need tostore and distribute them electronically, we have – through direct sales,strategic partnerships and continued product development – delivered ourAccuRoute product to the marketplace. Our AccuRoute product is a server-basedsoftware application that leverages existing electronic delivery and managementtools embodied in our Genifax and Genidocs products to enable users to capture,process and deliver hardcopy documents electronically. These productscollectively enable efficient, secure and controlled electronic delivery andarchiving, making hardcopy content available across an enterprise for easyreuse and redistribution. We believe that opportunities exist for us to sellour products in the legal, financial services and health care vertical markets.We believe our solutions are well suited to markets that require documentdistribution and faxing from data-centric applications; paper integration inmission critical business processes; and fax as the standard for electronicdocument exchange.

Our products enable usersto streamline the handling and management of their documents and assistbusinesses in complying with government regulations such as Sarbanes-Oxleyand HIPAA. Our technology also helps businesses track and archive theirdocuments and transactions, as well as secure and protect private information. Ourproducts include a suite of utility and control functions that enable theconversion of paper documents to standard electronic formats and integrate withindustry-standard document and records management systems. Our productsintegrate business processes that include the exchange of hard copy andelectronic documents such as legal contracts, records of financialtransactions, medical records and purchase orders. Further, our productsminimize risks by preserving the security of high-value documents, increasingproductivity through their user-friendly designs, reducing costs by saving lost

4

----

productivitytime and meeting emerging business requirements through the integration ofpaper into the corporate electronic information infrastructure.

**The Omtool Solution**

Facilitated byincreasingly simple, portable and affordable technologies, document capture isincreasingly moving from a centralized, back-office process into an everyday,network-enabled, front-office function*.*Simultaneously,the need for companies to integrate paper documents with their electroniccounterparts and integrate them into business workflows is becoming commonplace.For many companies, as their document management, storing, routing and deliveryneeds grow and become more diverse, document-management challenges are risingto the top of the agenda. In identifying the features necessary to tackle thesechallenges, companies desire solutions that provide:

·       Continuousand spontaneous document integration;

·       MFDhardware independence that enables the capture of documents from differentdevices and platforms;

·       Simultaneousdistribution of documents to multiple destinations such as fax, e-mail ordocument or records management systems;

·       Captureof paper, electronic and mixed-mode documents and integration of them into electronicfile structures (including document management and storage systems);

·       Decentralizeddocument integration and scanning; and

·       Creationof personal document-routing instructions for greater flexibility.

Our products address theseneeds and deliver simplified, distributed document handling for commonand daily use by end users and workgroups. Working with virtually all MFDs andelectronic information systems, our products are positioned as the documentrouting hub that provides all points of connectivity within an enterprise formixed-mode documents.

To effectively provide our comprehensive documentrouting solution, we continue to invest in our AccuRoute product, whichsupports virtually all MFDs. We continue to advance AccuRoute’s documentprocessing functionality while incrementally adding support for electronicinformation systems such as e-mail systems, enterprise content managementsystems, records management systems, archival systems and more.

Our products add the functionality and security that aremissing from existing messaging, enterprise resource planning and documentmanagement systems and MFDs. Along with our hardcopy and fax archive features,the document routing and delivery security that our products provide helpscompanies meet government mandates and best-practice policies regarding theprotection and preservation of confidential business and personal informationthat is transmitted electronically. Our enterprise software cost-effectivelyadds accountability, improved security, archiving and easy access to populardocument management systems.

Our products provide userswith an extensive and flexible feature set that captures, processes,distributes, archives and integrates documents in electronic formats,regardless of their original format. As a result, users of our products canstreamline the handling and management of business documents and comply moreeasily with government regulations regarding document storage and personalprivacy. Corporate customers deploy our products as a key component of businessprocess systems. Our customers deploy our products to facilitate the storage,routing, capture, sharing and archiving of documents crucial to financial andlegal transactions, insurance claims, purchase order processing and salesquoting. Our customers also use our products to process – easily andsecurely – medical records and legal documents.

5

----

*AccuRoute*

Our AccuRoute product captures, processes anddistributes paper and electronic documents. AccuRoute 2.1 – the currentversion of our product – lets business users administer their documentsfrom either their desktop computer or from a MFD panel, all while seamlesslyintegrating with their business workflow.

With our AccuRoute product, users capture and converthardcopy documents to either un-editable image-based format, such as atagged image file format (“TIFF”) or Adobe’s Portable Document Format (“PDF”),or an editable and searchable text-based format such as PDF text, MicrosoftWord document, or Rich Text Format. The users of our AccuRoute product can thenroute and archive documents to various document delivery and document storagesystems. Our AccuRoute product works with nearly all brands of scan-enabledMFDs by allowing the definition of document capture and delivery options at theend user’s desktop computer. During 2005, we extended this technology toinclude AccuRoute capabilities not only at the desktop, but also at MFD panelsor cost recovery systems to conform to varying business practices and varyingend user needs.

Our AccuRoute product is particularly flexible andfunctional because a user can, at his or her desktop, pre-define the documentrouting workflow, taking full advantage of systems that are present on his orher desktop, including access to the corporate global address list and personalcontacts. In addition, our AccuRoute product takes advantage of the documentimport/indexing functionality of a company’s enterprise content managementsystems and document/records management systems. Once defined, this routinginformation is stored on the AccuRoute server and assigned a unique code, knownas an *“embedded directive.”* That embeddeddirective is then inserted into an intelligent routing sheet and a scanneddocument is then automatically delivered back to the end user on his or herdesktop. Alternatively, workers who prefer to use the front panel of a MFD orother scanning device may access the same routing list from the device itself. Storedas a PDF, the intelligent routing sheet can be archived for re-use, distributedto team members or posted on a corporate Web site for general use routingdocuments to a predefined set of destinations.

The modular design of the Omtool message serverunderlying AccuRoute systems allows an organization to deploy a basic AccuRoutescan-to-route system for document capture, delivery and archive, while alsoallowing the addition of full enterprise fax functionality, including desktopand scan-to-fax, as needed simply by purchasing the appropriate components andfax modem hardware from our Genifax product line.

The document routinginstructions in an embedded directive that our AccuRoute product creates can becombined with server routing rule automatically to archive inbound faxesor route them to multiple recipients and locations. This type of automateddocument routing streamlines paper-intensive processes by eliminating in-housescanning (as a document is essentially scanned when it is faxed) andefficiently routes electronic documents. Our fax-based client/server softwareplatform – deployed as part of a full AccuRoute system or solely as partof our Genifax product – can be configured to automatically process datastreams from back-office manufacturing and other applications for automaticelectronic exchange, reducing material and manpower costs.

**Strategy**

We aim to maintain our position as a leading providerof enterprise-class document-routing software solutions and strive to become aleading provider of electronic document exchange solutions that includecapture, processing and distribution of paper or electronically formatteddocuments. We intend to take advantage of our penetration of the legal verticalmarket, our existing customer base, our partnerships and our extensiveknowledge of enterprise content management and document routing to implementthe following business strategy:

6

----

*EstablishOmtool as the Preeminent Enterprise-Class Software Provider.**  *Through our increased investment in sales andmarketing, we plan to establish the Omtool brand in enterprise-class documentrouting solutions while maintaining our strong position as an enterprise-levelfax software provider.

*MaintainTechnology Leadership Position in the Enterprise Market and Continue to EnhanceProducts.**  *Weintend to continue to extend our existing product offerings and form strategictechnology and distribution partnerships to further penetrate our targetmarkets. We intend to continue investments in our electronic document deliverystrategy by integrating with other document and records management systems, bycontinuing to refine our message server based platform with additional featuresand by integrating with other third-party systems. In addition, whereappropriate, we will continue to invest in and refine our fax andsecure-messaging technologies as part of the evolution of our AccuRouteplatform in order to keep pace with customer requirements. Where opportunitiesexist, we will investigate repackaging portions of our existing technology toaddress opportunities that we believe exist for low-cost, distributed productsthat provide limited document exchange capabilities.

*EstablishAccuRoute as the Universal Document Routing Hub.**  *Through product development and targeted marketingefforts, we plan to establish AccuRoute as a universal document routing hubsupporting virtually all devices related to document capture, documentmanagement and electronic information systems. We plan to support these effortsthrough general and vertical-market-specific marketing.

*LeverageInstalled Base of Customers.**  *We believe that with our AccuRoute product,opportunities exist to expand our user base and expand the use of our softwareapplications at our existing customer installations. We intend to pursue theseopportunities by leveraging both our solution/reseller channels and increasingour direct sales force. In addition, we believe that our ability to maintain ahigh level of customer satisfaction among our customer base is criticallyimportant in marketing our products. We will actively seek opportunities to licenseour AccuRoute product to existing customers who are currently using our Genifaxor FaxSr. software, specifically highlighting how our AccuRoute productimproves processes, reduces costs and addresses regulatory issues relating toinformation archiving, access and privacy.

*Focuson Vertical-Market Opportunities.**  *We believe that opportunity existsfor our electronic document delivery solutions in specific vertical markets. Wehave achieved market penetrations in the legal, health care, financial servicesand Fortune 1000 markets and we intend to continue focusing on those markets.

We plan to continue to broaden our position in thelegal vertical market. Our products are particularly well-suited to thedocument-centric environment of law firms that need to convert current aswell as legacy paper-based documents into electronic files for archiving indocument or records management systems. Ideally, these electronic documentsshould be in a searchable format and properly profiled for easy and fastretrieval.

Our AccuRoute product enables law firms quickly,easily and conveniently to convert paper documents using a one-scan process onvirtually all leading networked, scan-enabled office devices. These scan filesare converted (through our AccuRoute application) to selected formats includingsearchable PDF—a format required by many law firms. Our AccuRoute product candeliver these files to multiple recipients via fax and e-mail and store them ina document repository. Our AccuRoute product is tightly integrated with populardocument management systems offered by EMC Corporation (with its Documentum® product), Interwoven, Inc. (with its  iManage® product),Hummingbird, Ltd. (with its Hummingbird Enterprise DMTM product) and WorldSoftware Corporation (with its WORLDOX® product) to name a few. Further, throughAccuRoute, users have access to the native profiling screens of their documentmanagement systems so as to be able to capture document information prior toscanning, allowing law firms to take full advantage of their documentmanagement and archiving systems.

7

----

In addition to the need for increased productivity, wehave identified compliance initiatives and government mandates such asSarbanes-Oxley that prescribe corporate policies for tracking, securing andarchiving any and all communications and documents relating to financialreporting. These compliance requirements are driving enterprises to pay closeattention to their document management strategies. We believe these initiativeswill create the need for AccuRoute not just in the financial services markets, butin the broader enterprise marketplace where compliance and related documentmanagement requirements are a horizontal problem, spanning more than onevertical market.

We believe that government regulations regardingprivacy and the need to better manage paper documents will drive many healthcare organizations to re-examine their methods for managing patient-relatedinformation and investigate ways to streamline paper-based processes toimprove efficiency and eliminate redundancy while improving security. Today,health care organizations use e-mail and fax to communicate patient informationamong health care providers, payors and private corporations. Under HIPAAregulations for document portability and privacy, both e-mail and faxcommunications must undergo significant changes to ensure the confidentialityof patient information. Our products provide a fully capable fax and e-mailsolution that supports HIPAA-compliant processes. Our solutions combine bothprocedural changes to physical workflows and technological changes. The healthcare market represents a major opportunity for our products and, although wehave achieved some penetration into the health care market already, we willmake it a vertical market focus this year and in the future so that we canincrease our penetration into this market.

*Expandand Build Distribution Channels while Maintaining Our Direct Sales Organization.**  *We believe our success requires anexpanded distribution base to broaden both our reach into targeted verticalmarkets and to penetrate further our installed base. We will continue to usedirect sales efforts where appropriate to focus on account management. Wecontinue to refine our domestic and international distribution network with thegoal of developing close partner relationships that will augment ourdistribution channels, complement our direct sales efforts and provide marketstrength in various geographic regions.

*IncreaseInternational Sales Presence.**  *We intend to increase ourinternational presence (primarily in Europe) to address target markets outsideof the United States and serve customers that operate on a multinational basis.In 2003, 2004 and 2005, we derived approximately 23 percent, 22 percent and19 percent of our total revenue from sales outside of United States(primarily in Europe, Canada and South Africa).

*PromoteLeadership in the Enterprise Content Management and Document Routing SoftwareEnvironment.**  *OurAccuRoute product provides a common set of document capture, processing anddistribution tools that operate on a broad set of MFDs from virtually allleading manufacturers, while providing integration with installed enterprisecontent management and document management systems. We believe thatorganizations will adopt policies to control more effectively informationexchange and archiving as reliance on paper documents increasingly becomes anobstacle. In today’s business environment—which is an e-mail centric culture—managingpaper documents is both inefficient and ineffective given present day corporatedocument management strategies and infrastructures. Our AccuRoute productprovides a clear solution to bridge seamlessly the paper/electronic gap and isbecoming necessary infrastructure for efficient and effective enterprisecontent management.

*Continue to PursueStrategic Relationships.**  *We have and will continue to form strategicrelationships with leading providers of products and services that complementour product offerings. We believe that these relationships will provide avaluable means of market expansion, a solid source of sales leads and exposureof our products to new markets and prospective customers.  We have strategic alliances with XeroxCorporation, Ricoh Co., Ltd.; Hewlett-Packard Company and LexmarkInternational, Inc. — providers of digital scanning MFDs that, whencombined with our software products, enable users easily to 

8

----

integrate hardcopydocuments into their electronic workflow. We believe these strategic allianceswill expose us to additional opportunities in the corporate, legal and healthcare markets.

**Current Productsand Services**

Contrary to industrypredictions, the “paperless office” remains a goal for the distant future. Forthe foreseeable future, companies will continue to rely on paper documents tosupport virtually every significant business process. Our products helpenterprises manage critical aspects of the flow of paper documents throughouttheir organizations.

*AccuRoute*®

AccuRoute is the product for enterprise documentcapture, processing and distribution that enables businesses to handle complexdocument-routing requirements efficiently and cost-effectively. By integratingpaper and electronic documents into a single, efficient and managed system, ourAccuRoute product allows users to define document distribution rules andintegrate those documents into their electronic workflows. As a result, endusers can accomplish multiple, complex document routing tasks easily – rightfrom their desktop computers or front panels of MFDs – while providingtheir enterprises with increased control over security and compliance-relatedissues.

Our AccuRoute product is a sophisticated documentrouting hub******that provides all points ofconnectivity within an enterprise for both paper and electronic documents.Users can quickly and easily use virtually any MFD (such as a digital copier orprinter) to scan, fax, store, send, receive, archive and more easily sharedocuments with others.

Our unique use of “embedded directives” enables usersto define their own process and distribution rules at their desktopcomputers, leveraging familiar user interfaces and saving valuable employeetime previously wasted performing manual entry at the physical device. Further,our AccuRoute product allows users to store embedded directives for future useor modification, saving valuable employee time on repetitive documentdistribution tasks.

The key features ofour AccuRoute product include:

·       Documentcapture and conversion into a variety of formats;

·       Creationof  text-searchable documents;

·       User-friendlydesktop interface leveraging native and familiar user interfaces;

·       “Embeddeddirectives” for automated, user-defined distribution;

·        Empower end users todefine their document distribution from their desktop;

·        Can be re-used and shared,increasing productivity;

·       Simultaneousdistribution of mixed-mode documents to multiple recipients and multipleelectronic information systems;

·       Device-independenceto support any networked scanner, scan-enabled digital printer, copier, fax orMFD; and

·       Comprehensive security andtracking.

Designed to enable *“in-process”* document capture and processing, our AccuRouteproduct provides a personalized solution that automatically distributes contentin multiple formats to multiple destinations from a single action, makingdocuments immediately accessible. The result: faster processes, increasedproductivity and lower costs.

9

----

*GenifaxTM*

Our Genifax productis a multi-tiered client/server solution for automating and integratingfax communication throughout an enterprise. As a component of an enterprisesoftware system, our Genifax product is deployed on heterogeneous, multi-platformnetworks and integrates with desktop and enterprise software applications. OurGenifax product provides high availability and high volume enterprise faxcapabilities, incorporating features and functions that include:

·       Redundancyand failover that ensure availability where fax-based messaging is missioncritical;

·       Approvalworkflow that allows administrative review and approval for both inbound andoutbound activity;

·       Theability to receive fax messages as image-based (non-editable) or textbased (editable) PDF files;

·       Anenhanced web client that enables users to send, receive, manage and view thestatus of their fax inboxes; providing an alternative to e-mail based forms fororganizations wishing to separate e-mail and fax traffic; and

·       Aprivate fax feature that ensures senders that the receiving fax machine isidentified prior to actual fax delivery.

Genifax’s private faxfeature makes this product ideal for the legal, healthcare and financialservices markets as well as other markets where confidentiality of faxeddocuments is either a regulatory requirement or a best practice. Further, ourGenifax product is designed to allow an administrator also to take advantage ofpassword/security features native to the Windows server operating system toprovide needed protections.

*GenidocsTM*

Our Genidocs product is a client/server messagingapplication that enables users to deliver documents – with comprehensivesecurity and tracking – through the Internet to external parties. Genidocsoffers the security features and functionality of traditional, paper-basedcommunications with the speed, efficiency and cost advantages of electroniccommunications. Our Genidocs product also integrates with popular e-mailapplications and digital paper-scanning devices.

Our Genidocs product implements a modular, component-basedarchitecture that works within an enterprise’s existing securityinfrastructure. Genidocs provides multifaceted security that combinesencryption with authentication, a time-stamped audit trail and digitalsignatures. A Genidocs system can be configured for *ad hoc*communications in which each transmission is encrypted, delivered and processedindividually. Our Genidocs product also provides an enterprise solution forcreating and distributing documents in PDF format.

Our Genidocs product’sconfirmed and secure electronic document delivery capabilities integratereadily with existing e-mail, document management and time and billing systemsto provide:

·       AutomatedPDF conversion and delivery;

·       Cost-recoverytracking and client bill-back reporting;

·       Documentmanagement archiving;

·       Encryption(including public-key infrastructure);

·       Digitalsignatures;

·       Sender/recipientauthentication;

10

----

·       Certifieddelivery notification, audit trails, third-party time stamps; and

·       Secure reply.

*Fax Sr.*

Fax Sr., our legacynetwork fax product, is a client/server software solution for automating andintegrating fax communication throughout an enterprise. As an integratedcomponent of an enterprise software system, our Fax Sr. product is deployed onheterogeneous, multi-platform networks and integrates with desktop andenterprise software applications. Our Fax Sr. product is licensed typically ona shrink-wrap basis, primarily for Microsoft Windows NT® and Microsoft Windows 2000TM server operatingsystems.

**Hardware**

We resell certain hardwareproducts (such as intelligent fax boards) from third-party vendors. Typically,we make hardware sales as a result of either new sales or sales to existingcustomers upgrading their information technology infrastructure. Occasionally,where our customers also want fax capabilities, we sell hardware products withour AccuRoute product. We undertake these hardware sales as a convenience tocustomers, who alternatively can opt to obtain hardware directly from athird-party vendor. The fax boards and fax modems that we resell are notfunctional without our product software and we are not generally in thebusiness of selling fax boards and modems. We purchase these hardware productsas needed to ship to our customers and we only maintain a minimal inventory ofthese hardware products.

**Customer Service**

To aid insuccessful customer deployments, our customer service organization providestechnical support for all of our products. For an additional fee at the time ofthe initial licensing of our products, we provide support services to ourcustomers for a typical period of twelve months. Support servicestypically include telephone support and software support (such as maintenancereleases, minor feature enhancement releases, technical bulletins andreplacement of damaged media). Customers may renew their support services attheir discretion on an annual basis. We currently price our annual supportservices based on a percentage of our product license fee. We provideadditional services on an as-needed basis including installation, training andconsulting. Our professional services include:

·       Sitesurvey, assessment and recommendations;

·       Training,installation and integration;

·       Advantagesupport for maintenance, upgrades and support; and

·       Full range of professionalservices, including software customization and consulting.

**Sales and Marketing**

While our products have broad horizontal applicabilitythrough compliance and business continuity initiatives, our direct salesefforts will remain focused on vertical-specific solutions, primarily in theareas of legal, financial services and health care. We will build upon oursuccess in the legal vertical market while continuing to expand into thefinancial services and health care vertical markets. When we introduced ourAccuRoute product to the legal vertical market, we enhanced our core productswith features that address workflow needs and integrate with products that arespecific to the legal market. In addition, we invested in marketing programsand branding initiatives targeted to the legal vertical market. Through theseeffort and based on the capabilities of our AccuRoute product, today we havemore than 110 legal vertical market customers, including nearly thirty percentof the top one hundred US-based law firms.

11

----

Fueled by compliance and privacy regulatory issues andthe early selection of AccuRoute by customers within the financial services andhealth care vertical markets, we believe that opportunity exists in thesevertical markets. We also believe that government regulations regardingconfidentiality, portability and security of patient records may indicate ashift toward electronic delivery methods that are consistent with thecapabilities of our products.

To address the broad range of sales opportunities forour products, we have relied on the coordinated efforts of our salesorganization, key executives and our marketing department. We also offer ourproduct lines through indirect sales channels such as resellers, systemsintegrators, value added distributors and strategic partners — channelsthat we plan to expand in 2006. In order to establish a strong resellerchannel, we have dedicated sales resources specifically to finding, qualifyingand managing our channel partners. We will increase our efforts to expand andstrengthen our partner relations in 2006 and the coming years. In addition tosupport of our direct vertical sales and marketing initiatives, we will alignwith strategic partners that can provide access to a broad and horizontal baseof potential customers to complement our existing vertical market focus.

Outside of the United States, we have a renewedpresence and will continue to use independent distributors to promote, licenseand support our products. In addition to our direct sales efforts, we expect tocontinue to market our products through independent distributors in strategicinternational markets. In 2003, 2004 and 2005, sales outside of the UnitedStates (primarily Europe) represented approximately 23 percent, 22 percentand 19 percent, respectively, of total revenue. In 2003, 2004 and 2005, totalrevenue within the United States accounted for 77 percent, 78 percent and 81percent, respectively, of total revenue.

To support our salesorganization, we will continue to implement comprehensive marketing programsthat promote our products and position us in the enterprise-class documentdelivery and management software and client/server fax markets. These effortsmay include product advertising, public relations, trade show participation,educational seminars, direct mail and telemarketing campaigns (both online andoffline), as well as participation in industry programs and forums.

**Customers**

As of December 31,2005, we had more than 8,400 customers worldwide across  many industries illustrating thecross-industry applicability of our products and services. No single customeraccounted for 10 percent or more of our total revenue in 2003, 2004 or 2005.

**Research andDevelopment**

We continue to invest in research and development,believing our future success depends largely on our ability to continue toconsolidate and enhance our Genifax, Genidocs and AccuRoute products into asingle comprehensive, feature-rich extendable platform. Our engineering teamsfocus on the concurrent development of a range of product enhancements thatleverage modular product architectures. Our product development efforts focuson new products, the exploration of emerging technologies and the continuedenhancement of existing products. We also continually review opportunities toform alliances with third-party vendors of complementary technologies andproducts to enhance the functionality of our product families. We may, based ontiming and cost considerations, continue to explore opportunities to license oracquire technologies or products from third-parties.

We expect to retainskilled development engineers whose services are in short supply. Should weneed to replace these skilled engineers and should we face any delays ordifficulties in doing so, our business, financial condition and results ofoperations could be adversely affected. Our research and development expensefor fiscal years 2003, 2004 and 2005 was approximately $2.2 million,$1.9 million and $2.2 million, respectively. Since our inception, wehave not capitalized any software development costs. We plan to 

12

----

continueto make significant investments in research and development, expenses comprisedprimarily of the compensation of skilled engineers, independent contractors andoutside vendors.

**Competition**

In the market for distributed document processing,capture and distribution where our AccuRoute product competes, the perceivedcompetition is derived from four different categories. Other technologyproviders vie for the same technology budgetary dollars as we do by offeringcompetitive products, including MFDs with embedded scan capabilities,OEM-enhanced scanning solutions, production scanning devices and documentimaging and routing technology from independent software providers.

The functionality and focus of the providers of eachof these types of products is significantly different, ranging from highlycentralized production scanning solutions to distributed and decentralizedenterprise platforms for handling both paper and electronic documents, eachsuitable for differing business needs. Most major MFD vendors provide basicscanning capability with each digital device at little or no cost.

OEM-enhanced solutions extend the baseline embeddedscanning functionality device and address a portion of the scanning needs of anenterprise. This solution is very specific to a particular MFD hardware and istypically displaced as the hardware is refreshed. In a heterogeneousenvironment, users will employ differing scanning functionality at each device,something that can be inefficient and confusing. In this area, we are likely to see competitive products fromhardware vendors such as Xerox Corporation, Canon Inc., Hewlett-Packard Companyand Ricoh Co., Ltd. In some cases, these products are the result ofpartnerships with United States-based software companies.

Prior to the availability of MFDs withenterprise-level scanning support, many organizations created centralizedscanning departments equipped with specialized (and expensive) high-speed scanners.These departments continue to handle large-volume forms-based scanningrequirements. While these scanning departments functioned well, especially withbatch scanning tasks, they solve a completely different problem than thataddressed by our AccuRoute product and do not address distributed workgroupscanning requirements. Production scanning requirements exist in parallel tothe daily business and *ad hoc* (orasynchronously processed) scanning requirements that our AccuRoute productaddresses. We face competition in thismarket from a few independent software vendors, for example Kofax (a DicomGroup, plc company) and EMC Corporation (formerly Captiva Software), whosebusiness focus was initially the high-volume production scanning segment.

Given our transition from a fax software company to anenterprise application provider for document capture and distribution, theremay continue to be a perception that our previous competitors are currentcompetitors. While the marketing messages of these companies may in someinstances create confusion, there are significant differences between ourproducts and those of these competitors. In addition, there are vastdifferences between the approach that these other companies take to solving theproblems of paper handling in business enterprises.

We believe our ability to compete successfully in thedistributed document capture and delivery market depends on a number of factorsboth within and beyond our control, including product performance, reliability,features, ease of use, product scalability, quality of support services, priceas compared to performance, timeliness of enhancements and new product releasesby us and our competitors. We expect the document capture, routing, storage anddelivery market to mature and become increasingly competitive with successresulting from critical partnerships and alliances with select hardware andsoftware partners.

The market for enterprise-class computer-basedfacsimile solutions is intensely competitive and is more established and maturethan the markets in which our AccuRoute product competes. We believe our 

13

----

ability to competesuccessfully in the fax market depends upon a number of factors both within andbeyond our control, including product performance, reliability, features, easeof use, product scalability, quality of support services, price as compared toperformance and, most importantly, market dynamics and maturity of thefax-based business. Given these factors, we anticipate a natural, continuedsteady decrease in sales of our fax products.

We compete directly with several vendors of facsimileproducts, including providers of facsimile software products for client/servernetworks such as Captaris, Inc. (with its RightFax® product), Dicom Group, plc (with its TopCallTMproduct) and Biscom, Inc. (with its suite of fax products). We alsocompete with providers offering a range of alternative facsimile solutionsincluding outsourcing network facsimile solutions, such as eFax® (aj2 Global Communications, Inc. product), Easylink Document Capture andManagement ServiceTM (an Easylink Services Corporation product), andDocuManagerTM (a Premiere Global Services, Inc./Xpedite product); operatingsystems containing facsimile and document e-mail features; low-end fax modems;desktop fax software; single-platform facsimile software; and customizedproprietary software solutions. In addition, providers of operating systems orbusiness software applications may bundle competitive facsimile solutions aspart of their broader product offerings.

Many of our actual andpotential competitors have longer operating histories and greater financial,technical, sales, marketing and other resources, as well as greater namerecognition and market acceptance of their products and technologies than wedo. In addition, there are relatively low barriers to entry in the markets inwhich we operate and intend to operate. New competition may arise either fromexpansion by established companies, from new companies or from resellers of ourproducts. There can be no assurance that our current or potential competitorswill not develop products comparable or superior in price and performancefeatures to those that we develop, adapt more quickly than we do to new or emergingtechnologies and changes in market opportunities or customer requirements,establish alliances with industry leaders or take advantage of acquisitionopportunities more readily than we do. In addition, we cannot assure you thatwe will not be required to make substantial additional investments in research,development, engineering, marketing, sales and customer service efforts to meetcompetitive threats or that we will be able to compete successfully in thefuture. Increased competition could reduce market share or create downwardpressure on our stock and related reductions in our gross margins—any of whichcould materially and adversely affect our ability to achieve our financial andbusiness goals. We cannot assure you that in the future we will be able tosuccessfully compete against current and future competitors.

**Proprietary Rights**

We regard our software as a trade secret and attemptto protect it under a combination of copyright and trade secret laws, employeenondisclosure and assignment of invention agreements and nondisclosureagreements with other businesses, including current and prospective businesspartners. We have one United States patent, three pending United States patentapplications, one United States trademark and six foreign trademarks. Wecurrently intend to pursue one pending United States trademark application andone pending foreign trademark application. To date, we have not registered anycopyrights. We generally license our products to our customers under “shrink-wrap”or “click-wrap” licenses (i.e., licenses included as part of the productpackaging or as part of the installation process). We do not negotiate theseshrink-wrap and click-wrap licenses with individual licensees and theselicensees do not affirmatively sign a license agreement with us. Instead, theselicenses purport to take effect upon the opening by a customer of the productpackage. Certain provisions of these licenses, including provisions protectingagainst unauthorized use, copying, transfer and disclosure of the licensedprogram, may be unenforceable under the laws of many jurisdictions. Despite ourefforts to protect our proprietary rights, unauthorized parties may attempt tocopy aspects of our products or to obtain and use information that we regard asproprietary. Policing unauthorized use of our products is difficult and,although we are unable to 

14

----

determine the extent towhich piracy of our products exists, we expect this kind of piracy to be apersistent problem, particularly in international markets. In addition, thelaws of some foreign countries do not protect our proprietary rights to thesame extent as the laws of the United States. We cannot assure you that theseprotections will be adequate or that our competitors will not independentlydevelop technologies that are substantially equivalent or superior to ourtechnologies.

