** **

**U.S. SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

**FORM 10-QSB**

**(Mark One)**

x                              QUARTERLYREPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF1934

** **

**Forthe quarterly period ended: March 31, 2006**

** **

**OR**

** **

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

** **

**Forthe transition period from                                to**

 

**Commission File Number 000-50758**

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**VISTULA COMMUNICATIONS SERVICES, INC.**

(Exact name of small business issuer as specified inits charter)

 
| **Delaware**                                                    | ** ** | **20-0734966**                     |
|-----------------------------------------------------------------|------------|------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |       | (IRS Employer  Identification No.) |
|                                                            |       |
| **Suite 801,  405 Park Avenue**                            |       |
| **New  York, New York 10022**                                   |       |
| (Address of principal  executive offices and zip code)          |       |
|                                                            |       |
| **(212)  317-8900**                                             |       |
| (Issuer’s  telephone number)                               |       |
|                                                                 |            |                                    |  |

 

Checkwhether the issuer (1) filed all reports required to be filed by Section 13or 15(d) of the Exchange Act during the past 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.           Yes   x          No   o

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

Asof May 18, 2006, there were 34,164,898 shares of common stock, $0.001 parvalue, of the registrant issued and outstanding.

TransitionalSmall Business Disclosure Format (*Check one*):         Yes   o       No    x

 

 

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**VISTULA COMMUNICATIONS SERVICES,INC.**

**FORM 10-QSB**

**FOR THE THREE MONTHS ENDED MARCH 31,2006**

 
| Facing Page                                                                                                                    |     |                       |                                                                                        |   |
|--------------------------------------------------------------------------------------------------------------------------------|----------|----------------------------|---------------------------------------------------------------------------------------------|--------|
|                                                                                                                           |     |                       |                                                                                        |   |
| Table of Contents                                                                                                              |     |                       |                                                                                        |   |
|                                                                                                                           |     |                       |                                                                                        |   |
| PART I.                                                                                                                   |     | FINANCIAL  INFORMATION(*): |                                                                                        |   |
|                                                                                                                           |     |                       |                                                                                        |   |
|                                                                                                                           | Item  1. |                       | Financial  Statements                                                                       |   |   |
|                                                                                                                           |     |                       |                                                                                        |   |
| Consolidated Balance Sheets as of March 31, 2006  (unaudited) and December 31, 2005                                  |
|                                                                                                                           |     |                       |                                                                                        |   |
| Consolidated Statements of Operations for the Three  Months ended March 31, 2006 and March 31, 2005 (unaudited) |
|                                                                                                                           |     |                       |                                                                                        |   |
| Consolidated Statements of Stockholders’ Deficit for  the Three Months ended March 31, 2006 (unaudited)              |
|                                                                                                                           |     |                       |                                                                                        |   |
| Consolidated Statements of Cash Flows for the Three  Months ended March 31, 2006 and March 31, 2005 (unaudited) |
|                                                                                                                           |     |                       |                                                                                        |   |
| Notes to Consolidated Financial Statements                                                                                     |
|                                                                                                                           |     |                       |                                                                                        |   |
|                                                                                                                           | Item 2.  |                       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations |
|                                                                                                                           |     |                       |                                                                                        |   |
|                                                                                                                           | Item 3.  |                       | Controls and Procedures                                                                     |   |   |
|                                                                                                                           |     |                       |                                                                                        |   |
| PART II.                                                                                                                  |     | OTHER  INFORMATION         |                                                                                        |   |
|                                                                                                                           |     |                       |                                                                                        |   |
|                                                                                                                           | Item 5.  |                       | Other Events                                                                                |   |   |
|                                                                                                                           |     |                       |                                                                                        |   |
|                                                                                                                           | Item 6.  |                       | Exhibits                                                                                    |
|                                                                                                                           |     |                       |                                                                                        |   |
| SIGNATURES                                                                                                                     |

 

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(*)           All of the financial statementscontained in this Quarterly Report are unaudited with the exception of thefinancial information at December 31, 2005, which has been derived fromour audited financial statements at that date and should be read in conjunctiontherewith. Our audited financial statements as of December 31, 2005 andfor the year then ended, and the notes thereto, can be found in our AnnualReport on Form 10-KSB (File No. 000-50758), which wasfiled with the Securities and Exchange Commission on March 31, 2006.

2

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**PART I. FINANCIALINFORMATION**

**Item 1. FinancialStatements.**

***VISTULA COMMUNICATIONS SERVICES, INC.***ConsolidatedBalance Sheets as of March 31, 2006 andDecember 31, 2005
| ** **                                                                                                                                                                                  | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                  | ** ** | **(unaudited)**          | ** ** | **(audited)**               | ** ** |
| **ASSETS**                                                                                                                                                                                  | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Current assets:                                                                                                                                                                             |       |                     |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                   |       | $                        | 221,334    |                        | $          | 553,127 |   |
| Accounts receivable                                                                                                                                                                         |       | 131,440                  |       | 130,748                     |       |
| Prepaid expenses and other current assets                                                                                                                                                   |       | 692,441                  |       | 1,045,795                   |       |
| Total current assets                                                                                                                                                                        |       | 1,045,215                |       | 1,729,670                   |       |
|                                                                                                                                                                                        |       |                     |       |                        |       |
| Property and  equipment, net                                                                                                                                                                |       | 2,294,496                |       | 2,362,373                   |       |
| Deferred  financing costs                                                                                                                                                                   |       | 542,926                  |       | 613,742                     |       |
| Other assets                                                                                                                                                                                |       | 57,905                   |       | 57,272                      |       |
| Total Assets                                                                                                                                                                                |       | $                        | 3,940,542  |                        | $          | 4,763,057 |   |
|                                                                                                                                                                                        |       |                     |       |                        |       |
| **LIABILITIES AND STOCKHOLDERS’  DEFICIT**                                                                                                                                             | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Current liabilities:                                                                                                                                                                        |       |                     |       |                        |       |
| Accounts payable                                                                                                                                                                            |       | $                        | 694,296    |                        | $          | 398,841 |   |
| Accrued expenses                                                                                                                                                                            |       | 657,529                  |       | 628,154                     |       |
| Convertible promissory note to related party                                                                                                                                                |       | 175,000                  |       | 175,000                     |       |
| Notes payable                                                                                                                                                                               |       | 1,770,000                |       | 870,000                     |       |
| Total current liabilities                                                                                                                                                                   |       | 3,296,825                |       | 2,071,995                   |       |
| Convertible  debentures                                                                                                                                                                     |       | 5,523,783                |       | 5,424,902                   |       |
| Total liabilities                                                                                                                                                                           |       | 8,820,608                |       | 7,496,897                   |       |
|                                                                                                                                                                                        |       |                     |       |                        |       |
| Stockholders’ deficit:                                                                                                                                                                 |       |                     |       |                        |       |
| Preferred stock, $0.001 par value, 10,000,000 shares  authorized; no shares issued and outstanding                                                                                          |       | —                   |       | —                      |       |
| Common stock, $0.001 par value, 100,000,000 shares  authorized, 34,164,898 and 31,914,898 shares issued and outstanding as of  March 31, 2006 and December 31, 2005, respectively |       | 34,164                   |       | 31,914                      |       |
| Additional paid-in capital                                                                                                                                                                  |       | 15,992,171               |       | 13,975,077                  |       |
| Deferred compensation                                                                                                                                                                       |       | —                   |       | (13,422                     | )          |
| Accumulated deficit                                                                                                                                                                         |       | (20,764,776              | )          | (16,576,999                 | )          |
| Cumulative translation adjustment                                                                                                                                                           |       | (141,625                 | )          | (150,410                    | )          |
|                                                                                                                                                                                        |       |                     |       |                        |       |
| Total stockholders’ deficit                                                                                                                                                            |       | (4,880,066               | )          | (2,733,840                  | )          |
|                                                                                                                                                                                        |       |                     |       |                        |       |
| Total  Liabilities and Stockholders’ Deficit                                                                                                                                           |       | $                        | 3,940,542  |                        | $          | 4,763,057 |   |

 

See accompanyingnotes to unaudited consolidated financial statements.

3

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***VISTULA COMMUNICATIONS SERVICES, INC***Consolidated Statements of Operations for theThree Months ended March 31, 2006 and 2005
| ** **                                             | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                             | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| ** **                                             | ** ** | **(unaudited)**                                  | ** ** | **(unaudited)** | ** ** |
| Net revenues                                           |       | $                                                | 319,419    |   | $ | 122,198 |   |
|                                                   |       |                                             |       |   |   |
| Cost of revenues                                       |       | 351,513                                          |       | 188,269 |   |
|                                                   |       |                                             |       |   |   |
| Gross margin (loss)                                    |       | (32,094                                          | )          | (66,071 | ) |
|                                                   |       |                                             |       |   |   |
| Selling, general  and administrative expenses          |       | 3,840,580                                        |       | 1,183,105 |   |
|                                                   |       |                                             |       |   |   |
| Loss from operations                                   |       | (3,872,674                                       | )          | (1,249,176 | ) |
|                                                   |       |                                             |       |   |   |
| Interest expense,  net                                 |       | (315,103                                         | )          | (161,743 | ) |
|                                                   |       |                                             |       |   |   |
| Net loss                                               |       | $                                                | (4,187,777 | ) | $ | (1,410,919 | ) |
|                                                   |       |                                             |       |   |   |
| Weighted-average  basic and diluted shares outstanding |       | 33,339,898                                       |       | 24,591,350 |   |
|                                                   |       |                                             |       |   |   |
| Basic and diluted net  loss per common share           |       | $                                                | (0.13      | ) | $ | (0.06 | ) |

 

**See accompanying notes tounaudited consolidated financial statements.**

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***VISTULA COMMUNICATIONS SERVICES, INC.***Consolidated Statements of Stockholders’ Deficit for theThree Months ended March 31, 2006(unaudited)
| ** **                                                               | ** ** | ** **            | ** ** | **Additional** | ** ** | ** **   | ** ** | ** **       | ** ** | **Cumulative**  | ** ** | **Total**              | ** ** | ** **        | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------|------------|----------------|------------|--------------|------------|------------------|------------|-----------------|------------|------------------------|------------|-------------------|------------|
| ** **                                                               | ** ** | **Common Stock** | ** ** | **Paid-in**    | ** ** | **Deferred** | ** ** | **Accumulated**  | ** ** | **Translation** | ** ** | **Stockholders’** | ** ** | **Comprehensive** | ** ** |
| ** **                                                               | ** ** | **Shares**            | ** ** | **Amount**     | ** ** | **Capital**  | ** ** | **Compensation** | ** ** | **Deficit**     | ** ** | **Adjustment**         | ** ** | **Deficit**       | ** ** | **Loss** | ** ** |
| Balance, December 31, 2005                                          |       | 31,914,898            |       | $              | 31,914     |         | $          | 13,975,077       |       | $               | (13,422    | )                      | $          | (16,576,999       | )          | $ | (150,410 | ) | $ | (2,733,840 | ) |   |   |
| Application of deferred compensation against  additional paid-in capital |       |                  |       |           |       | (13,422      | )          | 13,422           |       |            |       |                   |       |              |       |   |   |
| Issuance of common stock                                                 |       | 1,500,000             |       | 1,500          |       | 1,873,500    |       |             |       |            |       |                   |       | 1,875,000         |       |   |   |
| Exercise of stock options                                                |       | 750,000               |       | 750            |       | 74,250       |       |             |       |            |       |                   |       | 75,000            |       |   |   |
| Issuance of stock options                                                |       |                  |       |           |       | 82,766       |       |             |       |            |       |                   |       | 82,766            |       |   |   |
| Net loss                                                                 |       |                  |       |           |       |         |       |             |       | (4,187,777      | )          |                   |       | (4,187,777        | )          | $ | (4,187,777 | ) |
| Change in cumulative translation adjustment                              |       |                  |       |           |       |         |       |             |       |            |       | 8,785                  |       | 8,785             |       | 8,785 |   |
| Balance,  March 31, 2006                                            |       | 34,164,898            |       | $              | 34,164     |         | $          | 15,992,171       |       | $               | —     |                   | $          | (20,764,776       | )          | $ | (141,625 | ) | $ | (4,880,066 | ) | $ | (4,178,992 | ) |

 

See accompanying notes tounaudited consolidated financial statements.

