**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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**AMENDMENT NO.****1 TO FORM 10-K**

 

| **(Mark  One)**                                       |       |                                                                                                     |
|-------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|
| ** **                                            | ** ** | ** **                                                                                               |
| **ý**                                            | ** ** | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**     |
|                                                  |       |                                                                                                     |
| **For the fiscal year ended December 31,  2004** |
| ** **                                            | ** ** | ** **                                                                                               |
| **or**                                                |
|                                                  |       |                                                                                                     |
| **o**                                                 | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |

 

**For thetransition period from         to        **

 

**Commissionfile number: 000-25755**

 

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**WorldGate Communications, Inc.**

(Exact name of registrant asspecified in its charter)

 

| **Delaware**                                                    | ** ** | **23-2866697**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State or  other jurisdiction of incorporation or organization) | ** ** | (I.R.S.  Employer Identification No.) |
|                                                            | ** ** |                                  |
| **3190  Tremont Avenue  Trevose, Pennsylvania**                 | ** ** | **19053**                             |
| (Address of  principal executive offices)                       | ** ** | (Zip Code)                            |

 

**(215) 354-5100**

(Registrant’s telephone number,including area code)

 

Securities registered pursuantto Section 12(b) of the Act: **None**

 

Securities registered pursuantto Section 12(g) of the Act:

 

**CommonStock, $0.01 Par Value**

(Title of Class)

 

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

 

Indicate by check mark if disclosure ofdelinquent filers pursuant to Item 405 of Regulation S-K is not containedherein, and will not be contained, to the best of registrant’s knowledge, indefinitive proxy or information statements incorporated by reference in Part IIIof this Form 10-K or any amendment to this Form 10-K. Yes ý

 

Indicate by check mark whether the registrantis an accelerated filer (as defined in Exchange Act Rule 12b-2) Yes o    No ý

 

The aggregate market value of the commonstock held by non-affiliates of the registrant was approximately $46.7 millionas of June 30, 2004, based on the closing sale price of $2.10 per share ofcommon stock, as reported on the NASDAQ Small Cap Market.

 

The number of shares of the registrant’scommon stock outstanding as of March 4, 2005 was 31,705,489.

 

**DOCUMENTSINCORPORATED BY REFERENCE**

**[None]**

 

 

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**WORLDGATECOMMUNICATIONS, INC.**

 

**ANNUALREPORT ON FORM 10-K**

**For theFiscal Year Ended December 31, 2004**

 

**TABLE OFCONTENTS**

 
| **PART I**   |
|-------------------|
| ** **        |
| Item 1.           | Business |   |
|              |   |   |
| Item  2.          | Properties |   |
|              |   |   |
| Item  3.          | Legal  Proceedings |   |
|              |   |   |
| Item 4.           | Submission of Matters to a Vote of Security Holders |   |
| ** **        | ** ** | ** ** |
| **PART II**  |
| ** **        |
| Item 5.           | Market for Registrant’s Common Equity, Related Stockholder Matters  and Issuer Purchases of Equity Securities |   |
|              |   |   |
| Item 6.           | Selected Financial Data |   |
|              |   |   |
| Item 7.           | Management’s Discussion and Analysis of Financial Condition and  Results of Operations |   |
|              |   |   |
| Item 7A.          | Quantitative and Qualitative Disclosures About Market Risk |   |
|              |   |   |
| Item 8.           | Financial Statements and Supplementary Data |   |
|              |   |   |
| Item 9.           | Changes in and Disagreements with  Accountants on Accounting and Financial Disclosure |   |
|              |   |   |
| Item 9a.          | Controls and Procedures |   |
|              |   |   |
| Item 9b.          | Other Information |   |
| ** **        | ** ** | ** ** |
| **PART III** |
| ** **        |
| Item 10.          | Directors and Executive Officers of the  Registrant |   |
|              |   |   |
| Item 11.          | Executive Compensation |   |
|              |   |   |
| Item 12.          | Security Ownership of Certain Beneficial  Owners and Management and Related Stockholder Matters |   |
|              |   |   |
| Item 13.          | Certain Relationships and Related  Transactions |   |
|              |   |   |
| Item 14           | Principal Accountants Fees and Services |   |
|              |   |   |
| **PART IV**  |
| ** **        |
| Item 15.          | Exhibits and Financial Statement Schedules |   |

 

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**WORLDGATECOMMUNICATIONS, INC.**

 

This report contains forward-lookingstatements that involve risks and uncertainties. These forward-lookingstatements are based on management’s current expectations and are subject to anumber of uncertainties and risks that could cause actual results to differsignificantly from those anticipated in these forward-looking statements.Factors that may cause such a difference include, but are not limited to, thoseset forth in the “Management’s Discussion and Analysis of Financial Conditionand Results of Operations” as well as those discussed elsewhere in this report.

 

**PART I**

 

**Item 1.****Business**

 

WorldGateCommunications, Inc. was incorporated in Delaware in 1996 to succeed tothe business of our predecessor, WorldGate Communications, L.L.C., whichcommenced operations in March 1995. In April 1999, we completed ourinitial public offering of 5,750,000 shares of our common stock. Since January 9,2003 our common stock has been listed on the NASDAQ Small Cap Market.Previously our common stock was traded on the NASDAQ National Market. Ourcommon stock is traded under the symbol “WGAT”. Our executive offices arelocated at 3190 Tremont Avenue, Suite 100, Trevose, Pennsylvania 19053.

 

**Overview**

 

Since our formation in 1995 and untilrecently, we were in the business of developing and selling interactivetelevision, or ITV, technology, products and services for use in conjunctionwith cable TV broadband networks (the “ITV Business”). Using our solutions,cable TV operators branded, marketed, and offered a wide variety of ITVpackages to consumers. These packages included walled gardens of information,communications solutions complete with Internet-based e-mail and chat, and Websurfing, all presented and engaged on the TV set.

 

During the third quarter of 2003, wecompleted a sale of significant assets, including our ITV intellectual propertyrights and our membership interest in TVGateway, LLC, for $3 million in cash toTVGateway, LLC, an ITV oriented company we were instrumental in forming. Ourtransaction with TVGateway, LLC marked a shift in our business away from theITV Business and toward a new video phone product and associated business.Although we continued to support our current ITV Business into the firstquarter of 2004, the development of our video phone product became a primarybusiness focus. The funds we received from the sale of assets to TVGateway,LLC, as well as the funds we subsequently received as a result of severalprivate placements of our securities have permitted us to fund the developmentof our new business.

 

During 2004, we continued development of avideo phone, designed specifically for personal video communication over highspeed data, or HSD or broadband networks, that we believe is differentiated,both from competitors and from previous efforts at personal video telephony, byproviding: “true to life” communication (meaning that images and sounds aresynchronized, that there are minimum delays between the two ends of thecommunication, and that the quality of the images are improved significantly),ease of deployment by HSD operators, ease of use by residential and businessend users, a highly styled ergonomic design, and interoperation with the publicswitched telephone network, or PSTN.  Thedesign of our first video phone product was substantially completed in late2004 and field trials were commenced. Commercial distribution of this productis expected to commence in the spring 2005 time frame.

 

On April 28, 2004, we entered into a multi-yearagreement with General Instrument Corporation d/b/a the Broadband CommunicationSector of Motorola, Inc. for the worldwide development and distribution ofthe Ojo personal video phone. Under the terms of the agreement, our video phonewill be co-branded with our trademark, OjoTM, and Motorola willmarket the Ojo personal video phone as part of its “connected home” portfolioof consumer HSD solutions. Motorola plans to distribute Ojo worldwide throughHSD service providers, retailers, and distributors of telecommunicationsproducts.

 

HSD service users provide a large, and webelieve conducive, target market for a quality video phone offering. We believethat Motorola, as a worldwide market leader in the HSD market iswell-positioned to assist us with our video phone offering.  Initial video phone sales are expected to bederived from new technology adopters and regular long distance communicatorssuch as families and close friends. We also expect that thebusiness-to-business opportunity will be attractive as a video phone provides meansto improve interpersonal communication and multi-location productivity.  Furthermore we expect that the growth in the

 

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voice overInternet protocol market (or “VoIP”) will also help to drive sales of our videophone since it can also serve as a VoIP endpoint.

 

Our business model is based on the sale ofvideo phones and related products. We expect that our products will be marketedto HSD operators as well as to consumers through traditional consumer electronicsdistribution channels. We believe that HSD operators could realize significantrecurring revenue streams associated with offering our product to end users. Wehave also developed this product to require very minimal capital investment orincremental costs by such operators. Our marketing objective is to have ourvideo phones supplement and hopefully replace ordinary home and business phonesworldwide.

 

**General Product Description**

 

We have developed a video phone,ergonomically designed specifically for in-home and business, personal videocommunication. We have identified several issues that have interfered withcommercial success and consumer acceptance of video phones and sought toaddress each of these issues within the Ojo video phone. The Ojo video phonewas designed for use on the existing HSD infrastructure. The Ojo phone will,however, also connect to the analog phone line for interoperability with thevoice only communications offered by the existing PSTN networks. Ojo,therefore, can be used for video calls, for ordinary voice only calls as wellas for voice over Internet protocol, or VoIP calls. We believe that Ojo isdifferentiated, both from competitors and from previous efforts at personalvideo telephony, by providing: true to life communication (meaning that imagesand sounds are synchronized, that there are minimum delays between the two endsof the communication, and that the quality of the images are improvedsignificantly), interoperation with the PSTN, ease of deployment by HSD operators,ease of use by consumers, and a highly styled ergonomic design. We believe Ojouniquely leverages the recent development of a state of the art connectivityinfrastructure, as well as the convergence of the latest improvements incompression technology, processing power and bandwidth availability, to helpensure, enable and maintain dedicated high quality end-to-end connections.

 

The Ojo solution consists of two primary components:

 

1. A display unit includes the camera, videoscreen and external interface ports. The video screen is used to display menusand provide a user interface as well as to view the images of the local andremote parties. Considerable effort has been expended in the ergonomic andstylistic design of the display unit. For example, it is taller than mostconventional phones to ensure that the user is looking into the unit and notdown at the unit. Similarly the camera of the unit is looking at the user atface level, instead of “up the user’s nose.” The display unit can be used as astandard speaker phone to receive both audio and audio/video calls. The displayunit is designed to be aesthetically usable in any room. Particular attentionwas given to the user interface to ensure that Ojo was installable and usablewithout the need to refer constantly to a manual. The display contains an RJ-45jack for connection to the cable or DSL modem and an RJ-11 jack for connectionto the PSTN or VoIP network. The consumer simply plugs the display unit intothe high-speed modem or router and into the standard house power outlet tofacilitate access to the necessary data network. In addition to a connection tothe high-speed modem or router, the display unit also connects to the standardphone line. This connection, while not required for a video phone call, allowsthe Ojo video phone to also be used as a standard telephone.

 

2. A cordless handset with an internalspeaker and microphone, a monochrome graphical display and most of the usercontrols for the device (numeric keypad, navigation device, talk, mute and endbuttons). Although the handset is discussed as a separate component, it willgenerally be seated in the lower portion of the display unit where it willserve as the navigation device while its batteries are being charged. Thehandset fits into a cradle on the display unit. It is designed to be used bothas part of a video call, or alone for standard PSTN phone calls. Since the Ojounit is designed to receive and make audio calls as well as video calls, thehandset functions as a typical cordless phone and has the features a usertypically expects for a cordless phone. Although video calls can be received atthe display unit even when the handset is not present, the handset is intendedto be the primary component used to operate the video phone (in a mannersimilar to a television remote control).

 

**Material Developments for WorldGate since December 31,2003**

 

The following is a summary of materialdevelopments for us that have occurred since December 31, 2003:

 

In January 2004, during the Consumer ElectronicsShow (CES) we successfully demonstrated the capability of delivering highquality video telephone over the Internet. Using our Ojo video phone, wedemonstrated repeated quality calls between our headquarters in suburbanPhiladelphia and Las Vegas. Using a data rate of 150 kbps, we made video callswith full motion video displayed at 30 frames per second, similar to that ofbroadcast television. The calls provided consistent, true-to-life,

 

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synchronized, voice and videocommunications during peak Internet usage time periods. We believe this was thefirst successful demonstration of H. 264-based signal processingtechnology in a personal video phone.

 

On January 21, 2004, we completed a privateplacement resulting in an issuance of 1,000,000 shares of our common stock at asale price of $1.50 per share, five-year warrants to purchase up to 300,000shares of our common stock at an exercise price of $1.875 per share, andadditional investment rights to purchase, for a limited period of time, up to200,000 shares of our common stock at an exercise price of $1.50 per share. Inaddition, we agreed to issue warrants to purchase up to an additional 10,000shares of our common stock at an exercise price of $1.875 per share upon theexercise of the additional investment rights. The January 2004 privateplacement resulted in gross proceeds to us of approximately $1.5 million.

 

On April 23, 2004, we completed a privateplacement of 666,666 shares of our common stock with Mototech Inc., at asale price of $1.50 per share. The private placement resulted in gross proceedsto us of $1 million.

 

On May 3, 2004, we announced that we had enteredinto a multi-year agreement with Motorola, Inc. for the worldwide developmentand distribution of the Ojo video phone. Under the terms of the agreement,Motorola will market the Ojo personal video phone as part of its “connectedhome” portfolio of consumer HSD solutions. Motorola will distribute Ojoworldwide through HSD service providers, retailers, and distributors oftelecommunications products. Additionally, Motorola and WorldGate will jointlydevelop future HSD video telephony solutions.

 

On June 24, 2004, we completed another privateplacement that resulted in the issuance of 7,550 shares of Series Apreferred stock at a sale price of $1000 per share (which preferred stock isconvertible into our common stock at a conversion price of $2.35 per share,)five-year warrants to purchase up to 803,190 shares of our common stock at anexercise price of $2.69 per share, and five-year warrants to purchase up to803,190 shares of our common stock at an exercise price of $3.14 per share. Theinvestors also received an additional investment right, for a limited period oftime, to purchase 1,606,383 additional shares of common stock shares at $3.14 ashare. The June 2004 private placement resulted in gross proceeds to ourCompany of $7,550,000.

 

On November 10, 2004 we announced that the Ojovideo phone was awarded a 2005 CES Best of Innovations Award from the ConsumerElectronics Association (CEA).

 

At the 2005 CES Show, held in Las Vegas on January 6— 9, we formally introduced our Ojo video phone. CES is one of the world’slargest annual consumer technology shows. We conducted live demonstrations toattendees and the press of the Ojo phone transmitting full-motion video withsynchronized audio over a HSD internet connection.

 

During December 2004, and through January 30,2005, we received cash proceeds of $7,565,000 from the exercise of outstandingwarrants issued pursuant to the private placements discussed above, by theexercise of non-executive employees’ and prior employees’ stock options, and bya private placement of an additional 208,333 shares of our common stock. Inconnection with this placement, we granted warrants to Mr. K.Y. Chou topurchase up to 62,500 shares of our common stock at an exercise price of $2.88per share.

 

**Business Strategy**

 

*General.*  Our business model, as is typical of aconsumer electronics product, is based upon the sale of Ojo video phones anddoes not rely upon any service fees or other recurring revenue stream forWorldGate, although such recurring streams may materialize. It is our plan forOjo video phone to be distributed through and in partnership with HSD serviceproviders, as well as through traditional electronics distribution channels.Video phone service, using the Ojo video phone, is expected to be offered byHSD service providers as a means of attracting new HSD subscribers as well asmaintaining existing subscribers. We believe that HSD service operators couldrealize potentially significant recurring revenue streams associated withoffering products such as our Ojo video phone, and accordingly we believe theywill embrace the concept and business model. The suggested consumer offeringfor a video phone service follows the traditional HSD model. We anticipate thatvideo phone service subscribers will be able to either purchase Ojo or lease aunit from the HSD service provider.

 

*Manufacturing.* Ojo video phones will be manufactured inAsia, to take advantage of the base of lower labor, tooling and componentcosting. A formal relationship with Mototech Inc. has already been establishedfor the volume manufacture of Ojo. Mototech, along with U.S. Robotics and SMCNetworks, are affiliates of the Accton Technology Group, a group of Taiwanesemanufacturers that we believe are well-known in the electronics industry.Mototech’s responsibilities in this role include:

 

Product design finalization for manufacturing;

 

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Component selection and procurement;

Tool sourcing and management;

Coordination of Ojo manufacturing;

Implementation and monitoring of Ojo’sQuality Plan; and

Product cost reduction.

 

Under the agreement, Mototech is required tomanufacture products in response to purchase orders issued by our company.  Although our company has no obligation topurchase any particular volume of products under the agreement, Mototech isgenerally required to accept all purchase orders, subject to certain limitsdescribed in the agreement.  As part ofour agreement with Mototech we retain formal sign-off control over any product,specification, or component changes proposed by Mototech. We also maintain allrights to the Ojo technology and intellectual property, as well as the right tosecond source the Ojo product.  Ouragreement with Mototech permits Mototech and our company to terminate theagreement at any time by giving 90 days written notice to the other party.

 

*ProductSales and Distribution.*  We have partnered with an experienceddistribution partner, Motorola, Inc. to market and distribute the Ojovideo phone. Such partnership is intended to reduce ourworking capital requirements by minimizing our sales and inventory costs, andprovide an entree to more extensive and accelerated coverage than wouldbe permitted by an internal organization. The name recognition, “shelf-space”potential and technology/product validation provided by Motorola are alsoexpected to provide a significant advantage. In addition we believe we willfurther benefit from the Motorola relationship as a result of their access tobroadband and telephony technology as well as their sourcing expertise. ThroughMotorola, Ojo will be marketed domestically and internationally to both theresidential and business sectors through the standard consumer and businesselectronics channels, as well as through HSD providers in a manner similar tobroadband modems.

 

We have entered into a six-year distributionagreement with Motorola, Inc. for the marketing and distribution of ourOjo video phone. This agreement provides for Motorola to be WorldGate’sexclusive distributor of its broadband video phone products and for WorldGateto be Motorola’s exclusive supplier of its broadband video phone products.  After a period of eighteen months followingthe commercial availability of the Ojo video phone this mutual exclusivity willterminate unless Motorola elects to continue the mutual exclusivity afterhaving achieved certain minimum sales targets for the Ojo video phone**. **Motorolamay, however, at its option, elect to terminate this mutual exclusivity at anytime.  In the event mutual exclusivityterminates or is terminated, then for a twelve month period thereafter,WorldGate will continue to be Motorola’s exclusive supplier of broadband videophones, but will be free to sell video phone products to customers other thancertain defined Motorola accounts. During this twelve month period, Motorola has a right of first refusalto accept and fill any orders for video phone products that WorldGate obtainsfrom non-Motorola accounts, and is obligated to use good faith efforts tosolicit and accept product orders from Motorola accounts in a commerciallyreasonable manner.  During any period ofexclusivity under this agreement we are reliant upon Motorola and itsdistribution partners, including, for example, wholesalers, retailers andservice providers, to provide the worldwide sales and distribution of the Ojovideo phone. Although the agreement requires Motorola to provide for certainmarketing and promotional activities for the Ojo video phone, there are norequired sales quotas for the agreement to remain in effect, and Motorolacontrols the volume of products being distributed by our company.  Neither party can terminate the agreementexcept in cases of uncured breaches of the agreement or as a result ofinsolvency events suffered by the other party. If Motorola and its partners are not successful, or if their activitiesdo not lead to significant sales of our product, our operating results will beadversely affected, our revenue could be significantly reduced and we couldlose potential customers.  In connectionwith our agreement with Motorola, our company has issued a warrant to purchase300,000 shares of WorldGate common stock, which we issued simultaneously withthe execution of the agreement in April 2004, and a second warrant for300,000 shares issued upon the delivery to Motorola of acceptable prototypesfor the product.

 

**Competition**

 

Many of the current video phone manufacturershave focused on two applications—business video phones and video conferencing.Business video phones are designed to be located on an executive’s desk andused to communicate with colleagues, employees and customers. Videoconferencing units are designed for conference rooms where multiple people onone end engage with multiple people on the other end. The following is a briefdescription of the potential competitors and their impact on the market.

 

*BusinessPhone Products.* Most of these products are targeted for corporate use and are priced at$650.00 and up per unit. Generally, the ergonomic design of these unitsemulates that of a traditional office telephone with the addition of a cameraand display. The products use standard corporate gray or black material colors,familiar button shapes and designs, traditional style handsets fornon-speakerphone conversation and often have business feature sets. Forconnectivity these products use VoIP, PSTN

 

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or ISDN. The maincompetitors in this sector include Viseon Inc., 8x8 Inc., Motion Media PLC, andLeadtek Research Inc.

 

*VideoConference Products.*  D-Link Systems, Inc. produces a TV-basedvideo phone product that is targeted to consumers and promotes itscompatibility with DSL and cable modem technologies. D-Link uses the hometelevision as the display device and utilizes either the TV’s speaker orconnection to a standard analog phone for the audio portion of the call. Themain disadvantages of this product are convenience and non-personal video. TheD-Link requires a television to send and receive calls. In many cases, thiswould obstruct the ability to watch television while a call is in progressthereby disrupting family television watching for the length of the call.Numerous video conferencing products exist for the business market.  Typically these devices cost $2000 or moreand involve complex installations of one or more cameras, monitors, microphonesand speakers within a conference room setting. The videoconference nature ofthese products eliminates the ability to communicate on a private, one-on-onelevel. The main competitors in this sector include Sony, D-Link Systems, Inc.,Sorenson Media and Polycom Inc.

 

*TelephoneProducts.* Vialta, Inc. produces the “Beamer”, an H.324 (POTS) video phonethat is designed for connection to a standard telephone. The product utilizes astandard analog telephone for connection to the PSTN and as the listeningdevice. Because the unit uses traditional telephone lines for connectivity itcannot take advantage of the high-speed data systems available through cableand DSL modems.

 

*Web CamProducts.* Web cams are different from other competitive products in that they didnot arise from either business video phones or video conferencing. Rather, theybegan in the early days of the Internet when “techies” were expanding thecapabilities of PC-based content and applications with low-cost attachments tothe computer. Currently, web cams are often used to display visual informationrather than as a means for personal communication. Many popular web sites useweb cams to show traffic, weather, adult activities and other visuallyinteresting subjects. Software such as Net Meeting, Instant Messenger and MSNmessenger are being supported in web cams to enable a video chat option tothese Internet-based services. Competitors in this category include Logitech, Inc.,Intel Corporation, 3Com Corporation, and Creative Technology, Ltd.

 

*Hybrid WebCam-Business Phone Products.*  In recent months, Cisco Systems, Inc.introduced a hybrid video phone product that is designed for the business phonemarket. The Cisco product consists of a web cam deviceand host software that enables video phone functionality when used inconjunction with an IP phone and call processing hardware. We believe thisproduct requires a significant capital investment for implementing the callprocessing hardware and IP phones.

 

**IntellectualProperty**

 

We plan to rely on patent, trade secret,trademark and copyright law to protect our video phone intellectual property.** **Although we havefiled multiple patent applications for our technology, we do not currently holdany granted patents and our patent position is subject to complex factual andlegal issues that may give rise to uncertainty as to the validity, scope andenforceability of a particular patent. Accordingly, there can be no assurancethat any patents will be issued pursuant to our current or future patentapplications or that patents issued pursuant to such applications will not beinvalidated, circumvented or challenged. Moreover, there can be no assurancethat the rights granted under any such patents will provide competitiveadvantages to us or be adequate to safeguard and maintain our proprietaryrights. In addition, effective patent, trademark, copyright and trade secretprotection may be unavailable, limited or not applied for in certain foreigncountries.

 

**GovernmentRegulation**

 

Our Ojo video phone will be required tocomply with various laws and government regulations, including Parts 15 and 68of the FCC’s regulations in the United States, which relate to radio frequencydevices and to terminal equipment that is connected to the telephone network.The legal and regulatory environment that pertains to our business is uncertainand changing rapidly. New legislation or regulation could be introduced thatcould substantially impact our ability to launch and promote the Ojo videophone. For example, in the United States, the FCC and state regulatorycommissions could undertake an examination of whether to impose surcharges oradditional regulations upon certain providers of Internet protocol, or IP,based communication services. The imposition of regulations on IPcommunications services may negatively impact our business.

 

**Researchand Development**

 

To date, our engineering and productdevelopment has been a significant focus. The principal focus of our currentengineering and development activities is the continued development andenhancement of our Ojo video phone. Development of the Ojo video phone hasrequired combining technical experience and knowledge from two historicallyseparate industries, cable

 

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and telephony.Our engineering and development expenditures in connection with our Ojo videophone were approximately $0, $3,000 and $4,001 for the years ended December 31,2002, 2003 and 2004, respectively.

 

**Employees**

 

As of December 31, 2004, on aconsolidated basis, we had approximately 50 full-time employees. All of ouremployees are located in Trevose, Pennsylvania. None of our employees arerepresented by a labor union, and we have no collective bargaining agreement.We consider our employee relations to be good.

 

**Financial Information Relating to Foreign andDomestic Operations and Export Sales from Continuing Operations**

 
| ** **                                                            | ** ** | **2002**                   | ** ** | **2003** | ** ** | **2004** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------|------------|----------|------------|----------|------------|
| ** **                                                            | ** ** | **(dollars in thousands)** | ** ** |
| Revenues  from continuing operations by geographic area               |       |                       |       |     |       |     |       |
| United States                                                         |       | $                          | 0          |     | $          | 0        |       | $ | 231 |   |
| Total                                                                 |       | $                          | 0          |     | $          | 0        |       | $ | 231 |   |
| Loss from  continuing operations (all from United States operations)  |       | $                          | 0          |     | $          | (6,497   | )          | $ | (11,111 | ) |
| Identifiable  Assets (all within the United States)                   |       | $                          | 14,019     |     | $          | 5,117    |       | $ | 13,172 |   |
| Identifiable  foreign assets (hardware and tooling for Manufacturing) |       | $                          | 0          |     | $          | 0        |       | $ | 650 |   |

 

**Item 2.****Properties.**

 

Our corporate headquarters is located inTrevose, Pennsylvania in a leased facility consisting of approximately 16,000square feet. Both we and the landlord, however, have the right to terminatethis lease at any time on 90 days prior written notice to the other party. In March 2005,the property was sold and our lease was transferred to the new owner. We arecurrently negotiating a long term lease with the new owner and we anticipatethat this facility will be suitable for our needs for the immediate future.

 

**Item 3.****Legal Proceedings.**

 

Although from time to time we may be involvedin litigation as a routine matter in conducting its business, we are notcurrently involved in any litigation which we believe is material to ouroperations or balance sheet. We comply with the requirements of currentlyprevailing accounting standards and provides for accruals where a liability isprobable and a reasonable estimate can be made as to the probable amount ofsuch liability.