The software industry has seen substantial litigationinvolving intellectual property rights. We cannot assure you that we will notbe the target of claims of infringement of intellectual property rights. Further,if asserted, a claim of intellectual property infringement might have amaterial adverse effect on our business, financial condition and results ofoperations. In addition, as we license certain components of our products fromthird-parties, our exposure to copyright and other infringement actionsmay increase because we must rely on those third-parties for informationas to the origin and ownership of the licensed components. In the future, wemay be required to initiate litigation to enforce and protect our tradesecrets, copyrights and other intellectual property rights.

We may also be subject tolitigation to defend against claimed infringement of the rights of others or todetermine the scope and validity of the intellectual property rights of others.Any litigation of this nature could be costly and require the diversion ofmanagement’s attention from other matters, either of which could have amaterial adverse effect on our business, financial condition and results ofoperations. Were any litigation of this kind to be adversely determined, wemight lose our proprietary rights, become subject to significant liabilities orbe forced to seek licenses from third-parties or prevented from sellingour products, any one of which would have a material adverse effect on ourbusiness, financial condition and results of operations.

**Employees**

As of December 31, 2005, we employed 87 peopleworldwide. We are not subject to any collective bargaining agreements, havenever experienced a work stoppage and consider our relations with ouremployees to be good.

15

----

**Item 1A.**                RiskFactors

We operate in a rapidly changing environment thatinvolves a number of risks, some of which are beyond our control. Thediscussion below highlights some of the risks that may affect future operatingresults.

Information provided by us from time to time,including statements in this Form 10-K that are not historicalfacts, consists of so-called “forward-looking statements” that involve risksand uncertainties, made pursuant to the safe harbor provisions of the PrivateSecurities Litigation Reform Act of 1995. In particular, statements containedin Management’s Discussion and Analysis of Financial Condition and Results ofOperations that are not historical facts (including, but not limited to,statements concerning: our plans and objectives; expectations for sales andmarketing, research and development and general and administrative expenses;developments relating to our product and service offerings, markets andacquisitions; anticipated trends in our business; our strategic alliances; changesin the regulatory environment; our expected liquidity and capital resources andour critical accounting policies) may constitute forward-looking statements. Theseforward-looking statements are neither promises nor guarantees, but are subjectto risk and uncertainties that could cause actual results to differ materiallyfrom the expectations set forth in the forward-looking statements. Factors thatmay cause these kinds of differences include, but are not limited to, thefactors discussed below and the other risks discussed from time to time in ourother filings with the Securities and Exchange Commission.

***Our futureoperating results are uncertain and difficult to predict.****  *We incorporated and shipped ourinitial facsimile software products in 1991. We had an operating loss in theyear ended December 31, 2005 and, although we recorded an operating profitin the year ended December 31, 2004, we had an operating loss and adecline in revenue for the year ending December 31, 2003. We introducedthe initial version of our AccuRoute product in the second quarter of 2002 andthe current version in the first quarter of 2004. Ultimately, our AccuRouteproduct represented 50% and 38% of software revenue for the years ended December 31,2005 and 2004. There can be no assurance that we will be able to increase ourlevel of revenue or become profitable again in the future, as our operatinghistory makes the accurate prediction of future operating results difficult orimpossible. We do, however, anticipate increases in operating expenses and,together with pricing pressures and any decline in the growth rate of theoverall United States economy or our industry in particular, we may experiencea decrease in our operating income and operating margin percentage.

Our ability to improve our operating results willdepend upon, among other things, our ability to increase sales of ourAccuRoute, Genifax and Genidocs products to new customers, as well as ourability to increase product penetration into existing customers. We recentlyexpanded our strategic focus to include document routing and distributionsoftware. To date, we have limited financial and operating data and a limitedoperating history relevant to this strategy. Accordingly, it is difficult toevaluate the prospects for the level of acceptance of this strategy. Inaddition, we plan to continue investing significantly in the expansion of ourAccuRoute product into new vertical markets, specifically first the financialservices vertical market and then the healthcare vertical market, in advance ofsignificant related revenue from those markets. We cannot predict the timing orlevel of revenue resulting from these investments. Future operating resultswill depend on many other factors, including, without limitation, the degreeand rate of growth of the markets in which we compete; the level of acceptanceof the Microsoft Windows NT, Windows 2000TM, Windows 2003TM and Windows XP® operating systems; the level of product andprice competition; our ability to establish strategic relationships and developand market new and enhanced products; our ability to control costs; our abilityto expand our direct sales force and indirect distribution channels bothdomestically and internationally; and our ability to attract and retain keypersonnel. As a result, it is possible that in the future, our operatingresults will be below the expectations of public market analysts and investors.In that event, the price of our common stock would likely be materiallyadversely affected.

16

----

***All of our productsare concentrated in the electronic document exchange market.****  *To date, much of our revenue hasbeen attributable to licenses of our facsimile-based enterprise solutions andrelated products and services. We expect these products and related services tocontinue to account for significant amounts of our future revenue. However,recently the amount of revenue attributable to licenses of these products hasdeclined and there can be no assurances that this decline will not continue. Furthermore,we introduced our secure business-to-business electronic document exchangeproducts, Genidocs and Genifax, to the market in the fourth quarter of 2000. Further,we introduced the initial version of our proprietary document and routingsoftware, AccuRoute, in the second quarter of 2002 and the current version ofthat product in the first quarter of 2004. We have only recently begun torecognize a significant amount of revenue from our AccuRoute product. We expectthis product to account for an increasing portion of future revenue. However,there can be no assurances that our AccuRoute product will be financiallysuccessful or result in any significant revenue in the future. Factorsadversely affecting the pricing of or demand for this product, such ascompetition or technological change, could have a material adverse effect onour business, financial condition and results of operations. All of ourproducts are concentrated in the electronic document exchange market and,therefore, any factors affecting demand for these sorts of solutions couldcause our operating results to decline. Investors must evaluate our prospectsin light of the risks and difficulties frequently encountered by companiesdependent upon operating revenue from a new product line in an emerging andrapidly evolving market.

***The markets for ourproducts are subject to rapid technological change and we may not be able tokeep pace with evolving industry standards or end-user requirements.***   The markets for our productsare relatively new and are characterized by rapid technological change,evolving industry standards, changes in end-user requirements and frequent newproduct introductions and enhancements. Our future success will depend upon ourability to enhance our current products and to develop and introduce newproducts that keep pace with technological developments and respond to evolvingend-user requirements. There can be no assurance that we will be successful indeveloping and marketing new products or product enhancements on a timelybasis, or that new products or product enhancements developed by us, such asour AccuRoute, Genidocs and Genifax products, will achieve market acceptance. Theintroduction of products embodying new technologies and the emergence of newindustry standards could render our existing products obsolete and unmarketable.From time to time, we and our competitors may announce new products,capabilities or technologies that have the potential to replace or shorten thelife cycle of our existing product offerings. There can be no assurance thatannouncements of new product offerings by us or our competitors will not causecustomers to defer or forego the licensing of our existing or planned productsand have a material adverse effect on our business, financial condition andresults of operations.

***The market forsecure business-to-business document exchange solutions is new and evolvingrapidly and there can be no assurance that our products will be successful inthis market.***   Themarket for Genidocs, our secure business-to-business electronic documentexchange solution is relatively new and evolving rapidly. Our success willdepend upon the extent and timing of adoption and use by current and potentialcustomers of secure business-to-business electronic document exchange solutions.Our success will also depend upon acceptance of our technology as the standardfor providing these solutions. The adoption and use of our securebusiness-to-business electronic document exchange solution will involve changesin the manner in which businesses have traditionally exchanged information. Ourability to influence usage of our secure business-to-business electronicdocument exchange solution by customers is limited. We intend to spend resourceseducating potential customers about the value of secure business-to-businesselectronic document exchange solutions. It is difficult to assess or to predictwith any assurance the present and future size of the potential market for oursecure business-to-business electronic document exchange solution, or thegrowth rate, if any, for this market. Moreover, we cannot predict whether oursecure business-to-business electronic document exchange solution will achieveany market acceptance. We note that we did not make any sales of our Genidocsproduct in the fiscal year 2005. If any of our future 

17

----

products or future productenhancements are not favorably received by our customers, we may be less or notprofitable and we may therefore suffer damage to our reputation or brand name.

***Were we to sufferan unexpectedly large decline in our legacy fax business, our financialcondition and results of operations would be significantly impaired.***   We currently derive asignificant though declining portion of our revenue from licenses of ourGenifax product, related services and resale of related hardware. However,sales of Genifax, our multi-tiered client/server software for automating andintegrating fax communications throughout an enterprise, were lower in 2005than they were in 2004 or 2003. Though we expect our sales of our legacy faxproducts to continue to decline in 2006, an unexpectedly large decline in themarket acceptance of our Genifax product would have a negative impact on ourfuture success. As a result, any unexpectedly large decline in demand for orfailure to maintain expected market acceptance of our Genifax product line as aresult of competition, technological change or otherwise, would have a materialadverse effect on our business, financial condition and results of operations. Ourfuture financial performance will depend in part on new and enhanced versionsof our Genifax product. There can be no assurance that we will continue to besuccessful in marketing our Genifax product or any new or enhanced versions ofthe Genifax product at expected levels. There can be no assurance that we willbe successful in developing products for new or enhanced operating systems suchas Microsoft’s Windows 2000 or Windows XP system, or that these systems willnot obviate the need for our products. If any new or enhanced operating systemgains widespread use and we fail to develop and provide our products for thisoperating system on a timely basis, our business, financial condition andresults of operations could be materially adversely affected.

***We depend on therevenue generated by sales of our AccuRoute product and would be negativelyimpacted if market interest – whether in the legal vertical market that wehave already targeted or the financial services and healthcare vertical marketsthat we are currently targeting – were to decline or fail to grow asexpected.***   Wecurrently derive a significant portion of our revenue from licenses of our AccuRouteproduct and related services. Sales of AccuRoute were higher in 2005 than theywere in 2004. Continued market acceptance of our AccuRoute product is criticalto our future success. As a result, any decline in demand for or failure tomaintain broad market acceptance of our AccuRoute product line as a result ofcompetition, technological change or otherwise would have a material adverseeffect on our business, financial condition and results of operations. Ourfuture financial performance will depend in large part on new and enhancedversions of our AccuRoute product. There can be no assurance that we willcontinue to be successful in marketing our AccuRoute product in the legalvertical market or that our marketing efforts in the financial services andhealthcare vertical markets will be successful. Further, there can be noassurance that any new or enhanced versions of our AccuRoute product will besuccessful.

***We havehistorically depended on our sales of fax products to generate revenue andcould face a decline in overall revenue if the declines we face in this marketare larger than expected.***   Our enterpriseclient/server facsimile software products are intended to help organizationsefficiently manage their facsimile communications, utilizing a client/servercomputing environment. There can be no assurance that organizations will moveaway from the use of stand-alone fax machines or continue to adoptclient/server environments, or that those of our customers who have begun themigration to a client/server environment will broadly implement this model ofcomputing. Our future financial performance will depend in large part on ourability to capture an expected portion of the market for client/serverapplications. The size of this market will depend in part on the growth in thenumber of organizations implementing client/server computing environments. Therecan be no assurance that these markets will continue to grow or that we will beable to capture sales to or respond effectively to the evolving requirements ofthese markets. If the market for client/server application products andservices does not grow in the future, grows more slowly than we anticipate orif we fail to respond effectively to evolving requirements of this market, ourbusiness, financial condition and results of operations could be materiallyadversely affected.

18

----

***Our common stock islisted on the Nasdaq Capital Market and any failure to maintain that listingcould significantly impair our stock price and our ability to raise future capital.***   Wecannot predict our ability to maintain our listing in the future on the NasdaqCapital Market. The delisting of our common stock from the Nasdaq CapitalMarket, if that were to occur, could materially impair stockholders’ ability tobuy and sell shares of our common stock and could have an adverse effect on themarket price of, and the efficiency of the trading market for, our common stock.Furthermore, the delisting of our common stock could significantly impair ourability to raise capital should we desire to do so in the future.

***The markets inwhich we sell our products are characterized by intense and growing competitionand our future success is dependent on our ability to distinguish our productsfrom those of our competitors and reach our target customers.***   In the distributed documentcapture and delivery market in which our AccuRoute software competes, we arelikely to see competitive products being offered by hardware vendors such asXerox Corporation, Canon, Inc., Ricoh Co., Ltd., Lexmark, Inc. andothers . In some cases these products are the result of partnerships withU.S.-based software companies. We also expect competition in this market from anumber of independent software vendors whose business focus was initially thehigh volume production scanning segment such as Kofax (a Dicom Group, plccompany) and EMC Corporation (formerly Captiva Software), or forms managementand process routing companies such as Cardiff Software (an Autonomy Groupcompany). e-Copy, Inc., a former Omtool business partner, has formed arelationship with Canon and has embedded their document capture and routingcapabilities into the front panel of the Canon ImageRunner® MultifunctionPrinter (“MFP”) device. Other potential software competitors include ScanSoft,as well as document management vendors like Hummingbird Ltd. and Interwoven, Inc.who are seeking to develop, either through partnerships or internal resources,scan-to-archive capabilities using standard e-mail as the transport and ageneric document profile as a means of entering the content into theirrepository. We believe that our ability to compete successfully in thedistributed document capture and delivery market depends upon a number offactors both within and beyond our control including product performance;reliability and features; ease of use; product scalability; quality of supportservices; price as compared to performance; timeliness of enhancements and newproduct releases by us and our competitors. We expect this market to mature andbecome increasingly competitive with success resulting from the formation ofcritical partnerships and alliances with both selected hardware and softwarepartners.

The market for client/server computer-based facsimilesolutions is also competitive and is more established and mature than themarkets in which the AccuRoute and Genidocs products compete. We believe thatour ability to compete successfully in the fax market depends upon a number offactors both within and beyond our control including product performance; reliabilityand features; ease of use; product scalability; quality of support services;price/performance; timeliness of enhancements and new product releases by usand our competitors. Given these factors, we believe that in order to besuccessful, we must continue our focus on delivering a core, modular andscalable product on one of the most prolific system platforms, MicrosoftWindows 2000 and Windows 2003, with features that appeal to the broadestsegment of the electronic document exchange market, which includes fax and allof the other document control and management features that we offer.

We compete directly with a number of vendors offacsimile products, including providers of facsimile software products forclient/server networks such as Captaris (with its RightFax product), Dicom(with its TopCall product) and Biscom (with its suite of fax products). We alsocompete with providers offering a range of alternative facsimile solutionsincluding outsourcing network facsimile solutions, such as Easylink ServicesCorporation (with its Document Capture and Management Sonic product) andPremiere Global Services/Xpedite (with its DocuManager product); operatingsystems containing facsimile and document e-mail features; low-end fax modemproducts; providers of desktop fax software; single-platform facsimile softwareproducts; and customized proprietary software solutions. In addition, providersof operating 

19

----

systems or businesssoftware applications may bundle competitive facsimile solutions as part oftheir broader product offerings.

In the intenselycompetitive and rapidly changing business-to-business secure document exchangemarket, we compete directly with Authentica, Inc.; Secure Data in Motion, Inc.(d/b/a Sigaba); Tumbleweed Communications Corp.; and Fix Corporation and anumber of other providers. There are also other categories of technologysolutions that overlap and compete in certain ways with aspects of our products.These include:

·       Documentmanagement solutions from vendors such as EMC Corporation (following itsacquisitions of Documentum, Inc. and Captiva Software), Hummingbird Ltd.and Interwoven, Inc. (following its merger with iManage) whose electroniccollaboration solutions compete with certain aspects of our solutions;

·       Electronicforms and electronic signature solutions from vendors such as Adobe SystemsIncorporated, IBM Corporation (following its acquisition of PureEdge Solutions, Inc.)Silanis Technology, Inc. that offer the creation of electronic documentswith electronic signatures; and

·       Securityinfrastructure solutions from vendors such as Verisign, Inc. and Entrust, Inc.whose solutions can be used to build applications that enable secure documentcommunications.

We expect the level of competition in thebusiness-to-business secure document exchange market to increase over time.

Many of our competitors and potential competitors havelonger operating histories and greater financial, technical, sales, marketingand other resources, as well as greater name recognition and market acceptanceof their products and technologies than we do. In addition, there arerelatively low barriers to entry in the markets in which we operate and intendto operate, and new competition may arise either from expansion by establishedcompanies or from new emerging companies or from resellers of our products. Therecan be no assurance that our current or potential competitors will not developproducts comparable or superior – in terms of price and performancefeatures – to those are developed. Further, our competitors may adapt morequickly than we do to new or emerging technologies and changes in marketopportunities or customer requirements, establish alliances with industryleaders or take advantage of acquisition opportunities more readily than we canor do. In addition, no assurance can be given that we will not be required tomake substantial additional investments in connection with our research,development, engineering, marketing, sales and customer service efforts inorder to meet any competitive threat, or that those required investments willnot have a material adverse effect on our operating margins. Changes ingoverning laws and regulations may also affect our ability to remain competitive.Increased competition may result in reduction in our market share, pressure forprice reductions and related reductions in our gross margins, any of whichcould materially adversely affect our ability to achieve our financial andbusiness goals. There can be no assurance that, in the future, we will be ableto successfully compete against current and future competitors.

20

----

***Our business issubject to seasonality and fluctuations on a quarterly and annual basis due tothe long sales cycle for our products and numerous other factors and,therefore, our results may vary from quarter-to-quarter and year-to-year.***   Our quarterly revenue andresults of operations have fluctuated significantly in the past and will likelycontinue to fluctuate significantly in the future. Causes of these fluctuationshave included and may include, among others: the demand for our products andservices; the size and timing of orders; the number, timing and significance ofnew product announcements by us and our competitors; our ability to develop,introduce, market and ship new and enhanced versions of our current and plannedproducts on a timely basis; the level of product and price competition; changesin operating expenses; changes in average selling prices and mix of ourproducts; changes in our sales incentive strategy; the mix of direct andindirect sales; and general economic factors, including factors affecting theoverall U.S. economy and the demand for enterprise information technologysolutions. In addition, the sale of our products often involves delays becausecustomers tend to implement the products they purchase from us on a largescale, requiring them first to establish certain minimum hardware capabilities.Moreover, we have historically experienced some seasonal fluctuations in thesales of our products, due to the fact that many companies make informationtechnology purchases either early or late in their fiscal years (when theyeither have a replenished annual budget or leftover money in the budget) andmore frequently scheduled vacations of key personnel at customers during thesummer months (particularly in Europe). Our products therefore often have alengthy sales cycle while potential customers evaluate and receive approvalsfor the purchase of our products. During these sales cycles, we may expendsubstantial funds and management efforts, yet receive no revenue. It isdifficult to predict accurately the sales cycle of any large order. If one ormore large orders fail to close as forecasted in a fiscal quarter, our revenueand operating results for that quarter could be materially adversely affected. Anyone or more of these or other factors could have a material adverse effect onour business, financial condition and results of operations. The potentialoccurrence of any one or more of these factors makes the prediction of revenueand results of operations on a quarterly basis difficult and performanceforecasts derived from these predictions unreliable.

In addition, we may invest in research and developmentand marketing expenses in order to promote further our products within currentor new vertical markets, including our current plan to incur additional salesand marketing expenses as we first target the financial services verticalmarket and then, shortly thereafter, the healthcare market with our AccuRoutesoftware product. Because we must make these investments in advance of related marketacceptance of and revenue from our AccuRoute product in those vertical markets,any failure of our products to achieve planned levels of acceptance would havea material adverse effect on our business, financial condition and results ofoperations on a quarter-to-quarter basis and overall.

In general, it is difficult for us to forecast revenuebecause the market for secure business-to-business electronic documentexchange, enterprise client/server facsimile solutions software and routing anddistribution software is evolving rapidly and our sales cycle – from thecustomer’s initial evaluation through purchase of licenses and the relatedsupport services – varies substantially from customer to customer. Licensefee revenue in any quarter depends on orders received and shipped in thatquarter, with a significant percentage of orders in any quarter arriving in thelast weeks of the quarter. License fee revenue from quarter-to-quarter isdifficult to forecast, as no significant order backlog exists at the end of anyquarter because our products typically are shipped upon receipt of customers’orders.

A substantial portion of our operating expense isrelated to personnel, facilities, equipment and marketing programs. The levelof spending for these expenses cannot be adjusted quickly and is thereforefixed in the short term. Our expense levels for personnel, facilities,equipment and marketing programs are based, in significant part, on ourexpectations of future revenue on a quarterly basis. If actual revenue levelson a quarterly basis are below our expectations, our results of operations arelikely to be adversely affected by a similar amount because a relatively smallamount of our expense varies with our revenue in the short term.

21

----

Due to all of the foregoing factors, it is likely thatin some future periods our results of operations will be below the expectationsof securities analysts and investors. In such event, the price of our commonstock could be materially adversely affected.

***In addition todirect sales, we utilize indirect sales and distribution channels and strategicalliances with compatible partners in order to broaden sales of our products. Anyfailure on our part to form and leverage relationships with these indirectsales and distribution channel partners could have a material adverse affect onour business and results of operations.***   We market our products andservices directly through telesales and indirectly through marketing channelssuch as value added resellers (“VARs”), systems integrators, distributors andstrategic business partners. Although we have historically focused our effortson marketing through our direct sales force, we continue to utilize resourcesto develop and expand our indirect marketing channels. There can be no assurancethat we will be able to attract and retain a sufficient number of qualifiedVARs, systems integrators, distributors and strategic business partners, orthat those third parties will successfully market our products. In addition,there can be no assurance that our resellers and strategic business partnerswill not develop, acquire or market computer-based electronic documentexchange, document routing and distribution and facsimile products that arecompetitive with our products. The failure to retain our VARs, systemsintegrators, distributors and strategic partners could have a material adverseeffect on our business, financial condition and results of operations.

The distributor agreements governing our relationshipswith third party distribution chain partners generally provide that eitherparty may terminate the agreement without cause upon 30 days writtennotice to the other party. We also resell our products on a purchase orderbasis through other VARs, systems integrators and distributors. Generally, inthose situations, either party may terminate the relationship at any time, andtherefore there can be no assurance that any VAR, systems integrator ordistributor will continue to represent and sell our products. Furthermore, ourstrategic alliances generally may be terminated by either party, at any time;there can therefore be no assurances that these strategic alliances willcontinue. The inability to retain certain VARs, systems integrators,distributors or strategic business partners, or the development ormarketing by VARs, systems integrators, distributors or strategic businesspartners of competitive offerings, could have a material adverse effect on ourbusiness, financial condition and results of operations.

Selling through indirect channels may limit ourcontacts with our customers, thereby hindering our ability to accuratelyforecast sales, evaluate customer satisfaction and recognize emerging customerrequirements. Our strategy of marketing our products directly to end-users andindirectly through VARs, systems integrators and distributors may result indistribution channel conflicts. Our direct sales efforts may compete with thoseof our indirect channels and, to the extent different resellers target the samecustomers, resellers may also come into conflict with each other. As we striveto expand our indirect distribution channels, there can be no assurance thatemerging channel conflicts will not materially adversely affect ourrelationships with existing VARs, systems integrators or distributors oradversely affect our ability to attract new VARs, systems integrators anddistributors.

***The success of ourbusiness is dependent on our ability to expand our sales internationally, whichwill subject us to regulatory, exchange rate and other risks that might hinderour ability to meet our targets for international sales and might impair ourresults of operation.***   An element of our strategy is to increase ourinternational sales. We expect to face competition from securebusiness-to-business electronic document exchange solutions and local facsimileproduct providers in the foreign countries in which we attempt to sell ourproducts. To maintain and grow our international sales, we need to recruit andretain additional international resellers and distributors. There can be noassurance that we will be able to maintain international sales of our productsor that our international distribution channels will be able to adequatelymarket, service and support our products. International operations generallyare subject to certain risks, including dependence on independent resellers,fluctuations in foreign currency exchange rates, compliance with foreignregulatory and market requirements, variability of foreign economic conditions 

22

----

and changing restrictionsimposed by United States export laws. Additional risks inherent in ourinternational business activities generally include unexpected changes inregulatory requirements, tariffs and other trade barriers, costs of localizingproducts for foreign countries, lack of acceptance of localized products inforeign countries, longer accounts receivable payment cycles, difficulties inmanaging international operations, difficulties in enforcing intellectualproperty rights and the burdens of complying with a wide variety of foreignlaws.

We currently have a sales office in the United Kingdom.Our non-United States presence subjects us to certain additional risksincluding difficulties in staffing and managing these foreign operations andpotentially adverse tax consequences including restrictions on the repatriationof earnings. There can be no assurance that these factors will not have amaterial adverse effect on our future international sales and, consequently,our business, financial condition and results of operations. To date, amajority of our sales have been made in United States dollars and we have notengaged in any hedging transactions through the purchase of derivativesecurities or otherwise. Our United Kingdom subsidiary transacts businessprimarily in its local currency. We translate our United Kingdom subsidiary’soperating results into U.S. dollars and consolidate them with our domesticresults for reporting purposes. As we make sales to customers in a variety ofcountries, significant currency exchange rate fluctuations could have amaterial impact on our results of operations.

***Given the nature ofour business, we may not be able to obtain sufficient or attractive financing,should that become necessary.***   We expect that our currentcash, cash equivalents and investments will meet our normal working capital andcapital expenditure needs for at least the next twelve months. We may, however,need to raise additional funding at that time or earlier if we decide toundertake more rapid expansion, including acquisitions of complementaryproducts or technologies, or if we increase our marketing and/or research anddevelopment efforts in order to respond to competitive pressures. We cannot becertain that we will be able to obtain additional financing on favorable terms,if at all. We may obtain additional financing by issuing shares of our commonstock, which could dilute our existing stockholders. If we cannot raise neededfunds on acceptable terms, or at all, we may not be able to develop or enhanceour products or respond appropriately to competitive pressures, which wouldseriously harm our business.

***We may notsuccessfully complete acquisitions or integrate acquisitions we do make, whichcould impair our ability to compete and could harm our operating results.***   Wemay augment our internal growth with acquisitions of businesses, products andtechnologies that could complement or expand our business. Certain of thesebusinesses may be only marginally profitable or even unprofitable. In order toachieve anticipated benefits from these acquisitions, we will have tosuccessfully integrate the acquired businesses with our existing operations. Wecannot assure you that we will be successful in this regard. We have limitedexperience in integrating acquired companies into our operations, in expandingthe scope of operations of required businesses, in managing geographicallydispersed operations and in operating internationally. In the past, we haveincurred one-time costs and expenses in connection with acquisitions and it islikely that we could incur similar one-time costs and expenses in connectionwith future acquisitions. In addition, we might be required to amortizesignificant intangible assets in connection with future acquisitions, whichcould adversely affect our operating results. Further, attractive acquisitionsare difficult to identify and complete for a number of reasons, includingcompetition among prospective buyers and the possible need to obtain regulatoryapproval. There can be no assurance that we will be able to complete futureacquisitions. In order to finance potential future acquisitions, we may need toraise additional funds either through public or private financings, includingbank borrowings. Any financing, if available at all, may be on terms that arenot favorable to us. Finally, we may also issue shares of our common stock toacquire attractive businesses, which may dilute our existing stockholders.

***Our future successdepends on our ability to manage the growth and expansion of our business.******  ***We may expandour operations as we anticipate that expansion may be required in order toaddress potential 

23

----

market opportunities. Wemay also increase the size of our sales and marketing and research anddevelopment expenditures as necessary. There can be no assurance that we willbe able to complete this expansion successfully or that the expansion wouldgenerate sufficient revenue to cover our expenses. We will need to continue toattract and retain highly qualified technical, sales and managerial personnel. Therecan be no assurance that we will be able to retain or continue to hire thiskind of personnel in the future or to retain this kind of personnel in asufficiently timely manner. Our inability to effectively expand operations andmanage growth, if any, could have a material adverse effect on our business,financial condition and results of operations.

***The effectivenessof our disclosure controls and procedures and internal control over financialreporting may be limited.******  ***Pursuant tothe requirements of the Sarbanes-Oxley Act of 2002, we must maintain andenhance our internal control over financial reporting. Presently, we are not an“accelerated filer” or a “large accelerated filer” as those terms are definedin the Securities Act of 1933, as amended. As a result, we are not required todeliver a report regarding our determination of the effectiveness of ourinternal control over financial reporting until we file our annual report on Form 10-Kfor the fiscal year ending December 31, 2007. Further, under Section 404of Sarbanes-Oxley, in connection with our annual report on Form 10-Kfor the fiscal year ending December 31, 2007, our independent registeredpublic accounting firm will be required to deliver an attestation reportregarding management’s assessment of the effectiveness of our internal controlover financial reporting. As a result, during the fiscal year ended December 31,2005, we expended considerable time, attention and resources to determining thestrength and effectiveness of our internal control over financial reportingand, where appropriate, making improvements. In fiscal years 2006 and 2007, wewill continue expending considerable time, attention and resources todetermining the strength and effectiveness of our internal control over financialreporting and, where appropriate, making improvements.

Our disclosure controls and procedures and internalcontrol over financial reporting may not prevent all errors and intentionalmisrepresentations. Any system of internal controls can only provide reasonableassurance that all control objectives have been and will continue to be met. Someof the potential risks involved could include, without limitation, managementjudgments, simple errors or mistakes, willful misconduct regarding controls ormisinterpretation. Though we believe that our disclosure controls andprocedures and internal control over financial reporting are effective, therecan be no guarantee that existing controls and procedures will prevent ordetect all material issues, errors or intentional misrepresentations. Further,our existing controls may not be effective in future situations. Any failure ofour disclosure controls and procedures or internal control over financialreporting could have a material impact on our financial condition and resultsof operation. Our assessment of our internal control over financial reportingmay identify weaknesses in our internal control over financial reporting thatwe need to remedy or may raise other issues of concern for our investors. Shouldwe determine that a material weakness exists in our internal control overfinancial reporting, the price of our common stock might decline.