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***VISTULA COMMUNICATIONS SERVICES, INC***Consolidated Statements of Cash Flows for theThree Months ended March 31, 2006 and 2005
| ** **                                                                                            | ** ** | **Three Months Ended March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                            | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| ** **                                                                                            | ** ** | **(unaudited)**                                      | ** ** | **(unaudited)** | ** ** |
| Cash flows from  operating activities:                                                                |       |                                                 |       |   |   |
| Net loss                                                                                              |       | $                                                    | (4,187,777 | ) | $ | (1,410,919 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities:                          |       |                                                 |       |   |   |
| Depreciation                                                                                          |       | 128,865                                              |       | 12,243 |   |
| Non-cash expense pursuant to financial advisory  agreement                                            |       | 1,875,000                                            |       | — |   |
| Non-cash compensation expense                                                                         |       | 82,766                                               |       | 198,500 |   |
| Non-cash interest expense                                                                             |       | 169,697                                              |       | 100,096 |   |
| Issuance of stock options pursuant to consulting  agreement                                           |       | —                                               |       | 29,913 |   |
| Company expenses paid by stockholder recorded as due  to stockholder                                  |       | 75,000                                               |       | — |   |
| Changes in  assets and liabilities:                                                                   |       |                                                 |       |   |   |
| (Increase)  decrease in:                                                                              |       |                                                 |       |   |   |
| Accounts receivable                                                                                   |       | (692                                                 | )          | 17,011 |   |
| Prepaid expenses and other current assets                                                             |       | 352,721                                              |       | (23,114 | ) |
| Increase  (decrease) in:                                                                              |       |                                                 |       |   |   |
| Accounts payable                                                                                      |       | 295,455                                              |       | (299,709 | ) |
| Accrued expenses                                                                                      |       | 29,375                                               |       | (574,953 | ) |
| Net cash used in operating activities                                                                 |       | (1,179,590                                           | )          | (1,950,932 | ) |
|                                                                                                  |       |                                                 |       |   |   |
| Cash flows from investing  activities:                                                                |       |                                                 |       |   |   |
| Purchases of property and equipment                                                                   |       | (55,010                                              | )          | (18,333 | ) |
| Net cash used in investing activities                                                                 |       | (55,010                                              | )          | (18,333 | ) |
|                                                                                                  |       |                                                 |       |   |   |
| Cash flows from  financing activities:                                                                |       |                                                 |       |   |   |
| Proceeds from revolving credit agreement                                                              |       | 1,000,000                                            |       | — |   |
| Proceeds from exercise of stock options                                                               |       | 75,000                                               |       | — |   |
| Payment on notes payable                                                                              |       | (100,000                                             | )          | — |   |
| Payments on due to stockholder                                                                        |       | (75,000                                              | )          | (801,630 | ) |
| Settlement of capital lease obligation                                                                |       | —                                               |       | (500,000 | ) |
| Increase in restricted cash                                                                           |       | —                                               |       | (200,020 | ) |
| Proceeds from issuance of convertible debentures and  warrants, net of deferred financing costs  |       | —                                               |       | 7,468,427 |   |
| Net cash provided by financing activities                                                             |       | 900,000                                              |       | 5,966,777 |   |
|                                                                                                  |       |                                                 |       |   |   |
| Effect of  exchange rates on cash                                                                     |       | 2,807                                                |       | 16,041 |   |
|                                                                                                  |       |                                                 |       |   |   |
| Net (decrease)  increase in cash and cash equivalents                                                 |       | (331,793                                             | )          | 4,013,553 |   |
| Cash and cash  equivalents, beginning of period                                                       |       | 553,127                                              |       | 3,221 |   |
|                                                                                                  |       |                                                 |       |   |   |
| Cash and cash  equivalents, end of period                                                             |       | $                                                    | 221,334    |   | $ | 4,016,774 |   |
|                                                                                                  |       |                                                 |       |   |   |
| **Supplemental disclosure of cash  flow information:**                                                | ** ** | ** **                                           | ** ** | ** ** | ** ** |
| ** **                                                                                            | ** ** | ** **                                           | ** ** | ** ** | ** ** |
| Cash paid for interest                                                                                |       | $                                                    | 149,838    |   | $ | 61,600 |   |
|                                                                                                  |       |                                                 |       |   |   |
| Cash paid for taxes                                                                                   |       | $                                                    | —     |   | $ | — |   |
|                                                                                                  |       |                                                 |       |   |   |
| **Supplemental disclosure of  non-cash financing activities:**                                        | ** ** | ** **                                           | ** ** | ** ** | ** ** |
|                                                                                                  |       |                                                 |       |   |   |
| Issuance of common stock pursuant to financial  advisory agreement                                    |       | $                                                    | 1,875,000  |   | $ | — |   |
|                                                                                                  |       |                                                 |       |   |   |
| Issuance of common stock pursuant to capital lease  obligation                                        |       | $                                                    | —     |   | $ | 324,874 |   |
|                                                                                                  |       |                                                 |       |   |   |
| Issuance of note payable pursuant to capital lease  obligation                                        |       | $                                                    | —     |   | $ | 1,170,000 |   |
|                                                                                                  |       |                                                 |       |   |   |
| Issuance of  common stock warrants in connection with convertible debenture financing                 |       | $                                                    | —     |   | $ | 184,844 |   |

 

See accompanyingnotes to unaudited consolidated financial statements.

6

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**VISTULACOMMUNICATIONS SERVICES, INC.**

**NOTES TO UNAUDITEDCONSOLIDATED FINANCIAL STATEMENTSMarch 31, 2006**

**(1)           Basisof Presentation**

The accompanyingunaudited consolidated financial statements of Vistula Communications Services, Inc.(“Vistula” or the “Company”) have been prepared in accordance with accountingprinciples generally accepted in the United States (GAAP) for interim financialinformation and with the instructions to Form 10-QSB and Item 310 ofRegulation S-B. Accordingly, they do not include all of the informationand footnotes required by GAAP for complete financial statements. In theopinion of management, all adjustments (consisting of normal recurringaccruals) considered necessary for the fair presentation of the results for theinterim periods have been included. The preparation of financial statements inconformity with GAAP requires management to make estimates and assumptions thataffect the amounts reported in the financial statements and accompanying notes.Interim results are not necessarily indicative of results to be expected forthe entire fiscal year ending December 31, 2006. These unaudited financialstatements should be read in conjunction with the Company’s audited annualfinancial statements for the fiscal year ended December 31, 2005 and thefootnotes thereto. Those audited financial statements are included in theCompany’s Annual Report on Form 10-KSB, which was filed with theSecurities and Exchange Commission (SEC) on March 31, 2006.

The Company usesthe United States dollar as its reporting currency. The British pound is thefunctional currency of its wholly-owned subsidiary, Vistula Limited. The SouthAfrican rand is the functional currency of its 60% owned subsidiary, VistulaCommunications Services SA (Pty) Ltd. Assets and liabilities of the Company’sinternational operations are translated into U.S. dollars at exchange ratesthat are in effect on the balance sheet date and equity accounts are translatedat historical exchange rates. Income and expense items are translated ataverage exchange rates which are in effect during the period. Translationadjustments are accumulated in other comprehensive loss as a separate componentof stockholders’ deficit in the consolidated balance sheet. Transaction gains(losses) were immaterial for the three-month periods ended March 31, 2006and March 31, 2005.

In the event thatthe Company is not successful in implementing its business plan, or does notraise third-party capital, the Company will have to curtail certainexpenditures, seek additional financing from one of its principal stockholders,or both in order to sustain operations. One of the Company’s principalstockholders has historically provided working capital advances and has causeda lender to issue letters of credit in favor of certain vendors. While thestockholder is not obligated to provide these working capital advances to theCompany or to cause a lender to issue standby letters of credit in favor of itsvendors, the Company expects that the stockholder will continue to providefunds for operations in 2006, as and if needed, until such time that theCompany’s operations are self-sustaining or the Company raises additionalexternal capital, as the case may be. As described in Note 10, in March 2006and April 2006 the Company received a total of $1.25 million in netproceeds under a revolving credit agreement. As described in Note 15, in May 2006the Company received net proceeds of approximately $15.2 million from thesale of units, each unit consisting of one share of common stock andeight-tenths of one warrant to acquire one share of common stock.

The report ofindependent registered public accounting firm on the Company’s auditedconsolidated financial statements as of December 31, 2005 and for the yearthen ended included a discussion on the Company’s ability to continue as agoing concern. The consolidated financial statements shown for the period endedMarch 31, 2006, have been prepared on a going concern basis whichcontemplates the realization of assets and the satisfaction of liabilities inthe normal course of business. As shown in the accompanying consolidatedfinancial statements, the Company incurred a net loss of $4,187,777 for theperiod ended March 31, 2006 and had an accumulated deficit of $20,764,776at March 31, 2006. Further, the Company had cash of $221,334 and a workingcapital deficit at March 31, 2006 of $2,251,610. These factors amongothers may indicate that the Company will be unable to continue as a goingconcern.

The consolidatedfinancial statements do not include any adjustments relating to therecoverability of assets and satisfaction of liabilities that might benecessary should the Company be unable to continue as a going concern. TheCompany has engaged financial advisors to assist in the raising of additionaldebt or equity capital. The Company has also engaged in discussions withcertain debt holders to restructure payment terms until additional debt orequity financing is obtained. The Company’s continuation as a going concern isdependent upon its ability to generate sufficient cash flow to meet itsobligations on a timely basis, to comply with the terms of its financingarrangements, to obtain additional financing as may be required, and ultimatelyto attain profitability.

Certain amountsfrom the three-month period ended March 31, 2005 have been reclassified toconform with the current presentation.

**(2)           Stock-BasedCompensation**

Effective January 1, 2006, theCompany adopted the fair value recognition provisions of Statement of FinancialAccounting Standards (“SFAS”) No. 123(R),*Share-Based Payment* (“SFAS 123R”), using themodified-prospective-transition method. Under this 

7

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transition method, compensation cost recognized forthe first three months of 2006 includes: (a) compensation cost for allstock-based payments granted, but not yet vested as of January 1, 2006,based on the grant-date fair value estimated in accordance with the originalprovisions of SFAS No. 123, *Accountingfor Stock Based Compensation*, and (b) compensation cost for allstock-based payments granted subsequent to January 1, 2006, based on thegrant-date fair value estimated in accordance with the provisions of SFAS 123R.Results for prior periods have not been restated. For stock options granted tonon-employees, the Company recognizes compensation expense in accordance withthe requirements of Emerging Issues Task Force (“EITF”) No. 96-18, *Accounting for Equity Instruments That Are Issued toOther Than Employees for Acquiring, or in Conjunction with Selling, Goods orServices*. EITF 96-18 requires that companies recognizecompensation expense based on the estimated fair value of options granted tonon-employees over their vesting period, which is generally the period duringwhich services are rendered by such non-employees. The fair value of unvestednon-employee stock awards is re-measured at each reporting period.

Prior to January 1,2006, consistent with the provisions of Accounting Principles Board Opinion No. 25,*Accounting for Stock Issued to Employees*(“APB 25”), the Company recorded deferred compensation in the stockholders’deficit section of the consolidated balance sheet when stock options weregranted at an exercise price that was less than the fair value of theunderlying common stock at the date of grant. These amounts were recognized asstock-based compensation expense over the vesting period. Effective January 1,2006, as provided in SFAS 123R, the Company has reversed the unamortizeddeferred compensation for the unvested portions of stock option grants awardedprior to the effective date of SFAS 123R, applying the balance to additionalpaid-in capital.

*Stock Incentive Plan.  *In February 2004, the board ofdirectors adopted the 2004 Stock Incentive Plan (the “Plan”). The Planinitially covered 6,000,000 shares of the Company’s common stock issuable uponexercise of incentive stock options and non-statutory stock options and inconnection with grants of restricted stock. The Plan was amended by the Boardon June 3, 2005 to, among other things, increase the number of sharesavailable for options or restricted stock grants from 6,000,000 to 8,000,000. Theshareholders of the Company approved the amendment to the Plan on July 14,2005. On December 23, 2005, the board of directors approved an increase,from 8,000,000 to 15,000,000, in the number of shares of common stockauthorized under the Plan and on April 11 and 12, 2006 the board ofdirectors approved an additional increase, from 15,000,000 to 18,000,000, inthe number of shares of common stock authorized under the Plan. These increaseswill be submitted to the Company’s stockholders for their ratification at thenext annual meeting.

The Board has the authority to select the employees,officers, directors, consultants and advisors to whom options are granted anddetermine the terms of each option, including (i) the number of shares ofcommon stock subject to the option, (ii) when the option becomesexercisable, (iii) the option exercise price, which must be at least 100%(110% in the case of incentive stock options granted to a stockholder owning inexcess of 10% of the Company’s common stock) of the fair market value of thecommon stock as of the date of grant and (iv) the duration of the option,which may be up to 10 years or, in the case of incentive stock options issuedto a stockholder owning in excess of 10% of the Company’s common stock, fiveyears.

As a result of the January 1,2006 adoption of SFAS 123R and stock compensation expense related to optionsgranted to non-employees, the Company recognized $82,766 in stock-basedcompensation expense for the three months ended March 31, 2006.

Thefollowing table illustrates the effect on net loss and net loss per share hadthe Company applied the fair value recognition provisions of SFAS 123R in thefirst quarter of 2005. For purposes of this pro-forma disclosure, the value ofthe options is estimated using a Black-Scholes option-pricing model andamortized to expense over the options’ vesting periods.
| ** **                                                                   | ** ** | **Three Months  Ended  March 31, 2005** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|
| Net loss as  reported                                                        |       | $                                                      | (1,410,919 | ) |
| Add: Stock  compensation expense included in net loss                        |       | 198,500                                                |       |
| Deduct: Stock  compensation expense determined under fair value based method |       | (241,458                                               | )          |
| Pro-forma net  loss                                                          |       | $                                                      | (1,453,877 | ) |
|                                                                         |       |                                                   |       |
| Basic and diluted net  loss per share:                                       |       |                                                   |       |
| As reported                                                                  |       | $                                                      | (0.06      | ) |
| Pro-forma                                                                    |       | $                                                      | (0.06      | ) |

 

8

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The fairvalue of each stock award is estimated on the grant date using theBlack-Scholes option-pricing model based on the assumptions noted in thefollowing table:
| ** **               | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------|------------|--------------------------------------------------|------------|
| ** **               | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Volatility               |       | 80                                               | %          | 80 | % |
| Risk-free  interest rate |       | 4.45                                             | %          | 3.95 | % |
| Expected life  (years)   |       | 5                                                |       | 5 |   |
| Dividend                 |       | None                                             |       | None |   |

 

Volatility is determined based on theCompany’s estimate of fluctuation in its common stock price and its review ofcomparable public company data due to the limited amount of time that theCompany’s common stock has been publicly traded. The expected life of stockoptions granted is based on the Company’s estimate of when options will beexercised in the future as there have been limited stock option exercises todate. The expected life is generally applied to one group as a whole as theCompany does not expect substantially different exercise or post-vestingtermination behavior amongst its employee population. The risk-free interestrate is based on the U.S. Treasury yield curve in effect at the time ofgrant commensurate with the expected life assumption.