 

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

 

At our annual meeting of stockholders held onOctober 13, 2004, our stockholders elected six members to our Board ofDirectors.  Those elected to the Boardwere Hal M. Krisbergh, Steven C. Davidson, Clarence L. Irving, Jr., MartinJaffe, Jeff Morris and Lemuel Tarshis. Stockholders also approved the issuance of shares pursuant to a privateplacement made during the year, an amendment in the Company’s Articles ofIncorporation to increase the number of authorized shares, and the WorldGateCommunications, Inc. 2003 Equity Incentive Plan.

 

(1)           Electionof Directors:

 
| **Nominee**                   | ** ** | **FOR**    | ** ** | **WITHHELD** | ** ** |
|-------------------------------|------------|------------|------------|--------------|------------|
| Steven C.  Davidson           |       | 26,198,630 |       | 75,752       |       |
| Martin Jaffe                  |       | 26,201,996 |       | 72,386       |       |
| Clarence L.  Irving, Jr. |       | 26,040,254 |       | 234,128      |       |
| Hal M.  Krisbergh             |       | 26,183,611 |       | 90,771       |       |
| Jeff Morris                   |       | 26,185,945 |       | 88,437       |       |
| Lemuel  Tarshis               |       | 26,199,580 |       | 74,802       |       |

 

(2)           Ratificationand approval of our issuance of common stock in accordance with June, 2004Private Placement.

 

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| **FOR**    | ** ** | **AGAINST** | ** ** | **ABSTENTION** | ** ** |
|------------|------------|-------------|------------|----------------|------------|
| 10,809,490 |       | 267,947     |       | 31,362         |       |

 

(3)           Amendmentof Certificate of Incorporation to increase authorized common shares to 80million.

 
| **FOR**    | ** ** | **AGAINST** | ** ** | **ABSTENTION** | ** ** |
|------------|------------|-------------|------------|----------------|------------|
| 25,855,524 |       | 382,056     |       | 36,802         |       |

 

(4)           Ratificationand approval of WorldGate Communications, Inc.  2003 Equity Incentive Plan.

 
| **FOR**    | ** ** | **AGAINST** | ** ** | **ABSTENTION** | ** ** |
|------------|------------|-------------|------------|----------------|------------|
| 10,405,028 |       | 623,248     |       | 77,413         |       |

 

**PART II**

 

**Item 5.****Market for Registrant’s Common Equity and Related Stockholder Mattersand Issuer Purchases of Equity Securities**.

 

Our common stock, $0.01 par value, commencedtrading on the NASDAQ National Market under the symbol “WGAT” since our initialpublic offering in April 15, 1999. We applied for and received permission,effective January 9, 2003 to transfer the listing of our common stock tothe NASDAQ Small Cap Market. The following table shows the high and low salesprice as reported by the NASDAQ National Market and the NASDAQ Small Cap Market,as is applicable, for each quarter of 2003 and 2004.

 
| ** **                             | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------------------------------|------------|----------|------------|---------|------------|
| **Year  Ended December 31, 2003** |       |     |       |    |       |
| First  Quarter                         |       | $        | 0.58       |    | $          | 0.22 |   |
| Second  Quarter                        |       | 0.60     |       | 0.25    |       |
| Third  Quarter                         |       | 0.74     |       | 0.31    |       |
| Fourth  Quarter                        |       | 1.82     |       | 0.51    |       |
| **Year  Ended December 31, 2004** |       |     |       |    |       |
| First  Quarter                         |       | $        | 2.29       |    | $          | 1.01 |   |
| Second  Quarter                        |       | 3.36     |       | 1.35    |       |
| Third  Quarter                         |       | 2.45     |       | 1.41    |       |
| Fourth  Quarter                        |       | 6.03     |       | 1.52    |       |

 

On March 4, 2005, the last reported saleprice of our common stock as reported on the NASDAQ Small Cap Market was $3.81per share.

 

As of March 4, 2005, we had 342 holdersof record of our common stock.

 

**Dividends**

 

We have never paid or declared any cashdividends on our common stock. We do not anticipate paying any cash dividendsin the foreseeable future. We currently expect to retain future earnings, ifany, to finance the growth and development of our business.

 

**Sale of Unregistered Securities**

 

(1)           InDecember 2003 we completed a private placement of 2,000,000 shares (the “December 2003Shares”) of our common stock to certain institutional investors.  The shares were sold for $0.80 per share,resulting in gross proceeds from the offering of $1.6 million. The investorsalso received a right, for a limited period of time, to purchase additionalshares of up to 20% of the common stock purchased by the investors in theplacement at $0.80 a share. During the first quarter of

 

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2004 these additional investment rights wereexercised resulting in an additional purchase of 400,000 shares and anadditional $320,000 in gross proceeds. The investors were also issued warrants (the “December 2003Warrants”) to purchase in the aggregate up to 720,000 additional shares(including shares available only as a result of the exercise of the aboveadditional investment rights) of common stock at a per share exercise price of$1.00. In December 2004 one of our investors exercised its warrantsresulting in an additional purchase of 168,750 shares and an additional$168,750 in gross proceeds. In January 2005 one of the investors exercisedits warrants resulting in an additional purchase of 382,500 shares and anadditional $382,500 in gross proceeds.

 

The December 2003 Shares and the December 2003Warrants were issued in reliance upon the exemption from the registrationrequirements of the Securities Act of 1933 afforded to transactions notinvolving a public offering by Section 4(2) of that Act and Rule 506thereunder. The December 2003 Shares and the December 2003 Warrantsissued in the offering were subsequently registered for resale by the investorson January 9, 2004.

 

(2)           InJanuary 2004 we completed a private placement of 1,000,000 shares (the “January 2004Shares”) of our common stock to certain institutional investors.  The shares were sold for $1.50 per share,resulting in gross proceeds from the offering of $1.5 million. The investorsalso received a right, for a limited period of time, to purchase additionalshares of up to 20% of the common stock purchased by the investors in the placementat $1.50 a share. During the second quarter of 2004 these additional investmentrights were exercised resulting in an additional purchase of 200,000 shares andan additional $300,000 in gross proceeds. The investors were also issued warrants (the “January 2004 Warrants”)to purchase in the aggregate up to 310,000 additional shares (including sharesavailable only as a result of the exercise of the above additional investmentrights) of common stock at a per share exercise price of $1.875. In December 2004,one of our investors exercised its warrants resulting in an additional purchaseof 60,000 shares and an additional $112,500 in gross proceeds. In January 2005one of the investors exercised its warrants resulting in an additional purchaseof 139,500 shares and an additional $261,527 in gross proceeds.

 

The January 2004 Sharesand the January 2004 Warrants were issued in reliance upon the exemptionfrom the registration requirements of the Securities Act of 1933 afforded totransactions not involving a public offering by Section 4(2) of thatAct and Rule 506 thereunder. The January 2004 Shares and the January 2004Warrants issued in the offering were subsequently registered for resale by theinvestors on April 19, 2004.

 

(3)           InJune 2004 we completed a private placement of 7,550 shares (the “June 2004Shares”) of Series A Convertible Preferred stockto certain institutional investors.  Theshares were sold for $1000 per share, resulting in gross proceeds from theoffering of $7.55 million. The preferred stock issued pursuant to thisplacement is convertible into WorldGate common stock at a conversion price of$2.35 per share. WorldGate has the right to require conversion of the preferredstock into common stock upon achieving certain price targets with respect toits common stock and the satisfaction of certain other conditions. Between November 2004and January 2005 one of the investors has fully converted its preferredshares resulting in the issuance of 372,340 of our common shares. The preferredstock has a dividend rate of 5% per annum, payable quarterly, which may be paideither by cash or through the issuance of common stock at WorldGate’s option(with stock payments being made at a 10% discount to the then current marketprice). For the first two quarters for which dividend payments were due,WorldGate exercised its right to make these dividend payments in stock,resulting in the issuance of an additional 87,137 shares of our common stock.The preferred stock has a staged maturity over three years with scheduledpayments of one third due after 18 months, one half of the remainder due after24 months and the balance due after 36 months. The preferred stock may beredeemed at maturity in cash or through the issuance of an indeterminablenumber of shares of common stock, at WorldGate’s option (subject to certainconditions). All dividend and maturity payments made in stock are subject tothe satisfaction of certain conditions including the listing and availabilityof an effective registration statement. As part of the transaction, WorldGateissued five-year warrants to purchase a total of 1,606,380 shares of WorldGatecommon stock, with one-half of the warrants having an exercise price of $2.69per share and the remaining half having an exercise price of $3.14 per share.In January 2005 one of the investors has fully exercised its warrantsresulting in the issuance of an addition 63,830 of our common shares and anadditional $186,064 in gross proceeds. The investors also received anadditional investment right, for a limited period of time, to purchase1,606,380 additional common stock shares at $3.14 a share. During December 2004all but one of the investors exercised their additional investment rightsresulting in the issuance of an additional 1,499,998 shares and an additional$4,709,994 in gross proceeds. During the first quarter of 2005, the remaininginvestor exercised their additional investment right resulting in the issuanceof an additional 106,383 shares and an additional $334,043 in gross proceeds.

 

The June 2004 Shares and the June 2004Warrants were issued in reliance upon the exemption from the registrationrequirements of the Securities Act of 1933 afforded to transactions notinvolving a public offering by Section 4(2) of that

 

8

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Act and Rule 506thereunder. The June 2004 Shares and the June 2004Warrants issued in the offering were subsequently registered for resale by theinvestors on July 30, 2004.

 

In December 2004, WorldGate completed aprivate placement of 208,333 shares of our common stock to K.Y. Chou, presidentof Mototech, at a sales price of $2.40 per share, which resulted in additionalgross proceeds to the Company of $500,000. In connection with this placement,the Company granted warrants to Mr. Chou to purchase up to 62,500 sharesof our common stock at an exercise price of $2.88 per share.

 

**Item 6.****Selected Financial Data.**

 

The following table represents selectedconsolidated financial information for the five-year period ended December 31,2004. This data should be read in conjunction with our financial statements andnotes thereto and “Management’s Discussion and Analysis of Financial Conditionand Results of Operations” included elsewhere in this report.

 
| ** **                                                                                    | ** ** | **Year ended December 31,**                     | ** ** |
|-----------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                    | ** ** | **2000**                                             | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** |
| ** **                                                                                    | ** ** | **(In thousands, except share and  per share data)** | ** ** |
| Statement of  operating activities of continuing operations data:                             |       |                                                 |       |   |   |   |   |   |   |   |   |
| Revenues                                                                                      |       | $                                                    | —     |   | $ | — |   | $ | — |   | $ | — |   | $ | 231 |   |
| Cost of  revenues                                                                             |       | —                                               |       | — |   | — |   | — |   | 103 |   |
| Gross  margins                                                                                |       | $                                                    | —     |   | $ | — |   | $ | — |   | $ | — |   | 128 |   |
| Costs and  expenses:                                                                          |       |                                                 |       |   |   |   |   |   |   |   |   |
| Engineering  and development                                                                  |       | —                                               |       | — |   | — |   | 3,000 |   | 4,001 |   |
| Sales and  marketing                                                                          |       | —                                               |       | — |   | — |   | 466 |   | 1,362 |   |
| General and  administrative                                                                   |       | —                                               |       | — |   | — |   | 3,031 |   | 5,399 |   |
| Depreciation  and amortization                                                                |       | —                                               |       | — |   | — |   | — |   | 477 |   |
| Total costs  and expenses                                                                     |       | —                                               |       | — |   | — |   | 6,497 |   | 11,239 |   |
| Loss from  operating activities of continuing operations                                      |       | —                                               |       | — |   | — |   | (6,497 | ) | (11,111 | ) |
| Other  interest and other income                                                              |       | —                                               |       | — |   | — |   | — |   | 1,023 |   |
| Change in fair  value of warrants and conversion options                                      |       | —                                               |       | — |   | — |   | — |   | (10,091 | ) |
| Interest and  other expense                                                                   |       | —                                               |       | — |   | — |   | — |   | (6 | ) |
| Loss from  continuing operations                                                              |       | —                                               |       | — |   | — |   | (6,497 | ) | (20,185 | ) |
| Income  (loss) from discontinued operations                                                   |       | (49,597                                              | )          | (31,346 | ) | (19,210 | ) | (2,908 | ) | 36 |   |
| Net loss                                                                                      |       | (49,597                                              | )          | (31,346 | ) | (19,210 | ) | (9,405 | ) | (20,149 | ) |
| Accretion on  preferred stock and dividends                                                   |       | —                                               |       | — |   | — |   | — |   | (951 | ) |
| Net loss  available to common Stockholders                                                    |       | $                                                    | (49,597    | ) | $ | (31,346 | ) | $ | (19,210. | ) | $ | (9,405 | ) | $ | (21,100 | ) |
| Basic and  diluted loss from continuing operations per common share                           |       | $                                                    | 0.00       |   | $ | 0.00 |   | $ | 0.00 |   | $ | (0.28 | ) | $ | (0.72 | ) |
| Basic and  diluted income (loss) from discontinued operations per common share                |       | (2.23                                                | )          | (1.33 | ) | (0.81 | ) | (0.12 | ) | 0.00 |   |
| Basic and  diluted net loss per common share                                                  |       | $                                                    | (2.23      | ) | $ | (1.33 | ) | $ | (0.81 | ) | $ | (0.40 | ) | $ | (0.72 | ) |
| Basic and  diluted net loss available to common shareholders per common share                 |       | $                                                    | (2.23      | ) | $ | (1.33 | ) | $ | (0.81 | ) | $ | (0.40 | ) | $ | (0.76 | ) |
| Weighted  average common stock Outstanding—basic and diluted                             |       | 22,246,143                                           |       | 23,501,543 |   | 23,573,935 |   | 23,259,611 |   | 27,881,347 |   |
|                                                                                          |       |                                                 |       |   |   |   |   |   |   |   |   |
| As adjusted  net loss available to common stockholders(2)                                     |       | $                                                    | (49,356    | ) | $ | (30,985 | ) | $ | (19,210 | ) | $ | (9,405 | ) | $ | (21,100 | ) |
| As adjusted  basic and diluted net loss available to common shareholders per common  share(2) |       | $                                                    | (2.22      | ) | $ | (1.32 | ) | $ | (0.81 | ) | $ | (0.40 | ) | $ | (0.76 | ) |
| Balance  sheet data:                                                                          |       |                                                 |       |   |   |   |   |   |   |   |   |
| Cash and  cash equivalents, restricted cash and short term equivalents                        |       | $                                                    | 46,505     |   | $ | 14,613 |   | $ | 3,807 |   | $ | 3,365 |   | $ | 11,840 |   |
| Total assets                                                                                  |       | 74,841                                               |       | 33,792 |   | 14,019 |   | 5,117 |   | 13,822 |   |
| Long-term  obligations, including current portion                                             |       | 421                                                  |       | 1 |   | — |   | — |   | — |   |
| Redeemable  Preferred Stock                                                                   |       | —                                               |       | — |   | — |   | — |   | 2,995 |   |
| Total  stockholders’ equity (deficit)                                                    |       | 55,781                                               |       | 25,415 |   | 7,295 |   | 3,680 |   | (5,572 | ) |
| Other data:                                                                                   |       |                                                 |       |   |   |   |   |   |   |   |   |
| Common  shares outstanding                                                                    |       | 23,308,196                                           |       | 23,565,295 |   | 23,077,963 |   | 25,706,843 |   | 30,865,777 |   |
|                                                                                               |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)   Forpurposes of computing the net loss per common share, net loss has been reducedby the accretion on preferred stock.

 

(2)   “Asadjusted net loss available to common stockholders” and “As adjusted basic anddiluted net loss per common share” amounts reflect the exclusion ofamortization of goodwill of approximately $241 and $361 for the years ended December 31,2000 and 2001, respectively. These amounts are presented to comply withSFAS 142 as if this standard had been adopted at the beginning of therespective periods.

 

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**Item 7.****Management’s Discussion and Analysis of FinancialCondition and Results of Operations.**(Dollar amountscontained in this Item 7 are in thousands, except for share and per shareamounts)

 

**FORWARD-LOOKINGAND CAUTIONARY STATEMENTS**

 

We may from time to time make written or oralforward-looking statements, including those contained in the followingManagement’s Discussion and Analysis of Financial Condition and Results ofOperations.  The words “estimate,” “project,”“believe,” “intend,” “expect,” and similar expressions are intended to identifyforward-looking statements, although not all forward-looking statements containthese identifying words.  In order totake advantage of the “safe harbor” provisions of the Private SecuritiesLitigation Reform Act of 1995, we are hereby identifying certain importantfactors that could cause our actual results, performance or achievement todiffer materially from those that may be contained in or implied by anyforward-looking statement made by or on our behalf.  The factors, individually or in theaggregate, that could cause such forward-looking statements not to be realizedinclude, without limitation, the following: (1) difficulty in developingand implementing marketing and business plans, (2) industry competitionfactors and other uncertainty that a market for our products will develop, (3) challengesassociated with HSD operators (including, uncertainty that they will offer ourproducts, inability to predict the manner in which they will market and priceour products and existence of potential conflicts of interests and contractuallimitations impeding their ability to offer our products), (4) continuedlosses, (5) difficulty or inability to raise additional financing on termsacceptable to us, (6) departure of one or more key persons, (7) delistingof our Common Stock from the NASDAQ Small Cap Market, (8) changes inregulatory requirements, and (9) other risks identified in our filingswith the Securities and Exchange Commission. We caution you that the foregoing list of important factors is notintended to be, and is not, exhaustive. We do not undertake to update any forward-looking statement that may bemade from time to time by or on our behalf.

 

**Results of Operations:**

 

**General**

 

Our ITV business has historically accountedfor substantially all of our revenue.  Inthe third quarter of 2003, we completed a sale of significant assets, includingour ITV intellectual property rights and our membership interest in TVGateway,LLC.  This transaction marked a shift inour business away from the ITV business and toward a new video phone productand related business.  Although wecontinued to support our remaining ITV business into the first quarter of 2004,the development of our video phone product became a primary business focus.

 

Our video phone business has not producedsignificant revenues to date.  The extentand timing of future revenues for our business depends on several factors,including the rate of market acceptance of our products and the degree ofcompetition from similar products.  Wecannot predict to what extent our video phone product will produce revenues, orwhen, or if, we will reach profitability.

 

**Critical Accounting Policies and Estimates**

 

Our consolidated financial statements havebeen prepared in accordance with accounting principles generally accepted inthe United States. These generally accepted accounting principles requiremanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the financial statements and the reported amounts of net salesand expenses during the reporting period. Actual results could differ fromthose estimates.

 

Our significant accounting policies aredescribed in note 2 to our consolidated financial statements includedelsewhere in this report. We believe that the following discussion addressesour critical accounting policies, which are those that are most important tothe portrayal of our financial condition and results and require management’smost difficult, subjective and complex judgments, often as a result of the needto make estimates about the effect of matters that are inherently uncertain.

 

The preparation of financial statements inconformity with accounting principles generally accepted in the United Statesrequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities, at the date the financial statements and the reported amount ofrevenues and expenses during the reporting period.  Actual results could differ from thoseestimates.

 

*RevenueRecognition.* Revenue is recognized when persuasive evidence of an arrangement exists,the price is fixed or determinable, the collectibility is reasonably assured,and either the delivery and the acceptance of the equipment has occurred or

 

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services havebeen rendered.

 

*Inventories.*  Our inventory consists primarily of finishedgoods equipment to be sold to our customers. The cost is determined on anaverage cost basis. A periodic review of inventory quantities on hand isperformed in order to determine and record a provision for excess and obsoleteinventories. Factors related to current inventories such as technologicalobsolescence and market conditions are analyzed to determine estimated netrealizable values. A provision is recorded to reduce the cost of inventories tothe estimated net realizable values. Any significant unanticipated changes inthe factors noted above could have an impact on the value of our inventoriesand our reported operating results. With the current shift in focus to our newvideo phone business, our inventory balance of $1,668 consisted of $1,622relating solely to our ITV business, which was fully reserved for at December 31,2004, and $46 related solely to our new video phone business.

 

*Long-LivedAssets.* Our long-lived assets consist of property and equipment. Theselong-lived assets are recorded at cost and are depreciated or amortized usingthe straight-line method over their estimated useful lives. The carrying valueof a long-lived asset is considered impaired when the anticipated undiscountedcash flows from such assets are separately identifiable and are less than thecarrying value. In that event, a loss is recognized based on the amount bywhich the carrying value exceeds the fair market value of the long-lived asset.Fair market value is determined by using the anticipated cash flows discountedat a rate commensurate with the risk involved. Measurement of the impairment,if any, will be based upon the difference between carrying value and the fairvalue of the asset. If useful life estimates or anticipated cash flows changein the future, we may be required to record an impairment charge.

 

*Accountingfor Income Taxes.*  As part of the process of preparing ourconsolidated financial statements we are required to estimate our income taxesin each of the jurisdictions in which we operate. This process involves usestimating our actual current tax exposure together with assessing temporarydifferences resulting from differing treatment of items, such as depreciationof property and equipment and valuation of inventories, for tax and accountingpurposes. These differences result in deferred tax assets and liabilities. Wemust then assess the likelihood that our deferred tax assets will be recoveredfrom future taxable income and, to the extent we believe that recovery is notmore likely than not, we must establish valuation allowances. To the extent weestablish valuation allowances or increase the allowances in a period, we mustinclude an expense within the tax provision in the statement of operations.

 

We have a full valuation allowance againstthe net deferred tax asset of $79,290 as of December 31, 2004, due to ourlack of earnings history and the uncertainty as to the reliability of theasset. In the future, if sufficient evidence of our ability to generatesufficient future taxable income becomes apparent, we would be required toreduce our valuation allowance, resulting in a benefit from income tax in theconsolidated statement of operations.

 

*Stock-BasedCompensation.** *The Company accounts forstock-based compensation in accordance with Accounting Principles Board OpinionNo. 25, “Accounting for Stock Issued to Employees,” and relatedinterpretations and has presented the required disclosures of SFAS No. 123,“Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accountingfor Stock-Based Compensation—Transition and Disclosure. At December 31,2004, the Company had stock-based compensation plans, which are describedseparately in Note 8 to the consolidated financial statements for the yearended December 31, 2004. The Company applies Accounting Principles Board OpinionNo. 25, “Accounting for Stock Issued to Employees” and relatedinterpretations in accounting for its plans, and accordingly, no compensationcost has been recognized for the Company’s fixed stock-basedcompensation.

 

*Accountingfor Preferred Shares.*  The Company accounts for preferred stock inaccordance with EITF topic D-98 “Classification and Measurement of RedeemableSecurities”, and the Redeemable Preferred Stock was recorded in the financialstatements as temporary equity. Additionally, the fair value of warrants andpreferred stock conversion options were recorded into the consolidatedfinancial statements as liabilities as a result of their features that requireaccounting under FAS 133 “Accounting for Derivative Instruments and HedgingActivities, as amended.” At each reporting balance sheet date, an evaluation ismade of these valuations and marked to market.

 

**2004 versus 2003**

 

**Revenues**

 

*Revenues.***Revenues from continuing operations of $231 were realizedduring the twelve months ended December 31, 2004. These revenues representthe initial deliveries of video phones for pre-market testing. There were norevenues from continuing operations for the twelve months ended December 31,2003. Revenue from the sale of equipment is recognized by the

 

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Company when the products are shipped.

 

**Costs and Expenses**

 

*Cost of revenues.*Thecost of revenues from continuing operations relating to the initial deliveriesof video phones was $103 for the twelve months ended December 31, 2004.There were no cost of revenues from continuingoperations for the twelve months ended December 31, 2003.

 

*Engineeringand Development*. Engineering and developmentexpenses primarily consist of compensation, and the cost of design,programming, testing, documentation and support of the Company’s video phoneproduct. Engineering and development costs were $4,001 for the twelve monthsended December 31, 2004, compared with $3,000 for the twelve months ended December 31,2003. This increase in 2004 over 2003 of $1,001 or 33%,reflects our increased shift of efforts of our engineering staff, and relatedcosts, from our ITV business (discontinued operations) to the continuingdevelopment of our video phone product.

 

*Sales andMarketing*. Sales and marketing expenses consistprimarily of compensation, attendance at conferences and trade shows, travelcosts, promotions and other marketing programs related to the introduction ofour video phone product. Sales and marketing costs were $1,362 for the twelvemonths ended December 31, 2004, compared with $466 for the twelve monthsended December 31, 2003. This increase of $896, or 192%, reflects theincreased marketing and promotional expenditures, trade shows attendance, aswell as a shift in efforts from our ITV business to our video phone product.

 

*General andAdministrative*. General and administrativeexpenses consist primarily of expenditures for administration, office andfacility operations, finance and general management activities, includinglegal, accounting and professional fees. General and administrative expenseswere $5,399 for the twelve months ended December 31, 2004, compared with$3,031 for the twelve months ended December 31, 2003. The increase of$2,368, or 78%, is attributable primarily to our transition of nearly all ofour administrative management compensation, facility, legal, finance andprofessional consulting fees toward the further development of the video phonebusiness, and a non cash charge of $1,332 during the twelve months ended December 31,2004, reflecting a Black Scholes estimate of the value of the warrants issuedas part of the private placement of our stock to certain investors in January, June andDecember 2004, and warrants issued to Motorola in September 2004 inconformity with the terms of the agreement signed in April 2004. For thetwelve months ended December 31, 2003, video phone related costs were$3,031, or 66% of total General and Administrative expense of $4,589 (including$1,558 in discontinued operations).

 

*Interest,Other Income and Interest Expense*. Interest,other income and interest expense from continuing operations consisted ofinterest earned on cash and cash equivalents, and interest expense onshort-term debt. Total interest and other income increased to $1,023 for thetwelve months ended December 31, 2004 from $0 for the twelve months ended December 31,2003. During the twelve months ended December 31, 2004, we earned interestincome of $86 on average cash balances of approximately $6,601, and incurredinterest expense of $6 related to insurance financing. In comparison, duringthe twelve months ended December 31, 2003, we earned interest on averagecash balances that are included with discontinued operations of approximately$2,222, and incurred interest expense of $6 related to our insurance financing.Included in total interest and other income is $928 which represents deferredrent credits of $143 and cancelled unpaid rent of $785 relating to theamendment of our facility lease with an effective date of June 2004. Formore details, refer to Note 11 to our consolidated financial statements for theyear ended December 31, 2004.

 

*Non CashChange in Fair Value of Warrants and Conversion Options.*For the twelve months ended December 31, 2004, the non cash change in fairvalue of warrants and conversion option was an expense of $10,091. This expensewas the result of a marked to market adjustment as of December 31, 2004related to our June 24, 2004 private placement of our Series A Convertible Preferred Stock and Warrants. Over the life ofthe instruments, these marked to market adjustment of gains and losses willoffset and net to $0.

