**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**FORM 10-K**

**FOR ANNUAL AND TRANSITIONREPORTS**

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

**SECURITIESEXCHANGE ACT OF 1934**

**(Mark One)**

**x**                              ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe fiscal year ended: December 31, 2006**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**For the transition period from             to             **

**Commission File Number 0-22871**

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**OMTOOL, LTD.**

(Exact Name of Registrant as Specified in Its Charter)

| **Delaware**                             |   | **02-0447481**                          |
|------------------------------------------|--------|-----------------------------------------|
| (State or Other Jurisdiction of          |   | (I.R.S. Employer Identification Number) |
| Incorporation or Organization)           |   |                                    |
| **6 Riverside Drive, Andover, MA**       |   | **01810**                               |
| (Address of Principal Executive Offices) |   | (Zip Code)                              |

 

Registrant’stelephone number, including area code: **(978) 327-5700**

Securitiesregistered pursuant to Section 12(b) of the Act:

**CommonStock, $.01 par value**

(Title of Class)

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

Indicate by check mark if the registrant is awell-known seasoned issuer, as defined in Rule 405 of the SecuritiesAct. Yes o  No x

Indicate by check mark if the registrant is notrequired to file reports pursuant to Section 13 or 15(d) of theExchange Act. Yes o  No x

Indicate by check mark whether the registrant: (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports) and (2) hasbeen subject to such filing requirements for the past90 days. Yes x  No o

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein andwill not be contained, to the best of registrant’s knowledge, in definitiveproxy or information statements incorporated by reference in Part III ofthis Form 10-K or any amendment to this Form 10-K. o

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 |   | Accelerated filer o |   | Non-accelerated filer x |
|--------------------------------|--------|--------------------------|--------|------------------------------|

 

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

As of June 30, 2006, theaggregate market value of the registrant’s common stock held by non-affiliatesof the registrant was $14,331,734 based on the average bid and asked price asreported on the NationalAssociation of Securities Dealers Automated Quotation System National MarketSystem.

The number of shares outstanding of the registrant’scommon stock as of March 21, 2007 was 4,545,561.

**DOCUMENTS INCORPORATED BY REFERENCE**

The registrant intends tofile a definitive proxy statement pursuant to Regulation 14A within120 days of the end of the fiscal year ended December 31, 2006. Portionsof such proxy statement are incorporated by reference into Part III ofthis report.

 

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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, some 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**

**Item1.**                        Business

We are a provider ofdocument and information handling solutions that control document-basedbusiness communications and processes that simplify the integration of paperand electronic documents into enterprise information systems. Our softwareproducts streamline the capture, conversion, and communication of both paperand electronic information, enabling fast, secure, and simultaneousdistribution to multiple destinations in multiple formats.

Our flagship product isAccuRoute®, adocument handling platform which provides faster, more efficient documentworkflows and increased worker productivity, while reducing cost, complexity,and risk. We also include full enterprise fax capabilities integrated withinour AccuRoute product. These solutions are used worldwide by businesses indocument-intensive industries such as the legal, financial services, andhealthcare vertical markets that demand secure handling, integration, andtracking of documents in full compliance with a range of regulatoryrequirements. Further, we provide compatibility with enterprise hardware andsupported software to leverage existing information technology infrastructures.

GenifaxTM, our enterprisefax product, offers a scalable, server-based feature set and shares a commonMicrosoft® Windows® server-basedarchitecture with our AccuRoute product line. Companies can deploy our softwareproducts on heterogeneous, multi-platform computer networks and digitalscanning and multi-function peripherals (devices that perform two or more ofthe following functions: printing, faxing, scanning and copying, referred to as“*MFPs*”) and integrate them with bothdesktop and enterprise software applications. Our products are modular andscaleable. Our customers can implement additional communication capacitythrough the addition of system components and connectors to keep pace withgrowing demand and changing infrastructure requirements. Our customers can alsoadd additional Omtool product servers to a configuration to provide failoverand redundancy, helping to ensure continuous operation. We license our productson a combination server/user basis and as external hardware devices becomeincreasingly technologically advanced, we will extend a portion of our licensefees to a device-based model.

Overall, we will continueto focus on vertical markets where industry or governmental regulations orbusiness practices require confidentiality, timely electronic delivery, andarchiving of critical documents in electronic and paper format. We also expectto maintain our established position in our traditional market—secureelectronic document handling.

**Acquisition of BlueChip Technologies**

On December 29, 2006,we closed our acquisition of BlueChip Technologies Ltd. (“*BlueChip*”),a privately-held provider of electronic forms automation, document imaging, andobject archiving solutions 

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for thehealthcare vertical market, and then merged BlueChip with and into ourwholly-subsidiary, Omtool Healthcare, LLC. The BlueChip acquisition providescomplementary value to us through both the company’s products and customer base.In particular, BlueChip’s products provide vertically specific documentworkflow solutions for healthcare providers, as well as forms processing anddocument archiving technologies that are expandable to other markets. Further,BlueChip brings deep domain expertise and longstanding customer relationshipsin the healthcare vertical market that will help to accelerate our marketpenetration. We intend to incorporate BlueChip’s forms automation and documentarchiving functionalities into our AccuRoute product line.

Specifically, BlueChip’ssolutions for document imaging and workflow for hospital admissions and billingfunctions allow us to deliver a more complete suite of products that handle thehealthcare document workflow. Omtool’s new Healthcare Suite, which is based onAccuRoute and now includes the applications acquired as a result of theBlueChip acquisition, will help to eliminate a significant portion of ahealthcare facility’s paper forms and improve productivity through electronicform delivery. Hundreds of healthcare facilities have already adoptedtechnologies from Omtool’s Healthcare Suite.

**Company Background**

We were incorporated inNew Hampshire in March 1991 and reincorporated in Delaware in January 1996.Our principal executive offices are located at 6 Riverside Drive, Andover,Massachusetts 01810 and our telephone number is (978) 327-5700. OurWeb site is at *http:*//*www.omtool.com.*We make available free of charge through ourWeb site our annual reports 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**

Organizations of all sizesmust increase employee productivity to improve their competitive posture.Simultaneously, they must also comply with a growing range of governmentmandates and regulatory frameworks. Collectively, these pressures andregulations are forcing organizations to focus on streamlining the exchange andmanagement of documents within the context of complete enterprise contentmanagement.

While many enterpriseshave invested heavily in powerful and reliable information technologyinfrastructures, these investments address only a portion of the problem. That isbecause a significant percentage of a company’s critical business informationremains locked in the company’s file drawers in the form of paper documents.

In their efforts to reinin disparate content sources and formats, many companies are encounteringsignificant challenges. According to an industry study, a typical office workerspends 40 percent of his time looking for information while professionals spendmore than 500 hours annually reviewing and routing documents and another 150hours annually looking for incorrectly filed documents. The cost of this timeis significant. Further, an average organization spends $20 in labor to fileeach document, while one out of every 20 documents is lost. We believecompanies seeking to remain competitive must address this lost productivity andwe believe that our products are well-suited to tackle this challenge.

New, revised and strictercompliance requirements are forcing companies to address the way they handletheir documents (both paper and electronic) and manage their informationmanagement infrastructure. To ensure that they retain required documents forthe prescribed periods of time and that retained documents are immediatelyaccessible, enterprises are revisiting their document retention policies based onspecific compliance requirements such as the Sarbanes-Oxley Act of 2002 (“*Sarbanes-Oxley*”); Section 17(a) of the SecuritiesExchange Act of 1934, as amended (“*SEC 17(a)*”);anti-money laundering 

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statutes;and other similar laws and regulations. At the same time, consumer privacycontinues to be a growing concern. Compliance requirements in support ofprivacy—such as the Gramm-Leach-Bliley Act and the Health InformationPortability and Accountability Act (“*HIPAA*”)—dictatespecific policies and procedures for capturing, distributing and storingconsumer and patient records and securing their privacy and security.

Law firms have document-centricenvironments and often need to convert paper-based documents into electronicfiles for archiving into document or records management systems. Ideally, lawfirms would convert these electronic documents into a searchable format thatmay be properly profiled for easy and fast retrieval. In addition, emergingmandates from courts in many jurisdictions are calling for electronic filing(e-filing) of all cases and associated documents, making the conversion ofpaper documents into electronic form all the more important.

Financial servicescompanies have to abide by the Securities and Exchange Commission rules, suchas those promulgated under SEC 17(a). As a result, financial service companiesmust take steps to safeguard the communication of documents against potentialabuses, including, in the case of broker-dealers, by implementing specificprocesses and policies related to the storage and management of records. Faxesand other paper records, which are integral components of business operationsof brokers, dealers and others subject to SEC 17(a), are an essential componentof the record-keeping requirements of SEC 17(a) compliance.

Healthcare organizationsoften use e-mail and fax to communicate patient information among providers,payors, and private corporations. Under HIPAA regulations for documentportability and privacy, both e-mail and fax communications must undergo significantchanges to ensure the confidentiality of patient information. Healthcareproviders face a daunting array of complex forms and documents—all carefullygoverned by clinical practices, strict patient confidentiality requirements,regulatory frameworks, and reimbursement issues. As a result, healthcareproviders spend millions of dollars each year to produce and process documentsand forms. Further, the adoption of electronic medical records is driving thehealthcare industry to higher levels of electronic automation.

Organizations across arange of industries beyond the legal, financial services and healthcarevertical markets face significant compliance demands. In recent years,regulatory compliance has expanded and evolved to become a separate organizationalfunction within large organizations, characterized by numerous needs andchallenges. These compliance initiatives, best practices and governmentmandates prescribe specific policies for tracking, securing and archivingnumerous types of communications and documents, and are driving enterprises topay close attention to their document management strategies.

**The Omtool Solution**

Our solution providesenterprises with extensive and flexible software that works on their computernetworks and MFPs and has features that capture, convert, distribute, andarchive documents in electronic formats, regardless of their original format. Collectively,our products add functionality, security, efficiency, and accuracy that aremissing from existing messaging, enterprise resource planning, and documentmanagement systems and MFPs. Along with our hardcopy and fax archive features,the document routing and delivery security that our products provide helpscompanies meet government regulations such as Sarbanes-Oxley, SEC 17(a) andHIPAA, industry mandates and best-practice policies regarding the protectionand preservation of confidential business and personal information that istransmitted electronically. Further, our document and information handlingsolutions provide organizations with a means to address the productivitychallenges presented by a myriad of documents and business processes.

Our AccuRoute solution isideal for law firms because it easily handles electronic documents that arriveby e-mail or fax, as well as paper documents that can be imaged by any standarddigital copier. 

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Withinfinancial service companies broker-dealers can use AccuRoute to create acomplete time-stamped, server-based audit trail of where each document camefrom, what was done to it, and where it went, along with an archived copy thatcan be quickly retrieved. AccuRoute can, therefore, reduce the costs and risksassociated with archiving and retrieving documents in a manner compliant withSEC 17(a). Our products also provide healthcare organizations with a fullycapable fax and e-mail solution that supports HIPAA-compliant processes.

Our software products canbe deployed on multi-platform, client-server computer networks and in the caseof our AccuRoute and Healthcare Suite of products, on MFPs.

As a result, we believethat opportunities exist for us to sell our software products in the legal,healthcare and financial services vertical markets. We also believe oursolutions are well suited to other document-intensive markets and segments thatrequire document distribution and faxing from data-centric applications, paperintegration in mission critical business processes, and fax as the standard forelectronic document exchange.

*AccuRoute Document Handling Platform*

OurAccuRoute product is a software solution that captures, converts, distributesand archives paper and electronic documents. AccuRoute transforms both paperand electronic-based documents into electronic files and routes the informationwithin and outside an organization. Through AccuRoute, we enable customers toadminister their documents from either a desktop computer or from a MFP panel,all while seamlessly integrating with their business workflow to:

·       ***Capture*** paper and electronic-basedinformation for efficient document handling with distributed end user access.

·       Achieve***Compatibility***with any networkedscanner, scan-enabled digital printer, copier, fax, or MFP.

·       ***Convert*** paper and electronicdocuments into a variety of formats including text-searchable Adobe PortableDocument Format (“*PDF*”), tagged image file format,JPEG, DOC and TXT files.

·       ***Combine*** paper and electronic-basedinformation to create “mixed-mode” documents.

·       ***Create*** personal and publicdocument-handling rules (embedded directives) that may be saved for reuse.

·       ***Compress*** documents up to 80 percentof original file size, thereby reducing electronic transmission (bandwidth) andstorage requirements.

·       ***Communicate*** with variousdestinations and recipients simultaneously, such as desktop computers, faxes,e-mail, network folders, printers, document repositories, document managementsystems, records management systems, enterprise content management systems, andlitigation support systems.

·       ***Collaborate***on documents that werepreviously difficult to share.

·       Usea ***Consistent*** and intuitive desktopinterface that directly leverages existing applications and eliminates the needto learn proprietary systems.

·       ***Comply***with a vast range ofcorporate record-retention requirements, government regulations, and industrymandates

Our AccuRoute productworks with nearly all brands of scan-enabled MFPs by allowing the definition ofdocument capture and delivery options at the end user’s desktop computer.During 2006, we extended this technology to include support for “smart MFPs”that use embedded software displays in a variety of manufacturers’ models.

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*Products Acquired through Our Acquisition of BlueChip*

Uponthe completion of our recent acquisition of BlueChip, we have expanded theproducts available to healthcare customers. The BlueChip products forhealthcare organizations—now included in the Omtool Healthcare Suite—includethe following products:

·       **ADT eFormsTM**production system****provideshospitals with on-demand admissions, discharge and transfer (or ADT) electronicforms for registration and patient identification such as identification (orID) bracelets and patient ID labels.

·       **eForms StationTM** electronic forms library gives immediateaccess to a hospital’s custom library of electronic and printable forms.

·       **Image-InTM Point of Service**image capture system scans****images of typically non-clinical documents such asinsurance cards, driver’s licenses, referral forms, HIPAA notices and the likeand displays them on a desktop paneled window.

·       **Image-In Business**document and form capture system convertspaper-based business documents to electronic records.

·       **Image-In Clinical**medical records scan facility enablesusers to capture fully the entire patient file after discharge.

·       **Image-In Queue**document viewer****enablesadministrators to manage, view, and disseminate electronic documents to theproper departments and/or patient files.

·       **ObjectArchiveTM**electronic archive provides the foundation tosecurely store information designed, developed and captured through any of theOmtool Healthcare Suite products.

We will continue to market these products individuallyas we integrate them into our flagship AccuRoute product line.

*GenifaxTM Enterprise Fax Solution*

OurGenifax product automates and integrates fax communication throughout anenterprise, and integrates with desktop and enterprise software applications.Our Genifax product, coupled with configured hardware components, provides highavailability and high-volume enterprise fax capabilities, incorporatingfeatures and functions that include:

·       Redundancyand failover to ensure availability when fax-based messaging is missioncritical;

·       Approvalworkflow to allow administrative review and approval for both inbound andoutbound activity;

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

·       Anenhanced Web client that enables users to send, receive, manage, and view thestatus of their fax in-boxes and that provides an alternative to e-mail basedforms for organizations wishing to separate e-mail and fax traffic; and

·       Cost-recoverytracking.

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

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Genifax’s private faxfeature makes this product ideal for organizations where confidentiality offaxed documents is either a regulatory requirement or a best practice. Further,our Genifax product is designed to allow an administrator to take advantage ofpassword/security features native to the Windows server operating system toprovide needed protections.

*Other Software*

While we no longeractively market our Genidocs secure document delivery or our Fax Sr. legacynetwork fax product lines, we continue to maintain these product lines and earnrecurring maintenance revenues from our installed base. At this time, however,we do not plan to extend the Fax Sr. product line with new features or newreleases.

**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 of our software productsor sales to existing customers upgrading their information technologyinfrastructure. Where our customers also want fax capabilities, we sellhardware products with our AccuRoute product. We undertake these hardware salesas a convenience to customers, who alternatively can opt to obtain hardwaredirectly from a third-party vendor. The fax boards and fax modems that weresell are not functional without our product software and we are not generallyin the business of selling fax boards and modems. We purchase these hardwareproducts as needed to ship to our customers and we only maintain a minimalinventory of these hardware products.

**StrategicObjectives**

To provide our document and information-handlingsolutions more effectively, we continue to advance our document processingfunctionality while incrementally adding support for electronic informationsystems such as e-mail systems, enterprise content management systems,records management systems, and archival systems. In the coming months, we willembark on integrating our acquired BlueChip’s products into our existing suiteof products.

We aim to extendour position as a provider of enterprise-class document-handling softwaresolutions and become a leading provider of electronic document exchangesolutions that include capture, processing, and distribution of paper orelectronically formatted documents. In order to reinforce the Omtool brand inenterprise-class document handling and exchange solutions, while maintainingour strong position as an enterprise-level fax software provider, we intend totake advantage of our penetration of the legal vertical market, extended ourpresence in the healthcare vertical market, broaden our customer base, industrypartnerships, and extensive knowledge of enterprise content management topursue the following business strategies:

·       *PromoteAccuRoute as a Universal Document Handling Platform**—t*hrough productdevelopment and targeted marketing efforts, establish AccuRoute as a universaldocument handling hub to support virtually all enterprise devices related todocument capture, document management and electronic information systems.

·       *Continue toExtend Product Offerings—*invest in and refine the features andfunctions of our AccuRoute, BlueChip and Genifax products. Specifically, weplan to continue to enhance our document routing, fax and secure-messagingtechnologies, as part of the evolution of our AccuRoute platform in order tokeep pace with customer requirements and, where appropriate opportunitiesexist, to repackage portions of our existing technology to addressopportunities that we believe exist for low-cost, distributed products thatprovide limited document exchange capabilities.

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·       *Integrate Key Portions of BlueChip’s Product Portfolio with AccuRoute*—buildBlueChip’s products into our flagship AccuRoute product line so that we candeliver the functionality of this full suite of products to healthcare andnon-healthcare markets alike.

·       *LeverageInstalled Base of Customers**—*extend our user base and the useof our software applications at our existing customer installations, byexpanding the use of our products across our customers’ organizations as wellas promoting customer adoption of additional Omtool products. In addition, weplan to cross-sell our solutions to both our legacy Omtool customer base andlegacy BlueChip customers, and over time to integrate AccuRoute and BlueChip technologycomponents.

·       *Focus onVertical-Market Opportunities**—target those vertical markets where*ourelectronic document handling solutions have specific applicability, such as thelegal, healthcare, and financial services vertical markets, as well as thecompliance organizations of Fortune 1000 companies.

·       *Continue toPursue Strategic Distribution Relationships—*continue to formstrategic relationships with leading providers of products and services thatcomplement our product offerings, such as our alliances with Ricoh, Xerox andHewlett-Packard Company (“*HP*”), as ameans of market expansion, a solid source of sales leads and exposure of ourproducts to new markets and prospective customers.

·       *ExpandInternational Sales**—*increase the returns on ourinternational presence and investments, primarily in Europe, to address targetmarkets outside of the United States and serve customers that operate on amultinational basis.

**Customer Service**

To help ourcustomers achieve successful deployments of our solutions, our customer serviceorganization provides technical support for all of our products. For anadditional fee at the time of the initial licensing of our products, we providesupport services for an additional period of time—typically 12 months.These support services typically include telephone support and softwareupgrades/updates (such as maintenance releases, minor feature-enhancementreleases, technical bulletins, and replacement of damaged media). Customers mayrenew their support services at their discretion on an annual basis. Wecurrently price our annual support services based on a percentage of ourproduct license fee. We provide additional services on an as-needed. Ourprofessional services include:

·       Sitesurvey, assessment, and recommendations;

·       Training,installation, and integration;

·       AdvantageSupport for maintenance, upgrades, and support; and

·       A full range ofprofessional services, including software customization and consulting.

**Sales and Marketing**

*Sales*

While our products havebroad horizontal applicability through compliance and business-continuityinitiatives, our direct sales efforts remain focused on vertical-specificsolutions, primarily in the legal and healthcare vertical markets withfinancial services and other vertical markets through our strategic partners. TheCompany has historically had a direct sales team that focuses on vertical andhorizontal markets. The direct sales team is comprised of both inside andoutside sales representatives. Inside representatives are primarily sellingover the telephone and outside representatives sell both over the telephone andby traveling to customer sites. Our direct sales efforts are primarily targetedon customers within the United States and Canada. We also maintain a salesoffice in London, England.

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*Indirect Channels*

To complement our direct vertical sales and marketinginitiatives, we align with strategic partners and indirect sales channelpartners such as resellers, systems integrators, and value addeddistributors that can provide access to a broad and horizontal base ofpotential customers. We believe that pursuing arrangements with channelpartners is a more efficient strategy for pursuing horizontal marketopportunities that might otherwise elude a company of our size. To establish astrong reseller channel, we dedicate sales resources specifically to finding,qualifying and managing our channel partners.

We currently have strategic alliances with XeroxCorporation and Ricoh Co., Ltd., providers of digital scanning MFPs that, whencombined with our software products, enable users easily to integrate hardcopydocuments into their electronic workflow. In 2007, we entered into adistribution agreement with HP, authorizing HP to resell and support ourAccuRoute product, which is tightly integrated with HP MFPs. This strategicalliance provides significant added value to users of HP’s MFPs and provides uswith a broad sales channel for our AccuRoute product.

Outside of the UnitedStates, we continue to use independent distributors to promote, license andsupport our products. In addition to our direct sales efforts, we expect tocontinue to market our products through independent distributors in strategicinternational markets. In 2004, 2005 and 2006, sales outside of the UnitedStates (primarily Europe) represented approximately 22 percent, 19 percentand 17 percent, respectively, of total revenue. In 2004, 2005 and 2006, totalrevenue within the United States accounted for 78 percent, 81 percent and 83percent, respectively, of total revenue.

*Marketing*

To support our salesorganization, we will continue to implement comprehensive marketing programsthat promote our products and position us in the enterprise-class documenthandling market. These efforts may include product advertising, publicrelations, trade show participation, educational seminars, direct mail andtelemarketing campaigns (both online and offline), as well as participation inindustry programs and forums.

**Customers**

As of December 31,2006, we had approximately 1,000 active customers worldwide across manyindustries illustrating the cross-industry applicability of our products andservices. No single customer accounted for 10 percent or more of our totalrevenue in 2004, 2005 or 2006.

**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 AccuRoute, BlueChip, and Genifax 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 standards, andthe continued enhancement of existing products. We also continually reviewopportunities to form alliances with third-party vendors of complementarytechnologies and products to enhance the functionality of our product families.We may, based on timing and cost considerations, continue to exploreopportunities to license or acquire 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 expense in2004, 2005 and 2006 was approximately $1.9 million, $2.2 million and$2.8 million, respectively. 

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Sinceour inception, we have not capitalized any software development costs. We planto continue to make significant investments in research and development,expenses comprised primarily of the compensation of skilled engineers,independent contractors and outside vendors.

**Competition**

In both the market forenterprise document handling and in our legacy enterprise fax software market,we face direct competition from independent software vendors as well asindirect competition from large infrastructure, hardware and other vendors thatoffer alternative approaches or that compete for customer visibility,relationships or information technology budgets.

*Enterprise DocumentHandling*

In the market forenterprise document handling where our AccuRoute product competes, we facecompetition from:

·       Originalequipment manufacturer enhanced scanning solutions;

·       Productionscanning devices; and

·       Documentimaging and routing technology from independent software providers.

Most major MFP vendors provide basic scanningcapability with each digital device at little or no cost. Competitors in thisarea include the hardware MFP providers we typically partner with such asRicoh, HP, and Xerox.

The companies that offer large production devicesinclude a few independent software vendors, for example Kofax (a Dicom Group,plc company) and EMC Corporation (formerly Captiva Software), whose businessfocus was initially the high-volume production scanning segment.

In the distributed document capture and deliverymarket in which our AccuRoute software competes, there are a select number ofsoftware providers with competitive products. e-Copy, Inc. also deliversdocument capture products to this marketplace as does Notable Solutions, Inc.Other potential software competitors include Nuance, who is seeking to develop,either through partnerships or internal resources, scan-to-archivecapabilities.

We currently and in the future may face competitionfrom vendors that offer products to address some or all of the components ofthe Healthcare Suite. We believe we uniquely offer products to streamline thedocument workflow at various points of service within a healthcare provider, aswell as providing a complementary distributed document handling solution formanaging document workflows within and throughout the many departments foundwithin a single healthcare provider. However, we face competition to certainaspects of our Healthcare Suite from traditional providers of medicalforms products to the healthcare vertical market . These competitive productsmay include Access EForms (with its Patient Flow product), Perceptive Software(with its Image Now product), Forms Fast (with its FastPrint product line),Standard Register (with its Patient Linkup Enterprise product), and Valco (withits QuickScan product).

We believe that our ability to compete successfully inthe distributed 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 versus performance; timeliness of enhancements and new productreleases by us and our competitors.

The market for client/server computer-based facsimilesolutions is also competitive and is more established and mature than themarkets in which our AccuRoute product competes.

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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 systems or business software applications may bundle competitivefacsimile solutions as part of their broader product offerings.

We believe that ourability to compete successfully in the fax 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/performance; timeliness of enhancements and new productreleases by us and our competitors.

**Proprietary Rights**

We regard our software as a trade secret. We attemptto protect it under applicable intellectual property laws, including copyright,patent, and trade secret laws, employee nondisclosure and assignment ofinvention agreements, and nondisclosure agreements with other businesses,including current and prospective business partners. We have two United Statespatents, three pending United States patent applications, two United Statestrademark registrations, six foreign trademarks, and five United States commonlaw trademarks. We intend to pursue one United States trademark application andone 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 licenses accepted by users as part of the installation process).We do not negotiate these shrink-wrap and click-wrap licenses with individuallicensees and these licensees do not affirmatively sign a license agreementwith us. Instead, these licenses take effect upon the opening by a customer of theproduct package or in connection with the installation of our software. Certainprovisions of these licenses, including provisions protecting againstunauthorized use, copying, transfer, and disclosure of the licensed program,may be unenforceable under the laws of many jurisdictions. Despite our effortsto protect our proprietary rights, unauthorized parties may attempt to copyaspects 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 determine the extent to which piracy of our productsexists, we expect this kind of piracy to be a persistent problem, particularlyin international markets. In addition, the laws of some foreign countries do notprotect our proprietary rights to the same extent as the laws of the UnitedStates. We cannot assure that these protections will be adequate or that ourcompetitors will not independently develop technologies that are substantiallyequivalent or superior to our technologies.