The Company is using thestraight-line attribution method to recognize stock-based compensation expense.The amount of stock-based compensation recognized during a period is based onthe value of the portion of the awards that are ultimately expected to vest.SFAS 123R requires forfeitures to be estimated at the time of grant andrevised, if necessary, in subsequent periods if actual forfeitures differ fromthose estimates. The term “forfeitures” is distinct from “cancellations” or “expirations”and represents only the unvested portion of the surrendered option. The Companyhas applied an annual forfeiture rate of 0% to all unvested options as of March 31,2006 as the Company believes that forfeitures to date are not representative oflikely future forfeitures. This analysis will be re-evaluated quarterly and theforfeiture rate will be adjusted as necessary. Ultimately, the actual expenserecognized over the vesting period will only be for those shares that vest.

Using the Black-Scholesoption-pricing model, the weighted average grant date fair value of optionsgranted during the three months ended March 31, 2006 was $0.95. There wereno options granted during the three months ended March 31, 2005.

Asummary of stock option activity as of March 31, 2006, and changes duringthe three-month period then ended, is presented below:
| ** **                                            | ** ** | **Options  Outstanding** | ** ** | **Weighted-  average  Exercise Price** | ** ** | **Weighted-average  Remaining  Contracted Term in  Years** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|-------------------------------------------------------|------------|--------------------------|------------|---------------------------------------------|------------|----------------------------------------------------------------------|------------|---------------------------------|------------|
|                                                  |       |                     |       |                                        |       |                                                                 |       |                            |       |
| Outstanding at  December 31, 2005                |       | 5,153,000                |       | $                                           | 0.31       |                                                                 |       |                            |       |   |
| Granted                                               |       | 250,000                  |       | $                                           | 1.42       |                                                                 |       |                            |       |   |
| Forfeited                                             |       | (2,200,000               | )          | $                                           | 0.10       |                                                                 |       |                            |       |   |
| Exercised                                             |       | (750,000                 | )          | $                                           | 0.10       |                                                                 |       |                            |       |   |
| Outstanding at  March 31, 2006                   |       | 2,453,000                |       | $                                           | 0.67       |                                                                 | 9.35       |                            | $          | 1,629,360 |   |
| Exercisable at  $0.05 at March 31, 2006          |       | 15,000                   |       | $                                           | 0.05       |                                                                 | 3.10       |                            | $          | 19,050 |   |
| Exercisable at  $0.45 at March 31,2006           |       | 1,760,000                |       | $                                           | 0.45       |                                                                 | 9.27       |                            | $          | 1,531,200 |   |
| Exercisable at $1.30 to  $1.42 at March 31, 2006 |       | 325,000                  |       | $                                           | 1.32       |                                                                 | 9.72       |                            | $          | 5,500 |   |

 

During the three months ended March 31,2006, the total intrinsic value of options exercised (i.e., the differencebetween the market price at exercise and the price paid by the employee toexercise the options) was $937,500 and the total amount of cash received fromexercise of these options was $75,000. The total grant-date fair value of stockoptions that vested during the three months ended March 31, 2006 was$47,500.

As of March 31, 2006, there was approximately$320,000 of total unrecognized compensation cost related to unvestedshare-based awards. This cost is expected to be recognized over a weightedaverage period of 3.6 years. The Company expects 353,000 unvested options tovest in the future.

**(3)           Income Taxes**

The Company accounts for income taxes in accordancewith Statement of Financial Accounting Standard (SFAS) No. 109, *Accounting for Income Taxes*(“SFAS 109”). Under SFAS 109,deferred tax assets or liabilities are computed based on the difference betweenthe financial statements and income tax basis of assets and liabilities, andnet operating loss carryforwards, using the enacted tax rates. Deferred incometax expense or benefit is based on changes in the asset or liability fromperiod to period. The Company did not record a provision for federal, state orforeign income taxes for the three-month periods ended March 31, 2006 and2005 because the Company has experienced losses since inception. The Companyhas not recorded a benefit for deferred tax assets as their

9

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realizability is uncertain.

**(4)           Balance Sheet Detail**

Prepaid expenses and othercurrent assets at March 31, 2006 and December 31, 2005 consisted ofthe following:
| ** **                        | ** ** | **March 31,  2006** | ** ** | **December 31,**2005 | ** ** |
|-----------------------------------|------------|--------------------------|------------|---------------------------|------------|
|                              |       |                     |       |                      |       |
| Prepaid  royalties                |       | $                        | 399,551    |                      | $          | 399,899 |   |
| Non-trade  receivables            |       | 164,431                  |       | 164,472                   |       |
| Value added tax                   |       | 43,693                   |       | 77,043                    |       |
| Prepaid call  termination charges |       | 42,464                   |       | 44,446                    |       |
| Rent                              |       | 10,705                   |       | 62,736                    |       |
| Professional  fees                |       | 10,439                   |       | 121,694                   |       |
| Insurance                         |       | 9,851                    |       | 44,610                    |       |
| Maintenance  agreement            |       | 5,767                    |       | 40,370                    |       |
| Software                          |       | —                   |       | 77,436                    |       |
| Other                             |       | 5,540                    |       | 13,089                    |       |
|                              |       | $                        | 692,441    |                      | $          | 1,045,795 |   |

 

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Other assets consisted ofthe following at March 31, 2006 and December 31, 2005:
| ** **                | ** ** | **March 31,  2006** | ** ** | **December 31,**2005 | ** ** |
|---------------------------|------------|--------------------------|------------|---------------------------|------------|
|                      |       |                     |       |                      |       |
| Rent                      |       | $                        | 29,848     |                      | $          | 29,522 |   |
| Call termination  charges |       | 21,378                   |       | 21,145                    |       |
| Legal deposit             |       | 4,590                    |       | 4,540                     |       |
| Other                     |       | 2,089                    |       | 2,065                     |       |
|                      |       | $                        | 57,905     |                      | $          | 57,272 |   |

 

Accrued expenses at March 31, 2006 and December 31,2005 consisted of the following:
| ** **                            | ** ** | **March 31,  2006** | ** ** | **December 31,**2005 | ** ** |
|---------------------------------------|------------|--------------------------|------------|---------------------------|------------|
|                                  |       |                     |       |                      |       |
| Professional  fees                    |       | $                        | 177,238    |                      | $          | 313,897 |   |
| Travel                                |       | 148,469                  |       | 33,415                    |       |
| Fees due  pursuant to credit facility |       | 112,500                  |       | —                    |       |
| Payroll and  payroll related          |       | 104,388                  |       | 141,983                   |       |
| Termination  costs                    |       | 49,858                   |       | 60,924                    |       |
| Interest                              |       | 20,756                   |       | 17,693                    |       |
| Marketing                             |       | 17,398                   |       | —                    |       |
| Telephone                             |       | 9,128                    |       | —                    |       |
| Printing                              |       | 5,865                    |       | 14,655                    |       |
| Rent                                  |       | —                   |       | 8,514                     |       |
| Directors’ fees                  |       | —                   |       | 20,200                    |       |
| Other                                 |       | 11,929                   |       | 16,873                    |       |
|                                  |       | $                        | 657,529    |                      | $          | 628,154 |   |

 

**(5)****          ****Comprehensive Loss**

For the three-month periods ended March 31,2006 and 2005, the components of other comprehensive loss consisted of theCompany’s net loss and foreign currency translation adjustments. Comprehensiveloss was $4,178,992 and $1,398,297 for the three months ended March 31,2006 and 2005, respectively.

**(6)****          ****Net Loss Per Share**

Basic net loss per share is computed by dividing netloss for the period by the weighted average number of common shares outstandingduring the period. Diluted net loss per share is computed by dividing net lossby the weighted average number of common shares outstanding during the periodplus the dilutive effect of outstanding stock options. As there was a net lossfor the three-month period ending March 31, 2006, 2,453,000 outstandingstock options (excluding 6,350,000 options pending shareholder ratification ofan amendment to the 2004 Stock Incentive Plan), 9,962,025 outstanding warrants,and 8,399,999 common shares obtainable upon exercise of the conversion featureof the convertible debentureswere excluded from the calculation of diluted earnings per share because theywere anti-dilutive. As there was a net loss for the three-month period ending March 31,2005, 3,025,000 outstanding stock options, 9,302,500 outstanding warrants,and 11,200,000 common shares obtainable upon exercise of the conversion featureof the convertible debentures wereexcluded from the calculation of diluted earnings per share because they wereanti-dilutive.

11

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**(7)           Employment Agreements**

On January 5,2006, the Company entered into an employment agreement with Ian Cope relatingto Mr. Cope’s employment as its chief operations officer. Under theemployment agreement, the Company will pay Mr. Cope an annual base salaryof $140,000 and provide him with certain employment-related benefits. Inaddition, the employment agreement provides that the Company will grant Mr. Copean incentive stock option to purchase 250,000 shares of the Company’s commonstock with an exercise price equal to $1.42 per share; 50,000 of those sharessubject to the option vested immediately and the remaining 200,000 sharessubject to the option will vest in four equal annual installments of 50,000shares beginning on January 5, 2007. The option is subject to the termsand conditions of the Company’s Amended and Restated 2004 Stock Incentive Plan.The employment agreement also provides that if Mr. Cope is terminatedwithout cause, the Company will pay him his base salary for three months.

On February 28,2006, the Company finalized an agreement with Mark Scully resolving mattersrelating to his cessation of employment as president and chief executive officerof Vistula USA, one of the Company’s wholly-owned subsidiaries, on November 2,2005. In connection with a mutual release of claims, the Company paid Mr. Scully$50,000 in severance and issued to him 750,000 shares of common stock inrespect of the exercise of an outstanding option issued under the Company’s Amendedand Restated 2004 Stock Incentive Plan.

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**(8)           Related Party Transactions**

OnMarch 10, 2006, on behalf of the Company, the Chairman advanced $75,000directly to an escrow agent, allowing the Company to fulfill a contractualcommitment in the normal course of business. The deposit was returned to theChairman in full on March 27, 2006.

**(9)****          ****AssetPurchase**

In January 2004, theCompany signed an agreement to purchase certain equipment from another entityin exchange for $2,000,000, less any fees, costs and expenses incurred by theCompany to re-certify or re-license such assets by June 30, 2004. TheCompany agreed to lease the equipment until it completed the purchase. Theagreement was amended on May 5, 2004. As a result of the amendment, thepurchase price for the equipment was $1,670,000 and 725,000 shares of commonstock and the agreement was extended through April 1, 2005. The agreementwas further amended on March 15, 2005, at which time the Company completedthe purchase. In consideration for the equipment purchased, the Company paid$500,000 in March 2005, issued 725,000 shares of common stock, and issueda promissory note for $1,170,000. The note was subsequently adjusted on May 16,2005 to reduce the principal amount to $970,000, reflective of unanticipatedrecertification costs. Under the terms of the promissory note, interest accruesdaily at a rate of 8.25% per annum and is payable monthly in arrears. Aninitial principal payment of $100,000 was paid in 2005. An additional principalpayment of $100,000 that was due on December 31, 2005 was extended to andpaid on March 31, 2006. The remaining principal amount ($770,000) and anyunpaid interest originally payable on the first anniversary of the closing ofthe purchase, March 15, 2006, was extended to May 23, 2006.

ThroughMarch 15, 2005, the Company accounted for the agreement as a capital leasein accordance with SFAS No. 13 *Accounting for Leases*and reflected the liability as a capitallease obligation. As of March 15, 2005, the obligation has been includedin the consolidated balance sheet under the caption “Long-term obligation.”

The Company originally recorded the present value ofthe minimum lease payments as an asset of $1,855,835. The equipment was notplaced in service as of March 31, 2005. The future minimum lease paymentsrelated to the capital lease was $2,000,000, which included $144,165 related tointerest. The Company recorded $0 and $27,997 related to interest expense onthe capital lease for the three-month periods ended March 31, 2006 and2005, respectively. The Company does not have any minimum sublease rentalincome related to the capital lease. There were no contingent rentals duringthe three-month period ended March 31, 2006.

The Company has deemed the May 5, 2004amendment described above to be a modification of the lease pursuant to SFAS No. 13.As of May 5, 2004, the balance of the asset and associated capital leaseobligation was adjusted by an amount equal to the difference between thepresent value of the future minimum lease payments under the modified agreementand the present balance of the obligation, with no resulting gain or lossrecognized. Under certain circumstances, the cash portion of the obligation wasconvertible into the Company’s common stock, at the lessor’s option. TheCompany accounted for the conversion feature associated with the capital leaseobligation included in the May 2004 amendment pursuant to EITF Issue No. 98-5,*Accounting for Convertible Securities withBeneficial Conversion Features or Contingently Adjustable Conversion Ratios*,whereby the Company measured the beneficial conversion feature on the amendmentdate, but did not record any charge until the contingencies were resolved. Uponcompletion of the purchase in March 2005, the conversion feature expired,therefore no charge was recorded. The promissory note does not include aconversion feature.

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**(10)         Commitments and Contingencies**

Since its inception, the Companyhas sustained its operations through funding provided by the Chairman, as wellas contributed services by the Chairman and other stockholders, and debt andequity financings. The Chairman has made various advances to the Company from acredit facility established in the name of the Chairman, as well as other ofthe Chairman’s personal assets. The Company may obtain future advances from theChairman from both the credit facility and the Chairman’s other personal assetsin order to meet certain working capital needs. The Chairman may also cause thelender under the credit facility to issue standby letters of credit in favor ofone or more of the Company’s vendors to secure the Company’s obligations tosuch vendor or vendors. While the Chairman is not obligated to provide theseadvances to the Company or to cause the lender to issue standby letters ofcredit in favor of the Company’s vendors, the Company expects the Chairman tocontinue providing funds for operations in 2006 as and if needed, until suchtime that the Company raises external capital. In the absence of externalcapital, the Company will continue to be dependent on the Chairman to fundexisting operations and provide growth capital. Although the Company raisedexternal capital subsequent to March 31, 2006 (see Note 15), therecan be no assurances that the Company can continue to raise such capital onacceptable terms, if at all.