 

*IncomeTaxes.* We have incurred net operating losses since inception and accordinglyhave had no income taxes and have not recorded any income tax benefit for thoselosses.

 

**2003 versus 2002**

 

Since our formation in 1995 and into January 2004,our company had been in the business of developing and selling interactivetelevision (“ITV”) technology, products and services for use in conjunctionwith cable TV broadband networks (the “ITV” Business”).  Using our solutions, cable TV operatorsbranded, marketed, and offered a wide variety of ITV packages toconsumers.  These packages includedwalled gardens of information, communications solutions complete withInternet-based e-mail

 

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and chat, and Websurfing, all presented and engaged on the TV set.

 

During the third quarter of 2003, wecompleted a sale of certain assets, including our ITV intellectual propertyrights and our membership interest in TVGateway, LLC, for $3 million in cash toTVGateway, LLC, a company we were instrumental in forming.  Our transaction with TVGateway, LLC marked ashift in our business away from the ITV Business and toward a new video phoneproduct and associated business. Although we continued to support our current ITV Business during thefirst quarter of 2004, our new video phone product became our primary productfocus. We advised our ITV customers of our de-emphasis of ITV going forward. Weinformed them that we were willing to continue our efforts into 2004 as long aswe could do so on a profitable basis. In January, with all our customers havingtaken steps to terminate their ITV service in their markets, we decided toformally end our ITV business and began to account for our ITV business as adiscontinued operation. The funds we received from the sale of assets toTVGateway, LLC, as well as the funds we received as a result of private placementsof our securities on December 1, 2003 and December 4, 2003, havepermitted us to fund the development of our new video phone business and ourcontinuing operations in 2004.

 

## **Revenues**

 

*Revenues.** *For the years ended December 31,2003 and December 2002, our revenues from continuing operations were $0.Revenues from discontinued operations for the year 2003 were primarily theresult of first quarter products sales and consulting fees to TVGateway, LLC, athen unconsolidated entity, subscriber fees from cable operators providing ourinteractive television products and services, and certain excess inventory andequipment sold during the year.  Revenuesfor the twelve months ended December 31, 2003 related to the discontinuedoperations were $3,886, compared to $13,878 for the same period in 2002.  This revenue decrease of $9,992 from 2002 to2003 is primarily attributable to reduced consulting fees with TVGateway. Forthe twelve months ended December 31, 2003, TVGateway consulting fees were$794, compared to $11,484 for the twelve months ended December 31, 2002.During the fourth quarter of 2003, we also sold approximately $300 of excessinventory at auction that was related to the discontinued operations.

 

**Costs and Expenses**

 

*Cost ofRevenues.* Cost of revenues from continuing operations were $0 for the twelvemonths ended December 31, 2003 and 2002. Cost of revenues for the year2003 related to discontinued operations consisted of primarily equipmentproduct costs related to commercial deployments, the sale of excess inventoryand equipment, and service fee revenue costs related primarily to the provisionof engineering and administrative services. Such discontinued operations costsof equipment product revenues for the twelve months ended December 31,2003 were $5,849, or approximately 261% of equipment product revenues, comparedto the discontinued operations product costs of revenues of $4,537, orapproximately 479% of equipment product revenues, for the twelve months ended December 31,2002. The decrease in the cost of equipment product revenues as a percent oftotal equipment product revenues for the twelve months ended December 31,2003, as compared to the twelve months ended December 31, 2002, wasprimarily the result of increased level of equipment revenues, partially offsetby an increase in inventory provisions recorded against the carrying amount ofinventory products to adjust them to their net realizable value. For the twelvemonths ended December 31, 2003, discontinued operations inventoryadjustments were $3,037. For the twelve months ended December 31, 2002,such inventory adjustments were $2,209. Service fee costs of revenues fromdiscontinued operations for the twelve months ended December 31, 2003 were$807, or approximately 49% of service fee revenues. Comparable service feecosts of revenues were $11,284 or approximately 87% of service fee revenues forthe twelve months ended December 31, 2002. The decrease in service feecost of revenues of $10,477 for the twelve months ended December 31, 2003,when compared to the same period in 2002, is primarily attributable todecreased costs related to consulting fees with TVGateway and the additionalsupport costs relating to a decreased subscriber base.

 

*Engineeringand Development.*  Engineering and development expenses fromcontinuing operations primarily consisted of compensation, the cost of design,programming, testing, documentation, and support of the Company’s video phoneproduct. For the twelve months ended December 31, 2003 and 2002, suchexpenses were $3,000 and $0, respectively. This increase in 2003 over 2002reflected our increased shift of efforts of our engineering staff, and relatedcosts from our discontinued ITV business to the continuing development of ourvideo phone product. Engineering and development expenses related to discontinued operations primarily consisted of the cost ofdesign, programming, testing, documentation and support of our ITV relatedhardware, software and services. For the twelve months ended December 31,2003, discontinued operation engineering and development costs were $792, adecrease of approximately 90% when compared to $7,705 for the twelve monthsended December 31, 2002. This decrease in expenses of $6,913 is primarilyattributable to the shift of efforts and related costs from the discontinuedITV business to the continuing video phone business.

 

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*Sales andMarketing.* Sales and marketing expenses from continuing operations consistedprimarily of compensation, attendance at conferences, trade shows, travelcosts, promotions and other marketing programs related to the introduction ofthe Company’s video phone product. For the twelve months ended December 31,2003 and 2002, such expenses were $466 and $0, respectively. This increase in2003 over 2002 reflected our marketing and promotional expenditures, trade showattendance, as well as a shift in efforts from our ITV business to thecontinuing marketing of our video phone product. Sales and marketing costs fromdiscontinued operations consisted primarily of compensation, attendance atconferences and trade shows, travel costs necessary to cover a domestic andinternational customer market base, promotions and other marketing programssubstantially related to ITV trial installations and commercial deployments.For the twelve months ended December 31, 2003 sales and marketing expensesfrom the discontinued ITV business were $405. This represents a decrease ofapproximately 84% when compared to such sales and marketing expenses of $2,585for the twelve months ended December 31, 2002. This decrease in expensesis primarily attributable to our shift in efforts to Ojo video phone marketingand promotional expenditures, trade show attendance as well as a shift inefforts from our ITV business to the continuing video phone business.

 

*General andAdministrative.* General and administrative expenses from continuing operations were$3,031 and $0 for the twelve months ended December 31, 2003 and 2002,respectively. This increase in 2003 over 2002 reflects our transition of ouradministrative management compensation, facility, legal, finance andprofessional consulting fees toward the further development of the video phonebusiness. General and administrative expenses from discontinued operationsconsisted primarily of expenditures for administration, office and facilityoperations, finance and general management activities, including legal,accounting, insurance and other professional fees. General and administrativeexpenses from discontinued operations were $1,558 for the twelve months ended December 31,2003, a decrease of 49% when compared to expenses of $3,069 for the same periodin 2002. This decrease in expenses is primarily attributable to our transitionof our management compensation, facility costs, and professional fees from ourITV business to the video phone business.

 

*GoodwillImpairment*. During the second quarter of 2002, in an effort to cut costs and achieveoperational efficiencies, we commenced the termination of all personnel of theformer DVA, which performed engineering development services. In conjunctionwith this action, it was determined that the carrying amount of the Company’sremaining goodwill, which was originally recorded with our acquisition of DVAand related to our discontinued operations, exceeded its fair value. As such,we measured the impairment loss by the amount the carrying value exceeded theimplied fair value of the goodwill. The amount of the non-cash impairment losswas $3,006. The fair value of goodwill was estimated using the expected presentvalue of future cash flows.

 

*Interestand Other Income and Interest Expense.*  Interest and other income and interestexpense were from discontinued operations and consisted of interest earned oncash and cash equivalents and short-term investments, and interest expense onequipment financing and short-term debt. Interest and other income decreasedfrom $462 for the twelve months ended December 31, 2002 to $75 for thetwelve months ended December 31, 2003, primarily due to declining averagecash and short term investment balances and to declining interest rates. Duringthe twelve months ended December 31, 2002, we earned interest on averagecash balances solely from discontinued operations of approximately $8,311 andincurred interest expense related to our equipment financing facility in theamount of $7. In comparison, during the twelve months ended December 31,2003 we earned interest on average cash balances that are consolidated withdiscontinued operations, of approximately $2,222 and incurred interest expenserelated to our insurance financing in the amount of $6.

 

*Gain on sale of intellectual property andinvestment in TVGateway.*  On September 30, 2003, we sold certainintellectual property rights and certain software and equipment related to ourdiscontinued ITV operations to TVGateway, LLC, for $2.4 million in cash,pursuant to an Asset Purchase Agreement (the “Purchase Agreement”), which weexecuted with TVGateway in August 2003. Pursuant to the Purchase Agreementwe retained a royalty-free license to the intellectual property rights thatwere sold, enabling us to use the intellectual property rights to continue toconduct our business as then being conducted. Concurrently with the executionof the Purchase Agreement, we and TVGateway also entered into a redemptionagreement pursuant to which we redeemed our equity interest in TVGateway for$600,000 in cash, paid concurrently with the execution of the redemptionagreement. The intellectual property rights had previously been expensed asincurred. Similarly, we did not carry an equity balance for our interest inTVGateway. The aggregate effect of these transactions was a gain of $3 million,which is reported in the loss from discontinued operations in 2003.

 

*IncomeTaxes.* The Company has incurred net operating losses since inception andaccordingly had no income taxes and has not recorded any income tax benefit forthose losses.

 

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**Liquidity and Capital Resources**

 

As of December 31, 2004, our primarysource of liquidity consisted of cash and cash equivalents that are highlyliquid, are of high quality investment grade and have original maturities ofless than three months.

 

At December 31, 2004, we had cash andcash equivalents of $11,840 (and no short-term investments) as compared to cashand equivalents of $3,365 (and no short-term investments) at December 31,2003. Net cash used in continuing operations was $7,084 for the twelve monthsended December 31, 2004, as compared to $3,644 used for the same period in2003. This increase in net cash used for continuing operations was primarilyattributable to our increase in expenditures during the twelve months ended December 31,2004, related to the video phone business. We recorded bad debt expense in theamount of $16 from discontinued operations in 2004 to reflect our currentassessment of the collectability of certain receivables.

 

Cash provided by financing activities fromcontinuing operations through various private placements of our company’ssecurities and through the exercise of non-executive employees’ and prioremployees’ stock options during the twelve months ended December 31, 2004,totaled $16,349 compared to $1,490 provided during the same period in 2003.During the third quarter of 2003, we completed a sale of certain assets,including our ITV intellectual property rights and our membership interest inTVGateway, LLC, for $3,000 in cash to TVGateway, LLC, a company we wereinstrumental in forming.

 

Operations and Liquidity.

 

To date, we have funded operations primarilythrough private sales of equity securities and through an initial publicoffering of common stock in April 1999. As of December 31, 2004 theCompany had cash and cash equivalents of $11,840. The operating cash usage fromcontinuing operations for the twelve months ended December 31, 2004 and2003 was $7,084 and $3,644, respectively. As of December 31, 2004 we have$37 of outstanding debt and our assets are not pledged as collateral. Wecontinue to evaluate the possibilities to obtain additional financing throughpublic or private equity or debt offerings, bank debt financing, assetsecuritizations, or from other sources. Such additional financing would besubject to the risk of availability, may be dilutive to our shareholders, orcould impose restrictions on operating activities. There can be no assurancethat this additional financing will be available on terms acceptable to us, ifat all.

 

The Company has funded operations through the privateplacement of our common stock in January 2004, which provided proceeds of$1,500, the private placement of our common stock in April 2004 providingproceeds of $1,000, the June 2004 private placement of our redeemablepreferred stock providing proceeds of $7,550, the private placement of commonstock in December 2004 providing $500, the exercise of additionalinvestment rights and warrants providing $6,200 in January, February and December 2004and January and February 2005, the exercise by employees and formeremployees of options throughout 2004 and January and February 2005providing aggregate proceeds of $900. We do however have an obligation to paydividends on, as well as to redeem, our outstanding Series A Preferred Stock upon maturity, or at the earlier option ofa holder of these securities. Under certain limited circumstances we may beforced to make such payments and redemptions with cash instead of shares of ourcommon stock. In such event our ability to fund continuing operations would benegatively impacted. The report of the independent registered public accountingfirm for the year ended December 31, 2004 included an explanatoryparagraph stating that the Company had suffered recurring losses fromoperations and had a net accumulated deficiency of $220,000, and that theseissues raised substantial doubt about the Company’s ability to continue as agoing concern.  No assurances can begiven that sufficient sales, if any, will materialize, or that, if pursued, afinancing transaction can be consummated. We however remain hopeful that sales will materialize and/or thatsufficient funding can be developed through ongoing operations or additionalfinancings to continue our operations.

 

In December 2003, WorldGate reachedagreement with Mototech, Inc. for the purchase of 625,000 shares of newlyissued common stock at $0.80 per share, in return for future design andengineering services by Mototech. WorldGate had previously contracted withMototech to assist the Company with the design and volume manufacture ofWorldGate’s Ojo personal video phone. The purchase price for these shares hasbeen fully paid as of December 31, 2004 by an equivalent reduction in thedevelopment and initial procurement payments that would otherwise be due toMototech. As of December 31, 2004, that payment was $500. Mototech is anaffiliate of Accton Technology Group. Mototech currently manufactures anddistributes a full range of high performance high speed data and computernetworking products, including cable set top boxes, home gateways, wirelessLANs, hubs, switches, routers, and other relatedproducts. In addition, in April 2004, Mototech invested $1 million topurchase 666,666 shares of newly issued common stock at $1.50 per share.

 

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Quantitative and Qualitative Disclosures AboutMarket Risk.

 

Interest RateRisk.  Ourexposure to market risk related to changes in interest rates relates primarilyto our investment portfolio.  We investin instruments that meet high credit quality standards, and we limit the amountof credit exposure with respect to any one issue, issuer and type ofinvestment.

 

As of December 31, 2004, our cash andcash equivalents were $11,840, most of which were securities having a maturityof less than three months.  Due to theaverage maturity and conservative nature of our investment portfolio,management believes a sudden change in interest rates would not have a materialeffect on the value of the portfolio. Management estimates that had the average yield of our investmentsdecreased by 100 basis points, our interest income for the twelve months ended December 31,2004 would have decreased by approximately $95. This estimate assumes that the decrease occurred on the first day of2004 and reduced the yield of each investment instrument by 100 basispoints.  The impact on our futureinterest income of future changes in investment yields will depend largely onour total investments.

 

ForeignCurrency Exchange Risk.  Although we transact business in variousforeign countries, the principal portion of our business is in the UnitedStates and substantially all of our revenues and costs to date have beendenominated in U.S. dollars.  Althoughour agreement with Mototech, our contract manufacturer in Taiwan, isdenominated in U.S. dollars, their material acquisition costs are subject toexchange rate changes that could impact our product costs.

 

*Disclosure of Contractual Obligations*

 
| ** **       | ** ** | **Total** | ** ** | **Less than 1 year** | ** ** | **1 — 3 years** | ** ** | **3 — 5 years** | ** ** | **Over 5 years** | ** ** |
|------------------|------------|-----------|------------|----------------------|------------|----------------------|------------|----------------------|------------|------------------|------------|
|             |       |      |       |                 |       |                 |       |                 |       |             |       |
| Operating  lease |       | $         | 23         |                 | $          | 6                    |       | $                    | 12         |             | $          | 5 |   | $ | — |   |
|                  |            |           |            |                      |            |                      |            |                      |            |                  |            |  |  |  |  |  |

 

*Recent Accounting Pronouncements*

 

In January 2003, the FASB issuedInterpretation (FIN) No. 46, *Consolidation of VariableInterest Entities*. FIN 46 addresses consolidation by business enterprisesof variable interest entities, which are entities that either (a) do nothave equity investors with vesting rights or (b) have equity investorsthat do not provide sufficient financial resources for the entity to supportits activities. The interpretation is effective immediately for variableinterest entities created after February 1, 2003. In December 2003,the FASB published FASB FIN 46 (R), *Consolidation of VariableInterest Entities*. FIN 46(R), among other things, defers theeffective date of implementation for certain entities. The revisedinterpretation is effective for the first interim or annual reporting periodending after March 15, 2004, with the exception of structures that arecommonly referred to as special-purpose entities, for which the statement iseffective for periods ending after December 15, 2003. The adoption of FIN46 did not have a material impact on WorldGate’s results of operations orfinancial position.

 

In November 2004, the FASB issued SFAS No. 151“Inventory Costs” which amends the guidance in ARB No. 43, Chapter 4 “InventoryPricing,” to clarify the accounting for abnormal amounts of idle facilityexpense, freight, handling costs, and wasted material (spoilage). Paragraph 5of ARB 43, Chapter 4, previously stated that under some circumstances, itemssuch as idle facility expense, excessive spoilage, double freight, andrehandling costs may be so abnormal as to requiretreatment as current period charges.” SFAS No. 151 requires that thoseitems be recognized as current-period charges regardless of whether they meetthe criterion of “so abnormal.” In addition, SFAS No. 151 requires thatallocation of fixed production overheads to the costs of conversion be based onthe normal capacity of the production facilities. SFAS No. 151 shall beeffective for inventory costs incurred during fiscal years beginning after June 15,2005. Earlier application is permitted for inventory costs incurred duringfiscal years beginning after the date SFAS No. 151 was issued. SFAS No. 151shall be applied prospectively. The Company does not expect the adoption ofSFAS No. 151 to have a material effect on its consolidated financialstatements.

 

In December 2004, the FASB issued SFAS No. 153“Exchanges of Nonmonetary Assets” which amends APB Opinion No. 29, “Accountingfor Nonmonetary Transactions.” APB No. 29 is based on the principle thatexchanges of nonmonetary assets should be measured based on the fair value ofthe assets exchanged. The guidance in that Opinion, however, included certainexceptions to that principle. SFAS No. 153 amends APB No. 29 toeliminate the exception for nonmonetary exchanges of similar productive assetsand replaces it with a general exception for exchanges of nonmonetary assetsthat do not have commercial substance. A nonmonetary exchange has commercialsubstance if the future cash flows of the entity are expected to changesignificantly as a result of the exchange. SFAS No. 153 shall be effectivefor nonmonetary asset exchanges occurring in fiscal periods beginning after June 15,2005. Earlier application is permitted for nonmonetary asset exchangesoccurring in fiscal periods beginning after the date SFAS No. 153 wasissued. SFAS No. 153 shall be applied prospectively. The Company does notexpect the adoption of SFAS No. 153 to have a material effect on itsconsolidated financial statements.

 

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In December 2004, the FASB issued SFAS No. 123(R), “Share-Based Payment” that focuses primarily on accounting fortransactions in which an entity obtains employee services in share-basedpayment transactions. This statement replaces SFAS No. 123, “Accountingfor Stock-Based Compensation”, and supersedes APB Opinion No. 25, “Accountingfor Stock Issued to Employees.” Beginning with our quarterly period that beginsafter June 15, 2005, we will be required to expense the fair value ofemployee stock options and similar awards. As a public company, we are allowedto select from two alternative transition methods, each having different reportingimplications. The impact of SFAS No. 123R has not been determined at thistime.

 

**FACTORSAFFECTING OUR BUSINESS CONDITION**

 

*In addition to other information in this Form 10-K,the following risk factors should be carefully considered in evaluating ourcompany and our business. Investing in our common stock involves a high degreeof risk, and you should be able to bear the complete loss of your investment.We also caution you that this Form 10-K includes forward-lookingstatements that are based on management’s beliefs and assumptions and oninformation currently available to management. Future events and circumstancesand our actual results could differ materially from those projected in anyforward-looking statements. You should carefully consider the risks describedbelow, the other information in this Form 10-K, the documents incorporatedby reference herein and the risk factors discussed in our other filings withthe Securities and Exchange Commission when evaluating our company and ourbusiness. The risks and uncertainties described below are not the only ones weface. Additional risks and uncertainties not presently known by us or that wecurrently deem immaterial also may impair our business operations. If any ofthe following risks actually occur, our business could be harmed. In such case,the trading price of our common stock would decline.*

 

**Our ITV Business has accounted for most ofour revenues to date; we cannot reliably project our continued revenues, and weexpect to incur significant losses for an indefinite period of time.**

 

Since our formation in 1995 and until thefirst quarter of 2004, we were in the business of developing and sellinginteractive television, or ITV, technology products and services for use inconjunction with cable television broadband networks.  Our ITV business has historically accountedfor substantially all of our revenue. Since we have discontinued the ITVBusiness and transitioned to become a developer, manufacturer and seller ofvideo phone products we cannot reliably predict our future revenues, and noassurances can be provided as to the amount of ongoing revenues, if any, or tothe periods in which any such revenues may be received. Our video phonebusiness involves the development of a new product line with no marketpenetration, in an undeveloped market sector. The extent and timing of our revenues depends on several factors,including the rate of market acceptance of our products, and the degree ofcompetition we face from similar products. We cannot predict to what extent our video phone product will begin toproduce revenues, or whether we will ever reach profitability. If we are unableto achieve significant levels of recurring revenue from our video phonebusiness, our losses will likely continue indefinitely. If this occurs, themarket price of our common stock and our viability as a going concern couldsuffer.

 

**Our auditors have expressed substantial doubtabout our company’s ability to continue as a going concern.**

 

The report of the independent registeredpublic accounting firm for the year ended December 31, 2004 included anexplanatory paragraph stating that our company has suffered recurring lossesfrom operations and had a net accumulated deficiency of $220 million thatraised substantial doubt about our company’s ability to continue as a goingconcern. No assurances can be given that the issues that led our auditors tothis conclusion will be addressed or that our business will continue to operateas a going concern.

 

**We expect to be increasingly dependent on asingle line of business that currently has no history of revenues. We cannotpredict our future results because our video phone business has no operatinghistory.**

 

Our primary line of business has become thedevelopment of video phone products and technology. We are still in the processof launching our first product based on this technology and consequently thereare currently no substantial revenues from this line of business. Given thelack of operating history in the video phone business, it is difficult topredict our future results. Investors should consider the risks anduncertainties that we may encounter as a pre-revenue-stage company in a new andunproven market. These uncertainties include:

 

•      our ability to design and engineer products having thetechnological features planned for the video phone product line in a costefficient manner;

•      our ability to enter into appropriate distributionrelationships for the product;

•      our ability to demonstrate the benefits of our products andservices to end users;

 

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•      our ability to offer our products at competitive prices;

•      consumer demand for, and acceptance of, the video phonebusiness products;

•      our unproven and evolving business model;

•      unfavorable economic conditions in the technology industry;

•      decreased capital spending on technology due to adverseeconomic conditions; and

•      global economic conditions.

 

**Our video phone technology and productsremain subject to significant uncertainty.**

 

Our video phone technology and products arein the early commercialization stage and have not been fully proven. The marketfor products related to video telephony is characterized by uncertain user andcustomer requirements, and the emergence of new communications standards andpractices. Each of these characteristics could impact our video phone products,intellectual property and system designs. The successful development of ourproducts is subject to the risks that:

 

•      our proposed product is found to be ineffective for theintended purposes;

•      the proposed product is uneconomical to manufacture, ormarket or does not achieve broad market acceptance; and

•      third parties hold proprietary rights that preclude us frommarketing the product.

 

Significant undetected errors or delays innew products or releases may affect market acceptance of our product. There canbe no assurance that, despite our testing, errors will not be found in theinitial product or subsequent releases after the commencement of commercialshipments, resulting in loss of customers or failure to achieve marketacceptance.  In addition, our video phonetechnology and product will need to be compatible with a broad array ofdisparate technologies in order to be interoperable with other productsroutinely used in HSD operations such as routers, switches, network interfaces,operating systems, security protocols and techniques, communication protocolsand protocol servers, and billing systems software. Without compatibility, wemay not achieve market acceptance or demand for our products within our targetbase of customers because our products will not operate with many of theapplications the target customers currently use.

 

**We rely on third parties to provide certaincomponents and services for our video phone products. If our vendors fail todeliver their products in a reliable, timely and cost-efficient manner, ourbusiness will suffer.**

 

We depend on relationships with third partiessuch as contract manufacturing companies, chip design companies and others whomay be sole source providers of key components and services critical for theproduct we are developing in our video phone business. A formal relationshipwith Mototech, Inc. has been established for the volume manufacture ofOjo.  Our agreement with Mototech allowseither party to terminate the agreement with 90 days prior notice.  If Mototech, Inc. or other providers ofcomponents and/or manufacturing services do not produce these components orprovide their services on a timely basis, if the components or services do notmeet our specifications and quality control standards, or if the components orservices are otherwise flawed, we may have to delay product delivery, or recallor replace unacceptable products. In addition, such failures could damage ourreputation and could adversely affect our operating results. As a result, wecould lose potential customers and any revenues that we may have at that timemay decline dramatically.

 

**We will rely on third parties to providecertain marketing and distribution services for our video phone products. Ifour vendors fail to deliver their services in a reliable, timely andcost-efficient manner, our business will suffer.**

 

We have entered into a six-year distributionagreement with Motorola, Inc. for the marketing and distribution of ourOjo video phone. This agreement provides for Motorola to be WorldGate’sexclusive distributor of its broadband video phone products and for WorldGateto be Motorola’s exclusive supplier of its broadband video phone products.  After a period of eighteen months followingthe commercial availability of the Ojo video phone this mutual exclusivity willterminate unless Motorola elects to continue the mutual exclusivity afterhaving achieved certain minimum sales targets for the Ojo video phone**. **Motorola may,however, at its option, elect to terminate this mutual exclusivity at anytime.  In the event mutual exclusivityterminates or is terminated, then for a twelve month period thereafter,WorldGate will continue to be Motorola’s exclusive supplier of broadband videophones, but will be free to sell video phone products to customers other thancertain defined Motorola accounts. During this twelve month period, Motorola has a right of first refusalto accept and fill any orders for video phone products that WorldGate obtainsfrom non-Motorola accounts, and is obligated to use good faith efforts tosolicit and accept product orders from Motorola accounts in a commerciallyreasonable manner.  During any period ofexclusivity under this agreement we are reliant upon Motorola and itsdistribution partners, including, for example, wholesalers, retailers andservice providers, to provide the worldwide sales and distribution of the Ojovideo phone. Although the agreement requires Motorola to provide for certainmarketing and

 

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promotionalactivities for the Ojo video phone, there are no required sales quotas for theagreement to remain in effect, and Motorola controls the volume of productsbeing distributed by our company. Neither party can terminate the agreement except in cases of uncuredbreaches of the agreement or as a result of insolvency events suffered by theother party.  If Motorola and itspartners are not successful, or if their activities do not lead to significantsales of our product, our operating results will be adversely affected, ourrevenue could be significantly reduced and we could lose potential customers.