The software industry has seen substantial litigationinvolving intellectual property rights. We cannot assure that we will not bethe 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 assurancesand information as to the origin and ownership of the licensed components. In the future,we may be required to initiate litigation to enforce and protect our tradesecrets, copyrights and other intellectual property rights.

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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,be 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 31,2006, we employed 118 people worldwide. We are not subject to any collectivebargaining agreements, have never experienced a work stoppage and considerour relations with our employees to be good.

**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;changes in the regulatory environment; our expected liquidity and capitalresources and our critical accounting policies) may constitute forward-lookingstatements. These forward-looking statements are neither promises norguarantees, but are subject to risk and uncertainties that could cause actualresults to differ materially from the expectations set forth in theforward-looking statements. Factors that may cause these kinds of differencesinclude, but are not limited to, the factors discussed below and the otherrisks discussed from time to time in our other filings with the Securities andExchange Commission.

***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, sales and/orresearch and development efforts in order to respond to competitive pressures.We cannot be certain that we will be able to obtain additional financing on favorableterms, if at all. We may obtain additional financing by issuing shares of ourcommon stock or other equity securities, which could dilute our existingstockholders. If we cannot raise needed funds on acceptable terms, or at all,we may not be able to develop or enhance our products or respond appropriatelyto competitive pressures, which would seriously harm our business.

***We have experiencedoperating losses and our future operating results are uncertain and difficultto predict.****  *Wehad an operating loss in the years ended December 31, 2006 and 2005 and werecorded an operating profit in the year ended December 31, 2004. Therecan be no assurance that we will be able to increase our level of revenue orbecome profitable again in the future, as our operating history makes theaccurate 

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prediction of futureoperating results difficult or impossible. We do, however, anticipate increasesin operating expenses and, together with any pricing pressures, failure toachieve broader market acceptance of our products and decline in the growthrate of the overall United States economy or our industry in particular, we mayexperience continuing operating losses.

Our AccuRoute product represented 59% and 50% ofsoftware revenue for the years ended December 31, 2006 and 2005,respectively. Our ability to improve our operating results will depend upon,among other things, our ability to increase sales of our AccuRoute, Genifax andBlueChip products to new customers, as well as our ability to increase productpenetration into existing customers. We expanded our strategic focus to includedocument routing and distribution software. To date, we have limited financialand operating data and a limited operating history relevant to this strategy.Accordingly, it is difficult to evaluate the prospects for the level ofacceptance of this strategy. In addition, we plan to continue investingsignificantly in the expansion of our AccuRoute product into new verticalmarkets, primarily by selling directly and indirectly with strategic partnersto the healthcare vertical market and the financial services market by sellingindirectly with strategic partners, in advance of significant related revenuefrom those markets. We cannot predict the timing or level of revenue resultingfrom these investments. Future operating results will depend on many otherfactors, including, without limitation, the degree and rate of growth of themarkets in which we compete; the level of acceptance of the Microsoft operatingsystems; the level of product and price competition; our ability to establishstrategic relationships and develop and market new and enhanced products; ourability to control costs; our ability to expand our direct and indirectdistribution channel sales both domestically and internationally; our abilityto integrate our products, and cross-sell our solutions across vertical marketsand our ability to attract and retain key personnel. As a result, it ispossible that in the future, our operating results will be below theexpectations of public market analysts and investors. In that event, the priceof our common stock would likely be materially adversely affected.

***Our products areconcentrated in the electronic document exchange market and we are dependent onincreased sales of our AccuRoute, BlueChip and Genifax products.***   To date, much of our revenuehas been attributable to licenses of our facsimile-based and document andinformation handling enterprise solutions and related products and services. Weexpect these products and related services to continue to account forsignificant amounts of our future revenue. However, recently, the amount ofrevenue attributable to licenses of these products has declined and there canbe no assurances that this decline will not continue. We introduced our securebusiness-to-business electronic document exchange products, Genidocs andGenifax, to the market in the fourth quarter of 2000. Further, we introducedthe initial version of our proprietary document and routing software, AccuRoute,in the second quarter of 2002 and the current version of that product in thefirst quarter of 2006. We have only recently begun to recognize a significantamount of revenue from our AccuRoute product. We expect AccuRoute to accountfor an increasing portion of future revenue. However, there can be noassurances that our AccuRoute product will be financially successful. 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 

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pace with technologicaldevelopments and respond to evolving end-user requirements. There can be noassurance that we will be successful in developing and marketing new productsor product enhancements on a timely basis, or that new products or productenhancements delivered by us, such as our AccuRoute, BlueChip and Genifaxproducts, will achieve market acceptance. The introduction of productsembodying new technologies and the emergence of new industry standards couldrender our existing products obsolete and unmarketable. From time to time, weand our competitors may announce new products, capabilities or technologiesthat have the potential to replace or shorten the life cycle of our existingproduct offerings. There can be no assurance that announcements of new productofferings by us or our competitors will not cause customers to defer or foregothe licensing of our existing or planned products and have a material adverseeffect on our business, financial condition and results of operations.

***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 we havealready targeted or the financial services and healthcare vertical markets thatwe are currently targeting—were to decline or fail to grow as expected.  ***Wecurrently derive a significant portion of our revenue from licenses of ourAccuRoute product and related services. Sales of AccuRoute were higher in 2006than they were in 2005. Continued market acceptance of our AccuRoute product iscritical to our future success. As a result, any decline in demand for orfailure to maintain broad market acceptance of our AccuRoute product line as aresult of competition, 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 BlueChip’s products in the healthcarevertical market and our AccuRoute product in the legal vertical market or thatour marketing efforts in the financial services and healthcare vertical marketswill be successful. Further, there can be no assurance that any new or enhancedversions of our AccuRoute product will be successful.

***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 2006than they were in 2005 or 2004. Though we expect our sales of our legacy faxproducts to continue to decline in 2007, 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.Our future financial performance will depend in part on new and enhancedversions of our Genifax product. There can be no assurance that we will continueto be successful in marketing our Genifax product or any new or enhancedversions of the Genifax product at expected levels. There can be no assurancethat we will be successful in developing products for new or enhanced operatingsystems such as Microsoft’s Windows 2000, Windows 2003, Windows XP and WindowsVista, or that these systems will not obviate the need for our products. If anynew or enhanced operating system gains widespread use and we fail to developand provide our products for this operating system on a timely basis, ourbusiness, financial condition and results of operations could be materiallyadversely affected.

***We may notsuccessfully complete acquisitions or integrate acquisitions we do make, whichcould impair our ability to compete and could harm our operating results.  ***Wehave (in the case of our recent acquisition of BlueChip) and may continue toaugment 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 

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assure you that we will besuccessful in this regard. We have limited experience in integrating acquiredcompanies into our operations, in expanding the scope of operations of acquiredbusinesses, in managing geographically dispersed operations and in operatinginternationally. In the past, we have incurred one-time costs and expenses inconnection with acquisitions and it is likely that we could incur similarone-time costs and expenses in connection with future acquisitions. Inaddition, we might be required to amortize significant intangible assets inconnection with future acquisitions, which could adversely affect our operatingresults. Further, attractive acquisitions are difficult to identify andcomplete for a number of reasons, including competition among prospectivebuyers and the possible need to obtain regulatory approval. There can be noassurance that we will be able to complete future acquisitions. In order tofinance potential future acquisitions, we may need to raise additional fundseither through public or private financings, including bank borrowings. Anyfinancing, if available at all, may be on terms that are not favorable to us.Finally, we may also issue shares of our common stock to acquire attractivebusinesses, which may dilute our existing stockholders.

***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 futurecapital.***   In November 2006, we received a letterfrom the Listing Qualifications Department of the Nasdaq Stock Market (“*Nasdaq*”) stating that we did not comply with Marketplace Rule 4310(c)(2)(B),which requires issuers on the Nasdaq Capital Market to have (i) a minimumof $2,500,000 in stockholders’ equity (the “*Stockholders’ EquityRequirement*”); (ii) $35,000,000 market value of listedsecurities; or (iii) $500,000 of net income from continuing operations forthe most recently completed fiscal year or two of the three most recentlycompleted fiscal years. We regained compliance with the Stockholders’ EquityRequirement by December 31, 2006, but Nasdaq has indicated to us that itwill continue to monitor our ongoing compliance with the Stockholders’ EquityRequirement. If we fail in the future to comply with the Stockholders’ EquityRequirement or any other listing criteria of the Nasdaq Capital Market, we maybe subject to delisting from the Nasdaq Capital Market and, therefore, 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 commonstock. Furthermore, the delisting of our common stock could significantlyimpair our ability 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.***   We believe that our ability tocompete successfully in the distributed document capture and delivery marketdepends upon a number of factors both within and beyond our control includingproduct performance; reliability and features; ease of use; productscalability; quality of support services; price versus performance; timelinessof enhancements and new product releases by us and our competitors. We expectthis market to mature and become increasingly competitive with successresulting from the formation of critical partnerships and alliances with bothselected hardware and software partners.

The market for client/server computer-based facsimilesolutions is also competitive and is more established and mature than themarkets in which our AccuRoute and Healthcare 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;reliability and features; ease of use; product scalability; quality of supportservices; price/performance; timeliness of enhancements and new product releasesby us and 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, Windows 2003, Windows 2003 and Windows Vista, with features thatappeal to the broadest segment of the electronic document exchange market,which includes fax and all of 

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the other document controland management features that we offer. In addition, providers of operatingsystems or business software applications may bundle competitive facsimilesolutions as part of their broader product offerings.

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.There can be no assurance that our current or potential competitors will notdevelop products 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 industry leaders,market their products more broadly or take advantage of acquisitionopportunities more readily than we can or do. In addition, no assurance can begiven that we will not be required to make substantial additional investmentsin connection with our research, development, engineering, marketing, sales andcustomer service efforts in order to meet any competitive threat, or that thoserequired investments will not have a material adverse effect on our operatingmargins. Changes in governing laws and regulations may also affect our abilityto remain competitive. Increased competition may result in reduction in ourmarket share, pressure for price reductions and related reductions in our grossmargins, any of which could materially adversely affect our ability to achieveour financial and business goals. There can be no assurance that, in thefuture, we will be able to successfully compete against current and futurecompetitors.

***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 can involve delays becausecustomers may implement the products they purchase from us on a large scale,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.Any one or more of these or other factors could have a material adverse effecton our 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. Because we must make these investments in 

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advance of relatedrevenue, any failure of our products to achieve planned levels of acceptancewould have a material adverse effect on our business, financial condition andresults of operations on a quarter-to-quarter basis and overall.

In general, it is difficult for us to forecast revenuebecause the market for, routing and distribution software and enterpriseclient/server facsimile solutions software is evolving rapidly and our salescycle—from the customer’s initial evaluation through purchase of licenses andthe related support services—varies substantially from customer to customer.License fee revenue in any quarter depends on orders received and shipped inthat quarter, with a significant percentage of orders in any quarter arrivingin the last weeks of the quarter. License fee revenue from quarter-to-quarteris difficult to forecast, as no significant order backlog exists at the end ofany quarter because our products typically are shipped upon receipt ofcustomers’ 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 our expectationsof future revenue on a quarterly basis. If actual revenue levels on a quarterlybasis are below our expectations, our results of operations are likely to beadversely affected by a similar amount because a relatively small amount of ourexpense varies with our revenue in the short term.

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.Any failure 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 prospect visits and indirectly throughmarketing channels such as value added resellers (“*VARs*”),systems integrators, distributors and strategic business partners. Although wehave historically focused our efforts on marketing through our direct salesforce, we continue to utilize resources to develop and expand our indirectmarketing channels. There can be no assurance that we will be able to attractand retain a sufficient number of qualified VARs, systems integrators,distributors and strategic business partners, or that those third parties willsuccessfully market our products. In addition, there can be no assurance thatour resellers and strategic business partners will not develop, acquire ormarket computer-based electronic document exchange, document routing anddistribution, document exchange and facsimile products that are competitivewith our products.

The distributor agreements governing our relationshipswith third party distribution chain partners generally do not require theseparties to purchase minimum volumes from us. Further, these relationshipsgenerally may be terminated by either party. There can be no assurance that anyVAR, systems integrator or distributor will continue to represent and sell ourproducts.

We continue to focus on the marketing and sale of ourproducts through leading hardware, computer system and software vendors, suchas HP, Xerox and Ricoh. The development of these relationships requires us tomake significant executive, marketing and product development investments inadvance of establishing the relationship and making our products availablethrough these partners. In addition, these strategic partners have broadproduct portfolios and industry alliances. There can be no assurance that wewill successfully market and sell our products through these strategicchannels.

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The inability to retain our VARs, systems integrators,distributors or strategic business partners, or to motivate these partiesto resell our products, or the development or marketing by VARs, systemsintegrators, distributors or strategic business partners of competitiveofferings, could have a material adverse effect on our business, financialcondition and results of operations.

Selling through indirect channels may limit ourcontacts with our customers, thereby hindering our ability to accurately forecastsales, 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 document andinformation handling solutions and local facsimile product providers in theforeign countries in which we attempt to sell our products. To maintain andgrow our international sales, we need to realize direct sales as well asrecruit and retain additional international resellers and distributors. Therecan be no assurance that we will be able to maintain international sales of ourproducts or that our international distribution channels will be able toadequately market, service and support our products. International operationsgenerally are subject to certain risks, including dependence on independentresellers, fluctuations in foreign currency exchange rates, compliance withforeign regulatory and market requirements, variability of foreign economicconditions and changing restrictions imposed by United States export laws.Additional risks inherent in our international business activities generallyinclude unexpected changes in regulatory requirements, tariffs and other tradebarriers, costs of localizing products for foreign countries, lack ofacceptance of localized products in foreign countries, longer accounts receivablepayment cycles, difficulties in managing international operations, difficultiesin enforcing intellectual property rights and the burdens of complying with awide variety of foreign laws.

We currently have a sales office in the UnitedKingdom. 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.

***Our future successdepends on our ability to manage the growth and expansion of our business.  ******W***e mayexpand our operations, as we anticipate that expansion may be required in orderto address potential market opportunities. In recent periods, we have increasedthe size of our sales and marketing expenditures in order to expand ourbusiness focus and grow our customer base. We expect to continue to invest insales and marketing, as well as research and development, with the goal ofgrowing our market share, vertical market penetration and overall revenue.There can be no assurance, however, that we will be able to complete or managethis expansion successfully or that this expansion will generate sufficient 

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revenue to cover ourcorresponding expenses. In addition, we will need to continue to attract andretain highly qualified technical, sales and managerial personnel. Ourinability to effectively expand operations and manage growth, if any, couldhave a material adverse effect on our business, financial condition and resultsof 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, 2008, 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. During the fiscal year ended December 31, 2006,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 year 2007, we willcontinue expending considerable time, attention and resources to determiningthe strength and effectiveness of our internal control over financial reportingand, 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.Some of the potential risks involved could include, without limitation,management judgments, simple errors or mistakes, willful misconduct regardingcontrols or misinterpretation. Though we believe that our disclosure controlsand procedures and internal control over financial reporting are effective,there can 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.

***We may be unable toadequately protect our proprietary rights.***   Tosucceed, we must adequately protect our proprietary technology. We rely on acombination of patents, copyrights, trademarks and trade secret laws,nondisclosure and other agreements and technical measures to protect ourproprietary technology, but those measures may be insufficient. Our competitorsmay challenge or circumvent the claims in our patents. Our current patents, orany future patents, may never provide us with any competitive advantages. Othermeasures that we take to protect our proprietary technology may not prevent ordeter misappropriation of our technology or the development of technologieswith similar characteristics. Moreover, our use of open systems architecture inthe design of our products may make it easier for competitors to misappropriateor replicate our designs and developments.

***Other companies mayclaim that we infringe their intellectual property or proprietary rights, whichcould cause us to incur significant expenses or be prevented from selling ourproducts.***   Our success depends on our abilityto operate without infringing the patents and proprietary rights of thirdparties. Product development is inherently uncertain in a rapidly evolvingtechnological environment in which there may be numerous patents and pendingpatent applications with regard to similar technologies. Historically, 

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competitors in ourindustry have filed numerous allegations of patent infringement, resulting inconsiderable litigation.

Any litigation,regardless of our success, would probably be costly and require significanttime and attention of our key management and technical personnel. Litigationcould also force us to:

·       stopor delay selling or using products that use the challenged intellectualproperty;

·       paydamages for infringement;

·       obtainlicenses, which may be unavailable on acceptable terms; or

·       redesignproducts or services that use the infringing technology

***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 thissupplier. Instead, we order hardware equipment through purchase orders from timeto time. We do not carry significant inventories of these hardware products anddo not have a guaranteed supply arrangement with this supplier. In 2006, oursole supplier of hardware products was acquired by a third-party. To date, thischange of ownership has not negatively impacted our ability to purchasehardware products from this supplier or the terms under which we make thosepurchases. Were this supplier to raise its prices or refocus its business, wemight be negatively impacted as we would have to develop a new supplyrelationship for these products. Although we believe that we could secure thesehardware products from alternative suppliers, in the event of a disruption ofsupply from this sole supplier, we might not be able to develop an alternativesource in a timely manner or at favorable prices. Even if we were able topurchase these hardware components from alternative sources, we would havelittle 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.Were we unable to provide this hardware to our customers, forcing our customersto buy 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 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 and our BlueChipacquisition. Competition for highly qualified personnel is intense and we havehistorically experienced difficulty in recruiting qualified technicalpersonnel. There can be no assurance that we will be able to retain or continueto hire key technical, sales and managerial personnel in the future.

**Item 2.**                        Properties

Our executive offices arelocated at 6 Riverside Drive, Andover, Massachusetts in a leased facilityconsisting of approximately 44,000 square feet, of which we occupy 38,500square feet and we sublease 5,500 square feet (at market rates) to eSped, Inc.Please see Item 8 of this Current Report on Form 10-K for moredetail on this sublease. The lease expires in April 2016 and we have theoption to terminate the lease after six years upon payment of a penalty. Thisfacility is adequate for our present operations. Additionally, we lease afacility for sales, customer service, accounting and support in London,England, which lease expires on November 14, 2007.

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**Item 3.**                        LegalProceedings

On or about September 15, 2006, J. Patrick Mansfield, a formeremployee of BlueChip, predecessor-in-interest to Omtool Healthcare, LLC, awholly-owned subsidiary of the Company, filed a complaint against BlueChip andWilliam J. Rynkowski, Jr. (together, the “*Defendants*”),BlueChip’s then-current chief executive officer and a current employee anddirector of the Company, with the Massachusetts Superior Court for Essex County(Civil Action No. 6-1756),asserting among other things breach of contract, violations of theMassachusetts Weekly Payment of Wages Act, breach of fiduciary duty,intentional misrepresentation, and breach of covenant of good faith and fairdealing for the alleged failure of Defendants to pay wages allegedly owed to Mr. Mansfield,the alleged failure of Defendants to acknowledge Mr. Mansfield’s allegedownership interest in BlueChip and the alleged improper termination of Mr. Mansfield’semployment.

While management currentlybelieves that resolving the aforementioned legal matter will not have amaterial adverse impact on the Company’s financial position, the litigationnoted above is subject to inherent uncertainties, including the risk of anunfavorable outcome, and management’s view of these matters may change in thefuture. An unfavorable outcome could include monetary damages or, in caseswhere injunctive relief is sought, an injunction prohibiting certain activities.Were an unfavorable final outcome to occur, there exists the possibility of amaterial adverse impact on the Company’s financial position, cash flows andresults of operations for the period in which the effect becomes reasonablyestimable.

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

None.

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**PART II**

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

Since November 26,2002, our Common Stock has been trading on The Nasdaq Capital Market or itspredecessor. The following table sets forth for the periods indicated the highand low bid prices or, on or after August 1, 2006, the high and low salesprices for the common stock as reported by The Nasdaq Capital Market.

| ** **              | ** ** | **Bid or Sales Price** | ** ** |
|-------------------------|------------|---------------------------------------|------------|
| ** **              | ** ** | **High**                              | ** ** | **Low** | ** ** |
| **Quarter ended:**      | ** ** | ** **                            | ** ** | ** ** | ** ** |
| **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 |   |
| **2006**                | ** ** | ** **                            | ** ** | ** ** | ** ** |
| March 31, 2006     |       | $                                     | 7.35       |   | $ | 6.41 |   |
| June 30, 2006      |       | $                                     | 7.19       |   | $ | 4.20 |   |
| September 30, 2006 |       | $                                     | 5.30       |   | $ | 3.28 |   |
| December 31, 2006  |       | $                                     | 5.07       |   | $ | 3.03 |   |

 

On March 21, 2007, the closing price for thecommon stock was $2.45 per share. As of March 21, 2007, there wereapproximately 100 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 10(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 31,2006.

**Recent Sales ofUnregistered 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 (the “*Securities Act*”).

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.

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On April 29, 2004, we filed a registrationstatement related to the shares of our common stock issued and sold in thistransaction. On June 17, 2004, we filed Amendment No. 1 to ourregistration statement on Form S-3. Subsequent to filing a requestfor acceleration, our registration statement on Form S-3 wasdeclared effective on July 22, 2004.

In connection with theclosing of our acquisition of BlueChip, on December 29, 2006, we issued375,331 shares of our common stock to William J. Rynkowski, Jr. as partialconsideration for all of the issued and outstanding shares of stock of BlueChip.We completed this transaction pursuant to Section 4(2) of theSecurities Act.

**Performance graph***

Thefollowing graph compares the percentage change in the cumulative totalstockholder return on the Company’s Common Stock during the period from the December 31,2001 through December 31, 2006 with the cumulative total return on (i) theNasdaq Market Index, and (ii) a broad peer group index prepared by Ipreo,LLC consisting of Nasdaq listed companies grouped under SIC Code 7372.

**COMPARE 5-YEARCUMULATIVE TOTAL RETURNAMONG OMTOOL LIMITED,NASDAQ MARKET INDEX AND SIC CODE INDEX**

****

**ASSUMES $100INVESTED ONDEC. 31, 2001ASSUMES DIVIDEND**

| ** **          | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** |
|---------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| OMTOOL LTD.         |       | 100.00   |       | 37.33    |       | 140.95   |       | 325.33   |       | 267.05   |       | 166.48   |       |
| SIC CODE INDEX      |       | 100.00   |       | 68.53    |       | 87.83    |       | 95.88    |       | 94.39    |       | 108.35   |       |
| NASDAQ MARKET INDEX |       | 100.00   |       | 69.75    |       | 104.88   |       | 113.70   |       | 116.19   |       | 128.12   |       |

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****                   **This* graph is not “solicitingmaterial,” is not deemed filed with the Securities and Exchange Commission andis not to be incorporated by reference in any filing of the Company under theSecurities Act of 1933, as amended, or the Securities Exchange Act of 1934, asamended, whether made before or after the date hereof and irrespective of anygeneral incorporation language in any such filing.

*****            **Cumulative*TotalReturn assumes $100 was invested on December 31, 2001 in the Company’s CommonStock and in the Nasdaq Market Index and Peer Group Index and assurereinvestment of dividends, if any.

The stock price performance shown on the graph aboveis not necessarily indicative of future price performance. Information used inthe graph was obtained from Ipreo, LLC, a source believed to be reliable,however, the Company is not responsible for any errors or omissions in suchinformation.

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**Item 6. SelectedConsolidated Financial Data**

The statement ofconsolidated operations and balance sheet data set forth below for the fiscalyears ended December 31, 2006 and 2005 have been derived from ourconsolidated financial statements, which statements have been audited by Vitale Caturano & Company, Ltd.,independent registered public accounting firm and are included herein. Thestatement of consolidated operations data set forth below for the fiscal yearended December 31, 2004 has been derived from our consolidated financialstatements, which statements have been audited by PricewaterhouseCoopers LLP,independent registered public accounting firm, and are included herein. Thestatements of consolidated operations data set forth below for the fiscal yearsended December 31, 2003 and 2002 and the balance sheet data as of December 31,2004, 2003 and 2002 have been derived from our consolidated financialstatements, which statements have been audited by PricewaterhouseCoopers 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,**                         | ** ** |
|------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                 | ** ** | **2002**                                                           | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                                                 | ** ** | **(in thousands, except per share data)** | ** ** |
| **Statement of Consolidated  Operations Data:**            |       |                                                               |       |   |   |   |   |   |   |   |   |
| Revenue:                                                   |       |                                                               |       |   |   |   |   |   |   |   |   |
| Software license                                           |       | $                                                                  | 4,373      |   | $ | 4,102 |   | $ | 4,505 |   | $ | 4,732 |   | $ | 4,238 |   |
| Hardware                                                   |       | 2,734                                                              |       | 2,767 |   | 3,177 |   | 2,705 |   | 2,086 |   |
| Service and other                                          |       | 7,370                                                              |       | 6,878 |   | 7,108 |   | 6,859 |   | 7,451 |   |
| Total revenue                                              |       | 14,477                                                             |       | 13,747 |   | 14,790 |   | 14,296 |   | 13,775 |   |
| Cost of revenue:                                           |       |                                                               |       |   |   |   |   |   |   |   |   |
| Software license                                           |       | 347                                                                |       | 280 |   | 196 |   | 154 |   | 211 |   |
| Hardware                                                   |       | 1,769                                                              |       | 1,859 |   | 1,944 |   | 1,694 |   | 1,289 |   |
| Service and other                                          |       | 3,282                                                              |       | 3,152 |   | 2,743 |   | 2,782 |   | 3,279 |   |
| Total cost of revenue                                      |       | 5,398                                                              |       | 5,291 |   | 4,883 |   | 4,630 |   | 4,779 |   |
| Gross profit                                               |       | 9,079                                                              |       | 8,456 |   | 9,907 |   | 9,666 |   | 8,996 |   |
| Operating expenses:                                        |       |                                                               |       |   |   |   |   |   |   |   |   |
| Sales and marketing                                        |       | 6,150                                                              |       | 4,745 |   | 4,100 |   | 5,256 |   | 8,215 |   |
| Research and development                                   |       | 2,815                                                              |       | 2,187 |   | 1,937 |   | 2,239 |   | 2,740 |   |
| General and administrative                                 |       | 4,559                                                              |       | 2,948 |   | 2,417 |   | 2,672 |   | 3,444 |   |
| Restructuring costs                                        |       | —                                                             |       | 806 |   | — |   | — |   | — |   |
| Total operating expenses                                   |       | 13,524                                                             |       | 10,686 |   | 8,454 |   | 10,167 |   | 14,399 |   |
| Income (loss) from  operations                             |       | (4,445                                                             | )          | (2,230 | ) | 1,453 |   | (501 | ) | (5,403 | ) |
| Interest and other income,  net                            |       | 181                                                                |       | 140 |   | 140 |   | 186 |   | 139 |   |
| Income (loss) before  provision (benefit) for income taxes |       | (4,264                                                             | )          | (2,090 | ) | 1,593 |   | (315 | ) | (5,264 | ) |
| Provision (benefit) for  income taxes                      |       | 1,255                                                              |       | (144 | ) | (7 | ) | (5 | ) | — |   |
| Net income (loss)                                          |       | $                                                                  | (5,519     | ) | $ | (1,946 | ) | $ | 1,600 |   | $ | (310 | ) | $ | (5,264 | ) |
| Net income (loss) per  share:                              |       |                                                               |       |   |   |   |   |   |   |   |   |
| Basic                                                      |       | $                                                                  | (1.54      | ) | $ | (0.56 | ) | $ | 0.42 |   | $ | (0.08 | ) | $ | (1.31 | ) |
| Diluted                                                    |       | $                                                                  | (1.54      | ) | $ | (0.56 | ) | $ | 0.41 |   | $ | (0.08 | ) | $ | (1.31 | ) |
| Weighted average number  of common shares outstanding:     |       |                                                               |       |   |   |   |   |   |   |   |   |
| Basic                                                      |       | 3,588                                                              |       | 3,494 |   | 3,765 |   | 3,924 |   | 4,025 |   |
| Diluted                                                    |       | 3,588                                                              |       | 3,494 |   | 3,946 |   | 3,924 |   | 4,025 |   |

 

| ** **                                         | ** ** | **December 31,**   | ** ** |
|----------------------------------------------------|------------|-------------------------|------------|
| ** **                                         | ** ** | **2002**                | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                                         | ** ** | **(in thousands)** | ** ** |
| **Consolidated  Balance Sheet Data:**              |       |                    |       |   |   |   |   |   |   |   |   |
| Cash, cash  equivalents and short-term investments |       | $                       | 9,790      |   | $ | 8,242 |   | $ | 10,655 |   | $ | 10,471 |   | $ | 5,469 |   |
| Working capital  (deficit)                         |       | 4,734                   |       | 3,237 |   | 6,862 |   | 6,655 |   | (240 | ) |
| Total assets                                       |       | 12,692                  |       | 10,492 |   | 13,100 |   | 12,669 |   | 14,427 |   |
| Total stockholders’  equity                   |       | 5,334                   |       | 3,439 |   | 6,631 |   | 6,432 |   | 3,187 |   |
|                                                    |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**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**

Two years ago, we introduced AccuRoute 2.0, ourinnovative document handling platform for enterprise document routing, managingthe distributed capture, processing, distribution and archive of both paper andelectronic documents. AccuRoute’s features are horizontal in nature and applyto many different markets—not just the legal vertical market.