On January 27, 2006, the Companyentered into a Financial Advisory Agreement (the “Agreement”) with IndigoVentures LLC (“Indigo”) in which the Company agreed to appoint Indigo as itsfinancial advisor to advise, consult with, and assist the Company in variousmatters which may include:

·                  a review of the Company’s business, operations andfinancial condition, including advising the Company on capitalizationstructures;

·                  advice relating to generalcapital-raising matters;

·                  recommendations relating to specificbusiness operations, transactions and joint ventures;

·                  advice regarding future financingsinvolving the Company or any of the Company’s affiliates’ debt or equitysecurities; and

·                  assistance in connection with thedue diligence review of any significant acquisition transactions proposed bythe Company during the term of the agreement.

In consideration for these services,the Company agreed to pay Indigo a cash fee of $20,000 per month in arrears,increasing to $30,000 per month beginning in the first month following theconsummation of a significant debt or equity financing from which the Companyobtains gross proceeds of at least $5 million. Also, the Company issued toIndigo 1,500,000 restricted shares of common stock, which shares will vest uponthe earlier of: (i) the closing of a significant acquisition as may bedescribed in a written notice delivered by the Company to Indigo on or afterthe date of the Agreement, (ii) subject to the approval of the Company’scompensation committee, the closing of another major acquisition or financingtransaction on which Indigo provides advice, (iii) a change of control ofthe Company, or (iv) January 27, 2007. The shares the Company issuedto Indigo are restricted shares and may not be sold, assigned or transferred byIndigo for a one (1) year period beginning on January 27, 2006 andending on January 27, 2007. If the Company terminates the Agreement as aresult of a material breach of this Agreement by Indigo, the Company will havethe right and option to repurchase fifty percent (50%) of all of the thenunvested shares at a purchase price of $0.001 per share.

On March 30,2006 the Company entered into a revolving credit agreement with IndigoInvestments I LLC that provides for up to $5,000,000 in advances to beavailable to the Company. Upon the closing of this credit facility, $1,000,000was advanced to the Company and an additional $250,000 was advanced under thecredit agreement in April 2006. Additional advances under the creditfacility are dependent upon the Company’s accounts receivable balances andadherence to certain covenants as described in the credit agreement. Outstandingprincipal under this credit facility bears interest at a rate of 1.5% permonth, increasing to 2.5% per month in the event of a default by the Companyunder the credit agreement. In addition, the Company is required to pay thelender a 2.25% commitment fee on the total amount of the credit facility andissue the lender a five-year warrant to purchase up to 500,000 shares of commonstock at an exercise price of $1.50 per share. The exercise price of thewarrant is subject to adjustment in certain circumstances.

All outstandingprincipal and interest on the credit facility plus the commitment fee are dueand payable on the earlier of (i) September 30, 2006, or (ii) theclosing of the sale of a minimum of $6,000,000 of the Company’s equitysecurities; provided, that, in the event that such a financing closes prior to September 30,2006, the Company will also be required to pay the lender an early repaymentfee equal to 2.25% of the total amount of the credit facility. The rights ofthe lender under the credit facility are junior to those of the outstandingconvertible debentures.

Advances drawnunder this agreement are personally guaranteed by the Company’s Chairman,Rupert Galliers-Pratt.

The sale of unitsconsisting of common stock and warrants described in Note 15, resulted inan anti-dilution adjustment to the exercise price of the outstanding warrantsdescribed above. Such adjustment reduced the exercise price of such warrantsfrom $1.50 to $1.34 per share of common stock and increased the number ofexercisable shares related to such warrants from 500,000 to 559,701.

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**(11)****         Indemnification**

As permitted under Delaware law, the Company hasagreements with its directors whereby it indemnifies them for certain events oroccurrences while they are, or were serving, at the Company’s request as adirector (or in any other capacity). The term of the indemnification period isthe director’s lifetime. The maximum potential amount of future payments theCompany could be required to make under these indemnification agreements isunlimited; however, the Company has a director and officer insurance policypursuant to which the Company may recover all or a portion of amounts it paysto directors under their indemnification agreements. As a result of itsinsurance policy coverage, the Company believes the estimated fair value ofthese indemnification agreements is minimal.

The Company enters into standard indemnificationagreements in the ordinary course of its business. Pursuant to theseagreements, the Company indemnifies, holds harmless, and agrees to reimbursethe indemnified party for losses suffered or incurred by the indemnified party,generally distributors, agents, or customers, in connection with any patent,copyright, trademark, trade secret or other intellectual property infringementclaim by any third party with respect to the Company’s products. The term ofthese indemnification agreements is generally perpetual. The maximum potentialamount of future payments the Company could be required to make under theseindemnification agreements is often capped at a dollar figure. In addition, theCompany has agreed to indemnify the investors in the convertible debenturefinancing described in Note 13 against certain losses. The Company has neverincurred costs to defend lawsuits or settle claims related to theseindemnification agreements. As a result, the Company believes the estimatedfair value of these agreements is minimal.

**(12)****        ****Convertible Promissory Note to Related Party**

On July 2, 2004, the Company entered into a notesubscription agreement with the J. Rothschild Assurance Self Invested PersonalPension Plan No. 2, the sole beneficiary of which is the Company’sChairman, Rupert Galliers-Pratt. The note subscription agreement wasamended and restated on August 11, 2004. Under the amended and restatednote subscription agreement, the Company issued and sold to Mr. Galliers-Pratt’spension plan convertible promissory notes in the principal amounts of$125,000 and $50,000 on July 12, 2004 and on August 11, 2004,respectively. Both convertible promissorynotes have a one year term, accrue interest at the rate of 7% per annum and areconvertible into shares of the Company’s common stock at the price of $1.50 pershare. On August 11, 2005, the pension plan confirmed its earlieragreement to extend the maturity date of both promissory notes until December 31,2005. On December 15, 2005, the pension plan confirmed its earlieragreement to extend the maturity date of both promissory notes until June 30,2006.

**(13)****         ConvertibleDebentures and Warrant Financing**

On February 18,2005 and March 4, 2005, the Company issued and sold convertible debentures and warrants to certainsophisticated institutional and individual investors pursuant to a SecuritiesPurchase Agreement between the Company and the investors. In the two closingsof the private placement under the Securities Purchase Agreement, the Company sold convertible debentures in the aggregateprincipal amount of $8,400,000, convertible into common stock of the Company at$0.75 per share, and warrants to purchase an aggregate of 8,400,000 shares ofcommon stock, at an exercise price of $1.00 per share. These warrants expirefive years after the issue date.

The debentures accrue interest daily at a rate of 8% per annum, whichinterest is payable quarterly on each March 31, June 30, September 30and December 31 following the issue date. The final interest payment isdue on the date of maturity of the debentures, the third anniversary of theissue date. In addition, on any date on which all or a portion of the principalof a debenture is converted, all unpaid interest having accrued on suchprincipal at the time of such conversion will become immediately payable. TheCompany is not permitted to prepay anyportion of the principal amount of any of the debentures without the priorconsent of the holder thereof.

The debentures are convertible at the option of the holders into sharesof common stock at any time at an initial conversion price of $0.75 per share.Except in the case of certain designated issuances, in the event theCompany issues shares of common stock orcommon stock equivalents (i.e., securities convertible into, or exercisable orexchangeable for, shares of common stock) at a price per share (or in the caseof common stock equivalents, a conversion, exercise or exchange price pershare) below the then applicable conversion price of the debentures, theconversion price of the debentures will be reduced to that lower price pershare. Issuances that will not result in adjustment to the conversion priceinclude issuances to employees, consultants, directors or officers pursuant toa stock or option plan adopted by the Company’s board of directors, securities issued upon conversion of othersecurities outstanding prior to the date of issuance of the warrants, warrantsissued in connection with obtaining bank financing, common stock issued inconnection with the settlement of claims, and securities issued in connectionwith acquisitions, joint ventures or other strategic transactions.

The Company has agreed to certain restrictions under the terms of thedebentures, including a prohibition on the payment of cash dividends tostockholders while any of the debentures are outstanding. Upon the occurrenceof an event of default under the debentures, an amount equal to (i) 130%of the then outstanding principal amount, plus any accrued and unpaid interest thereon,or (ii) the product of the then outstanding principal amount, plus anyaccrued and unpaid interest thereon, times the ratio obtained by dividing theconversion price of the debentures and the market price of the Company’s common stock, whichever is greater, will, atthe holder’s option, become immediately due and payable in cash along with anyother amounts, costs, expenses or liquidated damages then due in respect ofsuch debentures. The ratio referred to in clause (ii) is to becalculated based on the conversion price in effect on the date of such defaultor the 

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datethe accelerated amount is paid in full (whichever is less), and the marketprice of the Company’s common stockon the date of such default or the date the accelerated amount is paid in full(whichever is greater, such market price to be determined in accordance withthe terms of the debenture). Upon an event of a default, the interest rate onthe debentures will also be increased to 18% per annum.

Events of default under the debentures include failure to pay anyamounts under the debentures when due, a material default under theCompany’s other agreements with theinvestors or default in the Company’sobligations under mortgage, credit facility or similar agreements, a materialinaccuracy in the representations and warranties made to the investors inconnection with the convertible debenture and warrant financing, and theinitiation of voluntary or involuntary bankruptcy proceedings against theCompany.

Through March 31, 2006, $2,100,000 in outstanding principal amountof convertible debentures has been converted into 2,799,993 shares of commonstock, reducing the amount of interest required to be paid in future periods.

The common stock purchase warrants issued to the investors are exercisableat an initial exercise price of $1.00. The warrants have an expiration date offive years after the date of issuance. They contain a cashless exerciseprovision whereby the holder may pay the exercise price by having theCompany withhold upon exercise shares havinga fair market value equal to the applicable aggregate exercise price if afterthe first anniversary of the date of issuance of the warrant there is noeffective registration statement registering, or no current prospectusavailable for, the resale of the shares issuable upon the exercise of thewarrants. In the event this provision is used with respect to an exercise, theCompany would receive no proceeds from thesale of its common stock in connection with such exercise. The warrantswere initially exercisable for an aggregate 8,400,000 shares of common stock. Asof March 31, 2006, the Company had issued 3,190,499 shares upon exerciseof warrants, all in connection with the warrant exercise agreements describedbelow.

The exercise price is subject to adjustment in the event of certainissuances of new securities. Specifically, except in the case of certaindesignated issuances, if the Companyissues shares of common stock or common stock equivalents (i.e., securitiesconvertible into, or exercisable or exchangeable for, shares of theCompany’s common stock) at a price per share(or in the case of common stock equivalents, a conversion, exercise or exchangeprice per share) below the then applicable exercise price of the warrants, theexercise price of the warrants will be reduced to that lower price per share.In the event of such an adjustment, the number of shares for which the warrantsare exercisable will be increased such that the aggregate exercise price of thewarrants after the adjustment will equal the aggregate exercise priceimmediately prior to the adjustment. Issuances that will not result inadjustment to the exercise price include issuances to employees, consultants,directors or officers pursuant to a stock or option plan adopted by theCompany’s board of directors, securitiesissued upon conversion of other securities outstanding prior to the date ofissuance of the warrants, warrants issued in connection with obtaining bankfinancing, common stock issued in connection with the settlement of claims, andsecurities issued in connection with acquisitions, joint ventures or otherstrategic transactions.

In connection with the two closings of the private placement, theCompany paid placement fees in the aggregateamount of $802,500 to the placement agent. At the second closing, the Companyalso issued to the placement agent a warrant to purchase up to 802,500 sharesof common stock at an initial exercise price of $1.00 per share. The warrant,which expires on March 4, 2010, is on substantially the same terms as thewarrants issued to the investors in the private placement.

The Companyregistered for resale under the Securities Act of 1933, as amended, the sharesunderlying the debentures and warrants pursuant to a registration statement on Form SB-2,as amended, (File No. 333-123815). The registration statement wasdeclared effective on May 3, 2005.

*Warrant Exercise Agreements.  *In October 2005, theCompany entered into several Warrant Exercise Agreements with holders of warrantsissued in the private placement that closed in the first quarter of 2005.Pursuant to these agreements, the Company issued to these holders new commonstock purchase warrants exercisable for a number of shares equal to the numberof shares they purchased upon exercise of the warrants issued to them in theprivate placement. These new warrants have an exercise price of $1.50 per share.The Company received aggregate proceeds of $3,190,499 in connection with theexercise of the prior warrants, and issued new warrants, which expire fiveyears after the issue date, to purchase an aggregate of 3,190,499 shares ofcommon stock (plus an additional warrant, which expires five years after theissue date, to purchase 159,525 shares of common stock to a placement agent whoassisted with the transaction). The shares of common stock underlying thesewarrants have been registered for resale with the Securities and ExchangeCommission pursuant to a registration statement on Form SB-2 (File No. 333-130808).This registration statement was declared effective on January 31, 2006.

**(14)****         Distributionand Marketing Agreement**

On August 11,2004, the Company entered into a distribution and marketing agreement withNetYantra Inc. and NetYantra India Pvt. Ltd. (collectively, “NetYantra”)pursuant to which NetYantra grants to the Company the exclusive worldwiderights (other than in India where NetYantra is headquartered and subject tocertain existing distribution agreements) to market and distribute the V-CubeTMIP-PBX software platform developed by NetYantra to Tier 1 carriers,telecommunications equipment manufacturers, internet service providers, largecorporations, SMEs and other business entities and individual retail customers.Under this agreement, the Company paid NetYantra $400,000 and was required topay NetYantra fifty percent of certain net revenues that the Company derivedfrom the distribution of the V-CubeTM platform.