 

**We may not be able to meet our productdevelopment objectives or market expectations.**

 

Our video phone product development effortsare inherently difficult to manage and keep on schedule and there can beno assurance that we will be able to meet our development objectives or to meetmarket expectations. In addition to development delays, we may experiencesubstantial cost overruns in completing development of our product. Thetechnological feasibility for some aspects of the product that we envision isnot completely established. The product being developed by us may containundetected flaws when introduced. There can be no assurance that, despitetesting by us and by potential customers, flaws will not be found in theproduct, resulting in loss of or delay in market acceptance. We may be unable,for technological or other reasons, to develop and introduce the product in atimely manner in response to changing customer requirements. Further, there canbe no assurance that while we are attempting to finish development of ourproduct, a competitor will not introduce a similar product. The introduction bya competitor of either a similar product before we introduce our product, or asuperior alternative to our product, may diminish our technological advantage,render our product and technologies partially or wholly obsolete, or requiresubstantial re-engineering of our product in order to become commerciallyacceptable. Our failure to maintain our product development schedules, avoidcost overruns and undetected errors or introduce a product that is superior tocompeting products would have a materially adverse effect on our business,financial condition and results of operations.

 

**We may not be able to achieve competitivepricing in the marketplace.**

 

Because video phone products are relativelynew to the marketplace there is no established market pricing.  Our pricing for the Ojo video phone may beconsidered high for a consumer product offering. We cannot be assured that wewill be able to provide competitive market pricing.

 

**We are highly dependent on our key personnelto manage our business, and because of competition for qualified personnel wemay not be able to recruit or retain necessary personnel.**

 

Our continued growth and success depend to asignificant degree on the continued services of our senior management and otherkey employees and our ability to attract and retain highly skilled andexperienced technical, managerial, sales and marketing personnel. We havehistorically been a developer of products related to ITV. Our video phonebusiness represents an expansion into the development of HSD communicationshardware and software products in which we have limited experience. As we enterthis new line of business, we also expect to encounter new product developmentchallenges, new customer requirements, new competitors and other new businesschallenges, with which our existing management may be unfamiliar. There can beno assurance that we will be successful in recruiting new personnel or inretaining existing personnel. None of our employees is subject to a long-termemployment agreement. The loss of one or more key employees or our inability toattract additional qualified employees could have a material adverse effect onour business, results of operations and financial condition. In addition, wemay experience increased compensation costs in order to attract and retainskilled employees.

 

**We may not be successful in developing ormaintaining strong distribution channels for our video phone products.**

 

The success of the video phone businessdepends on developing strong relationships with service providers such as cableand DSL operators and other HSD communications providers and distributionchannel partners who are selling services to end-users. We plan to relyprimarily on Motorola and our HSD operator and electronics distribution channelrelationships to market our video phone products. If we are not successful increating a strong distribution channel in a timely manner, we may not gainsignificant sales.

 

**We may not be able to compete successfully inthe highly competitive and rapidly evolving HSD communications market.**

 

The market for products that utilize HSDcommunications is still developing and there can be no assurance that ourproduct will ever achieve market acceptance. Since we have no existing customersfor our video phone business, cable operators and other HSD network providersmust be convinced to buy our video phone product. To the extent we do notachieve growth, it will be difficult for us togenerate meaningful revenue or to achieve profitability.

 

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**We may not be able to protect intellectualproperty of our video phone business against third-party infringements orclaims of infringement.**

 

Failure to protect our intellectual propertyrights may result in a loss of our exclusivity or the right to use our videophone technology. We plan to rely on patent, trade secret, trademark andcopyright law to protect our video phone intellectual property. Although wehave filed multiple patent applications for our technology, our patent positionis subject to complex factual and legal issues that may give rise touncertainty as to the validity, scope and enforceability of a particularpatent. Accordingly, there can be no assurance that any patents will be issuedpursuant to our current or future patent applications or that patents issuedpursuant to such applications will not be invalidated, circumvented orchallenged. Moreover, there can be no assurance that the rights granted underany such patents will provide competitive advantages to us or be adequate tosafeguard and maintain our proprietary rights. In addition, effective patent,trademark, copyright and trade secret protection may be unavailable, limited ornot applied for in certain foreign countries.

 

We also seek to protect our proprietaryintellectual property, including intellectual property that may not be patentedor patentable, in part by confidentiality agreements and, if applicable,inventor’s rights agreements with our current and future strategic partners andemployees. We cannot assure you that these agreements will not be breached,that we will have adequate remedies for any breach or that such persons orinstitutions will not assert rights to intellectual property arising out ofthese relationships.

 

Some of our video phone intellectual propertyincludes technologies and processes that may be similar to the patentedtechnologies and processes of third parties. If we do not adequately secure ourfreedom to use our video phone technology, we may have to pay others for rightsto use their intellectual property, pay damages for infringement ormisappropriation or be enjoined from using such intellectual property. If weare found to be infringing third-party patents, we do not know whether we willbe able to obtain licenses to use such patents on acceptable terms, if at all.While we are not currently engaged in any material intellectual propertydisputes or litigation, we could become subject to lawsuits in which it isalleged that we have infringed the intellectual property rights of others orcommence lawsuits against others who we believe are infringing upon our rights.Our involvement in intellectual property litigation could result in significantexpense to us, adversely affecting the development of the challenged product orintellectual property and diverting the efforts of our technical and managementpersonnel, whether or not such litigation concludes favorably for our company.

 

**Legal and regulatory developments could haveadverse consequences for our business.**

 

The legal and regulatory environment thatpertains to our business is uncertain and changing rapidly. New legislation orregulations could be introduced that could substantially impact our ability tolaunch and promote the Ojo video phone. For example, in the United States, theFederal Communications Commission (FCC) could undertake an examination ofwhether to impose surcharges or additional regulations upon certain providersof Internet protocol, or IP, based communication services. The imposition ofregulations on IP communications services may negatively impact our business.

 

**The use of the high speed data infrastructureas a commercial marketplace is at an early stage of development.**

 

Demand and market acceptance for recentlyintroduced products and services over the high speed data, or HSD,infrastructure are still uncertain. We cannot predict whether customers will bewilling to shift their traditional telephone activities online. The HSDinfrastructure may not prove to be a viable commercial marketplace for a numberof reasons, including:

 

•      concerns about security and varying security techniques andprotocols;

•      changing and non-uniform standards

•      Internetcongestion;

•      quality of service issues;

•      inconsistent service; and

•      lack of cost-effective, high-speed access.

 

If the use of the HSD infrastructure as acommercial marketplace does not continue to grow, we may not be able to growour customer base, which may prevent us from achieving profitability.

 

**We may not have sufficient working capital tofund our continuing video phone business, and we may be unable to obtainadditional capital.**

 

The extent and timing of our future capitalrequirements will depend upon several factors, including the rate of market

 

20

----

 

acceptance of ourproducts, the degree of competition for our products, and our level ofexpenditures, including those for product development, sales andmarketing.  If our capital requirementsvary materially from those currently planned, we may require additionalfinancing sooner than anticipated. Despite the receipt of proceeds from several private placements of oursecurities, we may need to seek additional third party investment in order toprovide additional operating capital for our video phone business. We cannot becertain that financing from third parties will be available on acceptable termsto us or at all.  The levels of fundingof early-stage companies generally by both venture funds and strategicinvestors have fallen dramatically in the past few years. If we cannot raisefunds on acceptable terms, we may not be able to develop our products andservices, take advantage of future opportunities or respond to competitivepressures or unanticipated requirements, any of which could have a materialadverse effect on our ability to grow our business. If we are unable to securesuch additional financing, we will have to curtail or suspend our businessactivities, we may not be able to continue to operate our business as a goingconcern and we may have to seek protection of the bankruptcy courts. If thathappens, you could lose your entire investment.

 

**If we obtain additional financing, you maysuffer significant dilution.**

 

If we raise additional capital by issuingequity securities, our stockholders may experience severe dilution of theirownership percentage, which may adversely affect the value of our commonstock.  In addition, the new equitysecurities may have rights, preferences or privileges senior to those of our commonstock.

 

**NASDAQ Listing Requirements may limit ourability to raise additional capital.**

 

Our common stock is listed on the NASDAQSmallCap Market.  If our common stock islisted on The NASDAQ National Market or The NASDAQ SmallCap Market at the timeof a proposed equity financing resulting in the sale and issuance of twentypercent or more of the outstanding shares of our capital stock, we may berequired to obtain stockholder approval of such issuance. There can be noassurance that we will be able to obtain any necessary stockholder approval,and the failure to obtain such approval could limit our ability to obtainneeded capital.

 

**In the event that our common stock isdelisted from NASDAQ SmallCap Market, it may be subject to the requirements ofthe rules relating to “penny stocks.”**

 

Our common stock is currently listed on theNASDAQ SmallCap Market, which has requirements for the continued listing ofstock. If we fail to continue to meet these listing requirements we will becomesubject to delisting. For example, if our common stock trades below $1.00 for30 consecutive trading days, or if we fail to meet any of the other listingrequirements including the market capitalization and minimum stockholdersequity requirements, our common stock may be delisted from the NASDAQ SmallCapMarket. If our shares are delisted from the NASDAQ SmallCap Market, they arelikely to become subject to the SEC penny stock rules, which could adverselyaffect the market liquidity of our common stock. These rules impose additionalsales practice requirements on broker-dealers that sell low-priced securitiesto persons other than established customers and institutional accreditedinvestors; and require the delivery of a disclosure schedule explainingthe nature and risks of the penny stock market. As a result, the ability orwillingness of broker-dealers to sell or make a market in our common stockmight decline, and you could find it more difficult to sell your stock.

 

**Our stock price is volatile.**

 

The trading price for our common stock hasbeen volatile, ranging from a sales price of $0.22 in April 2003, to asales price of over $6.00 per share in December 2004. The price haschanged dramatically over short periods with changes of over 60% percent in asingle day. An investment in our stock is subject to such volatility and,consequently, is subject to significant risk.

 

**Prior offerings of our common stock may havean adverse impact on the market value of our stock.**

 

During 2003 and 2004 we issued shares of ourcommon stock as part of various private placements to certain institutionalinvestors and as part of that transaction filed three registration statements,which provided for the sale or distribution of these shares by theseinstitutional investors. When these investors sell their shares we will notreceive any proceeds from the sales. The sale of these blocks of stock, or eventhe possibility of its sale, may adversely affect the trading market for ourcommon stock and reduce the price available in that market.

 

In connection with these private placements,we also issued warrants and additional investment rights to purchase shares ofcommon stock. The existence of such rights to acquire common stock at fixedprices may prove a hindrance to our efforts to raise future equity and debtfunding, and the exercise of such rights will dilute the percentage ownershipinterest of our stockholders

 

21

----

 

and may dilutethe value of their ownership. The possible future sale of shares issuable onthe exercise of outstanding warrants and additional investment rights couldadversely affect the prevailing market price of our common stock. Further, theholders of the outstanding warrants and additional investment rights mayexercise them at a time when we would otherwise be able to obtain additionalequity capital on terms more favorable to us.

 

**Our board of directors’ right to authorizeadditional shares of preferred stock could adversely impact the rights ofholders of our common stock.**

 

Our board of directors currently has theright to designate and authorize the issuance of one or more series of ourpreferred stock with such voting, dividend and other rights as our directorsmay determine. The board of directors can designate new series of preferredstock without the approval of the holders of our common stock. The rights ofholders of our common stock may be adversely affected by the rights of anyholders of shares of preferred stock that may be issued in the future,including without limitation dilution of the equity ownership percentage of ourholders of common stock and their voting power if we issue preferred stock withvoting rights. Additionally, the issuance of preferred stock could make it moredifficult for a third party to acquire a majority of our outstanding votingstock.

 

22

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**Item 7A.****  Quantitativeand Qualitative Disclosures about Market Risk.**

 

Refer to Interest Rate Risk and ForeignCurrency Exchange Risk on page 16 for a discussion of this item.

 

23

----

 

**Item 8.****  FinancialStatements and Supplementary Data.**

 

**WORLDGATECOMMUNICATIONS, INC.**

 

**INDEX TOFINANCIAL STATEMENTS**

 
| Report of Grant Thornton LLP, Independent Registered Public  Accounting Firm                                                 |   |
|------------------------------------------------------------------------------------------------------------------------------|--------|
| Report of PricewaterhouseCoopers LLP, Independent Registered Public  Accounting Firm                                         |   |
| Consolidated Balance Sheets as of December 31, 2003 and 2004                                                            |   |
| Consolidated Statements of Operations for the years ended December 31,  2002, 2003 and 2004                             |   |
| Consolidated Statements of Stockholders’ (Deficiency) Equity for the  years ended December 31, 2002, 2003 and 2004 |   |
| Consolidated Statements of Cash Flows for the years ended December 31,  2002, 2003 and 2004                             |   |
| Notes to Consolidated Financial Statements                                                                                   |   |
| Schedule II  — Valuation and Qualifying Accounts*                                                                  |   |

 

----

* All other schedules for which provision is made inthe applicable accounting regulations of the Securities and Exchange Commissionare not required under the related instructions or are inapplicable, andtherefore have been omitted.

 

F-1

----

 

**Report of Independent Registered Public Accounting Firm**

 

To the Shareholders and Board of Directors

WorldGate Communications, Inc. and Subsidiaries

 

We have audited theaccompanying consolidated balance sheets of WorldGate Communications, Inc.and subsidiaries as of December 31, 2004 and 2003, and the relatedconsolidated statements of operations, stockholders’ deficiency, and cash flowsfor the years then ended. These financial statements are the responsibility ofthe Company’s management. Our responsibility is to express an opinion on thesefinancial statements based on our audits.

 

Weconducted our audits in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that weplan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement. The Company is notrequired to have, nor were we engaged to perform, an audit of its internalcontrol over financial reporting. Our audits included consideration of internalcontrol over financial reporting as a basis for designing audit procedures thatare appropriate in the circumstances, but not for the purpose of expressing anopinion on the effectiveness of the Company’s internal control over financialreporting. Accordingly, we express no such opinion. An audit also includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements, assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation. We believe that our audits provide areasonable basis for our opinion.

 

Inour opinion, the financial statements referred to above present fairly, in allmaterial respects, the consolidated financial position of WorldGateCommunications, Inc. and subsidiaries as of December 31, 2004 and2003, and the consolidated results of their operations and their cash flows forthe years then ended, in conformity with accounting principles generallyaccepted in the United States.

 

Ouraudits were conducted for the purpose of forming an opinion on the basicfinancial statements taken as a whole. Schedule II is presented forpurposes of additional analysis and is not a required part of the basicfinancial statements. This schedule has been subjected to the auditingprocedures applied in the audit of the basic financial statements and, in ouropinion, is fairly stated in all material respects in relation to the basicfinancial statements taken as a whole.

 

Theaccompanying financial statements have been prepared assuming that the Companywill continue as a going concern. As discussed in Note 2 to the financialstatements, the Company has suffered recurring losses from operations and has anet accumulated deficiency of $220 million that raises substantial doubtabout its ability to continue as a going concern. Management’s plans in regardto these matters are also described in Note 2. The financial statements donot include any adjustments that might result from the outcome of thisuncertainty.

 

Asdiscussed in Note 2 *Summary of SignificantAccounting Policies* (subsection, *Accounting for PreferredShares and Derivative Shares*) and Note 8 *Stockholders’Deficiency* (subsection, *Redeemable Preferred Stock*),the notes to the consolidated financial statements have been restated toprovide a more complete description of the accounting method and policy relatedto redeemable preferred stock.

 
| /s/ Grant Thornton LLP                                                                 |   |
|----------------------------------------------------------------------------------------|--------|
|                                                                                   |
| Philadelphia, Pennsylvania                                                             |
| February 24, 2005 (except for Note 2 *Summary of Significant Accounting Policies* |
| (subsection, *Accounting for Preferred  Shares and Derivative Shares*)                 |
| and Note 8 *Stockholders’ Deficiency*  (subsection, *Redeemable Preferred Stock*) |
| as to which the date is August 24, 2005)                                          |

 

F-2

----

 

**Report of Independent Registered Public Accounting Firm**

 

To the Shareholders and Boardof Directors of

WorldGate Communications, Inc.:

 

In our opinion, the consolidatedstatements of operations, stockholders’ (deficiency) equity and of cash flowsfor the year ended December 31, 2002 listed in the accompanying indexpresent fairly, in all material respects, the results of operations and cashflows of WorldGate Communications, Inc. and its Subsidiaries for the yearended December 31, 2002, in conformity with accounting principlesgenerally accepted in the United States of America. In addition, in ouropinion, the financial statement schedule listed in the accompanying indexfor the year ending December 31, 2002 presents fairly, in all materialrespects, the information set forth therein when read in conjunction with therelated consolidated financial statements. These financial statements andfinancial statement schedule are the responsibility of the Company’smanagement; our responsibility is to express an opinion on these financialstatements and financial statement schedule based on our audits. Weconducted our audits of these statements in accordance with the standards ofthe Public Company Accounting Oversight Board (United States), which requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements, assessing the accounting principles used andsignificant estimates made by management, and evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor our opinion.

 

The consolidated financialstatements have been prepared assuming that the Company will continue as agoing concern. As discussed in Note 2 to the financial statements, whichappears in the financial statements included in the Company’s Form 10-Kfor the year ended December 31, 2002 and not presented herein, the Companyhas incurred recurring losses from operations that raise substantial doubtabout its ability to continue as a going concern. Management’s plans in regardto these matters are also described in Note 2, which appears in the financialstatements included in the Company’s Form 10-K for the year ended December 31,2002 and not presented herein. The financial statements do not include anyadjustments that might result from the outcome of this uncertainty.

 
| /s/  PricewaterhouseCoopers LLP                                                                                                      |   |
|--------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                                 |
| Philadelphia,  PA                                                                                                                    |
| February 14, 2003,  except as to the discontinued operations described in Note 18 as to which the  date is March 21, 2005. |

 

F-3

----

 

**WORLDGATECOMMUNICATIONS, INC.CONSOLIDATED BALANCE SHEETS(DOLLARS IN THOUSANDS, EXCEPT SHARE AMOUNTS)**

 
| ** **                                                                                                                                                                                               | ** ** | **As of  December 31** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                               | ** ** | **2003**                    | ** ** | **2004** | ** ** |
| ASSETS                                                                                                                                                                                                   |       |                        |       |   |   |
| Current  assets:                                                                                                                                                                                         |       |                        |       |   |   |
| Cash and  cash equivalents                                                                                                                                                                               |       | $                           | 3,365      |   | $ | 11,840 |   |
| Trade  accounts receivable less allowance for doubtful accounts of $0 at December 31,  2004 and $381 at December 31, 2003                                                                 |       | 135                         |       | 0 |   |
| Other  receivables                                                                                                                                                                                       |       | 11                          |       | 28 |   |
| Inventory                                                                                                                                                                                                |       | 0                           |       | 46 |   |
| Prepaid and  other assets                                                                                                                                                                                |       | 199                         |       | 184 |   |
| Total current assets                                                                                                                                                                                     |       | 3,710                       |       | 12,098 |   |
| Property and  equipment                                                                                                                                                                                  |       | 2,605                       |       | 3,530 |   |
| Less:  accumulated depreciation and amortization                                                                                                                                                         |       | (1,338                      | )          | (1,815 | ) |
| Property and  equipment, net                                                                                                                                                                             |       | 1,267                       |       | 1,715 |   |
| Deposits and  other assets                                                                                                                                                                               |       | 140                         |       | 9 |   |
| Total assets                                                                                                                                                                                             |       | $                           | 5,117      |   | $ | 13,822 |   |
|                                                                                                                                                                                                     |       |                        |       |   |   |
| LIABILITIES  AND STOCKHOLDERS’ EQUITY (DEFICIENCY)                                                                                                                                                  |       |                        |       |   |   |
| Current liabilities:                                                                                                                                                                                     |       |                        |       |   |   |
| Accounts  payable                                                                                                                                                                                        |       | $                           | 440        |   | $ | 222 |   |
| Accrued  expenses                                                                                                                                                                                        |       | 594                         |       | 951 |   |
| Accrued  compensation and benefits                                                                                                                                                                       |       | 238                         |       | 540 |   |
| Dividend  payable on Preferred Stock                                                                                                                                                                     |       | 0                           |       | 85 |   |
| Detachable  Warrants                                                                                                                                                                                     |       | 0                           |       | 5,583 |   |
| Notes  payable                                                                                                                                                                                           |       | 0                           |       | 37 |   |
| Conversion  option on Preferred Stock                                                                                                                                                                    |       | 0                           |       | 8,612 |   |
| Deferred  revenues                                                                                                                                                                                       |       | 0                           |       | 369 |   |
| Deferred  rent credit                                                                                                                                                                                    |       | 30                          |       | 0 |   |
| Total  current liabilities                                                                                                                                                                               |       | 1,302                       |       | 16,399 |   |
| Deferred  rent credit                                                                                                                                                                                    |       | 135                         |       | 0 |   |
| Total  liabilities                                                                                                                                                                                       |       | 1,437                       |       | 16,399 |   |
|                                                                                                                                                                                                     |       |                        |       |   |   |
| Commitments                                                                                                                                                                                              |       | —                      |       | — |   |
| Redeemable  Preferred Stock; 7,550,000 shares authorized, 0 shares issued and outstanding  at December 31, 2003, and 6,775,000 outstanding at December 31,  2004                               |       | 0                           |       | 2,995 |   |
|                                                                                                                                                                                                     |       |                        |       |   |   |
| Total  Stockholders’ (deficiency) equity:                                                                                                                                                           |       |                        |       |   |   |
| Preferred  Stock, $.01 par value, 5,950,000 shares authorized                                                                                                                                            |       | 0                           |       | 0 |   |
| Common  Stock, $.01 par value; 80,000,000 shares authorized, 25,706,843 shares issued  and outstanding at December 31, 2003 and 30,865,777 shares issued and  outstanding at December 31, 2004 |       | 262                         |       | 308 |   |
| Additional  paid-in capital                                                                                                                                                                              |       | 202,466                     |       | 213,863 |   |
| Unearned  compensation                                                                                                                                                                                   |       | (400                        | )          | 0 |   |
| Accumulated  deficit                                                                                                                                                                                     |       | (198,643                    | )          | (219,743 | ) |
| Less  Treasury Stock, at cost 500,000 and 0 shares as of December 31, 2003 and  2004, respectively                                                                                                  |       | (5                          | )          | 0 |   |
| Total  stockholders’ equity (deficiency)                                                                                                                                                            |       | 3,680                       |       | (5,572 | ) |
| Total  liabilities and stockholders’ equity (deficiency)                                                                                                                                            |       | $                           | 5,117      |   | $ | 13,822 |   |

 

The accompanying notes are anintegral part of these consolidated financial statements.

 

F-4

----

 

**WORLDGATECOMMUNICATIONS, INC.CONSOLIDATED STATEMENTSOF OPERATIONS(DOLLARS IN THOUSANDS, EXCEPT SHARE AMOUNTS)**

 
| ** **                                                                                                       | ** ** | **Twelve  Months Ended  2002** | ** ** | **Twelve  Months Ended  2003** | ** ** | **Twelve  Months Ended  2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|--------------------------------|------------|
| Revenues                                                                                                         |       | $                              | 0          |                           | $          | 0                              |       | $ | 231 |   |
| Cost of  revenues                                                                                                |       | 0                              |       | 0                              |       | 103                            |       |
| Gross  margins                                                                                                   |       | 0                              |       | 0                              |       | 128                            |       |
| Engineering  and development (excluding depreciation and amortization amounts of $0, $0,  and $64, respectively) |       | 0                              |       | 3,000                          |       | 4,001                          |       |
| Sales and  marketing (excluding depreciation and amortization amounts of $0, $0 and $13,  respectively)          |       | 0                              |       | 466                            |       | 1,362                          |       |
| General and  administrative (excluding depreciation and amortization amounts of $0, $0 and  $400, respectively)  |       | 0                              |       | 3,031                          |       | 5,399                          |       |
| Depreciation  and amortization                                                                                   |       | 0                              |       | 0                              |       | 477                            |       |
| Total  expenses from continuing operations                                                                       |       | 0                              |       | 6,497                          |       | 11,239                         |       |
| Loss from  operating activities of continuing operations                                                         |       | 0                              |       | (6,497                         | )          | (11,111                        | )          |
| Interest and  other income                                                                                       |       | 0                              |       | 0                              |       | 1,023                          |       |
| Change in  fair value of warrants and conversion options                                                         |       | 0                              |       | 0                              |       | (10,091                        | )          |
| Interest and  other expense                                                                                      |       | 0                              |       | 0                              |       | (6                             | )          |
| Loss from  continuing operations                                                                                 |       | 0                              |       | (6,497                         | )          | (20,185                        | )          |
| Income  (loss) from discontinued operations                                                                      |       | (19,210                        | )          | (2,908                         | )          | 36                             |       |
| Net loss                                                                                                         |       | (19,210                        | )          | (9,405                         | )          | (20,149                        | )          |
| Accretion on  preferred stock and dividends                                                                      |       | 0                              |       | 0                              |       | (951                           | )          |
| Net loss  available to common stockholders                                                                       |       | $                              | (19,210    | )                              | $          | (9,405                         | )          | $ | (21,100 | ) |
| Loss from  continuing operations per common share (Basic and Diluted)                                            |       | $                              | 0.00       |                           | $          | (0.28                          | )          | $ | (0.72 | ) |
| Income  (loss) from discontinued operations per common share (Basic and Diluted)                                 |       | (0.81                          | )          | (0.12                          | )          | 0.00                           |       |
| Net loss per  common share (Basic and Diluted)                                                                   |       | $                              | (0.81      | )                              | $          | (0.40                          | )          | $ | (0.72 | ) |
| Net loss  available to common shareholders per common share (Basic and Diluted)                                  |       | $                              | (0.81      | )                              | $          | (0.40                          | )          | $ | (0.76 | ) |
| Weighted  average common shares outstanding (Basic and Diluted)                                                  |       | 23,573,935                     |       | 23,259,611                     |       | 27,881,347                     |       |

 

The accompanying notes are anintegral part of these consolidated financial statements.