Our position in document handling in the legalvertical market will continue to be an area of primary focus for us, but inorder to grow our business, we will expand on this focus. Based on our successin the legal vertical market, the industry accolades about AccuRoute that wecontinue to receive from third parties (including industry experts), and thefact that AccuRoute sales presently represent 59 percent of our softwarelicense revenue, we see a large market opportunity for AccuRoute in othervertical market segments. To this end, we have turned our attention to thehealthcare vertical market, with expansion to the financial services and othervertical markets to come through our strategic partners. In April 2005, we outlined a strategicinitiative to significantly increase our investments in sales and marketing inorder to capitalize on these larger market opportunities and our sales andmarketing expenses increased gradually during the latter half of 2005. 2006was a year of planned investment in sales, marketing, and business developmentefforts targeted at the financial services, healthcare and legal verticalmarkets. Through these efforts, we experienced significant market advancementsin the legal vertical market and also saw our initiatives in developingstrategic relationships begin to bear fruit as evidenced by the fact that wewon the Ricoh and Sun JavaTM Solutions $100,000 Developers Challenge, weintroduced our support for Xerox’s new Extensible Interface Platform, and weentered into a partner relationship with HP through which our products andservices will be available through HP.

While we have invested considerable resources topenetrate further the financial services vertical market and we have createdand are pursuing opportunities within that vertical market, we have found thatsales opportunities for our AccuRoute product in the financial servicesvertical market, though significant, are longer term opportunities. Therefore,while we will continue to pursue these opportunities, primarily working withour large strategic and channel partners, we believe the best opportunities forreplicating our continued success in the legal vertical market is in thehealthcare vertical market. Similar to our views on the legal vertical market,and based on the high level of focus by healthcare providers on electronicmedical records, we see a significant opportunity to present AccuRoute as thesolution of choice to the challenge of how to capture paper documents that areendemic in healthcare systems.

We anticipate that the structure and buying patternsin the healthcare vertical market will present us with more near-termopportunities. Based on this view, in December 2006, we acquired BlueChip,a privately held provider of electronic forms automation, document imaging, andobject archiving solutions for the healthcare vertical market. BlueChipprovides complementary value to us through vertically specific 

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document workflowsolutions for healthcare providers, as well as forms processing and documentarchiving technologies for other markets. Further, BlueChip brings deep domainexpertise and longstanding customer relationships in the healthcare market thatwill help to accelerate our market penetration. We intend to incorporateBlueChip forms automation and document archiving functionalities into our AccuRouteproduct line.

In the coming months, our primary focus will be topenetrate further vertical and geographic markets through sales and marketinginvestments, primarily in the healthcare and legal vertical markets. At thesame time, we will continue to expand our strategic relationships in thosemarkets, the financial services market and other vertical markets. We willcontinue these efforts through both direct sales and growing and deepeningconnections with our strategic and channel partners, all with the goal ofincreasing AccuRoute opportunities in other markets.

Clearly, we have many remaining challenges as we seekto expand our business into new vertical markets, including the challenges ofincreasing our software license revenue from AccuRoute sales to offset declinesin our legacy fax business (including the hardware revenues associated withsuch sales) and improving our results outside of the Americas. As indicated byour operating results for 2006, we continue to invest in direct and indirect salesefforts, as well as marketing efforts, ahead of anticipated revenuesattributable to these expenses.

Sales from our Europeanoperations, which were in a steady decline for several years, have beenrelatively flat for the past four quarters. We remain optimistic that we willsee improvements outside the Americas, but for now, we will rely primarily onour U.S. sales organization for our shorter-term growth. Despite thesechallenges, the recent stabilization of our legacy fax maintenance business andthe continued growth of our AccuRoute business give us confidence that ourcontinued investments are warranted, as we believe they will producesignificant improvements in our financial results over time.

**Products andServices Overview**

We are a provider of document and information-handlingsolutions that control document lifecycles and simplify the integration ofpaper and electronic documents in enterprise information systems. Ourenterprise document-handling platform streamlines the capture, conversion, andcommunication of any combination of paper and electronic information, enablingfast, secure, and simultaneous distribution to multiple destinations inmultiple formats.

AccuRoute, our flagship product, provides faster, moreefficient document workflows, while reducing cost, complexity, and risk oflosing documents. We also include full enterprise fax capabilities integratedwithin our AccuRoute product. These solutions are used worldwide by businessesin document-intensive industries and sectors such as legal, financial services,government, and healthcare that demand secure handling, integration, andtracking of documents in full compliance with a range of regulatoryrequirements.

Companies can deploy our software products onheterogeneous, multi-platform networks, digital scanning devices and MFPs andintegrate them with both desktop and enterprise software applications. Toaddress customer needs, our products are modular and scaleable. As a result,customers can add additional communication capacity through the addition ofsystem components and connectors to keep pace with growing demands. Inaddition, due to this scalable, modular design, customers can add additionalOmtool product servers to a configuration to provide failover redundancy,helping to ensure continuous operation.

Our Genifax product is a multi-tieredclient/server solution for automating and integrating fax communicationthroughout an enterprise. As a component of an enterprise software system, ourGenifax product is deployed on heterogeneous, multi-platform networks andintegrates with desktop and enterprise software applications.

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Our Genidocs product is aclient/server messaging application that enables users to deliver documents—withcomprehensive security and tracking—through the Internet to external parties.Genidocs offers the security features and functionality of traditional, paper-basedcommunications with the speed, efficiency, and cost advantages of electroniccommunications.

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.

We continue to maintainGenidocs and Fax Sr. and earn recurring maintenance revenues from our installedbase. At this time, however, we do not have plans to extend these technologieswith new features or new releases.

We resell certain hardwareproducts (such as intelligent fax boards) from third-party vendors as aconvenience to our customers, who alternatively can opt to obtain hardwaredirectly from a third-party vendor. We sell support contracts for the softwareproducts that we license to our customers and offer certain consulting,training and installation services for our products.

*Products stemming from our acquisition of BlueChip*

Our December 2006acquisition of BlueChip brought us vertically specific document workflowsolutions for healthcare providers, as well as forms processing and documentarchiving technologies for other markets. Further, BlueChip brings deep domainexpertise and longstanding customer relationships in the healthcare verticalmarket that will help to accelerate our market penetration. We intend toincorporate BlueChip’s forms automation and document archiving functionalitiesinto our AccuRoute product line.

Thisacquisition will enable us to extend our AccuRoute product line to include theBlueChip solutions for document imaging and workflow systems for hospitaladmissions and billing functions, as well as BlueChip’s document archiveproduct. The end result will be a more complete suite of products that arewell-suited to handle the healthcare document workflow.

·       **ADT eFormsTM**a production system****thatprovides hospitals with on-demand ADT (admissions, discharge and transfer)electronic forms for registration and patient identification.

·       **eForms StationTM** an electronic forms library****that gives immediate access to a hospital’s custom libraryof electronic and printable forms.

·       **Image-InTM Point of Service**an image capture system thatscans****images of typically non-clinicaldocuments such as insurance cards, driver’s licenses, referral forms HIPAA noticesand the like and displays them on a desktop paneled window.

·       **Image-In Business**a document and form capture system thatconverts paper-based business documents to electronic records

·       **Inage-In Clinical** a medical records scan facility thatenables users to capture fully the entire patient file after discharge.

·       **Image-In Queue**a document viewer****thatenables administrators to manage, view, and disseminate electronic documents tothe proper departments and/or patient files.

·       **AccuRoute** a document-handling platform that supportsdistributed document capture for scanning, routing, and archiving medicalinformation throughout the patient service cycle and provides documentdistribution into the document workflow products found in Omtool’s HealthcareSuite.

·       **ObjectArchiveTM**an electronic archive that provides the foundation to securely storeinformation designed, developed and captured through any of the OmtoolHealthcare Suite products.

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**Recent Acquisition**

On December 29, 2006,we acquired all of the outstanding shares of BlueChip for $562,090 in cash,$1,683,702 in a promissory note issued to BlueChip’s sole shareholder (“*Seller*”), 375,331 shares of the Company’s common stock(valued at $1,478,804), the issuance of options to purchase the Company’scommon stock in substitution for outstanding BlueChip stock options (valued at$368,090), and direct acquisition costs of $456,793, which consisted primarilyof financial advisory, legal and accounting services. The cash portion of thedeal consideration was paid in early January 2007. We acquired BlueChip, aprovider of electronic forms automation, document imaging, and object archivingsolutions for the healthcare vertical market, in order to strengthen and expandour presence in the healthcare vertical market.

**Headquarters LeaseArrangements**

In January 2006, weentered into a new lease agreement for approximately 44,000 square feet ofoffice space. We moved our headquarters to this facility in Andover,Massachusetts at the end of April 2006. The lease has a ten-year term andwe have an option to renew the lease for an additional five-year term at thethen-applicable fair market rent. Under the terms of the lease, we receivedfree rent for the first six months and the landlord provided us with a tenantimprovement allowance of up to $308,000, which we have fully utilized as of December 31,2006. Additionally, we have a one-time right to terminate the lease, upontwelve months’ written notice, after the sixth year of the lease term. If wedecide to terminate the lease, we must pay a penalty of nine months’ rent andthe unamortized portion of the tenant improvement allowance. We believe the newfacility will be suitable and sufficient for our needs for the foreseeablefuture, including after we consolidate BlueChip’s operations and employees intoour facilities in Andover, Massachusetts.

**Critical AccountingPolicies 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 ofcontingent assets and liabilities as of the date of the financial statementsincluded herein and the reported amounts of revenue and expenses during theperiod covered by this report. There can be no assurance that actual resultswill not differ 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 consultingrevenue. We license our software products on a perpetual basis. We generaterevenue from licensing the rights to use our software products and sales ofhardware directly to end-users and indirectly through resellers. Our resellersorder products from us based on purchase orders received from end-users and donot order 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 and support, installation, training andconsulting services to end-users and indirectly through resellers.

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We apply the provisions of Statement of Position (“*SOP*”) 97-2,**“*SoftwareRevenue Recognition*,” as amended by SOP 98-9,Modification of SOP 97-2,**“*SoftwareRevenue Recognition with Respect to Certain Transactions*” (“*SOP 98-9*”), to all transactions involving the sale ofmultiple elements including software, hardware and service revenue. We applythe provisions of Statement of Financial Accounting Standards (“*SFAS*”) 48,**“*RevenueRecognition When Right of Return Exists*,” with respect toproviding for potential future product returns. As described below, we must makeand use significant judgments and estimates in connection with the revenuerecognized in any accounting period. Material differences may have resulted inthe amount and timing of our revenue if we had made different judgments orutilized 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 probable and there areno uncertainties regarding customer acceptance. We maintain a reserve forpotential product returns. We sell monthly, annual and multiple-yearmaintenance contracts and the associated revenue is recognized over the term ofthe related maintenance period, beginning on the date of delivery. We recognizeother service revenue as we perform the associated services. If an arrangementincludes an acceptance provision and acceptance is uncertain, then we willdefer all revenue until the customer accepts the products purchased. Acceptancein these instances generally occurs upon the earlier of receipt of a writtencustomer acceptance or expiration of the acceptance period. If an arrangementincludes an acceptance provision tied to determination that our product meetspublished specifications and there are no uncertainties with regard to thecustomer’s acceptance, then we will recognize revenue at the time of sale,provided that all of the other previously mentioned revenue recognitioncriteria have been met and the acceptance period is of short duration.

Our transactions frequently involve the sale ofsoftware, hardware and related services under multiple element arrangements.Revenue under multiple element arrangements is allocated to each element underthe residual method, in accordance with SOP 98-9. Under this method,revenue is allocated first to all undelivered elements, such as services, basedon the fair value of those elements, which is calculated to be the pricecharged when these elements are sold separately and unaccompanied by otherelements. Our services generally are not essential to the functionality of thesoftware, as these services do not alter the capabilities of the software anddo not carry a significant degree of risk to perform. The amount allocated tothe delivered elements, such as software license and hardware revenue, is thedifference between the total arrangement value and the amount allocated to theundelivered elements. If the delivered elements include both software andhardware, the amount allocated to hardware revenue is based on the pricecharged to us by the third party vendor plus an additional mark up, with theremainder allocated to software revenue. To the extent that a discount isoffered in the arrangement, the entire discount is allocated to the deliveredelement or elements. If the delivered elements include hardware and software,the discount is allocated to the hardware and software based on theirrespective list prices.

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

At the time of a transaction, we assess whether thefee associated with the transaction is fixed or determinable and whether or notcollection is probable. If a significant portion of a fee is due beyond ournormal payment terms, which are thirty to sixty days from invoice date, weaccount for the fee as not being fixed or determinable. In these cases, werecognize revenue as the fees become due. We assess collection based on anumber of factors, including past transaction history with the customer and thecredit-worthiness of the customer. We review Dunn & Bradstreet creditreports 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 

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customers. If we determinethat collection of a fee is not reasonably assured, the fee is deferred andrevenue is recognized at the time collection becomes probable, which isgenerally upon receipt of 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 accountingperiod. Material differences may have resulted in the amount and timing ofrevenue for this or any prior period if we made different judgments or utilizeddifferent estimates.

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 $14,000 and $33,000 at December 31, 2006 and December 31, 2005,respectively. Both components of calculating the estimated reserve—specificidentification and historic experience—are material judgments that we make. Webase these judgments on historic trends, taking into consideration currentbusiness and economic conditions, which could change materially, thus changingthe required reserve level materially. The potential change to the size of ourrequired reserve could be positive, in the event the reserve estimate provesunnecessary, 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 86,**“*Accounting for the Costs of Computer Software To BeSold, Leased or Otherwise Marketed*.” We sell software in amarket that is subject to rapid technological change, new product introductionsand changing 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.

*Goodwilland Intangible Assets.**  *Weaccount for goodwill in accordance with SFAS 142 “*Goodwill andOther Intangible Assets*”. Goodwill represents the excess of purchaseprice in a business combination over the fair value of net tangible andintangible assets acquired. In accordance with SFAS 142, goodwill amounts arenot amortized, but rather are tested for impairment at least annually.Intangible assets that are not considered to have an indefinite useful life areamortized over their useful lives, which range from three to ten years.

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We account for intangible assets in accordance withSFAS 144 *“Accounting for the Impairment or Disposal ofLong-Lived Asset”*. Intangible assets include customer contracts andrelationships, purchased technology, trade names and non-compete agreements.The carrying amount of the intangible assets is reviewed whenever events orchanges in circumstances indicate that the carrying value of an asset may notbe recoverable. Recoverability of these intangible assets is measured bycomparison of the carrying amount of the asset to the future undiscounted cashflows the asset is expected to generate. If the intangible asset is consideredto be impaired, the amount of any impairment is measured as the differencebetween the carrying value and the fair value of the impaired asset.

We account for business combinations in accordancewith SFAS 141, “*Business Combinations*”**(“*SFAS 141*”),which requires the use of the purchase method of accounting for businesscombinations. In accordance with SFAS 141, we determine the recognition ofintangible assets based on the following criteria: (i) the intangibleasset arises from contractual or other rights; or (ii) the intangible isseparable or divisible from the acquired entity and capable of being sold,transferred, licensed, returned or exchanged. In accordance with SFAS 141,we allocate the purchase price of our business combinations to the tangibleassets, liabilities and intangible assets acquired, including in-processresearch and development (“*IPR&D*”),based on their estimated fair values. The excess purchase price over those fairvalues is recorded as goodwill.

*StockBased Compensation.**  *Prior toJanuary 1, 2006, we accounted for our stock-based compensation foremployees under Accounting Principles Board (“*APB*”)Opinion 25, “*Accounting for Stock Issued toEmployees*” andrelated interpretations and followed the disclosure-only alternative under SFAS123, “*Accounting for Stock-BasedCompensation*,” as amended by SFAS 148, “*Accounting for Stock-Based Compensation—Transition and Disclosure*,” for options granted using theBlack-Scholes option pricing model.

Effective January 1, 2006, we adopted theprovisions of SFAS 123R, “*Share-Based Payment*”**(“*SFAS 123R*”),using the modified prospective method. SFAS 123R requires us to measure thecost of employee services in exchange for an award of an equity instrumentbased on the grant-date fair value of the award and to recognize expense overthe requisite service period. Under the modified prospective method, financialstatements for periods prior to the date of adoption are not adjusted for thechange in accounting, thus, prior period financial statements have not beenrestated. However, compensation expense is recognized for (a) allshare-based payments granted after the effective date and (b) all awardsgranted to employees prior to the effective date that remain unvested on theeffective date. Based upon historical information and management’s estimate offuture voluntary turnover rates, we have calculated our stock basedcompensation expense using an annualized estimated forfeiture rate of 10%. Estimatedforfeitures are trued-up to actual at the end of each reporting period.

On November 10, 2005, the Financial AccountingStandards Board (“*FASB*”) issued FASB Staff PositionFAS 123R-3 “*Transition Election Related to Accountingfor Tax Effects of Share-Based Payment Awards.”* The Company haselected to adopt the alternative transition method provided the FASB StaffPosition for calculating the tax effects (if any) of stock-based compensationexpense pursuant to SFAS 123R. The alternative transition method includessimplified methods to establish the beginning balance of the additional paid-incapital pool related to the tax effects of employee stock-based compensation,and to determine the subsequent impact to the APIC pool and the consolidatedstatements of operations and cash flows of the tax effects of employeestock-based compensation awards that are outstanding upon adoption of SFAS123R.

*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 

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state sales taxliabilities. We include deferred income tax assets and liabilities and accruedstate sales tax liabilities in our balance sheet.

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 thevaluation allowance as an expense or benefit within the tax provision in ourstatement of operations.

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.

**New AccountingPronouncements**

In June 2006, the FASB issued FASB Interpretation48, “*Accounting for Uncertainty in Income Taxes, anInterpretation of FASB Statement No. 109*”**(“*FIN 48*”)*,* whichclarifies the accounting for uncertainty in income taxes recognized in acompany’s financial statements in accordance with SFAS 109 “*Accounting for Income Taxes*”. FIN 48 prescribes arecognition threshold and measurement attribute for the financial statementrecognition and measurement of a tax position taken or expected to be taken ina tax return. FIN 48 becomes effective for fiscal years beginning after December 15,2006. We do not currently expect to elect early adoption of this statement andwe do not expect FIN 48 to have a material impact on our financial position orresults of operations.

In September 2006, the FASB issued Statement 157 “*Fair Value Measurements”*(“*SFAS 157*”),which establishes a framework for measuring fair value in generally acceptedaccounting principles and expands disclosures about fair value financialinstruments. SFAS 157 becomes effective for fiscal years beginning after November 15,2007. We will adopt this statement prospectively once it is effective andapplicable to us. We do not expect SFAS 157 to have a material impact on ourfinancial position or results of operations.

In September 2006, the Securities and ExchangeCommission issued Staff Accounting Bulletin 108 (“*SAB 108*”),which provides guidance on the consideration of the effects of prior yearmisstatements in quantifying current year misstatements for the purpose of amateriality assessment. SAB 108 is effective for fiscal years ending after November 15,2006. The adoption of SAB 108 did not have a material impact on our financialpotion or results of operations.

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**Results ofOperations**

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

| ** **                      | ** ** | **Year ended December 31,** | ** ** |
|---------------------------------|------------|--------------------------------------------|------------|
| ** **                      | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue:                        |       |                                       |       |   |   |   |   |
| Software license                |       | 30.8                                       | %          | 33.1 | % | 30.4 | % |
| Hardware                        |       | 15.1                                       |       | 18.9 |   | 21.5 |   |
| Service and other               |       | 54.1                                       |       | 48.0 |   | 48.1 |   |
| Total revenue                   |       | 100.0                                      |       | 100.0 |   | 100.0 |   |
| Cost of revenue:                |       |                                       |       |   |   |   |   |
| Software license                |       | 1.5                                        |       | 1.1 |   | 1.3 |   |
| Hardware                        |       | 9.4                                        |       | 11.8 |   | 13.2 |   |
| Service and other               |       | 23.8                                       |       | 19.5 |   | 18.5 |   |
| Total cost of  revenue          |       | 34.7                                       |       | 32.4 |   | 33.0 |   |
| Gross profit                    |       | 65.3                                       |       | 67.6 |   | 67.0 |   |
| Operating expenses:             |       |                                       |       |   |   |   |   |
| Sales and marketing             |       | 59.6                                       |       | 36.8 |   | 27.8 |   |
| Research and development        |       | 20.5                                       |       | 15.6 |   | 13.1 |   |
| General and administrative      |       | 24.4                                       |       | 18.7 |   | 16.3 |   |
| Total operating  expenses       |       | 104.5                                      |       | 71.1 |   | 57.2 |   |
| Income (loss)  from operations  |       | (39.2                                      | )          | (3.5 | ) | 9.8 |   |
| Interest and  other income, net |       | 1.0                                        |       | 1.3 |   | 1.0 |   |
| Net income (loss)               |       | (38.2                                      | )%         | (2.2 | )% | 10.8 | % |
| Gross profit:                   |       |                                       |       |   |   |   |   |
| Software license                |       | 95.0                                       | %          | 96.7 | % | 95.7 | % |
| Hardware                        |       | 38.2                                       |       | 37.4 |   | 38.8 |   |
| Service and other               |       | 56.0                                       |       | 59.4 |   | 61.4 |   |

 

Ourrevenue consists primarily of software license revenue, hardware revenue andservice and other revenue, all as further described below. The following tableis a presentation of our total revenue for the twelve months ended December 31,2006, 2005 and 2004, as well as the percentage change year over year:

| ** **               | ** ** | ** **                                               | ** ** | **Percent Change** | ** ** |
|--------------------------|------------|----------------------------------------------------------|------------|-------------------------|------------|
| ** **               | ** ** | **Twelve months ended December 31,** | ** ** | **2006  versus**        | ** ** | **2005  versus** | ** ** |
| ** **               | ** ** | **2006**                                                 | ** ** | **2005**                | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Total revenue            |       | $                                                        | 13,775,222 |                    | $          | 14,296,165 |   | $ | 14,790,194 |   | (3.6 | )% | (3.3 | )% |
| Net income (loss)        |       | $                                                        | (5,263,612 | )                       | $          | (309,751 | ) | $ | 1,599,588 |   | (1,599.3 | )% | (119.4 | )% |
| Software license revenue |       | $                                                        | 4,237,830  |                    | $          | 4,732,121 |   | $ | 4,504,899 |   | (10.4 | )% | 5.0 | % |

 

During 2006, we experienced a decrease in our revenuedue primarily to a decrease in sales for our legacy fax product that impactedboth our software license and hardware revenue. This decrease was, however,partially offset by an increase in our AccuRoute software license revenueduring the same period. Our service and other revenue increased during 2006 ascompared to 2005 as a result of a 73% increase in AccuRoute-related supportservices revenue.

During 2005, we experienced an increase in oursoftware license revenue as a result of continued acceptance of our AccuRouteproduct. We achieved this increase in total software license revenue despite a10% decrease in our legacy fax software license revenue in 2005 as compared to2004. These increase in 

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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. These decreases wereprimarily due to a decrease in sales related to our legacy fax products.

Two years ago, when we introduced AccuRoute 2.0,we made a strategic decision to focus primarily on the legal vertical market. Today,we view this strategy as very successful. Our position in document handling in the legal vertical market will continueto be an area of primary focus for us, but in order to grow our business, wewill expand on this focus.