In addition, the agreement stated that in the event that the Company’scommon stock was quoted or traded on a stock market on or before the firstanniversary of the agreement, the Company would issue to NetYantra shares ofthe Company’s common stock having a market value of $1,000,000 based on theopening price of the Company’s common stock on the first day of trading (or, atthe Company’s option, pay to 

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NetYantraa cash payment of $1,000,000 instead of issuing such shares). On July 21,2005, public trading in the Company’s common stock began jointly on the OTCBulletin Board and the Pink Sheets Electronic Quotation Service under thetrading symbol “VSTL.”  The opening salewas at a price of $2.00 per share. The Company issued 500,000 shares of itscommon stock to NetYantra in compliance with the agreement.

On May 1, 2006, the Company executed and delivered an AssetPurchase Agreement with NetYantra relating to the V-CubeTM IP-PBX software platform. The terms of thisagreement are described in Note 15 below.

**(15)****         SubsequentEvents**

On May 22, 2006, the Company entered into a stock and warrantpurchase agreement with 23 accredited investors whereby the Company sold16,300,000 units. Each unit consists of one share of common stock andeight-tenths of one warrant to acquire one share of common stock and is sold ata purchase price of $1.00 per unit. In exchange for the units sold, the Companyreceived gross cash proceeds of $16,300,000. The warrants are exercisable untilMay 2011 at an exercise price of $1.00 per share.

CRT Capital Group LLC acted as the placement agent in connection withthe offering. The aggregate commissions payable to CRT in connection with theprivate placement were approximately $978,000. In addition, the Company issuedwarrants to the placement agent to purchase 1,467,000 shares of common stocksimilar to those sold to the investors.

The Companyrealized net proceeds from the sale of units, after deducting placement agentfees and expenses, of approximately $15.2 million. The Company expects touse these proceeds to purchase the software and intellectual property rights ofNetYantra’s V-Cube IP-PBX platform as described below ($8.8 million); pay theoutstanding principal, interest and fees related to the revolving creditagreement with Indigo Investments I LLC described in Note 10 ($1.5million); pay the outstanding principal and interest related to the promissorynote for equipment described in Note 9 ($0.8 million); and for generalcorporate purposes.

The Company agreed to register the resale of the shares of common stocksold in the offering and issuable upon exercise of the warrants. The Company isrequired to file the registration statement with the Securities and ExchangeCommission (“SEC”) within forty-five (45) days of the closing and use itsbest efforts to cause the registration statement to be declared effective underthe Securities Act of 1933, as amended, no later than the earlier of (i) ninety(90) days (or in the case of a full review one hundred and twenty (120) days)after the closing date and (ii) the sixth (6th) business dayfollowing the date on which the Company is notified by the SEC that theregistration statement will not be reviewed or is no longer subject to furtherreview and comments. The Company is required to use its best efforts to keepthe registration statement continuously effective under the Securities Actuntil the earlier of the date when all the registrable securities covered bythe registration statement have been sold or are freely saleable and the secondanniversary of the closing. In the event that the registration statement is nottimely filed or declared effective when due, or after effectiveness ceases toremain effective, the Company is obligated to make cash payments in the natureof liquidated damages up to a limit of 10% of the purchase price of the units.

 On May 1, 2006, Vistula executed anddelivered an Asset Purchase Agreement (the “Purchase Agreement”) with NetYantra.Under the terms of the Purchase Agreement, Vistula agrees to purchase NetYantra’sV-Cube IP-PBX platform software and associated intellectual property that theCompany is currently licensed to market and distribute pursuant to thedistribution and marketing agreement described in Note 14. The purchase pricefor the software and associated intellectual property is $8.8 million in cashand 14 million shares of Vistula’s common stock. Completion of the acquisitionis subject to Vistula obtaining sufficient financing to pay the cash portion ofthe purchase price, the negotiation of ancillary agreements between the parties(including a services agreement under which NetYantra will provide support anddevelopment services with respect to the acquired software and a registrationrights agreement under which Vistula will grant NetYantra certain rights torequire registration of the shares received as part of the purchase price forresale under the Securities Act of 1933 (the “Securities Act”)), completion toVistula’s satisfaction of a due diligence review in connection with theacquisition, and customary closing conditions.

On April 11,2006, the Company entered into an employment agreement with J. Keith Markleyrelating to Mr. Markley’s employment as its chief executive officer. Underthe employment agreement, the Company will pay Mr. Markley an annual basesalary of $290,000 and provide him with customary employment-related benefits.In addition, the employment agreement provides for the grant to Mr. Markleyof two non-qualified stock options to purchase shares of common stock, oneexercisable for 3,052,000 shares and the other exercisable for 948,000 shares,with the latter option grant subject to the ratification by stockholders at thenext annual meeting of an increase in the number of shares available under theAmended and Restated 2004 Stock Incentive Plan to at least 16,000,000 shares.The Company’s compensation committee approved these grants on April 11,2006, and fixed the exercise price per share at $1.18, representing the fairmarket value of the Company’s common stock on the date of grant based on theprevious day’s closing price.

Each option vestswith respect to one-sixth of the total number of shares subject to the optionsix months after the date of grant. Each option continues to vest with respect toan additional one thirty-sixth of the total number of shares subject to theoption on 

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a monthly basisthereafter until fully vested. The options will accelerate in full upon achange of control of the Company or a termination without cause (as defined inthe employment agreement).

In the event theCompany terminates Mr. Markley’s employment without cause, or heterminates his employment for good reason (as defined in the employmentagreement), the Company will be required to make severance payments equivalentto the base salary he would have received had his employment continued and tocontinue to provide medical benefits, in each case for a period of twelvemonths following the termination.

Mr. Markleyhas agreed not to engage during his employment and for a period of one yearfollowing the termination of his employment in any activities competitive withthat of the Company in the United States or any foreign territory where theCompany or any of its subsidiaries are conducting business. He has also agreed,during that period, not to solicit any of the Company’s employees or theemployees of its subsidiaries to leave the Company or to solicit any of theCompany’s clients to terminate or curtail their business relationships with theCompany.

On April 11, 2006,the board of directors formally appointed Mr. Markley as chief executiveofficer and elected him as a director. On April 11, 2006, the board ofdirectors elected Jack Early as a director of the Company to fill the vacancycreated by the departure of Kevin West in June of 2005.

On April 12,2006, the board of directors approved an increase in the number of shares ofcommon stock authorized under the Amended and Restated 2004 Stock IncentivePlan (the “Plan”) to 18,000,000 shares. The increase will be submitted to theCompany’s stockholders for their ratification at the next annual meeting.

On April 12,2006, the Company granted options to purchase common stock to the persons andin the amounts that follow:

| Employee, Consultant or Director | ** ** | **Shares** | ** ** |
|-------------------------------------------------|------------|------------|------------|
|                                            |       |       |       |
| Adam Bishop                                     |       | 150,000    |       |
|                                            |       |       |       |
| Ian Cope                                        |       | 50,000     |       |
|                                            |       |       |       |
| Olympic  Corporate Holdings Limited             |       | 100,000    |       |
|                                            |       |       |       |
| Nick Topham                                     |       | 50,000     |       |
|                                            |       |       |       |
| George R. Vaughn                                |       | 20,000     |       |
|                                            |       |       |       |
| Executive  Management Services Limited          |       | 800,000    |       |
|                                            |       |       |       |
| Anthony  Warrender                              |       | 50,000     |       |
|                                            |       |       |       |
| J. Marcus Payne                                 |       | 50,000     |       |
|                                            |       |       |       |
|                                            |       | 1,270,000  |       |

 

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All of the aboveoptions have an exercise price of $1.25 per share and an expiration date of April 12,2016. The options were granted as compensation for consulting, employment ordirector services, as applicable. The options will become vested as to 25% ofthe total number of option shares upon shareholder ratification of the increasein the number of shares authorized under the Company’s 2004 Stock IncentivePlan to at least 18,000,000 shares described above. Thereafter, the optionswill become vested as to an additional 6.25% of the total number of optionshares in quarterly installments beginning on September 30, 2006. However,all vesting will be contingent upon shareholder approval of the increase in thenumber of shares available under the Plan. Mr. Payne is a director ofOlympic Corporate Holdings Limited. Rupert Galliers-Pratt holds indirect votingand investment control over shares held by Executive Management ServicesLimited.

The Company alsogranted options to purchase shares of common stock to J. Keith Markley asdescribed above and to Jack Early in connection with his election as adirector. The option granted to Mr. Early is exercisable for 250,000shares, subject to vesting, at an exercise price per share of $1.18 (the fairmarket value on the date of grant). The option is immediately exercisable withrespect to 50,000 of the shares purchasable thereunder and will vest withrespect to 50,000 additional shares on a quarterly basis until fully vested.The vesting of Mr. Early’s option is also subject to acceleration in fullupon a change of control.

**Item 2.**                          Management’sDiscussion and Analysis of Financial Condition and Results of Operations.

**Introduction**

Thefollowing information should be read in conjunction with the financialstatements and notes thereto in Part I, Item 1 of this Quarterly Reportand with Management’s Discussion and Analysis of Financial Condition andResults of Operations contained in our Annual Report on Form 10-KSBfor the year ended December 31, 2005 (File No. 000-50758).

**Cautionary Statements**

We do not provideforecasts of our future financial performance. However, from time to time,information provided by us or statements made by our employees may contain “forward-looking”information that involves risks and uncertainties. In particular, statementscontained in this Quarterly Report that are not historical facts constituteforward-looking statements and are made under the safe harbor provisions of thePrivate Securities Litigation Reform Act of 1995. Forward-looking statementsinvolve substantial risks and uncertainties. You can identify these statementsby forward-looking words such as “may”, “will”, “expect”, “anticipate”, “believe”,“estimate”, “continue”, and similar words. You should read forward-lookingstatements carefully because they: (1) discuss our future expectations; (2) containprojections of our future operating results or financial condition; or (3) stateother “forward-looking” information. Various factors described below, as wellas any other instances of cautionary language in this Quarterly Report, referto or provide examples of risks, uncertainties and events that may cause ouractual results to be materially different than the expectations described inour forward-looking statements. You should be aware that the occurrence of anyof the events or factors described below and elsewhere in this Quarterly Reportcould materially and adversely affect our business. All forward-lookingstatements included in this Quarterly Report are based on information availableto us on the date hereof, and we assume no obligation to update any suchforward-looking statements.

Each forward-looking statement should be read in conjunctionwith the financial statements and notes thereto in Part I, Item 1 of thisQuarterly Report, this section, and Management’s Discussion and Analysis ofFinancial Condition and Results of Operations contained in our Annual Report onForm 10-KSB for the year ended December 31, 2005 (File No.000-50758),including but not limited to the section therein entitled “FactorsAffecting Future Performance.”

In addition to the risks and uncertainties faced generally byparticipants in the telecommunication industry, we face the following risks anduncertainties:

·                                          We have alimited operating history; therefore, we may not be able to accurately forecastfuture results and operating losses in future periods could be greater thanexpected.

·                                          If we do notobtain a substantial amount of additional financing, we may have to curtail orsuspend operations.

·                                          We may continueto lose money on our operations.

·                                          If we areunable to preserve our exclusive rights to market and distribute the V-CubeTM, our business may suffer.

·                                          If we fail to establish the Vistula and Cardlinkbrands or to attract repeat customers, we may not be able to increase ourrevenues sufficiently to fund our operations.

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·                                          We have only limited revenue of which a significantportion is derived from a limited number of contracts and customers. If we areunable to replace contracts upon completion and maintain customerrelationships, we could have a significant decrease in our revenues that wouldnegatively impact our results.

·                                          We may experience significantfluctuations in our results as a result of uncertainties relating to ourability to generate additional revenues, manage our expenditures and otherfactors, certain of which are outside of our control.

·                                          Our contracts typically containprovisions giving customers the ability to terminate their contracts undervarious circumstances and we may not be able to replace the revenues from suchcontracts that may have an adverse effect on our revenues and operatingresults.

·                                          We may not beable to promptly reduce expenses in response to any decrease in our revenues,which would result in lower net margins.

·                                          If we areunable to collect receivables from development stage customers and othertelecommunications companies, our operating results may be materially harmed.

·                                          The extent ofour dependence on international operations may give rise to increasedmanagement challenges and could harm our results of operations.

·                                          Providingservices outside the United States carries the additional risk of currencyfluctuations and foreign exchange controls imposed by certain countries sincemany of our non-U.S. projects are undertaken in local currency.

·                                          Our inabilityto anticipate or adapt to changes in technology may harm our competitiveposition, reputation and opportunities for revenue growth.

·                                          We may not beable to hire or retain a sufficient number of qualified engineers and otheremployees to meet our customers’ needs or maintain the quality of our services.

·                                          Futureacquisitions of new companies or technologies may result in disruption to ourbusiness and expose us to risks associated with acquisitions.

·                                          Theconsolidation of telecommunication service providers could adversely impact ourbusiness.

·                                          Governmentregulations may adversely affect our business.

·                                          If we fail toretain our key personnel and attract and retain additional qualified personnel,we might not be able to meet our customers’ needs.

·                                          The managementof our finances and the quality and timeliness of our financial reporting maybe adversely affected if we are unable to increase the size and capabilities ofour internal administrative and finance function as our business grows.

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·                                          We will not besuccessful if we do not grow our customer base beyond our initial customers.

·                                          If we do notrespond rapidly to technological changes or to changes in industry standards,our products and services could become obsolete.