***Our reliance on asole hardware supplier could adversely impact our business.****  *We currently purchase hardwareproducts for sale to our customers from a single third-party supplier. We donot have a long-term, fixed-price or minimum volume contract with this supplier.Instead, we order hardware equipment through purchase orders from time to time.We do not carry significant inventories of these hardware products and do nothave a guaranteed supply arrangement with this supplier. Recently, our solesupplier of hardware products was sold to a third-party. We do not believe thatthis change of ownership will impact our ability to purchase hardware productsfrom this supplier or the terms under which we make those purchases. Were thissupplier to raise its prices or refocus its business, we might be negativelyimpacted as we would have to develop a new supply relationship for theseproducts. Although we believe that we could secure these hardware products fromalternative suppliers, in the event of a disruption of supply from this solesupplier, we might not be able to develop an alternative source in a timelymanner or at favorable 

24

----

prices. Even if we wereable to purchase these hardware components from alternative sources, we wouldhave little control over the costs of these products. Were we forced to paysignificantly higher prices for these hardware products, it might limit themark-up over the price paid by us that we can reasonably charge our customers. Werewe unable to provide this hardware to our customers, forcing our customers tobuy this hardware directly from third parties, or were we forced to decreasethe size of our mark-up, our hardware and total revenue would be negativelyimpacted.

***We will faceadditional expenses and disruption due to the upcoming relocation of ourcorporate headquarters.******  ***We leaseoffice space, used as our headquarters and primary business location, at 8AIndustrial Way in Salem, New Hampshire. Our current lease terminated on December 31,2005 and we have remained in this space on a month-to-month arrangement. In January 2006,we entered into a lease for new office space at Six Riverside Drive in Andover,Massachusetts. We intend to move our headquarters to the new premises in April 2006.As a result, we will incur related expenses and will encounter disruption ofoperations related to the move, all of which could have a material adverseeffect on our financial condition and results of operation.

***We are dependent on our key personnel and anyinability to retain or hire key personnel could impact our business and resultsof operations.***   Our future performance depends, in significant part, uponthe continued service of our key technical, sales and senior managementpersonnel, most of whom are not bound by employment agreements ornoncompetition agreements. The loss of the services of one or more of ourexecutive officers or other key employees could have a material adverse effecton our business, financial condition and results of operations. Our futuresuccess also depends on our continuing ability to attract and retain highlyqualified technical, sales and managerial personnel, particularly in light ofour expanded AccuRoute sales and marketing strategy. Competition for highlyqualified personnel is intense and we have historically experienced difficultyin recruiting qualified technical personnel. There can be no assurance that wewill be able to retain or continue to hire key technical, sales and managerialpersonnel in the future.

**Item 2.**                        Properties

Our executive offices are located at 8A IndustrialWay, Salem, New Hampshire in a leased facility consisting of approximately30,000 square feet, of which we occupy 25,500 square feet and we sublease 4,500square feet (at market rates) to a third party. Our lease for these facilitiesexpired on December 31, 2005 and we arranged with the owner of this spaceto remain in those premises until April 2006. This facility is adequatefor our present operations. Additionally, we lease a facility for sales,customer service, accounting and support in London, England, which leaseexpires in November 2006.

In January 2006, weentered into a new lease agreement for space located at Six Riverside Drive,Andover, Massachusetts consisting of approximately 44,000 square feet. Weintend to move our executive offices and headquarters to this new space in April 2006.The lease expires 10 years from the date of occupancy and we have the option toterminate the lease after six years upon payment of a penalty. We anticipatesubleasing approximately 5,500 square feet of this new space to a third partyat market rates.

**Item 3.**                        LegalProceedings

None.

**Item 4.**                        Submissionof Matters to a Vote of Security Holders

None.

25

----

**PART II**

**Item 5.**                        Marketfor Registrant’s Common Equity, Related Stockholder Matters and IssuerPurchases of Equity Securities.

From August 8, 1997, the date of our initialpublic offering of common stock, until November 19, 2002, our common stockwas traded on The Nasdaq National Market under the symbol OMTL. Since November 26,2002, our Common Stock has been trading on the Nasdaq Capital Market. On March 30,2004, our Board of Directors approved a two-for-one forward split of our commonstock. The stock split was effected in the form of a stock dividend andentitled each shareholder of record at the close of business on April 7,2004 (record date) to receive one additional share for every share of Omtoolcommon stock held on that date. Shares resulting from the split weredistributed by our transfer agent on April 27, 2004. On January 14,2003, our Board of Directors and stockholders, at a special meeting ofstockholders, voted to approve an amendment to our certificate of incorporationthat effected a one-for-seven reverse stock split of our common stock effectiveJanuary 15, 2003.

Priorto August 8, 1997, there was no public market for our common stock. Thefollowing table sets forth for the periods indicated the high and low bidprices for the common stock as reported by The Nasdaq Capital Market based on asplit-adjusted actual sales price.

| ** **               | ** ** | **Stock Price** | ** ** |
|--------------------------|------------|----------------------|------------|
| ** **               | ** ** | **High**             | ** ** | **Low** | ** ** |
| **Quarter ended:**       | ** ** | ** **           | ** ** | ** ** | ** ** |
| **2004**                 |       |                 |       |   |   |
| March 31,  2004     |       | $                    | 8.63       |   | $ | 3.13 |   |
| June 30,  2004      |       | $                    | 12.49      |   | $ | 8.68 |   |
| September 30,  2004 |       | $                    | 11.25      |   | $ | 6.00 |   |
| December 31,  2004  |       | $                    | 9.03       |   | $ | 7.00 |   |
| **2005**                 |       |                 |       |   |   |
| March 31,  2005     |       | $                    | 8.40       |   | $ | 6.25 |   |
| June 30,  2005      |       | $                    | 7.70       |   | $ | 4.90 |   |
| September 30,  2005 |       | $                    | 9.89       |   | $ | 5.76 |   |
| December 31, 2005   |       | $                    | 8.89       |   | $ | 5.81 |   |

 

On March 24, 2006, the closing price for thecommon stock was $7.15 per share. As of March 24, 2006, there wereapproximately 104 stockholders of record of our common stock.

We have not paid any cash dividends on our capitalstock and we do not anticipate paying cash dividends in the foreseeable future.We intend to retain any earnings or other cash resources we generate to financefuture growth of our business. Any future determinations to pay cash dividendswill be at the discretion of our Board of Directors and will be dependent uponour results of operations, financial condition and other factors deemedrelevant by the Board of Directors.

All references in the Consolidated FinancialStatements included herein referring to shares, share prices, per share amountsand stock plans have been adjusted retroactively for the two-for-one stocksplit and the one-for-seven reverse stock split referred to above. Additionalinformation is presented in Footnote 6(e) of Notes to the ConsolidatedFinancial Statements.

For information on ourequity compensation plans, please see our definitive proxy statement pursuantto Regulation 14A, to be filed with the Securities and Exchange Commissionwithin 120 days of the end of the fiscal year ended December 31,2005.

26

----

**RecentSales of Unregistered Securities and Use of Proceeds from Registered Securities**

On March 29, 2004, we entered into a stockpurchase agreement with certain institutional and other accredited investorsnamed therein pursuant to which we completed the private placement of$3.6 million worth of shares of our common stock. We completed thistransaction pursuant to Section 4(2) of the Securities Act of 1933,as amended.

In consideration of services provided as placementagent on this transaction, we issued 51,000 shares of our common stock and awarrant to purchase up to 51,000 shares of our common stock to BroadbandCapital Management LLC. The exercise price for the warrant to purchase sharesof our common stock is $6.00 per share. This warrant is exercisable at any timebetween October 1, 2004 and September 30, 2009.

We used the proceeds from this transaction foradditional working capital and other general corporate purposes.

On April 29, 2004, wefiled a registration statement related to the shares of our common stock issuedand sold in this transaction. On June 17, 2004, we filed Amendment No. 1to our registration statement on Form S-3. Subsequent to filing arequest for acceleration, our registration statement on Form S-3 wasdeclared effective on July 22, 2004.

27

----

**Item 6.**                        SelectedConsolidated Financial Data

Thestatement of consolidated operations data set forth below for the fiscal yearended December 31, 2005 and the balance sheet data as of December 31,2005 have been derived from our consolidated financial statements, whichstatements have been audited by VitaleCaturano & Company, Ltd., independent registered publicaccounting firm and are included herein. The statements of consolidatedoperations data set forth below for each of the fiscal years ended December 31,2004 and 2003 and the balance sheet data as of December 31, 2004 have beenderived from our consolidated financial statements, which statements have beenaudited by PricewaterhouseCoopers LLP, independent registered public accountingfirm and are included herein. The statements of consolidated operations dataset forth below for the fiscal year ended December 31, 2002 and thebalance sheet data as of December 31, 2003 and 2002 is derived from ourfinancial statements, which statements have been audited byPricewaterhouseCoopers LLP and are not included herein. The statements ofconsolidated operation data for the fiscal years ended December 31, 2001and the balance sheet data as of December 31, 2001 are derived from ourfinancial statements, which statements have been audited by Arthur Andersen LLPand are not included herein. The selected financial data set forth below shouldbe read in conjunction with the Consolidated Financial Statements and the Notesthereto and with Management’s Discussion and Analysis of Financial Conditionand Results of Operations appearing elsewhere in this Form 10-K.

| ** **                                                 | ** ** | **Year Ended December 31,**                         | ** ** |
|------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                 | ** ** | **2001**                                                           | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                                 | ** ** | **(in thousands, except per share data)** | ** ** |
| **Statement of Consolidated  Operations Data:**            |       |                                                               |       |   |   |   |   |   |   |   |   |
| Revenue:                                                   |       |                                                               |       |   |   |   |   |   |   |   |   |
| Software license                                           |       | $                                                                  | 5,051      |   | $ | 4,373 |   | $ | 4,102 |   | $ | 4,505 |   | $ | 4,732 |   |
| Hardware                                                   |       | 3,129                                                              |       | 2,734 |   | 2,767 |   | 3,177 |   | 2,705 |   |
| Service and other                                          |       | 7,174                                                              |       | 7,370 |   | 6,878 |   | 7,108 |   | 6,859 |   |
| Total revenue                                              |       | 15,354                                                             |       | 14,477 |   | 13,747 |   | 14,790 |   | 14,296 |   |
| Cost of revenue:                                           |       |                                                               |       |   |   |   |   |   |   |   |   |
| Software license                                           |       | 431                                                                |       | 347 |   | 280 |   | 196 |   | 154 |   |
| Hardware                                                   |       | 2,082                                                              |       | 1,769 |   | 1,859 |   | 1,944 |   | 1,694 |   |
| Service and other                                          |       | 4,091                                                              |       | 3,282 |   | 3,152 |   | 2,743 |   | 2,782 |   |
| Total cost of revenue                                      |       | 6,604                                                              |       | 5,398 |   | 5,291 |   | 4,883 |   | 4,630 |   |
| Gross profit                                               |       | 8,750                                                              |       | 9,079 |   | 8,456 |   | 9,907 |   | 9,666 |   |
| Operating expenses:                                        |       |                                                               |       |   |   |   |   |   |   |   |   |
| Sales and marketing                                        |       | 6,254                                                              |       | 6,150 |   | 4,745 |   | 4,100 |   | 5,256 |   |
| Research and development                                   |       | 3,219                                                              |       | 2,815 |   | 2,187 |   | 1,937 |   | 2,239 |   |
| General and  administrative                                |       | 3,616                                                              |       | 4,559 |   | 2,948 |   | 2,417 |   | 2,672 |   |
| Restructuring costs and  asset write-off                   |       | —                                                             |       | — |   | 806 |   | — |   | — |   |
| Total operating expenses                                   |       | 13,089                                                             |       | 13,524 |   | 10,686 |   | 8,454 |   | 10,167 |   |
| Income (loss) from  operations                             |       | (4,339                                                             | )          | (4,445 | ) | (2,230 | ) | 1,453 |   | (501 | ) |
| Interest and other  income, net                            |       | 631                                                                |       | 181 |   | 140 |   | 140 |   | 186 |   |
| Income (loss) before  provision (benefit) for income taxes |       | (3,708                                                             | )          | (4,264 | ) | (2,090 | ) | 1,593 |   | (315 | ) |
| Provision (benefit) for  income taxes                      |       | —                                                             |       | 1,255 |   | (144 | ) | (7 | ) | (5 | ) |
| Net income (loss)                                          |       | $                                                                  | (3,708     | ) | $ | (5,519 | ) | $ | (1,946 | ) | $ | 1,600 |   | $ | (310 | ) |
| Net income (loss) per  share:                              |       |                                                               |       |   |   |   |   |   |   |   |   |
| Basic                                                      |       | $                                                                  | (1.02      | ) | $ | (1.54 | ) | $ | (0.56 | ) | $ | 0.42 |   | $ | (0.08 | ) |
| Diluted                                                    |       | $                                                                  | (1.02      | ) | $ | (1.54 | ) | $ | (0.56 | ) | $ | 0.41 |   | $ | (0.08 | ) |
| Weighted average number  of common shares outstanding:     |       |                                                               |       |   |   |   |   |   |   |   |   |
| Basic                                                      |       | 3,639                                                              |       | 3,588 |   | 3,494 |   | 3,765 |   | 3,924 |   |
| Diluted                                                    |       | 3,639                                                              |       | 3,588 |   | 3,494 |   | 3,946 |   | 3,924 |   |

 

| ** **                                         | ** ** | **December 31,**   | ** ** |
|----------------------------------------------------|------------|-------------------------|------------|
| ** **                                         | ** ** | **2001**                | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                         | ** ** | **(in thousands)** | ** ** |
| **Consolidated Balance Sheet Data:**               | ** ** | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash, cash  equivalents and short-term investments |       | $                       | 12,491     |   | $ | 9,790 |   | $ | 8,242 |   | $ | 10,655 |   | $ | 10,471 |   |
| Working capital                                    |       | 10,225                  |       | 4,734 |   | 3,237 |   | 6,862 |   | 6,655 |   |
| Total assets                                       |       | 17,216                  |       | 12,692 |   | 10,492 |   | 13,100 |   | 12,669 |   |
| Total  stockholders’ equity                   |       | 11,075                  |       | 5,334 |   | 3,439 |   | 6,631 |   | 6,432 |   |
|                                                    |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

28

----

**Item 7.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations

Except for the historicalinformation contained herein, this Report contains forward-lookingstatements within the meaning of Section 27A of the Securities Act of 1933and Section 21E of the Securities Exchange Act of 1934, includingstatements regarding, among other items: our growth strategies; anticipatedtrends in our business; our ability to expand our product and serviceofferings; and our ability to satisfy our working capital requirements. Theseforward-looking statements are based largely on our expectations and aresubject to a number of risks and uncertainties, certain of which are beyond ourcontrol. In addition, we may face additional risks and uncertainties notpresently known to us or that we presently deem to be immaterial. If any ofthese known or unknown risks or uncertainties were actually to occur, ouractual results could differ materially from these forward-lookingstatements. Further, our actual results could materially differ from theseforward-looking statements as a result of a number of factors including,but not limited to, those factors described in Item 1A – Risk Factors.

**Overview**

We provide document routing solutions and servicesthat enable organizations to manage the capture, processing and distribution of“mixed-mode” documents (i.e., documents that contain both paper and electroniccomponents) to electronic information systems such as enterprise contentmanagement, document management, records management, e-mail anddocument-archiving systems, leveraging application interfaces with which usersare already familiar. Our enterprise-class products are used by organizationsthat manage paper-based documents as part of their standard business processesand or have stringent compliance requirements for secure document handling,storage, integration and tracking of a variety of documents to or fromcorporate information systems.

We help companies achieve those levels of control byleveraging existing information technology (“IT”) infrastructures andintegrating with industry-leading electronic information systems. We add securedocument management and routing functions, along with high-volume faxfunctionality, to a company’s existing communication infrastructure. Sincepaper remains integral to many business processes, we also provide technologythat incorporates electronic delivery, security and billing functionality intoindustry-leading multi-function and scanning devices.

AccuRoute®, our flagship product, is the softwareplatform for simplified, simultaneous and secure document distribution. OurAccuRoute product allows companies to control the integration and distributionof mixed-mode documents into ever-changing corporate information systems andprocesses. Similar in concept to a network router, our AccuRoute product is thedocument routing hub, transforming both paper and electronic-based documentsinto electronic files and routing that information within and outside anorganization.

Working with virtually all multi-function devices andelectronic information systems (enterprise content management, documentmanagement, records management and archival systems, as well as fax and e-mailsystem), our AccuRoute product provides a device-independent, personalizedsolution so users can distribute documents from a multi-function device panelor right from their desktop computers using a familiar and comfortableinterface. In addition, our AccuRoute product supports the movement ofelectronic documents and information, enabling companies to increase employeeproductivity by quickly capturing hardcopy documents, distributing them inelectronic form and, through its security features, complying with privacyregulations related to health, financial or other confidential information.

GenidocsTM, our secure document-delivery applicationproduct, integrates with existing e-mail systems and provides multiple optionsfor content and attachment encryption, authentication, audit trail, deliveryconfirmation and digital signatures. GenifaxTM, our enterprise fax product,offers a scalable, server-based feature set and shares a common Microsoft® Windows® server-basedarchitecture with our Genidocs product line.

29

----

Our AccuRoute product further unifies the code basesand architecture of our Genidocs and Genifax products. With its routingcapabilities, our AccuRoute product provides a customer-specific software thateasily manages both paper and electronic documents, with little or no usertraining required.

Companies can deploy our software products onheterogeneous, multi-platform networks and digital scanning and MFDs and canintegrate them with both desktop and enterprise software applications such ascontent management, e-mail and groupware systems. To address customer needs,our products are modular and scaleable. As a result, customers can addadditional communication capacity through the addition of system components andconnectors to keep pace with growing demands. In addition, due to thisscalable, modular design, customers can add additional Omtool product serversto a configuration to provide failover redundancy, helping to ensure continuousoperation. We license our products on a combination server/seat basis and asexternal hardware devices become more technologically advanced, we will extenda portion of our license fees to a device-based model.

We will continue to focus on those vertical marketswhere regulations or business practices require confidentiality, timelyelectronic delivery and archiving of critical documents in electronic and paperformat. We expect to maintain an established position in our traditional market —secure electronic document exchange primarily via fax. In addition, we plan tocontinue the evolution of our AccuRoute product line; encapsulate thefunctionality of all our products into a single, configurable platform; expandour integration with complementary technologies (such as document and recordsmanagement tools); and to extend our document capture capabilities to continueto include compatibility with virtually all multi-functional devices andscanners. In this manner, we will pursue a leadership position in the broaderdocument delivery/routing and management market that we believe will grow inresponse to increasingly regulated communications and stringent privacyrequirements.

We resell certain hardware products (such asintelligent fax boards) from third-party vendors. Typically, hardware sales area result of either new sales or sales to existing customers who are upgradingtheir IT infrastructure. Occasionally, where our customers also want faxcapabilities, we sell hardware products with our AccuRoute product. Weundertake these hardware sales as a convenience to our customers, whoalternatively can opt to obtain hardware directly from a third-party vendor.The fax boards and fax modems that we resell are not functional without ourproduct software and we are not generally in the business of selling fax boardsand modems. We purchase these hardware products as needed to ship to ourcustomers and we typically maintain a minimal inventory of these hardwareproducts.

Service and other revenue has historically consistedprimarily of the sale of support contracts to complement software products welicense to our customers. We generate a smaller portion of our service andother revenue from consulting, training and installation services. We arefocused on and are considering adding additional resources to increase ourservice and other revenue.

Infiscal year 2005, we expanded our presence and penetration of the legalvertical market through the development of reference accounts and by provingAccuRoute’s viability as evidenced by adoption of our AccuRoute product by over110 law firms. In parallel, we built a firm base upon which to launch ourAccuRoute product in the financial services vertical market. During the secondhalf of 2005, we dramatically increased our sales and marketing spending, ascalled for in our strategic plan. As expected, these investments in sales andmarketing had no material impact on our revenue in 2005, which was a nearbreak-even year. Going forward, our primary focus is to penetrate furthertargeted vertical and geographic markets, reaping the benefits of our sales andmarketing investments. In both the United States and Europe, during 2006, wewill focus our AccuRoute sales in the financial services, healthcare and legalvertical markets through direct sales efforts. In parallel, we will also expandour focus on distribution and reseller partners. During 2006, we will continue —in fact accelerate — our investment in sales and marketing and businessdevelopment and we expect to start seeing the impact of these investments ingrowing our business during 2006. Achieving quarterly profitability with theseinvestments will require an 

30

----

overall increase in revenue. We expect revenue toincrease gradually during 2006. We believe that our existing cash and cashequivalents will be sufficient to meet our working capital and capitalexpenditure needs for at least the next twelve months.

|                                               | ** ** | **Total Revenue** | ** ** | **Net (Loss)  Income** | ** ** | **Software License  Revenue** | ** ** |
|-----------------------------------------------|------------|------------------------|------------|-----------------------------|------------|------------------------------------|------------|
| Twelve months ended  December 31, 2005   |       | $                      | 14,296,165 |                        | $          | (309,751                           | )          |   | $ | 4,732,121 |   |   |
| Twelve months  ended December 31, 2004   |       | $                      | 14,790,194 |                        | $          | 1,599,588                          |       |   | $ | 4,504,899 |   |   |
| Change over same period of  prior fiscal year |       | $                      | (494,029)  |                        | $          | (1,909,339                         | )          |   | $ | 227,222 |   |   |
|                                               |       | or (3.3)%              |       | or (119.4)%                 |       |                               | or 5.0%    |   |   |
| Twelve months  ended December 31, 2004   |       | $                      | 14,790,194 |                        | $          | 1,599,588                          |       |   | $ | 4,504,899 |   |   |
| Twelve months ended  December 31, 2003   |       | $                      | 13,747,246 |                        | $          | (1,945,765                         | )          |   | $ | 4,101,588 |   |   |
| Change over same  period of prior fiscal year |       | $                      | 1,042,948  |                        | $          | 3,545,353                          |       |   | $ | 403,311 |   |   |
|                                          |       | or 7.6%                |       | or 182.2%                   |       |                               | or 9.8%    |   |   |

 

During 2005, we experienced an increase in oursoftware license revenue as a result of continued market acceptance of ourAccuRoute product. We achieved this increase in overall software licenserevenue despite a ten percent decrease in our fax software license revenue fromin 2005 as compared to 2004. The increase in overall software license revenue,however, was offset by declines in our hardware and service and other revenue,resulting in an overall decline in our total revenue. The decline in ourhardware revenue was due to a decrease in legacy fax product sales, which arethe main driver for our hardware revenue, and an overall decrease in demand forour legacy fax products from existing customers who have upgraded informationsystems hardware in their worldwide locations. The decline in service and otherrevenue was due primarily to a decline in our fax related maintenance supportrevenue. This decrease was partially offset by increased overall servicerevenue from consulting services for the same periods.

In January 2006, we entered into a new leaseagreement for approximately 44,000 square feet of office space and plan to moveour headquarters to this facility in Andover, Massachusetts in April 2006.The lease has a ten year term and we have an option to renew the lease for anadditional five-year term at the then-applicable fair market rent. Under theterms of the lease, the landlord will provide us with a tenant improvementallowance of up to $308,000. Additionally, we have a one-time right toterminate the lease, upon twelve months’ written notice, after the sixth yearof the lease term. If we decide to terminate the lease, we must pay a penaltyof six months’ rent and the unamortized portion of the tenant improvementallowance. We believe the new facility will be suitable and sufficient for ourneeds for the foreseeable future.

Any decrease in demand for our products would likelyresult in decreased revenue, which would, in turn, have a significant negativeimpact on our financial results because a significant portion of our operatingcosts such as personnel, rent and depreciation are fixed in advance of aparticular quarter. As a result, our costs for sales and marketing, researchand development and general and administrative could continue to increase as apercentage of revenue, thereby negatively affecting our operating results.

Our future revenue and operating results may fluctuatefrom quarter to quarter based on the number and size of sales transactions weenter into with customers, the adequacy of provisions for losses, generaleconomic conditions and other factors. In addition, revenue from one or morelarge orders may constitute a significant portion of our total revenue in aparticular quarter, further exacerbating fluctuations in quarterly results.

Commencing at the end of the third quarter of 2005, weincreased the resources allocated to our United Kingdom subsidiary, an effortthat we expect will result in increased European revenue in future quarters. Althoughwe believe that, over the last several quarters, there has been someimprovement in the demand for enterprise software solutions and increasedmarket acceptance of our products in Europe, we 

31

----

cannot predict whether orwhen that market will soften or if market acceptance of our products will occur.If the European market or the market acceptance of our products changes, wecannot predict whether and to what extent, the demand for our products willincrease or decrease.

We have historically derived a majority of our totalrevenue from sales within the United States. Revenue from our Europeanoperations decreased during the twelve months ended December 31, 2005, ascompared to the same period in 2004, due to a decrease in Europe of sales ofour legacy fax software. We will continue to leverage our AccuRoute base inEurope, as well as our indirect channel relationships in Europe, to focus salesresources on the legal vertical market. In addition, we have recently added newresources to our European operations, including a new managing director ofEurope, Middle East and Africa, which we expect will help to improve ourresults in the region. There can be, however, no assurance that we will be ableto increase international sales of our products and the failure to do so mayhave a material adverse effect on business, financial condition and results ofoperations.

Thefollowing is a presentation of our domestic and international revenue:

|                                               | ** ** | **Total Revenue** | ** ** | **United States Revenue** | ** **    | **Non-United States Revenue** | ** ** |
|-----------------------------------------------|------------|------------------------|------------|-------------------------------------|---------------|-----------------------------------------|------------|
| Twelve months ended  December 31, 2005   |       | $                      | 14,296,165 |                                |          | $                                       | 11,536,784 |   |   |   | $ | 2,759,381 |   |   |
|                                               |       |                   |       |                                | or 80.7% of   |                                    |       |   | or 19.3% of |   |   |
|                                               |       |                   |       |                                | Total Revenue |                                    |       |   | Total Revenue |   |   |
| Twelve months ended December 31, 2004    |       | $                      | 14,790,194 |                                |          | $                                       | 11,502,207 |   |   |   | $ | 3,287,987 |   |   |
|                                          |       |                   |       |                                | or 77.8% of   |                                    |       |   | or 22.2% of |   |   |
|                                          |       |                   |       |                                | Total Revenue |                                    |       |   | Total Revenue |   |   |
| Change from same period of  prior fiscal year |       | $                      | (494,029   | )                                   |          | $                                       | 34,577     |   |   |   | $ | (528,606 | ) |   |
|                                               |       | or (3.3)%              |       |                                | or 0.3%       |                                    |       |   | or (16.1)% |   |   |
| Twelve months ended December 31, 2004    |       | $                      | 14,790,194 |                                |          | $                                       | 11,502,207 |   |   |   | $ | 3,287,987 |   |   |
|                                          |       |                   |       |                                | or 77.8% of   |                                    |       |   | or 22.2% of |   |   |
|                                          |       |                   |       |                                | Total Revenue |                                    |       |   | Total Revenue |   |   |
| Twelve months ended  December 31, 2003   |       | $                      | 13,747,246 |                                |          | $                                       | 10,647,321 |   |   |   | $ | 3,099,925 |   |   |
|                                               |       |                   |       |                                | or 77.5% of   |                                    |       |   | or 22.5% of |   |   |
|                                               |       |                   |       |                                | Total Revenue |                                    |       |   | Total Revenue |   |   |
| Change from same period of prior fiscal year  |       | $                      | 1,042,948  |                                |          | $                                       | 854,886    |   |   |   | $ | 188,062 |   |   |
|                                          |       | or 7.6%                |       |                                | or 8.0%       |                                    |       |   | or 6.1% |   |   |

 

Our United Kingdom subsidiary, Omtool Europe Limited,transacts business primarily in its local currency. We then translate resultsgenerated by that entity into United States dollars and consolidate them withour domestic results for reporting purposes. As we make sales to customers in avariety of countries, significant currency exchange rate fluctuations couldhave a material impact on our results of operations. We manage our foreigncurrency exchange exposure by monitoring our net monetary position usingnatural hedges of our assets and liabilities denominated in local currencies. Therecan be no assurance that this policy will eliminate all foreign currencyexchange exposure. Foreign currency exposure has not been material to ourfinancial position or results of operations to date. If the volume of ourbusiness denominated in foreign currencies increases, we may be required to usederivatives to hedge foreign currency exposure.

32

----

We will continue toleverage our existing distribution channels, where appropriate, to broaden ourreach to our target vertical markets and further penetrate our installed base. Weare pursuing sales opportunities via our solution/reseller channels, as well asfocusing sales efforts on specific market segments, in order to facilitateacceptance of our products. However, we currently have more of our salesresources focused on the direct model. As a result, we derive a significantportion of our revenue from direct sales.

|                                               | ** ** | **Total Software  License and  Hardware  Revenue** | ** ** | **Software License   and Hardware  Revenue from  Indirect  Distribution  Channel Sales** | ** ** | **Software License  and Hardware  Revenue From  Indirect Distribution  Channel Sales as a  Percentage of Total  Software License  and Hardware Revenue** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Twelve months ended  December 31, 2005   |       | $                                                            | 7,437,230  |                                                                                                              |       | $                                                                                                                                                                                                                    | 2,742,598  |   |   |   | 36.9 | % |   |
| Twelve months  ended December 31, 2004   |       | $                                                            | 7,682,242  |                                                                                                              |       | $                                                                                                                                                                                                                    | 2,885,926  |   |   |   | 37.6 | % |   |
| Change from same period of  prior fiscal year |       | $                                                            | (245,012   | )                                                                                                                 |       | $                                                                                                                                                                                                                    | (143,328   | ) |   |   | (0.7 | )% |   |
|                                               |       | or (3.2)%                                                    |       |                                                                                                              | or (5.0)%  |                                                                                                                                                                                                                 |       |   |   |   |   |
| Twelve months  ended December 31, 2004   |       | $                                                            | 7,682,242  |                                                                                                              |       | $                                                                                                                                                                                                                    | 2,885,926  |   |   |   | 37.6 | % |   |
| Twelve months ended  December 31, 2003   |       | $                                                            | 6,869,158  |                                                                                                              |       | $                                                                                                                                                                                                                    | 3,517,217  |   |   |   | 51.2 | % |   |
| Change from same  period of prior fiscal year |       | $                                                            | 813,084    |                                                                                                              |       | $                                                                                                                                                                                                                    | (631,291   | ) |   |   | (13.6 | )% |   |
|                                          |       | or 11.8%                                                     |       |                                                                                                              | or (17.9)% |                                                                                                                                                                                                                 |       |   |   |   |   |

 

**CriticalAccounting Policies and Estimates**

We have identified the policies and estimates below ascritical to our business operations and the understanding of our results ofoperations. The impact and any associated risks related to these policies onour reported and expected financial results and business operations arediscussed in appropriate sections throughout Management’s Discussion andAnalysis of Financial Condition and Results of Operations. Our preparation ofthis Form 10-K required us to make estimates and assumptions thataffect the reported amount of assets and liabilities, the disclosure of contingentassets and liabilities as of the date of the financial statements includedherein and the reported amounts of revenue and expenses during the periodcovered by this report. There can be no assurance that actual results will notdiffer materially from those estimates.