 

F-5

----

 

**WORLDGATECOMMUNICATIONS, INC.CONSOLIDATED STATEMENTSOF STOCKHOLDERS’ (DEFICIENCY) EQUITY(DOLLARS AND SHARES IN THOUSANDS)**

 
| ** **                                                                | ** ** | **Common Stock** | ** ** | ** ** | ** ** | ** **     | ** ** | ** **       | ** ** | ** **      | ** ** | ** **       | ** ** | ** **         | ** ** |
|---------------------------------------------------------------------------|------------|------------------|------------|------------|------------|----------------|------------|------------------|------------|-----------------|------------|------------------|------------|--------------------|------------|
| ** **                                                                | ** ** | ** **       | ** ** | ** ** | ** ** | **Additional** | ** ** | **Warrants for** | ** ** | ** **      | ** ** | **Unearned**     | ** ** | ** **         | ** ** | ** ** | ** ** | **Totals Stock** | ** ** |
| ** **                                                                | ** ** | ** **       | ** ** | ** ** | ** ** | **Paid-In**    | ** ** | **Class A** | ** ** | **Accumulated** | ** ** | **Stock-based**  | ** ** | **Treasury Stock** | ** ** | **holders’** | ** ** |
| ** **                                                                | ** ** | **Shares**       | ** ** | **Amount** | ** ** | **Capital**    | ** ** | **Common Stock** | ** ** | **Deficit**     | ** ** | **Compensation** | ** ** | **Shares**         | ** ** | **Amount** | ** ** | **Equity** | ** ** |
| **Balance at December 31, 2001**                                     |       | 25,565           |       | $          | 236        |           | $          | 193,488          |       | $               | 1,911      |             | $          | (170,028           | )          | $ | (192 | ) |   |   |   |   | $ | 25,415 |   |
| Authorization of deferred Compensation                                    |       |             |       |       |       |           |       |             |       |            |       | 192              |       |               |       |   |   | 192 |   |
| Sale of Common Stock                                                      |       | 13               |       |       |       | 15             |       |             |       |            |       |             |       |               |       |   |   | 15 |   |
| Acquisition of Treasury Stock                                             |       |             |       |       |       |           |       |             |       |            |       |             |       | (500               | )          | $ | (5 | ) | (5 | ) |
| Other – includes partial Contractual Obligation  termination of $801 |       |             |       |       |       | 888            |       |             |       |            |       |             |       |               |       |   |   | 888 |   |
| Net Loss for the year                                                     |       |             |       |       |       |           |       |             |       | (19,210         | )          |             |       |               |       |   |   | (19,210 | ) |
| **Balance at December 31, 2002**                                     |       | 23,578           |       | 236        |       | 194,391        |       | 1,911            |       | (189,238        | )          | 0                |       | (500               | )          | (5 | ) | 7,295 |   |
| Remaining portion of unearned compensation to vendor                      |       |             |       |       |       |           |       |             |       |            |       | (400             | )          |               |       |   |   | (400 | ) |
| Non-cash stock based Compensation                                         |       |             |       |       |       | 817            |       |             |       |            |       |             |       |               |       |   |   | 817 |   |
| Issuance of Common Stock                                                  |       | 2,629            |       | 26         |       | 2,175          |       |             |       |            |       |             |       |               |       |   |   | 2,201 |   |
| Termination of Warrants                                                   |       |             |       |       |       | 1,911          |       | (1,911           | )          |            |       |             |       |               |       |   |   |   |   |
| Other – includes final Contractual Obligation termination  of $3,283 |       |             |       |       |       | 3,172          |       |             |       |            |       |             |       |               |       |   |   | 3,172 |   |
| Net Loss for the year                                                     |       |             |       |       |       |           |       |             |       | (9,405          | )          |             |       |               |       |   |   | (9,405 | ) |
| **Balance at December 31, 2003**                                     |       | 26,207           |       | 262        |       | 202,466        |       | 0                |       | (198,643        | )          | (400             | )          | (500               | )          | (5 | ) | 3,680 |   |
| Authorization of earned compensation to vendor                            |       |             |       |       |       |           |       |             |       | 400             |       |             |       |               |       |   |   | 400 |   |
| Non-cash stock based Compensation                                         |       |             |       |       |       | 1,332          |       |             |       |            |       |             |       |               |       |   |   | 1,332 |   |
| Cancellation of Treasury Stock                                            |       | (500             | )          | (5         | )          |           |       |             |       |            |       |             |       | 500                |       | 5 |   |   |   |
| Issuance of Common Stock                                                  |       | 2,361            |       | 23         |       | 3,668          |       |             |       |            |       |             |       |               |       |   |   | 3,691 |   |
| Exercise of Stock Options                                                 |       | 446              |       | 4          |       | 809            |       |             |       |            |       |             |       |               |       |   |   | 813 |   |
| Exercise of Warrants                                                      |       | 2,352            |       | 24         |       | 5,588          |       |             |       |            |       |             |       |               |       |   |   | 5,612 |   |
| Accretion on preferred stock and dividends                                |       |             |       |       |       |           |       |             |       | (951            | )          |             |       |               |       |   |   | (951 | ) |
| Net Loss for the year                                                     |       |             |       |       |       |           |       |             |       | (20,149         | )          |             |       |               |       |   |   | (20,149 | ) |
| **Balance at December 31, 2004**                                     |       | 30,866           |       | $          | 308        |           | $          | 213,863          |       | $               | 0          |             | $          | (219,743           | )          | $ | 0 |   | $ | 0 |   | $ | 0 |   | $ | (5,572 | ) |
|                                                                           |            |                  |            |            |            |                |            |                  |            |                 |            |                  |            |                    |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

The accompanying notes are anintegral part of these consolidated financial statements.

 

F-6

----

 

**WORLDGATECOMMUNICATIONS, INC.CONSOLIDATED STATEMENTSOF CASH FLOWS(DOLLARS IN THOUSANDS)**

 
| ** **                                                                                         | ** ** | **Twelve  Months  Ended  2002** | ** ** | **Twelve  Months  Ended  2003** | ** ** | **Twelve  Months  Ended  2004** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| Cash flows  from operating activities:                                                             |       |                            |       |                            |       |                            |       |
| Net loss                                                                                           |       | $                               | (19,210    | )                               | $          | (9,405                          | )          | $ | (20,149 | ) |
| Loss  (income) from discontinued operations                                                        |       | 19,210                          |       | 2,908                           |       | (36                             | )          |
| Adjustments  to reconcile net loss to cash used in operating activities of continuing  operations: |       |                            |       |                            |       |                            |       |
| Depreciation  and amortization                                                                     |       | 0                               |       | 0                               |       | 477                             |       |
| Non-cash  stock based compensation to product development vendor                                   |       | 0                               |       | 200                             |       | 400                             |       |
| Change in  fair value of warrants and conversion options                                           |       | 0                               |       | 0                               |       | 10,091                          |       |
| Non-cash  stock based compensation                                                                 |       | 0                               |       | 778                             |       | 1,332                           |       |
| Changes in  operating assets and liabilities:                                                      |       |                            |       |                            |       |                            |       |
| Accounts  receivable                                                                               |       | 0                               |       | 0                               |       | (17                             | )          |
| Inventory                                                                                          |       | 0                               |       | 0                               |       | (46                             | )          |
| Prepaid and  other assets                                                                          |       | 0                               |       | 816                             |       | 219                             |       |
| Accounts  payable                                                                                  |       | 0                               |       | 184                             |       | (218                            | )          |
| Accrued  expenses                                                                                  |       | 0                               |       | 374                             |       | 357                             |       |
| Accrued  compensation and benefits                                                                 |       | 0                               |       | 501                             |       | 302                             |       |
| Other                                                                                              |       | 0                               |       | 0                               |       | 204                             |       |
| Net  operating cash flow from continuing operations                                                |       | 0                               |       | (3,644                          | )          | (7,084                          | )          |
| Net  operating cash flow from discontinued operations                                              |       | (10,767                         | )          | (1,248                          | )          | 135                             |       |
| Net cash  used in operating activities                                                             |       | (10,767                         | )          | (4,892                          | )          | (6,949                          | )          |
|                                                                                               |       |                            |       |                            |       |                            |       |
| Cash flows  from investing activities of continuing operations:                                    |       |                            |       |                            |       |                            |       |
| Capital  expenditures from continuing operations                                                   |       | 0                               |       | 0                               |       | (925                            | )          |
| Net  investing cash flow from discontinued operations                                              |       | 7,937                           |       | 6,788                           |       | 0                               |       |
| Net cash provided  by (used in) investing activities                                               |       | 7,937                           |       | 6,788                           |       | (925                            | )          |
|                                                                                               |       |                            |       |                            |       |                            |       |
| Cash flows  from financing activities of continuing operations:                                    |       |                            |       |                            |       |                            |       |
| Proceeds  from issuance of common stock                                                            |       | 0                               |       | 1,490                           |       | 2,813                           |       |
| Proceeds  from the issuance of redeemable preferred stock                                          |       | 0                               |       | 0                               |       | 7,111                           |       |
| Proceeds  from the exercise of stock options                                                       |       | 0                               |       | 0                               |       | 813                             |       |
| Proceeds  from the exercise of stock rights and warrants                                           |       | 0                               |       | 0                               |       | 5,612                           |       |
| Net cash  provided by financing activities from continuing operations                              |       | 0                               |       | 1,490                           |       | 16,349                          |       |
| Net  financing cash flow from discontinued operations                                              |       | 63                              |       | (610                            | )          | 0                               |       |
| Net cash  provided by financing activities                                                         |       | 63                              |       | 880                             |       | 16,349                          |       |
| **Net  increase (decrease) in cash and equivalents**                                               |       | (2,767                          | )          | 2,776                           |       | 8,475                           |       |
| **Cash and  cash equivalents, beginning of year**                                                  |       | 3,356                           |       | 589                             |       | 3,365                           |       |
| **Cash and  cash equivalents, end of year**                                                        |       | $                               | 589        |                            | $          | 3,365                           |       | $ | 11,840 |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

F-7

----

 

**WORLDGATECOMMUNICATIONS, INC.NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS(Dollars in thousands except for share and per share amounts)**

 

**1. Basis of Presentation**

 

The consolidated financialstatements of WorldGate Communications, Inc. (“WorldGate” or the “Company”)presented herein have been prepared by the Company pursuant to the rules andregulations of the Securities and Exchange Commission for annual reports on Form 10-K.WorldGate was incorporated in Delaware in 1996 to succeed to the business ofthe predecessor company, WorldGate Communications, L.L.C., which commencedoperations in March 1995.  WorldGatehas developed a video phone designed specifically for personal videocommunication, and is differentiated, both from competitors and from previousefforts at personal video telephony, by providing: true-to-life communication;ease of deployment by high-speed data, or HSD, operators as well as businesses;a highly styled ergonomic design; and interoperation with the public switchedtelephone network, or PSTN.

 

The consolidated financialstatements of the company include the accounts of WorldGate Communications, Inc.and its wholly owned subsidiaries WorldGate Service, Inc., WorldGateFinance, Inc., and WorldGate Acquisition Corp. All significantintercompany accounts and transactions have been eliminated in consolidation.

 

**2. Summary of Significant Accounting Policies**

 

*Liquidityand Going Concern Considerations.*

 

As of December 31, 2004 the Company hadcash and cash equivalents of $11,840. The operating cash usage from continuing operations for the twelvemonths ended December 31, 2004 was $7,084. During the third quarter of2003, we completed a sale of certain assets, including our ITV intellectualproperty rights and our membership interest in TVGateway, LLC, for $3,000 incash to TVGateway, LLC, a company we were instrumental in forming. Ourtransaction with TVGateway, LLC marked a shift in our business away from theITV business and toward a new video phone product and associated business. Thefunds we received from the sale of assets to TVGateway, LLC, as well as thefunds we received as a result of private placements of our securities on December 1,2003 and December 4, 2003, January 21, 2004, April 22, 2004, June 24,2004 and December 15, 2004, have permitted us to fund the development ofour new business.

 

In December 2003 and January 2004,WorldGate received investments aggregating $3,100 by certain institutionalinvestors. These investors purchased an aggregate of 3,000,000 shares of newlyissued common stock. The investors also received a right, for a limited periodof time, to purchase additional shares of up to 20% of the common stockpurchased by the investors in their investment, at the same price as theirinvestment, and five-year warrants to purchase up to 30% of the common stockpurchased by the investors in their investment, at an exercise price equal to atwenty-five percent premium to their purchase price for the investment. Thepurchase price for the 2 million shares purchased in the December 2003transactions were $0.80 per share, with the warrants having a $1.00 per shareexercise price. The purchase price for the 1 million shares purchased in the January 2004transaction was $1.50 per share, with the warrants having a $1.875 per shareexercise price. All additional investment rights associated with the December 2003transaction were exercised during January and February of 2004,resulting in an incremental investment of $320. All additional investmentrights associated with the January 2004 transaction were exercised in May 2004,resulting in an incremental investment of $300. A portion of the warrants andadditional investment right warrants associated with the December 2003 andJanuary 2004 transactions were exercised in December 2004, resultingin an incremental investment of $281.

 

In December 2003, WorldGate reachedagreement with Mototech, Inc. for the purchase of 625,000 shares of newlyissued common stock at $0.80 per share, in return for future design andengineering services by Mototech. WorldGate had previously contracted withMototech to assist the Company with the design and volume manufacture ofWorldGate’s Ojo personal video phone. The purchase price for these shares hasbeen fully paid as of December 31, 2004 by an equivalent reduction in thedevelopment and initial procurement payments that would otherwise be due toMototech. As of December 31, 2004, that payment was $500. Mototech is anaffiliate of Accton Technology Group. Mototech currently manufactures anddistributes a full range of high performance high speed data and computernetworking products, including cable set top boxes, home gateways, wirelessLANs, hubs, switches, routers, and other related products. In addition, in April 2004,Mototech invested $1 million to purchase 666,666 shares of newly issued commonstock at $1.50 per share.

 

In June 2004, WorldGate completed aprivate placement of 7,550 shares of its Series APreferred Stock at a stated value

 

F-8

----

 

of $1000 per share, which preferred stock is convertible into theCompany’s common stock at a conversion price of $2.35 per share; five-yearwarrants to purchase up to 803,190 shares of our common stock at an exerciseprice of $2.69 per share; and five-year warrants to purchase up to 803,190shares of our common stock at an exercise price of $3.14 per share. Theinvestors also received an additional investment right, for a limited period oftime, to purchase 1,606,383 additional shares of common stock shares at $3.14 ashare. In November and December 2004, 775 preferred shares wereconverted to common stock, and in December 2004, 1,500,000 additionalinvestment rights were exercised, resulting in an incremental investment of$4,710.

 

In December 2004, WorldGate completed aprivate placement of 208,333 shares of our common stock to K. Y. Chou,president of Mototech, at a sales price of $2.40 per shares, which resulted inadditional gross proceeds to the Company of $500,000.  In connection with this placement the Companygranted warrants to Mr. Chou to purchase up to 62,500 shares of our commonstock at an exercise price of $2.88 per share.

 

The Company has $16,399 of liabilities andits assets are not pledged as collateral as of December 31, 2004. Theseliabilities include $14,280 related to the Company’s private placement of Series A Preferred Stock (refer to Footnote 8), and $369 ofadvanced funds from Motorola for future shipments of video phones in conformitywith the Agreement signed in April 2004.

 

The Company continues to evaluatepossibilities to obtain additional financing through public or private equityor debt offerings, bank debt financing, asset securitizations, or from othersources, should it need to obtain such financing. Such additional financingwould be subject to the risk of availability, may be dilutive to our shareholders,or could impose restrictions on operating activities. There can be no assurancethat this additional financing will be available on terms acceptable to theCompany, if at all. The Company has limited capacity to further reduce itsworkforce and scale back on capital and operational expenditures to decreaseits cash usage given the measures it has already taken to reduce staff andexpenses.

 

The consolidated financial statements havebeen prepared on a going concern basis, which contemplates the realization ofassets and the satisfaction of liabilities and commitments in the normal courseof business. Therefore, the financial statements do not include any adjustmentsrelating to the Company’s ability to operate as a going concern. Theappropriateness of using the going concern basis in the future, however, willbe dependent upon the Company’s ability to address its liquidity needs asdescribed above. There is no assurance that the Company will be able to addressits liquidity needs through the measures described above on acceptable termsand conditions, or at all, and accordingly, there is substantial doubt aboutthe Company’s ability to continue as a going concern. The independent auditors’report for the year ended December 31, 2004 included an explanatoryparagraph stating that because the Company had suffered recurring losses fromoperations and had a net accumulated deficiency of $220 million, those issuesraised substantial doubt about the Company’s ability to continue as a goingconcern.

 

Use of Estimates

 

The preparation of financial statements inconformity with accounting principles generally accepted in the United Statesrequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities, at the date the financial statements and the reported amount ofrevenues and expenses during the reporting period.  Actual results could differ from thoseestimates.

 

###### *Cashand Cash Equivalents*

###### * *

The Company considers all highly liquidinvestments with original maturities of three months or less to be cashequivalents. The Company maintains cash balances at financial institutions,which at times exceed the $100 FDIC limit.

 

*Inventories*

 

Inventories are stated at the lower of costor market on an average cost basis.

 

*Property and Equipment*

 

Property and equipment is carried at originalcost. Depreciation is recorded on the straight-line method over the estimateduseful lives of the related assets. The Company depreciates furniture andfixtures over seven years; office equipment over five years; and computerequipment and trade show exhibits over three years. Leasehold improvements arecapitalized and amortized on the straight-line basis over the shorter of theiruseful life or the term of the lease. Maintenance and repairs are expensed asincurred. When the property or equipment is retired or otherwise disposed of,related costs and accumulated depreciation are removed from the accounts andany resulting gain or loss is included in operations.

 

F-9

----

 

*Goodwill*

 

Goodwill in the amount of $3,608 was recordedin connection with the Company’s acquisition of Digital Video Art, Inc. (“DVA”)and represents the excess of cost over the fair value of net assets acquired.On January 1, 2002, the Company adopted Statement of Financial AccountingStandards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets.” Thispronouncement changes the accounting for goodwill and intangible assets withindefinite lives from an amortized method to an impairment approach. SFAS No. 142requires that goodwill and intangible assets be tested annually for impairmentusing a two-step process. The first step is to identify a potential impairmentand, in transition, this step must be measured as of the beginning of thefiscal year. The second step of the goodwill impairment test measures theamount of the impairment loss (measured as of the beginning of the year ofadoption), if any, and must be completed by the end of the Company’s fiscalyear. The Company’s transitional impairment test, measured as of January 1,2002, did not result in an impairment loss. However, as described inNote 5, an impairment of our goodwill was recorded in the second quarterof 2002.

 

*Long-lived Assets*

 

The Company periodically evaluates thecarrying value of long-lived assets when events and circumstances warrant suchreview. The carrying value of a long-lived asset is considered impaired whenthe anticipated undiscounted cash flows from such assets are separatelyidentifiable and are less than the carrying value. In that event, a loss isrecognized based on the amount by which the carrying value exceeds the fairmarket value of the long-lived asset. Fair market value is determined by usingthe anticipated cash flows discounted at a rate commensurate with the riskinvolved. Measurement of the impairment, if any, will be based upon thedifference between carrying value and the fair value of the asset.

 

On January 1, 2002, the Company adoptedSFAS No. 144, “Accounting for the Impairment or Disposal of Long-LivedAssets”. SFAS No. 144 provides new guidance on the recognition ofimpairment losses on long-lived assets to be held and used or to be disposedof, and also broadens the definition of what constitutes a discontinuedoperation and how the results of a discontinued operation are to be measuredand presented.

 

*Accounting for Preferred Shares andDerivative Shares [Restated]*

 

The following information has been restatedto provide a more complete description of the accounting method and policyrelated to redeemable preferred shares and derivative shares.

 

In June 2004, WorldGate completed a privateplacement of redeemable preferred stock. The Series AConvertible Preferred Stock has attached warrants and conversion options.  Specifically, the holders of the PreferredStock may convert their shares into our common stock at a conversion price of$2.35 per share.  In addition the Companymay force conversion of the Preferred Stock into common stock if the Companyachieves certain price targets for its common stock and satisfaction of certainother conditions.  In either event theconversion price is subject to adjustment in the event the Company enters intoanother transaction which is dilutive to the subject transaction.  As part of this transaction, the Company hasalso issued five-year warrants to purchase 1.6 million shares of the Company’scommon stock, one-half of the warrants at an exercise price of $2.69 per shareand the remaining half at an exercise price of $3.14 per share.  The preferred stock has a dividend rate of 5%per annum, payable quarterly, either by cash or through the issuance of commonstock at the Company’s option.  ThePreferred Stock has a staged maturity over three years with one-third of thepreferred stock to be redeemed after 18 months, one-third after 24 months andone-third after 36 months, and may be redeemed at maturity in cash or, subjectto certain conditions, through the issuance of an indeterminable number ofshares of common stock, at the Company’s option (with stock payments being madeat the then current market price).  Ofthe 7,550 preferred shares issued under this private placement, 775 shares havebeen redeemed as of December 31, 2004.

 

EITF Issue D-98, paragraph 4, states that Rule 5.02.28of Regulation S-X requires securities with redemption features that are notsolely within the control of the issuer to be recorded as a liability outsideof permanent equity.  The value ascribedto the redeemable preferred stock upon initial issuance, i.e. at June 24,2004, was the amount received in the transaction minus the value ascribed tothe conversion option and warrants.  Thisinitial value of the redeemable preferred stock is accreted up to theredemption value (the amount received in the transaction) over the futurerelevant periods using the interest method.

 

The conversion options and warrants areconsidered embedded derivative instruments under SFAS No. 133, paragraph11a, and are classified as liabilities. The company identifies and measures these derivatives under the fairvalue method at the end of each quarter, and their value is marked to market atthe end of each reporting period with the gain or loss recognition

 

F-10

----

 

recorded againstearnings.  We continue to revalue theseinstruments each quarter to reflect their current value in light of the currentmarket price of our common stock.  The warrants and conversion options arevalued using the Black-Scholes valuation model. Actual period close common stock prices, applicable volatility rates,and the period close risk-free interest rate for the instrument’s expectedremaining life (continuously compounded), are the key assumptions used in thevaluation calculation. On a quarterly basis, WorldGate will make a marked tomarket addition to or deduction from earnings, which will have no cash effectover the life of the instruments, with the cumulative non-cash mark-to-marketadjustments of gains and losses offsetting and netting to $0.

 

###### *RevenueRecognition*

###### * *

Revenue is recognized when persuasiveevidence of an arrangement exists, the price is fixed or determinable, thecollectability is reasonably assured, and either the delivery and acceptance ofthe equipment has occurred or services have been rendered.

 

*Cost of Revenues*

 

Cost of equipment product revenues reflectsthe purchase of video phones from the Company’s supplier Mototech.

 

*Engineering and Development Costs*

 

Engineering and development costs are expensedas incurred. Engineering and development costs from continuing operations were$0, $3,000 and $4,001 for the years ended December 31, 2002, 2003 and2004, respectively.

 

*Advertising Costs*

 

Advertising costs, included in sales andmarketing expense, are expensed in the period incurred. Advertising expensesfrom continuing operations were $0, $43 and $50 for the years ended December 31,2002, 2003 and 2004, respectively.

 

*Income Taxes*

 

Provision for income taxes is determinedbased on the asset and liability method. The asset and liability methodprovides that deferred tax balances are recorded based on the differencebetween the tax basis of assets and liabilities and their carrying amounts forfinancial reporting purposes. Deferred tax liabilities or assets at the end ofeach period are determined using the tax rate enacted under the current taxlaw. The measurement of net deferred tax assets is reduced by the amount of anytax benefits that, based on available evidence, are not expected to berealized, and a corresponding valuation allowance is established.

 

*Stock-Based Compensation*

 

The Company accounts for stock-basedcompensation in accordance with Accounting Principles Board Opinion No. 25,“Accounting for Stock Issued to Employees,” and related interpretations and haspresented the required SFAS No. 123, “Accounting for Stock-BasedCompensation,” as amended by SFAS No. 148, “Accounting for Stock-BasedCompensation—Transition and Disclosure,” pro forma disclosure in the tablebelow.

 

At December 31, 2004, the Company hadstock based compensation plans, which are described separately in Note 8.The Company applies Accounting Principles Board Opinion No. 25, “Accountingfor Stock Issued to Employees” and related interpretations inaccounting for its plans, and accordingly, no compensation cost has beenrecognized for the Company’s fixed stock based compensation.  Had compensation cost been determinedconsistent with SFAS No. 123, as amended by SFAS No. 148, the Company’snet loss would have been increased to the following pro forma amounts:

 

F-11

----

 
| ** **                                                                                                                          | ** ** | **Year Ended December 31** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                          | ** ** | **2002**                        | ** ** | **2003** | ** ** | **2004** | ** ** |
| Loss from  continuing operations                                                                                                    |       | $                               | 0          |   | $ | (6,497 | ) | $ | (20,185 | ) |
| (Loss)  income from discontinued operations                                                                                         |       | (19,210                         | )          | (2,908 | ) | 36 |   |
| Net loss                                                                                                                            |       | (19,210                         | )          | (9,405 | ) | (20,149 | ) |
| Accretion on preferred stock and dividends                                                                                          |       | 0                               |       | 0 |   | (951 | ) |
| Net loss  available to common shareholders, as reported                                                                             |       | $                               | (19,210    | ) | $ | (9,405 | ) | $ | (21,100 | ) |
| Add:  Stock-based employee compensation expense included in reported net income,  net of related tax effects                        |       | 192                             |       | 0 |   | 0 |   |
| Deduct:  Total stock-based employee compensation expense determined under fair value  based method for all awards, net of tax of $0 |       | (4,631                          | )          | (5,523 | ) | (2,072 | ) |
| Pro forma  net loss                                                                                                                 |       | $                               | (23,649    | ) | $ | (14,928 | ) | $ | (23,172 | ) |
|                                                                                                                                |       |                            |       |   |   |   |   |
| Net loss per  share:                                                                                                                |       |                            |       |   |   |   |   |
| Basic and  diluted loss from continuing operations                                                                                  |       | $                               | 0.00       |   | $ | (0.28 | ) | $ | (0.72 | ) |
| Basic and  diluted loss from discontinued operations                                                                                |       | (0.81                           | )          | (0.12 | ) | 0.00 |   |
| Basic and  diluted net loss—as reported                                                                                        |       | $                               | (0.81      | ) | $ | (0.40 | ) | $ | (0.72 | ) |
| Basic and  diluted net loss available to common shareholders—as reported                                                       |       | $                               | (0.81      | ) | $ | (0.40 | ) | $ | (0.76 | ) |
| Basic and  diluted net loss available to common shareholders—pro forma                                                         |       | $                               | (1.00      | ) | $ | (0.64 | ) | $ | (0.83 | ) |

 

Such pro forma disclosures may not berepresentative of future compensation expense because options vest over severalyears and additional grants are made each year.

 

*Net Loss Per Share(Basic and Diluted)*

 

Basic and diluted net loss per common shareis computed by dividing the net loss available to common stockholders for theperiod by the weighted average number of shares of common stock outstandingduring the period. The calculation of diluted net loss per common shareexcludes potential common shares if the effect is antidilutive. Potentialcommon shares are composed of shares of common stock issuable upon the exerciseof stock options and warrants. The number of potential common shares whichwould have been assumed to be converted in the years ended December 31,2002, 2003, and 2004 that have a dilutive effect if the Company had income fromcontinuing operations is 6,001,324, 7,243,403 and 11,295,669, respectively.