·                                          We will not retain customers or attractnew customers if we do not anticipate and meet specific customer requirementsand if our products and services do not adequately interoperate with ourcustomers’ existing networks.

·                                          If we fail to compete successfully, ourability to increase our revenues or achieve profitability will be impaired.

·                                          Our business is exposed to the generalconditions of the telecommunications market.

·                                          The markets forwholesale voice services (particularly VoIP services) and pre-pay products arenew and evolving and, if these markets do not develop as expected, then itcould have a material adverse effect on our business.

·                                          Intellectualproperty infringement claims against us or any of our subsidiaries, evenwithout merit, could require us to enter into costly licenses or deprive us ofthe technology we need.

·                                          Failure toprotect our intellectual property rights could have a material adverse effecton our business.

·                                          If our productscontain defects, then our sales are likely to suffer, and we may be exposed tolegal claims.

·                                          We may besubject to litigation.

Because of the foregoing and other factors, we may experience materialfluctuations in our future operating results on a quarterly or annual basiswhich could materially adversely affect our business, financial condition andoperating results.

**Overview**

VistulaCommunications Services, Inc. (“VCS”, the “Company” or “we”) currently hasthree wholly-owned subsidiaries: Vistula Limited (“Vistula”), Vistula USA, Inc.(“Vistula USA”) and Cardlink Services Limited (“Cardlink”), and has onesubsidiary that is 60% owned, Vistula Communications Services SA (Pty) Ltd. (“VistulaSA”). Through Vistula and Vistula USA, we currently provide wholesalevalue-added telecommunications services (including direct and partner voicerouting services) to Tier 1 and Tier 2 telecommunication carriers and transitoperators. In the first quarter of 2005, through Vistula, Vistula USA, andVistula SA we began to market our V-CubeTM Voice over Internet Protocol, or “VoIP,”IP-PBX software platform to telecommunications carriers, Internet serviceproviders, or “ISPs,” large corporations and small and medium enterprises, or “SMEs,”throughout the world.

Through ourCardlink subsidiary we plan to market and distribute electronic top-upsoftware, which enables prepayment for services provided by mobile telephoneoperators, and associated services to Tier 1 and Tier 2 telecommunicationscarriers and transit network operators throughout the world. Cardlink hasdeveloped a software product suite that enables mobile operators toelectronically process prepayments from “pay-as-you-go” mobile phone customers.

***Vistula, Vistula USA, and Vistula SA***

Vistula, VistulaUSA, and Vistula SA are aggregators of wholesale telecommunications services toTier 1 and Tier 2 telecommunications carriers and transit network operators.Vistula, Vistula USA, and Vistula SA are collectively referred to as the “VistulaCompanies.” The Vistula Companies have switching facilities in London and LosAngeles and interconnect agreements with suppliers and customers in theselocations. We believe that the Vistula Companies are well positioned to takeadvantage of the disruption and uncertainty in the telecommunications sectorover the past few years. We believe the opportunity for well-managed andwell-financed wholesale carriers is significant.

The VistulaCompanies began to actively market our V-CubeTM IP-PBX platform to carriers,transit network operators, large corporations, and SMEs in the first quarter of2005. We expect this multiple feature VoIP platform, which will enablecustomers to convert their existing PBX phone systems to provide VoIP capabilitywithout the need for significant investment in new hardware, will provide theVistula Companies with a highly competitive VoIP solution.

On April 1,2005, we entered into a distribution and marketing agreement with TelstraEurope Limited, a U.K.-based telecommunications carrier. Under this agreement,we license Telstra Europe to provide hosted IP-PBX services to its customersusing the hosted V-CubeTM IP-PBX platform. The agreement grants Telstra European exclusive license to provide the hosted solution to its 

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customers in the UnitedKingdom and Ireland for a period of five years. The monthly license fee payableby Telstra Europe to us is based on the number of individual users at thevarious Telstra Europe customers who are using the VoIP services provided byTelstra Europe through use of the V-CubeTM platform. We anticipate leveragingthe marketing advantages and customer relationships of Telstra Europe toprovide us with regular monthly revenue. We expect Telstra to launch theproduct to their customers during the second quarter of 2006.

***Cardlink***

Cardlink was firstacquired by Rupert Galliers-Pratt and certain members of his family in April 2003.VCS acquired Cardlink through the share exchange completed in March 2004.Cardlink will offer an electronic top-up, or “ETU”, software product suitewhich will enable mobile operators to electronically process prepayments from “pay-as-you-go”customers. Cardlink’s products will allow these customers to “electronicallytop-up” their accounts with the mobile operator. We believe that the market forthese prepayment services is expanding both in the developed and in theunderdeveloped regions in the world and we believe that Cardlink’s ETU productwill be of value as new mobile operators throughout the world seek to adoptthis technology.

We believe thatthe potential for providing ETU services in markets where the adoption and useof mobile telephony is growing rapidly will create opportunities and long-termgrowth potential for Cardlink. We intend that Cardlink will typically receive apercentage of the total mobile revenues transacted through the Cardlink system.As a result, Cardlink will be a beneficiary of any increase in mobile telephonyrevenues without any investment of capital in building infrastructure. Wecurrently expect to use third parties to provide necessary software updates,maintenance and support for these activities.

**RecentDevelopments**

On May 1,2006, we executed and delivered an asset purchase agreement with NetYantraInc., a Delaware corporation, and NetYantra India Private Limited, an Indiancompany and wholly-owned subsidiary of NetYantra Inc. (to which we collectivelyrefer below as “NetYantra”).

Under the terms ofthe asset purchase agreement, we have agreed to purchase NetYantra’s VoIPIP-PBX platform software and associated intellectual property. We currentlydistribute this software as the V-CubeTM VoIP IP-PBX platform offering under adistribution and marketing agreement with NetYantra. The V-CubeTM VoIP IP-PBXplatform enables telecom carriers and internet service providers to offer abroad range of IP telephony services from simple IP telephone calls to videoconferencing to their customers.

The purchase pricefor the software and associated intellectual property is $8.8 million in cashand 14 million shares of our common stock. Completion of the acquisition issubject to our obtaining sufficient financing to pay the cash portion of thepurchase price, the negotiation of ancillary agreements between the parties(including a services agreement under which NetYantra will provide support anddevelopment services with respect to the acquired software and a registrationrights agreement under which we will grant NetYantra certain rights to requireregistration of the shares received as part of the purchase price for resaleunder the Securities Act of 1933), completion to our satisfaction of a duediligence review in connection with the acquisition, and customary closingconditions.

As describedfurther below and in Note 15, in May 2006 we received net proceeds of approximately$15.2 million from the sale of units, each unit consisting of one share ofcommon stock and eight-tenths of one warrant to acquire one share of commonstock.

**CriticalAccounting Policies**

Our consolidatedfinancial statements are prepared in accordance with accounting principles generallyaccepted in the United States. These accounting principles require us to makecertain estimates, judgments and assumptions. We believe that the estimates,judgments and assumptions upon which we rely are reasonable based uponinformation available to us at the time that these estimates, judgments andassumptions are made. These estimates, judgments and assumptions can affect thereported amounts of assets and liabilities as of the date of the financialstatements, as well as the reported amounts of revenues and expenses during theperiods presented. Those estimates and judgments are based on management’shistorical experience, the terms of existing agreements, our observance oftrends in the industry, information that we obtain from our customers andoutside sources, and on various other assumptions that management believes tobe reasonable and appropriate under the circumstances, the results of whichform the basis for making judgments about the carrying values of assets andliabilities that are not readily apparent from other sources. To the extentthere are material differences between these estimates, judgments orassumptions and actual results, our financial statements will be affected.

We believe thatthe following accounting policies reflect our more significant judgments andestimates used in the preparation of our financial statements.

*RevenueRecognition*.   Our revenue is derived primarily from feescharged to terminate voice services over our network. We recognize suchrevenue, net of reserves, when persuasive evidence of a sales arrangementexists, delivery has occurred or services 

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have been rendered, thesales price is fixed and determinable and collectibility is reasonably assured.We reserve for potential billing disputes at the time revenue is recognized orthe dispute is known. Such disputes can result from disagreements withcustomers regarding the duration, destination or rates charged for each call.These revenue allowances are based on estimates derived from factors thatinclude, but are not limited to, historical results, analysis of creditsissued, current economic trends and changes in demand. Amounts billed inadvance of the service month are recorded as deferred revenue and recognized asrevenue as the underlying services are rendered.

Reciprocalcompensation is the amount paid by one carrier to complete particular calls onanother local exchange carrier’s network. Reciprocal compensation paid to andreceived from other carriers is based on contractual fixed rate per minutecharges. We apply the receipt of reciprocal compensation against the cost ofreciprocal compensation and reflect the net amount as either revenue (receiptsgreater than costs) or expense (costs greater than receipts) at each settlementdate.

We have enteredinto transactions such as buying, selling, swapping or exchanging capacity tocomplete and complement our network. In general, these transactions representthe exchange of productive assets not held for sale in the ordinary course ofbusiness and, as such, do not result in the culmination of the earningsprocess. Accordingly, we do not recognize any revenue for these types oftransactions. We account for the exchange of a non-monetary asset based on therecorded amount of the non-monetary asset relinquished with no gain or lossrecognized in accordance with Accounting Principles Board (APB) Opinion No. 29,*Accounting for Non-Monetary Transactions*.

*Stock-BasedCompensation*. Commencing on January 1, 2006 we beganapplying the provisions of Statement of Financial Accounting Standards (SFAS) No. 123R,Share Based Payment, or SFAS 123R, in accounting for stock-based compensation. SFAS123R requires measurement of the cost of employee services received in exchangefor an award of equity instruments based on the grant-date fair value of theaward. That cost is recognized over the period during which an employee isrequired to provide service in exchange for the award (usually the vestingperiod). Prior to January 1, 2006, we followed Accounting Principles Board(APB), Opinion No. 25, *Accounting for StockIssued to Employees*, or APB 25, and related interpretations, inaccounting for our stock-based compensation plans, rather than thealternative fair-value method provided for under SFAS No. 123, *Accounting for Stock-Based Compensation*, or SFAS 123.In the notes to our financial statements, we provide pro-forma disclosures inaccordance with SFAS 123. We account for transactions in which servicesare received from non-employees in exchange for equity instruments based on thefair value of such services received or of the equity instruments issued,whichever is more reliably measured, in accordance with SFAS 123 and theEmerging Issues Task Force (EITF) Issue 96-18, *Accountingfor Equity Instruments That Are Issued to Other than Employees for Acquiring,or in Conjunction with Selling, Goods or Services*, or EITF 96-18.

Accounting for equity instruments granted or sold byus under APB 25, SFAS 123, SFAS 123R and EITF 96-18 requiresfair-value estimates of the equity instrument granted or sold. If our estimatesof the fair value of these equity instruments are too high or too low, ourexpenses may be over- or understated. For equity instruments granted or sold inexchange for the receipt of goods or services, we estimate the fair value ofthe equity instruments based upon consideration of factors that we deem to berelevant at that time. Because shares of our common stock were not publiclytraded prior to July 21, 2005, market factors historically considered invaluing stock and stock option grants included comparative values of publiccompanies discounted for the risk and limited liquidity provided for in theshares we are issuing; prior valuations of stock grants and the effect ofevents that occurred between the time of such grants; economic trends; and thecomparative rights and preferences of the security being granted compared tothe rights and preferences of our other outstanding equity.

Prior to July 21,2005, the fair value of our common stock was determined by our board of directorscontemporaneously with the grant. In the absence of a public trading market forour common stock, our board of directors considered numerous objective andsubjective factors in determining the fair value of our common stock. At thetime of option grants and other stock issuances, our board of directorsconsidered the status of private and public financial markets; valuations ofcomparable private and public companies; the likelihood of achieving aliquidity event such as an initial public offering; our existing financialresources; our anticipated continuing operating losses and increased spendinglevels required to meet our business plan; dilution to common stockholders fromanticipated future financings; and a general assessment of future businessrisks.

**Results of Operations**

Net revenues for the three-month period ended March 31, 2006 were $319,419 which represents an increase of $197,221 (161.4%) over the $122,198 in revenues for the three-month period ended March 31, 2005. This increase is primarily attributable to an increase in wholesale revenues from UK customers.

Cost of revenues for thethree-month period ended March 31, 2006 were $351,513, an increase of86.7% over the $188,269 in the three-month period ended March 31, 2005.This increase is primarily due to an increase in wholesale revenues, net of a38.6% decrease in engineering costs ($42,606) classified as cost of revenuesfor the three-month period ended March 31, 2006 as compared to the sameperiod in fiscal 2005, due to a reduction in personnel costs.

Selling, general andadministrative costs for the three-month period ended March 31, 2006 were$3,840,580, an increase of 

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224.6% over the$1,183,105 for the three-month period ended March 31, 2005. During thethree-month period ended March 31, 2006, we incurred non-cash expenses of$1,875,000 as a result of the issuance of common stock to a financial advisoryfirm as partial compensation for its services to us. In addition, we incurredincreases in expenses associated with our periodic public company filingrequirements including professional and consulting fees, public and investorrelations fees, public company recordkeeping costs, insurance, and printing. Increasesin operational expenses were also incurred including compensation of employeesand consultants, expenses relating to maintenance and support agreements,marketing activities related to our VoIP product offering, increased facilitiescosts, and fees for the establishment of a credit facility.

During the three month period ended March 31, 2006, we incurred net interest expense of approximately $315,000, comprised of amortization of capital finance fees, amortization of the debt discount for the debentures held and interest on the convertible debentures, net of interest income received on cash balances as a result of the financing described in Note 13. During the three-month period ended March 31, 2005, we incurred net interest expense of approximately $162,000, comprised of interest on the convertible debentures and imputed interest on a capital lease obligation we entered into during 2004.