*RevenueRecognition and Accounts Receivable Reserves.**  *We derive our revenue primarilyfrom two sources: (i) product revenue, which includes software license andhardware revenue, and (ii) service and support revenue, which includessoftware maintenance and support, installation, training and consulting revenue.We license our software products on a perpetual basis. We generate revenue fromlicensing the rights to use our software products and sales of hardwaredirectly to end-users and indirectly through resellers. Our resellers orderproducts from us based on purchase orders received from end-users and do notorder stock. We generally sell our products to resellers and directly toend-users without any specifically stated rights of return. Occasionally,however, in our sole discretion, we will accept a product return if theend-user finds that the product does not fit its needs. We also sell hardwareproducts, which are provided by a third-party, at cost plus an additionalmark-up, to end-users and indirectly through resellers. The hardware productsthat we resell are not functional without our software. To support our softwareproducts, we sell software maintenance, support, installation, training andconsulting services to end-users and indirectly through resellers.

We apply the provisions of Statement of Position (“SOP”)97-2,*Software Revenue Recognition*,as amended by SOP 98-9, Modification of SOP 97-2,*Software Revenue Recognition with Respect to CertainTransactions*, to all transactions involving the sale of multipleelements including software, hardware and service revenue. We apply theprovisions of Statement of Financial Accounting Standards (“SFAS”) 

33

----

No. 48,*Revenue Recognition When Right of Return Exists*,with respect to providing for potential future product returns. As describedbelow, we must make and use significant judgments and estimates in connectionwith the revenue recognized in any accounting period. Material differences mayhave resulted in the amount and timing of our revenue if we had made differentjudgments or utilized different estimates.

We recognize revenue from the sale of softwareproducts and hardware to both end-users and resellers when persuasive evidenceof an arrangement exists, the products have been delivered, the fee is fixed ordeterminable, collection of the resulting receivable is reasonably assured andthere are no uncertainties regarding customer acceptance. We maintain a reservefor potential product returns. We recognize software maintenance and supportrevenue over the term of the related maintenance period, which is typically aone-year period. On those occasions when we sell multiple-year maintenancecontracts, we recognize the associated revenue over the multiple-year term ofthe maintenance contract. We recognize other service revenue as we perform theservices. If an arrangement includes an acceptance provision and acceptance isuncertain, then we will defer all revenue until the customer accepts theproducts purchased. Acceptance in these instances generally occurs upon theearlier of receipt of a written customer acceptance or expiration of theacceptance period. If an arrangement includes an acceptance provision tied todetermination that our product meets published specifications and there are nouncertainties with regard to the customer’s acceptance, then we will recognizerevenue at the time of sale, provided that all other revenue recognitioncriteria previously mentioned have been met and the acceptance period is ofshort duration.

Our transactions frequently involve the sale ofsoftware, hardware and related services under multiple element arrangements. Revenueunder multiple element arrangements is allocated to each element under theresidual method, in accordance with SOP 98-9, Modification of SOP 97-2,*Software Revenue Recognition with Respect to CertainTransactions*. Under this method, revenue is allocated first to allundelivered elements, such as services, based on the fair value of thoseelements, which is calculated to be the price charged when these elements aresold separately and unaccompanied by other elements. Our services generally arenot essential to the functionality of the software, as these services do notalter the capabilities of the software and do not carry a significant degree ofrisk to perform. The amount allocated to the delivered elements, such assoftware license and hardware revenue, is the difference between the totalarrangement value and the amount allocated to the undelivered elements. If thedelivered elements include both software and hardware, the amount allocated tohardware revenue is based on the price charged to us by the third party vendorplus an additional mark up, with the remainder allocated to software revenue. Tothe extent that a discount is offered in the arrangement, the entire discountis allocated to the delivered element or elements. If the delivered elementsinclude hardware and software, the discount is allocated to the hardware andsoftware based on their respective list prices.

For all sales, we use a binding purchase order, asigned contract or a credit card authorization as evidence of an arrangement. Salesthrough our resellers are evidenced by a master agreement governing therelationship, together with binding purchase orders on atransaction-by-transaction basis.

At the time of a transaction, we assess whether thefee associated with the transaction is fixed or determinable and whether or notcollection is reasonably assured. If a significant portion of a fee is duebeyond our normal payment terms, which are thirty to sixty days from invoicedate, we account for the fee as not being fixed or determinable. In thesecases, we recognize revenue as the fees become due. We assess collection basedon a number of factors, including past transaction history with the customerand the credit-worthiness of the customer. We review Dunn & Bradstreetcredit reports for all of our resellers and adjust our credit limits with thoseresellers accordingly. If a particular reseller does not have a favorablereport or if we do not have enough credit information to determine if thereseller is credit-worthy then we predominantly sell to those resellers on cashon delivery terms. We do not request collateral from our customers. If wedetermine that collection of a fee is not reasonably assured, the fee isdeferred and 

34

----

revenue is recognized atthe time collection becomes reasonably assured, which is generally upon receiptof payment.

We maintain reserves for potential product returns andmake adjustments to these reserves as needed based on historical product returnrates. We also consider the impact of new product introductions, changes incustomer demand and acceptance of our products on the adequacy of thesereserves. Our calculation of the estimated return reserve is based upon (1) anaccount specific review of potential returns, where a return probability isknown and (2) an estimate based upon past historical returns as apercentage of revenue. We must make and use significant judgments and estimatesin connection with establishing the product returns reserve in any accounting period.Material differences may have resulted in the amount and timing of revenue forthis or any prior period if we made different judgments or utilized differentestimates.

As with the product return reserve, we must makeestimates of our ability to collect on our accounts receivable. We record tradeaccounts receivable at the invoiced amount and these accounts do not bearinterest. We specifically analyze accounts receivable, historical bad debts,customer credit-worthiness, current economic trends and changes in customerpayment patterns when evaluating the adequacy of our allowance for doubtfulaccounts. We review our allowance for doubtful accounts on a monthly basis. Ourcalculation of the estimated accounts receivable reserve is also based upon (1) anaccount specific review of potential uncollectible accounts, where a bad debtprobability is known, and (2) an estimate based upon past historical baddebts as a percentage of accounts receivable. We do not have anyoff-balance-sheet credit exposure to our customers.

Our combined accounts receivable and product returnsreserve was $33,000 and $82,000 at December 31, 2005 and December 31, 2004,respectively. Both components of calculating the estimated reserve – specificidentification and historic experience – are material judgments that wemake. We base these judgments on historic trends, taking into considerationcurrent business and economic conditions, which could change materially, thuschanging the required reserve level materially. The potential change to thesize of our required reserve could be positive, in the event the reserveestimate proves unnecessary, or negative, if the reserve proves inadequate.

Our deferred revenue is comprised mainly of revenuethat is deferred for software maintenance and support contracts. The othercomponents of deferred revenue are amounts from sales transactions that weredeferred because they did not meet all of the provisions of our revenuerecognition policy.

*SoftwareDevelopment Costs.**  *Weconsider software development costs for capitalization when technologicalfeasibility is established in accordance with SFAS No. 86,*Accounting for the Costs of Computer Software To BeSold, Leased or Otherwise Marketed*. We sell software in a marketthat is subject to rapid technological change, new product introductions andchanging customer needs. Accordingly, we have determined that we cannotascertain technological feasibility until the development state of the productis nearly complete. The time period during which cost could be capitalized fromthe point of reaching technological feasibility until the time of generalproduct release is very short and, consequently, the amounts that might becapitalized are not material to our consolidated financial position or resultsof operations. Therefore, we charge all software development costs tooperations in the period incurred.

*Taxes.**  *We are required to estimate our income andstate sales taxes. This process involves estimating our actual current taxobligations, while also assessing differences resulting from the differenttreatment of items for tax and accounting purposes that result in deferredincome tax assets and liabilities and accrued state sales tax liabilities. Weinclude deferred income tax assets and liabilities and accrued state sales taxliabilities in our balance sheet.

35

----

We assess our deferred tax assets for each reportingperiod to determine whether it is more likely than not that we will recoverfrom future taxable income. In making this assessment, we include assumptionsregarding ongoing tax planning strategies. We establish a valuation allowancefor assets when their recovery is not certain.  We include changes to the valuation allowanceas an expense or benefit within the tax provision in our statement ofoperations.

We provide a full valuation allowance against all ofour net deferred tax assets and will continue to do so until we return to anappropriate level of sustained taxable income. The ultimate realization ofthese deferred tax assets depends upon our ability to generate sufficientfuture taxable income. If we are successful in generating sufficient futuretaxable income, we will reduce the valuation allowance through a reduction inincome tax expense in the future.

We estimate accrued statesales taxes for each reporting period based on tax rates in effect for thereporting periods in each of the states where we have a potential nexus and forthe time period during which we have that nexus. The assumptions and estimatesused to determine this liability are subject to change as they are difficult tomeasure or value. In the event that actual results differ from these estimates,our state sales taxes expense could be materially impacted. We had a $356,000reduction in the state sales tax accrual for the year ended December 31,2005. This reduction results from the settlement of sales tax obligations withcertain states at an amount less than what we had estimated. A portion of thisreduction is due to the fact that we received a refund from a particular statethat we had previously settled state sales taxes in and we enrolled in theStreamlined Sales Tax Program in December 2005, which relieved us from anypast sales tax liabilities from twelve states in which we were not reportingstate sales taxes and had estimated and accrued an amount equal to ourpotential sales tax liability. As a result, we eliminated our accrual for thesestate sales taxes, as we are now required to pay applicable sales taxes only ona go-forward basis for those member states of the Streamlined Sales TaxProgram.

**New Accounting Pronouncements**

In May 2005, the Financial Accounting StandardsBoard (“FASB”) issued FASB Statement No. 154, “*AccountingChanges and Error Corrections, a replacement of APB Opinion No. 20 andFASB Statement No. 3*” (“SFAS No. 154”). Previously, APB No. 20,“*Accounting Changes*” and SFAS No. 3,“*Reporting Accounting Changes in Interim FinancialStatements*” required the inclusion of the cumulative effect ofchanges in accounting principle in net income of the period of the change. SFASNo. 154 instead requires companies to recognize a change in accountingprinciple, including a change required by a new accounting pronouncement whenthe pronouncement does not include specific transition provisions,retrospectively to prior periods’ financial statements. We will assess the impactof a retrospective application of a change in accounting principle inaccordance with SFAS No. 154 if such a change arises after the January 1,2006 effective date.

In December 2004,the FASB issued SFAS No. 123(R),*“Share-BasedPayment*.” SFAS No. 123(R) amends SFAS No. 123 torequire that companies record as an expense the effect of equity-basedcompensation, including stock options over the requisite service period.Historically, we disclosed the effect on income that stock options would havehad were they recorded as expense. SFAS No. 123(R) also requires moreextensive disclosures concerning stock options than required under priorstandards. The new rule applies to option grants made after a company’sadoption of the standard, as well as options that are not vested at the date ofadoption. SFAS No. 123(R) permits public companies to adopt itsrequirements using one of two methods:

·       A“modified prospective” method in which compensation cost is recognizedbeginning with the effective date, based on the requirements of SFAS No. 123(R) (a) forall share-based payments granted after the effective date and (b) for allawards granted to employees prior to the effective date of SFAS No. 123(R) thatremain unvested on the effective date.

36

----

·       A“modified retrospective” method that includes the requirements of the modifiedprospective method described above, but also permits entities to restate basedon the amounts previously recognized under SFAS No. 123 for purposes ofpro forma disclosures for either (a) all prior periods presented or (b) priorinterim periods of the year of adoption.

We will implement SFAS No. 123(R) in thefirst quarter of 2006 and intend to use the modified prospective method. Weexpect that the adoption will not have a material impact on our 2006 results.

In November 2004, theFASB issued SFAS No. 151,*InventoryCosts, an Amendment of ARB No. 43, Chapter 4.* SFAS No. 151modifies the accounting for abnormal inventory costs and the manner in whichcompanies allocate fixed overhead expenses to inventory. SFAS No. 151 iseffective for inventory costs incurred during annual periods beginning after June 15,2005. We do not expect SFAS No. 151 to have a material impact on ourfinancial position and results of operations.

**Results of Operations**

Thefollowing table sets forth certain financial data for the periods indicated asa percentage of total revenue:

| ** **                      | ** ** | **Year ended December 31,** | ** ** |
|---------------------------------|------------|--------------------------------------------|------------|
| ** **                      | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenue:                        |       |                                       |       |   |   |   |   |
| Software license                |       | 33.1                                       | %          | 30.4 | % | 29.9 | % |
| Hardware                        |       | 18.9                                       |       | 21.5 |   | 20.1 |   |
| Service and other               |       | 48.0                                       |       | 48.1 |   | 50.0 |   |
| Total revenue                   |       | 100.0                                      |       | 100.0 |   | 100.0 |   |
| Cost of revenue:                |       |                                       |       |   |   |   |   |
| Software license                |       | 1.1                                        |       | 1.3 |   | 2.0 |   |
| Hardware                        |       | 11.8                                       |       | 13.2 |   | 13.6 |   |
| Service and other               |       | 19.5                                       |       | 18.5 |   | 22.9 |   |
| Total cost of  revenue          |       | 32.4                                       |       | 33.0 |   | 38.5 |   |
| Gross profit                    |       | 67.6                                       |       | 67.0 |   | 61.5 |   |
| Operating expenses:             |       |                                       |       |   |   |   |   |
| Sales and marketing             |       | 36.8                                       |       | 27.8 |   | 34.5 |   |
| Research and development        |       | 15.6                                       |       | 13.1 |   | 15.9 |   |
| General and administrative      |       | 18.7                                       |       | 16.3 |   | 21.4 |   |
| Restructuring                   |       | —                                     |       | — |   | 5.9 |   |
| Total operating  expenses       |       | 71.1                                       |       | 57.2 |   | 77.7 |   |
| (Loss) income  from operations  |       | (3.5                                       | )          | 9.8 |   | (16.2 | ) |
| Interest and  other income, net |       | 1.3                                        |       | 1.0 |   | 1.0 |   |
| Tax benefit                     |       | —                                     |       | — |   | (1.0 | ) |
| Net (loss) income               |       | (2.2                                       | )%         | 10.8 | % | (14.2 | )% |
| Gross profit:                   |       |                                       |       |   |   |   |   |
| Software license                |       | 96.7                                       | %          | 95.7 | % | 93.2 | % |
| Hardware                        |       | 37.4                                       |       | 38.8 |   | 32.8 |   |
| Service and other               |       | 59.4                                       |       | 61.4 |   | 54.2 |   |

 

37

----

**FiscalYears Ended December 31, 2005 and 2004**

*Revenue*

*SoftwareLicense.**  *Duringthe twelve months ended December 31, 2005, our total revenue was$14.3 million, a decrease of approximately $494,000 from $14.8 million forthe twelve months ended December 31, 2004. However, our software licenserevenue increased by 5% to $4.7 million in the twelve months ended December 31,2005 as compared to $4.5 million in the same period in 2004. Further, revenuefrom our AccuRoute product increased to $2.3 million during the twelve monthsended December 31, 2005 as compared to $1.7 million during the twelvemonths ended December 31, 2004. This increase reflects the continuedmarket acceptance of our AccuRoute product. Software revenue from our legacyfax product line decreased to $2.3 million during the twelve months ended December 31,2005 from $2.5 million during the same period in 2004, as we continue to focusour resources on the expansion of our AccuRoute product line and we experiencediminished sales from our maturing legacy fax market. Various other componentsof software license revenue, including sales returns and allowance adjustmentsand sales of our other software products such as Genidocs and Swiftwriter, havedecreased to $17,000 for the twelve months ended December 31, 2005 ascompared to $43,000 during the same period in 2004.

Duringthe twelve months ended December 31, 2005, as compared to the same periodduring 2004, the mix of products accounting for our revenue has continuedshifting towards our AccuRoute product, as displayed in the table below, whichtable summarizes our revenue and particularly our software license revenue, byproduct category (excluding freight and allowances for returns) for the twelvemonths ended December 31, 2005, as compared to the same period in theprior fiscal year.

|                                               | ** ** | **Total  Revenue** | ** ** | **Software  License  Revenue** | ** ** | **AccuRoute  License  Revenue** | ** ** | **Legacy Fax  License  Revenue** | ** ** | **Other  Software  License  Revenue** | ** ** |
|-----------------------------------------------|------------|--------------------|------------|--------------------------------|------------|---------------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|
| Twelve months ended  December 31, 2005   |       | $                  | 14,296,165 |                           | $          | 4,732,121                       |       | $                                     | 2,342,577  |                                  | $          | 2,295,196 |   | $ | 17,444 |   |
| Twelve months  ended December 31, 2004   |       | $                  | 14,790,194 |                           | $          | 4,504,899                       |       | $                                     | 1,727,960  |                                  | $          | 2,548,740 |   | $ | 43,199 |   |
| Change from same period of  prior fiscal year |       | $                  | (494,029   | )                              | $          | 227,222                         |       | $                                     | 614,617    |                                  | $          | (253,544 | ) | $ | (25,755 | ) |
|                                               |       | or (3.3)%          |       | or 5.0%                        |       | or 35.6%                        |       | or (9.9)%                             |       | or (59.6)%                            |       |

 

Duringthe twelve months ended December 31, 2005, our software license revenuerepresented an increased percentage of our total revenue, based primarily onthe fact that hardware and services revenue declined during the twelve monthsended December 31, 2005 when compared to the same period in 2004.

| ** **                                    | ** ** | **Software License Revenue as a  Percentage of Total Revenue** | ** ** |
|-----------------------------------------------|------------|---------------------------------------------------------------------------------------------------|------------|
| Twelve months  ended December 31, 2005   |       |                                                                                              | 33.1       | % |   |
| Twelve months  ended December 31, 2004   |       |                                                                                              | 30.5       | % |   |
| Change from same period  of prior fiscal year |       |                                                                                              | 2.6        | % |   |

 

38

----

Duringthe twelve months ended December 31, 2005 and 2004, our license revenuefrom each of our major product lines and other components of revenue (excludingfreight and allowances for returns) represented the following percentages ofour total software license revenue:

| ** **                                    | ** ** | **AccuRoute License  Revenue as  a Percentage of Software  License Revenue** | ** ** | **Legacy Fax License  Revenue as  a  Percentage of  Software License  Revenue** | ** ** | **Other Software  License  Revenue as a  Percentage of  Software License  Revenue** | ** ** |
|-----------------------------------------------|------------|------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------|------------|
| Twelve months  ended December 31, 2005   |       |                                                                                                       | 49.5       | %                                                                                                                  |       |                                                                                                         | 48.5       | % |   |   | 0.4 | % |   |
| Twelve months  ended December 31, 2004   |       |                                                                                                       | 38.4       | %                                                                                                                  |       |                                                                                                         | 56.6       | % |   |   | 1.0 | % |   |
| Change from same period  of prior fiscal year |       |                                                                                                       | 11.1       | %                                                                                                                  |       |                                                                                                         | (8.1       | )% |   |   | (0.6 | )% |   |

 

Included in our software license revenue for thetwelve months ended December 31, 2005 and 2004 is a reduction of $69,000and $185,000, respectively, in our sales returns and allowance reserve relatingprimarily to a general estimate based upon past historical returns for fiscalyear 2005 and to the recovery of specific accounts that were previously writtenoff and to specific accounts from fiscal year 2004, where we determined thatthe risk of a return was no longer present. Although we cannot accuratelypredict the exact mix of products that we will sell in the future, we expectthat software license revenue will constitute a larger percentage of our totalrevenue in the future if demand for our AccuRoute product, which generally doesnot require the purchase of additional hardware, continues to grow and if ourAccuRoute product gains additional market acceptance.

*Hardware.**  *Hardware revenue decreased duringthe twelve month period ended December 31, 2005 as compared to the twelvemonth period ended December 31, 2004 due to a decrease in sales of ourlegacy fax product, which sales are the main driver for our hardware revenue,and an overall decrease in demand from our existing customers who have alreadyupgraded information systems hardware in their worldwide locations.

|                                               | ** ** | **Hardware Revenue** | ** ** | **Hardware Revenue as a  Percentage of Total Revenue** | ** ** |
|-----------------------------------------------|------------|---------------------------|------------|--------------------------------------------------------------------------------------|------------|
| Twelve months ended  December 31, 2005   |       |                      | $          | 2,705,109                                                                            |       |   |   | 18.9 | % |   |
| Twelve months  ended December 31, 2004   |       |                      | $          | 3,177,343                                                                            |       |   |   | 21.5 | % |   |
| Change from same period of  prior fiscal year |       |                      | $          | (472,234                                                                             | )          |   |   | (2.6 | )% |   |
|                                               |       |                      | or (14.9)  | %                                                                                    |       |   |   |   |   |

 

Included in hardware revenue for the twelve monthsended December 31, 2005 and 2004 is a reduction of $17,000 and $63,000,respectively, in the sales returns and allowance reserve relating primarily toa general estimate based upon past historical returns for fiscal year 2005 andto the recovery of specific accounts that were previously written off and tospecific accounts from fiscal year 2004 where we determined that the risk of areturn is no longer present and to the recovery of specific accounts that werepreviously written off. We expect market demand for our AccuRoute product,which generally does not require our customers to purchase additional hardware,to increase and, if it does, we anticipate hardware revenue will constitute asmaller percentage of our total revenue.

*Service and Other.**  *Service and other revenue, whichconsists primarily of the sale of support contracts to complement softwareproducts we sell to our customers and, to a lesser extent, consulting, trainingand installation services, decreased in the twelve months ended December 31,2005, as compared to the same period in the prior fiscal year. This decreasewas due primarily to a 19% reduction in fax-related maintenance revenue for thetwelve months ended December 31, 2005 as compared to the previous year asmost****of our historic service and otherrevenue is related to sales of our legacy fax product. This 

39

----

decrease was partially offset by increased overallservice revenue from consulting services for the same periods.

| ** **                                    | ** ** | **Service and Other Revenue** | ** ** | **Service and Other Revenue as  a Percentage of Total Revenue** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|------------|
| Twelve months  ended December 31, 2005   |       |                                         | $          | 6,858,935                                                                                               |       |   |   | 48.0 | % |   |
| Twelve months  ended December 31, 2004   |       |                                         | $          | 7,107,952                                                                                               |       |   |   | 48.1 | % |   |
| Change from same period  of prior fiscal year |       |                                         | $          | (249,017)  or (3.5)                                                                                     | %          |   |   | (0.1 | )% |   |

 

We are focused onimproving the renewal rate of software maintenance contracts with our existingcustomer base in both our North American and European operations and we arefocusing greater attention on generating additional service and other revenuein future periods.

***Cost of Revenue***

*SoftwareLicense.**  *Costof software license revenue consists primarily of the costs we incur insublicensing third-party software products, product media and productduplication. Cost of software license revenue for the twelve months ended December 31,2005 decreased by 21% as compared to the corresponding period in the previousfiscal year. The decrease is due primarily to decreased royalty paymentsassociated with sales of royalty-bearing products. We have recently addedthird-party software into our products and we expect that our software licensecost as a percentage of software license revenue will increase slightly in thefuture. We believe that these newly licensed third-party software componentswill improve the capabilities and functionality of our products.

As aresult of the decrease in the cost of software license revenue that we incurredduring the twelve months ended December 31, 2005, we incurred an increasein our software license gross margin percentage as set forth in the followingtable:

| ** **                                    | ** ** | **Software License  Gross Margin** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------|------------|
| Twelve months  ended December 31, 2005   |       |                                         | 96.7       | % |   |
| Twelve months  ended December 31, 2004   |       |                                         | 95.7       | % |   |
| Change from same period  of prior fiscal year |       |                                         | 1.0        | % |   |

* *

*Hardware.**  *Cost of hardware revenue consists primarily ofthe costs we incur in purchasing third-party hardware products. Cost ofhardware revenue represented 63% and 61% of hardware revenue for fiscal years2005 and 2004, respectively. During the twelve months ended December 31,2005, we incurred decreased costs related to hardware revenue due primarily tothe decrease in our hardware unit sales. Further, our gross margin percentagefor hardware sales decreased during this period due to a change in the mix ofparticular hardware products sold. We do not expect significant changes in unitprices for fiscal year 2006.

| ** **                                    | ** ** | **Hardware Gross Margin** | ** ** |
|-----------------------------------------------|------------|-------------------------------------|------------|
| Twelve months  ended December 31, 2005   |       |                                | 37.4       | % |   |
| Twelve months  ended December 31, 2004   |       |                                | 38.8       | % |   |
| Change from same period  of prior fiscal year |       |                                | (1.4       | )% |   |

* *

40

----

*Service and Other.**  *Cost of service and other revenueconsists primarily of the costs we incur in providing telephone support, aswell as other miscellaneous customer service-related expenses. The gross marginpercentage for service and other revenue decreased to 59% for the twelve monthsended December 31, 2005, compared to 61% in the same period in 2004. Thedecrease in gross margin percentage is due to an increase in wage-relatedexpenses and associated overhead costs of employees in the support department,as well as increased travel costs. We do not expect any significant variancesin our service and other gross margin percentages for fiscal year 2006.

| ** **                                    | ** ** | **Cost of Service and  Other Revenue** | ** ** | **Gross Margin for Service  and Other Revenue** | ** ** |
|-----------------------------------------------|------------|------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| Twelve months  ended December 31, 2005   |       |                                                       | $          | 2,781,828                                                                |       |   |   | 59.4 | % |   |
| Twelve months  ended December 31, 2004        |       |                                                       | $          | 2,743,258                                                                | ** ** |   |   | 61.4 | % |   |
| Change from same  period of prior fiscal year |       |                                                       | $          | 38,570                                                                   | ** ** |   |   | (2.0 | )% |   |
|                                          |       |                                                       | or 1.4%    | ** **                                                               |       |   |   |   |   |

 

***Operating Expenses***

*Salesand Marketing.**  *Salesand marketing expenses consist primarily of employee salaries, benefits,commissions and associated overhead costs, as well as the cost of marketingprograms such as advertisements, direct mailings, public relations, tradeshows, seminars and related communication costs. Sales and marketing expensesincreased in the fiscal year ended December 31, 2005 as compared to thesame period in 2004, due to an increased number of employees in our sales andmarketing departments and the associated costs of supporting those employees.

Additionally,we increased our general advertising and consulting expenditures during thefiscal year ended December 31, 2005 as compared to the same period in theprior fiscal year. These expense increases reflect our initiative to furtherpenetrate the legal vertical market with our AccuRoute product, as well as ourinitiative to target new vertical markets. Building on the success of thecurrent version of our AccuRoute product within the legal vertical market sinceits introduction in 2004, we intend to continue broadening our current salesand marketing strategy, which we began in the second quarter of 2005, toencompass first the financial services vertical market and, thereafter, thehealthcare vertical market. In 2005, we experienced some delays in investingthe full budgeted amount for these initiatives due primarily to some delays inthe hiring of our executive sales and marketing team, all of whom have now beenhired. During fiscal year 2006, we will continue—in fact accelerate—ourinvestment in sales and marketing and business development and we expect tostart seeing the impact of these investments in growing our business during2006.

| ** **                                    | ** ** | **Sales and  Marketing Expenses** | ** ** | **Sales and Marketing Expenses as  a Percentage of Total Revenue** | ** ** |
|-----------------------------------------------|------------|---------------------------------------------|------------|------------------------------------------------------------------------------------------------------------|------------|
| Twelve months  ended December 31, 2005   |       |                                        | $          | 5,256,283                                                                                                  |       |   |   | 36.8 | % |   |
| Twelve months  ended December 31, 2004   |       |                                        | $          | 4,100,765                                                                                                  |       |   |   | 27.8 | % |   |
| Change from same  period of prior fiscal year |       |                                        | $          | 1,155,518                                                                                                  |       |   |   | 9.0 | % |   |
|                                          |       |                                        | or 28.2%   |                                                                                                       |       |   |   |   |   |

 

*Research and Development.**  *Research and development expensesinclude expenses associated with the development of new products, enhancementsof existing products and quality assurance activities. These expenses consistprimarily of employee salaries, benefits, associated overhead costs, consultingexpenses and the cost of software development tools. In the most recentlycompleted fiscal year, our research and development expenses increased ascompared to the same period in the prior fiscal year due 

41

----

to an increased number of employees in our researchand development department during fiscal year 2005 and the associated costs ofsupporting those new personnel.

| ** **                                     | ** ** | **Research and  Development Expenses** | ** ** | **Research and Development  Expenses as a Percentage of  Total Revenue** | ** ** |
|------------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|
| Twelve months  ended December 31, 2005    |       |                                             | $          | 2,239,250                                                                                                   |       |   |   | 15.7 | % |   |
| Twelve months  ended December 31, 2004    |       |                                             | $          | 1,936,779                                                                                                   |       |   |   | 13.1 | % |   |
| Change from same  period of prior  fiscal year |       |                                             | $          | 302,471                                                                                                     |       |   |   | 2.6 | % |   |
|                                           |       |                                             | or 15.6%   |                                                                                                        |       |   |   |   |   |

 

Additionally, the increase in research and developmentexpenses in dollars and as a percentage of total revenue is a result of anincrease in consulting expenses in the research and development departmentduring fiscal year 2005 as compared with the same period in 2004. We expect ourresearch and development expenses to increase in absolute dollars as we hireadditional engineers and engage in more third-party consulting arrangements tosupport our expansion of our AccuRoute product into other vertical markets.