In April 2005, we outlined a strategic initiativeto significantly increase our investments in sales and marketing in order tocapitalize on these larger market opportunities and our sales and marketingexpenses increased gradually during the latter half of 2005. 2006 was a year ofplanned investment in sales, marketing, and business development effortstargeted at the financial services, healthcare and legal vertical markets. Throughthese efforts, we experienced significant market advancements in the legalvertical market and also saw our initiatives in developing strategicrelationships begin to bear fruit.

While we have invested considerable resources topenetrate further the financial services vertical market and we have createdand are pursuing opportunities within that vertical market, we have found thatsales opportunities for our AccuRoute product in the financial servicesvertical market, though significant, are longer term opportunities. Therefore,while we will continue to pursue these opportunities, primarily working withour large strategic and channel partners, we believe the best opportunities forreplicating our continued success in the legal vertical market is in thehealthcare vertical market. Similar to our views on the legal vertical market,and based on the high level of focus by healthcare providers on electronicmedical records, we see a significant opportunity to present AccuRoute as thesolution of choice to the challenge of how to capture paper documents that areendemic in healthcare systems.

In the coming months, our primary focus will be topenetrate further vertical and geographic markets through sales and marketinginvestments, primarily in the healthcare and legal vertical markets. At thesame time, we will continue to expand our strategic relationships in thosemarkets as well as in the financial services and other vertical markets. Wewill continue these efforts through both direct sales and growing and deepeningconnections with our strategic and channel partners, all with the goal ofincreasing AccuRoute opportunities in other markets.

Thefollowing is a presentation of our domestic and international revenue for thetwelve months ended December 31, 2006, 2005 and 2004, as well as theyear-over-year percentage changes:

|                                | ** ** | ** **                                               | ** ** | **Percent Change** | ** ** |
|--------------------------------|------------|----------------------------------------------------------|------------|-------------------------|------------|
| ** **                     | ** ** | **Twelve months ended December 31,** | ** ** | **2006  versus**        | ** ** | **2005  versus** | ** ** |
| ** **                     | ** ** | **2006**                                                 | ** ** | **2005**                | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Total revenue                  |       | $                                                        | 13,775,222 |                    | $          | 14,296,165 |   | $ | 14,790,194 |   | (3.6 | )% | (3.3 | )% |
| United States revenue          |       | $                                                        | 11,502,622 |                    | $          | 11,536,784 |   | $ | 11,502,207 |   | (0.3 | )% | 0.3 | % |
| As a percent of total  revenue |       | 83.5                                                     | %          | 80.7                    | %          | 77.8 | % | 2.8 | percentage | 2.9 | ppt |
|                                |       |                                                     |       |                    |       |   |   |   | points (“ppt”) |   |   |
| Non-United States  revenue     |       | $                                                        | 2,272,600  |                    | $          | 2,759,381 |   | $ | 3,287,987 |   | (17.6 | )% | (16.1 | )% |
| As a percent of total  revenue |       | 16.5                                                     | %          | 19.3                    | %          | 22.2 | % | (2.8 | )ppt | (2.9 | )ppt |

 

We have historically derived a majority of our totalrevenue from sales within the United States. Revenue from outside of the UnitedStates decreased by $487,000 during the twelve months ended December 31,2006 as compared to the same period in 2005. We will continue to leverage ourAccuRoute 

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base in Europe, as well asour indirect channel relationships in Europe, to focus sales resources on thelegal and financial services vertical markets. However, we expect that in theshort-term, US sales are likely to constitute a greater percentage of revenuethan sales outside the US and there can be no assurance that we will be able toincrease international sales of our products and the failure to do so may havea material adverse effect on business, financial condition and results ofoperations.

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.There can 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.

Wewill continue to leverage our existing distribution channels, whereappropriate, to broaden our reach to our target vertical markets and furtherpenetrate our installed base. We are pursuing sales opportunities via oursolution/reseller channels, as well as focusing sales efforts on specificmarket segments, in order to facilitate acceptance of our products. However, asshown in the following table, in recent periods, more of our sales resourceshave been focused on the direct model and we have consequently derived asignificant portion of our revenue from direct sales:

| ** **                                                                                                                         | ** ** | ** **                                               | ** ** | **Percent Change** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                                                                         | ** ** | **Twelve months ended December 31,** | ** ** | **2006  versus**        | ** ** | **2005  versus** | ** ** |
| ** **                                                                                                                         | ** ** | **2006**                                                 | ** ** | **2005**                | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Total software  license and hardware revenue                                                                                       |       | $                                                        | 6,324,187  |                    | $          | 7,437,230 |   | $ | 7,682,242 |   |   | (15.0 | )% |   |   | (3.2 | ) |   |
| Total software  license and hardware revenue from indirect distribution channel sales                                              |       | $                                                        | 2,195,704  |                    | $          | 2,742,598 |   | $ | 2,885,926 |   |   | (19.9 | )% |   |   | (5.0 | )% |   |
| Software license revenue  from indirect distribution channel sales as a percentage of total software  license and hardware revenue |       | 34.7                                                     | %          | 36.9                    | %          | 37.6 | % |   | (2.2 | )ppt |   |   | (0.7 | )ppt |   |

 

**Fiscal Years Ended December 31,2006, 2005 and 2004**

*Revenue*

*SoftwareLicense.**  *Oursoftware license revenue decreased by approximately $494,000 in the twelvemonths ended December 31, 2006, compared to the same period in 2005, dueto a 24% decline in software license revenue for our legacy fax products offsetin part by a 6% increase in our AccuRoute software license revenue. We did nothave any sales of our other software products during the twelve months ended December 31,2006, which reflects our continued focus on the development and sale of ourAccuRoute product.

Our software license revenue increased byapproximately $227,000 in the twelve months ended December 31, 2005 ascompared to the same period in 2004, due to a 36% increase in software licenserevenue from our AccuRoute product. This increase reflected the continued marketacceptance of our AccuRoute product during 2005. This increase was offset inpart by a decline in software license revenue 

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for our legacy faxproducts, as we continued to focus our resources on the expansion of ourAccuRoute product line and we experienced diminished sales from our maturinglegacy fax market. Various other components of software license revenue,including sales returns and allowance adjustments and sales of our othersoftware products such as Genidocs and Swiftwriter, decreased to $17,000 forthe twelve months ended December 31, 2005 as compared to $43,000 duringthe same period in 2004.

Duringthe twelve months ended December 31, 2006, our software license revenue byproduct category, as compared to the same period in 2005 and 2004 was asfollows:

| ** **                          | ** ** | ** **                                               | ** ** | **Percent Change** | ** ** |
|-------------------------------------|------------|----------------------------------------------------------|------------|-------------------------|------------|
| ** **                          | ** ** | **Twelve months ended December 31,** | ** ** | **2006  versus**        | ** ** | **2005  versus** | ** ** |
| ** **                          | ** ** | **2006**                                                 | ** ** | **2005**                | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Total revenue                       |       | $                                                        | 13,775,222 |                    | $          | 14,296,165 |   | $ | 14,790,194 |   | (3.6 | )% |   | (3.3 | )% |   |
| Software license  revenue           |       | $                                                        | 4,237,830  |                    | $          | 4,732,121 |   | $ | 4,504,899 |   | (10.4 | )% |   | 5.0 | % |   |
| AccuRoute license  revenue          |       | $                                                        | 2,481,844  |                    | $          | 2,342,577 |   | $ | 1,727,960 |   | 6.0 | % |   | 35.6 | % |   |
| Legacy fax  license revenue         |       | $                                                        | 1,737,480  |                    | $          | 2,295,196 |   | $ | 2,548,740 |   | (24.3 | )% |   | (9.9 | )% |   |
| Other software  license revenue     |       | $                                                        | —     |                    | $          | 17,444 |   | $ | 43,199 |   | (100.0 | )% |   | (59.6 | )% |   |
| Freight and allowances  for returns |       | $                                                        | 18,506     |                    | $          | 76,904 |   | $ | 185,000 |   | (75.9 | )% |   | (58.4 | )% |   |

 

Thefollowing table presents software license revenue as a percentage of totalrevenue for the twelve months ended December 31, 2006, as compared to thesame period in 2005 and 2004.

| ** **                                              | ** ** | ** **                                               | ** ** | **Percent Change** | ** ** |
|---------------------------------------------------------|------------|----------------------------------------------------------|------------|-------------------------|------------|
| ** **                                              | ** ** | **Twelve months ended December 31,** | ** ** | **2006  versus**        | ** ** | **2005  versus** | ** ** |
| ** **                                              | ** ** | **2006**                                                 | ** ** | **2005**                | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Software license  revenue as a percent of total revenue |       | 30.8                                                     | %          | 33.1                    | %          | 30.5 | % |   | (2.3 | )ppt |   |   | 2.6 | ppt |   |
|                                                         |            |                                                          |            |                         |            |  |  |  |  |  |  |  |  |  |  |

 

During the twelve months ended December 31, 2006,our software license revenue represented a decreased percentage of our totalrevenue compared to same period in 2005 due to a decrease in sales of ourlegacy fax products as discussed above.

During the twelve months ended December 31, 2005compared to the same period in 2004, our software license revenue representedan increased percentage of our total revenue, based on the facts that AccuRoutesoftware license revenue grew during the period and hardware and servicesrevenue declined during that same period.

Theresults for the twelve months ended December 31, 2006, 2005 and 2004demonstrate that our software license revenue continues to shift toward ourAccuRoute product, as displayed in the table below, which summarizes revenuefrom each of our major product lines (excluding freight and allowances forreturns) as a percentage of our total software license revenue:

| ** **                                 | ** ** | ** **                                               | ** ** | **Percent Change** | ** ** |
|--------------------------------------------|------------|----------------------------------------------------------|------------|-------------------------|------------|
| ** **                                 | ** ** | **Twelve months ended December 31,** | ** ** | **2006  versus**        | ** ** | **2005  versus** | ** ** |
| ** **                                 | ** ** | **2006**                                                 | ** ** | **2005**                | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| As a percent of software  license revenue: |       |                                                     |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| AccuRoute software license revenue         |       | 58.6                                                     | %          | 49.5                    | %          | 38.4 | % |   | 9.1 | ppt |   |   | 11.1 | ppt |   |
| Legacy fax software license revenue        |       | 41.0                                                     | %          | 48.5                    | %          | 56.6 | % |   | (7.5 | )ppt |   |   | (8.1 | )ppt |   |
| Other software  license revenue            |       | 0.0                                                      | %          | 0.4                     | %          | 1.0 | % |   | (0.4 | )ppt |   |   | (0.6 | )ppt |   |

 

During fiscal 2006, we did not have a materialreduction in our sales returns and allowance reserve.****Includedin software license revenue for the twelve months ended December 31, 2005 and2004 is a 

35

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reduction of $69,000 and$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 accurately predict the exact mix ofproducts that we will sell in the future, we expect that software licenserevenue will continue to constitute a larger percentage of our total revenue inthe future if demand for our AccuRoute product, which generally does notrequire the purchase of additional hardware, continues to grow and if ourAccuRoute product gains additional market acceptance. Further, we expect thatsoftware license revenue from our AccuRoute product will represent anincreasing percentage of our total software license revenue as we continue tofocus on expanding the market for our AccuRoute product and as revenue from ourlegacy fax products continues to decline.

*Hardware.**  *As shown in the following table,**hardwarerevenue decreased approximately $619,000 during the twelve month period ended December 31,2006 as compared to the twelve month period ended December 31, 2005 due toa decrease in sales of our legacy fax products, which sales are the main driverfor our hardware revenue:

| ** **                     | ** ** | ** **                                               | ** ** | **Percent Change** | ** ** |
|--------------------------------|------------|----------------------------------------------------------|------------|-------------------------|------------|
| ** **                     | ** ** | **Twelve months ended December 31,** | ** ** | **2006  versus**        | ** ** | **2005  versus** | ** ** |
| ** **                     | ** ** | **2006**                                                 | ** ** | **2005**                | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Hardware revenue               |       | $                                                        | 2,086,357  |                    | $          | 2,705,109 |   | $ | 3,177,343 |   |   | (22.9 | )% |   |   | (14.9 | )% |   |
| As a percent of total  revenue |       | 15.1                                                     | %          | 18.9                    | %          | 21.5 | % |   | (3.8 | )ppt |   |   | (2.6 | )ppt |   |
|                                |            |                                                          |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Further, our hardware revenue decreased $472,000during the twelve month period ended December 31, 2005 as compared to thetwelve month period ended December 31, 2004 due to a decrease in sales ofour legacy fax products and an overall decrease in demand from our existingcustomers who have already upgraded information systems hardware in theirworldwide locations.

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 continue toconstitute a smaller percentage of our total revenue.

*Service and Other.**  *Service and other revenue, whichconsists primarily of the sale of support contracts to complement softwareproducts sold to customers and, to a lesser extent, consulting, training andinstallation services, increased approximately $592,000 in the twelve monthsended December 31, 2006 as compared to the same period in 2005. Thisincrease is due primarily to an increase in sales of AccuRoute-related supportservices, which increased by 73% for the twelve months ended December 31,2006 as compared to the same period in 2005. Our fax-related support servicesrevenue remained relatively flat for the period ended December 31, 2006 ascompared to the same period in the prior fiscal year. 

| ** **                     | ** ** | ** **                                               | ** ** | **Percent Change** | ** ** |
|--------------------------------|------------|----------------------------------------------------------|------------|-------------------------|------------|
| ** **                     | ** ** | **Twelve months ended December 31,** | ** ** | **2006  versus**        | ** ** | **2005  versus** | ** ** |
| ** **                     | ** ** | **2006**                                                 | ** ** | **2005**                | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Service and other  revenue     |       | $                                                        | 7,451,035  |                    | $          | 6,858,935 |   | $ | 7,107,952 |   |   | 8.6 | % |   |   | (3.5 | )% |   |
| As a percent of total  revenue |       | 54.1                                                     | %          | 48.0                    | %          | 48.1 | % |   | 6.1 | ppt |   |   | (0.1 | )ppt |   |
|                                |            |                                                          |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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Service and other revenue decreased $249,000 in thetwelve months ended December 31, 2005, as compared to the same period inthe prior fiscal year. This decrease was due primarily to a 19% reduction infax-related support services revenue for the twelve months ended December 31,2005 as compared to the previous year, as most****ofour historic service and other revenue is related to sales of our legacy faxproduct. This fiscal year 2005 decrease was partially offset by increasedoverall service revenue from consulting services for fiscal year 2005, ascompared with the same period in 2004.

We are focused onimproving the renewal rate of software maintenance contracts with our existingcustomer base in the United States, Europe and other non-U.S. locations, and wecontinue to focus our attention on generating additional service and otherrevenue in fiscal 2007.

***Cost of Revenue***

*Software License.**  *Cost of software license revenueconsists primarily of the costs we incur in sublicensing third-party softwareproducts, product media and product duplication. Our software license grossmargin percentage decreased and the cost of software license revenue increasedfor the twelve months ended December 31, 2006 as compared to thecorresponding period in 2005. This increase in absolute dollars and decrease ingross margin percentage was due primarily to increased royalty paymentsassociated with additional third-party software that we incorporated into ourproducts during the third quarter of 2005.

| ** **                        | ** ** | ** **                                               | ** ** | ** **       | ** ** | ** **       | ** ** | **Percent Change** | ** ** |
|-----------------------------------|------------|----------------------------------------------------------|------------|------------------|------------|------------------|------------|-------------------------|------------|
| ** **                        | ** ** | **Twelve months ended December 31,** | ** ** | **2006  versus** | ** ** | **2005  versus** | ** ** |
| ** **                        | ** ** | **2006**                                                 | ** ** | **2005**         | ** ** | **2004**         | ** ** | **2005**                | ** ** | **2004** | ** ** |
| Cost of software  license revenue |       | $                                                        | 210,675    |             | $          | 154,165          |       | $                       | 195,299    |   |   | 36.6 | % |   |   | (21.0 | )% |   |
| Software license gross  margin    |       | 95.0                                                     | %          | 96.7             | %          | 95.7             | %          |                    | (1.7       | )ppt |   |   | 1.0 | ppt |   |
|                                   |            |                                                          |            |                  |            |                  |            |                         |            |  |  |  |  |  |  |  |  |  |

 

Software license gross margin percentage increased andthe cost of software license revenue decreased for the twelve months ended December 31,2005, as compared to the corresponding period in fiscal 2004. This decrease inabsolute dollars and increase in gross margin was due primarily to decreasedroyalty payments associated with sales of royalty-bearing products.

Where necessary or appropriate in order to improve ourproducts, we may license additional third-party software components in thefuture and, therefore, we expect that our software license cost as a percentageof software license revenue may increase slightly in the future.

*Hardware.**  *Cost of hardware revenue consistsprimarily of the costs we incur in purchasing third-party hardware products. Asshown in the following table, during the twelve months ended December 31,2006, we experienced a decrease in our cost of hardware revenue and a slightincrease in our hardware gross margin percentage compared to the twelve monthsended December 31, 2005. This decrease in absolute dollars of the cost ofhardware revenue is due to a decrease in hardware units sold, largelyattributable to the continued decline in sales of our legacy fax product, whichtypically includes hardware, and growth in sales of our AccuRoute product,which typically does not require hardware purchases. The increase in the grossmargin percentage for hardware sales is primarily due to a change in the mix ofparticular hardware products sold.

| ** **                | ** ** | ** **                                               | ** ** | **Percent Change** | ** ** |
|---------------------------|------------|----------------------------------------------------------|------------|-------------------------|------------|
| ** **                | ** ** | **Twelve months ended December 31,** | ** ** | **2006  versus**        | ** ** | **2005  versus** | ** ** |
| ** **                | ** ** | **2006**                                                 | ** ** | **2005**                | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Cost of hardware  revenue |       | $                                                        | 1,289,395  |                    | $          | 1,694,407 |   | $ | 1,944,293 |   |   | (23.9 | )% |   |   | (12.8 | )% |   |
| Hardware gross margin     |       | 38.2                                                     | %          | 37.4                    | %          | 38.8 | % |   | 0.8 | ppt |   |   | (1.4 | )ppt |   |
|                           |            |                                                          |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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During the twelve months ended December 31, 2005,we incurred decreased costs related to hardware revenue and a decrease in thehardware gross margin compared to the twelve months ended December 31,2004. This decrease in absolute dollars of the cost of hardware revenue was dueprimarily to a decrease in hardware unit sales as a result of the continuedgrowth in sales of our AccuRoute product and continued decline in sales of ourlegacy fax product as described above. The decrease in our gross marginpercentage for hardware sales was primarily due to a change in the mix ofparticular hardware products sold.

We do not expect significant changes in hardware unitprices for fiscal year 2007 as compared to fiscal year 2006.

*Service and Other.**  *Cost of service and other revenueconsists primarily of the costs we incur in providing telephone support for ourproducts, as well as other miscellaneous customer service-related expenses. Asshown in the following tables, our cost of service and other revenue increasedin absolute dollars and the gross margin percentage for service and otherrevenue decreased during the twelve months ended December 31, 2006, ascompared to the same period in 2005, due primarily to an increase in overheadexpenses, including an increase in healthcare costs and additional costsassociated with our new headquarters, as well as an increase in recruiting feesassociated with new employees hired in the service department during theperiod. To a lesser extent and also shown in the table below, our cost ofservice and other revenue increased in the twelve months ended December 31,2006 in absolute terms as a result of an increased wages expense as a result ofthe new employees hired.

| ** **                         | ** ** | ** **                                               | ** ** | **Percent Change** | ** ** |
|------------------------------------|------------|----------------------------------------------------------|------------|-------------------------|------------|
| ** **                         | ** ** | **Twelve months ended December 31,** | ** ** | **2006  versus**        | ** ** | **2005  versus** | ** ** |
| ** **                         | ** ** | **2006**                                                 | ** ** | **2005**                | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Cost of service  and other revenue |       | $                                                        | 3,279,166  |                    | $          | 2,781,828 |   | $ | 2,743,258 |   |   | 17.9 | % |   |   | 1.4 | % |   |
| Service and other gross margin     |       | 56.0                                                     | %          | 59.4                    | %          | 61.4 | % |   | (3.4 | )ppt |   |   | (2.0 | )ppt |   |
|                                    |            |                                                          |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The gross margin percentage for service and otherrevenue decreased for the twelve months ended December 31, 2005, ascompared to the same period in 2004, 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 anysignificant variances in our service and other gross margin percentages forfiscal year 2007, as compared to fiscal year 2006.

***Operating Expenses***

*Sales and MarketingExpenses.**  *Salesand marketing expenses consist primarily of employee salaries, benefits,commissions and associated overhead costs, as well as the cost of marketingprograms such as direct mailings, public relations, trade shows, seminars andrelated communication costs. Consistent with our strategic plan, our sales andmarketing expenses, as shown in the next table, increased $3.0 million in thetwelve months ended December 31, 2006 as compared to the same period in2005, due to an increased number of employees in our sales and marketingdepartments and the associated costs of supporting those employees. To a lesserextent, our sales and marketing expenses increased during the twelve monthsended December 31, 2006 due to higher overhead expenses as a result of anincrease in healthcare costs and additional costs associated with our newheadquarters. Additionally, during 2006, we increased our marketing programexpenditures, including expenditures related to lead generation programs,tradeshows, market research, and public relations during the twelve monthsended December 31, 2006, as compared to the same period in 2005. Theseincreased expenditures reflect our initiative to further market penetration ofour AccuRoute product in the legal vertical market, as well as our initiativeto target new markets, including the healthcare and financial services verticalmarkets. As previously discussed, building on the success of the currentversion of our AccuRoute product within the legal vertical market since itsintroduction in 2004, we intend to continue broadening our current sales andmarketing strategy, which we 

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began in the secondquarter of 2005, to encompass both the healthcare and financial servicesvertical markets. 

| ** **                     | ** ** | ** **                                               | ** ** | **Percent Change** | ** ** |
|--------------------------------|------------|----------------------------------------------------------|------------|-------------------------|------------|
| ** **                     | ** ** | **Twelve months ended December 31,** | ** ** | **2006  versus**        | ** ** | **2005  versus** | ** ** |
| ** **                     | ** ** | **2006**                                                 | ** ** | **2005**                | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Sales and  marketing expenses  |       | $                                                        | 8,214,696  |                    | $          | 5,256,283 |   | $ | 4,100,765 |   |   | 56.3 | % |   |   | 28.2 | % |   |
| As a percent of total  revenue |       | 59.6                                                     | %          | 36.8                    | %          | 27.8 | % |   | 22.8 | ppt |   |   | 9.0 | ppt |   |
|                                |            |                                                          |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Our sales and marketing expenses increased $1.2million in the twelve months 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 thetwelve months ended December 31, 2005 as compared to the same period in2004.

During fiscal year 2007, we expect our investment insales and marketing and business development will remain at the current leveland we expect that these investments will increasingly have a positive impacton our financial results going forward.

*Research and DevelopmentExpenses.**  *Researchand development expenses include expenses associated with the development ofnew products, enhancements of existing products, and quality assuranceactivities. These expenses consist primarily of employee salaries, benefits,associated overhead costs, consulting expenses and the cost of softwaredevelopment tools. In the most recently completed fiscal year, as shown in thefollowing table, our research and development expenses increased byapproximately $581,000 as compared to the same period in the prior fiscal yeardue to an increase in resources allocated to the department resulting inincreased wages expense as well as an increase in consulting costs related toproduct development. To a lesser extent, our research and development expensesincreased during the twelve months ended December 31, 2006 due to anincrease in overhead costs as a result of higher healthcare costs andadditional costs associated with our new headquarters as well as a write-off ofin-process research and development costs associated with the acquisition ofBlueChip.

| ** **                         | ** ** | ** **                                               | ** ** | **Percent Change** | ** ** |
|------------------------------------|------------|----------------------------------------------------------|------------|-------------------------|------------|
| ** **                         | ** ** | **Twelve months ended December 31,** | ** ** | **2006  versus**        | ** ** | **2005  versus** | ** ** |
| ** **                         | ** ** | **2006**                                                 | ** ** | **2005**                | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Research and  development expenses |       | $                                                        | 2,819,750  |                    | $          | 2,239,250 |   | $ | 1,936,779 |   |   | 25.9 | % |   |   | 15.6 | % |   |
| As a percent of total  revenue     |       | 20.5                                                     | %          | 15.7                    | %          | 13.1 | % |   | 4.8 | ppt |   |   | 2.6 | ppt |   |
|                                    |            |                                                          |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Our research and development expenses increasedapproximately $302,000 for the twelve months ended December 31, 2005 ascompared to the same period in 2004 due to an increased number of employees inour research and development department during 2005 and the associated costs ofsupporting those personnel. Additionally, the increase in research anddevelopment expenses in dollars and as a percentage of total revenue is aresult of an increase in consulting expenses in the research and developmentdepartment during the twelve months ended December 31, 2005 as comparedwith the same period in 2004.

We expect that, in fiscal year 2007, our research anddevelopment expenses will remain consistent as a percentage of total revenue,but will increase in absolute dollars due to the increase in the numberemployees in our research and development department as a result of ourrecently completed acquisition of BlueChip.

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*General and AdministrativeExpenses.**  *Generaland administrative expenses consist primarily of employee salaries and benefitsfor administrative, executive, and finance personnel and associated corporategeneral and administrative expenses. As shown in the table below, our general andadministrative expenses increased by approximately $693,000 in the twelvemonths ended December 31, 2006 as compared to the same period in 2005 dueprimarily to an increase in wages expense due primarily to the full year ofexpense in 2006 of Managing Director for our United Kingdom subsidiary who washired in the third quarter of 2005 as well as an increase in stock-basedcompensation expense resulting from the vesting of previous grants ofrestricted stock to employees in the general and administrative department.During the twelve months ended December 31, 2006, as compared to the sameperiod in 2005, we experienced an increase in state sales tax expense. Theincrease results from the fact that we did not settle sales tax obligations inas many states during 2006 as we did during 2005 at amounts less than what wehad estimated. We also experienced increases in accounting and legal expensesduring the twelve months ended December 31, 2006 as a result of increasedsales tax compliance and patent work, which was partially offset by a decreasein professional fees related to compliance with Section 404 of theSarbanes-Oxley Act of 2002.

| ** **                           | ** ** | ** **                                               | ** ** | **Percent Change** | ** ** |
|--------------------------------------|------------|----------------------------------------------------------|------------|-------------------------|------------|
| ** **                           | ** ** | **Twelve months ended December 31,** | ** ** | **2006  versus**        | ** ** | **2005  versus** | ** ** |
| ** **                           | ** ** | **2006**                                                 | ** ** | **2005**                | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| General and  administrative expenses |       | $                                                        | 3,364,491  |                    | $          | 2,671,200 |   | $ | 2,417,091 |   |   | 25.6 | % |   |   | 10.5 | % |   |
| As a percent of total  revenue       |       | 24.4                                                     | %          | 18.7                    | %          | 16.3 | % |   | 5.7 | ppt |   |   | 2.4 | ppt |   |
|                                      |            |                                                          |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

General and administrative expenses increased in bothdollar amount and as a percentage of total revenue for the twelve months ended December 31,2005 as compared to the corresponding period in 2004 due primarily to anincrease in management consulting expenses related to our initial complianceefforts with Section 404 of the Sarbanes-Oxley Act of 2002, fees paid toour board of directors and wage-related expenses. This increase was offset inpart by decreases in accounting and legal fees and by a $356,000 reduction inthe state sales tax accrual for the twelve months ended December 31, 2005compared to a $277,000 reduction in the state sales tax accrual in 2004. Eachof these reductions in our sales tax accrual resulted from our settlement ofsales tax obligations with certain states at an amount less than what we hadestimated. A portion of the 2005 reduction in our sales tax accrual is due tothe fact that we received a refund from a particular state with which we hadpreviously settled state sales taxes and we enrolled in the Streamlined SalesTax Program in December 2005, which relieved us from any past sales taxliabilities from twelve states in which we were not reporting state sales taxesand 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, for those member states of the Streamlined Sales Tax Program, we are nowrequired to pay applicable sales taxes only on a go-forward basis.