 

*Comprehensive Loss*

 

As it relates to the Company, components ofcomprehensive loss include net loss and unrealized gains and losses onavailable for sale securities. For the years ended December 31, 2002, 2003and 2004, net loss and comprehensive loss were identical because the carryingvalue of the Company’s available for sale securities equaled the fair marketvalue of such securities.

 

*Fair Value of Financial Instruments*

 

The Company’s financial instruments consistprimarily of cash and cash equivalents, embedded derivatives, accountsreceivable and accounts payable. The book value of cash and cash equivalents,accounts receivable, and accounts payable is considered to be representative oftheir fair value because of their short maturities.

 

###### *Concentrationof Credit Risk*

###### * *

Financial instruments that potentiallysubject the Company to a concentration of credit risk principally consist ofcash and cash equivalents and accounts receivable. The Company has its cash andcash equivalents placed with high quality, creditworthy financial institutions.As part of its cash management process, the Company performs periodicevaluation of the relative credit standing of these institutions.

 

Accounts receivables consisted of receivablesfrom cable operators in 2003. In 2004, accounts receivable consists ofreceivables with our video phone distribution partner. In 2003, a significantportion of our revenues were generated from outside the U.S. The Companyperforms ongoing credit evaluations of its customers’ financial condition andgenerally requires no collateral. In 2003, the Company established allowancesfor potential credit losses and such losses did not exceed managementexpectations.

 

Accounts receivable from major customers inexcess of 10% of total accounts receivable were as follows (2003 percentageswere from discontinued operations, there were no continuing operation sales in2002 and 2003):

 

F-12

----

 
| **Customer** | ** ** | **2003** | ** ** | **2004** | ** ** |
|--------------|------------|----------|------------|----------|------------|
|         |       |     |       |     |       |
| A            |       | 0        |       | 0        |       |
| B            |       | 36       | %          | 0        |       |
| C            |       | 6        | %          | 0        |       |
| D            |       | 10       | %          | 0        |       |
| E            |       | 0        |       | 0        |       |
|         |       | 52       | %          | 0        |       |

 

Sales to major customers, in excess of 10% oftotal revenues, were as follows for each of the years ended December 31(years 2002 and 2003 percentages were from discontinued operations, there wereno continuing operation sales in 2002 and 2003):

 
| **Customer** | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** |
|--------------|------------|----------|------------|----------|------------|----------|------------|
|         |       |     |       |     |       |     |       |
| A            |       | 84       | %          | 48       | %          | 0        |       |
| E            |       | 0        |       | 0        |       | 100      | %          |

 

F-13

----

 

Revenues from continuing operations bygeographic area are attributed to the United States in 2004.

 

At December 31, 2004, all of the Company’slong-lived assets, which total $3,530, are located in the United States, exceptfor $650 located in Taiwan, R.O.C.

 

*Recent Accounting Pronouncements*

 

In January 2003, the FASB issuedInterpretation No. 46, *Consolidation of VariableInterest Equities*. Interpretation No. 46 addressesconsolidation by business enterprises of variable interest entities, which areentities that either (a) do not have equity investors with vesting rightsor (b) have equity investors that do not provide sufficient financialresources for the entity to support its activities. The interpretation iseffective immediately for variable interest entities created after February 1,2003. In December 2003, the FASB published FASB Interpretation No. 46(R), *Consolidation of Variable Interest Entities*(FIN 46(R)). FIN 46(R), among other things, defers the effective date ofimplementation for certain entities. The revised interpretation is effectivefor the first interim or annual reporting period ending after March 15,2004, with the exception of structures that are commonly referred to asspecial-purpose entities, for which the statement is effective for periodsending after December 15, 2003. The adoption of Interpretation No. 46did not have a material impact on WorldGate’s results of operations orfinancial position.

 

In November 2004, the FASB issued SFAS No. 151“Inventory Costs” which amends the guidance in ARB No. 43, Chapter 4 “InventoryPricing,” to clarify the accounting for abnormal amounts of idle facilityexpense, freight, handling costs, and wasted material (spoilage). Paragraph 5of ARB 43, Chapter 4, previously stated that under some circumstances, itemssuch as idle facility expense, excessive spoilage, double freight, andrehandling costs may be so abnormal as to requiretreatment as current period charges.” SFAS No. 151 requires that thoseitems be recognized as current period charges regardless of whether they meetthe criterion of “so abnormal.” In addition, SFAS No. 151 requires thatallocation of fixed production overheads to the costs of conversion be based onthe normal capacity of the production facilities. SFAS No. 151 shall beeffective for inventory costs incurred during fiscal years beginning after June 15,2005. Earlier application is permitted for inventory costs incurred duringfiscal years beginning after the date SFAS No. 151 was issued. SFAS No. 151shall be applied prospectively. The Company does not expect the adoption ofSFAS No. 151 to have a material effect on its consolidated financialstatements.

 

In December 2004, the FASB issued SFAS No. 153“Exchanges of Nonmonetary Assets” which amends APB Opinion No. 29, “Accountingfor Nonmonetary Transactions.” APB No. 29 is based on the principle thatexchanges of nonmonetary assets should be measured based on the fair value ofthe assets exchanged. The guidance in that Opinion, however, included certainexceptions to that principle. SFAS No. 153 amends APB No. 29 toeliminate the exception for nonmonetary exchanges of similar productive assetsand replaces it with a general exception for exchanges of nonmonetary assetsthat do not have commercial substance. A nonmonetary exchange has commercialsubstance if the future cash flows of the entity are expected to changesignificantly as a result of the exchange, SFAS No. 153 shall be effectivefor nonmonetary asset exchanges occurring in fiscal periods beginning after June 15,2005. Earlier application is permitted for nonmonetary asset exchangesoccurring in fiscal periods beginning after the date SFAS No. 153 wasissued. SFAS No. 153 shall be applied prospectively. The Company does notexpect the adoption of SFAS No. 153 to have a material effect on itsconsolidated financial statements.

 

In December 2004, the FASB issued SFAS No. 123(R), “Share-Based Payment” that focuses primarily on accounting for transactionsin which an entity obtains employee services in share-based paymenttransactions. This statement replaces SFAS No. 123, “Accounting forStock-Based Compensation”, and supersedes APB Opinion No. 25, “Accountingfor Stock Issued to Employees.” Beginning with our quarterly period that beginsafter June 15, 2005, we will be required to expense the fair value ofemployee stock options and similar awards. As a public company, we are allowedto select from two alternative transition methods, each having differentreporting implications. The impact of SFAS No. 123R has not beendetermined at this time.

 

**3. Inventories**

 

Inventories as of December 31, 2003 and2004 are summarized as follows:

 
| ** **                                   | ** ** | **2003** | ** ** | **2004** | ** ** |
|----------------------------------------------|------------|----------|------------|----------|------------|
| Raw material  (from discontinued operations) |       | $        | 1,622      |     | $          | 1,622 |   |
| Work-in-progress                             |       | 0        |       | 0        |       |
| Finished  goods (from continuing operations) |       | 0        |       | 46       |       |
| Inventory  held by customers and vendors     |       | 0        |       | 0        |       |
| Total  Inventory                             |       | 1,622    |       | 1,668    |       |
| Inventory  Reserve                           |       | (1,622   | )          | (1,622   | )          |
| Inventory                                    |       | $        | 0          |     | $          | 46 |   |

 

F-14

----

 

During the year ended December 31, 2003,as a response to the continued slow economy, turmoil in the cable industry andthe Company’s slower than expected deployment of WorldGate’s ITV products andservices, the Company periodically re-evaluated its inventory and determinedthat it was in excess of foreseeable needs and should be resold. The carryingvalues of the inventory that were identified to be used in operations werewritten down to market value. Total charges to reduce thecarrying amount of inventory to the lower of cost of market was $3,037for the year ended December 31, 2003. These non-cash charges are includedin the “Income (loss) from discontinued operations “ lineitem on the consolidated statements of operations. There wereno further reduction of inventory values to market values in 2004.

 

**4. Property and Equipment**

 

Property and equipment consist of thefollowing at December 31, 2003 and 2004:

 
| ** **                                      | ** ** | **2003** | ** ** | **2004** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
| Computer  equipment and system packages         |       | $        | 965        |     | $          | 1,034 |   |
| Office  equipment                               |       | 211      |       | 211      |       |
| Furniture  and fixtures                         |       | 625      |       | 625      |       |
| Hardware,  software and tooling                 |       | 0        |       | 856      |       |
| Leasehold  improvements                         |       | 804      |       | 804      |       |
|                                            |       | 2,605    |       | 3,530    |       |
| Less  accumulated depreciation and amortization |       | (1,338   | )          | (1,815   | )          |
| Property and  equipment, net                    |       | $        | 1,267      |     | $          | 1,715 |   |

 

Depreciation and amortization on property andequipment in the amount of $1,158, $742 and $477 was recorded for each of thethree years ending December 31, 2002, 2003 and 2004, respectively.

 

**5. Goodwill**

 

The Company had goodwill of $3,608 andaccumulated amortization of $602 at December 31, 2001. In accordance withSFAS No. 142, no goodwill amortization expense was recognized during thetwelve month period ended December 31, 2002. During the second quarter of2002, in an effort to cut costs and achieve operational efficiencies, theCompany commenced the termination of all personnel of the former Digital VideoArt, Inc. (“DVA”) who performed engineering development services. Inconjunction with this action, it was determined that the carrying amount of theCompany’s remaining goodwill exceeded its fair value. As such, the Companymeasured the impairment loss by the amount the carrying value exceeded theimplied fair value of the goodwill. The amount of the non-cash impairment losswas $3,006 and is included in the loss from discontinued operations. The fairvalue of goodwill was estimated using the expected present value of future cashflows.

 

**6. Financing Agreements**

 

During 2004, the Company financed itsDirectors and Officers’ Insurance Policy for the policy period ending April 15,2005. At December 31, 2004, the remaining unpaid portion of the notepayable totaled $37. This balance was paid subsequent to year end. The weightedaverage interest rate on the outstanding note payable for the year ended December 31,2004 was 4.25%. At December 31, 2003, the Directors and officers’Insurance Policy was paid in full for the policy period ending April 15,2004.

 

**7.  Income Taxes**

 

The significant components of deferred tax assetsat December 31, 2003 and 2004 are as follows:

 
| ** **                                               | ** ** | **2003** | ** ** | **2004** | ** ** |
|----------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                     |       |     |       |     |       |
| Federal tax  loss carryforward                           |       | $        | 60,726     |     | $          | 64,979 |   |
| State tax  loss carryforward                             |       | 8,270    |       | 10,352   |       |
| Property and  equipment                                  |       | 688      |       | 157      |       |
| Research and  experimentation credit                     |       | 2,637    |       | 2,739    |       |
| Officers’  compensation, accrued expenses and other |       | 426      |       | 1,063    |       |
| Bad debt  expense                                        |       | 154      |       | 0        |       |
|                                                     |       | 72,901   |       | 79,290   |       |
| Less:  valuation allowance                               |       | (72,901  | )          | (79,290  | )          |
|                                                     |       | 0        |       | 0        |       |
|                                                          |            |          |            |          |            |  |  |

 

F-15

----

 

A valuation allowance was established againstthe Company’s net deferred tax asset due to the Company’s lack of earningshistory and, accordingly, the uncertainty as to the realization of the asset. Aportion of the gross deferred asset and related valuation allowance isattributable to stock option expense. To the extent that such assets arerealized in the future, the benefit is applied to equity.

 

At December 31, 2004, the Company had anet operating loss carryforward of approximately $191,112 for federal taxpurposes, expiring between 2012 and 2024 if not utilized. The net operatingloss carryforward for state tax purposes is approximately $103,624, which willexpire in 2024. These carryforwards may be applied as a reduction to futuretaxable income of the Company, if any. The state net operating losscarryforwards are limited by state tax law to a maximum utilization of $2,000per year. The Company also has federal and state research and experimentationcredit carryforwards of approximately $2,739 and $52, respectively. The federalresearch and experimentation credit carryforwards expire between 2012 and 2024and the state research and experimentation credit carryforward expires 2017.The Company’s ability to utilize its net operating loss carryforwards andcredit carryforwards may be subject to annual limitations as a result of prioror future changes in ownership and tax law as defined under Section 382 ofthe Internal Revenue Code of 1986. Such limitations are based on the marketvalue of the Company at the time of ownership change multiplied by thelong-term exempt note supplied by the Internal Revenue Service.

 

**8. Stockholders’ Equity (Deficiency)**

 

*Preferred Stock*

 

The Company has the authority to issue fromtime to time up to an aggregate of 13,500,000 shares of preferred stock in oneor more classes or series and to determine the designation and the number ofshares of any class or series as well as the voting rights, preferences,limitations and special rights, if any, of the shares of any class or series.The issuance of preferred stock may have the effect of delaying, deferring orpreventing a change of control of our company. At December 31, 2004 therewere 6,775,000 shares of preferred stock outstanding.

 

*Redeemable Preferred Stock [Restated]*

 

The following information has been restatedto provide a more complete description of the accounting method and policyrelated to redeemable preferred shares and derivative shares.

 

In June 2004, WorldGate completed aprivate placement of 7,550 shares of its Series APreferred Stock at a stated value of $1000 per share, which preferred stock isconvertible into the Company’s common stock at a conversion price of $2.35 pershare. The Company has the right to require conversion of the preferred stockinto common stock upon achieving certain price targets with respect to itscommon stock and the satisfaction of certain other conditions. As of December 31,2004 such conditions were not met. As part of the transaction, the companyissued five-year detachable warrants to purchase a total of 1.6 million sharesof the Company’s common stock, with one-half of the warrants having an exerciseprice of $2.69 per share and the remaining half having an exercise price of$3.14 per share. The preferred stock has a dividend rate of 5% per annum,payable quarterly, which may be paid either by cash or through the issuance ofcommon stock at the Company’s option (with stock payments being made at a 10%discount to the then current market price). The preferred stock has a stagedmaturity over three years with scheduled payments of one third due after 18months, one half of the remainder due after 24 months and the balance due after36 months. The preferred stock may be redeemed at maturity in cash or throughthe issuance of an indeterminable number of shares of common stock, at theCompany’s option (with stock payments being made at their current marketprice). All dividend and maturity payments made in stock are subject to thesatisfaction of certain conditions including the listing of the stock andavailability of an effective registration statement. The investors alsoreceived an additional investment right, for a limited period of time, topurchase 1.6 million additional shares of common stock shares at $3.14 a share.In November and December 2004, 775 preferred shares were converted tocommon stock, and in December 2004 and February 2005, 1,606,383additional investment rights were exercised, resulting in an

 

F-16

----

 

incrementalinvestment of $5,044.

 

In accordance with EITF topic D-98 “Classificationand Measurement of Redeemable Securities”, the Redeemable Preferred Stock wasrecorded in the financial statements as temporary equity. At December 31,2004, that amount was $1,318. Additionally, the fair value of warrants andpreferred stock conversion options were recorded into the financial statementsas liabilities as a result of their features that require accounting under FAS133 “Accounting for derivative instruments and hedging activities.” At December 31,these amounts totaled $14,195. At each reporting balance sheet date anevaluation is made of these valuations and marked to market. During the twelvemonths ended December 31, 2004, the Company recorded an increase of $951to the Accumulated Deficit resulting from $189 for dividends on redeemablepreferred stock, and $762 for the accretion of redeemable preferred stock toits redemption value.

 

Although the conversion options and warrantsare considered embedded instruments under SFAS No. 133, paragraph 11a,these conversion options and warrants are conventional elements of financingtransactions and were necessary to obtain critical funding needed by theCompany.  They are not hedginginstruments.  The risks inherent in theconversion options is the dilution to shareholders upon the conversion ofpreferred shares if conversion and/or redemption is made in shares of commonstock or in the reduction of cash available to the Company if the conversionand/or redemption of the preferred shares is made in cash.  Similarly, the exercise of warrants and theresulting issuance of common stock could also result in additional dilution toshareholders.  This dilution wasnecessary to obtain the funding required by the Company to continue operations.

 

*Warrants*

 

In connection with the issuance of notespayable in March 1999 (that have since been repaid), the holders of thenotes received warrants to purchase up to 331,490 shares of common stock,subject to adjustment, at an exercise price of $16.50 per share, subject toadjustment. The warrants expired unexercised in March 2002.

 

In August 2000, the Company issuedwarrants to the TVGateway partners as part of the TVGateway Joint Venture morefully described in Note 13. These warrants may be exercised to purchase inthe aggregate up to 1,500,000 shares of common stock at an exercise price of$24.78 and up to 500,000 additional shares of common stock at an exercise priceof $12.39. The warrants are subject to vesting at varying rates based on thedeployment of the Company’s Internet TV service on each operator’s digitalcable systems. On September 30, 2003, 1,000,000 warrants were cancelled.At December 31, 2004, none of the remaining warrants have vested.

 

In November 2000, we entered into adeployment agreement with AT&T Broadband to deploy the Company’sinteractive services to AT&T digital customers in Cedar Falls and Waterloo,Iowa and Tacoma, Washington. As part of this agreement, the Company issuedwarrants to AT&T to purchase up to 1,000,000 shares of the Company’s commonstock at a per share exercise price of $16.02. The warrants are subject tovesting at varying rates based on the deployment of the Company’s Internet TVservice on AT&T’s digital cable systems. At December 31, 2004, none ofthe warrants have vested.

 

In April and September 2004 weissued warrants to purchase shares of our common stock, with the April warrantshaving an exercise price of $1.4375 per share and the September warrantshaving an exercise price of $1.75 per share. Included with General andAdministrative expenses in September 2004 were $606 of expenses relatingto the valuation of these warrants in December 2004. This valuation wasdetermined by using the Black-Scholes fair value option model. The followingassumptions were used: expected volatility of 65%; average risk-free interestrate of 3.43 percent; dividend yield of 0%; and an expected life of 5.0 years.

 

In connection with the June 2004 privateplacement, we issued warrants to purchase shares of our common stock, withone-fourth of the warrants having an exercise price of $2.69 per share and theremaining three-fourths having an exercise price of $3.14 per share.

 

In connection with the December 2003 andJanuary 2004 private placements, we issued warrants and additionalinvestment rights to purchase shares of common stock. For the December 2003transactions the warrants had an exercise price of $1.00 per share and theadditional investment rights were priced at $0.80 per share. For the January 2004transaction the warrants had an exercise price of $1.875 per share and theaddition investment rights were priced at $1.50 per share. In addition, if theselling security holders exercise their additional investment rights, we willbe obligated to issue additional warrants to purchase our common stock at anexercise price of $1.00 per share and $1.875 per share, respectively, for the December 2003and the January 2004 transactions. Included with General andAdministrative expenses in 2003 and 2004 were $817 and $630, respectively, ofexpenses relating to the valuation of the above investment rights, warrants andwarrant rights issued in December 2003 and January

 

F-17

----

 

2004. This valuation was determined by using the Black-Scholes fairvalue option valuation model. The following assumptions were used for the sharerights and the warrants and warrant rights, respectively: expected volatilityof 100% and 100%; average risk-free interest rates of .81% and 3.20%; dividendyields of 0% and 0%; and expected lives of .8 and 5.0 years. For the twelvemonths ended December 31, 2003, we recorded $778 of expense to continuingoperations. Included in discontinued operations was $40 of non cash expense.

 

In connection with the December 2004private placement, we issued warrants to purchase shares of common stock. Forthis transaction the warrants had an exercise price of $2.88 per share.Included with General and Administrative expenses in December 2004 were$94 of expenses relating to the valuation of the above warrants issued in December 2004.This valuation was determined by using the Black-Scholes fair value optionvaluation model. The following assumptions were used: expected volatility of65%; average risk-free interest rate of 3.48%; dividend yield of 0%; and anexpected life of 5 years. For the twelve months ended December 31, 2004,we recorded $1,332 of expense to continuing operations.

 

*Stock Option Plan*

 

In December 1996, the Company adoptedthe 1996 Stock Option Plan (“1996 Plan”). This plan provides for the grantingof stock options to officers, directors, employees and consultants. Grantsunder this plan may consist of options intended to qualify as incentive stockoptions (“ISO s”), or nonqualified stock options that are not intended to soqualify (“NQSOs”). The option price of any ISO will not be less than the fairmarket value on the date the option is granted (110% of fair value in certaininstances). The option price of NQSOs may be greater than, equal to, or lessthan the fair market value on the date the option is granted. The 1996 Planoriginally authorized a maximum of 933,333 shares of common stock.

 

In May 1999 and May 2000, the Boardincreased the total number of shares of common stock available under the 1996Plan to 1,600,000 and 3,200,000 shares, respectively. In October 2000, theCompany’s stockholders approved these increases. In February 2001, theBoard approved an automatic annual increase of shares reserved under the 1996Plan in an amount equal to the lesser of 4% of thethen outstanding shares of the Company’s common stock or 1,000,000 shares. In October 2001,the Company’s stockholders approved this increase.

 

In October 2004, the Company’sstockholders approved the 2003 Equity Incentive Plan (“2003 Plan”). This planis intended to replace the 1996 Plan for new grants. No additional shares werereserved for the new plan but rather all available shares under the 1996 Planwere made available for the new plan. As with the 1996 Plan, the 2003 Planincludes the same automatic annual increase in the number of shares reservedfor use with the plan equal to the lesser of 4% of the then outstanding sharesof the Company’s common stock or 1,000,000 shares. In addition to incentivestock options and nonqualified stock options, the new plan also provides forperformance based awards and restricted stock.

 

Both the 1996 Plan and its successor, the2003 Plan are administered by a committee of the Board of Directors. Thecommittee determines the term of each award, provided, however, that the exerciseperiod may not exceed ten years from the date of grant, and for ISOs, incertain instances, may not exceed five years. The options granted under thisplan vest ratably over a four-year period from the date of grant.

 

Unearned compensation expense ofapproximately $1,133 and $340 was recorded, for certain options which weregranted to employees in 1998 and 1999, respectively, at below the estimatedfair value at the time of grant, to acquire 213,343 and 39,058 shares of commonstock, respectively. The compensation expense is being recognized over afour-year vesting period. Compensation expense of approximately $396, $388 and$192 was recognized in 2000, 2001 and 2002, respectively, related to thesegrants. As of December 31, 2003 and 2004, no compensation expense remainsto be recognized. No such options were granted during the years 2000 through2004.

 

On February 15, 2001, the Company’sBoard of Directors approved a plan (the “Exchange Offer”) pursuant to which theCompany would offer its employees and directors the opportunity to exchange alloutstanding options to purchase shares of the Company’s common stock grantedunder the Company’s 1996 stock option plan having an exercise price of $5.00 ormore per share (the “eligible options”) together with all options granted toholders of eligible options within the six month period prior to the expirationdate of the Exchange Offer, for new options to be granted six months and oneday after the expiration of the Exchange Offer. On June 22, 2001, theCompany commenced the Exchange Offer and filed with the SEC a Tender OfferStatement on Schedule TO. The Exchange Offer expired on July 30,2001. Pursuant to the Exchange Offer, the Company accepted for exchange optionsto purchase 696,359 shares of the Company’s common stock, representingapproximately 21.31% of the options that were eligible to be tendered in theExchange Offer. Subject to the terms of the Exchange Offer, on January 31,2002 the Company granted options to purchase an aggregate of 558,742 shares ofcommon stock, in exchange for such tendered options, having an

 

F-18

----

 

exercise priceper share equal to the closing price of a share of the Company’s common stockas reported on the NASDAQ National Market on January 31, 2002, which was$1.9297. The Exchange Offer did not result in the recognition of compensationexpense by the Company.

 

The weighted-average fair value of theoptions granted was $1.85, $0.50 and $1.16 per option during the years ended December 31,2002, 2003 and 2004, respectively. The fair value of each option grant isestimated on the date of grant using the Black-Scholes fair value optionvaluation model. The following weighted-average assumptions were used forgrants in 2002, 2003 and 2004, respectively: expected volatility of 100%, 100%and 90%; average risk-free interest rates of 4.69%, 2.96% and 2.97%; dividendyield of 0%; and expected lives of 5.8, 3.8 and 4.0 years.

 

A summary of the Company’s stock plan ispresented below:

 
| ** **                           | ** ** | **Stock Options** | ** ** | **Weighted-Average  Exercise Price** | ** ** |
|--------------------------------------|------------|-------------------|------------|--------------------------------------|------------|
| ** **                           | ** ** | ** **        | ** ** | ** **                           | ** ** |
| Outstanding,  December 31, 2002 |       | 2,715,197         |       | $                                    | 3.57       |   |
|                                 |       |              |       |                                 |       |
| Granted                              |       | 2,115,452         |       | $                                    | 0.48       |   |
| Exercised                            |       | —            |       | —                               |       |
| Cancelled/forfeited                  |       | (709,746          | )          | $                                    | 2.50       |   |
| Outstanding,  December 31, 2003 |       | 4,120,903         |       | $                                    | 2.17       |   |
|                                 |       |              |       |                                 |       |   |
| Granted                              |       | 1,171,250         |       | $                                    | 1.95       |   |
| Exercised                            |       | (446,203          | )          | $                                    | 2.39       |   |
| Cancelled/forfeited                  |       | 309,273           |       | $                                    | 5.57       |   |
| Outstanding,  December 31, 2004 |       | 4,536,677         |       | $                                    | 1.87       |   |

 

The following table summarizes informationabout stock options outstanding at December 31, 2004:

 
| ** **                   | ** ** | **Stock Options Outstanding** | ** ** | **Stock Options Exercisable**                                | ** ** |
|------------------------------|------------|-------------------------------|------------|--------------------------------------------------------------|------------|
| **Range of Exercise Prices** | ** ** | **Shares**                    | ** ** | **Weighted-  Average  Remaining  Contractual  Life (Years)** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** |
| $ 0.26  - $0.39         |       | 320,225                       |       | 8.17                                                         |       | $ | 0.37 |   | 77,969 |   | $ | 0.37 |   |
| $ 0.40  - $0.59         |       | 1,336,742                     |       | 8.75                                                         |       | 0.54 |   | 456,617 |   | 0.55 |   |
| $ 0.60  - $0.89         |       | 14,666                        |       | 4.07                                                         |       | 0.66 |   | 14,666 |   | 0.66 |   |
| $ 0.90  - $1.34         |       | 779,500                       |       | 8.97                                                         |       | 1.06 |   | 9,750 |   | 1.17 |   |
| $.1.35 -  $2.01              |       | 549,688                       |       | 7.16                                                         |       | 1.76 |   | 397,325 |   | 1.82 |   |
| $ 2.02  - $3.02         |       | 966,505                       |       | 6.65                                                         |       | 2.58 |   | 771,202 |   | 2.66 |   |
| $ 3.03  - $4.53         |       | 383,851                       |       | 8.23                                                         |       | 4.41 |   | 118,601 |   | 4.37 |   |
| $ 4.54  - $6.80         |       | 101,914                       |       | 5.94                                                         |       | 6.34 |   | 101,914 |   | 6.34 |   |
| $ 6.81  - $10.20        |       | 40,000                        |       | 6.13                                                         |       | 8.25 |   | 30,000 |   | 8.25 |   |
| $10.21 -  $15.30             |       | 0                             |       | 0                                                            |       | 0 |   | 0 |   | 0 |   |
| $15.31 -  $22.95             |       | 38,949                        |       | 5.05                                                         |       | 20.27 |   | 38,949 |   | 20.27 |   |
| $22.96 -  $34.43             |       | 4,286                         |       | 5.51                                                         |       | 28.59 |   | 4,286 |   | 28.59 |   |
| $34.44 -  $41.13             |       | 351                           |       | 4.97                                                         |       | 41.10 |   | 351 |   | 41.10 |   |
|                         |       | 4,536,677                     |       | 7.91                                                         |       | $ | 1.93 |   | 2,033,879 |   | $ | 2.67 |   |

 

For a period of approximately three (3) weeksin May 2001, executives (including the Chief Executive Officer) weregranted four options, which vest in equal installments over a three-yearperiod, for each share of common stock they purchased. The 4-for-1 matchinggrant was capped at the point that the aggregate purchase price of sharesbought by an executive reached one hundred thousand dollars.