*Generaland Administrative.**  *Generaland administrative expenses consist primarily of employee salaries and benefitsfor administrative, executive and finance personnel and associated corporategeneral and administrative expenses. In the most recently completed fiscalyear, our general and administrative expenses increased as compared to the sameperiod in the prior fiscal year.

| ** **                                    | ** ** | **General and  Administrative Expenses** | ** ** | **General and Administrative Expenses  as a Percentage of Total Revenue** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------|------------|
| Twelve months  ended December 31, 2005   |       |                                               | $          | 2,671,200                                                                                                         |       |   |   | 18.7 | % |   |
| Twelve months  ended December 31, 2004   |       |                                               | $          | 2,417,091                                                                                                         |       |   |   | 16.3 | % |   |
| Change from same  period of prior fiscal year |       |                                               | $          | 254,109                                                                                                           |       |   |   | 2.4 | % |   |
|                                          |       |                                               | or 10.5%   |                                                                                                              |       |   |   |   |   |

 

The increase in dollar amount and as a percentage oftotal revenue for the twelve months ended December 31, 2005 as compared tothe corresponding period in 2004 is due primarily to an increase in managementconsulting expenses related to our initial compliance efforts with Section 404of the Sarbanes-Oxley Act of 2002, fees paid to our board of directors andwage-related expenses. This increase was offset in part by decreases inaccounting and legal fees and by a $356,000 reduction in the state sales taxaccrual for the year ended December 31, 2005 compared to a $227,000reduction in the state sales tax accrual in 2004. Each of these reductionsresults from the settlement of sales tax obligations with certain states at anamount less than what we had estimated. A portion of the 2005 reduction is dueto the fact that we received a refund from a particular state that we hadpreviously settled state sales taxes in and we enrolled in the StreamlinedSales Tax Program in December 2005, which relieved us from any past salestax liabilities from twelve states in which we were not reporting state salestaxes and had estimated and accrued an amount equal to our potential sales taxliability. As a result, we eliminated our accrual for these state sales taxes,as we are now required to pay applicable sales taxes only on a go-forward basisfor those member states of the Streamlined Sales Tax Program. We expect that wewill continue to experience slight increases to general and administrativeexpenses in the form of additional professional fees. In addition, we expectfewer reductions, if any, to our state sales tax accrual. We expect thatconsulting expenditures may be relatively flat in 2006 as compared to 2005 dueto recent pronouncements from the Securities and Exchange Commission delayingthe applicability of Section 404 of the Sarbanes-Oxley Act of 2002 untilat 

42

----

least the first fiscalyear ending on or after July 15, 2007 for companies like Omtool withpublic float of less than $75 million.

*Interest and Other Income.**  *Interest and other income consistsprincipally of interest income earned on cash and cash equivalent balances. Thefollowing table sets forth our interest and other income for the fiscal yearsended December 31, 2005 and 2004.

| ** **                                     | ** ** | **Interest and Other Income** | ** ** | **Interest and Other Income as a  Percentage of Total Revenue** | ** ** |
|------------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|------------|
| Twelve months  ended December 31,  2005   |       |                                         | $          | 185,725                                                                                                 |       |   |   | 1.3 | % |   |
| Twelve months  ended December 31,  2004   |       |                                         | $          | 140,172                                                                                                 |       |   |   | 0.9 | % |   |
| Change from same  period of prior  fiscal year |       |                                         | $          | 45,553                                                                                                  |       |   |   | 0.4 | % |   |
|                                           |       |                                         | or 32.5%   |                                                                                                    |       |   |   |   |   |

 

The increase in interest income is primarily a resultof higher interest rates earned on our investment accounts during the twelvemonths ended December 31, 2005 as compared to the twelve months ended December 31,2004. We expect that interest and other income will be relatively stablequarter over quarter for fiscal year 2006.

*Income Tax Benefit.**  *We did not record an income taxbenefit associated with any pre-tax loss for the twelve months ended December 31,2005 due to uncertainty regarding future taxable income. We did, however,record $5,492 of tax benefit related to the true-up of certain income taxaccounts during 2005 related to the twelve months ended December 31, 2004.During the twelve months ended December 31,2004, we recorded a net tax benefit of $6,707 resulting primarily from adecrease in our estimated taxes payable as a result of a revised internationaltransfer pricing agreement with our United Kingdom subsidiary. Our fiscal year2004 tax position also benefited from a $28,800 adjustment related to atransfer pricing adjustment related to fiscal year 2003.

**FiscalYears Ended December 31, 2004 and 2003**

*Revenue*

*SoftwareLicense.**  *Duringthe twelve months ended December 31, 2004, our total revenue was$14.8 million, an increase of $1.1 million from $13.7 million for thetwelve months ended December 31, 2003. Our software license revenueincreased by approximately 10% to $4.5 million in the twelve months ended December 31,2004 compared to $4.1 million in the same period in 2003. Software license revenue for the fiscal year endedDecember 31, 2004 reflected an overall increase in demand for ourAccuRoute product, while offset by a decline in demand for our legacy faxproduct line as compared to the fiscal year ended December 31, 2003.

43

----

Thefollowing table summarizes our revenue and particularly our software licenserevenue, by product category (excluding freight and allowances for returns) forthe twelve months ended December 31, 2004, as compared to the same periodin the prior fiscal year.

| ** **                                    | ** ** | **Total  Revenue** | ** ** | **Software License  Revenue** | ** ** | **AccuRoute  License  Revenue** | ** ** | **Legacy Fax  Product License  Revenue** | ** ** | **Other Software  Product License  Revenue** | ** ** |
|-----------------------------------------------|------------|--------------------|------------|------------------------------------|------------|---------------------------------|------------|----------------------------------------------------|------------|--------------------------------------------------------|------------|
| Twelve months  ended December 31, 2004   |       | $                  | 14,790,194 |                               |       | $                               | 4,504,899  |                                               |       | $                                                      | 1,727,960  |   |   | $ | 2,548,740 |   |   |   | $ | 43,199 |   |   |
| Twelve months  ended December 31, 2003   |       | $                  | 13,747,246 |                               |       | $                               | 4,101,588  |                                               |       | $                                                      | 276,821    |   |   | $ | 3,559,129 |   |   |   | $ | 118,638 |   |   |
| Change from same  period of prior fiscal year |       | $                  | 1,042,948  |                               |       | $                               | 403,311    |                                               |       | $                                                      | 1,451,138  |   |   | $ | (1,010,389 | ) |   |   | $ | (75,439 | ) |   |
|                                          |       | or 7.6%            |       |                               | or 9.8%    |                            |       | or 524.2%                                          |       |                                                   | or (28.4)% |   |   |   | or (63.6)% |   |   |

 

During the twelve months ended December 31, 2004and 2003, our software license revenue as a percentage of total revenueremained relatively constant as set forth in the following table:

| ** **                                    | ** ** | **Software License Revenue as a  Percentage of Total Revenue** | ** ** |
|-----------------------------------------------|------------|---------------------------------------------------------------------------------------------------|------------|
| Twelve months  ended December 31, 2004   |       |                                                                                              | 30.5       | % |   |
| Twelve months  ended December 31, 2003   |       |                                                                                              | 29.8       | % |   |
| Change from same period  of prior fiscal year |       |                                                                                              | 0.7        | % |   |

 

Duringthe twelve months ended December 31, 2004 and 2003, our license revenuefrom each of our major product lines and other components of revenue (excludingfreight and allowances for returns) represented the following percentages ofour total software license revenue:

| ** **                                    | ** ** | **AccuRoute License  Revenue as  a Percentage of Software  License Revenue** | ** ** | **Legacy Fax Product License  Revenue as  Percentage of  Software License Revenue** | ** ** | **Other Software  Product License  Revenue as a Percentage of  Software License Revenue** | ** ** |
|-----------------------------------------------|------------|------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------|------------|
| Twelve months  ended December 31, 2004   |       |                                                                                                       | 38.4       | %                                                                                                                                |       |                                                                                                                              | 56.6       | % |   |   | 1.0 | % |   |
| Twelve months  ended December 31, 2003   |       |                                                                                                       | 6.7        | %                                                                                                                                |       |                                                                                                                              | 86.8       | % |   |   | 2.9 | % |   |
| Change from same period  of prior fiscal year |       |                                                                                                       | 31.7       | %                                                                                                                                |       |                                                                                                                              | (30.2      | )% |   |   | (1.9 | )% |   |

 

Included in software license revenue for the yearsended December 31, 2004 and 2003 is a reduction in the sales returns andallowance reserve of $185,000 and $147,000, respectively, relating to specificaccounts where we have determined that the risk of a return is no longerpresent.

*Hardware.**  *Hardware revenue increased duringthe twelve month period ended December 31, 2004 as compared to the twelvemonth period ended December 31, 2003 dueto an increase in demand from existing customers who upgraded information systemshardware in their worldwide locations.

| ** **                                    | ** ** | **Hardware Revenue** | ** ** | **Hardware Revenue as a  Percentage of Total Revenue** | ** ** |
|-----------------------------------------------|------------|---------------------------|------------|--------------------------------------------------------------------------------------|------------|
| Twelve months  ended December 31, 2004   |       |                      | $          | 3,177,343                                                                            |       |   |   | 21.5 | % |   |
| Twelve months  ended December 31, 2003   |       |                      | $          | 2,767,570                                                                            |       |   |   | 20.1 | % |   |
| Change from same  period of prior fiscal year |       |                      | $          | 409,773                                                                              |       |   |   | 1.4 | % |   |
|                                          |       |                      | or 14.8%   |                                                                                 |       |   |   |   |   |

 

44

----

Included in hardware revenue for the twelve monthsended December 31, 2004 and 2003 is a reduction of $63,000 and $51,000, respectively, in thesales return and allowance reserve relatingto specific accounts where the risk of a return is no longer present.

*Serviceand Other.**  *Serviceand other revenue were $7.1 million and $6.9 million for the twelvemonths ended December 31, 2004 and 2003, respectively, representing anincrease of 3%. The increase in service and other revenue is due primarily toan increase in maintenance revenue from a larger installed customer base.

| ** **                                     | ** ** | **Service and Other Revenue** | ** ** | **Service and Other Revenue as  a Percentage of Total Revenue** | ** ** |
|------------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|------------|
| Twelve months  ended December 31, 2004    |       |                                         | $          | 7,107,952                                                                                               |       |   |   | 48.1 | % |   |
| Twelve months  ended December 31, 2003    |       |                                         | $          | 6,878,088                                                                                               |       |   |   | 50.0 | % |   |
| Change from same period  of prior  fiscal year |       |                                         | $          | 229,864  or 3.3%                                                                                        |       |   |   | (1.9 | )% |   |

 

The decrease in serviceand other revenue as a percentage of total revenue is due primarily to theincrease in both software license and hardware revenue.

***Cost of Revenue***

*SoftwareLicense.**  *Costof software license revenue was $195,000 and $280,000 for the twelve monthsended December 31, 2004 and 2003, respectively. The decrease in cost andimprovement in gross margin is due primarily to the fact that we replacedcertain third-party software that was imbedded in our products with ourown internally-developed solutions, thus reducing the royalties that wemust pay when a product containing third-party software is sold.

As aresult of the decrease in the cost of software license revenue that we incurredduring the fiscal year ended December 31, 2004, we incurred an increase inour software license gross margin percentage as set forth in the followingtable:

| ** **                                    | ** ** | **Software License Gross Margin** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------------|------------|
| Twelve months  ended December 31, 2004   |       |                                             | 95.7       | % |   |
| Twelve months  ended December 31, 2003   |       |                                             | 93.2       | % |   |
| Change from same period  of prior fiscal year |       |                                             | 2.5        | % |   |

* *

*Hardware.**  *Cost of hardware revenue was $1.9 millionfor each of the twelve months ended December 31, 2004 and 2003,respectively, representing 61% and 67% of hardware revenue for each respectiveperiod. The gross margin increase is due mainly to a change in the particularmix of hardware products sold.

| ** **                                    | ** ** | **Hardware Gross Margin** | ** ** |
|-----------------------------------------------|------------|-------------------------------------|------------|
| Twelve months  ended December 31, 2004   |       |                                | 38.8       | % |   |
| Twelve months  ended December 31, 2003   |       |                                | 32.8       | % |   |
| Change from same period  of prior fiscal year |       |                                | 6.0        | % |   |

 

 

45

----

*Service and Other.**  *Cost of service and other revenuewas $2.7 million and $3.2 million for the twelve months ended December 31,2004 and 2003, respectively, representing 39% and 46% of service and otherrevenue for each respective period. The decrease in dollar amount of cost ofservice and other revenue is due to decreased wage expense and the associatedoverhead costs resulting from a decrease in the number of employees in theservice department resulting from the restructuring that occurred in the third quarterof 2003.

| ** **                                    | ** ** | **Cost of Service and  Other Revenue** | ** ** | **Gross Margin for Service  and Other Revenue** | ** ** |
|-----------------------------------------------|------------|------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| Twelve months  ended December 31, 2004   |       |                                                       | $          | 2,743,258                                                                |       |   |   | 61.4 | % |   |
| Twelve months  ended December 31, 2003   |       |                                                       | $          | 3,151,851                                                                |       |   |   | 54.2 | % |   |
| Change from same  period of prior fiscal year |       |                                                       | $          | (408,593                                                                 | )          |   |   | 7.2 | % |   |
|                                          |       |                                                       | or (13.0   | )%                                                                       |       |   |   |   |   |

 

**Operating Expenses**

*Sales and Marketing.**  *Our sales and marketing expensesdecreased for the twelve months ended December 31, 2004 as compared to thesame period in the prior fiscal year.   

| ** **                                    | ** ** | **Sales and Marketing Expenses** | ** ** | **Sales and Marketing Expenses as  a Percentage of Total Revenue** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------|------------|
| Twelve months  ended December 31, 2004   |       |                                            | $          | 4,100,765                                                                                                  |       |   |   | 27.8 | % |   |
| Twelve months  ended December 31, 2003   |       |                                            | $          | 4,745,375                                                                                                  |       |   |   | 34.5 | % |   |
| Change from same  period of prior fiscal year |       |                                            | $          | (644,610                                                                                                   | )          |   |   | (6.7 | )% |   |
|                                          |       |                                            | or (13.6   | )%                                                                                                         |       |   |   |   |   |

 

The decrease in sales and marketing expenses, both indollar amount and as a percentage of total revenue, is due to decreased wages,commissions and travel costs resulting from fewer management level personnel inthe department as a result of the restructuring that occurred in the thirdquarter of 2003. The decrease is also due to reduced trade show expenses during2004 as compared to 2003.

*Research and Development.**  *Our research and developmentexpenses decreased for the twelve months ended December 31, 2004 ascompared to the same period in the prior fiscal year.

| ** **                                    | ** ** | **Research and  Development Expenses** | ** ** | **Research and Development  Expenses as a Percentage  of Total Revenue** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|
| Twelve months  ended December 31, 2004   |       |                                             | $          | 1,936,779                                                                                                   |       |   |   | 13.1 | % |   |
| Twelve months  ended December 31, 2003   |       |                                             | $          | 2,186,615                                                                                                   |       |   |   | 15.9 | % |   |
| Change from same  period of prior fiscal year |       |                                             | $          | (249,836                                                                                                    | )          |   |   | (2.8 | )% |   |
|                                          |       |                                             | or (11.4   | )%                                                                                                          |       |   |   |   |   |

 

The decrease in the expense and in research anddevelopment expenses, both in dollar amount and as a percent of total revenue,is a result of fewer employees in the research and development department andthe decreased associated costs of supporting those personnel due to therestructuring that occurred in the third quarter of 2003.

46

----

*General and Administrative.**  *Our general and administrativeexpenses decreased for the twelve months ended December 31, 2004 ascompared to the same period in the prior fiscal year.

| ** **                                    | ** ** | **General and  Administrative Expenses** | ** ** | **General and Administrative  Expenses as a Percentage  of Total Revenue** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------|------------|
| Twelve months  ended December 31, 2004   |       |                                               | $          | 2,417,091                                                                                                     |       |   |   | 16.3 | % |   |
| Twelve months  ended December 31, 2003   |       |                                               | $          | 2,947,869                                                                                                     |       |   |   | 21.4 | % |   |
| Change from same  period of prior fiscal year |       |                                               | $          | (530,778                                                                                                      | )          |   |   | (5.1 | )% |   |
|                                          |       |                                               | or (18.0   | )%                                                                                                            |       |   |   |   |   |

 

The decrease in general and administrative expenses,both in dollar amount and as a percentage of total revenue, is due to thereduction in general and administrative personnel and overhead costs associatedwith supporting those personnel. The decrease is also due to a $227,000 reductionin the state sales tax accrual for the year ended December 31, 2004resulting from the settlement of sales taxes obligations with certain states atan amount less than what we had estimated.

*Restructuringcosts.**  *Inthe third quarter of 2003, we announced a restructuring of certain of ouroperations and recorded a pretax charge of $806,581 in accordance with SFAS No. 146,“*Accounting for Costs Associated with Exitor Disposal Activities.”* The charge included severance-relatedcosts associated with the workforce reduction, primarily in our domesticoperations and costs associated with closing of our Oregon office. Thereduction in workforce consisted of three employees in the sales and marketingdepartment, two employees performing general and administrative functions,three employees performing technical support services and five employees in theresearch and development department.

Thefollowing table summarizes the accrual and usage of the restructuring chargesin 2003 and 2004:

| ** **                              | ** ** | **Lease** | ** ** | **Severance** | ** ** | **Total** | ** ** |
|-----------------------------------------|------------|-----------|------------|---------------|------------|-----------|------------|
| Total charge                            |       | $         | 17,420     |          | $          | 789,161   |       | $ | 806,581 |   |
| Cash payments  2003                     |       | (17,420   | )          | (345,331      | )          | (362,751  | )          |
| Ending balance,  December 31, 2003 |       | —    |       | 443,830       |       | 443,830   |       |
| Cash payments,  2004                    |       | —    |       | (443,830      | )          | (443,830  | )          |
| Ending balance,  December 31, 2004 |       | —    |       | —        |       | —    |       |
|                                         |            |           |            |               |            |           |            |  |  |  |

 

The total cash impact of the restructuring was$806,581, all of which was paid by the end of the third quarter of 2004.

*Interest and Other Income.**  *Interest and other income was$140,000 for the twelve months ended each of December 31, 2004 and 2003.Included in interest and other income the year ended December 31, 2003interest and other income is other income of $51,000 related to the sale ofcommon stock of Verso Technologies, Inc. In 2004, our interest and otherincome remained flat as compared to 2003 due to a change in our investmentservice provider, which change resulted in a higher rate of return on ourinvestments.

| ** **                                    | ** ** | **Interest and Other Income** | ** ** | **Interest and Other Income as a  Percentage of Total Revenue** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|------------|
| Twelve months  ended December 31, 2004   |       |                                         | $          | 140,172                                                                                                 |       |   |   | 1.0 | % |   |
| Twelve months  ended December 31, 2003   |       |                                         | $          | 139,894                                                                                                 |       |   |   | 1.0 | % |   |
| Change from same  period of prior fiscal year |       |                                         | $          | 278                                                                                                     |       |   |   | — |   |   |
|                                          |       |                                         | or 0.2     | %                                                                                                       |       |   |   |   |   |

 

*Benefitfor Income Taxes.**  *During2004, we recorded a net tax benefit of $6,707 resulting primarily from adecrease in our estimated taxes payable as a result of a revised internationaltransfer pricing 

47

----

agreement with our UnitedKingdom subsidiary. Our fiscal year 2004 tax position also benefited from a$28,800 adjustment related to a transfer pricing adjustment related to fiscalyear 2003.

During fiscal year 2003,we recorded $155,398 of tax benefit due to a tax refund that our United Kingdomsubsidiary received during the first quarter of 2003. This subsidiary hadincurred a loss for the year ended December 31, 1999 that resulted in anincome tax benefit. The tax benefit was carried back to prior years’ taxes paidand resulted in a tax refund. Because this subsidiary was undergoing an InlandRevenue audit for tax year 1999, the realizability of this refund was notcertain and therefore we did not record the benefit on its books until theaudit was cleared and the cash was received, both of which occurred in thefirst quarter of 2003. We provided a tax provision of $11,076 for our UnitedKingdom subsidiary based on the level of profitability that this subsidiarygenerated in fiscal year 2003.

**Inflation**

During the fiscal yearsended December 31, 2005, 2004 and 2003, neither inflation nor changingprices have had a material impact on our net sales, revenue or income fromcontinuing operations.

**Liquidity and Capital Resources**

Since1996, we have financed our operations primarily through cash flow fromoperations, private sales of preferred stock and common stock and our initialpublic offering of common stock completed in August 1997. As of December 31,2005, we had cash and cash equivalents of $10.5 million and working capital of$6.7 million. We believe that our existing cash and cash equivalents will besufficient to meet our working capital, capital expenditures and otherliquidity requirements for at least the next twelve months.

| ** **                                    | ** ** | **Cash (Used) Provided** | ** ** |
|-----------------------------------------------|------------|------------------------------------|------------|
| ** **                                    | ** ** | **Operating  Activities**          | ** ** | **Investing  Activities** | ** ** | **Financing  Activities** | ** ** |
| Twelve months  ended December 31, 2005   |       | $                                  | (15,867    | ) | $ | (120,339 | ) | $ | 38,263 |   |
| Twelve months  ended December 31, 2004   |       | $                                  | 873,297    |   | $ | (73,376 | ) | $ | 1,558,356 |   |
| Change from same  period of prior fiscal year |       | $                                  | (889,164   | ) | $ | (46,963 | ) | $ | (1,520,093 | ) |
|                                          |       | or (101.8                          | )%         | or (64.0 | )% | or (97.5 | )% |

 

Our operating activities used cash of $15,867 for thetwelve months ended December 31, 2005 and provided cash of $873,297 forthe twelve months ended December 31, 2004, respectively. We believe thatthe additional resources we are allocating to improve the success of ourAccuRoute product in the legal vertical market and its expansion first into thefinancial services vertical market and, thereafter, the healthcare verticalmarket, will continue to put pressure on our earnings during 2006, but that ourexisting cash is sufficient for at least the next twelve months.

Net cash used during the twelve months ended December 31,2005 consisted primarily of a net loss from operations, a decrease to theaccounts receivable reserve and accrued state sales tax, combined with anincrease in prepaid expenses and other current assets and offset by thenon-cash effects of depreciation and amortization and deferred compensationexpense, decreases in accounts receivable and inventory and an increase inaccounts payable and deferred revenue.

The decrease to the accounts receivable reserverelates primarily to an estimate based upon historical returns, which estimatedemonstrated a reduced need for this reserve. The increase in accounts payableis due to the timing of vendor payments. The decrease to accrued state salestax is a result of a reduction in the state sales tax accrual for the yearended December 31, 2005 resulting from the settlement of sales taxobligations with certain states at an amount less than what was estimated. Aportion of this reduction is due to the fact that we enrolled in theStreamlined Sales Tax Program in December 2005, which relieved us from anypast sales tax liabilities from twelve states where we were not reporting statesales taxes and had 

48

----

estimated and accrued anamount equal to our potential sales tax liability. We therefore eliminated thataccrual as we are required to pay applicable sales taxes only on a go-forwardbasis for those member states of the Streamlined Sales Tax Program. Theincrease in prepaid expenses and other current assets is due primarily to cashpaid for an annual contract with a market research firm in connection with ourincreased sales and marketing expenditures, in accordance with our strategicplan. The decrease to accounts receivable is primarily due to continued and successfulefforts to expedite timely payments from our customers. The decrease toinventory is related to a reduction in onsite hardware inventory and continuedemphasis on shipments directly from our third party vendor. The increase indeferred revenue is primarily related to the increase in software maintenancecontracts sold during fiscal year 2005 that complement our AccuRoute product,offset by a decline in the software maintenance contracts sold during the sameperiod that complement our legacy fax product line.

Net cash provided during the twelve months ended December 31,2004 consisted primarily of a net profit from operations, depreciation and adecrease in accounts receivable and an increase in deferred revenue, partiallyoffset by an increase in inventory and a decrease to the accounts receivablereserve and decreases to accrued restructuring and accrued state sales tax.

Investing activities used cash of $120,339 and $73,376during the twelve months ended December 31, 2005 and 2004, respectively. Thesole use of cash for investing activities for each period was for purchases ofproperty and equipment related to computer-related software and hardwareproducts. In January 2006, we enteredinto a new lease agreement for office space located at Six Riverside Drive,Andover, Massachusetts consisting of approximately 44,000 square feet. Weintend to move our executive offices and headquarters to this new space in April 2006.We expect that we will increase our investments in computer-relatedsoftware and hardware products in 2006 as we improve our information technologyinfrastructure as part of this relocation.

Financing activities provided cash of $38,263 and$1,558,356 for the twelve months ended December 31, 2005 and 2004,respectively. Cash provided for the twelve months ended December 31, 2005was due primarily to the net proceeds from the issuance of common stock fromour employee stock purchase program and employee exercises of stock options. Cashprovided for the twelve months ended December 31, 2004 was due to the netproceeds from the issuance of common stock. On March 29, 2004, wecompleted the sale of 600,000 shares of common stock, at a price of $6.00 pershare, in a private placement to institutional and other accredited investors. Theproceeds of that private placement, which totaled $3.6 million, are being usedfor additional working capital and other general corporate purposes. The cashwe received on the consummation of this private placement was offset by ourusage of $2.0 million in cash during the twelve months ended December 31,2004, when we repurchased 350,000 shares of our outstanding common stock fromASA International Ltd., an existing shareholder, in a private transaction at aprice of $5.75 per share. We repurchased those shares from ASA InternationalLtd. with generally available corporate funds and we hold those shares intreasury.

Based on our performance for the twelve months ended December 31,2005 and current expectations for fiscal year 2006, we believe that our currentcash and cash equivalents balance, as well as the cash expected to be generatedfrom operations during 2006, will satisfy our working capital needs, capitalexpenditures and other liquidity requirements associated with our operationsthrough at least the next twelve months. We expect that principal uses of cashwill be for operations, working capital, payment of sales taxes, purchases ofproperty and equipment and payment of certain leasehold improvements resultingfrom our move to Andover, Massachusetts.  There can be no assurance that any necessaryadditional financing will be available to us on commercially reasonable terms,or at all.

49

----

Thefollowing table represents the approximate amounts of payments due underspecified contractual obligations as of December 31, 2005:

| **Contractual Obligations** | ** ** | ** ** | ** ** | **Total** | ** ** | **Less than  one year** | ** ** | **One to  three years** | ** ** | **Three to  five years** | ** ** | **More than  five years** | ** ** |
|----------------------------------|------------|------------|------------|-----------|------------|-----------------------------------|------------|-----------------------------------|------------|------------------------------------|------------|-------------------------------------|------------|
| Operating lease  obligations     |       | $          | 201,000    |      | $          | 201,000                           |       |                              | —     |                               |       |                                | —     |   |   |   | — |   |   |
|                                  |            |            |            |           |            |                                   |            |                                   |            |                                    |            |                                     |            |  |  |  |  |  |  |  |  |

 

Operating lease requirements consist mainly of ouroffices in London, England, United Kingdom. Our lease for our headquarters andprimary business location in Salem, NH expired on December 31, 2005. Wecurrently are a tenant-at-will with a monthly lease obligation of $21,000. In January 2006,we entered into a new lease agreement, the terms of which require us to makelease payments of $95,000 in less than one year, $758,000 in one to threeyears, $1.2 million in three to five years and $2.0 million in more than fiveyears. The term of this new lease is for ten years and we have an option torenew the lease for an additional five-year term at the then-applicable fairmarket rent. Under the terms of this new lease, we are not required to pay rentfor the first six months commencing upon the date of occupancy and the landlordwill provide us with a tenant improvement allowance up to $308,000. Additionally,we have a one-time right to terminate the lease, upon twelve months’ writtennotice, after the sixth year of the lease term. If we decide to terminate thelease, we must pay a penalty of six months’ rent and the unamortized portion ofthe tenant improvement allowance.

As of December 31,2005, we did not have any long-term debt obligations, material commitments forcapital expenditures, capital lease obligations or other long-term liabilitiesfor which payments are required. However, in January 2006, we entered intoa new lease agreement and we plan to move our headquarters to Andover,Massachusetts in April 2006. We will be required to make lease paymentsrelated to this new lease of $95,000, $379,000, $379,000, $395,000 and $401,000for the years ended December 31, 2006, 2007, 2008, 2009 and 2010,respectively. The term of the lease is ten years and we have an option to renewthe lease for an additional five-year term at the then-applicable fair marketrent. Under the terms of the lease, we are not required to pay rent for thefirst six months commencing upon the date of occupancy and the landlord willprovide us with a tenant improvement allowance up to $308,000. Additionally, wehave a one-time right to terminate the lease, upon twelve months’ writtennotice, after the sixth year of the lease term. If we decide to terminate thelease, we must pay a penalty of six months’ rent and the unamortized portion ofthe tenant improvement allowance. On January 24, 2006, we entered into anagreement for construction projects with Prism Builders, Inc. Under theterms of the contract, the Prism Builders, Inc. will receive approximately$435,000 to perform certain interior renovations at our future corporateheadquarters. Prism Builders, Inc. believes it will achieve substantialcompletion of the build-out project within eleven weeks from the date of itscommencement of work.

**Off-Balance Sheet Arrangements**

We do not have anyrelationships with unconsolidated entities or financial partnerships, such asentities often referred to as structured finance or special purpose entities,that would have been established for the purpose of facilitating off-balancesheet arrangements (as that term is defined in Item 303(a)(4)(ii) ofRegulation S-K) or other contractually narrow or limited purposes. As such, weare not exposed to any financing, liquidity, market or credit risk that couldarise if we had engaged in those types of relationships.