We expect our general and administrative expenses toremain consistent as a percentage of total revenue in fiscal 2007 but increasein absolute dollars as a result of the addition of employees to our general andadministrative department due to our recent acquisition of BlueChip.

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*Interest Income andInterest Expense.**  *Interestincome consists principally of interest income earned on cash and cashequivalent balances. Interest expense represents the interest associated with acapital lease that we entered into in May 2006 to finance the purchase offurniture and equipment for our new headquarters. The decrease in interestincome for the twelve months ended December 31, 2006 as compared to thesame period in 2005 is primarily a result of a lower average investment balanceduring the twelve months ended December 31, 2006 as compared to the sameperiod in 2005. The increase in interest expense is due to the interest relatedto the capital lease which we entered into during 2006.

| ** **                                     | ** ** | ** **                                               | ** ** | **Percent Change** | ** ** |
|------------------------------------------------|------------|----------------------------------------------------------|------------|-------------------------|------------|
| ** **                                     | ** ** | **Twelve months ended December 31,** | ** ** | **2006  versus**        | ** ** | **2005  versus** | ** ** |
| ** **                                     | ** ** | **2006**                                                 | ** ** | **2005**                | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Interest income                                |       | $                                                        | 159,450    |                    | $          | 185,725 |   | $ | 140,172 |   |   | (14.1 | )% |   |   | 32.5 | % |   |
| Interest expense                               |       | $                                                        | 20,111     |                    | $          | — |   | $ | — |   |   | — | % |   |   | — | % |   |
| Interest income  as a percent of total revenue |       | 1.0                                                      | %          | 1.3                     | %          | 0.9 | % |   | (0.3 | )ppt |   |   | 0.4 | ppt |   |
| Interest expense as  percent of total revenue  |       | 0.1                                                      | %          | 0.0                     | %          | 0.0 | % |   | (0.1 | )ppt |   |   | 0.0 | ppt |   |

 

Interest income increased for the twelve months ended December 31,2005 as compared to the same period in 2004 due primarily to higher interestrates earned on our investment accounts during the twelve months ended December 31,2005 as compared to the compared to the same period in 2004.

We expect that interest income will remain relativelystable during 2007. We expect interest expense to increase  in fiscal 2007 due to the interest expenseassociated with the promissory note related to the acquisition of BlueChip. Weare required to repay this note over a three-year term commencing on March 30,2007, with interest payable monthly.

*Income Tax Benefit.**  *We did not record an income taxbenefit associated with any pre-tax loss for the twelve months endedDecember 31, 2006 and 2005 due to uncertainty regarding future taxableincome. We did, however, record $5,492 of tax benefit related to the true-up ofcertain income tax accounts during 2005 related to the twelve months endedDecember 31, 2004. During the twelve months ended December 31, 2004,we recorded a net tax benefit of $6,707 resulting primarily from a decrease inour estimated taxes payable as a result of a revised international transferpricing agreement with our United Kingdom subsidiary. Our fiscal year 2004 taxposition also benefited from a $28,800 adjustment related to a transfer pricingadjustment related to fiscal year 2003.

**Inflation**

During the fiscal yearsended December 31, 2006, 2005 and 2004, neither inflation nor changingprices have had a material impact on our net sales, revenue or income fromcontinuing operations.

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**Liquidity andCapital 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 31,2006, we had cash and cash equivalents of $5.5 million and a net workingdeficit of $240,000.  The cash paymentdue to BlueChip’s sole shareholder, in the amount of $562,090 was paid in January 2007**.**We believe that our existing cash and cash equivalentswill be sufficient to meet our working capital, capital expenditures and otherliquidity requirements for at least the next twelve months. 

| ** **                   | ** ** | ** **                                               | ** ** | **Percent Change** | ** ** |
|------------------------------|------------|----------------------------------------------------------|------------|-------------------------|------------|
| ** **                   | ** ** | ** **                                               | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **                   | ** ** | **Twelve months ended December 31,** | ** ** | **versus**              | ** ** | **versus** | ** ** |
| ** **                   | ** ** | **2006**                                                 | ** ** | **2005**                | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Cash (used in) provided  by: |       |                                                     |       |                    |       |   |   |   |   |   |   |
| Operating  activities        |       | $                                                        | (3,881,360 | )                       | $          | (15,867 | ) | $ | 873,297 |   | (24,361.8 | )% | (101.8 | )% |
| Investing  activities        |       | $                                                        | (970,447   | )                       | $          | (120,339 | ) | $ | (73,376 | ) | (706.4 | )% | (64.0 | )% |
| Financing activities         |       | $                                                        | (191,397   | )                       | $          | 38,263 |   | $ | 1,558,356 |   | (600.2 | )% | (97.5 | )% |

 

Our operating activities used cash of $3.9 million and$15,867 for the twelve months ended December 31, 2006 and December 31,2005, respectively, and provided cash of $873,297 for the twelve months ended December 31,2004. We believe that the additional resources we are allocating to improve thepenetration and success of our AccuRoute product in the legal vertical marketand our expansion into the healthcare and financial services vertical marketswill continue to put pressure on our earnings and liquidity during 2007, butthat our existing cash is sufficient for at least the next twelve months.

Net cash used during the twelve months ended December 31,2006 consisted primarily of a net loss from operations, an increase in prepaidexpenses and other current assets, offset in part by an increase in accountspayable and deferred rent as well as the non-cash effects of stock-basedcompensation expense and depreciation.

The increase in prepaid expenses and other currentassets noted above is the result of payments made for third-party royaltyagreements for software licenses and tradeshows. The increase in accountspayable noted above is the result of expenses associated with our acquisitionof BlueChip and the timing of vendor payments. The increase in deferred rent isa result of cash received from a tenant improvement allowance related to ournew headquarters and the six-month free rental period associated with the leasefor our headquarters office space.

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, offset by the non-casheffects of depreciation and stock-based compensation expense, decreases inaccounts receivable and an increase in deferred revenue.

Net cash provided during the twelve months ended December 31,2004 consisted primarily of a net profit from operations and the non-casheffects of depreciation, partially offset by decreases to accruedrestructuring, accrued sales tax and to the accounts receivable reserves.

Investing activities used cash of $970,447 and$120,339 and $73,376 during the twelve months ended December 31, 2006,2005 and 2004, respectively. The primary use of cash for investing activitiesfor the twelve months ended December 31, 2006 was for the purchase ofproperty and equipment for our new headquarters, offset in part by the net cashacquired in connection with our purchase of BlueChip. As noted above, the cashpayment due to BlueChip’s sole shareholder was paid in January 2007. We donot expect to make any significant investments in computer-related software andhardware products during 2007 since we have already improved our informationtechnology infrastructure and facilities during fiscal 2006 as part of therelocation of our headquarters office space. The sole use of cash for thetwelve months 

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ended December 31,2005 and 2004 was for purchases of property and equipment related tocomputer-related software and hardware products.

Financing activities used cash of $191,397 during thetwelve months ended December 31, 2006 and provided cash of $38,263 and$1.6 million for the twelve months ended December 31, 2005 and 2004,respectively. Cash used for the twelve months ended December 31, 2006 wasdue primarily due to the purchase of stock from an unaffiliated stockholder andthe repayment of capital lease obligations. Cash provided for the twelve monthsended December 31, 2005 was due primarily to the net proceeds from theissuance of common stock from our employee stock purchase program and employeeexercises of stock options. Cash provided for the twelve months ended December 31,2004 was due to the net proceeds from an issuance of common stock.  On March 29, 2004 we completed the saleof 600,000 shares of common stock, at a price of $6.00 per share, in a privateplacement to institutional and other accredited investors. The cash we receivedon the consummation of this private placement was offset by our usage of $2.0 millionin cash when we purchased 350,000 shares of our outstanding stock from ASAInternational 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.

Based on our performance for the twelve months ended December 31,2006 and current expectations for fiscal year 2007, we believe that our currentcash and cash equivalents balance, will be sufficient to satisfy our workingcapital needs and other liquidity requirements associated with our operationsthrough at least the next twelve months. We expect that principal uses of cashwill be for operations, amounts due in connection with our acquisition ofBlueChip (including required repayments under the promissory note issued aspart of the acquisition price) and repayment of capital lease obligations.There can be no assurance that any necessary additional financing will beavailable to us on commercially reasonable terms, or at all. The issuance ofadditional equity or equity-related securities would be dilutive to ourstockholders. If we cannot raise funds on acceptable terms, or at all, we maynot be able to develop or enhance our products or respond appropriately to competitivepressures, which would seriously limit our ability to increase our revenue andgrow our business.

Thefollowing table represents the approximate amounts of payments due underspecified contractual obligations as of December 31, 2006:

| **Contractual Obligations**         | ** ** | ** ** | ** ** | **Total** | ** ** | **Less than  one year** | ** ** | **One to  Three years** | ** ** | **Three to  five years** | ** ** | **More than  Five years** | ** ** |
|------------------------------------------|------------|------------|------------|-----------|------------|-----------------------------------|------------|-----------------------------------|------------|------------------------------------|------------|-------------------------------------|------------|
| Capital lease  obligations               |       | $          | 520,767    |      | $          | 520,767                           |       | $                                 | —     |                               | $          | —                              |       | $ | — |   |
| Operating lease  obligation(1)           |       | $          | 4,422,547  |      | $          | 748,405                           |       | $                                 | 816,528    |                               | $          | 834,710                             |       | $ | 2,022,904 |   |
| Note payable                             |       | $          | 1,683,702  |      | $          | 467,695                           |       | $                                 | 1,122,468  |                               | $          | 93,539                              |       | $ | — |   |
| Cash payment owed  to BlueChip Seller(2) |       | $          | 562,090    |      | $          | 562,090                           |       | $                                 | —     |                               | $          | —                              |       | $ | — |   |
| Total contractual  obligations           |       | $          | 7,189,106  |      | $          | 2,298,957                         |       | $                                 | 1,938,996  |                               | $          | 928,249                             |       | $ | 2,022,904 |   |

----

(1)          Excludes sublease rentalincome of $419,150.

(2)          This cash payment wasmade on January 2, 2007.

Operating lease obligations consist of lease paymentsfor our offices in Andover, Massachusetts, London, England, United Kingdom andBlueChip’s former headquarters in Danvers, Massachusetts. The lease in Danvers,Massachusetts terminates in July 2007 and we currently do not have anyplans to renew this lease**.**As of December 31,2006, we did not have any material commitments for capital expenditures orother long-term liabilities for which payments are required.

The Company entered into a capital lease agreement inthe amount of $491,000 on May 1, 2006 to finance the purchase of furnitureand equipment for the Company’s new headquarters located in Andover, 

43

----

Massachusetts. The leasehas a five year term which expires on May 31, 2011 and is payable in 60equal monthly installments. The lease contains a provision whereby the Companywould be required to immediately repay the outstanding principal balance shouldthe Company’s cash balance ever be less than $5.0 million. In January 2007,the Company’s cash balance fell below $5.0 million and therefore the entireprincipal balance of $442,438 may be required to be paid in full in 2007.

The note payable and cashpayment due to the BlueChip Seller are amounts resulting from our acquisitionof BlueChip on December 29, 2006. We issued a promissory note to BlueChip’ssole shareholder on December 29, 2006, which note is payable in 36 monthlyinstallments of $47,000 commencing March 30, 2007. The cash payment due toBlueChip’s sole shareholder, in the amount of $562,090, was paid on January 2,2007.

**Off-Balance SheetArrangements**

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**

**Derivative FinancialInstruments, Other Financial Instruments and Derivative Commodity Instruments**

As of December 31,2006, the Company did not participate in any derivative financial instrumentsor other financial and commodity instruments for which fair value disclosurewould be required under SFAS  133, “Accountingfor Derivative Instruments and Hedging Activities.” All of the 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 RiskExposures**

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. TheCompany’s exposure to currency exchange rate fluctuations has been and isexpected to continue to be modest due to the fact that the operations of itsUnited Kingdom subsidiary are almost exclusively conducted in the UnitedKingdom subsidiary’s local currency. The Company translates the operatingresults of its United Kingdom subsidiary into U.S. dollars and consolidatesthem for reporting purposes. The impact of currency exchange rate movements onintercompany transactions was immaterial for the year ended December 31,2006. The Company manages its foreign currency exchange risk by monitoring itsnet monetary position using natural hedges of its assets and liabilitiesdenominated in local currencies. There can be no assurance that this approachwill eliminate all foreign currency exchange rate exposure. Currently, theCompany does not engage in foreign 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-32,respectively, of this Form 10-K.

44

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**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 31,2006 (the “*Evaluation Date*”), the Company, underthe supervision and with the participation of the Company’s management,including the Company’s Chief Executive Officer and Chief Financial Officer,evaluated the effectiveness of the design and operation of the Company’sdisclosure controls and procedures pursuant to Rule 13a-15(b) promulgatedunder the Securities Exchange Act of 1934, as amended (the “Exchange Act”).Based upon that evaluation, the Company’s Chief Executive Officer and ChiefFinancial 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 inthe Company’s internal control over financial reporting during the Company’sfiscal quarter ended December 31, 2006 or in other factors that havematerially affected, or are reasonably likely to materially affect the Company’sinternal control over financial reporting.

**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 theCommission not later than 120 days after the close of the Company’s fiscalyear ended December 31, 2006.

**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, 2006.

**Item 11.**                 ExecutiveCompensation

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, 2006.

**Item 12.**                 SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters

The information required under this item isincorporated herein by reference to the Company’s definitive proxy statementpursuant to Regulation 14A, to be filed with the Commission not later than120 days after the close of the Company’s fiscal year ended December 31,2006.

45

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**Item13.**                 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, 2006.

**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, 2006.

**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.

(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) |
|             | 2.2        |                                  |   | Agreement and Plan of  Merger, dated November 13, 2006, by and among the Company, Blue Chip  Technologies Ltd., BC Acquisition, Inc., Omtool Healthcare, LLC and  William J. Rynkowski, Jr. (filed as Exhibit 2.1 to the Company’s  Current Report on Form 8-K dated November 13, 2006 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 (filed as  Exhibit 3.3 to the Company’s Annual Report on Form 10-K dated  March 11, 2003 and incorporated herein by reference) |
|             | 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) |

46

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|        | 4.5    |   |   | Registration Rights  Agreement, dated as of December 29, 2006, by and among the Company and  William J. Rynkowski, Jr. (filed as Exhibit 4.1 to the Company’s  Current Report on Form 8-K dated December 29, 2006 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)                                                   |
|   | *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)                                                              |

47

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|        | *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 and incorporated  herein by reference)                                                                                                    |
|   | 10.19  |   |   | Lease Agreement, dated  January 6, 2006, between SFI I, LLC and the Company (filed as  Exhibit 10.1 to the Company’s Current Report on Form 8-K  dated January 6, 2006 and incorporated herein by reference)                                                         |
|   | 10.20  |   |   | Agreement for  Construction Projects, dated January 24, 2006, between the Company and  Prism Builders, Inc. (filed as Exhibit 10.1 to the Company’s  Current Report on Form 8-K dated January 24, 2006 and  incorporated herein by reference)                   |
|   | 10.21  |   |   | Sublease Agreement,  dated July 28, 2006 and effective as of July 1, 2006, by and  between the Company and eSped.com, Inc. (filed as Exhibit 10.1 to  the Company’s Current Report on Form 8-K dated July 28, 2006  and incorporated herein by reference). |
|   | *10.22 |   |   | Employment Agreement,  dated as of December 29, 2006, by and between the Company and William J.  Rynkowski, Jr. (filed as Exhibit 10.1 to the Company’s Current  Report on Form 8-K dated December 29, 2006 and incorporated  herein by reference)              |
|   | 21     |   |   | Subsidiaries of the Company                                                                                                                                                                                                                                                                   |
|   | 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.                                                                                                                           |

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

(b)         Exhibits.

The exhibitsrequired by this Item are listed under Item 15(a)(3).

(c)          Financial StatementSchedules.

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

48

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized, in the Town of Andover,State of Massachusetts, on the 26th day of March 2007.

|          | 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**

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, this report has been signed below by the following persons on behalf ofthe 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 26, 2007 |
| /s/   DANIEL  A. COCCOLUTO |     | Chief Financial  Officer, Secretary and |       |                |
| Daniel  A. Coccoluto                 |     | Treasurer (principal financial and      |       | March 26, 2007 |
|                                 |     | accounting officer)                     |       |                |
| /s/   RICHARD  D. CRAMER   |     | Director                                |       |                |
| Richard D. Cramer                    |     |                                    |       | March 26, 2007 |
| /s/   ARNOLD  E. DITRI     |     | Director                                |       |                |
| Arnold E. Ditri                      |     |                                    |       | March 26, 2007 |
| /s/   WILLIAM  J. DRUMMEY  |     | Director                                |       |                |
| William J.  Drummey                  |     |                                    |       | March 26, 2007 |

49

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| /s/   JAMES  P. O’HALLORAN |   | Director |   |                |
|-------------------------------------------|--------|----------|--------|---------------------|
| James  O’Halloran                    |   |     |   | March 26, 2007 |
| /s/   WILLIAM  J. RYNKOWSKI     |   | Director |   |                |
| William  Rynkowski                        |   |     |   | March 26, 2007 |
| /s/   MARTIN  A. SCHULTZ        |   | Director |   |                |
| Martin A. Schultz                         |   |     |   | March 26, 2007 |

 

50

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**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,  2006 and 2005                                              |       |     | F-4        |   |   |
| Consolidated Statements of Operations for the years  ended December 31, 2006, 2005 and 2004                |       |     | F-5        |   |   |
| Consolidated Statements of Stockholders’ Equity for  the years ended December 31, 2006, 2005 and 2004 |       |     | F-6        |   |   |
| Consolidated Statements of Cash Flows for the years  ended December 31, 2006, 2005 and 2004                |       |     | F-7        |   |   |
| Notes to Consolidated Financial Statements                                                                      |       |     | F-9        |   |   |

 

F-1

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**Reportof Independent Registered Public Accounting Firm**

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

We have audited the accompanying consolidated balancesheets of Omtool, Ltd. and Subsidiaries (the Company) as of December 31,2006 and 2005, and the related statements of operations, stockholders’ equityand cash flows for each of the years in the two year period ended December 31,2006. These financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these financialstatements based on our audits.

We conducted our audits 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. The Company is not required to have, nor were we engaged toperform an audit of its internal controls over financial reporting. Our auditincluded consideration of internal controls over financial reporting as a basisfor designing audit procedures that are appropriate in the circumstances, butnot for the purpose of expressing an opinion on the effectiveness of theCompany’s internal controls over financial reporting. Accordingly, we expressno such opinion. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the consolidated financial statements.An audit also includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor our opinion.

In our opinion, the financial statements referred toabove present fairly, in all material respects, the financial position ofOmtool, Ltd. and Subsidiaries as of December 31, 2006 and 2005, and theresults of its operations and its cash flows for each of the years in the twoyear period ended December 31, 2006 in conformity with accountingprinciples generally accepted in the United States of America.

As discussed in Note 2 tothe consolidated financial statements, the Company adopted the provision ofStatement of Financial Accounting Standard No. 123(R), “Share-BasedPayment”, effective January 1, 2006.

/s/ Vitale, Caturano andCompany, Ltd.

VITALE, CATURANO & COMPANY, LTD.

Boston, MassachusettsMarch 26, 2007

F-2

----

**Reportof Independent Registered Public Accounting Firm**

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

In our opinion, theconsolidated statement of operations, of stockholders’ equity and of cash flowsfor the year ended December 31, 2004 (appearing on pages F-5through F-7 of the Omtool, Ltd. Annual Report on Form 10K) presentfairly, in all material respects, the results of operations and cash flows ofOmtool, Ltd. and its subsidiaries for the year ended December 31, 2004, inconformity with accounting principles generally accepted in the United Statesof America. These financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these financialstatements based on our audit. We conducted our audit of these statements inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements, assessingthe accounting principles used and significant estimates made by management,and evaluating the overall financial statement presentation. We believe thatour audit provides a reasonable basis for our opinion.

/s/PricewaterhouseCoopers, LLP

Boston, MassachusettsMarch 28, 2005

F-3

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**OMTOOL, LTD.AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**

| ** **                                                                                                                                                                                           | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                           | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **ASSETS**                                                                                                                                                                                           | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current assets:                                                                                                                                                                                      |       |                  |       |   |   |
| Cash and cash  equivalents                                                                                                                                                                           |       | $                     | 5,469,366  |   | $ | 10,471,272 |   |
| Accounts receivable, net  of reserves of $14,000 and $33,000 at December 31, 2006 and 2005,  respectively                                                                                       |       | 2,100,266             |       | 1,618,799 |   |
| Unbilled accounts  receivable                                                                                                                                                                        |       | 677,624               |       | — |   |
| Inventory                                                                                                                                                                                            |       | 111,389               |       | 58,380 |   |
| Prepaid expenses and  other current assets                                                                                                                                                           |       | 491,483               |       | 333,419 |   |
| Total current assets                                                                                                                                                                                 |       | 8,850,128             |       | 12,481,870 |   |
| Property and equipment,  net                                                                                                                                                                         |       | 1,525,028             |       | 175,566 |   |
| Goodwill                                                                                                                                                                                             |       | 1,776,051             |       | — |   |
| Intangible assets                                                                                                                                                                                    |       | 1,785,000             |       | — |   |
| Unbilled accounts  receivable, long term                                                                                                                                                             |       | 424,469               |       | — |   |
| Other assets                                                                                                                                                                                         |       | 66,730                |       | 11,562 |   |
|                                                                                                                                                                                                 |       | $                     | 14,427,406 |   | $ | 12,668,998 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                        | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current liabilities:                                                                                                                                                                                 |       |                  |       |   |   |
| Accounts payable                                                                                                                                                                                     |       | $                     | 2,069,727  |   | $ | 905,288 |   |
| Accrued liabilities                                                                                                                                                                                  |       | 1,521,644             |       | 1,513,787 |   |
| Deferred revenue,  current                                                                                                                                                                           |       | 4,026,773             |       | 3,408,002 |   |
| Capital lease  obligations                                                                                                                                                                           |       | 442,438               |       | — |   |
| Amount due to seller  (Note 3)                                                                                                                                                                       |       | 562,090               |       | — |   |
| Note payable, current                                                                                                                                                                                |       | 467,695               |       | — |   |
| Total current  liabilities                                                                                                                                                                           |       | 9,090,367             |       | 5,827,077 |   |
| Long term liabilities:                                                                                                                                                                               |       |                  |       |   |   |
| Deferred rent                                                                                                                                                                                        |       | 498,348               |       | — |   |
| Deferred revenue,  long-term                                                                                                                                                                         |       | 436,086               |       | 410,232 |   |
| Note payable, long-term                                                                                                                                                                              |       | 1,216,007             |       | — |   |
| Total liabilities                                                                                                                                                                                    |       | 11,240,808            |       | 6,237,309 |   |
| Commitments, contingencies and guarantees (Notes 13  and 15)                                                                                                                                         |       |                  |       |   |   |
| 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—4,743,209 and 4,367,878 shares in 2006 and 2005,  respectively, Outstanding—4,432,101 and 3,977,022 shares in 2006 and 2005,  respectively |       | 47,432                |       | 43,679 |   |
| Treasury stock, at cost,  311,108 and 390,856 shares in 2006 and 2005, respectively                                                                                                                  |       | (1,858,435            | )          | (2,005,618 | ) |
| Deferred compensation                                                                                                                                                                                |       | —                |       | (775,865 | ) |
| Additional paid-in  capital                                                                                                                                                                          |       | 36,668,927            |       | 35,556,639 |   |
| Accumulated deficit                                                                                                                                                                                  |       | (31,608,373           | )          | (26,327,762 | ) |
| Accumulated other  comprehensive loss                                                                                                                                                                |       | (62,953               | )          | (59,384 | ) |
| Total stockholders’  equity                                                                                                                                                                     |       | 3,186,598             |       | 6,431,689 |   |
|                                                                                                                                                                                                 |       | $                     | 14,427,406 |   | $ | 12,668,998 |   |

 