The non-cash expense for employee compensation for stock options was $60,103 and $198,500 for the three-month periods ended March 31, 2006 and ended March 31, 2005, respectively.

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For the three-month period ended March 31, 2006,we incurred a loss of $4,187,777 or $0.13 loss per common share, basic anddiluted.

**Liquidity And Capital Resources**

As of March 31, 2006, we had cash and cashequivalents of approximately $221,000 and a working capital deficit ofapproximately $2,252,000. This represents a decrease in cash and cashequivalents of approximately $332,000 from December 31, 2005 and anincrease in the working capital deficit of approximately $1,909,000 from thatat December 31, 2005. Since our inception through March 31, 2006, wehave generated losses of approximately $20,765,000. Accounts receivable wereapproximately $131,000 at March 31, 2006, an increase of approximately$1,000 from December 31, 2005. Accounts payable and accrued expenses at March 31,2006 increased approximately $325,000 from December 31, 2005.

We have made expenditures for capital equipment fromour inception until March 31, 2006 of approximately $867,000, inconnection with the purchase of telecommunications equipment necessary to beginour business. This amount excludes the $1.9 million in telecommunicationsequipment acquired from MRS Partners LLC (“MRS Partners”) described furtherbelow.

On May 22, 2006, we entered into a stock andwarrant purchase agreement with 23 accredited investors whereby we sold 16,300,000units. Each unit consists of one share of our common stock and eight-tenths ofone warrant to acquire one share of common stock and is sold at a purchaseprice of $1.00 per unit. In exchange for the units sold, we received gross cashproceeds of $16,300,000. The warrants are exercisable until May 2011 at anexercise price of $1.00 per share.

CRT Capital Group LLC acted as the placement agent inconnection with the offering. The aggregate commissions payable to CRT inconnection with the private placement were approximately $978,000. In addition,we issued warrants to the placement agent to purchase 1,467,000 shares ofcommon stock similar to those sold to the investors.

We realized net proceeds from the sale of units, afterdeducting placement agent fees and expenses, of approximately $15.2 million.We expect to use these proceeds to purchase the software and intellectualproperty rights of NetYantra’s V-Cube IP-PBX platform as described below ($8.8million); pay the outstanding principal, interest and fees related to therevolving credit agreement with Indigo Investments I LLC described in Note10 ($1.5 million); pay the outstanding principal and interest related to thepromissory note for equipment described in Note 9 ($0.8 million); and forgeneral corporate purposes.

We agreed to register the resale of the shares ofcommon stock sold in the offering and issuable upon exercise of the warrants.We are required to file the registration statement with the Securities andExchange Commission (“SEC”) within forty-five (45) days of the closing anduse our best efforts to cause the registration statement to be declaredeffective under the Securities Act of 1933, as amended, no later than theearlier of (i) ninety (90) days (or in the case of a full review onehundred and twenty (120) days) after the closing date and (ii) the sixth (6th) businessday following the date on which the Company is notified by the SEC that theregistration statement will not be reviewed or is no longer subject to furtherreview and comments. We are required to use our best efforts to keep theregistration statement continuously effective under the Securities Act untilthe earlier of the date when all the registrable securities covered by theregistration statement have been sold or are freely saleable and the secondanniversary of the closing. In the event that the registration statement is nottimely filed or declared effective when due, or after effectiveness ceases toremain effective, the Company is obligated to make cash payments in the natureof liquidated damages up to a limit of 10% of the purchase price of the units.

On March 30, 2006 we entered into a revolvingcredit agreement with Indigo Investments I LLC that provides for up to$5,000,000 in advances to be available to us. Upon the closing of this creditfacility, $1,000,000 was advanced to us and an additional $250,000 advanceunder the credit agreement was made to us in April 2006. Additionaladvances under the credit facility are dependent upon our accounts receivablebalances and adherence to certain covenants as described in the credit agreement.Outstanding principal under this credit facility bears interest at a rate of1.5% per month, increasing to 2.5% per month in the event of a default by usunder the credit agreement. In addition, we are required to pay the lender a2.25% commitment fee on the total amount of the credit facility and issue thelender a five-year warrant to purchase up to 500,000 shares of our common stockat an exercise price of $1.50 per share. The exercise price of the warrant issubject to adjustment in certain circumstances.

All outstanding principal and interest on the creditfacility plus the commitment fee are due and payable on the earlier of (i) September 30,2006, or (ii) the closing of the sale of a minimum of $6,000,000 of ourequity securities; provided, that, in the event that such a financing closesprior to September 30, 2006, we will also be required to pay the lender anearly repayment fee equal to 2.25% of the total amount of the credit facility.The rights of the lender under the credit facility are junior to those of theoutstanding convertible debentures.

Advances drawn under this agreement are personallyguaranteed by our Chairman, Rupert Galliers-Pratt.

The sale of units consisting of common stock andwarrants described in Note 15, resulted in an anti-dilution adjustment tothe exercise price of the outstanding warrants described above. Such adjustmentreduced the exercise price of such warrants from $1.50 to $1.34 per share ofcommon stock and increased the number of exercisable shares related to suchwarrants from 500,000 to 559,701.

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Since our inception, we have sustained our operationsthrough funding provided by our Chairman, contributed services by our Chairmanand other stockholders, and debt and equity financings.

On March 10, 2006, on behalf of the Company, theChairman advanced $75,000 directly to an escrow agent, allowing the Company tofulfill a contractual commitment in the normal course of business. The depositwas returned to the Chairman in full on March 27, 2006.

On February 18, 2005 and March 4, 2005, weissued and sold convertible debentures and warrants to certain sophisticatedinstitutional and individual investors pursuant to a Securities PurchaseAgreement between the Company and the investors. In the two closings of the privateplacement under the Securities Purchase Agreement, we sold convertibledebentures in the aggregate principal amount of $8,400,000, convertible intocommon stock of the Company at $0.75 per share, and warrants to purchase anaggregate of 8,400,000 shares of our common stock, at an exercise price of$1.00 per share. These warrants expire five years after the issue date.

The debentures accrue interest daily at a rate of 8%per annum, which interest is payable quarterly on each March 31, June 30,September 30 and December 31 following the issue date. The finalinterest payment is due on the date of maturity of the debentures, the thirdanniversary of the issue date. In addition, on any date on which all or aportion of the principal of a debenture is converted, all unpaid interesthaving accrued on such principal at the time of such conversion will becomeimmediately payable. We are not permitted to prepay any portion of theprincipal amount of any of the debentures without the prior consent of theholder thereof.

The debentures are convertible at the option of theholders into shares of our common stock at any time at an initial conversionprice of $0.75 per share. Except in the case of certain designated issuances,in the event we issue shares of common stock or common stock equivalents (i.e.,securities convertible into, or exercisable or exchangeable for, shares of ourcommon stock) at a price per share (or in the case of common stock equivalents,a conversion, exercise or exchange price per share) below the then applicableconversion price of the debentures, the conversion price of the debentures willbe reduced to that lower price per share. Issuances that will not result inadjustment to the conversion price include issuances to employees, consultants,directors or officers pursuant to a stock or option plan adopted by our boardof directors, securities issued upon conversion of other securities outstandingprior to the date of issuance of the warrants, warrants issued in connectionwith obtaining bank financing, common stock issued in connection with thesettlement of claims, and securities issued in connection with acquisitions,joint ventures or other strategic transactions.

We have agreed to certain restrictions under the termsof the debentures, including a prohibition on the payment of cash dividends toour stockholders while any of the debentures are outstanding. Upon theoccurrence of an event of default under the debentures, an amount equal to (i) 130%of the then outstanding principal amount, plus any accrued and unpaid interestthereon, or (ii) the product of the then outstanding principal amount,plus any accrued and unpaid interest thereon, times the ratio obtained bydividing the conversion price of the debentures and the market price of our commonstock, whichever is greater, will, at the holder’s option, become immediatelydue and payable in cash along with any other amounts, costs, expenses orliquidated damages then due in respect of such debentures. The ratio referredto in clause (ii) is to be calculated based on the conversion pricein effect on the date of such default or the date the accelerated amount ispaid in full (whichever is less), and the market price of our common stock onthe date of such default or the date the accelerated amount is paid in full(whichever is greater, such market price to be determined in accordance withthe terms of the debenture). Upon an event of a default, the interest rate onthe debentures will also be increased to 18% per annum.

Events of default under the debentures include failureto pay any amounts under the debentures when due, a material default under ourother agreements with the investors or default in our obligations undermortgage, credit facility or similar agreements, a material inaccuracy in therepresentations and warranties we made to the investors in connection with theconvertible debenture and warrant financing, and the initiation of voluntary orinvoluntary bankruptcy proceedings against us.

Through March 31, 2006, $2,100,000 in outstandingprincipal amount of convertible debentures has been converted into 2,799,993shares of common stock, reducing the amount of interest required to be paid infuture periods.

The common stock purchase warrants issued to theinvestors are exercisable at an initial exercise price of $1.00. The warrantshave an expiration date of five years after the date of issuance. They containa cashless exercise provision whereby the holder may pay the exercise price byhaving us withhold upon exercise shares having a fair market value equal to theapplicable aggregate exercise price if after the first anniversary of the dateof issuance of the warrant there is no effective registration statementregistering, or no current prospectus available for, the resale of the sharesissuable upon the exercise of the warrants. In the event this provision is usedwith respect to an exercise, we would receive no proceeds from the sale of ourcommon stock in connection with such exercise. The warrants were initiallyexercisable for an aggregate 8,400,000 shares of our common stock. As of March 31,2006, we had issued 3,190,499 shares upon exercise of warrants, all inconnection with the warrant exercise agreements described below.

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The exercise price is subject to adjustment in theevent of certain issuances of new securities. Specifically, except in the caseof certain designated issuances, if we issue shares of common stock or commonstock equivalents (i.e., securities convertible into, or exercisable orexchangeable for, shares of our common stock) at a price per share (or in thecase of common stock equivalents, a conversion, exercise or exchange price pershare) below the then applicable exercise price of the warrants, the exerciseprice of the warrants will be reduced to that lower price per share. In theevent of such an adjustment, the number of shares for which the warrants areexercisable will be increased such that the aggregate exercise price of thewarrants after the adjustment will equal the aggregate exercise price immediatelyprior to the adjustment. Issuances that will not result in adjustment to theexercise price include issuances to employees, consultants, directors orofficers pursuant to a stock or option plan adopted by our board of directors,securities issued upon conversion of other securities outstanding prior to thedate of issuance of the warrants, warrants issued in connection with obtainingbank financing, common stock issued in connection with the settlement ofclaims, and securities issued in connection with acquisitions, joint venturesor other strategic transactions.

In connection with the two closings of the privateplacement, we paid placement fees in the aggregate amount of $802,500 to theplacement agent. At the second closing, we also issued to the placement agent awarrant to purchase up to 802,500 shares of our common stock at an initialexercise price of $1.00 per share. The warrant, which expires on March 4,2010, is on substantially the same terms as the warrants issued to theinvestors in the private placement.

We have registered for resale under the Securities Actof 1933, as amended, the shares underlying the debentures and warrants pursuantto a registration statement on Form SB-2, as amended, (File No. 333-123815).The registration statement was declared effective on May 3, 2005.

In October 2005, we entered into several WarrantExercise Agreements with holders of warrants issued in the private placementthat closed in the first quarter of 2005. Pursuant to these agreements, weissued to these holders new common stock purchase warrants exercisable for anumber of shares equal to the number of shares they purchased upon exercise ofthe warrants issued to them in the private placement. These new warrants havean exercise price of $1.50 per share. We received aggregate proceeds of$3,190,499 in connection with the exercise of the prior warrants, and issuednew warrants, which expire five years after the issue date, to purchase anaggregate of 3,190,499 shares of our common stock (plus an additional warrant,which expires five years after the issue date, to purchase 159,525 shares ofcommon stock to a placement agent who assisted with the transaction). Theshares of common stock underlying these warrants have been registered forresale with the Securities and Exchange Commission pursuant to a registrationstatement on Form SB-2 (File No. 333-130808). Thisregistration statement was declared effective on January 31, 2006.

On March 15, 2005, we completed the purchase ofcertain telecommunications equipment (including two Sonus Networks switches)from MRS Partners for $500,000 in cash, 725,000 shares of our common stock anda promissory note for an aggregate principal amount of $1,170,000. Prior to theclosing, we were leasing this equipment from MRS Partners. The principal amountof the note was subsequently adjusted to $970,000, reflective of unanticipatedrecertification costs. Under the terms of the promissory note, interest accruesdaily at a rate of 8.25% and is payable monthly in arrears. An initial principal payment of $100,000 waspaid in 2005. An additional principal payment of $100,000 that was due on December 31,2005 was extended to and paid on March 31, 2006. The remaining principalamount ($770,000) and any unpaid interest originally payable on the firstanniversary of the closing of the purchase, March 15, 2006, was extendedto May 23, 2006.

We expect that we will need to raise additional debtor equity financing to pay the required interest and principal payments underthe convertible debentures issued in our private placement.

On August 11, 2004, we entered into adistribution and marketing agreement with NetYantra Inc. and NetYantra IndiaPvt. Ltd. (collectively, “NetYantra”) pursuant to which NetYantra grants to theCompany the exclusive worldwide rights (other than in India where NetYantra isheadquartered and subject to certain existing distribution agreements) tomarket and distribute the V-CubeTM IP-PBX software platform developed byNetYantra to Tier 1 carriers, telecommunications equipment manufacturers,internet service providers, large corporations, SMEs and other businessentities and individual retail customers. Under this agreement, we have paidNetYantra $400,000 and were required to pay NetYantra fifty percent of certainnet revenues that the Company derives from the distribution of the V-CubeTMplatform.