**Item 7(a).**       Quantitativeand Qualitative Disclosures About Market Risk

**DerivativeFinancial Instruments, Other Financial Instruments and Derivative CommodityInstruments**

As of December 31,2005, the Company did not participate in any derivative financial instrumentsor other financial and commodity instruments for which fair value disclosurewould be required. All of the 

50

----

Company’sinvestments consist of money market funds and commercial paper that are carriedon the Company’s books at amortized cost, which approximates fair market value.Accordingly, the Company has no quantitative information concerning the marketrisk of participating in such investments.

**Primary Market Risk Exposures**

The Company’s primarymarket risk exposures are in the areas of interest rate risk and foreigncurrency exchange rate risk. The Company’s current investment portfolio of cashequivalents is subject to interest rate fluctuations, but the Company believesthis risk is immaterial due to the short-term nature of these investments. The Company’sexposure to currency exchange rate fluctuations has been and is expected tocontinue to be modest due to the fact that the operations of its United Kingdomsubsidiary are almost exclusively conducted in the United Kingdom subsidiary’slocal currency. The United Kingdom subsidiary operating results are translatedinto United States dollars and consolidated for reporting purposes. The impactof currency exchange rate movements on intercompany transactions was immaterialfor the year ended December 31, 2005; however, significant currencyexchange rate fluctuations could have a material impact on the Company’sresults of operations in the future. Currently, the Company does not engage inforeign currency hedging activities.

**Item 8.**                        FinancialStatements and Supplementary Data

The Company’s ConsolidatedFinancial Statements, together with the independent registered publicaccounting firm report thereon, appear at pages F-1 through F-26,respectively, of this Form 10-K.

**Item 9.**                        Changesin and Disagreements with Accountants on Accounting and Financial Disclosure

None.

**Item 9a.**                 Controlsand Procedures

(a)           Evaluation ofdisclosure controls and procedures.

As of December 31, 2005 (the “Evaluation Date”),the Company, under the supervision and with the participation of the Company’smanagement, including the Company’s Chief Executive Officer and Chief FinancialOfficer, evaluated the effectiveness of the design and operation of the Company’sdisclosure controls and procedures pursuant to Rule 13a-15promulgated under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”). Based upon that evaluation, the Company’s Chief Executive Officer andChief Financial Officer concluded that, as of the Evaluation Date, the Company’sdisclosure controls and procedures were effective in ensuring that informationrelating to the Company (including its consolidated subsidiaries) required tobe disclosed by the Company in the reports that it files or submits under theExchange Act is recorded, processed, summarized and reported within the timeperiods specified in the Securities and Exchange Commission’s rules andforms, including ensuring that this information is accumulated and communicatedto the Company’s management, including the Company’s Chief Executive Officerand Chief Financial Officer, as appropriate to allow timely decisions regardingrequired disclosure.

(b)          Changes in internalcontrols

There were no changes in the Company’s internalcontrol over financial reporting during the Company’s fiscal quarter ended December 31,2005 or in other factors that have materially affected, or are reasonablylikely to materially affect the Company’s internal control over financialreporting.

51

----

**PART III**

**Item 10.**                 Directorsand Executive Officers of the Registrant

**Directors**

The information requiredunder this item is incorporated herein by reference to the Company’s definitiveproxy statement pursuant to Regulation 14A, to be filed with the Commissionnot later than 120 days after the close of the Company’s fiscal year endedDecember 31, 2005.

**Executive Officers**

The information requiredunder this item is incorporated herein by reference to the Company’s definitiveproxy statement pursuant to Regulation 14A, to be filed with theCommission not later than 120 days after the close of the Company’s fiscalyear ended December 31, 2005.

**Item 11.**                 ExecutiveCompensation and Other Information

The information requiredunder this item is incorporated herein by reference to the Company’s definitiveproxy statement pursuant to Regulation 14A, to be filed with theCommission not later than 120 days after the close of the Company’s fiscalyear ended December 31, 2005.

**Item 12.**                 SecurityOwnership of Certain Beneficial Owners and Management and Certain RelatedParties

The information requiredunder this item is incorporated herein by reference to the Company’s definitiveproxy statement pursuant to Regulation 14A, to be filed with theCommission not later than 120 days after the close of the Company’s fiscalyear ended December 31, 2005.

**Item 13.**                 CertainRelationships and Related Transactions

The information requiredunder this item is incorporated herein by reference to the Company’s definitiveproxy statement pursuant to Regulation 14A, to be filed with theCommission not later than 120 days after the close of the Company’s fiscalyear ended December 31, 2005.

**Item 14.**                 PrincipalAccountant Fees and Services

The information requiredunder this item is incorporated herein by reference to the Company’s definitiveproxy statement pursuant to Regulation 14A, to be filed with theCommission not later than 120 days after the close of the Company’s fiscalyear ended December 31, 2005.

**PART IV**

**Item 15.**                 Exhibitsand Financial Statement Schedule

(a)          List of documents filedas part of this report

(1)          Consolidated FinancialStatements listed under Part II, Item 8 and included herein by reference.

(2)          Consolidated FinancialStatement Schedules

No schedules are submitted because they are notapplicable, not required or because the information is included in theConsolidated Financial Statements as Notes to Consolidated FinancialStatements.

52

----

(3)          Exhibits

| **Exhibit  Number** | ** ** | **Description of Document** | ** **                                                                                                                                                                                                                                                              |
|---------------------|------------|---------------------------------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2                   | .1         |                                  | Stock Repurchase  Agreement (filed as Exhibit 2.1 to the Company’s Current Report on  Form 8-K dated March 31, 2004 and incorporated herein by  reference)                                                                                          |   |
| 3                   | .1         |                                  | Amended and Restated  Certificate of Incorporation of the Company (filed as Exhibit 3.3 to the  Company’s Registration Statement on Form S-1, No. 333-29397  and incorporated herein by reference)                                                  |   |
| 3                   | .2         |                                  | Amended and Restated By-laws  of the Company (filed as Exhibit 3.4 to the Company’s Registration  Statement on Form S-1, No. 333-29397 and incorporated  herein by reference)                                                                       |   |
| 3                   | .3         |                                  | Certificate of Amendment of Amended and Restated  Certificate of Incorporation                                                                                                                                                                                          |   |
| 4                   | .1         |                                  | Specimen certificate representing the common stock  (filed as Exhibit 4.1 to the Company’s Registration Statement on  Form S-1, No. 333-29397 and incorporated herein by  reference)                                                                |   |
| 4                   | .2         |                                  | Stock Purchase Agreement (filed as Exhibit 4.1  to the Company’s Current Report on Form 8-K dated March 30,  2004 and incorporated herein by reference)                                                                                             |   |
| 4                   | .3         |                                  | Registration Rights Agreement (filed as  Exhibit 4.2 to the Company’s Current Report on Form 8-K dated  March 30, 2004 and incorporated herein by reference)                                                                                        |   |
| 4                   | .4         |                                  | Common Stock Warrant (filed as Exhibit 4.3 to  the Company’s Current Report on Form 8-K dated March 30, 2004  and incorporated herein by reference)                                                                                                 |   |
| *10                 | .1         |                                  | 1996 Stock Option Plan (filed as Exhibit 10.1  to the Company’s Registration Statement on Form S-1, No. 333-29397  and incorporated herein by reference)                                                                                            |   |
| *10                 | .2         |                                  | 1997 Stock Plan, as amended, (filed as  Exhibit 4.1 to the Company’s Registration Statement on Form S-8,  No. 333-91659 and incorporated herein by reference)                                                                                       |   |
| *10                 | .3         |                                  | 1997 Employee Stock Purchase Plan (filed as  Exhibit 10.3 to the Company’s Registration Statement on Form S-1,  No. 333-29397 and incorporated herein by reference)                                                                                 |   |
| 10                  | .4         |                                  | Lease dated November 26, 1997 between H.J.  Brooks Limited Liability Company and the Company (filed as Exhibit 10.4  to the Company’s Annual Report on Form 10-K dated March 31,  1998 and incorporated herein by reference)                   |   |
| 10                  | .5         |                                  | Form of Omtool Software License (filed as  Exhibit 10.12 to the Company’s Registration Statement on Form S-1,  No. 333-29397 and incorporated herein by reference)                                                                             |   |
| 10                  | .6         |                                  | Agreement of Sublease dated as of October 31,  2000, by and between eSped.com, Inc. and the Company (filed as  Exhibit 10.6 to the Company’s Form 10-K for the fiscal year  ended December 31, 2000 and incorporated herein by reference) |   |
| *10                 | .7         |                                  | Letter dated December 14, 1999 from the Company  to Robert L. Voelk (filed as Exhibit 10.9 to the Company’s Form 10-K  for the fiscal year ended December 31, 2000 and incorporated herein by  reference)                                      |   |
| *10                 | .8         |                                  | Letter dated July 19, 2000 from the Company to  Robert L. Voelk (filed as Exhibit 10.10 to the Company’s Form 10-K  for the fiscal year ended December 31, 2000 and incorporated herein by  reference)                                         |   |
| *10                 | .9         |                                  | Consulting Arrangement with Arnold E. Ditri (filed  as Exhibit 10.9 to Company’s Form 10-Q for the fiscal quarter  ended March 31, 2002 and incorporated herein by reference)                                                                       |   |
| *10                 | .10        |                                  | Severance Agreement with Robert L. Voelk, dated  August 29, 2003 (filed as Exhibit 10.13 to the Company’s  Form 10-Q for the fiscal quarter ended September 30, 2003 and  incorporated herein by reference)                                    |   |

53

----

 

| *10 | .11    |   | Severance Agreement with Daniel A. Coccoluto, dated  August 29, 2003 (filed as Exhibit 10.14 to the Company’s  Form 10-Q for the fiscal quarter ended September 30, 2003 and  incorporated herein by reference) |   |
|-----|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| *10 | .12    |   | Form of Incentive Stock Option Agreement (filed  as Exhibit 10.17 to the Company’s Form 10-Q for the fiscal  quarter ended September 30, 2004 and incorporated herein by reference)                             |   |
| *10 | .13    |   | Form of Incentive Stock Option Agreement (filed  as Exhibit 10.18 to the Company’s Form 10-Q for the fiscal  quarter ended September 30, 2004 and incorporated herein by reference)                             |   |
| *10 | .14    |   | Form of Non-Qualified Stock Option  Agreement (filed as Exhibit 10.19 to the Company’s Form 10-Q  for the fiscal quarter ended September 30, 2004 and incorporated herein  by reference)                        |   |
| *10 | .15    |   | Form of Non-Qualified Stock Option  Agreement (filed as Exhibit 10.20 to the Company’s Form 10-Q  for the fiscal quarter ended September 30, 2004 and incorporated herein  by reference)                        |   |
| *10 | .16    |   | Form of Stock Purchase and Restriction  Agreement—Officer (filed as Exhibit 10.1 to the Company’s Current Report  on Form 8-K dated February 2, 2005 and incorporated herein by  reference)                |   |
| *10 | .17    |   | Form of Stock Purchase and Restriction  Agreement—Director (filed as Exhibit 10.2 to the Company’s Current  Report on Form 8-K dated February 2, 2005 and incorporated  herein by reference)               |   |
| *10 | .18    |   | Form of Indemnification Agreement (filed as  Exhibit 10.1 to the Company’s Current Report on Form 8-K  dated July 28, 2005)                                                                                     |   |
| 21  |   |   | Subsidiaries of the Company (filed as  Exhibit 21 to the Company’s Form 10-K for the fiscal year  ended December 31, 2001 and incorporated herein by reference)                                                      |   |
| 23  | .1     |   | Consent of Vitale, Caturano & Company                                                                                                                                                                                           |   |
| 23  | .2     |   | Consent of PricewaterhouseCoopers                                                                                                                                                                                                        |   |
| 24  |   |   | Power of Attorney (included on signature page)                                                                                                                                                                                           |   |
| 31  | .1     |   | Rule 13a-14(a)/15d-14(a) Certification                                                                                                                                                                                         |   |
| 31  | .2     |   | Rule 13a-14(a)/15d-14(a) Certification                                                                                                                                                                                         |   |
| 32  | .1     |   | Certification of Chief Executive Officer Pursuant to  18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002.                                                                      |   |
| 32  | .2     |   | Certification of  Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as  Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                      |   |

----

(*)          Indicates a managementcontract or any compensatory plan, contract or arrangement.

(b)          Exhibits.

The exhibits required by this Item are listed underItem 15(a)(3).

(c)           Financial StatementSchedules.

The financial statement schedules required by thisItem are listed under Item 15(a)(2).

54

----

**SIGNATURES**

Pursuant to the requirements of Section 13 or15(d) of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized, in the City of Salem, State of New Hampshire, on the 28th dayof March 2006.

|        | OMTOOL, LTD. |
|--------|--------------|
|   | By:          | /s/  DANIEL A. COCCOLUTO |
|   |         | Daniel A.  Coccoluto |
|   |         | *Chief  Financial Officer, Secretary and Treasurer* |

 

**POWER OF ATTORNEY**

We, the undersignedofficers and directors of Omtool, Ltd., hereby severally constitute andappoint Robert L. Voelk and Daniel A. Coccoluto and each of them singly, ourtrue and lawful attorneys-in-fact and agents with full power of substitutionand resubstitution in each of them, to sign for us and in our names in thecapacities indicated below and generally to do all such things in our names andon our behalf in our capacities as officers and directors to enableOmtool, Ltd. to comply with the provisions of the Securities Exchange Actof 1934, as amended and all requirements of the Securities and ExchangeCommission, hereby ratifying and confirming our signatures as they may besigned by our said attorneys, or any of them.

**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, this report has been signed below by the following persons onbehalf of the registrant and in the capacities and on the date indicated.

|                                         | **Name** | ** **                                              | ** ** |                     | **Title** | ** ** | ** ** |  | **Date** | ** ** |
|-----------------------------------------|----------|---------------------------------------------------------|------------|---------------------|-----------|------------|------------|--|----------|------------|
| /s/   ROBERT L. VOELK         |     | Chairman, Chief  Executive Officer and                  |       |                |
| Robert L. Voelk                         |     | President (principal  executive officer)                |       | March 28, 2006 |
| /s/   DANIEL A. COCCOLUTO     |     | Chief Financial Officer,  Secretary and                 |       |                |
| Daniel A.  Coccoluto                    |     | Treasurer (principal  financial and accounting officer) |       | March 28, 2006 |
| /s/   RICHARD D. CRAMER  |     | Director                                                |       |                |
| Richard D. Cramer                       |     |                                                    |       | March 28, 2006 |
| /s/   ARNOLD E. DITRI         |     | Director                                                |       |                |
| Arnold E. Ditri                         |     |                                                    |       | March 28, 2006 |
| /s/   WILLIAM J. DRUMMEY      |     | Director                                                |       |                |
| William J.  Drummey                     |     |                                                    |       | March 28, 2006 |

55

----

 

| /s/   ANDREW E. LIETZ       |   | Director |   |                |
|---------------------------------------|--------|----------|--------|---------------------|
| Andrew E. Lietz                       |   |     |   | March 28, 2006 |
| /s/   JAMES O’HALLORAN |   | Director |   |                |
| James O’Halloran                 |   |     |   | March 28, 2006 |
| /s/   MARTIN A. SCHULTZ     |   | Director |   |                |
| Martin A. Schultz                     |   |     |   | March 28, 2006 |

 

 

56

----

**OMTOOL, LTD. AND SUBSIDIARIES**

**INDEXTO CONSOLIDATED FINANCIAL STATEMENTS**

|                                                                                                                 | ** ** | **Page** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| Reports of Independent Registered Public Accounting Firms                                                       |       |     | F-2        |   |   |
| Consolidated  Balance Sheets as of December 31, 2005 and 2004                                              |       |     | F-4        |   |   |
| Consolidated Statements of Operations for the years  ended December 31, 2005, 2004 and 2003                |       |     | F-5        |   |   |
| Consolidated Statements of Stockholders’ Equity for  the years ended December 31, 2005, 2004 and 2003 |       |     | F-6        |   |   |
| Consolidated Statements of Cash Flows for the years  ended December 31, 2005, 2004 and 2003                |       |     | F-7        |   |   |
| Notes to  Consolidated Financial Statements                                                                     |       |     | F-8        |   |   |

 

F-1

----

**Reportof Independent Registered Public Accounting Firm**

To the Board of Directors andStockholders of Omtool, Ltd.:

We have audited the accompanying consolidated balancesheet of Omtool, Ltd. as of December 31, 2005 and the related statementsof operations, stockholders’ equity and cash flows for the year then ended. Thesefinancial statements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of material misstatement.The Company is not required to have, nor were we engaged to perform an audit ofits internal controls over financial reporting. Our audit includedconsideration of internal controls over financial reporting as a basis fordesigning audit procedures that are appropriate in the circumstances, but notfor the purpose of expressing an opinion on the effectiveness of the Company’sinternal controls over financial reporting. Accordingly, we express no suchopinion. An audit includes examining, on a test basis, evidence supporting theamounts and disclosures in the consolidated financial statements. An audit alsoincludes assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall financial statementpresentation. We believe that our audit provides a reasonable basis for ouropinion.

In our opinion, thefinancial statements referred to above present fairly, in all materialrespects, the financial position of Omtool, Ltd. as of December 31, 2005 andthe results of its operations and its cash flows for the year then ended inconformity with accounting principles generally accepted in the United Statesof America.

/s/ Vitale, Caturano andCompany, Ltd.

Boston, MassachusettsJanuary 24, 2006

F-2

----

**Reportof Independent Registered Public Accounting Firm**

To****the Board ofDirectors andStockholders of Omtool, Ltd.:

In our opinion, theconsolidated balance sheet as of December 31, 2004 and the relatedconsolidated statements of operations, of stockholders’ equity and of cashflows for each of two years in the period ended December 31, 2004(appearing on pages F-4 through F-7 of the Omtool, Ltd. AnnualReport on Form 10K) present fairly, in all material respects, thefinancial position of Omtool, Ltd. and its subsidiaries****atDecember 31, 2004, and theresults of their operations and their cash flows for each of the two years inthe period ended December 31, 2004 in conformity with accountingprinciples generally accepted in the United States of America. These financialstatements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audits. We conducted our audits of these statements in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements, assessing theaccounting principles used and significant estimates made by management, andevaluating the overall financial statement presentation. We believe that ouraudits provide a reasonable basis for our opinion.

/s/PricewaterhouseCoopers, LLP

Boston, MassachusettsMarch 28, 2005

F-3

----

**OMTOOL, LTD. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS**

| ** **                                                                                                                                                              | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                              | ** ** | **2005**              | ** ** | **2004** | ** ** |
| **ASSETS**                                                                                                                                                              |       |                  |       |   |   |
| Current assets:                                                                                                                                                         |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                               |       | $                     | 10,471,272 |   | $ | 10,655,121 |   |
| Accounts receivable, net of reserves of $33,000 and  $82,000 at December 31, 2005 and 2004, respectively                                                           |       | 1,618,799             |       | 1,802,784 |   |
| Inventories                                                                                                                                                             |       | 58,380                |       | 137,992 |   |
| Prepaid expenses and other current assets                                                                                                                               |       | 333,419               |       | 278,972 |   |
| Total current assets                                                                                                                                                    |       | 12,481,870            |       | 12,874,869 |   |
| Property and  equipment, net                                                                                                                                            |       | 175,566               |       | 213,512 |   |
| Other assets                                                                                                                                                            |       | 11,562                |       | 11,562 |   |
|                                                                                                                                                                    |       | $                     | 12,668,998 |   | $ | 13,099,943 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                          |       |                  |       |   |   |
| Current liabilities:                                                                                                                                                    |       |                  |       |   |   |
| Accounts payable                                                                                                                                                        |       | $                     | 905,288    |   | $ | 849,572 |   |
| Accrued liabilities                                                                                                                                                     |       | 1,222,972             |       | 1,258,672 |   |
| Accrued state sales tax                                                                                                                                                 |       | 290,815               |       | 699,816 |   |
| Deferred revenue, current                                                                                                                                               |       | 3,408,002             |       | 3,205,072 |   |
| Total current liabilities                                                                                                                                               |       | 5,827,077             |       | 6,013,132 |   |
| Long term liabilities:                                                                                                                                                  |       |                  |       |   |   |
| Deferred revenue, long-term                                                                                                                                             |       | 410,232               |       | 455,604 |   |
| Total liabilities                                                                                                                                                       |       | 6,237,309             |       | 6,468,736 |   |
| Commitments,  contingencies and guarantees (Notes 9 and 11)                                                                                                             |       |                  |       |   |   |
| Stockholders’ equity:                                                                                                                                              |       |                  |       |   |   |
| Preferred stock,  $0.01 par value                                                                                                                                       |       |                  |       |   |   |
| Authorized—2,000,000 shares; Issued and  outstanding—none                                                                                                     |       | —                |       | — |   |
| Common stock,  $0.01 par value                                                                                                                                          |       |                  |       |   |   |
| Authorized—35,000,000 shares; Issued—4,367,878  shares in 2005 and 2004, Outstanding—3,977,022 and 3,851,472 shares in  2005 and 2004, respectively |       | 43,679                |       | 43,679 |   |
| Deferred compensation                                                                                                                                                   |       | (775,865              | )          | — |   |
| Additional paid-in capital                                                                                                                                              |       | 35,556,639            |       | 35,259,706 |   |
| Accumulated deficit                                                                                                                                                     |       | (26,327,762           | )          | (26,018,011 | ) |
| Treasury stock, at cost, 390,856 and 516,406 shares  in 2005 and 2004, respectively                                                                                     |       | (2,005,618            | )          | (2,649,756 | ) |
| Accumulated other comprehensive loss                                                                                                                                    |       | (59,384               | )          | (4,411 | ) |
| Total stockholders’ equity                                                                                                                                         |       | 6,431,689             |       | 6,631,207 |   |
|                                                                                                                                                                    |       | $                     | 12,668,998 |   | $ | 13,099,943 |   |

 

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

F-4

----

**OMTOOL, LTD. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

| ** **                                               | ** ** | **Years ended December 31,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                               | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenue:                                                 |       |                                        |       |   |   |   |   |
| Software license                                         |       | $                                           | 4,732,121  |   | $ | 4,504,899 |   | $ | 4,101,588 |   |
| Hardware                                                 |       | 2,705,109                                   |       | 3,177,343 |   | 2,767,570 |   |
| Service and other                                        |       | 6,858,935                                   |       | 7,107,952 |   | 6,878,088 |   |
| Total revenue                                            |       | 14,296,165                                  |       | 14,790,194 |   | 13,747,246 |   |
| Cost of revenue:                                         |       |                                        |       |   |   |   |   |
| Software license                                         |       | 154,165                                     |       | 195,299 |   | 279,573 |   |
| Hardware                                                 |       | 1,694,407                                   |       | 1,944,293 |   | 1,859,363 |   |
| Service and other                                        |       | 2,781,828                                   |       | 2,743,258 |   | 3,151,851 |   |
| Total cost of revenue                                    |       | 4,630,400                                   |       | 4,882,850 |   | 5,290,787 |   |
| Gross profit                                             |       | 9,665,765                                   |       | 9,907,344 |   | 8,456,459 |   |
| Operating expenses:                                      |       |                                        |       |   |   |   |   |
| Sales and marketing                                      |       | 5,256,283                                   |       | 4,100,765 |   | 4,745,375 |   |
| Research and development                                 |       | 2,239,250                                   |       | 1,936,779 |   | 2,186,615 |   |
| General and administrative                               |       | 2,671,200                                   |       | 2,417,091 |   | 2,947,869 |   |
| Restructuring                                            |       | —                                      |       | — |   | 806,581 |   |
| Total operating expenses                                 |       | 10,166,733                                  |       | 8,454,635 |   | 10,686,440 |   |
| Income (loss) from operations                            |       | (500,968                                    | )          | 1,452,709 |   | (2,229,981 | ) |
| Interest and  other income, net                          |       | 185,725                                     |       | 140,172 |   | 139,894 |   |
| Income (loss) before income tax benefit                  |       | (315,243                                    | )          | 1,592,881 |   | (2,090,087 | ) |
| Income tax  benefit                                      |       | (5,492                                      | )          | (6,707 | ) | (144,322 | ) |
| Net income (loss)                                        |       | $                                           | (309,751   | ) | $ | 1,599,588 |   | $ | (1,945,765 | ) |
| Net income (loss) per  share:                            |       |                                        |       |   |   |   |   |
| Basic                                                    |       | $                                           | (0.08      | ) | $ | 0.42 |   | $ | (0.56 | ) |
| Diluted                                                  |       | $                                           | (0.08      | ) | $ | 0.41 |   | $ | (0.56 | ) |
| Weighted average shares  used in per share calculations: |       |                                        |       |   |   |   |   |
| Basic                                                    |       | 3,923,963                                   |       | 3,764,809 |   | 3,494,474 |   |
| Diluted                                                  |       | 3,923,963                                   |       | 3,946,306 |   | 3,494,474 |   |

 

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

F-5

----

**OMTOOL, LTD.AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS’ EQUITY**

**FORTHE YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003**

| ** **                                                                                                                                   | ** ** | **Common Stock**      | ** ** | **Treasury Stock**   | ** ** | ** **                 | ** ** | **Additional** | ** ** | ** **                 | ** ** | **Accumulated  Other** | ** ** | **Total**                | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|---------------------------|------------|----------------------------|------------|----------------|------------|----------------------------|------------|------------------------|------------|--------------------------|------------|
| ** **                                                                                                                                   | ** ** | **Number of  Shares** | ** ** | **$0.01 Par  Value** | ** ** | **Number of  Shares** | ** ** | **Amount**     | ** ** | **Deferred  Compensation** | ** ** | **Paid-in  Capital**   | ** ** | **Accumulated  Deficit** | ** ** | **Comprehensive  Loss** | ** ** | **Stockholders’  Equity** | ** ** |
| Balance, December 31, 2002                                                                                                              |       |                       | 3,716,878  |                      |       |                       | $          | 37,169         |       |                       |       | (227,878               | )          |                     | $          | (924,570 | ) |   | $ | — |   |   | $ | 31,972,136 |   |   | $ | (25,671,834 | ) |   |   | $ | (78,641 | ) |   |   | $ | 5,334,260 |   |   |
| Comprehensive loss:                                                                                                                          |       |                       |       |                      |       |                       |       |           |       |                       |       |                   |       |                     |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net loss                                                                                                                                     |       |                       | —     |                      |       |                       | —     |           |       |                       | —     |                   |       | —                   |       |   | — |   |   | — |   |   | (1,945,765 | ) |   |   | — |   |   |   | (1,945,765 | ) |   |
| Change in cumulative translation adjustment                                                                                                  |       |                       | —     |                      |       |                       | —     |           |       |                       | —     |                   |       | —                   |       |   | — |   |   | — |   |   | — |   |   |   | 40,194 |   |   |   | 40,194 |   |   |
| Total comprehensive loss                                                                                                                     |       |                       | —     |                      |       |                       | —     |           |       |                       | —     |                   |       | —                   |       |   | — |   |   | — |   |   | — |   |   |   | — |   |   |   | (1,905,571 | ) |   |
| Exercise of stock options and issuance of shares  through Employee Stock Purchase Plan                                                       |       |                       | —     |                      |       |                       | —     |           |       |                       | 11,500     |                   |       | 46,636                   |       |   | — |   |   | (36,098 | ) |   | — |   |   |   | — |   |   |   | 10,538 |   |   |
| Balance, December 31, 2003                                                                                                              |       |                       | 3,716,878  |                      |       |                       | 37,169     |           |       |                       | (216,378   | )                      |       | (877,934                 | )          |   | — |   |   | 31,936,038 |   |   | (27,617,599 | ) |   |   | (38,447 | ) |   |   | 3,439,227 |   |   |
| Comprehensive loss:                                                                                                                          |       |                       |       |                      |       |                       |       |           |       |                       |       |                   |       |                     |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income                                                                                                                                   |       |                       | —     |                      |       |                       | —     |           |       |                       | —     |                   |       | —                   |       |   | — |   |   | — |   |   | 1,599,588 |   |   |   | — |   |   |   | 1,599,588 |   |   |
| Change in cumulative translation adjustment                                                                                                  |       |                       | —     |                      |       |                       | —     |           |       |                       | —     |                   |       | —                   |       |   | — |   |   | — |   |   | — |   |   |   | 34,036 |   |   |   | 34,036 |   |   |
| Total comprehensive income                                                                                                                   |       |                       | —     |                      |       |                       | —     |           |       |                       | —     |                   |       | —                   |       |   | — |   |   | — |   |   | — |   |   |   | — |   |   |   | 1,633,624 |   |   |
| Purchase of treasury stock                                                                                                                   |       |                       | —     |                      |       |                       | —     |           |       |                       | (350,000   | )                      |       | (2,012,500               | )          |   | — |   |   | — |   |   | — |   |   |   | — |   |   |   | (2,012,500 | ) |   |
| Issuance of common stock and a warrant in a private  placement to institutional and accredited investors, net of issuance costs of  $154,135 |       |                       | 651,000    |                      |       |                       | 6,510      |           |       |                       | —     |                   |       | —                   |       |   | — |   |   | 3,439,355 |   |   | — |   |   |   | — |   |   |   | 3,445,865 |   |   |
| Exercise of stock options and issuance of shares  through Employee Stock Purchase Plan                                                       |       |                       | —     |                      |       |                       | —     |           |       |                       | 49,972     |                   |       | 240,678                  |       |   | — |   |   | (115,687 | ) |   | — |   |   |   | — |   |   |   | 124,991 |   |   |
| Balance, December 31, 2004                                                                                                              |       |                       | 4,367,878  |                      |       |                       | 43,679     |           |       |                       | (516,406   | )                      |       | (2,649,756               | )          |   | — |   |   | 35,259,706 |   |   | (26,018,011 | ) |   |   | (4,411 | ) |   |   | 6,631,207 |   |   |
| Comprehensive loss:                                                                                                                          |       |                       |       |                      |       |                       |       |           |       |                       |       |                   |       |                     |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net loss                                                                                                                                     |       |                       | —     |                      |       |                       | —     |           |       |                       | —     |                   |       | —                   |       |   | — |   |   | — |   |   | (309,751 | ) |   |   | — |   |   |   | (309,751 | ) |   |
| Change in cumulative translation adjustment                                                                                                  |       |                       | —     |                      |       |                       | —     |           |       |                       | —     |                   |       | —                   |       |   | — |   |   | — |   |   | — |   |   |   | (54,973 | ) |   |   | (54,973 | ) |   |
| Total comprehensive loss                                                                                                                     |       |                       | —     |                      |       |                       | —     |           |       |                       | —     |                   |       | —                   |       |   | — |   |   | — |   |   | — |   |   |   | — |   |   |   | (364,724 | ) |   |
| Exercise of stock options and issuance of shares  through Employee Stock Purchase Plan                                                       |       |                       | —     |                      |       |                       | —     |           |       |                       | 11,290     |                   |       | 57,918                   |       |   | — |   |   | (20,798 | ) |   | — |   |   |   | — |   |   |   | 37,120 |   |   |
| Issuance of restricted stock                                                                                                                 |       |                       | —     |                      |       |                       | —     |           |       |                       | 114,260    |                   |       | 586,220                  |       |   | (902,808 | ) |   | 317,731 |   |   | — |   |   |   | — |   |   |   | 1,143 |   |   |
| Deferred compensation expense                                                                                                                |       |                       |       |                      |       |                       |       |           |       |                       |       |                   |       |                     |       |   | 126,943 |   |   |   |   |   |   |   |   |   |   |   |   |   | 126,943 |   |   |
| Balance,  December 31, 2005                                                                                                             |       |                       | 4,367,878  |                      |       |                       | $          | 43,679         |       |                       |       | (390,856               | )          |                     | $          | (2,005,618 | ) |   | $ | (775,865 | ) |   | $ | 35,556,639 |   |   | $ | (26,327,762 | ) |   |   | $ | (59,384 | ) |   |   | $ | 6,431,689 |   |   |