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,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                               | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue:                                                 |       |                                        |       |   |   |   |   |
| Software license                                         |       | $                                           | 4,237,830  |   | $ | 4,732,121 |   | $ | 4,504,899 |   |
| Hardware                                                 |       | 2,086,357                                   |       | 2,705,109 |   | 3,177,343 |   |
| Service and other                                        |       | 7,451,035                                   |       | 6,858,935 |   | 7,107,952 |   |
| Total revenue                                            |       | 13,775,222                                  |       | 14,296,165 |   | 14,790,194 |   |
| Cost of revenue:                                         |       |                                        |       |   |   |   |   |
| Software license                                         |       | 210,675                                     |       | 154,165 |   | 195,299 |   |
| Hardware                                                 |       | 1,289,395                                   |       | 1,694,407 |   | 1,944,293 |   |
| Service and other                                        |       | 3,279,166                                   |       | 2,781,828 |   | 2,743,258 |   |
| Total cost of revenue                                    |       | 4,779,236                                   |       | 4,630,400 |   | 4,882,850 |   |
| Gross profit                                             |       | 8,995,986                                   |       | 9,665,765 |   | 9,907,344 |   |
| Operating expenses:                                      |       |                                        |       |   |   |   |   |
| Sales and marketing                                      |       | 8,214,696                                   |       | 5,256,283 |   | 4,100,765 |   |
| Research and development                                 |       | 2,819,750                                   |       | 2,239,250 |   | 1,936,779 |   |
| General and administrative                               |       | 3,364,491                                   |       | 2,671,200 |   | 2,417,091 |   |
| Total operating expenses                                 |       | 14,398,937                                  |       | 10,166,733 |   | 8,454,635 |   |
| Income (loss) from operations                            |       | (5,402,951                                  | )          | (500,968 | ) | 1,452,709 |   |
| Interest income                                          |       | 159,450                                     |       | 185,725 |   | 140,172 |   |
| Interest expense                                         |       | (20,111                                     | )          | — |   | — |   |
| Income (loss) before income tax benefit                  |       | (5,263,612                                  | )          | (315,243 | ) | 1,592,881 |   |
| Income tax  benefit                                      |       | —                                      |       | (5,492 | ) | (6,707 | ) |
| Net income (loss)                                        |       | $                                           | (5,263,612 | ) | $ | (309,751 | ) | $ | 1,599,588 |   |
| Net income (loss) per  share:                            |       |                                        |       |   |   |   |   |
| Basic                                                    |       | $                                           | (1.31      | ) | $ | (0.08 | ) | $ | 0.42 |   |
| Diluted                                                  |       | $                                           | (1.31      | ) | $ | (0.08 | ) | $ | 0.41 |   |
| Weighted average shares  used in per share calculations: |       |                                        |       |   |   |   |   |
| Basic                                                    |       | 4,024,845                                   |       | 3,923,963 |   | 3,764,809 |   |
| Diluted                                                  |       | 4,024,845                                   |       | 3,923,963 |   | 3,946,306 |   |

 

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, 2006, 2005 AND 2004**

| ** **                                                                                                                                   | ** ** | **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, 2003                                                                                                              |       |                       | 3,716,878  |                      |       |                       | 37,169     |           |       |                       | (216,378   | )                      |       | (877,934                 | )          |   | — |   |   | 31,936,038 |   |   | (27,617,599 | ) |   |   | (38,447 | ) |   |   | 3,439,227 |   |   |
| Comprehensive income:                                                                                                                        |       |                       |       |                      |       |                       |       |           |       |                       |       |                   |       |                     |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| 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 common stock                                                                                                          |       |                       | —     |                      |       |                       | —     |           |       |                       | 115,516    |                   |       | 592,665                  |       |   | (910,264 | ) |   | 320,972 |   |   | — |   |   |   | — |   |   |   | 3,373 |   |   |
| Forfeiture of restricted common stock                                                                                                        |       |                       | —     |                      |       |                       | —     |           |       |                       | (1,256     | )                      |       | (6,445                   | )          |   | 7,456 |   |   | (3,241 | ) |   | — |   |   |   | — |   |   |   | (2,230 | ) |   |
| 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 |   |   |
|----------------------------------------------------------------------------------------|--------|--------|-----------|--------|--------|--------|--------|--------|--------|--------|---------|----------|--------|----------|--------|------------|---------|--------|--------|-----------|--------|--------|------------|------------|--------|--------|--------|-------------|--------|--------|------------|--------|---------|---|--------|--------|---|-----------|--------|--------|
| Reclassification of deferred compensation to  additional paid-in capital               |   |   | —    |   |   |   | — |   |   |   | —  |     |   | —   |   |       | 775,865 |   |   | (775,865  | )      |   | —     |       |   |   | — |        |   |   | —     |   |    |
| Comprehensive loss:                                                                    |   |   |      |   |   |   |   |   |   |   |    |     |   |     |   |       |    |   |   |      |   |   |       |       |   |   |   |        |   |   |       |   |    |
| Net loss                                                                               |   |   | —    |   |   |   | — |   |   |   | —  |     |   | —   |   |       | —  |   |   | —    |   |   | (5,263,612 | )          |   |   | — |        |   |   | (5,263,612 | )      |    |
| Change in cumulative translation adjustment                                            |   |   | —    |   |   |   | — |   |   |   | —  |     |   | —   |   |       | —  |   |   | —    |   |   | —     |       |   |   | (3,569 | )           |   |   | (3,569     | )      |    |
| Total comprehensive loss                                                               |   |   | —    |   |   |   | — |   |   |   | —  |     |   | —   |   |       | —  |   |   | —    |   |   | —     |       |   |   | — |        |   |   | (5,267,181 | )      |    |
| Purchase of treasury stock                                                             |   |   | —    |   |   |   | — |   |   |   | (25,000 | )        |   | (137,750 | )      |       | —  |   |   | (26,858   | )      |   | —     |       |   |   | — |        |   |   | (164,608   | )      |    |
| Issuance of common stock and options in acquisition                                    |   |   | 375,331   |   |   |   | 3,753  |   |   |   | —  |     |   | —   |   |       | —  |   |   | 1,843,141 |   |   | —     |       |   |   | — |        |   |   | 1,846,894  |   |    |
| Exercise of stock options and issuance of shares  through Employee Stock Purchase Plan |   |   | —    |   |   |   | — |   |   |   | 6,678   |     |   | 37,506   |   |       | —  |   |   | —    |   |   | (16,999    | )          |   |   | — |        |   |   | 20,507     |   |    |
| Issuance of restricted common stock                                                    |   |   | —    |   |   |   | — |   |   |   | 108,196 |     |   | 1,082    |   |       | —  |   |   | —    |   |   | —     |       |   |   | — |        |   |   | 1,082      |   |    |
| Forfeiture of restricted common stock                                                  |   |   | —    |   |   |   | — |   |   |   | (7,970  | )        |   | (80      | )      |       | —  |   |   | —    |   |   | —     |       |   |   | — |        |   |   | (80        | )      |    |
| Cancellation of restricted stock in payment of  withholding tax requirements           |   |   | —    |   |   |   | — |   |   |   | (2,156  | )        |   | (15,502  | )      |       | —  |   |   | —    |   |   | —     |       |   |   | — |        |   |   | (15,502    | )      |    |
| Stock-based compensation expense                                                       |   |   | —    |   |   |   | — |   |   |   | —  |     |   | 261,927  |   |       | —  |   |   | 71,870    |   |   | —     |       |   |   | — |        |   |   | 333,797    |   |    |
| Balance,  December 31, 2006                                                       |   |   | 4,743,209 |   |   |   | $      | 47,432 |   |   |    | (311,108 | )      |     | $      | (1,858,435 | )       |   | $      | —    |   |   | $          | 36,668,927 |   |   | $      | (31,608,373 | )      |   |       | $      | (62,953 | ) |   |   | $ | 3,186,598 |   |   |

 

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

F-6

----

**OMTOOL, LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS**

| ** **                                                                                                | ** ** | **Years ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Cash Flows from  Operating Activities:                                                                    |       |                                        |       |   |   |   |   |
| Net income (loss)                                                                                         |       | $                                           | (5,263,612 | ) | $ | (309,751 | ) | $ | 1,599,588 |   |
| Adjustments to  reconcile net income (loss) to net cash provided by (used in) operating  activities— |       |                                        |       |   |   |   |   |
| Depreciation                                                                                              |       | 231,794                                     |       | 157,338 |   | 255,649 |   |
| Accounts receivable reserves                                                                              |       | (19,164                                     | )          | (47,806 | ) | (287,692 | ) |
| Stock-based compensation expense                                                                          |       | 333,797                                     |       | 126,943 |   | — |   |
| In-process research and development                                                                       |       | 80,000                                      |       | — |   | — |   |
| Changes in assets  and liabilities, net of amounts acquired—                                    |       |                                        |       |   |   |   |   |
| Accounts receivable                                                                                       |       | (62,748                                     | )          | 205,101 |   | 79,998 |   |
| Prepaid expenses and other current assets                                                                 |       | (158,508                                    | )          | (58,528 | ) | (8,896 | ) |
| Inventory                                                                                                 |       | (32,313                                     | )          | 79,612 |   | (100,193 | ) |
| Other assets                                                                                              |       | (41,568                                     | )          | — |   | 2,400 |   |
| Accounts payable                                                                                          |       | 549,896                                     |       | 62,998 |   | (58,089 | ) |
| Accrued liabilities                                                                                       |       | (26,873                                     | )          | (429,184 | ) | (275,844 | ) |
| Accrued restructuring                                                                                     |       | —                                      |       | — |   | (443,830 | ) |
| Deferred revenue                                                                                          |       | 29,591                                      |       | 197,410 |   | 110,206 |   |
| Deferred rent                                                                                             |       | 498,348                                     |       | — |   | — |   |
| Net cash (used in) provided by operating activities                                                       |       | (3,881,360                                  | )          | (15,867 | ) | 873,297 |   |
| Cash Flows from  Investing Activities:                                                                    |       |                                        |       |   |   |   |   |
| Cash acquired from business acquisition, net of  acquisition costs paid                                   |       | 67,475                                      |       | — |   | — |   |
| Purchases of property and equipment                                                                       |       | (1,037,922                                  | )          | (120,339 | ) | (73,376 | ) |
| Net cash used in investing activities                                                                     |       | (970,447                                    | )          | (120,339 | ) | (73,376 | ) |
| Cash Flows from  Financing Activities:                                                                    |       |                                        |       |   |   |   |   |
| Net proceeds from issuance of common stock and  common stock warrant                                      |       | 20,507                                      |       | 37,120 |   | 3,570,856 |   |
| Net proceeds from issuance of restricted common stock                                                     |       | 1,082                                       |       | 3,373 |   | — |   |
| Forfeiture of restricted common stock                                                                     |       | (80                                         | )          | (2,230 | ) | — |   |
| Purchase of treasury stock                                                                                |       | (164,608                                    | )          | — |   | (2,012,500 | ) |
| Principal payments for capital lease obligations                                                          |       | (48,298                                     | )          | — |   | — |   |
| Net cash (used in) provided by financing activities                                                       |       | (191,397                                    | )          | 38,263 |   | 1,558,356 |   |
| Exchange rate  effect on cash and cash equivalents                                                        |       | 41,298                                      |       | (85,906 | ) | 54,777 |   |
| Net (decrease)  increase in cash and cash equivalents                                                     |       | (5,001,906                                  | )          | (183,849 | ) | 2,413,054 |   |
| Cash and cash  equivalents, beginning of year                                                             |       | 10,471,272                                  |       | 10,655,121 |   | 8,242,067 |   |
| Cash and cash  equivalents, end of year                                                                   |       | $                                           | 5,469,366  |   | $ | 10,471,272 |   | $ | 10,655,121 |   |
| Noncash Investing and  Financing Activities:                                                              |       |                                        |       |   |   |   |   |
| Property and equipment purchased under capital lease                                                      |       | $                                           | 490,736    |   | $ | — |   | $ | — |   |
| Supplemental Disclosure  of Cash Flow Information:                                                        |       |                                        |       |   |   |   |   |
| Cash paid during the period for interest                                                                  |       | $                                           | 20,483     |   | $ | — |   | $ | — |   |
| Cancellation of  restricted common stock in payment of withholding tax requirements                       |       | $                                           | 15,502     |   | $ | — |   | $ | — |   |

 

F-7

----

**OMTOOL, LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)**

OnDecember 29, 2006, the Company acquired the assets and liabilities ofBlueChip Technologies, Inc. as follows (see Note 3)

| ** **                                                              | ** ** | **Years ended December 31,** | ** ** |
|-------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                              | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Accounts  receivable                                                    |       | $                                           | 375,527    |   |   | $ | — |   |   |   | $ | — |   |   |
| Unbilled accounts  receivable                                           |       | 1,102,093                                   |       |   | — |   |   |   | — |   |   |
| Other assets                                                            |       | 24,719                                      |       |   | — |   |   |   | — |   |   |
| Property and  equipment                                                 |       | 49,976                                      |       |   | — |   |   |   | — |   |   |
| Intangible assets                                                       |       | 1,785,000                                   |       |   | — |   |   |   | — |   |   |
| In-process  research and development                                    |       | 80,000                                      |       |   | — |   |   |   | — |   |   |
| Goodwill                                                                |       | 1,776,051                                   |       |   | — |   |   |   | — |   |   |
| Cash acquired  from business acquisition, net of acquisition costs paid |       | 67,475                                      |       |   | — |   |   |   | — |   |   |
|                                                                    |       | 5,260,841                                   |       |   | — |   |   |   | — |   |   |
| Note payable                                                            |       | (2,245,792                                  | )          |   | — |   |   |   | — |   |   |
| Accrued direct  acquisition costs                                       |       | (434,540                                    | )          |   | — |   |   |   | — |   |   |
| Value of common  stock issued                                           |       | (1,478,804                                  | )          |   | — |   |   |   | — |   |   |
| Value of stock  options issued                                          |       | (368,090                                    | )          |   | — |   |   |   | — |   |   |
| Liabilities assumed                                                     |       | $                                           | 733,615    |   |   | $ | — |   |   |   | $ | — |   |   |

 

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

F-8

----

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

**(1) Operations**

Omtool, Ltd. (“*Omtool*” or the “*Company*”) provides document and information handlingsolutions that control document lifecycles and simplify the integration ofpaper and electronic documents in enterprise information systems. The Company’senterprise document handling platform streamlines the capture, conversion andcommunication of any combination of paper and electronic information, enablingfast, secure and simultaneous distribution to multiple destinations in multipleformats.

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.These hardware sales are undertaken as a convenience to customers, whoalternatively can opt to obtain hardware directly from a third-party vendor.The fax boards and fax modems that are resold are not functional without theCompany’s product software and it is not generally in the business of sellingfax boards and modems. The Company purchases these hardware products as neededto ship to its customers and it maintains a minimal inventory of these hardwareproducts.

Service and other revenue has historically consistedprimarily of the sale of support contracts to complement software productslicensed to customers. The Company generates a smaller portion of its serviceand other revenue from consulting, training and installation services.

In December 2006,the Company acquired BlueChip Technologies, Ltd. (“*BlueChip*”),a provider of electronic forms automation, document imaging, and objectarchiving solutions for the healthcare vertical market. The Company intends toincorporate BlueChip forms automation and document archiving functionalitiesinto our AccuRoute product line.

**(2) Summary of SignificantAccounting 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) Principlesof Consolidation*

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

*(b) Revenue Recognition*

The Company derives its revenue from primarily twosources (i) product revenue, which includes software license and hardwarerevenue and (ii) service and support revenue, which includes softwaremaintenance and support, installation, training and consulting revenue. TheCompany licenses its software products on a perpetual basis. The Companygenerates revenue from licensing the rights to use its software products andsales of hardware directly to end-users and indirectly through resellers. TheCompany’s resellers order products from the Company based on purchase ordersreceived from end-users and do not order stock. The Company’s products are soldto resellers and directly to end-users without any specifically stated rightsof return. Occasionally, however, the Company, in its sole discretion, willaccept a product return if the end-user finds that the product does not fit itsneeds. The Company also sells hardware products, which are provided by athird-party, at cost plus an additional mark-up, to end-users and 

F-9

----

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

**(2)Summary of Significant Accounting Policies and Estimates (Continued)**

indirectly throughresellers. The hardware products that are resold are not functional without theCompany’s software. To support its software products, the Company sellssoftware maintenance and support, installation, training and consultingservices to end-users and indirectly through resellers.

The Company appliesthe 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 Certain**Transactions,”*(“*SOP 98-9*”) to alltransactions involving the sale of multiple elements including software,hardware and service revenue. The Company applies the provisions of Statementof Financial Accounting Standards (“*SFAS*”) 48, “*Revenue Recognition When Right of Return Exists*,”with respect to providing for potential future product returns.

The Company recognizes revenue from the sale ofsoftware products and hardware to both end-users and resellers when persuasiveevidence of an arrangement exists, the products have been delivered, the fee isfixed or determinable, collection of the resulting receivable is probable andthere are no uncertainties regarding customer acceptance. The Company maintainsa reserve for potential product returns. The Company sells monthly, annual andmultiple-year maintenance contracts and the associated revenue is recognizedover the term of the related maintenance period, beginning on the date ofdelivery. 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 transactions frequently involve thesales of software, hardware and related services under multiple elementarrangements. Revenue under multiple element arrangements is allocated to eachelement under the residual method, in accordance with SOP 98-9. Underthis method, revenue is allocated first to all undelivered elements, such asmaintenance and services, based on the fair value of those elements, which isthe price charged when these elements are sold separately and unaccompanied byother elements. The Company’s services generally are not essential to thefunctionality of the software as these services do not alter the capabilitiesof the software and do not carry a significant degree of risk to perform. Theamount allocated to the delivered elements, such as software license andhardware revenue, is the difference between the total arrangement value and theamount allocated to the undelivered elements. If the delivered elements includeboth software and hardware, the amount allocated to hardware revenue is basedon the price charged to the Company by the third party vendor plus anadditional mark up, with the remainder allocated to software revenue. To theextent that a discount is offered in the arrangement, the entire discount isallocated 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.

The Company’s currentdeferred revenue and long-term deferred revenue is comprised mainly of revenuethat is deferred for software maintenance and support contracts. The othercomponents of deferred revenue are the amounts from sales transactions thatwere deferred because they did not meet all 

F-10

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

**(2)Summary of Significant Accounting Policies and Estimates (Continued)**

of the provisions of the Company’s revenue recognitionpolicy. At December 31, 2006 and 2005, deferred revenue consisted of thefollowing:

| ** **                                                   | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                   | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Deferred  revenue—licenses, implementation and hardware |       | $                     | 509,942    |   | $ | 15,594 |   |
| Deferred revenue—support  and other services, current   |       | 3,516,831             |       | 3,392,408 |   |
| Deferred revenue—support  and other services, long-term |       | 436,086               |       | 410,232 |   |
|                                                         |       | $                     | 4,462,859  |   | $ | 3,818,234 |   |

 

In March 2006,BlueChip, which was acquired by the Company during 2006 (Note 3), reached asettlement with a customer which resolved certain licensing and servicingissues. As part of this settlement, BlueChip received $4,000,000. Inaddition,  the parties reached anagreement whereby BlueChip will provide maintenance on installed software for aperiod of 4 years. In purchase accounting, the Company recorded the fair valueof the obligation to provide these services as a component of current deferredrevenue and long-term deferred revenue in the accompanying consolidated balancesheet as of December 31, 2006. The present value of the ,maintenanceportion of the settlement has been recorded as current unbilled accountsreceivable and long-term unbilled accounts receivable in the accompanyingconsolidated balance sheet as of December 31, 2006. Current unbilledaccounts receivable and deferred revenue also includes the estimated costs toprovide implementation services not yet performed by BlueChip as of December 31,2006.

***(c) Cost of Sales***

Cost of software licenserevenue consists primarily of the costs incurred for sublicensing third-partysoftware products, product media and product duplication. Cost of hardwarerevenue consists of the costs the Company incurs in purchasing third-partyhardware products including associated shipping and handling costs. Cost ofservice and other revenue consists primarily of the costs incurred forproviding telephone support for the Company’s software license products, aswell as other miscellaneous customer service-related expenses.

***(d) Software Development Costs***

Software development costsare considered for capitalization when technological feasibility is establishedin accordance with SFAS 86, “*Accounting forthe Costs of Computer Software to Be Sold, Leased or Otherwise Marketed.*” The Company sells software in amarket that is subject to rapid technological change, new product introductionsand changing customer needs. Accordingly, the Company has determined that itcannot determine technological feasibility until the development state of theproduct is nearly complete. The time period during which costs could becapitalized from the point of reaching technological feasibility until the timeof general product release is very short and, consequently, the amounts thatcould be capitalized are not material to the Company’s consolidated financialposition or results of operations. Consequently, no amounts have beencapitalized.

F-11

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

**(2)Summary of Significant Accounting Policies and Estimates (Continued)**

***(e) Cash and Cash Equivalents***

The Company considers allhighly liquid investments with original maturities of three months or less tobe cash equivalents. Cash equivalents were approximately $4,493,000 and$6,945,000 at December 31, 2006 and 2005, respectively. Cash equivalentsat December 31, 2006 and 2005 primarily consisted of investments in moneymarket funds.

***(f) Advertising Expense***

TheCompany recognizes advertising expense as incurred. For the years ended December 31,2006, 2005 and 2004, the Company recognized approximately $41,000, $196,000 and$64,000, respectively, as advertising expense.

***(g) Inventory***

Inventoryconsists of circuit boards and media purchased from third-party vendors, all ofwhich are finished goods and are stated at lower of cost or market, with costdetermined on the first-in, first-out basis. The Company reviews its inventoryat the end of each month to ensure that there are no factors that would renderthe inventory excess or obsolete. To determine obsolescence, the Companyconsiders current market conditions as well as specific vendor informationrelated to the hardware products sold by the Company. If inventory isconsidered obsolete, then the Company will write the inventory down to zerovalue.

*(h) Property andEquipment*

Propertyand equipment are stated at cost, net of accumulated depreciation. Depreciationis calculated using straight-line methods over the following useful lives:

| ** **                          | ** ** | ** **                                                      | ** ** | **December 31**                         | ** ** |                                         |
|-------------------------------------|------------|-----------------------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|
| **Asset Classification**       | ** ** | ** **                                                      | ** ** | **Estimated Useful Life**          | ** ** | **2006**                                     | ** ** | **2005** | ** ** |   |
| Computer  equipment                 |       | 1—5  years                                                 |       | $                                            | 551,605    |                                         | $ | 3,193,669 |   |   |
| Computer software                   |       | 2—3  years                                                 |       |        290,291 |       |     1,316,035                 |   |   |
| Equipment under  capital lease      |       | Shorter  of the life of the lease or  the estimated useful life |       | 483,220                                      |       | —                                       |   |   |
| Furniture and  fixtures             |       | 5—7  years                                                 |       |        202,699 |       |        923,169 |   |   |
| Leasehold  improvements             |       | Shorter  of the life of the lease or  the estimated useful life |       |        763,254 |       |        231,821 |   |   |
|                                |       |                                                            |       | $                                            | 2,291,069  |                                         | $ | 5,664,694 |   |   |
| Less—Accumulated  depreciation |       |                                                            |       |      (766,041            | )          | (5,489,128                                   | ) |
|                                |       |                                                            |       | $                                            | 1,525,028  |                                         | $ | 175,566 |   |   |
|                                     |            |                                                                 |            |                                              |            |                                              |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

F-12

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

**(2)Summary of Significant Accounting Policies and Estimates (Continued)**

Accumulated depreciationand depreciation expense related to equipment under capital lease wasapproximately $47,000 as of December 31, 2006. The Company did not haveany capital leases for the years ended December 31, 2005 and 2004. Totaldepreciation expense was $231,794, $157,338 and $255,649 for the years ended December 31,2006, 2005 and 2004, respectively. The Company capitalizes expenditures thatmaterially increase asset lives and charges ordinary repairs and maintenance tooperations as incurred.

***(i) Goodwill and IntangibleAssets***

The Company accounts for goodwill in accordance withSFAS 142 “*Goodwill and Other Intangible Assets*”. Goodwillrepresents the excess of purchase price in a business combination over the fairvalue of net tangible and intangible assets acquired. In accordance with SFAS142, goodwill amounts are not amortized, but rather are tested for impairmentat least annually. Intangible assets that are not considered to have anindefinite useful life are amortized over their useful lives, which range fromthree to ten years.

The Companyaccounts for intangible assets in accordance with SFAS 144 *“Accountingfor the Impairment or Disposal of Long-Lived Asset”.*Intangibleassets include customer contracts and relationships, purchased technology,trade names and non-compete agreements. The carrying amount of the intangibleassets is reviewed whenever events or changes in circumstances indicate thatthe carrying value of an asset may not be recoverable. Recoverability of theseintangible assets is measured by comparison of the carrying amount of the assetto the future undiscounted cash flows the asset is expected to generate. If theintangible asset is considered to be impaired, the amount of any impairment ismeasured as the difference between the carrying value and the fair value of theimpaired asset. The Company did not recognize any goodwill or intangible assetimpairment charges in the twelve months ended December 31, 2006.

***(j) Business Combinations***

The Company accounts for business combinations inaccordance with SFAS  141, “*Business Combinations*”**(“*SFAS 141*”),which requires the use of the purchase method of accounting for businesscombinations. In accordance with SFAS 141, the Company determines therecognition of intangible assets based on the following criteria: (i) theintangible asset arises from contractual or other rights; or (ii) theintangible is separable or divisible from the acquired entity and capable ofbeing sold, transferred, licensed, returned or exchanged. In accordance withSFAS 141, the Company allocates the purchase price of its businesscombinations to the tangible assets, liabilities and intangible assetsacquired, including in-process research and development (“*IPR&D*”),based on their estimated fair values. The excess purchase price over those fairvalues is recorded as goodwill.

The Company must make valuation assumptions thatrequire significant estimates, especially with respect to intangible assets.Critical estimates in valuing certain intangible assets include, but are notlimited to future expected cash flows from customer contracts andrelationships, trade names, non-compete agreements and acquired developedtechnologies. The Company estimates fair value based upon assumptions theCompany believes to be reasonable, but which are inherently uncertain andunpredictable and, as a result, actual results may differ from estimates.

F-13

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

**(2)Summary of Significant Accounting Policies and Estimates (Continued)**

***(k) Stock Based Compensation***

Prior to January 1, 2006, the Company accountedfor its stock-based compensation for employees under Accounting PrinciplesBoard (“*APB*”) Opinion 25, “*Accounting for Stock Issued to Employees*” and related interpretations andfollowed the disclosure-only alternative under SFAS 123, “*Accounting for Stock-Based Compensation*,”as amended by SFAS 148, “*Accounting forStock-Based Compensation—Transition and Disclosure*,” for options granted using theBlack-Scholes option pricing model.