In addition, the agreement stated that in the eventthat our common stock was quoted or traded on a stock market on or before thefirst anniversary of the agreement, we would issue to NetYantra shares of theCompany’s common stock having a market value of $1,000,000 based on the openingprice of the Company’s common stock on the first day of trading (or, at theCompany’s option, pay to NetYantra a cash payment of $1,000,000 instead ofissuing such shares). On July 21, 2005, public trading in the Company’scommon stock began jointly on the OTC Bulletin Board and the Pink SheetsElectronic Quotation Service under the trading symbol “VSTL.”  The opening sale was at a price of $2.00 pershare. The Company issued 500,000 shares of its common stock to NetYantra incompliance with the agreement.

On May 1, 2006, we executed and delivered anAsset Purchase Agreement with NetYantra relating to the V-CubeTM IP-PBX softwareplatform. The terms of this agreement are described above under the heading “RecentDevelopments”.

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We do not believe that our available cash and cashequivalents, including the cash proceeds from the recently completed privateplacement described above, will be sufficient to meet our working capitalrequirements, including the funding of operating losses, and capitalexpenditure requirements for our next fiscal year. Previously, our primarysources of capital have been the revenues generated from interconnectagreements with our customers and advances made by one of our principalstockholders from a credit facility established in the name of the stockholderand other of the stockholder’s personal assets.

In the event that we do not succeed in implementingour business plan, and do not otherwise raise additional third-party capital,we will have to curtail certain expenditures, seek additional financing fromour principal stockholder, or both in order to sustain operations. As notedabove, the principal stockholder has historically provided working capitaladvances. While the stockholder is not obligated to provide these workingcapital advances to us, we expect the stockholder to continue providing fundsfor operations as and if needed, until such time that our operations areself-sustaining or we raise additional external capital, as the case may be. Asdescribed in Note 13, in October 2005 the Company realized approximately$3.0 million in net proceeds from the exercise of warrants associated with theconvertible debentures.

Our plans for growth and expansion will require theneed for additional capital in the future. As a result, we may have to relyupon the issuance of additional debt or equity securities in order to continueto grow our business as well as to fund the negative cash flow we haveexperienced to date, and may experience in the future, as a result of theseactivities. If additional funds are raised through the issuance of equitysecurities, our existing stockholders may experience significant dilution. Inthe absence of achieving profitable operations in future periods, obtainingadditional capital through asset sales, securing a revolving credit facility,debt or equity offerings, or a combination of the foregoing, we may encounterliquidity difficulties. No assurance can be given that we will be able to raiseadditional capital when needed, or at all, or that such capital, if available,will be on acceptable terms.

To date, inflation has not had a material impact onour financial results. There can be no assurance, however, that inflation willnot adversely affect our financial results in the future.

**Other Arrangementsand Obligations**

On March 24, 2006 we received a notice fromNetYantra India Pvt Ltd. claiming that we are in breach of certain provisionsof the August 11, 2004 distribution and marketing agreement that weentered into with NetYantra Inc. and NetYantra India Pvt. Ltd. (collectively “NetYantra”).The notice claimed that we have not fulfilled certain requirements contained inthe agreement as to the training of personnel, recognition of NetYantra as thedeveloper of certain technology, and the forwarding of documentation toNetYantra regarding the licensing and sublicensing of certain technology. Further,the notice claimed that our marketing of the consumer VoIP portal product is inbreach of the non-competition provisions of the agreement. We responded toNetYantra in a letter dated April 19, 2006, which denied all claims ofbreach alleged by NetYantra in relation to the distribution and marketingagreement. The letter specifically addressed each alleged provision breach andexplained why we have not breached the agreement as to the training ofpersonnel, recognition of NetYantra as the developer of certain technology, andhave forwarded documentation to NetYantra regarding the licensing andsublicensing of certain technology. We detailed specific functionality of theVoIP portal product to explain how it is different than and does not competewith the V-CubeTM product and why, for those reasons, we are notin breach of the non-competition provisions of the agreement. (Please refer tothe information elsewhere in this section under the headings “Liquidity andCapital Resources” and “Recent Developments” for additional discussion relatingto our relationship with NetYantra.)

On December 13, 2005, we entered into aConsultant, Representative and Professional Services Agreement with QuestTelecommunications, Inc. (“Quest”). Under this agreement, we haveappointed Quest as an independent advisor and our exclusive representative inthe geographic areas of Vietnam, Cambodia, Malaysia and Turkey (and any otherareas to which we and Quest agree in writing). Within these geographic areas,Quest will (i) assist in structuring and establishing businessrelationships, including introducing us and the V-CubeTM IP-PBX softwareplatform to potential partners, distributors, licensees and/or purchasers, and (ii) provideproject management services relating to business operations, including developingrevenue targets, establishing technical support capability, facilitatingtechnical support delivery, and monitoring license fee reconciliation. Questwill also act as our agent for the V-CubeTM to consumers from, but residingoutside, the geographic area covered by this agreement (except for consumersresiding in territories for which we or any of our affiliates have granted orhereafter grant exclusive distribution or agency rights).

Under this agreement, we paid Quest $50,000 inconsideration for Quest’s assistance relating to the execution by us and SaigonPost and Telecommunications Services Corporation (“SPT”) of a memorandum ofunderstanding and pilot license agreement with respect to the V-CubeTM. Thememorandum of understanding, which we entered into on September 20, 2005,contemplates that, 

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following legal andtechnical evaluation of the V-CubeTM platform by SPT, SPT and the Company willnegotiate and enter into an agreement with respect to the deployment andcommercialization of the V-CubeTM platform in Vietnam. The pilot licenseagreement, which we entered into on October 15, 2005, permits SPT to usethe V-CubeTM platform for evaluation and testing purposes on a royalty-freebasis from November 15, 2005 through February 15, 2006.

In addition, in the event we and SPT enter into adefinitive distribution or license agreement with respect to the V-CubeTM, wewill be obligated to issue to Quest 300,000 shares of our common stock and topay to Quest $150,000 in cash, plus a continuing commission of thirty percentof the license fees we receive from SPT in connection with the licensing anddistribution of the V-CubeTM in the above-mentioned geographic areas (net ofsales, use and value added taxes, if any, payable by us in connection with suchlicense fees).

On January 27, 2006, we entered into a FinancialAdvisory Agreement (the “Agreement”) with Indigo Ventures LLC (“Indigo”) inwhich we agreed to appoint Indigo as our financial advisor to advise, consultwith, and assist us in various matters which may include:

·                  a review of our business, operationsand financial condition, including advising us on capitalization structures;

·                  advice relating to general capitalraising matters;

·                  recommendations relating to specificbusiness operations, transactions and joint ventures;

·                  advice regarding future financingsinvolving our or any of our affiliates’ debt or equity securities; and

·                  assistance in connection with thedue diligence review of any significant acquisition transactions proposed by usduring the term of the agreement.

In consideration for these services, we have agreed topay Indigo a cash fee of $20,000 per month in arrears, increasing to $30,000per month beginning in the first month following the consummation by us of asignificant debt or equity financing from which we obtain gross proceeds of atleast $5 million. Also, we issued to Indigo 1,500,000 restricted shares of ourcommon stock, which shares will vest upon the earlier of: (i) the closingof a significant acquisition as may be described in a written notice deliveredby us to Indigo on or after the date of the Agreement, (ii) subject to theapproval of our compensation committee, the closing of another majoracquisition or financing transaction on which Indigo provides advice to us, (iii) achange of control of our company, or (iv) January 27, 2007. Theshares we issued to Indigo are restricted shares and may not be sold, assignedor transferred by Indigo for a one (1) year period beginning on January 27,2006 and ending on January 27, 2007. If we terminate the Agreement as aresult of a material breach of this Agreement by Indigo, we will have the rightand option to repurchase fifty percent (50%) of all of the then unvested sharesat a purchase price of $0.001 per share.

*Guarantyof Vistula Limited.**  *Oneof our subsidiaries, Vistula, had agreed to unconditionally guarantee theobligations of one of our principal stockholders under a $3,000,000 creditfacility established in the name of the stockholder. This guarantee wasreleased by the financial institution on March 27, 2006.

**Item 3.**                          Controlsand Procedures.

**Evaluation of DisclosureControls and Procedures**

Based on Company management’s evaluation (with theparticipation of the Company’s principal executive officer and principalfinancial officer), as of the end of the period covered by this report, theCompany’s principal executive officer and principal financial officer haveconcluded that the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended,(the “Exchange Act”)) are effective to ensure that information required to bedisclosed by the Company in reports that it files or submits under the ExchangeAct is recorded, processed, summarized and reported within the time periodsspecified in Securities and Exchange Commission rules and forms.

It should be noted that any system of controls,however well designed and operated, can provide only reasonable, and notabsolute, assurance that the objectives of the system are met. In addition, thedesign of any control system is based in part upon certain assumptions aboutthe likelihood of future events. Because of these and other inherentlimitations of control systems, there can be no assurance that any design willsucceed in achieving its stated goals under all potential future conditions,regardless of how remote.

**Changes in Internal Controlover Financial Reporting**

The Company’s management, in connection with itsevaluation of internal controls (with the participation of the Company’sprincipal executive officer and principal financial officer), did not identifyany change in internal control over the financial reporting process thatoccurred during the Company’s first fiscal quarter of 2006 that would havematerially affected, or would have been reasonably likely to materially affect,the Company’s internal control over financial reporting.

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**PART II.                OTHERINFORMATION**

**Item 5. Other Events**

*Closing of PrivatePlacement*

On May 22, 2006, pursuantto our stock and warrant purchase agreement dated May 19, 2006 with 23accredited investors, we closed a private placement of 16,300,000 shares of ourcommon stock and warrants to purchase an additional 13,040,000 shares of ourcommon stock at an exercise price of $1.00 per share.  We recognized $16,300,000in gross proceeds from the private placement, of which approximately $978,000was paid to the placement agent for the transaction as compensation for itsservices.  We issued to the placement agent as additional compensationwarrants to purchase 1,467,000 shares of our common stock at an exercise priceof $1.00 per share.  Our current report on Form 8-K dated May 19, 2006,which we filed with the SEC on May 22, 2006, contains a description of thetransaction, including a description of the terms of the stock and warrantpurchase agreement and the registration rights agreement we entered into inconnection therewith.  The issuance and sale of the shares and warrantswere exempt under Section 4(2) of the Securities Act of 1933 as a transactionnot involving a public offering.

**Item 6. Exhibits**

**     (a) Exhibits.**
|                     | ** ** | ** **                                                                                                                                                                                                                                           | ** ** | ** **                        | ** ** | **Incorporated by  Reference** |
|---------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|--------------------------------|
| **Exhibit  Number** | ** ** | **Exhibit Description**                                                                                                                                                                                                                         | ** ** | **Filed with  this Form  10-QSB** | ** ** | ****Form                       | ** ** | ****Filing  Date | ** ** | **Exhibit No.** |
| 10.1                |       | Employment  Agreement with Ian Cope dated January 5, 2006.                                                                                                                                                                                      |       |                              |       | Form 8-K                  |   | January 10, 2006 |   | 10.1 |
| 10.2                |       | Financial  Advisory Agreement with Indigo Ventures LLC dated January 27, 2006.                                                                                                                                                                  |       |                              |       | Form 8-K                  |   | January 31, 2006 |   | 10.1 |
| 10.3                |       | Subscription  Agreement by and between Vistula Communications Services, Inc. and  Indigo Investments I LLC dated March 30, 2006.                                                                                                           |       |                              |       | Form 10-KSB               |   | March 31, 2006 |   | 10.42 |
| 10.4                |       | Loan and  Security Agreement by and between Vistula Communications Services, Inc.  and Indigo Investments I LLC dated as of March 30, 2006.                                                                                                |       |                              |       | Form 10-KSB               |   | March 31, 2006 |   | 10.43 |
| 10.5                |       | Revolving  Loan Note issued by Vistula Communications Services, Inc. to Indigo  Investments I LLC on March 30, 2006.                                                                                                                       |       |                              |       | Form 10-KSB               |   | March 31, 2006 |   | 10.44 |
| 10.5                |       | Common  Stock Purchase Warrant issued by Vistula Communications Services, Inc.  to Indigo Investments I LLC on March 30, 2006.                                                                                                             |       |                              |       | Form 10-KSB               |   | March 31, 2006 |   | 10.45 |
| 31.1                |       | Certification  by John Keith Markley pursuant to Rule 13a-14(a) and 15d-14(a),  as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002,  relating to Vistula Communications Services, Inc.                         |       | X                                 |       |                           |   |   |   |   |
| 31.2                |       | Certification  by George R. Vaughn pursuant to Rule 13a-14(a) and 15d-14(a),  as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002,  relating to Vistula Communications Services, Inc.                           |       | X                                 |       |                           |   |   |   |   |
| 32.1                |       | Certification  by John Keith Markley pursuant to Section 1350, Chapter 63 of Title 18,  United States Code, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002, relating to Vistula Communications  Services, Inc. |       | X                                 |       |                           |   |   |   |   |
| 32.2                |       | Certification  by George R. Vaughn pursuant to Section 1350, Chapter 63 of Title 18,  United States Code, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002, relating to Vistula Communications  Services, Inc.   |       | X                                 |       |                           |   |   |   |   |

 

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**SIGNATURES**

Inaccordance with the requirements of the Exchange Act, the registrant causedthis report to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 
|                         |   | Vistula Communications Services, Inc. |
|-------------------------|--------|--------------------------------------------|
|                    |   |                                       |   |   |
| Date: May 22, 2006 |   | By:                                        |   | /s/ JOHN KEITH MARKLEY |
|                    |   |                                       |   | John Keith Markley |
|                    |   |                                       |   | Chief Executive Officer |

 

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