 

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

F-6

----

**OMTOOL, LTD. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

| ** **                                                                                                | ** ** | **Years ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Cash Flows from  Operating Activities:                                                                    |       |                                        |       |   |   |   |   |
| Net income (loss)                                                                                         |       | $                                           | (309,751   | ) | $ | 1,599,588 |   | $ | (1,945,765 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided by (used in) operating  activities— |       |                                        |       |   |   |   |   |
| Depreciation                                                                                              |       | 157,338                                     |       | 255,649 |   | 413,525 |   |
| Accounts receivable reserves                                                                              |       | (47,806                                     | )          | (287,692 | ) | (260,609 | ) |
| Amortization of deferred compensation                                                                     |       | 126,943                                     |       | — |   | — |   |
| Changes in assets  and liabilities—                                                                  |       |                                        |       |   |   |   |   |
| Accounts receivable                                                                                       |       | 205,101                                     |       | 79,998 |   | 420,432 |   |
| Prepaid expenses and other current assets                                                                 |       | (58,528                                     | )          | (8,896 | ) | 157,691 |   |
| Inventory                                                                                                 |       | 79,612                                      |       | (100,193 | ) | 151,904 |   |
| Accounts payable                                                                                          |       | 62,998                                      |       | (58,089 | ) | (146,238 | ) |
| Accrued liabilities                                                                                       |       | (20,183                                     | )          | 34,836 |   | (487,997 | ) |
| Accrued restructuring                                                                                     |       | —                                      |       | (443,830 | ) | 443,830 |   |
| Other assets                                                                                              |       | —                                      |       | 2,400 |   | — |   |
| Accrued state sales tax                                                                                   |       | (409,001                                    | )          | (310,680 | ) | (265,239 | ) |
| Deferred revenue                                                                                          |       | 197,410                                     |       | 110,206 |   | 71,697 |   |
| Net cash (used in) provided by operating activities                                                       |       | (15,867                                     | )          | 873,297 |   | (1,446,769 | ) |
| Cash Flows from  Investing Activities:                                                                    |       |                                        |       |   |   |   |   |
| Purchases of property and equipment                                                                       |       | (120,339                                    | )          | (73,376 | ) | (189,120 | ) |
| Purchases of short-term investments                                                                       |       | —                                      |       | — |   | (1,999,449 | ) |
| Proceeds from sale of short-term investments                                                              |       | —                                      |       | — |   | 3,596,604 |   |
| Net cash (used in) provided by investing activities                                                       |       | (120,339                                    | )          | (73,376 | ) | 1,408,035 |   |
| Cash Flows from  Financing Activities:                                                                    |       |                                        |       |   |   |   |   |
| Net proceeds from issuance of common stock and  common stock warrant                                      |       | 37,120                                      |       | 3,570,856 |   | 10,538 |   |
| Net proceeds from issuance of restricted common  stock                                                    |       | 1,143                                       |       | — |   | — |   |
| Purchase of treasury stock                                                                                |       | —                                      |       | (2,012,500 | ) | — |   |
| Net cash provided by financing activities                                                                 |       | 38,263                                      |       | 1,558,356 |   | 10,538 |   |
| Exchange rate  effect on cash and cash equivalents                                                        |       | (85,906                                     | )          | 54,777 |   | 77,740 |   |
| Net (decrease)  increase in cash and cash equivalents                                                     |       | (183,849                                    | )          | 2,413,054 |   | 49,544 |   |
| Cash and cash  equivalents, beginning of year                                                             |       | 10,655,121                                  |       | 8,242,067 |   | 8,192,523 |   |
| Cash and cash  equivalents, end of year                                                                   |       | $                                           | 10,471,272 |   | $ | 10,655,121 |   | $ | 8,242,067 |   |

 

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

F-7

----

**OMTOOL, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**(1) Operations**

Omtool, Ltd. (“Omtool” or the “Company”) providesdocument routing solutions and services that enable organizations to manage thecapture, processing and distribution of “mixed-mode” documents (i.e., documentsthat contain both paper and electronic components) to electronic informationsystems such as enterprise content management, document management, recordsmanagement, e-mail and document-archiving systems, leveraging applicationinterfaces with which users are already familiar.

AccuRoute® isthe software platform for simplified, simultaneous and secure documentdistribution. It lets companies control the integration and distribution of “mixed-mode”documents into ever-changing corporate information systems and processes.Similar in concept to a network router, the Company’s AccuRoute product is thedocument routing hub, transforming between both paper and electronic-basedformats and routing the information within and outside the company.

GenidocsTM, the Company’s secure document-deliveryapplication product, integrates with existing e-mail systems and providesmultiple options for content and attachment encryption, authentication, audittrail, delivery confirmation and digital signatures. GenifaxTM, the Company’senterprise fax product, offers a scalable, server-based feature set and sharesa common Microsoft Windows® server-basedarchitecture with the Genidocs TM product line.

The Company’s AccuRoute product further unifies thecode bases and architecture of the Genidocs and Genifax products. With itsrouting capabilities, the Company’s AccuRoute product provides a customer-specific software that easilymanages both paper and electronic documents, with little or no user trainingrequired.

The Company resells certain hardware products (such asintelligent fax boards) from third-party vendors. Typically, hardware sales area result of either new sales or existing customers upgrading their informationtechnology infrastructure. Occasionally, where the Company’s customers alsowant fax capabilities, it sells hardware products with its AccuRoute product. Thesehardware sales are undertaken as a convenience to customers, who alternativelycan opt to obtain hardware directly from a third-party vendor. The fax boardsand fax modems that are resold are not functional without the Company’s productsoftware and it is not generally in the business of selling fax boards andmodems. The Company purchases these hardware products as needed to ship to itscustomers and it maintains a minimal inventory of these hardware products.

Serviceand other revenue has historically consisted primarily of the sale of supportcontracts to complement software products licensed to customers. The Companygenerates a smaller portion of its service and other revenue from consulting,training and installation services.

**(2) Summaryof Significant Accounting Policies and Estimates**

The accompanyingconsolidated financial statements reflect the application of certain accountingpolicies and estimates as described in this note and elsewhere in the notes tothe consolidated financial statements.

*(a) Principles of Consolidation*

The accompanyingconsolidated financial statements include the accounts of the Company and itswholly owned subsidiaries. All intercompany transactions have been eliminatedin consolidation.

F-8

----

**OMTOOL, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**(2) Summaryof Significant Accounting Policies and Estimates (Continued)**

*(b) Revenue Recognition*

The Company derives itsrevenue from primarily two sources (i) product revenue, which includessoftware license and hardware revenue and (ii) service and supportrevenue, which includes software maintenance and support, installation,training and consulting revenue. The Company licenses its software products ona perpetual basis. The Company generates revenue from licensing the rights touse its software products and sales of hardware directly to end-users andindirectly through resellers. The Company’s resellers order products from theCompany based on purchase orders received from end-users and do not orderstock. The Company’s products are sold to resellers and directly to end-userswithout any specifically stated rights of return. Occasionally, however, theCompany, in its sole discretion, will accept a product return if the end-userfinds that the product does not fit its needs. The Company also sells hardwareproducts, which are provided by a third-party, on a pass through basis plus anadditional mark-up, to end-users and indirectly through resellers. The hardwareproducts that are resold are not functional without the Company’s software. Tosupport its software products, the Company sells software maintenance andsupport, installation, training and consulting services to end-users and indirectlythrough resellers.

The Company applies the provisions of Statement ofPosition (“SOP”) 97-2, *SoftwareRevenue Recognition*, as amended by SOP 98-9, Modification ofSOP 97-2, “*Software RevenueRecognition, With Respect to Certain Transactions*,” to alltransactions involving the sale of multiple elements including software,hardware and service revenue. The Company applies the provisions of SFAS No. 48,“*Revenue Recognition When Right of ReturnExists*,” with respect to providing for potential future productreturns.

The Company recognizesrevenue from the sale of software products and hardware to both end-users andresellers when persuasive evidence of an arrangement exists, the products havebeen delivered, the fee is fixed or determinable, collection of the resultingreceivable is reasonably assured and there are no uncertainties regardingcustomer acceptance. The Company maintains a reserve for potential productreturns. Software maintenance and support revenue is recognized over the termof the related maintenance period. Typically this is a one-year period, butoccasionally the Company sells multiple-year maintenance contracts, in whichcase the associated revenue is recognized over the multiple-year term of thecontract. Other service revenue is recognized as the services are performed. Ifan arrangement includes an acceptance provision and acceptance is uncertainthen the Company will defer all revenue until the customer accepts theproducts. Acceptance in these instances generally occurs upon the earlier ofreceipt of a written customer acceptance or expiration of the acceptanceperiod. If an arrangement includes an acceptance provision regarding theCompany’s product meeting published specifications and there are nouncertainties with regard to the customer’s acceptance then the Company willrecognize revenue at the time of sale, provided that all other revenuerecognition criteria previously mentioned have been met and the acceptanceperiod is of short duration.

The Company’s transactionsfrequently involve the sales of software, hardware and related services undermultiple element arrangements. Revenue under multiple element arrangements isallocated to each element under the residual method, in accordance with SOP 98-9,Modification of SOP 97-2, “*SoftwareRevenue Recognition, With Respect to Certain Transactions*.” Underthis method, revenue is allocated first to all undelivered elements, such asservices, based on the fair value of those elements, which is the price chargedwhen these elements are sold separately and unaccompanied by other elements.The Company’s services are not essential to the functionality of the softwareas these services do not alter the capabilities of the software and do notcarry a significant degree of risk to perform. The amount allocated to thedelivered elements, such as software license and hardware revenue, is thedifference between the total 

F-9

----

**OMTOOL, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**(2) Summaryof Significant Accounting Policies and Estimates (Continued)**

arrangementvalue and the amount allocated to the undelivered elements. If the deliveredelements include both software and hardware, the amount allocated to hardwarerevenue is based on the price charged to the Company by the third party vendorplus an additional mark up, with the remainder allocated to software revenue.To the extent that a discount is offered in the arrangement, the entirediscount is allocated to the delivered element or elements. If the deliveredelements include hardware and software, the discount is allocated to thehardware and software based on their respective list prices.

TheCompany’s short term deferred revenue and long term deferred revenue iscomprised mainly of revenue that is deferred for software maintenance andsupport contracts. The other components of deferred revenue are the amountsfrom sales transactions that were deferred because they did not meet all of theprovisions of the Company’s revenue recognition policy. At December 31,2005 and 2004, deferred revenue consisted of the following:

| ** **                                   | ** ** | **December 31,** | ** ** |
|----------------------------------------------|------------|-----------------------|------------|
| ** **                                   | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Deferred revenue—licenses               |       | $                     | 15,594     |   | $ | 152,116 |   |
| Deferred  maintenance and support, current   |       | $                     | 3,392,408  |   | $ | 3,052,956 |   |
| Deferred  maintenance and support, long-term |       | $                     | 410,232    |   | $ | 455,604 |   |
|                                         |       | $                     | 3,818,234  |   | $ | 3,660,676 |   |

 

*(c) Software Development Costs*

Software development costsare considered for capitalization when technological feasibility is establishedin accordance with Statement of Financial Accounting Standards (“SFAS”) No. 86,“*Accounting for the Costs of ComputerSoftware To Be Sold, Leased or Otherwise Marketed.”* The Companysells software in a market that is subject to rapid technological change, newproduct introductions and changing customer needs. Accordingly, the Company hasdetermined that it cannot determine technological feasibility until thedevelopment state of the product is nearly complete. The time period duringwhich costs could be capitalized from the point of reaching technologicalfeasibility until the time of general product release is very short and,consequently, the amounts that could be capitalized are not material to theCompany’s consolidated financial position or results of operations.Consequently, no amounts have been capitalized.

*(d) Cash and Cash Equivalents*

The Company considers allhighly liquid investments with original maturities of three months or less tobe cash equivalents. Cash equivalents were $6,944,924 and $6,812,560 at December 31,2005 and 2004, respectively. Cash equivalents at December 31, 2005 and2004 primarily consisted of investments in money market funds.

*(e) Advertising Expense*

The Company recognizesadvertising expense as incurred. For the years ended December 31, 2005,2004 and 2003, the Company recognized $195,925, $64,211 and $78,803,respectively, as advertising expense.

F-10

----

**OMTOOL, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**(2) Summaryof Significant Accounting Policies and Estimates (Continued)**

*(f) Inventory*

Inventories consist ofcircuit boards purchased from third-party vendors, all of which are finished goodsand are stated at lower of cost or market, with cost determined on thefirst-in, first-out basis. The Company reviews its inventory at the end of eachmonth to ensure that there are no factors that would render the inventoryexcess or obsolete. To determine obsolescence, the Company considers currentmarket conditions as well as specific vendor information related to thehardware products sold by the Company. If inventory is considered obsolete,then the Company will write the inventory down to zero value.

*(g) Property and Equipment*

Propertyand equipment are stated at cost, net of accumulated depreciation andamortization. Depreciation and amortization is calculated using straight-linemethods over the following useful lives:

| ** **                                           | ** ** | ** **                                                      | ** ** | **December 31**                | ** ** |     |
|------------------------------------------------------|------------|-----------------------------------------------------------------|------------|-------------------------------------|------------|----------|
| **Asset Classification**                        | ** ** | ** **                                                      | ** ** | **Estimated Useful Life** | ** ** | **2005** | ** ** | **2004** | ** ** |   |
| Computer  equipment                                  |       | 1—5  years                                                 |       | $                                   | 3,193,669  |     | $ | 3,132,632 |   |   |
| Computer software                                    |       | 2—3  years                                                 |       | $                                   | 1,316,035  |     | $ | 1,333,107 |   |   |
| Furniture and  fixtures                              |       | 5—7  years                                                 |       | $                                   | 923,169    |     | $ | 945,309 |   |   |
| Leasehold  improvements                              |       | Shorter  of the life of the lease or  the estimated useful life |       | $                                   | 231,821    |     | $ | 229,061 |   |   |
|                                                 |       |                                                            |       | $                                   | 5,664,694  |     | $ | 5,640,109 |   |   |
| Less—Accumulated  depreciation and amortization |       |                                                            |       | $                                   | (5,489,128 | )        | $ | (5,426,597 | ) |
|                                                 |       |                                                            |       | $                                   | 175,566    |     | $ | 213,512 |   |   |
|                                                      |            |                                                                 |            |                                     |            |          |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Depreciation expense was$157,338, $255,649 and $413,525 for the years ended December 31, 2005,2004 and 2003, respectively. The Company capitalizes expenditures thatmaterially increase asset lives and charges ordinary repairs and maintenance tooperations as incurred.

*(h) Stock Based Compensation*

The Company accounts forstock-based compensation for employees under the recognition and measurementprinciples of Accounting Principles Board Opinion No. 25, “*Accounting for Stock Issued to Employees”* and related interpretations. In December 2004,the FASB issued SFAS No. 123(R), “*Share-Based Payment*.”  SFAS No. 123(R) amends SFAS No. 123.SFAS No. 123(R) permits public companies to adopt its requirementsusing one of two methods:

·       A“modified prospective” method in which compensation cost is recognizedbeginning with the effective date based on the requirements of SFAS No. 123(R) (a) forall share-based payments granted after the effective date and (b) for allawards granted to employees prior to the effective date of SFAS No. 123(R) thatremain unvested on the effective date.

·       A“modified retrospective” method which includes the requirements of the modifiedprospective method described above, but also permits entities to restate basedon the amounts previously recognized under SFAS No. 123 for purposes ofpro forma disclosures for either (a) all prior periods presented or (b) priorinterim periods of the year of adoption.

F-11

----

**OMTOOL, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**(2) Summaryof Significant Accounting Policies and Estimates (Continued)**

The Company will implement SFAS No. 123(R) inthe first quarter of 2006 and intends to use the modified prospective method. TheCompany expects the adoption will not have a material effect on its 2006results. The following table illustrates the effect on net income (loss) andnet income (loss) per share if the Company had applied the fair valuerecognition provisions of SFAS No. 123, “*Accountingfor Stock-Based Compensation,”* as amended by SFAS No. 148, “*Accounting for Stock-Based Compensation—Transitionand Disclosure,”* to stock-based employee compensation.

| ** **                                                                                                  | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                  | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net (loss)  income, as reported                                                                             |       | $                                          | (309,751   | ) | $ | 1,599,588 |   | $ | (1,945,765 | ) |
| Add: Stock  compensation included in net (loss) income                                                      |       | $                                          | 126,943    |   | — |   | — |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value method  for all awards |       | $                                          | (187,036   | ) | $ | (232,995 | ) | $ | (662,166 | ) |
| Pro forma net  (loss) income                                                                                |       | (369,844                                   | )          | $ | 1,366,593 |   | $ | (2,607,931 | ) |
| Net (loss) income  per share:                                                                               |       |                                       |       |   |   |   |   |
| Basic, as reported                                                                                          |       | $                                          | (0.08      | ) | $ | 0.42 |   | $ | (0.56 | ) |
| Diluted, as reported                                                                                        |       | $                                          | (0.08      | ) | $ | 0.41 |   | $ | (0.56 | ) |
| Basic, pro forma                                                                                            |       | $                                          | (0.09      | ) | $ | 0.36 |   | $ | (0.75 | ) |
| Diluted, pro  forma                                                                                         |       | $                                          | (0.09      | ) | $ | 0.35 |   | $ | (0.75 | ) |

 

See the assumptions usedin calculating the pro-forma stock option expense described in Note 7.

*(i) Use ofEstimates*

The preparation offinancial statements in conformity with generally accepted accountingprinciples requires management to make estimates, judgments and assumptionsthat affect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenue and expenses during the reporting periods. Significantestimates include the reserve for returns and bad debts, valuation of incometaxes and the accrual for state sales tax. Actual results could differ from therecorded estimates.

*(j) Concentrationof Credit Risk, Fair Value of Financial Instruments and Significant Customers*

The amount reflected in the consolidated balancesheets for cash and cash equivalents, accounts receivable, accounts payable andaccrued expenses approximate their fair value due to their short-termmaturities. Financial instruments that potentially subject the Company toconcentration of credit risk consist primarily of cash and cash equivalents,and accounts receivable. The Company’s cash and cash equivalents are held withfinancial institutions and, at times, may exceed federally insured limits thatthe Company believes to be of high credit standing.

The Company has not experienced significant lossesrelated to receivables from individual customers or groups of customers in anyspecific industry or by geographic area. Due to these factors, no additionalcredit risk beyond amounts provided for collection losses is believed bymanagement to be inherent in the Company’s accounts receivable.

F-12

----

**OMTOOL, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**(2) Summaryof Significant Accounting Policies and Estimates (Continued)**

As of December 31,2005, one customer accounted for 11% of the Company’s accounts receivablebalance. As of December 31, 2004, one customer accounted for 12% of theCompany’s accounts receivable balance. The Company does not believe that thisconcentration of credit risk represents a material risk of loss with respect toits financial position as of December 31, 2005 and 2004. For the yearsended December 31, 2005, 2004 and 2003, no single customer accounted forgreater than 10% of the Company’s total revenue.

*(k) AccountsReceivable and Related Reserves*

The Company records trade accounts receivable at theinvoiced amount; these accounts do not bear interest. The Company maintainsreserves for potential product returns and makes adjustments to these reservesas needed based on historical product return rates and considers the impact ofnew product introductions, changes in customer demand and acceptance of theCompany’s products. Management’s calculation of the estimated return reserve isbased upon (1) an account specific review of potential returns from recentsales, where a return probability is known and (2) an estimate based uponpast historical returns as a percentage of revenue. Management specificallyanalyzes accounts receivable and historical bad debts, customercredit-worthiness, current economic trends and changes in customer paymentpatterns when evaluating the adequacy of the allowance for doubtful accounts.The Company reviews the allowance for doubtful accounts on a monthly basis.Management’s calculation of the estimated accounts receivable reserve is alsobased upon (1) an account specific review of potential uncollectibleaccounts, where a bad debt probability is known and (2) an estimate basedupon past historical bad debts, as a percentage of accounts receivable. TheCompany does not have any off-balance-sheet credit exposure to its customers.

Thefollowing schedule summarizes the activity of the Company’s accounts receivablereserve for the three years ended December 31, 2005:

| **Year Ended**     | ** ** | ** ** | ** ** | **Balance at  Beginning of  Year** | ** ** | **Increases** | ** ** | **Reductions** | ** ** | **Balance at  End of  Year** | ** ** |
|-------------------------|------------|------------|------------|----------------------------------------------|------------|---------------|------------|----------------|------------|----------------------------------------|------------|
| December 31,  2003 |       |       | $          | 615,000                                      |       |          | 345,000(1) |           |       | (593,000                               | )(2)       |   | $ | 367,000 |   |
| December 31,  2004 |       |       | $          | 367,000                                      |       |          | 50,000(1)  |           |       | (335,000                               | )(2)       |   | $ | 82,000 |   |
| December 31, 2005  |       |       | $          | 82,000                                       |       |          | 58,000(1)  |           |       | (107,000                               | )(2)       |   | $ | 33,000 |   |

----

(1)*         *Amounts represent the establishment ofreserves for potential sales returns or uncollectible accounts receivable.Increases to the reserve were made by decreasing revenue for sales returns andby increasing bad debt expense, respectively, for those accounts receivablethat were deemed to be uncollectible.

(2)*         *Amounts represent the reversal ofreserves that were no longer required. These reversals were made to revenue forsales returns and to bad debt expense on collection of accounts receivable previouslydeemed to be uncollectible or to accounts receivable for accounts that werewritten off during the period.

F-13

----

**OMTOOL, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**(2) Summaryof Significant Accounting Policies and Estimates (Continued)**

Inaccordance with APB Opinion No. 20, *AccountingChanges,* the following table displays the effects of the netreduction in the accounts receivable reserve which impacted net income (loss)and net income (loss) per share (excludes write-offs):

| **Year Ended**     | ** ** | ** ** | ** ** | **Net Income   (Loss)** | ** ** | **Net Income (Loss)  per Basic and Diluted Share** | ** ** |
|-------------------------|------------|------------|------------|-----------------------------------|------------|----------------------------------------------------------------------------------|------------|
| December 31,  2003 |       |       | $          | (218,000                          | )          |                                                                             |       | $ | (0.06 | ) |   |
| December 31,  2004 |       |       | $          | 272,000                           |       |                                                                             |       | $ | 0.07 |   |   |
| December 31, 2005  |       |       | $          | 40,000                            |       |                                                                             |       | $ | 0.00 |   |   |

 

*(l) ForeignCurrency Translation*

The Company translates thefinancial statements of its foreign subsidiaries in accordance with SFAS No. 52,“*Foreign Currency Translation*.”Accordingly, assets and liabilities are translated at exchange rates in effectat the end of the year and revenue and expenses are translated at the averageexchange rates during the year. All cumulative translation gains or losses fromthe translation into the Company’s reporting currency are included as a separatecomponent of stockholders’ equity (accumulated other comprehensive income) inthe accompanying consolidated balance sheets. Net gains and losses resultingfrom foreign exchange transactions were not material for the years ended December 31,2005, 2004 and 2003.

*(m) Earnings PerShare*

TheCompany reports earnings per share in accordance with SFAS No. 128, “*Earnings per Share*.” Diluted weightedaverage shares outstanding for the year ended December 31, 2005 exclude157,475 potential common shares from stock options and a stock warrant becauseto include them would have been anti-dilutive for the period presented as theCompany reported a net loss during the period. The dilutive effect of potentialcommon shares in 2004, consisting of outstanding stock options and a stockwarrant, is determined using the treasury stock method, in accordance with SFASNo. 128. For the year ended December 31, 2004, the dilutivecalculation excludes the potential common shares related to 179,990 outstandingstock options that have an anti-dilutive effect since their exercise priceexceeds the market value of the Company’s common stock. Diluted weightedaverage shares outstanding for the year ended December 31, 2003 exclude495,586 potential common shares from stock options because to include themwould have been anti-dilutive for the period presented as the Company reporteda net loss during the period. A reconciliation of basic and diluted commonshares outstanding is as follows:

| ** **                                                       | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                       | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Weighted average  number of common shares outstanding            |       | 3,923,963                                  |       | 3,764,809 |   | 3,494,474 |   |
| Potential common  shares pursuant to stock options and warrant   |       | —                                     |       | 181,497 |   | — |   |
| Diluted weighted  average shares                                 |       | 3,923,963                                  |       | 3,946,306 |   | 3,494,474 |   |
| Basic net (loss)  income per common share                        |       | $                                          | (0.08      | ) | $ | 0.42 |   | $ | (0.56 | ) |
| Diluted net (loss)  income per common and potential common share |       | $                                          | (0.08      | ) | $ | 0.41 |   | $ | (0.56 | ) |

 

F-14

----

**OMTOOL, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**(2) Summaryof Significant Accounting Policies and Estimates (Continued)**

*(n) New AccountingPronouncements*

In May 2005, the FASB issued FASB Statement No. 154,“Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20and FASB Statement No. 3” (SFAS No. 154). Previously, APB No. 20,“Accounting Changes” and SFAS No. 3, “Reporting Accounting Changes inInterim Financial Statements” required the inclusion of the cumulative effectof changes in accounting principle in net income of the period of the change. SFASNo. 154 requires companies to recognize a change in accounting principle,including a change required by a new accounting pronouncement when thepronouncement does not include specific transition provisions, retrospectivelyto prior periods’ financial statements. We will assess the impact of aretrospective application of a change in accounting principle in accordancewith SFAS No. 154 if such a change arises after the effective date of January 1,2006.

In November 2004,the FASB issued SFAS No. 151, “*Inventory Costs, anamendment of ARB No. 43, Chapter 4*.”  SFAS No. 151 modifies the accounting forabnormal inventory costs and the manner in which companies allocate fixedoverhead expenses to inventory. SFAS No. 151 is effective for inventorycosts incurred during annual periods beginning after June 15, 2005. TheCompany does not expect SFAS No. 151 to have a material impact on itsfinancial position and results of operations.

**(3) Related PartyTransactions**

On October 31, 2000,the Company entered into an agreement with eSped.com, Inc. (“eSped”) tosublease from the Company 4,500 square feet of the premises the Company isoccupying at its Salem, New Hampshire, headquarters. Robert L. Voelk, the ChiefExecutive Officer and Chairman of the Board of Omtool, is also the ChiefExecutive Officer and Chairman of the Board of eSped and Mr. Schultz, aDirector of Omtool, is a Director of eSped. The sub-lease is a tenancy at willand commenced on February 1, 2001. Either party may terminate the subleasewith 120 days written notice to the other party. The amount of rentpayments and building maintenance charges received was $62,037 in each of theyears ended December 31, 2005, 2004 and 2003 and has been recorded as areduction in general and administrative expenses in the accompanyingconsolidated financial statements. The Company believes that the terms of thesublease have been negotiated at arms-length.

**(4) AccruedLiabilities**

Accruedliabilities consist of the following:

| ** **                         | ** ** | **December 31,** | ** ** |
|------------------------------------|------------|-----------------------|------------|
| ** **                         | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Accrued health  insurance expense  |       | $                     | 169,811    |   | $ | 178,464 |   |
| Accrued salary  and salary-related |       | 639,297               |       | 688,622 |   |
| Accrued  professional fees         |       | 128,801               |       | 141,322 |   |
| Other accrued  expenses            |       | 285,063               |       | 250,264 |   |
|                               |       | $                     | 1,222,972  |   | $ | 1,258,672 |   |

 

**(5) Income Taxes**

The Company accounts for income taxes in accordancewith SFAS No. 109*, “Accounting forIncome Taxes,”* the objective of which is to recognize the amount ofcurrent and deferred income taxes at the date 

F-15

----

**OMTOOL, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**(5) IncomeTaxes (Continued)**

of the financialstatements as a result of all differences in the tax basis and financialstatement carrying amount of assets and liabilities as measured by enacted taxlaws. At December 31, 2005, the Company had available federal netoperating loss carryforwards of approximately $20.0 million to be used tooffset future taxable income, if any. The Company also has federal tax creditcarryforwards of approximately $1.1 million. If not utilized, thesecarryforwards expire through 2024. If certain ownership changes occur, asdefined by Section 382 of the Internal Revenue Code of 1986, as amended (“IRC”),there could be annual limitations on the amount of carryforwards that can berealized in future periods.