Effective January 1, 2006, the Company adoptedthe provisions of SFAS  123R, “*Share-Based Payment*”**(“*SFAS 123R*”), using the modified prospective method. SFAS123R requires the Company to measure the cost of employee services in exchangefor an award of an equity instrument based on the grant-date fair value of theaward and to recognize expense over the requisite service period. Under themodified prospective method, financial statements for periods prior to the dateof adoption are not adjusted for the change in accounting, thus, prior periodfinancial statements have not been restated. However, compensation expense isrecognized for (a) all share-based payments granted after the effectivedate and (b) all awards granted to employees prior to the effective datethat remain unvested on the effective date. As a result of adopting SFAS 123Ras of January 1, 2006, the Company incurred stock-based compensationexpense during the twelve months ended December 31, 2006 of approximately$26,000 for stock options and shares purchased under the employee stockpurchase plan, of which $6,000 is recorded in cost of service and other revenueand $20,000 is recorded in operating expenses. The impact on basic and dilutedand loss per share was ($0.01). The amounts previously shown on the balancesheet as Deferred Compensation have been reclassified to Additional Paid-inCapital in accordance with SFAS 123R.

On November 10,2005, the Financial Accounting Standards Board (“*FASB*”)issued FASB Staff Position SFAS 123R-3 “*TransitionElection Related to Accounting for Tax Effects of Share-Based Payment Awards.”*  The Company has elected to adopt thealternative transition method provided the FASB Staff Position for calculatingthe tax effects (if any) of stock-based compensation expense pursuant to SFAS123R. The alternative transition method includes simplified methods toestablish the beginning balance of the additional paid-in capital pool relatedto the tax effects of employee stock-based compensation, and to determine thesubsequent impact to the additional paid-in capital pool and the consolidatedstatements of operations and cash flows of the tax effects of employeestock-based compensation awards that are outstanding upon adoption of SFAS123R.

The proforma information regarding net loss and lossper share prepared in accordance with SFAS 123, as amended, has been determinedas if the Company had accounted for its employee stock option plan under thefair value method prescribed by SFAS 123 for the years ended December 31,2005 and 2004. The Company did not grant any stock options in fiscal 2006 and2005, other than those exchanged in connection with the acquisition describedin Note 3.

F-14

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

**(2)Summary of Significant Accounting Policies and Estimates (Continued)**

The risk-free interestrate assumption is based on observed interest rates appropriate for the termsof the Company’s options. The Company estimated stock price volatility usingthe historical volatility in the market price of its common stock for theexpected term of the options. The Company has never paid nor does it expect topay dividends in the foreseeable future. The expected life is estimated basedupon historical option information. The fair value of options was estimated asof the date of grant with the following assumptions:

| ** **                                               | ** ** | **Year ended**   | ** ** |
|----------------------------------------------------------|------------|-----------------------|------------|
| ** **                                               | ** ** | **December 31,** | ** ** |
| ** **                                               | ** ** | **2004**              | ** ** |
| Risk-free  interest rate                                 |       |                  | 2.67       | % |   |
| Volatility                                               |       |                  | 95.0       | % |   |
| Expected dividend  yield                                 |       |                  | —     |   |   |
| Expected lives                                           |       |                  | 4 Years    |   |   |
| Weighted average fair  value of options at date of grant |       |                  | $          | 4.57 |   |   |
|                                                          |            |                       |            |  |  |  |

 

Forpurposes of proforma disclosures pursuant to SFAS 123, the estimated fair valueof employee stock options is amortized to expense over the options’ vestingperiod. The following table illustrates the effect on net loss and net loss pershare that would have been reported if the Company had applied the fair valuerecognition provisions of SFAS 123 to stock-based compensation in 2005 and2004:

| ** **                                                                                                  | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                  | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
| Net (loss)  income, as reported                                                                             |       | $                                          | (309,751   | ) | $ | 1,599,588 |   |
| 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 | ) |
| Pro forma net  (loss) income                                                                                |       | (369,844                                   | )          | $ | 1,366,593 |   |
| Net (loss) income  per share:                                                                               |       |                                       |       |   |   |
| Basic, as reported                                                                                          |       | $                                          | (0.08      | ) | $ | 0.42 |   |
| Diluted, as reported                                                                                        |       | $                                          | (0.08      | ) | $ | 0.41 |   |
| Basic, pro forma                                                                                            |       | $                                          | (0.09      | ) | $ | 0.36 |   |
| Diluted, pro  forma                                                                                         |       | $                                          | (0.09      | ) | $ | 0.35 |   |

** **

F-15

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

**(2)Summary of Significant Accounting Policies and Estimates (Continued)**

***(l) Use of Estimates***

Thepreparation of financial statements in conformity with generally acceptedaccounting principles requires management to make estimates, judgments andassumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenue and expenses during thereporting periods. Actual results could differ from the recorded estimates.

***(m) Concentration of 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,accrued expenses, amount due to seller and current notes payable approximatetheir fair value due to their short-term maturities. Financial instruments thatpotentially subject the Company to concentration of credit risk consistprimarily of cash and cash equivalents, and accounts receivable. The Companybelieves the amount reflected in the consolidated balance sheet for long-termnotes payable approximates fair value as of December 31, 2006. The Company’scash and cash equivalents are held with financial institutions that the Companybelieves to be of high credit standing and, at times, may exceed federallyinsured limits.

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 are believed bymanagement to be inherent in the Company’s accounts receivable.

As of December 31,2006 no one single customer accounted for greater than 10% of the Company’saccounts receivable balance. As of December 31, 2005 one customeraccounted for 11% of the Company’s accounts receivable balance. The Company doesnot believe that this concentration of credit risk represents a material riskof loss with respect to its financial position as of December 31, 2006 and2005. For the years ended December 31, 2006, 2005 and 2004, no singlecustomer accounted for greater than 10% of the Company’s total revenue.

***(n) Accounts Receivable andRelated 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.

F-16

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

**(2)Summary of Significant Accounting Policies and Estimates (Continued)**

The following schedulesummarizes the activity of the Company’s accounts receivable reserve for thethree years ended December 31, 2006:

| **Year Ended**     | ** ** | ** ** | ** ** | **Balance at  Beginning of  Year** | ** ** | **Increases** | ** ** | **Reductions** | ** ** | **Balance at  End of  Year** | ** ** |
|-------------------------|------------|------------|------------|----------------------------------------------|------------|---------------|------------|----------------|------------|----------------------------------------|------------|
| 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 |   |
| December 31, 2006  |       |       | $          | 33,000                                       |       |          | 23,000(1)  |           |       | (42,000                                | )(2)       |   | $ | 14,000 |   |

----

(1)          Amounts represent theestablishment of reserves for potential sales returns or uncollectible accountsreceivable. Increases to the reserve were made by decreasing revenue for salesreturns and by increasing bad debt expense, respectively, for those accountsreceivable that were deemed to be uncollectible.

(2)          Amounts represent thereversal of reserves that were no longer required. These reversals were made torevenue for sales returns and to bad debt expense on collection of accountsreceivable previously deemed to be uncollectible or to accounts receivable foraccounts that were written off during the period.

Thefollowing table displays the effects of the net reduction in the accountsreceivable reserve which impacted net income (loss) and net income (loss) pershare (excludes write-offs):

| **Year Ended**     | ** ** | ** ** | ** ** | **Effect on  Net Income   (Loss)** | ** ** | **Effect on**

**Net Income (Loss)  per Basic and Diluted Share** | ** ** |
|-------------------------|------------|------------|------------|---------------------------------------------------|------------|------------------------------------------------------------------------------------------------------|------------|
| December 31,  2004 |       |       | $          | 272,000                                           |       |                                                                                                 |       | $ | 0.07 |   |   |
| December 31,  2005 |       |       | $          | 40,000                                            |       |                                                                                                 |       | $ | 0.00 |   |   |
| December 31, 2006  |       |       | $          | 400                                               |       |                                                                                                 |       | $ | 0.00 |   |   |

 

***(o) Foreign Currency Translation***

TheCompany translates the financial statements of its foreign subsidiaries inaccordance with SFAS  52, “*ForeignCurrency Translation*.” Accordingly, assets and liabilities aretranslated at exchange rates in effect at the end of the year and revenue andexpenses are translated at the average exchange rates during the year. Allcumulative translation gains or losses from the translation into the Company’sreporting currency are included as a separate component of stockholders’ equity(accumulated other comprehensive loss) in the accompanying consolidated balancesheets. Net gains and losses resulting from foreign exchange transactions werenot material for the years ended December 31, 2006, 2005 and 2004.

***(p) Earnings Per Share***

The Company reportsearnings per share in accordance with SFAS  128, “*Earnings per Share*” (“*SFAS 128*)Diluted weighted average shares outstanding for the years ended December 31,2006 and 2005 exclude 180,539, and 157,475, respectively, potential commonshares from stock options and a stock warrant because to include them wouldhave been anti-dilutive for the periods presented as the Company reported a netloss during the periods. The dilutive effect of potential common shares in2004, consisting of 

F-17

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

**(2)Summary of Significant Accounting Policies and Estimates (Continued)**

outstanding stock options and a stock warrant, isdetermined using the treasury stock method, in accordance with SFAS 128. Forthe year ended December 31, 2004, the dilutive calculation excludes thepotential common shares related to 179,990 outstanding stock options that have ananti-dilutive effect since their exercise price exceeds the market value of theCompany’s common stock. A reconciliation of basic and diluted common sharesoutstanding is as follows:

| ** **                                                       | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                       | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Weighted average  number of common shares outstanding            |       | 4,024,845                                  |       | 3,923,963 |   | 3,764,809 |   |
| Potential common  shares pursuant to stock options and warrant   |       | —                                     |       | — |   | 181,497 |   |
| Diluted weighted  average shares                                 |       | 4,024,845                                  |       | 3,923,963 |   | 3,946,306 |   |
| Basic net (loss)  income per common share                        |       | $                                          | (1.31      | ) | $ | (0.08 | ) | $ | 0.42 |   |
| Diluted net (loss)  income per common and potential common share |       | $                                          | (1.31      | ) | $ | (0.08 | ) | $ | 0.41 |   |

 

***(q) New Accounting Pronouncements***

In June 2006, the FASB issued FASBInterpretation  48, “*Accountingfor Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109*”**(“*FIN 48*”), whichclarifies the accounting for uncertainty in income taxes recognized in acompany’s financial statements in accordance with SFAS  109 “*Accounting for IncomeTaxes*.”  FIN 48 prescribes arecognition threshold and measurement attribute for the financial statementrecognition and measurement of a taxposition taken or expected to be taken in a tax return. FIN 48 becomeseffective for fiscal years beginning after December 15, 2006. The Companydoes not expect the adoption of FIN 48 to have a material impact on itsfinancial position or results of operations.

In September 2006, the FASB issued Statement  157 “*Fair Value Measurements”*(“*SFAS 157*”), which establishes a framework for measuring fairvalue in generally accepted accounting principles and expands disclosures aboutfair value financial instruments. SFAS 157 becomes effective for fiscal yearsbeginning after November 15, 2007. The Company will adopt this statementprospectively once it is effective and applicable. The Company does not expectSFAS 157 to have a material impact on its financial position or results ofoperations.

In September 2006, the Securities and ExchangeCommission issued SAB 108, which provides guidance on the consideration of theeffects of prior year misstatements in quantifying current year misstatementsfor the purpose of a materiality assessment. SAB 108 was effective for fiscal2006. The adoption of  SAB 108 did nothave a material impact on the Company’s financial position or results ofoperations.

F-18

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

**(3) Acquisition**

On December 29, 2006 (the “*AcquisitionDate*”), the Company acquired all of the outstanding shares of BlueChip Technologies Ltd for $562,090 in cash, $1,683,702 in a promissory noteissued to BlueChip’s sole shareholder (“*Seller*”),375,331 shares of the Company’s common stock (valued at $1,478,804), theissuance of vested options to purchase the Company’s common stock insubstitution for outstanding BlueChip stock options (valued at $368,090), anddirect acquisition costs of $456,793, which consisted primarily of financialadvisory, legal and accounting services. BlueChip is a provider of electronicforms automation, document imaging, and object archiving solutions for thehealthcare vertical market. The Company acquired BlueChip in order to strengthenand expand its presence in the healthcare market.

As of December 31,2006, the $562,090 owed to the principal shareholder of BlueChip is classifiedin the accompanying consolidated balance sheet as “Amount due to seller” asthis amount was not paid until January 2007.

The promissory note entered into with the principalshareholder of BlueChip is payable in thirty-six equal monthly installments ofapproximately $47,000, commencing on March 30, 2007 (See Note 7).

The valuation of the Company’s stock and stock optionswas set using an average closing price of the Company’s common stock on theNasdaq Stock Market over the five trading days immediately preceding andincluding the acquisition date. The fair value of the stock options the Companyissued of $368,090 was estimated as of December 29, 2006 using theBlack-Scholes option-pricing model with the following assumptions: no expecteddividend yield, expected volatility of 79%, risk-free interest rate of 4.72%and expected life of 3.8 - 4.1 years.

The total purchase priceis allocated to BlueChip’s net tangible and identifiable intangible assetsbased upon their estimated fair values as of the acquisition date. The excessof the purchase price over the net tangible and identifiable intangible assetshas been recorded to goodwill. The following represents the allocation of theaggregate purchase price to the acquired net assets of BlueChip:

| Purchase price:                    |       |    |
|------------------------------------|------------|---------|
| Amount due to seller               | $          | 562,090 |   |
| Note payable                       | 1,683,702  |    |
| Direct acquisition costs           | 456,793    |    |
| Value of common stock issued       | 1,478,804  |    |
| Value of stock options issued      | 368,090    |    |
| Total purchase  consideration paid | $4,549,479 |    |
|                                    |            |         |  |

 

F-19

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

**(3) Acquisition (Continued)**

| Fair value of assets acquired and liabilities  assumed: |      |      |
|---------------------------------------------------------|-----------|-----------|
| Cash                                                    | $         | 89,728    |   |
| Accounts receivable and unbilled accounts receivable    | 1,477,620 |      |
| Property and equipment                                  | 49,976    |      |
| Other assets                                            | 24,719    |      |
| Goodwill                                                | 1,776,051 |      |
| Identifiable intangible assets                          | 1,785,000 |      |
| In-process research and development                     | 80,000    |      |
| Accounts payable and accrued expenses                   | (177,561  | )         |
| Deferred revenue                                        | (556,054  | )         |
| Total purchase  consideration paid                      | $         | 4,549,479 |   |

 

The fair value of the deferred revenue was determinedin accordance with Emerging Issues Task Force 01-3, “*Accountingin a Business Combination for Deferred Revenue of an Acquiree*.” TheCompany considers postcontract customer support (“*PCS*”)contracts to be legal obligations, and has estimated fair value of the PCScontracts based on the cost build-up approach. The cost build-up approachdetermines fair value by estimating the costs relating to the fulfilling theobligations plus a normal profit margin.

The IPR&D of $80,000 was written off at the dateof acquisition because the IPR&D had no alternative uses and had notreached technological feasibility. The write-off has been recorded in researchand development expenses in the accompanying consolidated statement ofoperations for the twelve months ended December 31, 2006. The IPR&Dconsisted of a single project to develop an imaging module to be used withtablet personal computers. The value assigned to IPR&D was determinedutilizing the replacement cost approach. The state of completion of thein-process project was estimated to determine the discount rate to be appliedto the valuation of the in-process technology. Based upon the level ofcompletion and the risk associated with in-process technology, the Companydeemed a discount rate of 24% as appropriate for valuing IPR&D.

As of December 31,2006 identifiable intangible assets consist of:

| ** **                            | ** ** | ** **          | ** ** | ** **           | ** ** | **Average  Annual** | ** ** |
|---------------------------------------|------------|---------------------|------------|----------------------|------------|---------------------|------------|
| ** **                            | ** ** | **Fair Value** | ** ** | **Useful Life** | ** ** | **Amortization**    | ** ** |
| Purchased  technology                 |       | $                   | 774,000    |                 |       | 5 years             |       |   |   | $ | 154,800 |   |   |
| Customer  contracts and relationships |       | 850,000             |       |                 | 10 years   |                |       |   | 85,000 |   |   |
| Trade names                           |       | 110,000             |       |                 | 6 years    |                |       |   | 18,333 |   |   |
| Non-compete  agreements               |       | 51,000              |       |                 | 3 years    |                |       |   | 17,000 |   |   |
|                                  |       | $                   | 1,785,000  |                 |       |                |       |   |   | $ | 275,133 |   |   |

 

The fair value of purchased technology and trade nameswas based upon the relief from royalty method, the fair value of customercontracts and relationships was determined using an excess earnings methodunder the income approach, and the fair value of non-compete agreements wasvalued using the discounted cash flow method. The rate used to discountthe net cash flows to their present values was based upon a cost of equity of24%. The discount rate was determined after consideration of market rates 

F-20

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

**(3)Acquisition (Continued)**

or return on equitycapital and the risk associated with achieving forecasted sales related to thetechnology and assets acquired from BlueChip.

The $3.6 million allocated to goodwill and otheridentifiable intangible assets is not deductible for tax purposes.

Thefollowing unaudited pro forma condensed consolidated results of operations havebeen prepared as if the acquisition of BlueChip had occurred as of January 1,2005.

| ** **                            | ** ** | **Year ended December 31,** | ** ** |
|---------------------------------------|------------|--------------------------------------------|------------|
| ** **                            | ** ** | **2006**                                   | ** ** | **2005** | ** ** |
| Total revenue                         |       | $                                          | 16,216,917 |   | $ | 18,238,246 |   |
| Net loss                              |       | $                                          | (3,080,497 | ) | $ | (834,240 | ) |
| Net loss per  share:                  |       |                                       |       |   |   |
| Basic                                 |       | $                                          | (0.70      | ) | $ | (0.19 | ) |
| Diluted                               |       | $                                          | (0.70      | ) | $ | (0.19 | ) |
| Weighted average  shares outstanding: |       |                                       |       |   |   |
| Basic                                 |       | 4,400,156                                  |       | 4,299,274 |   |
| Diluted                               |       | 4,400,156                                  |       | 4,299,274 |   |

 

The unaudited pro formacondensed consolidated results of operations are not necessarily indicative ofresults that would have occurred had the acquisition occurred as of January 1,2005, nor are they necessarily indicative of the results that may occur in thefuture.

**(4) Goodwill andIntangible Assets**

Thechanges in the carrying amount of goodwill for the years ended December 31,2006 and 2005 was as follows:

| ** **               | ** ** | **December 31,** | ** ** |
|--------------------------|------------|-----------------------|------------|
| ** **               | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Beginning of the  year   |       | $                     | —     |   | $ | — |   |
| Acquisition of  BlueChip |       | 1,776,051             |       | — |   |
| End of the year          |       | $                     | 1,776,051  |   | $ | — |   |

 

The Company will test goodwill balances for impairmentannually each December 31.

Grosscarrying amounts and accumulated amortization of intangible assets were asfollows as of December 31, 2006 for each intangible asset class:

|                                  |   | **Gross Carrying** | ** ** | **Accumulated**  |   | **Net**      |   |
|---------------------------------------|--------|--------------------|------------|------------------|--------|--------------|--------|
|                                  |   | **Amount**         | ** ** | **Amortization** |   | **Balances** |   |
| Purchased  technology                 |   | $                  | 774,000    |             | $      | —       |   | $ | 774,000 |   |
| Customer  contracts and relationships |   | 850,000            |       | —           |   | 850,000      |   |
| Trade names                           |   | 110,000            |       | —           |   | 110,000      |   |
| Non-compete  agreements               |   | 51,000             |       | —           |   | 51,000       |   |
|                                  |   | $                  | 1,785,000  |             | $      | —       |   | $ | 1,785,000 |   |

 

F-21

----

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

**(4)Goodwill and Intangible Assets (Continued)**

No amortization wasrecorded for the year ended December 31, 2006. At December 31, 2006,the estimated future amortization of intangible assets was as follows:

| **Year ending December 31,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|------------|------------|------------|------------|
| 2007                                        |       | $          | 508,343    |       |
| 2008                                        |       | 376,249    |       |
| 2009                                        |       | 307,265    |       |
| 2010                                        |       | 237,778    |       |
| 2011                                        |       | 196,673    |       |
| Thereafter                                  |       | 158,692    |       |
| Total                                       |       | $          | 1,785,000  |       |

 

**(5) Related PartyTransactions**

On October 6, 2006, the Company entered into anoption termination and release agreement (the “*OptionTermination Agreement*”) with a director of the Company who hadresigned from his position on July 24, 2006. Under the terms of aNon-Qualified Stock Option Agreement (the “*Option Agreement*”)entered into by the Company and the director on August 1, 2001, upon thedirector’s resignation (a) any outstanding unvested options to purchaseshares of the Company’s common stock were terminated and (b) the directorhad until October 22, 2006 to exercise the vested options to purchase28,572 shares of the Company’s common stock (the “*OptionShares*”). In exchange for the director terminating his rights toacquire the Option Shares, the Company agreed to pay the director an amountequal to $0.94 per share (which amount represents the difference between theclosing market price of the common stock on the date immediately preceding thedate of the Option Termination Agreement, $3.57, and the exercise price perOption Share under the Option Agreement, $2.63) for an aggregate purchase priceof $26,858. In accordance with SFAS 123R, the Company recorded this amount as areduction to additional paid in capital in the accompanying consolidatedstatement of stockholders’ equity for the twelve months ended December 31,2006.

On July 28, 2006, the Company entered into aSublease Agreement (the “*Massachusetts Sublease*”),effective as of July 1, 2006, with eSped.com, Inc. (“*eSped*”) whereby the Company will sublease approximately 7,205rentable square feet of the Company’s office space located at Six RiversideDrive, Andover, Massachusetts (“*Six Riverside Drive*”)to eSped. Robert L. Voelk, the Chief Executive Officer and Chairman of theBoard of the Company, is also the Chief Executive Officer and Chairman of theBoard of eSped and Martin A. Schultz, a director of the Company, is also adirector of eSped. The term of the Massachusetts Sublease is fifty-eight (58)months, during which the eSped will pay the Company monthly base rent of $8,383(“*Base Rent*”). The Base Rent includesadjustments for office furniture that the Company provided to eSped and thebuild-out of a computer room shared by the Company and eSped at Six RiversideDrive. eSped occupies approximately sixteen percent (16%) of the Company’soffice space at Six Riverside Drive and, accordingly, will pay sixteen percent(16%) of the Company’s share of operating expenses and real estate taxes forSix Riverside Drive, in addition to the Base Rent.

On October 31, 2000, the Company entered into anagreement with eSped to sublease from the Company 4,500 square feet of thepremises the Company formerly occupied at its Salem, New Hampshire,headquarters (the “*New Hampshire Sublease*”).The New Hampshire Sublease was a tenancy at will and commenced on February 1,2001 and was terminated on April 30, 2006.

F-22

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

**(5)Related Party Transactions (Continued)**

The amount of rent payments and building maintenancecharges received for both the Massachusetts Sublease and New Hampshire Subleasewas approximately $91,000 for the year ended December 31, 2006. The amountof rent payments and building charges received for the New Hampshire Subleasewas approximately $62,000 for each of the years ended December 31, 2005and 2004. These amounts have been recorded as a reduction in general andadministrative expenses in the accompanying consolidated financial statements.The Company believes that the terms of the Massachusetts Sublease and the NewHampshire Sublease were negotiated at arms-length.

In October 2006, the Company entered into asoftware maintenance and support agreement with eSped for approximately$11,000. The term of the agreement is 12 months and expires in October 2007.

On December 29, 2006, the Company issued apromissory note in the amount of $1,683,702 (See Note 7) to the principalshareholder of BlueChip, William Rynkowski, in partial consideration of all theoutstanding shares of BlueChip. On January 4, 2007, the Board of Directorsof the Company appointed William Rynkowski a director of the Company.

On December 29, 2006,in connection with the consummation of the Company’s acquisition ofBlueChip, the Company entered into both an Employment Agreement (the “*Employment Agreement*”) and a Registration Rights Agreement(the “*Registration Rights Agreement*”) with Mr. Rynkowski.Pursuant to the terms of the Registration Rights Agreement, Mr. Rynkowskiis entitled to certain “piggy-back” registration rights for the shares ofcommon stock of the Company that he received pursuantto our Agreement and Plan of Merger with BlueChip, Mr. Rynkowskiand certain other parties. Therefore, if the Company proposes to registersecurities under the Securities Act of 1933, as amended, on a registrationstatement that includes a secondary component for the account of existingsecurityholders (other than registration statements for certain specifiedtransactions), the Company is required to provide Mr. Rynkowski withcertain rights to participate in that registration. Pursuant to the terms ofthe Employment Agreement, Mr. Rynkowski will serve as a Senior VicePresident of the Company. Mr. Rynkowski will receive $120,000 per year ascompensation for his part-time employment with the Company.

**(6) Accrued Liabilities**

Accrued liabilitiesconsist of the following:

| ** **                         | ** ** | **December 31,** | ** ** |
|------------------------------------|------------|-----------------------|------------|
| ** **                         | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Accrued health  insurance expense  |       | $                     | 258,083    |   | $ | 169,811 |   |
| Accrued state  sales tax           |       | 343,212               |       | 290,815 |   |
| Accrued salary  and salary-related |       | 538,224               |       | 639,297 |   |
| Accrued  professional fees         |       | 154,306               |       | 128,801 |   |
| Other accrued  expenses            |       | 227,819               |       | 285,063 |   |
|                               |       | $                     | 1,521,644  |   | $ | 1,513,787 |   |

 

 

F-23

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

**(7) Note Payable**

On December 29,2006, the Company issued a promissory note in the amount of $1,683,702 to theprincipal shareholder of BlueChip in partial consideration of all theoutstanding shares of BlueChip. The note is payable in thirty-six equal monthlyinstallments of approximately $47,000, commencing on March 30, 2007. Thepromissory note bears interest on the unpaid principal amount at a rate perannum equal to (a) the Prime Rate as set forth in the Wall Street JournalMoney Rates column on the last business day of each month, which rate shall bedeemed to be in effect for the entirety of such month; plus (b) onepercent. Future principal payments under this promissory note at December 31,2006 are approximately $468,000, $561,000, $561,000 and $94,000 for the twelvemonth periods ended December 31, 2007, 2008, 2009 and 2010, respectively.

**(8) Deferred Rent**

In January 2006,the Company entered into a new lease agreement for approximately 44,000 squarefeet of office space at Six Riverside Drive, Andover, Massachusetts. TheCompany moved to its new headquarters location in April 2006. The leasehas a ten-year term with an option to renew the lease for an additionalfive-year term at the then-applicable fair market rent. Under the terms of thelease, the Company received free rent for the first six months and the landlordprovided a tenant improvement allowance of up to $308,000, which the Companyhas fully utilized as of December 31, 2006. The balance of deferred rentin the accompanying balance sheet as of December 31, 2006 represents theaccumulated amount due for the free rent period plus the tenant improvementallowance of $308,000, less rent payments made as of December 31, 2006. Rentexpense is recorded on a straight-line basis over the term of the lease.