 

F-19

----

 

*Employee Stock Purchase Plan*

 

In October 2001, our shareholdersapproved the WorldGate 2001 Employee Stock Purchase Plan that provides eligibleparticipants with the opportunity to periodically acquire shares of our commonstock through payroll deductions. Eligible participants may contribute up tofifteen percent of their compensation towards the purchase of our common stock.At the end of each calendar quarter, the contributions of the participants areused to purchase shares of the Company’s common stock at the lower ofeighty-five percent of the market price of our common stock: (i) at thebeginning of each calendar quarter or (ii) at the end of each calendarquarter. A maximum of 750,000 shares of the Company’s common stock (plus anannual increase of 375,000 shares) may be purchased in the aggregate byparticipants in the Stock Purchase Plan.

 

During 2003 and 2004, the Company sold 3,880and 48,832 shares of common stock under the Stock Purchase Plan for proceeds of$1 and $45, respectively.

 

**10. Net Loss Per Share**

 

The following table is a reconciliation ofthe numerators and denominators of the basic and diluted per sharecomputations:

 
| ** **                                            | ** ** | **Years Ended December 31** | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                            | ** ** | **2002**                         | ** ** | **2003** | ** ** | **2004** | ** ** |
| Loss from  continuing operations                      |       | $                                | 0          |   | $ | (6,497 | ) | $ | (20,185 | ) |
| (Loss)  income from discontinued operations           |       | (19,210                          | )          | (2,908 | ) | 36 |   |
| Net loss                                              |       | (19,210                          | )          | (9,405 | ) | (20,149 | ) |
| Accretion on preferred stock and dividends            |       | 0                                |       | 0 |   | (951 | ) |
| Net loss  available to common shareholders            |       | $                                | (19,210    | ) | $ | (9,405 | ) | $ | (21,100 | ) |
|                                                  |       |                             |       |   |   |   |   |
| **Basic  and diluted loss per average common share:** |       |                             |       |   |   |   |   |
| Weighted  average shares outstanding                  |       | 23,573,935                       |       | 23,259,611 |   | 27,881,347 |   |
|                                                  |       |                             |       |   |   |   |   |
| Loss from  continuing operations                      |       | $                                | 0.00       |   | $ | (0.28 | ) | $ | (0.72 | ) |
| (Loss)  income from discontinued operations           |       | (0.81                            | )          | (0.12 | ) | 0.00 |   |
| Net loss                                              |       | $                                | (0.81      | ) | $ | (0.40 | ) | $ | (0.72 | ) |
| Net loss  available to common shareholders            |       | $                                | (0.81      | ) | $ | (0.40 | ) | $ | (0.76 | ) |

 

**11. Commitments and Contingencies**

 

*Leases*

 

In 1998 the Company entered into a leasingarrangement for a building with an entity formed by non-employee investors. TheCompany stopped paying rent on this lease in May 2003, and in lieu of rentpayments the Company’s landlord, 3190 T General, Inc. (an entity formed bynon-employee investors in the Company), began drawing down the security depositfor the facility. Prior to stopping rent payments, the Company had commencednegotiations with its landlord for an amendment of its lease to reduce thespace commitment and the rent payable. These negotiations were not successful,and in September 2003, the Company’s landlord filed an action in the Courtof Common Pleas, Bucks County Pennsylvania to perfect its interest to takepossession of the Company’s facility, and to establish damages for past rentand expenses. Although a judgment was granted allowing the Company’s landlordto regain possession of the facility, the Company remained in the facility andcontinued negotiations with its landlord. During 2004, the landlord deeded thefacility to its mortgage holders and negotiations commenced with GMAC asrepresentative for the mortgage holders. These negotiations were successful andin June 2004 the Company’s lease was amended to reduce the leaseobligation in line with the Company’s current space requirements, and to bringthe Company current with respect to all outstanding back rent.  The current lease permits both the Companyand the landlord to terminate the lease at any time on 90 days written noticeto the other party.  In November 2003,the Company entered into a 60 month lease for office equipment. As of December 31,2004 there remains a total of $23 to be paid over the remaining period of thelease.

 

*Disclosure of Contractual Obligations*

 
| ** **       | ** ** | **Total** | ** ** | **Less than 1 year** | ** ** | **1 — 3 years** | ** ** | **3 — 5 years** | ** ** | **Over 5 years** | ** ** |
|------------------|------------|-----------|------------|----------------------|------------|----------------------|------------|----------------------|------------|------------------|------------|
|             |       |      |       |                 |       |                 |       |                 |       |             |       |
| Operating  lease |       | $         | 23         |                 | $          | 6                    |       | $                    | 12         |             | $          | 5 |   | $ | 0 |   |
|                  |            |           |            |                      |            |                      |            |                      |            |                  |            |  |  |  |  |  |

 

F-20

----

 

Total rent expense resulting from this leasefor the years ended December 31, 2002, 2003 and 2004, respectively,amounted to approximately $1,442, $957 and $1,027, respectively. The rentexpense for 2004 of $1,027 includes $785 of unpaid rent that was cancelled as aresult of a lease amendment entered into November 2004 with an effectivedate of June 2004. This cancellation is included in total interest andother income in our consolidated financial statements.

 

**12. Significant Agreements and Transactions**

 

In 1997, the Company entered into agreementswith certain customers who are investors. Revenues recognized from suchinvestors were approximately, $0, $0 and $231, respectively, for the twelvemonths ended December 31, 2002, 2003 and 2004. One of these investorsaccounted for 100% of the revenues for the twelve months ended December 31,2004. Advances received from this investor were $396 and as of December 31,2004 and are included in deferred revenue in the accompanying balance sheet.

 

Revenues from discontinued operationsrecognized from such investors were approximately $11,991, $2,153 and $0(included in discontinued operations), respectively, for the twelve monthsended December 31, 2002, 2003 and 2004. Accounts receivable from suchinvestors amounted to approximately $1,185, $53 and $0, respectively, as of December 31,2002, 2003 and 2004.

 

The Company has a current agreement with aninvestor, and previously had agreements with certain other investors, toprovide the Company with engineering and development support. As a result ofthose agreements, the Company has expensed approximately $1,837, $557 and $0(included in discontinued operations), respectively, for the twelve monthsended December 31, 2002, 2003 and 2004. Accounts payable to theseinvestors amounted to $117 and $170 at December 31, 2004 and December 31,2003, respectively. Some of these stockholders were suppliers of technology andcomponents for the Company’s discontinued ITV products and services. Theseagreements provided for licensing of technology, as well as contractedservices, including hardware and software development, product testing andcertification, and the creation and development of tools and systems tofacilitate the Company’s engineering efforts. These agreements did not providefor ongoing royalties, purchase provisions, or for any requirement to provideadditional funding to the Company.

 

**13. TVGateway Joint Venture and Related Cable Operator Agreements**

 

*TVGateway Joint Venture*

 

On July 24, 2000, the Company formed aseparate joint venture, TVGateway, LLC, with four cable operators.  As part of this venture WorldGate enteredinto a management agreement with TVGateway to provide engineering, operationsand administrative support services.  Inaddition to providing for the terms and conditions under which such serviceswere to be provided, the management agreement provided for WorldGate andTVGateway to cooperate to transition to TVGateway some or all of the supportservices being provided by WorldGate and/or the employees providing theseservices.  In addition, this provisionrequired WorldGate to remain available to provide support services until July 24,2005.  During 2002 WorldGate andTVGateway agreed to commence the transition of services pursuant to thisprovision.  In addition, the partiesagreed that the management agreement would be of no further force and effectwith respect to the services that are transferred as of the date of completion ofthe specific transfers.  The companiescompleted this transition in first quarter 2003, and accordingly, WorldGate hasnow been relieved of any continuing obligation to provide such transitionedservices. WorldGate no longer receives revenues from the management agreementwith TVGateway.

 

Revenues for such services, which areincluded in service fee revenue, totaled $11,484, $794 and $0, for the twelvemonths ended December 31, 2002, 2003 and 2004 (included in discontinuedoperations), respectively. In addition, product sales to TVGateway totaled $92,$1,078 and $0 for the twelve months ended December 31, 2002, 2003 and2004, respectively (included in discontinued operations). Accounts receivablefrom TVGateway amounted to $0 at December 31, 2004 and $0 at December 31,2003.  WorldGate was accounting for its18% investment in the TVGateway joint venture, which was previously reduced toa carrying value of $0 due to prior losses, under the equity method.

 

On September 30, 2003 the Companyannounced that it had sold to TVGateway, LLC certain ITV intellectual propertyrights and certain software and equipment related to the ITV business, whichTVGateway was currently using, for $2, 400. In addition, on August 7, 2003, WorldGate and TVGateway enteredinto a redemption agreement pursuant to which TVGateway redeemed WorldGate’sequity interest in TVGateway for $600 in cash. The purchase price for theseassets in the aggregate was $3,000 and was used by the Company to fundcontinuing operations, as well as to develop and distribute its new Ojo videotelephony product. As part of this transaction WorldGate retained aroyalty-free license to certain of the transferred intellectual

 

F-21

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property rightsand software. At this time the Company has completely exited from theinteractive television (ITV) business.

 

In connection with the Asset PurchaseAgreement we entered into with TVGateway for the sale of certain ITV Businessassets, we have an obligation to indemnify TVGateway for any losses frombreaches of our representations or warranties in the Asset Purchase Agreementthat occur within twelve months after the closing date of the TVGatewaytransaction or within the applicable statute of limitations period for claimsrelating to our ownership of our assets, payment of our taxes, and ourcompliance with applicable laws, if longer. Our indemnification obligations arelimited by an overall cap of $500 on the amount of the indemnification.Although we know of no breaches of our representations or warranties and theinitial twelve-month period has expired, the paymentof any such indemnification obligations would adversely impact our cashresources and our ability to pursue our video phone business.

 

**14. Employee Benefit Plan**

 

In 2000, the Company established a RetirementSavings Plan that is funded by the participant’s salary reductioncontributions. All employees of the Company are eligible to participate in theplan upon joining the Company. The plan is intended to permit any eligibleemployee who wishes to participate to contribute up to 12% of the employee’scompensation on a before-tax basis under Section 401(k) of the InternalRevenue Code. The plan provides for discretionary Company matchingcontributions and discretionary Company profit-sharing contributions.Contributions are invested, in such proportions as the employee may elect inany of 10 mutual investment funds. In 2002 and 2003, the Company made nodiscretionary profit-sharing contributions to the plan.  On May 28, 2003, this Retirement SavingsPlan was terminated by the Company.

 

In January of 2005 the Companyestablished a new Retirement Savings Plan that is funded by the participant’ssalary reduction contributions. All employees of the Company are eligible toparticipate in the plan upon joining the Company. The plan is intended topermit any eligible employee who wishes to participate to contribute up to 12%of the employee’s compensation on a before-tax basis under Section 401(k)of the Internal Revenue Code. The plan provides for discretionary Companymatching contributions and discretionary Company profit-sharing contributions.Contributions are invested, in such proportions as the employee may elect in avariety of mutual investment funds.

 

**16. Supplemental disclosure of cash flow information**

 
| ** **                                                                         | ** ** | **Year ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                         | ** ** | **2002**                         | ** ** | **2003** | ** ** | **2004** | ** ** |
| ** **                                                                         | ** ** | **(dollars in thousands)**       | ** ** |
| Cash paid  for interest                                                            |       | $                                | 12         |   | $ | 15 |   | $ | 6 |   |
|                                                                               |       |                             |       |   |   |   |   |
| **Non-cash  investing and financing activities:**                                  |       |                             |       |   |   |   |   |
| Utilization  of contractual obligation related to equity financing                 |       | 82                               |       | 0 |   | 0 |   |
| Settlement  of contractual obligation related to equity financing                  |       | 802                              |       | 3,283 |   | 0 |   |
| Acquisition  of treasury stock resulting from settlement of contractual obligation |       | 5                                |       | 0 |   | 0 |   |
| Issuance of  common stock in payment for product development                       |       | 0                                |       | 600 |   | 0 |   |
| Issuance of  notes payable for Directors and Officers’ insurance policy       |       | 443                              |       | 560 |   | 328 |   |
| Accretion on  preferred stock                                                      |       | 0                                |       | 0 |   | 763 |   |
| Conversion  of preferred stock to common                                           |       | 0                                |       | 0 |   | 775 |   |
| Dividends on  preferred stock                                                      |       | 0                                |       | 0 |   | 188 |   |
| Cancellation  of treasury stock shares                                             |       | 0                                |       | 0 |   | 5 |   |
|                                                                                    |            |                                  |            |  |  |  |  |  |  |  |

 

**17. Recent Developments**

 

We filed a registration statement with theSecurities and Exchange Commission in September 2002 relating to aproposed distribution to our shareholders of subscription rights to purchaseadditional shares of common stock and warrants of the Company. Thisregistration was withdrawn during the last quarter of 2003.

 

We filed a registration statement with theSecurities and Exchange Commission in December 2003 relating to a privateplacement of our common stock to certain institutional investors and theresulting proposed resale by such investors of up to 3,745,000 shares of ourcommon stock. This registration statement was declared effective in January 2004.

 

We filed a registration statement with theSecurities and Exchange Commission in April 2004 relating to a private

 

F-22

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placement of ourcommon stock to certain institutional investors and the resulting proposedresale by such investors of up to 3,105,345 shares of our common stock. Thisregistration statement was declared effective in April, 2004.

 

We filed a registration statement with theSecurities and Exchange Commission in July 2004 relating to a privateplacement of our common stock to certain institutional investors and theresulting proposed resale by such investors of up to 10,343,997 shares of itscommon stock. This registration statement was declared effective in July, 2004.

 

**18. Discontinued Operations**

 

During the first quarter of 2004, the Companydecided to transition from the business of developing and selling interactivetelevision, or ITV, technology, products and services for use in conjunctionwith cable TV broadband networks (the “ITV business”) to the development ofvideophone products. In accordance with Statement of Financial AccountingStandards 144, Accounting for the Impairment or Disposal of Long-Lived Assets,all assets related to the ITV business have been written down to their netrealizable value. Related operating results of the ITV business have beenreported as discontinued operations for all years presented.

 

Revenue and net income (loss) before income taxes from discontinuedoperations were as follows:

 
| ** **                         | ** ** | **For the Twelve-Month Period  ended December 31,** | ** ** |
|------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                         | ** ** | **2002**                                                 | ** ** | **2003** | ** ** | **2004** | ** ** |
| Revenues                           |       | $                                                        | 13,878     |   | $ | 3,886 |   | $ | 82 |   |
| (Loss)  income before income taxes |       | (19,210                                                  | )          | (2,908 | ) | 36 |   |
|                                    |            |                                                          |            |  |  |  |  |  |  |  |

 

**Supplemental Quarterly Data (unaudited):**

 
| ** **                                                                             | ** ** | **First**                                                | ** ** | **Second (As Amended)** | ** ** | **Third** | ** ** | **Fourth** | ** ** |
|----------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|-------------------------|------------|-----------|------------|------------|------------|
| ** **                                                                             | ** ** | **(dollars in thousands  other than per share amounts)** | ** ** |
|                                                                                   |       |                                                     |       |                    |       |      |       |       |       |
| 2004                                                                                   |       |                                                     |       |                    |       |      |       |       |       |
| Net revenues                                                                           |       | $                                                        | 0          |                    | $          | 0         |       | $          | 106        |   | $ | 125 |   |
| Loss from  continuing operations                                                       |       | (2,760                                                   | )          | (1,951                  | )          | (1,517    | )          | (13,957    | )          |
| Income from  discontinued operations                                                   |       | 22                                                       |       | 7                       |       | 7         |       | 0          |       |
| Net loss                                                                               |       | (2,738                                                   | )          | (1,944                  | )          | (1,510    | )          | (13,957    | )          |
| Accretion on  preferred stock and dividends                                            |       | 0                                                        |       | 31                      |       | (400      | )          | (520       | )          |
| Net loss  available to common shareholders                                             |       | (2,738                                                   | )          | (1,975                  | )          | (1,910    | )          | (14,477    | )          |
| Basic and  diluted loss from continuing operations per common share                    |       | (0.10                                                    | )          | (0.07                   | )          | (0.06     | )          | (0.49      | )          |
| Basic and  diluted income (loss) from discontinued operations per common share         |       | 0.00                                                     |       | 0.00                    |       | 0.00      |       | 0.00       |       |
| Basic and  diluted net loss per common share                                           |       | (0.10                                                    | )          | (0.07                   | )          | (0.06     | )          | (0.49      | )          |
| Basic and  diluted net loss available to common shareholders per common share          |       | (0.10                                                    | )          | (0.07                   | )          | (0.07     | )          | (0.51      | )          |
|                                                                                   |       |                                                     |       |                    |       |      |       |       |       |
| 2003                                                                                   |       |                                                     |       |                    |       |      |       |       |       |
| Net revenues                                                                           |       | $                                                        | 0          |                    | $          | 0         |       | $          | 0          |   | $ | 0 |   |
| Loss from  continuing operations                                                       |       | (813                                                     | )          | (1,372                  | )          | (1,652    | )          | (2,659     | )          |
| (Loss) income  from discontinued operations                                            |       | (1,072                                                   | )          | (1,627                  | )          | 1,755     |       | (1,965     | )          |
| Net (loss)  income                                                                     |       | (1,885                                                   | )          | (2,999                  | )          | 103       |       | (4,624     | )          |
| Net (loss)  income available to common shareholders                                    |       | (1,885                                                   | )          | (2,999                  | )          | 103       |       | (4,624     | )          |
| Basic and  diluted loss from continuing operations per common share                    |       | (0.03                                                    | )          | (0.06                   | )          | (0.07     | )          | (0.11      | )          |
| Basic and  diluted (loss) income from discontinued operations per common share         |       | (0.05                                                    | )          | (0.07                   | )          | 0.07      |       | (0.08      | )          |
| Basic and  diluted net (loss) income per common share                                  |       | (0.08                                                    | )          | (0.13                   | )          | 0.00      |       | (0.19      | )          |
| Basic and  diluted net (loss) income available to common shareholders per common share |       | (0.08                                                    | )          | (0.13                   | )          | 0.00      |       | (0.19      | )          |

 

F-23

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**Item 9. Changes in and Disagreements WithAccountants on Accounting and Financial Disclosure.**

 

None

 

**Item 9A.  Controls andProcedures.**

 

As of the end of the period covered by this Form 10-K, our management,with the participation of our chief executive officer and chief financialofficer, conducted an evaluation of the effectiveness of our disclosurecontrols and procedures (as defined in Rules 13a-15(e) and 15d -15(e) under theSecurities Exchange Act of 1934, as amended (the “Exchange Act”)).

 

Based on thatevaluation, our chief executive officer and chief financial officer determinedthat we have a material weakness (as defined under the standards established bythe American Institute of Certified Public Accountants) that exists withrespect to our reporting of complex transactions. As a result of this materialweakness, we restated our financial statements in our June 30, 2004 10-QA.

 

To addressthis material weakness, we have engaged outside experts to provide counsel andguidance in areas where we cannot economically maintain the required expertiseinternally (e.g., with the appropriate classifications and treatments ofcomplex and non-routine transactions).

 

As a result ofthe material weakness identified with respect to our reporting of complex transactions,the chief executive officer and chief financial officer concluded that ourdisclosure controls and procedures are not designed and effective in ensuringthat the information required to be disclosed by our company in the reportsthat we file and submit under the Exchange Act is recorded, processed,summarized and reported within the time periods specified in the Commission’srules and forms.  Except as identifiedabove, there have been no changes in our internal control over financialreporting that occurred during the quarter ended December 31, 2004, that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

**Item 9B. Other Information.**

 

None

** **

**PART III**

** **

**Item 10. Directors and Executive Officers of the Registrant.**

 

We haveadopted a Code of Conduct that applies to all of our directors and employees,including, without limitation, our principal executive officer, our principalfinancial and accounting officer, and all of our employees performing financialor accounting functions.  We have postedour Code of Conduct on our website, www.wgate.com, under the “Investors”section. We intend to satisfy the disclosure requirements under Item 10 of Form8-K regarding an amendment to, or waiver from, any provisions of our Code ofConduct by posting such information on our website at the location specifiedabove.

 

As of December31, 2004 our executive officers and directors are as follows:

 
| **Name**                   | ** ** | **Age** | ** ** | **Position**                                                   |
|----------------------------|------------|---------|------------|----------------------------------------------------------------|
| Hal M. Krisbergh (3)       |       | 57      |       | Chairman of the Board of Directors and Chief Executive Officer |
| Joel Boyarski              |       | 58      |       | Vice President and Chief Financial Officer                     |
| Randall J. Gort            |       | 55      |       | Vice President, Chief Legal Officer and Secretary              |
| James E. McLoughlin        |       | 52      |       | Vice President, Account Development and Marketing              |
| Richard Westerfer          |       | 46      |       | Vice President and Chief Operations Officer                    |
| Steven C. Davidson(2)      |       | 56      |       | Director                                                       |
| Clarence L. Irving, Jr.(1) |       | 49      |       | Director                                                       |
| Martin Jaffe(2)            |       | 58      |       | Director                                                       |
| Jeff Morris(1)             |       | 54      |       | Director                                                       |
| Lemuel Tarshis(2)          |       | 63      |       | Director                                                       |

 

----

(1)                                  Memberof Compensation Committee

(2)                                  Memberof Audit Committee

(3)                                  Resignedfrom Compensation Committee in August 2004

 

24

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Hal M.Krisbergh has served as our Chairman and Chief Executive Officer since ourinception in March 1995. From September 1981 to September 1994, Mr. Krisberghwas an executive officer of General Instrument (now a part of Motorola, Inc.).Mr. Krisbergh served as President of General Instrument’s CommunicationsDivision and, for the past 17 years, has been a well-known figure in the cableindustry. He is a recognized leader in the development of addressable cableboxes, impulse pay-per-view, opto-electronics and digital audio technologies.In 1991, Mr. Krisbergh received cable television’s prestigious Vanguard award.Prior to joining General Instrument, Mr. Krisbergh was employed by W. R. Grace& Co., Deloitte & Touche and Raytheon Company.

 

Joel I.Boyarski joined our company in October 1999 and was named Vice President andChief Financial Officer in September 2002. Prior to becoming Vice President andChief Financial Officer, Mr. Boyarski served as General Manager of TVGateway,LLC from December 2001 until September 2002 and as Vice President of BusinessDevelopment for TVGateway, LLC from June 2000 until December 2001. From October1999 to June 2000, he served as a consultant for our company. Prior to joiningus, Mr. Boyarski was a business and financial consultant from June 1998 toOctober 1999, and for 23 years prior to June 1998, he held a variety ofmanagement positions at Joseph E. Seagram and Sons, Inc., including VicePresident of Finance and Business Planning for several of Seagram’s Domesticand International divisions including North America, Asia Pacific and GlobalDuty Free.

 

Randall J.Gort joined our company in August 1997 as Vice President, Legal and CorporateAffairs, General Counsel and Secretary. In January 2003 Mr. Gort became theCompany’s Chief Legal Officer. From July 1995 to August 1997, Mr. Gort wasGeneral Counsel, Secretary, and Director of Legal and Corporate Affairs forIntegrated Circuit Systems, Inc. Mr. Gort was in private practice from August1994 through June 1995. Prior to that time, from May 1987 through July 1994, hewas an Associate General Counsel for Commodore International Ltd. Mr. Gort waswith Schlumberger Ltd. from October 1982 through early 1987, originally asSenior Attorney and then as General Counsel, FACTRON Division. From April 1979through October 1982, Mr. Gort was Counsel for various divisions of the 3MCompany, including Medical and Surgical Products Divisions, Orthopedic ProductsDivision, Electro-Mechanical Resources Division and 3M’s four tape divisions.

 

James E.McLoughlin joined our company in February 2001 and in January 2002 was namedVice President, Marketing, Business and Account Development. Prior to thisposition, Mr. McLoughlin served as Vice President, Sales and Marketing. FromFebruary 1981 through February 2001, Mr. McLoughlin was Vice President,Affiliate Operations for Home Box Office, where he was responsible for salesand marketing of premium television services to affiliated cable televisioncompanies.

 

RichardWesterfer joined our company in February 2000 as Vice President of Engineering.In December 2000, Mr. Westerfer became Senior Vice President of Operations. Heserved in this position until April 2002, when he became Chief OperationsOfficer of WorldGate. Prior to joining us, from 1979 to February 2000, Mr.Westerfer served as the Senior Director of Engineering for General Instruments(now a part of Motorola, Inc.).

 

Steven C.Davidson has been a member of our board of directors since April 2002. From1979 until his retirement in April 2002, Mr. Davidson held various executivepositions with HBO, Inc., most recently serving as Senior Vice President andGeneral Manager of Affiliate Operations. In February 2004 Mr. Davidson returnedto HBO, Inc. as Executive Vice President of Affiliate Sales. Mr. Davidson isalso a director of Nation Fatherhood Initiative, a non-profit organization.

 

Clarence L.Irving, Jr. has been a member of our board of directors since July 2000. He hasbeen President and Chief Executive Officer of Irving Information Group, aconsulting services firm, since October 1999 and has served as a director ofCovad Communications Group, Inc. since April 1999. On August 15, 2002, CovadCommunications Group, Inc. filed a voluntary petition for relief under Chapter11 of the Federal bankruptcy code in the United States Bankruptcy Court for theDistrict of Delaware. Mr. Irving served as Assistant Secretary of Commerce tothe United States Department of Commerce from June 1993 to October 1999.