Thecomponents of the net deferred tax asset are as follows:

| ** **                                         | ** ** | **December 31,** | ** ** |
|----------------------------------------------------|------------|-----------------------|------------|
| ** **                                         | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Net operating  loss carryforward                   |       | $                     | 6,961,000  |   | $ | 6,811,000 |   |
| Research and  development tax credit carryforwards |       | 1,137,000             |       | 954,000 |   |
| Capital loss  carryforward                         |       | 309,000               |       | 309,000 |   |
| Accrued  liabilities and reserves                  |       | 514,000               |       | 628,000 |   |
| Valuation  allowance                               |       | (8,921,000            | )          | (8,702,000 | ) |
| Net deferred tax asset                             |       | $                     | —     |   | $ | — |   |

 

SFAS No. 109 requires a valuation allowance to berecorded against deferred tax assets when it is more likely than not that someor all of the deferred tax assets will not be realized. As a result ofcumulative losses in recent years and continued economic uncertainty, theCompany has provided a full valuation allowance against all of its net deferredtax assets and will continue to do so until it returns to an appropriate levelof sustained taxable income. If the Company is successful in generatingsufficient future taxable income, the Company will reduce the valuationallowance through a reduction in income tax expense in the future for thatportion not related to the exercise of stock options.

At December 31, 2005, the Company hasapproximately $331,000 of net operating loss carryforwards and relatedvaluation allowance in the United States resulting from the exercise of stockoptions. The Company will realize the benefit of these losses through increasesto stockholders’ equity in the periods in which the losses are utilized toreduce tax payments.

Areconciliation of the federal statutory rate to the Company’s effective taxrate is as follows:

| ** **                                                | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Income tax  (benefit) provision at federal statutory rate |       | (34.0                                      | )%         | 34.0 | % | (34.0 | )% |
| (Decrease)  increase in tax resulting from—          |       |                                       |       |   |   |   |   |
| State tax provision, net of federal benefit               |       | 4.1                                        |       | 3.6 |   | 2.8 |   |
| Research and development tax credits                      |       | (58.1                                      | )          | (3.8 | ) | (3.6 | ) |
| (Decrease) increase in valuation allowance                |       | 81.0                                       |       | (34.0 | ) | 37.9 |   |
| Difference in foreign tax rates                           |       | (0.9                                       | )          | (1.0 | ) | (6.9 | ) |
| Other                                                     |       | 6.2                                        |       | 0.8 |   | (3.1 | ) |
| Income tax benefit                                        |       | (1.7                                       | )%         | (0.4 | )% | (6.9 | )% |

 

F-16

----

**OMTOOL, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**(5) IncomeTaxes (Continued)**

The income tax benefit inthe accompanying consolidated statements of operations consists of thefollowing:

| ** **         | ** ** | **Year Ended December 31,** | ** ** |
|--------------------|------------|--------------------------------------------|------------|
| ** **         | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Current            |       |                                       |       |   |   |   |   |
| Federal            |       | $                                          | (2,619     | ) | $ | 8,681 |   | $ | — |   |
| State              |       | —                                     |       | — |   | — |   |
| Foreign            |       | (2,873                                     | )          | (15,388 | ) | (144,322 | ) |
| Deferred           |       |                                       |       |   |   |   |   |
| Federal            |       | —                                     |       | — |   | — |   |
| State              |       | —                                     |       | — |   | — |   |
| Foreign            |       | —                                     |       | — |   | — |   |
|               |       | —                                     |       | — |   | — |   |
| Income tax benefit |       | $                                          | (5,492     | ) | $ | (6,707 | ) | $ | (144,322 | ) |

 

Thecomponents of domestic and foreign (loss) income before income taxes are asfollows:

| ** ** | ** ** | **Year Ended December 31,** | ** ** |
|------------|------------|--------------------------------------------|------------|
| ** ** | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Domestic   |       | $                                          | 2,943      |   | $ | 1,496,137 |   | $ | (2,601,795 | ) |
| Foreign    |       | (318,186                                   | )          | 96,744 |   | 511,708 |   |
|       |       | $                                          | (315,243   | ) | $ | 1,592,881 |   | $ | (2,090,087 | ) |

 

**(6) Stockholders’Equity**

*(a) PrivatePlacement to Institutional Investors and Other Accredited Investors*

On March 29, 2004,the Company raised $3.6 million through the private placement toinstitutional and other accredited investors of 600,000 shares of its commonstock at a price of $6.00 per share (the “Private Placement”). The feesassociated with issuing the shares in connection with the Private Placementwere $154,135 and were recorded as a reduction of additional paid-in capital.Furthermore, Omtool issued 51,000 shares of common stock and a warrant topurchase an additional 51,000 shares of common stock, exercisable over a fiveyear period at a price of $6.00 per share, to its financial advisor or theadvisor’s designees as payment for advisory services related to the PrivatePlacement. In conjunction with the transaction, the Company repurchased sharesof its outstanding common stock from an existing shareholder. See TreasuryStock below for more information.

*(b) Treasury Stock*

In October 1998 and in October 2002, theCompany’s Board of Directors authorized the repurchase of up to 285,714 sharesand $250,000 worth of shares, respectively, of the Company’s common stock.Subject to price and market considerations and applicable securities laws, suchpurchases will be made from time to time on the open market. No time limit wasplaced on the duration of the repurchase programs. The Company may use therepurchased shares to offset shares issued in connection with various Companyemployee stock plans.

F-17

----

**OMTOOL, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**(6) Stockholders’Equity (Continued)**

In March 2004, the Company’s Board of Directorsauthorized the repurchase of 350,000 shares of its outstanding common stockfrom ASA International, an existing shareholder, in a private transaction at aprice of $5.75 per share. The shares were purchased with the use of generallyavailable corporate funds and are held in treasury.

As of December 31, 2005, the Company hadrepurchased a total of 280,446 shares under the 1998 program and $250,000worth, or 142,856 shares, under the 2002 program. The combined total of allrepurchases is $773,302.

*(c) Reserved CommonStock*

As of December 31,2005, 1,104,746 shares of common stock were reserved for issuance pursuant toall stock option plans, the employee stock purchase plan and the outstanding warrant.

*(d) Preferred Stock*

The Company’s Amended andRestated Certificate of Incorporation provides for and the Board of Directorsand stockholders authorized, 2,000,000 shares of $0.01 par value preferredstock. The Board of Directors has the authority to issue such shares in one ormore series and to fix the relative rights and preferences without vote oraction by the stockholders. No shares have been issued as of December 31,2005.

*(e) Stock Splits*

On March 30, 2004, Omtool’s Board of Directorsapproved a two-for-one forward stock split of the Company’s common stock in theform of a dividend, effective April 27, 2004, payable to each stockholderof record as of April 7, 2004. All references in the consolidatedfinancial statements referring to shares, share prices, per share amounts andstock plans have been adjusted retroactively for this two-for-one stock split.

On January 14, 2003,Omtool’s Board of Directors approved a one-for-seven reverse stock split of theCompany’s common stock, effective January 15, 2003. All references in theconsolidated financial statements referring to shares, share prices, per shareamounts and stock plans have been adjusted retroactively for this one-for-sevenstock split.

*(f) Stock Warrant*

As described above, inconjunction with the Private Placement, the Company issued a warrant topurchase 51,000 shares of common stock exercisable over a five year period at aprice of $6.00 per share to the Company’s financial advisor or the advisor’sdesignees as payment for advisory services related to the transaction. Thewarrant may only be exercised during the period commencing on October 1,2004 and ending on September 30, 2009. The warrant has not been exercisedas of December 31, 2005.

*(g) RestrictedCommon Stock*

During 2005, the Company sold a total of 115,516shares of restricted common stock shares under the Company’s 1997 Stock Plan,as amended, to its Board of Directors and certain employees of the Company at aprice per share of $0.01. The shares of restricted common stock vest ratablyover a four year service 

F-18

----

**OMTOOL, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**(6) Stockholders’Equity (Continued)**

period. In the event thata restricted stockholder ceases to provide services to the Company prior to thevesting of any of the then unvested shares held by that stockholder, therestricted stockholder is required to sell all such unvested shares ofrestricted common stock back to the Company at the original purchase price of$0.01 per share. During 2005, 1,256 shares of unvested restricted common stockwere forfeited.

The Company recordeddeferred compensation of approximately $903,000 during 2005 for the intrinsicvalue of the restricted common stock. Compensation expense included in net lossfor the year ended December 31, 2005 was approximately $127,000. TheCompany is recognizing deferred compensation as compensation expense ratablyover the expected four year vesting period.

**(7) Stock Plans**

*(a) Stock OptionPlans*

The Company’s 1996 Stock Option Plan (the “1996 Plan”)provided for the granting of options covering 428,572 shares of common stock.The 1996 Plan, administered by the Board of Directors, allowed for the grantingof “incentive stock options” within the meaning of the IRC and nonqualifiedstock options. Incentive stock options under the 1996 Plan were granted at notless than the fair market value per share of common stock on the date of grantor 110% of fair market value for any stockholder who holds more than 10% of thetotal combined voting power of all classes of stock of the Company. Under theterms of the 1996 Plan, options vest and become exercisable as determined bythe Board of Directors and expire 10 years after the date of grant. In1997, the Company’s Board of Directors voted that no further options may begranted or issued under the 1996 Plan.

The Company’s 1997 Stock Plan, as amended, (the “1997Plan”) provides for the issuance of common stock pursuant to the grant toemployees of “incentive stock options” within the meaning of the IRC and thegrant of nonqualified stock options, stock awards or opportunities to makedirect purchases of stock in the Company to employees, consultants, directorsand officers of the Company. Under the terms of the 1997 Plan, options vest andbecome exercisable as determined by the Board of Directors and expire10 years after the date of grant. The aggregate number of shares of commonstock which may be issued pursuant to the 1997 Plan is 1,228,570. In accordancewith the 1997 Plan, stock options that are canceled or expired are added back tothe potential options available for future issuance.

The Company accounts for stock-based compensation foremployees under APB Opinion No. 25, “*Accountingfor Stock Issued to Employees”* and related interpretations andfollows the disclosure-only alternative under SFAS No. 123, “*Accounting for Stock-Based Compensation*,”as amended by SFAS No. 148, “*Accountingfor Stock-Based Compensation — Transition and Disclosure,”* foroptions granted using the Black-Scholes option pricing model prescribed by SFASNo. 123. In December 2004, the FASB issued SFAS No. 123(R), “*Share-Based Payment*.” SFAS No. 123(R) amends SFAS No. 123. The Company isrequired to adopt  SFAS 123(R) inthe first quarter of 2006 and does not expect it to have a material impact onits future results of operations. Based on the use of the Black-Scholes optionpricing model, options granted in 2004 and 2003 had a weighted average grantdate fair value per share of $4.57 and $1.10, respectively. No options weregranted in 2005.

F-19

----

**OMTOOL, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**(7) Stock Plans(Continued)**

Theassumptions used are as follows:

| ** **               | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------|------------|--------------------------------------------|------------|
| ** **               | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Risk-free  interest rate |       | N/A                                        | %          | 2.67 | % | 2.68 | % |
| Volatility               |       | N/A                                        | %          | 95.0 | % | 95.0 | % |
| Expected dividend  yield |       | N/A                                        |       | — |   | — |   |
| Expected lives           |       | N/A                                        |       | 4 Years |   | 4 Years |   |

 

Thefollowing is a summary of all stock option activity:

| ** **                           | ** ** | **Number of  Shares** | ** ** | **Exercise Price  Per Share** | ** ** | **Weighted  Average  Exercise Price** | ** **  |
|--------------------------------------|------------|----------------------------|------------|-----------------------------------------|------------|--------------------------------------------|-------------|
| Outstanding,  December 31, 2002 |       |                       | 757,396    |                                    |       | $                                          | 0.74-$28.88 |   |   | $ | 6.14 |   |   |
| Granted                              |       |                       | 50,000     |                                    |       | 0.74-1.85                                  |        |   | 1.63 |   |   |
| Exercised                            |       |                       | (572       | )                                       |       | 0.88                                       |        |   | 0.88 |   |   |
| Canceled and expired                 |       |                       | (311,238   | )                                       |       | 0.74-17.06                                 |        |   | 3.85 |   |   |
| Outstanding, December 31, 2003  |       |                       | 495,586    |                                    |       | 0.74-19.25                                 |        |   | 6.17 |   |   |
| Granted                              |       |                       | 5,260      |                                    |       | 6.76                                       |        |   | 6.76 |   |   |
| Exercised                            |       |                       | (42,206    | )                                       |       | 0.74-4.10                                  |        |   | 2.55 |   |   |
| Canceled and expired                 |       |                       | (12,264    | )                                       |       | 2.63-17.06                                 |        |   | 9.87 |   |   |
| Outstanding, December 31, 2004  |       |                       | 446,376    |                                    |       | 0.74-19.25                                 |        |   | 6.41 |   |   |
| Granted                              |       |                       | —     |                                    |       | —                                     |        |   | — |   |   |
| Exercised                            |       |                       | (6,992     | )                                       |       | 0.74-4.10                                  |        |   | 1.40 |   |   |
| Canceled and expired                 |       |                       | (75,670    | )                                       |       | 2.63-17.06                                 |        |   | 10.15 |   |   |
| Outstanding,  December 31, 2005 |       |                       | 363,714    |                                    |       | $                                          | 0.74-$19.25 |   |   | $ | 5.73 |   |   |
| Exercisable,  December 31, 2005 |       |                       | 335,320    |                                    |       | $                                          | 1.85-$19.25 |   |   | $ | 6.05 |   |   |

 

At December 31, 2005, options to purchase 687,869shares of common stock were available for future grants under the 1997 Plan.

F-20

----

**OMTOOL, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**(7) StockPlans (Continued)**

The range of exerciseprices for options outstanding and options exercisable at December 31,2005 are as follows:

| ** **                                  | ** ** | **Options Outstanding** | ** ** | ** **                                                  | ** ** | **Options Exercisable**                                       | ** ** |
|---------------------------------------------|------------|------------------------------|------------|-------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| **Range of Exercise Prices** | ** ** | **Options  Outstanding**     | ** ** | **Weighted Average  Remaining  Contractual Life** | ** ** | **Weighted Average  Exercise Price Per Share** | ** ** | **Options  Exercisable** | ** ** | **Weighted Average  Exercise Price  Per Share** | ** ** |
| ** **                                  | ** ** | ** **                   | ** ** | **(Years)**                                                 | ** ** | ** **                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| $0.74-0.74                                  |       |                         | 5,000      |                                                        |       |                                                               | 7.3        |   |   |   | $ | 0.74 |   |   |   | — |   |   |   | $ | — |   |   |
| 1.85-2.63                                   |       |                         | 206,748    |                                                        |       |                                                               | 5.9        |   |   |   | 2.47 |   |   |   | 185,783 |   |   |   | 2.54 |   |   |
| 3.19-4.20                                   |       |                         | 7,332      |                                                        |       |                                                               | 5.4        |   |   |   | 3.64 |   |   |   | 6,328 |   |   |   | 3.57 |   |   |
| 6.48-8.54                                   |       |                         | 69,820     |                                                        |       |                                                               | 4.5        |   |   |   | 7.71 |   |   |   | 68,395 |   |   |   | 7.73 |   |   |
| 10.06-12.69                                 |       |                         | 33,430     |                                                        |       |                                                               | 4.0        |   |   |   | 10.11 |   |   |   | 33,430 |   |   |   | 10.11 |   |   |
| 15.31-19.25                                 |       |                         | 41,384     |                                                        |       |                                                               | 3.0        |   |   |   | 16.12 |   |   |   | 41,384 |   |   |   | 16.12 |   |   |
|                                        |       |                         | 363,714    |                                                        |       |                                                               | 5.1        |   |   |   | $ | 5.73 |   |   |   | 335,320 |   |   |   | $ | 6.05 |   |   |

 

*(b) 1997Employee Stock Purchase Plan*

The 1997 Employee StockPurchase Plan (the “1997 Purchase Plan”) provides for the issuance of a maximumof 57,142 shares of common stock pursuant to the exercise of nontransferableoptions granted to participating employees. The exercise price for the optionfor each six-month purchase period is 85% of the lesser of the market price ofthe common stock on the first or last business day of the six-month purchaseperiod. As of December 31, 2005, 49,046 shares had been issued under the1997 Purchase Plan.

**(8) 401(k) andProfit-Sharing Plan**

The Company’s 401(k) andProfit-Sharing Plan (the “Profit-Sharing Plan”) covers all eligible employeesand allows for voluntary contributions by eligible employees. The Companymatches 50% of eligible employee contributions up to a specified amount. TheCompany contributed $131,000, $109,000 and $114,000 to the Profit-Sharing Planfor the years ended December 31, 2005, 2004 and 2003, respectively.Additional profit-sharing contributions to the Profit-Sharing Plan are at thediscretion of the Company’s management. During 2005, 2004 and 2003, the Companymade no additional discretionary contributions.

**(9) Lease Commitments**

The Company leases certain equipment and its officefacilities under operating leases that expire at various times through December 2006.Future minimum lease payments under these leases at December 31, 2005 are$201,000 for the year ending December 31, 2006. At December 31, 2005,the Company had no other operating lease commitments.

The Company’s lease of its current office space usedas its headquarters and primary business location in Salem, New Hampshireexpired on December 31, 2005 and the Company is currently a tenant-at-willat this location and is making monthly lease payments of $21,000.

In January 2006, the Company entered into a newlease agreement and plans to move its headquarters to Andover, Massachusetts inApril 2006. The Company will be required to make lease payments related tothis new lease of $95,000, $379,000, $379,000, $395,000 and $401,000 for theyears ended December 31, 

F-21

----

**OMTOOL, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**(9) LeaseCommitments (Continued)**

2006, 2007, 2008, 2009 and2010, respectively. The term of the lease is ten years and the Company has anoption to renew the lease for an additional five-year term at thethen-applicable fair market rent. Under the terms of the lease, the Company isnot required to pay rent for the first six months commencing upon the date ofoccupancy and the landlord will provide the Company with a tenant improvementallowance up to $308,000. Additionally, the Company has a one-time right toterminate the lease, upon twelve months’ written notice, after the sixth yearof the lease term. If the Company decides to terminate the lease, it must pay apenalty of six months’ rent and the unamortized portion of the tenantimprovement allowance. On January 24, 2006, the Company entered into anagreement for construction projects with a contractor whereby the Company willpay approximately $435,000 to the contractor in exchange for the contractorperforming certain interior renovations at the Company’s future corporateheadquarters located at Six Riverside Drive, Andover, Massachusetts.

Rent expense, net ofsub-lease rentals, included in the accompanying consolidated statements ofoperations was $516,000, $476,000 and $444,000 for the years ended December 31,2005, 2004 and 2003, respectively.

**(10) RestructuringCosts**

In the third quarter of 2003, the Company announced arestructuring of certain of its operations and recorded a pretax charge of$806,581 in accordance with SFAS No. 146, “*Accounting for Costs Associated with Exit or Disposal Activities*.”The charge included severance-related costs associated with the workforcereduction in the Company’s domestic operations and costs associated with theclosing of its Oregon office. The reduction in workforce consisted of threeemployees in the Company’s sales and marketing department, two employeesperforming general and administrative functions, three employees performingtechnical support and five employees in the Company’s research and developmentdepartment. The balance of this charge consisted of costs incurred as a resultof the closure of the Company’s Oregon facility.

Thefollowing table summarizes the accrual and usage of the restructuring chargesin 2003 and 2004:

| ** **                              | ** ** | **Lease** | ** ** | **Severance** | ** ** | **Total** | ** ** |
|-----------------------------------------|------------|-----------|------------|---------------|------------|-----------|------------|
| Total charge                       |       | $         | 17,420     |          | $          | 789,161   |       | $ | 806,581 |   |
| Cash payments  2003                     |       | (17,420   | )          | (345,331      | )          | (362,751  | )          |
| Ending balance,  December 31, 2003 |       | —    |       | 443,830       |       | 443,830   |       |
| Cash payments  2004                     |       | —    |       | (443,830      | )          | (443,830  | )          |
| Ending balance,  December 31, 2004 |       | $         | —     |          | $          | —    |       | $ | — |   |

 

The total cash impact ofthe restructuring was $806,581, all of which was paid by the end of the thirdquarter of 2004.

**(11) Guarantees**

In November 2002, the FASB issued FASBInterpretation 45, “*Guarantor’s Accounting andDisclosure Requirements for Guarantees, Including Indirect Guarantees ofIndebtedness of Others”* (“FIN 45”). FIN 45 elaborates on theexisting disclosure requirements for most guarantees, including loan guaranteessuch as standby letters of credit. It also clarifies that at the time a companyissues a guarantee, the company must 

F-22

----

**OMTOOL, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**(11) Guarantees(Continued)**

recognize an initialliability for the fair value, or market value, of the obligations it assumesunder the guarantee and must disclose that information in its interim andannual financial statements. The provisions related to recognizing a liabilityat inception of the guarantee for the fair value of the guarantor’s obligationsdoes not apply to product warranties or to guarantees accounted for asderivatives. The disclosure requirements are effective for financial statementsissued after December 15, 2002 and the recognition/measurementrequirements are effective on a prospective basis for guarantees issued ormodified after December 31, 2002. The following is a summary of theCompany’s agreements that it has determined are within the scope of FIN 45.

The Company enters into standard indemnificationagreements in its ordinary course of business. Pursuant to these agreements,the Company indemnifies, holds harmless and agrees to reimburse the indemnifiedparty for losses suffered or incurred by the indemnified party, generally itsresellers or certain customers, in connection with any United States patent, orany copyright or other intellectual property infringement claim by any thirdparty with respect to its products. The term of these indemnificationagreements is generally perpetual any time after execution of the agreement.The maximum potential amount of future payments the Company could be requiredto make under these indemnification agreements is unlimited. The Company hasnever incurred costs to defend lawsuits or settle claims related to theseindemnification agreements. As a result, the Company believes that theestimated amounts of potential liability arising out of these agreements isminimal.

The Company warrants thatits software products will perform in all material respects in accordance withits standard published specifications in effect at the time of delivery of thelicensed products to certain of its customers for the life of the product. If necessary,the Company would provide for the estimated cost of product warranty based onspecific warranty claims and claim history, however, the Company has neverincurred significant expense under its product warranty. As a result, theCompany believes that the estimated amounts of potential liability arising outof these agreements is minimal.

**(12) Segment andGeographic Information**

To date, the Company has viewed its operations andmanages its business as principally one segment — software and hardwaresales and associated services. As a result, the financial information disclosedherein represents all of the material financial information related to theCompany’s principal operating segment in accordance with SFAS No. 131, “*Disclosures About Segments of an Enterprise andRelated Information*.”

Total revenue from international sources wasapproximately $2.8 million, $3.3 million and $3.1 million in2005, 2004 and 2003, respectively. The Company’s revenue from internationalsources was primarily generated from customers located in Canada, Europe andSouth Africa.

F-23

----

**OMTOOL, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**(12) Segmentand Geographic Information (Continued)**

The following tablerepresents amounts relating to geographic locations for the years ended December 31,2005, 2004 and 2003:

| ** **           | ** ** | **Year Ended December 31,** | ** ** |
|----------------------|------------|--------------------------------------------|------------|
| ** **           | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Total revenue(1)     |       |                                       |       |   |   |   |   |
| United States        |       | $                                          | 11,536,784 |   | $ | 11,502,207 |   | $ | 10,647,321 |   |
| United Kingdom       |       | 985,129                                    |       | 1,228,182 |   | 1,281,283 |   |
| Canada               |       | 656,280                                    |       | 784,927 |   | 503,222 |   |
| South Africa         |       | 294,243                                    |       | 296,816 |   | 264,784 |   |
| Rest of World        |       | 823,729                                    |       | 978,062 |   | 1,050,636 |   |
|                 |       | $                                          | 14,296,165 |   | $ | 14,790,194 |   | $ | 13,747,246 |   |
| Long-lived assets(2) |       |                                       |       |   |   |   |   |
| United States        |       | $                                          | 168,360    |   | $ | 215,879 |   |   |   |
| United Kingdom       |       | 18,768                                     |       | 9,195 |   |   |   |
|                 |       | $                                          | 187,128    |   | $ | 225,074 |   |   |   |

----

(1)          Revenue is attributed togeographic regions based on location of customer.

(2)*         *Long-lived assets include property andequipment and other assets.

**(13) Asset Write-off**

In April 1999, the Company purchased 262,346shares of Series B Preferred Stock (“Preferred Stock”) of .comfax, Inc.(which later changed its name to MessageClick, Inc. (“MessageClick”)), adevelopment-stage company that developed and marketed Internet-based facsimilecommunications devices. As part of the transaction, the Company purchased apatent, United States Patent No. 5,872,845, entitled Method and Apparatusfor Interfacing Fax Machines to Digital Communication Networks fromMessageClick. The Company paid $850,000 for the Preferred Stock and the patent.

The Company initially recorded its investment inMessageClick at the total purchase price of $850,000 and placed no value on thepatent, which patent, to date, the Company has not used . At the end of eachquarter following this purchase, the Company evaluated the carrying cost of thisinvestment and adjusted the balance, if it was deemed appropriate, to what theCompany believed to be its realizable value. In making this decision, theCompany reviewed the most recent MessageClick financial statements that weremade available to the Company’s management, had discussions with MessageClick’smanagement and reviewed documents relating to subsequent rounds of financingreceived by MessageClick. Based on the aforementioned, the Company determinedthat as of December 31, 1999, the carrying value of the investment was$708,335. During each of the first, second and third quarters of fiscal year2000, the Company reduced the carrying value of the investment by $70,833.During the fourth quarter of 2000, the Company wrote-off the entire remaining carryingvalue of the investment. The decision to write-off the investment is describedbelow.

On November 3, 2000, MessageClick was acquired byVerso Technologies, Inc. (“Verso”), a company publicly traded on theNasdaq National Market under the symbol VRSO. The Company received 45,487shares of Verso common stock, $243.47 cash, which included cash the Company wasentitled to and cash in 

F-24

----

**OMTOOL, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**(13) AssetWrite-off (Continued)**

lieu of fractional sharesof Verso and a warrant to purchase 8,580 shares of Verso common stock inexchange for its 262,346 shares of Preferred Stock. The 45,487 shares of Versocommon stock received by the Company were unregistered and the Company wasrestricted from selling these shares for twelve months from the date of theacquisition. Additionally, the Company only had “piggy back” registrationrights for those shares of Verso common stock. Furthermore, the Companypotentially would receive an additional 20,642 shares of Verso common stock ifcertain conditions of the purchase agreement were met.

At the time of the acquisition, Verso was trading at$3.38 per share and at December 31, 2000, Verso was trading at $1.50(resulting in $68,230.50 in value for the 45,487 shares). Additionally, as of March 30,2001 (prior to the Company filing its Form 10-K for the year ended December 31,2000), Verso was trading at $0.75 a share, thus providing a trading value as ofMarch 30, 2001 of the Company’s investment of $34,115.25. Due to the rapidand significant decline in Verso’s common stock, the restriction on sale of thestock, the uncertainty of the ultimate realizability of the stock and theimmateriality of the value of the shares, the Company decided to write-off theentire carrying value of $708,335 of the investment as of December 31,2000.

In 2002, the Company sold 45,487 of its Verso CommonStock for approximately $11,000 and recorded the realized value in Interest andOther Income at that time.

On July 18, 2003, theCompany received an additional 11,029 shares of Verso Common Stock as certainconditions described in the purchase agreement were met. The Company sold thoseshares on September 8, 2003 for $4.63 per share for total gross proceedsof $51,000. This amount is included in Interest and Other Income. The Companydoes not expect to receive any additional shares of Verso common stock. TheCompany’s warrant to purchase 8,580 shares of Verso common stock expired in November 2005.

F-25

----

**OMTOOL, LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**(14) Quarterly Results ofOperations (unaudited)**

The following tablepresents a condensed summary of quarterly results of operations for the yearsended December 31, 2005 and 2004.

| ** **                   | ** ** | **Year Ended December 31, 2005** | ** ** |
|------------------------------|------------|------------------------------------------------------|------------|
| ** **                   | ** ** | **First  Quarter**                                   | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** |
| Total revenue                |       | $                                                    | 3,861,484  |   | $ | 3,570,299 |   | $ | 3,165,770 |   | $ | 3,698,612 |   |
| Gross profit                 |       | 2,579,665                                            |       | 2,354,409 |   | 2,107,130 |   | 2,624,561 |   |
| Net income (loss)            |       | 142,040                                              |       | 11,764 |   | (343,430 | ) | (120,125 | ) |
| Net income (loss) per share: |       |                                                 |       |   |   |   |   |   |   |
| Basic                        |       | $                                                    | 0.04       |   | $ | 0.00 |   | $ | (0.09 | ) | $ | (0.03 | ) |
| Diluted                      |       | $                                                    | 0.04       |   | $ | 0.00 |   | $ | (0.09 | ) | $ | (0.03 | ) |

 

| ** **            | ** ** | **Year Ended December 31, 2004** | ** ** |
|-----------------------|------------|------------------------------------------------------|------------|
| ** **            | ** ** | **First  Quarter**                                   | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** |
| Total revenue         |       | $                                                    | 4,028,078  |   | $ | 3,367,581 |   | $ | 3,448,004 |   | $ | 3,946,531 |   |
| Gross profit          |       | 2,575,083                                            |       | 2,322,234 |   | 2,334,727 |   | 2,675,300 |   |
| Net income            |       | 379,755                                              |       | 277,680 |   | 394,209 |   | 547,944 |   |
| Net income per share: |       |                                                 |       |   |   |   |   |   |   |
| Basic                 |       | $                                                    | 0.11       |   | $ | 0.07 |   | $ | 0.10 |   | $ | 0.14 |   |
| Diluted               |       | $                                                    | 0.10       |   | $ | 0.07 |   | $ | 0.10 |   | $ | 0.14 |   |

 

F-26

----