**(9) Income Taxes**

The Company accounts for income taxes in accordancewith SFAS  109*,*“*Accountingfor Income Taxes*,” the objective of which is to recognize theamount of current and deferred income taxes at the date 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, 2006, the Company had available federal netoperating loss carryforwards of approximately $26.0 million to be used tooffset future taxable income, if any. The Company also has federal tax creditcarryforwards of approximately $1.2 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,there could be annual limitations on the amount of carryforwards that can berealized in future periods.

F-24

----

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

**(9)Income Taxes (Continued)**

The components of the netdeferred tax asset are as follows:

| ** **                                         | ** ** | **December 31,** | ** ** |
|----------------------------------------------------|------------|-----------------------|------------|
| ** **                                         | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Net operating loss  carryforward                   |       | $                     | 8,840,000  |   | $ | 6,961,000 |   |
| Research and development  tax credit carryforwards |       | 1,222,000             |       | 1,137,000 |   |
| Capital loss  carryforward                         |       | 309,000               |       | 309,000 |   |
| Accrued liabilities and  reserves                  |       | 600,000               |       | 514,000 |   |
| Deferred tax assets                                |       | 10,971,000            |       | 8,921,000 |   |
| Acquired intangible  assets                        |       | (719,000              | )          | — |   |
| Acquired unbilled  receivable                      |       | (444,000              | )          | — |   |
| Deferred tax liabilities                           |       | (1,163,000            | )          | — |   |
| Valuation allowance                                |       | (9,808,000            | )          | (8,921,000 | ) |
| Net deferred tax asset                             |       | $                     | —     |   | $ | — |   |

 

SFAS  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, 2006, the Company has approximately$346,000 of net operating loss carryforwards and related valuation allowance inthe United States resulting from the exercise of stock options. The Companywill realize the benefit of these losses through increases to stockholders’equity in the periods in which the losses are utilized to reduce tax payments.

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

| ** **                                                | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| 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               |       | 2.3                                        |       | 4.1 |   | 3.6 |   |
| Research and development tax credits                      |       | (1.6                                       | )          | (58.1 | ) | (3.8 | ) |
| (Decrease) increase in valuation allowance                |       | 36.2                                       |       | 81.0 |   | (34.0 | ) |
| Difference in foreign tax rates                           |       | (0.0                                       | )          | (0.9 | ) | (1.0 | ) |
| Other                                                     |       | (2.9)                                      |       | 6.2 |   | 0.8 |   |
| Income tax benefit                                        |       | —                                     | %          | (1.7 | )% | (0.4 | )% |

 

F-25

----

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

**(9)Income Taxes (Continued)**

The income tax benefit in the accompanyingconsolidated statements of operations consists of the following:

| ** **         | ** ** | **Year Ended December 31,** | ** ** |
|--------------------|------------|--------------------------------------------|------------|
| ** **         | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Current            |       |                                       |       |   |   |   |   |
| Federal            |       | $                                          | —     |   | $ | (2,619 | ) | $ | 8,681 |   |
| State              |       | —                                     |       | — |   | — |   |
| Foreign            |       | —                                     |       | (2,873 | ) | (15,388 | ) |
| Deferred           |       |                                       |       |   |   |   |   |
| Federal            |       | —                                     |       | — |   | — |   |
| State              |       | —                                     |       | — |   | — |   |
| Foreign            |       | —                                     |       | — |   | — |   |
|               |       | —                                     |       | — |   | — |   |
| Income tax benefit |       | $                                          | —     |   | $ | (5,492 | ) | $ | (6,707 | ) |

 

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

| ** ** | ** ** | **Year Ended December 31,** | ** ** |
|------------|------------|--------------------------------------------|------------|
| ** ** | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Domestic   |       | $                                          | (4,491,134 | ) | $ | 2,943 |   | $ | 1,496,137 |   |
| Foreign    |       | (772,478                                   | )          | (318,186 | ) | 96,744 |   |
|       |       | $                                          | (5,263,612 | ) | $ | (315,243 | ) | $ | 1,592,881 |   |

 

**(10) Stockholders’ Equity**

***(a) Private Placement toInstitutional 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 fees associated with issuing the shares in connection with the PrivatePlacement were $154,135 and were recorded as a reduction of additional paid-incapital. Furthermore, Omtool issued 51,000 shares of common stock and a warrantto purchase an additional 51,000 shares of common stock, exercisable over afive year 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. Subjectto 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-26

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

**(10)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.

In May 2006, the Company’s Board of Directorsauthorized the repurchase of 25,000 shares of its outstanding stock from anon-affiliated stockholder in an open market transaction. The Company effectedthis share repurchase at a purchase price of $5.51 per share. The shares werepurchased with the use of generally available corporate funds and are held intreasury.

As of December 31,2006, the Company had repurchased a total of 280,446 shares under the 1998program and $250,000 worth, or 142,856 shares, under the 2002 program. Thecombined total of all repurchases is $773,302.

***(c) Reserved Common Stock***

As of December 31,2006, 874,691 shares of common stock were reserved for issuance pursuant to allstock option plans, the employee stock purchase plan and the outstandingwarrant.

***(d) Preferred Stock***

TheCompany’s Amended and Restated Certificate of Incorporation provides for andthe Board of Directors and stockholders authorized, 2,000,000 shares of $0.01par value preferred stock. The Board of Directors has the authority to issuesuch shares in one or more series and to fix the relative rights andpreferences without vote or action by the stockholders. No shares have beenissued as of December 31, 2006.

***(e) Stock Splits***

On March 30, 2004,Omtool’s Board of Directors approved a two-for-one forward stock split of theCompany’s common stock in the form of a dividend, effective April 27,2004, payable to each stockholder of record as of April 7, 2004. Allreferences in the consolidated financial statements referring to shares, shareprices, per share amounts and stock plans have been adjusted retroactively forthis two-for-one stock 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, 2006.

F-27

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

**(11) Stock Plans**

***(a) Stock Options***

The Company’s 1996 Stock Option Plan and 1997 StockPlan, as amended, provide for the issuance of common stock pursuant to thegrant to employees of “incentive stock options” within the meaning of theInternal Revenue Code and the grant of nonqualified stock options, stock awardsor opportunities to make direct purchases of stock in the Company to employees,consultants, directors and officers of the Company. The aggregate number ofshares of common stock that may be issued pursuant to the 1997 Stock Plan is1,228,570. Shares issued pursuant to these plans are issued from treasury tothe extent they are available. Under the terms of the Company’s 1996 Stock OptionPlan and 1997 Stock 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 would begranted or issued under the Company’s 1996 Stock Option Plan. In accordancewith the 1997 Stock Plan, stock options that are canceled or expired are addedback to the potential options available for future issuance.

Stock option compensation expense calculated under thefair value approach is recognized ratably over the four year vesting period.The fair value for granted options was estimated at the time of grant using theBlack-Scholes option-pricing model. Based upon historical information andmanagement’s estimate of future voluntary turnover rates, the Company hascalculated this expense based on an annualized estimated forfeiture rate of10%. The Company trues-up estimated forfeitures to actual at the end of eachreporting period. The Company did not grant any stock options during the twelvemonths ended December 31, 2006 and 2005. However, in conjunction with theCompany’s acquisition of BlueChip (see Note 3), the Company issued 123,151fully vested options to purchase the Company’s common stock in substitution foroutstanding BlueChip stock options. The total fair value of these stock optionswas $368,090. The total fair value of stock options vested during the periodended December 31, 2006 was $20,000.

Total compensation expense related to unvested stockoptions was approximately $12,000 as of December 31, 2006, which amountthe Company expects to recognize over a weighted average period of 0.9 years.

F-28

----

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

**(11)Stock Plans (Continued)**

The following is a summaryof all stock option activity:

| ** **                                      | ** ** | **Number of  Shares** | ** ** | **Exercise Price  Per Share** | ** ** | **Weighted  Average  Exercise Price** | ** **  |
|-------------------------------------------------|------------|----------------------------|------------|-----------------------------------------|------------|--------------------------------------------|-------------|
| 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 |   |   |
| Granted                                         |       |                       | —     |                                    |       | —                                     |        |   | — |   |   |
| Granted in connection with BlueChip acquisition |       |                       | 123,151    |                                    |       | 1.51-2.20                                  |        |   | 1.76 |   |   |
| Exercised                                       |       |                       | (2,572     | )                                       |       | 0.74-4.10                                  |        |   | 0.83 |   |   |
| Canceled and expired                            |       |                       | (36,670    | )                                       |       | 0.74-17.06                                 |        |   | 3.38 |   |   |
| Outstanding, December 31, 2006             |       |                       | 447,623    |                                    |       | $                                          | 1.51-$19.25 |   |   | $ | 4.86 |   |   |
| Exercisable,  December 31, 2006            |       |                       | 436,813    |                                    |       | $                                          | 1.51-$19.25 |   |   | $ | 4.92 |   |   |

 

At December 31, 2006, options to purchase 515,133shares of common stock were available for future grants under the 1997 Plan.

The range of exerciseprices for options outstanding and options exercisable as of December 31,2006 was 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)**                                                 | ** ** | ** **                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| $1.51-2.63                                  |       |                         | 301,041    |                                                        |       |                                                               | 6.1        |   |   |   | $ | 2.16 |   |   |   | 291,041 |   |   |   | $ | 2.18 |   |   |
| 3.19-4.20                                   |       |                         | 6,830      |                                                        |       |                                                               | 4.3        |   |   |   | 3.61 |   |   |   | 6,830 |   |   |   | 3.61 |   |   |
| 6.76-8.53                                   |       |                         | 65,366     |                                                        |       |                                                               | 3.5        |   |   |   | 7.66 |   |   |   | 64,556 |   |   |   | 7.67 |   |   |
| 10.06-12.69                                 |       |                         | 33,430     |                                                        |       |                                                               | 3.0        |   |   |   | 10.11 |   |   |   | 33,430 |   |   |   | 10.11 |   |   |
| 15.31-19.25                                 |       |                         | 40,956     |                                                        |       |                                                               | 2.0        |   |   |   | 16.11 |   |   |   | 40,956 |   |   |   | 16.11 |   |   |
|                                        |       |                         | 447,623    |                                                        |       |                                                               | 5.1        |   |   |   | $ | 4.86 |   |   |   | 436,813 |   |   |   | $ | 4.92 |   |   |

 

F-29

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

**(11)Stock Plans (Continued)**

The aggregate intrinsicvalue of in-the-money stock options outstanding and stock options exercisablewas approximately $669,000 and $644,000, respectively as of December 31,2006. Total cash received for stock options exercised during the twelve monthsended December 31, 2006 was approximately $2,000. The total intrinsicvalue of stock options exercised during the twelve months ended December 31,2006 was approximately $15,000.

***(b) Employee Stock Purchase Plan***

TheCompany’s 1997 Employee Stock Purchase Plan (the “*1997Purchase Plan*”) provides for the issuance of a maximum of 57,142shares of common stock pursuant to the exercise of nontransferable optionsgranted to participating employees. The exercise price for the option for eachsix-month purchase period is 85% of the lesser of the market price of thecommon stock on the first or last business day of the six-month purchaseperiod. Employee stock purchase plancompensation expense calculated under the fair value approach is recognizedratably over the six-month purchase period. The weighted average fair value ofthe shares purchased under the 1997 Purchase Plan was $2.35 for the twelvemonth period ended December 31, 2006, based upon the followingassumptions:

| ** **               | ** ** | **Year ended  December 31, 2006** | ** ** |
|--------------------------|------------|--------------------------------------------------|------------|
| Risk-free  interest rate |       |                                             | 4.82       | % |   |
| Volatility               |       |                                             | 95.0       | % |   |
| Expected dividend  yield |       |                                             | 0.0        |   |   |
| Expected life            |       |                                             | 0.5 Years  |   |   |

 

Historical information regarding the Company’s commonstock was the primary basis for the expected volatility assumptions. Theexpected life is equal to the six-month purchase period. As of December 31,2006, there was no unrecognized expense related to estimated purchases. As aresult of adopting SFAS 123R as of January 1, 2006, the Company incurredstock-based compensation expense during the twelve months ended December 31,2006 of approximately $26,000 for stock options and shares purchased under theemployee stock purchase plan, of which $6,000 is recorded in cost of serviceand other revenue and $20,000 is recorded in operating expenses. As of December 31,2006, 53,152 shares had been issued under the 1997 Purchase Plan.

***(c) Restricted Common Stock***

The Company sells sharesof restricted common stock (“*restricted stock*”)under the Company’s 1997 Stock Plan, as amended, to its Board of Directors andcertain employees of the Company at a price per share of $0.01. The shares ofrestricted stock vest ratably over a four year service period. In the eventthat a restricted stockholder ceases to provide services to the Company priorto the vesting of any of the then unvested shares held by that stockholder, therestricted stockholder is required to sell any unvested shares of restrictedstock back to the Company at the original purchase price of $0.01 per share.

During 2006 and 2005, theCompany sold a total of 108,196 and 115,516 shares, respectively, of restrictedstock shares under the Company’s 1997 Stock Plan, as amended, to its Board ofDirectors and certain employees of the Company at a price per share of $0.01.During 2006 and 2005, 7,970 and 1,256 shares, respectively, of unvestedrestricted common stock were forfeited.

F-30

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

**(11)Stock Plans (Continued)**

The Company recordeddeferred compensation of approximately $903,000 during 2005 for the intrinsicvalue of the restricted common stock. Due to the adoption of SFAS  123R, the balance of deferred compensation ofapproximately $776,000 as of December 31, 2005, relating entirely torestricted stock grants, has been reclassified to additional paid-in-capital inthe accompanying consolidated balance sheet as of December 31, 2006. Withrespect to restricted stock, the Company recognized approximately $308,000 and$127,000 of stock-based compensation expense during the twelve month periodsended December 31, 2006 and 2005, respectively.

Restricted stockcompensation expense calculated under the fair value approach is based upon thecurrent stock price at the time of grant and is recognized ratably over thefour year vesting period. Based upon historical information and management’sestimate of future voluntary turnover rates, the Company has calculated thisexpense based on an annualized estimated forfeiture rate of 10%. The Companytrues-up estimated forfeitures to actual at the end of each reporting period.The aggregate fair value of restricted stock vested during the twelve monthperiod ended December 31, 2006 was approximately $226,000.

Total compensation expenserelated to unvested shares of restricted stock was approximately $1,013,000 asof December 31, 2006, which amount the Company expects to recognize over aweighted average period of 2.9 years.

The following is a summaryof the Company’s nonvested restricted stock awards:

| ** **                         | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Grant Date  Fair Value** | ** ** |
|------------------------------------|------------|----------------------------|------------|---------------------------------------------------------|------------|
| Nonvested,  December 31, 2004 |       |                       | —     |                                                    |       |   | — |   |   |
| Granted                            |       |                       | 115,516    |                                                    |       |   | $ |      7.90 |   |   |
| Vested                             |       |                       | —     |                                                    |       |   | — |   |   |
| Forfeited                          |       |                       | (1,256     | )                                                       |       |   | 7.70 |   |   |
| Nonvested,  December 31, 2005 |       |                       | 114,260    |                                                    |       |   | $ | 7.90 |   |   |
| Granted                            |       |                       | 108,196    |                                                    |       |   | 5.59 |   |   |
| Vested                             |       |                       | (28,560    | )                                                       |       |   | 7.90 |   |   |
| Forfeited                          |       |                       | (7,970     | )                                                       |       |   | 7.38 |   |   |
| Nonvested,  December 31, 2006 |       |                       | 185,926    |                                                    |       |   | $ |      6.58 |   |   |

 

Shares issued under all ofthe Company’s stock plans are issued from Treasury, to the extent they areavailable.

F-31

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

**(12) 401(k) andProfit-Sharing Plan**

TheCompany’s 401(k) and Profit-Sharing Plan (the “*Profit-SharingPlan*”) covers all eligible employees and allows for voluntarycontributions by eligible employees. The Company matches 50% of eligibleemployee contributions up to a specified amount. This 401(k) match is atthe discretion of the Board of Directors and there can be no assurance that itwill continue in the future. The Company contributed approximately $158,000,$131,000 and $109,000 to the Profit-Sharing Plan for the years ended December 31,2006, 2005 and 2004, respectively. Additional profit-sharing contributions tothe Profit-Sharing Plan are at the discretion of the Company’s management.During 2006, 2005 and 2004, the Company made no additional discretionarycontributions.

**(13) Lease Commitments**

The Company leases certain equipment and its officefacilities under operating leases that expire at various times through April 2016.

At December 31,2006, the estimated future minimum lease payments (net of sublease rentals)under operating and leases were as follows:

| ** **                                  | ** ** | **Operating** | ** ** |
|---------------------------------------------|------------|---------------|------------|
| **Year ending December 31,** | ** ** | ** **    | ** ** | **Leases** | ** ** |
| 2007                                        |       | $             | 647,809    |   |
| 2008                                        |       | 304,986       |       |
| 2009                                        |       | 310,350       |       |
| 2010                                        |       | 300,241       |       |
| 2011                                        |       | 417,107       |       |
| Thereafter                                  |       | 2,022,904     |       |
| Total                                       |       | $             | 4,003,397  |   |
|                                             |            |               |            |  |  |  |

 

Total rent expense under operating leases, net ofsub-lease rentals, included in the accompanying consolidated statements ofoperations was approximately $845,000, $516,000 and $476,000 for the yearsended December 31, 2006, 2005 and 2004, respectively.

On May 1, 2006, the Company entered into acapital lease agreement in the amount of $491,000 to finance the purchase offurniture and equipment for the Company’s new headquarters. The lease has afive year term which expires on May 31, 2011 and is payable in 60 equal monthlyinstallments. The interest rate on the capital lease is 6.2%. Total interestpayments over the life of the lease are estimated to be $99,000. The leasecontains a provision whereby the Company would be required to immediately repaythe outstanding principal balance should the Company’s cash balance ever beless than $5,000,000.

F-32

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

**(13)Lease Commitments (Continued)**

In January 2007, theCompany’s cash balance fell below $5,000,000 and therefore the entire principalbalance of $442,438 could be required to be paid in full in 2007 and has beenclassified as a current liability in the accompanying consolidated balancesheet as of December 31, 2006.

| ** **                               | ** ** | **Capital** | ** ** |
|------------------------------------------|------------|-------------|------------|
| ** **                               | ** ** | **Lease**   | ** ** |
| Total lease  payments                    |       | $           | 520,767    |   |
| Less: amounts  representing interest     |       | 78,329      |       |
| Present value of  minimum lease payments |       | 424,438     |       |
| Less: current  portion                   |       | $           | (442,438   | ) |
| Long-term portion                        |       | $           | —     |   |

 

Total payments made undercapital leases were approximately $69,000, of which approximately $20,000relates to interest expense, for the year ended December 31, 2006. TheCompany did not have any capital leases for the years ended December 31,2005 and 2004.

**(14) Restructuring Costs**

In the thirdquarter of 2003, the Company announced a restructuring of certain of itsoperations and recorded a pretax charge of $806,581 in accordance with SFAS 146, “*Accounting for Costs Associatedwith Exit or Disposal Activities*.” The charge includedseverance-related costs associated with the workforce reduction in the Company’sdomestic operations and costs associated with the closing of its Oregon office.The reduction in workforce consisted of three employees in the Company’s salesand marketing department, two employees performing general and administrativefunctions, three employees performing technical support and five employees inthe Company’s research and development department. The balance of this chargeconsisted of costs incurred as a result of the closure of the Company’s Oregonfacility.

Thetotal cash impact of the restructuring was $806,581; the remaining balance of$443,830 was paid by the end of the third quarter of 2004.

**(15) Guarantees**

In November 2002, the FASB issued FASBInterpretation 45, “*Guarantor’s Accounting andDisclosure Requirements for Guarantees, Including Indirect Guarantees ofIndebtedness of Others*” (“*FIN 45*”). FIN45 elaborates on the existing disclosure requirements for most guarantees,including loan guarantees such as standby letters of credit. It also clarifiesthat at the time a company issues a guarantee, the company must recognize aninitial liability for the fair value, or market value, of the obligations itassumes under the guarantee and must disclose that information in its interimand annual financial statements. The provisions related to recognizing aliability at inception of the guarantee for the fair value of the guarantor’sobligations does not apply to product warranties or to guarantees accounted foras derivatives. The following is a summary of the Company’s agreements that ithas 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 

F-33

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

**(15)Guarantees (Continued)**

customers, in connectionwith any United States patent, or any copyright or other intellectual propertyinfringement claim by any third party with respect to its products. The term ofthese indemnification agreements is generally perpetual any time afterexecution of the agreement. The maximum potential amount of future payments theCompany could be required to make under these indemnification agreements isunlimited. The Company has never incurred costs to defend lawsuits or settleclaims related to these indemnification agreements. As a result, the Companybelieves that the estimated amounts of potential liability arising out of theseagreements are minimal.

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. Ifnecessary, the Company would provide for the estimated cost of product warrantybased on specific warranty claims and claim history, however, the Company hasnever incurred significant expense under its product warranty. As a result, theCompany believes that the estimated amounts of potential liability arising outof these agreements are minimal.

**(16) Segment andGeographic Information**

To date, the Company has viewed its operations andmanages its business as principally one segment—software and hardware sales andassociated services. As a result, the financial information disclosed hereinrepresents all of the material financial information related to the Company’sprincipal operating segment in accordance with SFAS  131, “*Disclosures About Segments of an Enterprise andRelated Information*.”

Total revenue from international sources wasapproximately $2.3 million, $2.8 million and $3.3 million in2006, 2005 and 2004, respectively. The Company’s revenue from internationalsources was primarily generated from customers located in Canada, Europe andSouth Africa.

Thefollowing table represents amounts relating to geographic locations for theyears ended December 31, 2006, 2005 and 2004:

| ** **           | ** ** | **Year Ended December 31,** | ** ** |
|----------------------|------------|--------------------------------------------|------------|
| ** **           | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Total revenue(1)     |       |                                       |       |   |   |   |   |
| United States        |       | $                                          | 11,502,622 |   | $ | 11,536,784 |   | $ | 11,502,207 |   |
| United Kingdom       |       | 881,975                                    |       | 985,129 |   | 1,228,182 |   |
| Canada               |       | 638,674                                    |       | 656,280 |   | 784,927 |   |
| South Africa         |       | 291,876                                    |       | 294,243 |   | 296,816 |   |
| Rest of World        |       | 460,075                                    |       | 823,729 |   | 978,062 |   |
|                 |       | $                                          | 13,775,222 |   | $ | 14,296,165 |   | $ | 14,790,194 |   |
| Long-lived assets(2) |       |                                       |       |   |   |   |   |
| United States        |       | $                                          | 5,549,313  |   | $ | 168,360 |   |   |   |
| United Kingdom       |       | 27,965                                     |       | 18,768 |   |   |   |
|                 |       | $                                          | 5,577,278  |   | $ | 187,128 |   |   |   |

----

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

(2)          Long-lived assets includeproperty and equipment, goodwill, intangibles and other assets.

F-34

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

**(17) Quarterly Results ofOperations (unaudited)**

Thefollowing table presents a condensed summary of quarterly results of operationsfor the years ended December 31, 2006 and 2005.

| ** **                   | ** ** | **Year Ended December 31, 2006** | ** ** |                |
|------------------------------|------------|------------------------------------------------------|------------|---------------------|
| ** **                   | ** ** | **First  Quarter**                                   | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** |   |
| Total revenue                |       | $                                                    | 3,336,504  |                | $ | 3,068,556 |   | $ | 3,641,111 |   | $ | 3,729,051 |   |   |
| Gross profit                 |       | 2,246,886                                            |       | 1,865,268           |   | 2,352,468 |   | 2,531,364 |   |   |
| Net loss                     |       | (1,368,002                                           | )          | (1,797,497          | ) | (1,082,917 | ) | (1,015,196 | ) |   |
| Net loss per share:          |       |                                                 |       |                |   |   |   |   |   |   |
| Basic and diluted            |       | $                                                    | (0.34      | )                   | $ | (0.45 | ) | $ | (0.27 | ) | $ | (0.25 | ) |   |
| ** **                   | ** ** | **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 and Diluted            |       | $                                                    | 0.04       |                | $ | 0.00 |   | $ | (0.09 | ) | $ | (0.03 | ) |
|                              |            |                                                      |            |                     |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**(18) Legal Proceedings**

On or about September 15, 2006, J. Patrick Mansfield, a formeremployee of BlueChip, predecessor-in-interest to Omtool Healthcare, LLC, awholly-owned subsidiary of the Company, filed a complaint against BlueChip andWilliam J. Rynkowski, Jr. (together, the “*Defendants*”),BlueChip’s then-current chief executive officer and a current employee anddirector of the Company, with the Massachusetts Superior Court for Essex County(Civil Action No. 6-1756),asserting among other things breach of contract, violations of theMassachusetts Weekly Payment of Wages Act, breach of fiduciary duty,intentional misrepresentation, and breach of covenant of good faith and fairdealing for the alleged failure of Defendants to pay wages allegedly owed to Mr. Mansfield,the alleged failure of Defendants to acknowledge Mr. Mansfield’s allegedownership interest in BlueChip and the alleged improper termination of Mr. Mansfield’semployment.

While management currentlybelieves that resolving the aforementioned legal matter will not have amaterial adverse impact on the Company’s financial position, the litigationnoted above is subject to inherent uncertainties, including the risk of anunfavorable outcome, and management’s view of these matters may change in thefuture. An unfavorable outcome could include monetary damages or, in caseswhere injunctive relief is sought, an injunction prohibiting certainactivities. Were an unfavorable final outcome to occur, there exists thepossibility of a material adverse impact on the Company’s financial position,cash flows and results of operations for the period in which the effect becomesreasonably estimable.

F-35

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

**(19) Subsequent Event**

On March 6, 2007, the Board of Directors of theCompany committed to a plan of cost reductions pursuant to which the Company’sworkforce will be reduced by approximately fourteen (14) positions. The Companycommunicated this decision to affected employees on March 12 and 13, 2007.

The estimated amount of the costs expected to beincurred in connection with the plan of termination is approximately $105,000,consisting primarily of one-time employee severance costs. The Companyanticipates that approximately $50,000 of the costs incurred in connection withthe plan of termination will result in cash expenditures following the firstquarter of 2007.

F-36

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