 

Martin Jaffehas been a member of our board of directors since April 2002. Since January2002, Mr. Jaffe has been the Chief Operating Officer, Managing Director andCo-Founder of Silvercrest Asset Management Group LLC. From November 2000 untilSeptember 2001, Mr. Jaffe was Chief Financial Officer of Credit Suisse AssetManagement Group LLC, and from 1981 until 

 

25

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November 2000, Mr. Jaffe wasChief Operating Officer of Donaldson, Lufkin & Jenrette Asset ManagementGroup.

 

Jeff Morrishas been a member of our board of directors since April 2001. Since April 2001,Mr. Morris has been the President of Digital Media Consulting, a new mediaconsulting company. From July 2000 to April 2001, he was President and ChiefExecutive Officer of Yack, Inc., an Internet events and program guide. Mr.Morris is a veteran of the cable television industry, including a fifteen-yeartenure from 1984 through 2000 at Showtime Networks, Inc., where his lastposition was Senior Vice President of New Media and Technology Development.

 

Lemuel Tarshishas been a member of our board of directors since April 2001. Since August1991, Dr. Tarshis has been a director for the Alliance for TechnologyManagement at the Stevens Institute of Technology. In addition, he has recentlyworked as a management consultant for Lucent Technologies Inc., Bell Atlantic,GTECH Corporation, AT&T Corporation, Aequus Technologies, LLC and VerizonCommunications, Inc.

 

**Audit Committee**

 

The AuditCommittee is responsible for providing general oversight with respect to theaccounting principles employed in our financial reporting and operates inaccordance with a written charter adopted by our Board of Directors. The AuditCommittee monitors our financial reporting process and internal control system,reviews and appraises the audit efforts of our independent accountants andprovides an avenue of communication among the independent accountants,financial and senior management and the Board of Directors. The Audit Committeemeets at least three times annually, and meets at least once annually with ourmanagement and independent public accountants to review the scope of auditingprocedures, our policies relating to internal auditing and accountingprocedures and controls, and to discuss results of the annual audit of ourfinancial statements. The Audit Committee is currently composed of Dr. Tarshis,Mr. Davidson and Mr. Jaffe, each of whom is “independent” as such term isdefined under Rule 4200(a)(15) of the NASDAQ listing standards. The AuditCommittee also complies with the financial sophistication requirement under theNASDAQ listing standards. In addition, the Board has determined that Mr. Jaffeis an audit committee financial expert as defined by SEC rules.

 

**Section 16(a) Beneficial Ownership Reporting Compliance**

 

Section 16(a)of the Securities Exchange Act of 1934 requires our directors and executiveofficers and persons who beneficially own more than 10% of our common stock(collectively, the “reporting persons”) to file reports of ownership andchanges in ownership with the Securities and Exchange Commission and to furnishus with copies of these reports. Based solely on our review of those documentsreceived by us, and written representations, if any, received from reportingpersons with respect to the filing of reports on Form 3, 4 and 5, we believethat all filings required to be made by the reporting persons for fiscal year2004 were made on a timely basis.

 

**Item 11. Executive Compensation.**

 

**Compensation Committee Interlocks and Insider Participation**

 

TheCompensation and Stock Option Committee (the “Compensation Committee”) is currentlycomposed of Messrs. Morris and Irving. The Compensation Committee isresponsible for determining the general compensation and benefits philosophyfor the Company, including administering the Company’s equity compensationprograms, and for setting cash and long-term incentive compensation forexecutive officers and other key employees of the Company. No member of theCompensation Committee is an officer or employee of the Company.

 

**Report of Compensation and Stock Option Committee on Executive Compensation**

 

This report bythe Compensation Committee of the Board of Directors (the “Committee”)discusses the Committee’s compensation objectives and policies applicable tothe Company. The report reviews the Committee’s policy generally with respectto the compensation of all executive officers as a group for fiscal 2004 andspecifically reviews the compensation established for the Company’s ChiefExecutive Officer as reported in the Summary Compensation Table. The Committeeis composed entirely of non-employee directors of the Company. The Committeealso administers the Company’s Stock Option Plan and Employee Stock PurchasePlan.

 

26

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**Compensation**

 

Ourcompensation policies are intended to create a direct relationship between thelevel of compensation paid to employees and our current and long-term level ofperformance. The Committee believes that this relationship is best implementedby providing a compensation package of separate components, all of which are designedto enhance our overall performance. The components are base salary, short-termcompensation in the form of annual bonuses and long-term incentive compensationin the form of stock options.

 

The basesalaries, targeted bonus amounts and number of stock options established for orgranted to our executive officers for 2004 are based, in part, on the Committee’sunderstanding of compensation amounts and forms paid to persons in comparableroles performing at comparable levels at other companies in the same or relatedindustries. Such amounts, however, mainly reflect the subjective discretion ofthe members of the Committee based on the evaluation of our current andanticipated future performance and the contribution of the individual executiveofficers to such performance, and the contribution of the individual executiveofficers to us in areas not necessarily reflected by our performance.

 

Base Salaries

The basesalaries for our senior executive officers for 2004 were establishedsubjectively by the Committee based on the market environment and our need toattract and retain key personnel for whom we must compete against larger, moreestablished companies. Also considered was the absence of a general salaryincrease during 2003 in light of our need to conserve cash.

 

Short-Term Annual Bonuses

Annual bonusesestablished for the executive officers are intended to provide an incentive forimproved performance in the short term. Normally the Committee would establishtarget bonus levels at the beginning of the year based on predetermined goalswith respect to individual, department and Company performance, however, giventhe Company’s need to conserve cash, no bonuses were provided during 2004.

 

Long-Term Incentive Compensation

Our long-termincentive compensation plan for its senior executive officers, administeredthrough the Company’s stock option plan, promotes ownership of the our CommonStock, which, in turn, provides a common interest between our shareholders andour executive officers. Options granted to executive officers under the planhave an exercise price equal to the fair market value of the shares on the dateof grant, an exercise period of ten years and generally vest over four years.The number of options granted to executive officers is determined by theCommittee, which is charged with administering the stock option plan. During2003 the Committee analyzed various equity incentive programs provided by peergroup companies and determined that it was advisable to include equityalternatives other than traditional stock options within its compensationstrategy. Accordingly, in November 2003, the Committee, as well as the othermembers of the board of directors, unanimously approved a new equitycompensation plan (the “2003 Plan”) and requested that this plan be submittedfor shareholder approval at our next shareholder meeting. This plan wasapproved by our shareholders at the October 2004 annual shareholders’ meeting.The plan as approved by the board and our shareholders does not authorize anyincremental shares for issuance thereunder, but rather transfers the balanceavailable for issuance under its predecessor, the 1996 Plan, after allissuances thereunder. The 1996 Plan will continue to be in effect for thegrants which are currently outstanding under that plan, however, new grantswill be issued under the 2003 Plan.

 

**Summary Compensation Table**

 

The followingtable sets forth information concerning compensation paid with respect to ourchief executive officer and four other most highly compensated officers whowere serving as such as of December 31, 2004, each of whose aggregatecompensation for fiscal 2004 exceeded $100,000, for services rendered in allcapacities for us and our subsidiaries.

 

27

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**SUMMARY COMPENSATION TABLE**

**FISCAL YEARS 2004, 2003 and 2002**

** **
| ** **                                         | ** ** | ** ** | ** ** | ** **              | ** ** | **Long Term Compensation   Awards** | ** ** |
|----------------------------------------------------|------------|------------|------------|-------------------------|------------|-------------------------------------|------------|
| ** **                                         | ** ** | ** ** | ** ** | **Annual Compensation** | ** ** | **Securities   Underlying**         | ** ** | **All Other** | ** ** |
| **Name and Principal Position**                    | ** ** | **Year**   | ** ** | **Salary**              | ** ** | **Bonus**                           | ** ** | **Options (#)** | ** ** | **Compensation** | ** ** |
| Hal M. Krisbergh                                   |       | 2002       |       | $                       | 337,080    |                                | $          | 37,913 |   | 80,000 |   | — |   |
| Chairman and Chief Executive Officer               |       | 2003       |       | $                       | 337,080    |                                | —     |   | — |   | — |   |
|                                               |       | 2004       |       | $                       | 349,497    |                                | —     |   | — |   | — |   |
| Richard Westerfer                                  |       | 2002       |       | $                       | 214,616    |                                | $          | 17,145 |   | 49,000 |   | — |   |
| Vice President, Chief Operations Officer           |       | 2003       |       | $                       | 209,192    |                                | —     |   | 200,000 |   | — |   |
|                                               |       | 2004       |       | $                       | 219,531    |                                | —     |   | 225,000 |   | — |   |
| Randall J. Gort                                    |       | 2002       |       | $                       | 200,769    |                                | $          | 15,831 |   | 24,000 |   | — |   |
| Vice President, Chief Legal Officer                |       | 2003       |       | $                       | 200,000    |                                | —     |   | 200,000 |   | — |   |
|                                               |       | 2004       |       | $                       | 207,385    |                                | —     |   | 222,250 |   | — |   |
| Joel Boyarski                                      |       | 2002       |       | $                       | 188,884    |                                | $          | 13,038 |   | 75,000 |   | — |   |
| Vice President, Chief Financial Officer            |       | 2003       |       | $                       | 195,570    |                                | —     |   | 200,000 |   | — |   |
|                                               |       | 2004       |       | $                       | 202,791    |                                | —     |   | 195,000 |   | — |   |
| James McLoughlin                                   |       | 2002       |       | $                       | 189,513    |                                | $          | 16,450 |   | 18,400 |   | — |   |
| Vice President, Account Development and  Marketing |       | 2003       |       | $                       | 190,800    |                                | —     |   | 161,500 |   | — |   |
|                                               |       | 2004       |       | $                       | 197,845    |                                | —     |   | 195,000 |   | — |   |

 

TheCompensation Committee has the authority to administer the long term incentiveplans and to exercise all the powers and authorities either specificallygranted to it under, or necessary or advisable in the administration of theplans, including, without limitation, the authority to grant awards; todetermine the persons to whom and the time or times at which awards shall begranted; to determine the type and number of awards to be granted, the numberof shares of common stock to which an award may relate and the terms,conditions, restrictions and performance goals relating to any award; todetermine whether, to what extent, and under what circumstances an award may besettled, canceled, forfeited, exchanged, or surrendered; to make adjustments inthe performance goals in recognition of unusual or non-recurring eventsaffecting us or our financial statements of WorldGate (to the extent notinconsistent with Section 162(m) of the Code, if applicable), or inresponse to changes in applicable laws, regulations, or accounting principles;to construe and interpret the plans and any award; to prescribe, amend andrescind rules and regulations relating to the plans; to determine the terms andprovisions of agreements evidencing awards; and to make all otherdeterminations deemed necessary or advisable for the administration of theplans. Generally, outstanding awards vest in equal installments over a four-yearperiod. However, in no event may a stock option be exercised more than tenyears following the date of its grant, subject to acceleration in the event ofsome changes of control of WorldGate.

 

The purchaseprice per share payable upon the exercise of an option (the “option exerciseprice”) will be established by the Compensation Committee, provided, however,that incentive stock options may not have an option exercise price less thanthe fair market value of a share of common stock on the date of grant. Theoption exercise price is payable by any one of the following methods or acombination thereof, to the extent permitted by the Compensation Committee:

 

•                                          incash or by check or wire transfer,

 

•                                          subjectto the approval of the Compensation Committee, in common stock owned by theparticipant for at least six months prior to the date of exercise and valued attheir fair market value on the effective date of such exercise, or

 

•                                          subjectto the approval of the Compensation Committee, by such other provision as theCompensation Committee may from time to time authorize.

 

Our board ofdirectors or the Compensation Committee may suspend, revise, terminate or amendthe equity incentive plans at any time, provided, however, that:

 

•                                          stockholderapproval will be obtained if and to the extent required under Rule 16b-3promulgated under the Exchange Act or if and to the extent the board determinesthat such approval is required for purposes of satisfying Section 162(m)or Section 422 of the Code, and

 

•                                          nosuch suspension, revision, termination or amendment may, without the consent ofa participant, reduce the participant’s rights under any outstanding award.

 

OnOctober 5, 2001, our shareholders approved the WorldGate 2001 EmployeeStock Purchase Plan (the “Stock Purchase Plan”). The Stock Purchase Planprovides our eligible employees with the opportunity to periodically acquireshares of our 

 

28

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common stock through payroll deductions. In general, the Stock PurchasePlan provides that:

 

•                                          eachemployee who has completed six months of continuous employment with us iseligible to participate in the Stock Purchase Plan so long as the employeecustomarily works at least 20 hours per week and 5 months per year;

 

•                                          participantsin the Stock Purchase Plan are permitted to contribute up to fifteen percent oftheir compensation towards the purchase of our common stock;

 

•                                          atthe end of each calendar quarter, the contributions of the participants areused to purchase shares of our common stock at the lower of eighty-five percentof the market price of our common stock: (i) at the beginning of eachcalendar quarter or (ii) at the end of each calendar quarter;

 

•                                          sharesof our common stock that are purchased under the Stock Purchase Plan are nottransferable by the participant until at least nine months has elapsed from theacquisition of the shares;

 

•                                          amaximum of 750,000 shares of our common stock (plus an annual increase of375,000 shares) may be purchased in the aggregate by participants in the StockPurchase Plan; and

 

•                                          ourBoard of Directors has the power and authority to administer the Stock PurchasePlan and may, subject to certain limitations suspend, revise, terminate oramend the Stock Purchase Plan.

 

The followingtable presents information regarding options granted to our named executiveofficers during fiscal 2004 to purchase shares of our common stock. Inaccordance with SEC rules, the table shows the hypothetical “gains” or “optionspreads” that would exist for the respective options based on assumed rates ofannual compound stock price of 5% and 10% from the date the options weregranted over the full option term.

 

**Options/SAR Grants in Last Fiscal Year**

 
| ** **        | ** ** | **Individual Grants**                                              | ** ** | ** **                                                  | ** ** |
|-------------------|------------|--------------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **        | ** ** | **Number of   Securities   Underlying   Options/  SARs   Granted** | ** ** | **% of Total   Options/  SARs   Granted to   Employees in** | ** ** | **Exercise  or Base  Price** | ** ** | ** ** | ** ** | **Potential Realizable Value at   Assumed Annual Rates of   Stock Price Appreciation for   Option Term** | ** ** |
| **Name**          | ** ** | **(#)**                                                            | ** ** | **Fiscal Year**                                             | ** ** | **($/SH)** | ** ** | **Expiration Date** | ** ** | **5% ($)** | ** ** | **10% ($)** | ** ** |
| Hal M. Krisbergh  |       | —                                                             |       | —                                                      |       | — |   | — |   | — |   | — |   |
| Richard Westerfer |       | 200,000                                                            |       | 17.1                                                        |       | 1.06 |   | 1/1/14 |   | 133,494 |   | 338,398 |   |
|              |       | 25,000                                                             |       | 2.1                                                         |       | 4.43 |   | 12/22/14 |   | 69,738 |   | 176,781 |   |
| Randall J. Gort   |       | 200,000                                                            |       | 17.1                                                        |       | 1.06 |   | 1/1/14 |   | 133,494 |   | 338,398 |   |
|              |       | 22,250                                                             |       | 2.1                                                         |       | 4.43 |   | 12/22/14 |   | 62,764 |   | 159,103 |   |
| Joel Boyarski     |       | 175,000                                                            |       | 14.9                                                        |       | 1.06 |   | 1/1/14 |   | 116,807 |   | 296,098 |   |
|              |       | 20,000                                                             |       | 1.7                                                         |       | 4.43 |   | 12/22/14 |   | 55,791 |   | 141,425 |   |
| James McLoughlin  |       | 175,000                                                            |       | 14.9                                                        |       | 1.06 |   | 1/1/14 |   | 116,807 |   | 296,098 |   |
|              |       | 20,000                                                             |       | 1.7                                                         |       | 4.43 |   | 12/22/14 |   | 55,791 |   | 141,425 |   |

 

The followingtable shows the number of shares of common stock subject to exercisable andunexercisable stock options held by each of the named executive officers as ofDecember 31, 2004. The table also reflects the values of such options based onthe positive spread between the exercise price of such options and $4.99, whichwas the per share closing sales price reported on the NASDAQ Small Cap Marketon December 31, 2004.

 

29

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**Aggregated Option/SAR Exercises in LastFiscal Year and FY-End Option SAR Values**

** **
| **Name**          | ** ** | **Shares   acquired on   exercise   (#)** | ** ** | **Value Realized   ($)** | ** ** | **Number of securities   underlying   unexercised options/   SARS at fiscal year   end (#) Exercisable/   Unexercisable** | ** ** | **Value of unexercised   in-the-money   options/SARS at   fiscal year end ($)   Exercisable/Unexercisable** | ** ** |
|-------------------|------------|-------------------------------------------|------------|--------------------------|------------|---------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|
| Hal M. Krisbergh  |       | —                                    |       | —                   |       | 220,000/40,000                                                                                                            |       | 534,416/136,016                                                                                             |       |
|              |       |                                      |       |                     |       |                                                                                                                      |       |                                                                                                        |       |
| Richard Westerfer |       | —                                    |       | —                   |       | 235,500/399,500                                                                                                           |       | 645,204/1,537,840                                                                                           |       |
|              |       |                                      |       |                     |       |                                                                                                                      |       |                                                                                                        |       |
| Randall J. Gort   |       | —                                    |       | —                   |       | 189,333/384,500                                                                                                           |       | 537,281/1,504,065                                                                                           |       |
|              |       |                                      |       |                     |       |                                                                                                                      |       |                                                                                                        |       |
| Joel Boyarski     |       | —                                    |       | —                   |       | 115,738/360,000                                                                                                           |       | 410,309/1,422,535                                                                                           |       |
|              |       |                                      |       |                     |       |                                                                                                                      |       |                                                                                                        |       |
| James McLoughlin  |       | —                                    |       | —                   |       | 79,575/335,325                                                                                                            |       | 204,952/1,266,149                                                                                           |       |

 

**Compensation of Directors**

 

Pursuant toour 2003 Equity Incentive Plan, non-employee directors, currentlyMessrs. Davidson, Jaffe, Irving, Morris and Tarshis, will receive anannual stock grant of 10,000 shares, vesting in equal amounts over four years,issued at the fair market value on the date of grant, a stipend of $1,000 foreach board or committee meeting the director attends in person, and $250 foreach meeting attended telephonically. Furthermore, we paid an annual stipend of$5,000 for 2004 and will pay $10,000 for each year thereafter, as well as aninitial stock grant of 30,000 shares upon becoming a non-employeedirector.  We will continue to reimbursenon-employee directors for reasonable travel expenses for attending board orcommittee meetings.

 

**Item 12.  Security Ownership of CertainBeneficial Owners and Management, and Related Stockholder Matters.**

 

The followingtable sets forth information as of December 31, 2004 regarding securitiesauthorized for issuance under the Company’s equity compensation plans:

 

##### Equity Compensation Plan Information

 
| **Plan Category**                                           | ** ** | **Number of securities to   be issued upon exercise   of outstanding options,   warrants and rights   (a)** | ** ** | **Weighted-average   exercise price of   outstanding   options, warrants   and rights   (b)** | ** ** | **Number of securities   remaining available   for future issuance   under equity   compensation plans   (excluding securities   reflected in column (a)   (c)** | ** ** |
|-------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity  compensation plans approved by security holders     |       | 4,536,677                                                                                                   |       | $                                                                                             | 1.87       |                                                                                                                                                                  | 1,673,774  | (1) |
| Equity  compensation plans not approved by security holders |       | —                                                                                                      |       | —                                                                                        |       | —                                                                                                                                                                |       |
|                                                             |            |                                                                                                             |            |                                                                                               |            |                                                                                                                                                                       |            |  |

 

----

(1)                                  InOctober 2004 our shareholders approved a new Equity Incentive Plan.  The Equity Incentive Plan as approved doesnot authorize any incremental shares for issuance thereunder, but rathertransfers the balance available for issuance under the 1996 Stock Option Planafter all issuances thereunder. Although our 1996 Stock Option Plan remains ineffect for any outstanding options issued under that plan we do not intend toissue new grants under that plan.  Boththe 1996 Stock Option Plan and its successor, the Equity Incentive Plan containa provision that automatically increases the number of shares available forfuture issuances as of January 1st of each calendar year.  The increase is equal to the lesser of (i)four (4) percent of the issued and outstanding shares of company stock(determined as of the first day of each such year), or 

 

30

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(ii)   1,000,000shares of common stock.

 

The followingtable sets forth information as of March 10, 2004 regarding beneficialownership of our common stock by the following persons:

 

•                                          eachperson who is known to us to own beneficially more than 5% of the outstandingshares of common stock,

 

•                                          eachdirector,

 

•                                          eachexecutive officer named in the executive compensation table above, and

 

•                                          alldirectors and executive officers as a group.

 

Unless otherwise indicated below, to our knowledge, all persons listedbelow have sole voting and investment power with respect to their shares ofcommon stock, except to the extent authority is shared by spouses underapplicable law. Beneficial ownership is determined in accordance with the rulesof the SEC, based on factors including voting and investment power with respectto shares, subject to applicable community property laws. Shares of commonstock subject to options or warrants exercisable within 60 days of March5, 2005 are deemed outstanding for the purpose of computing the percentageownership of the person holding such options or warrants, but are not deemedoutstanding for computing the percentage ownership of any other person. Unlessotherwise indicated, the mailing address of the beneficial owners is 3190Tremont Avenue, Suite 100, Trevose, Pennsylvania 19053.

 
| **Name of Beneficial Owner**                                          | ** ** | **Number of Shares of   Common Stock   Beneficially Owned** | ** ** | **Percent of   Ownership** | ** ** |
|-----------------------------------------------------------------------|------------|-------------------------------------------------------------|------------|----------------------------|------------|
| Hal M. Krisbergh(1)                                                   |       | 6,008,613                                                   |       | 19.0                       | %          |
| Randall J. Gort(2)                                                    |       | 429,525                                                     |       | 1.4                        | %          |
| Richard Westerfer (3)                                                 |       | 307,241                                                     |       |                       | *          |
| Joel Boyarski(4)                                                      |       | 183,238                                                     |       |                       | *          |
| James McLoughlin(5)                                                   |       | 142,550                                                     |       |                       | *          |
| Steven C. Davidson(6)                                                 |       | 28,250                                                      |       |                       | *          |
| Martin Jaffe(7)                                                       |       | 33,250                                                      |       |                       | *          |
| Clarence L. Irving, Jr.(8)                                            |       | 36,357                                                      |       |                       | *          |
| Jeff Morris(9)                                                        |       | 31,125                                                      |       |                       | *          |
| Lem Tarshis(10)                                                       |       | 61,191                                                      |       |                       | *          |
| All current directors and executive  officers as a group (10 persons) |       | 7,261,340                                                   |       | 22.9                       | %          |

 

----

*                                         Less than 1%of the outstanding Common Stock.

 

(1)                                  Includes options topurchase 220,000 shares of common stock. Also includes 3,488,670 shares ofcommon stock held directly, 1,700,000 shares of common stock held withingrantor retained trusts in which either Mr. Krisbergh or his spouse aretrustees, 299,938 shares of common stock held by Mr. Krisbergh’s spouseand 300,000 shares of common stock held by the Krisbergh Family Foundation,with Mr. Krisbergh acting as the custodian for these shares.

 

(2)                                  Includes options topurchase 254,583 shares of common stock. Also includes 106,063 shares of common stock held directly and 68,879shares of common stock held by Mr. Gort as custodian for his minorchildren.

 

(3)                                  Includes options topurchase 307,000 shares of common stock and 241 shares of common stock held byMr. Westerfer’s minor son.

 

(4)                                  Includes options topurchase 181,238 shares of common stock. Also includes 2,000 shares of commonstock held directly.

 

(5)                                  Includes options topurchase 142,550  shares of common stock.

 

(6)                                  Includes options topurchase 18,250 shares of common stock. Also includes 10,000 shares of commonstock held directly.

 

31

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(7)                                  Includes options topurchase 18,250 shares of common stock. Also includes 15,000 shares of commonstock held directly.

 

(8)                                  Includes options topurchase 36,375 shares of common stock.

 

(9)                                  Includes options topurchase 31,125 shares of common stock.

 

(10)                            Includes options topurchase 44,791 shares of common stock. Also includes 5,200 shares of common stock held directly and 12,000shares of common stock held by Mr. Tarshis’ spouse.

 

**Item 13. Certain Relationships and Related Transactions**

 

None.

 

**Item 14. Principal Accountant Fees and Services**

 

The aggregatefees for professional services rendered to us by Grant Thornton LLP andPricewaterhouseCoopers LLP, our independent registered public account firms,for the fiscal year ended December 31, 2003 and Grant Thornton LLP, ourindependent registered public account firm for this fiscal year ended December31, 2004, are as follows (in whole dollars):

 
| ** **         | ** ** | **Fiscal Years Ended December 31** | ** ** |
|--------------------|------------|------------------------------------|------------|
| ** **         | ** ** | **2003**                           | ** ** | **2004** | ** ** |
|               |       |                               |       |   |   |
| Audit fees         |       | $                                  | 112,780    | (1) | $ | 93,320 |   |
| Audit related fees |       | 22,650                             | (2)        | 45,328 |   |
| Tax fees           |       | 27,000                             | (3)        | 36,401 |   |
| All other fees     |       | 0                                  |       | 0 |   |
|               |       |                               |       |   |   |
| Total              |       | $                                  | 162,430    |   | $ | 175,049 |   |

 

----

(1)                                  Ofthis amount $83,430 was attributable to Grant Thornton and $29,350 wasattributable to PricewaterhouseCoopers LLP.

(2)                                  Ofthis amount $0 was attributable to Grant Thornton and $22,650 was attributableto PricewaterhouseCoopers LLP.

(3)                                  Ofthis amount $0 was attributable to Grant Thornton and $27,000 was attributableto PricewaterhouseCoopers LLP.

 

###### *Audit Fees*

 

The “audit fees” reportedabove were billed to us by Grant Thornton LLP and PricewaterhouseCoopers LLPfor professional services rendered in connection with their audit of ourconsolidated financial statements and their limited reviews of our unauditedconsolidated financial statements and our unaudited consolidated interimfinancial statements included in our quarterly reports, and for servicesnormally provided by Grant Thornton LLP and PricewaterhouseCoopers LLP inconnection with other statutory and regulatory filings or engagements,including audit consultations and SEC comment letters.

 

*AuditRelated Fees*

 

The “auditrelated fees” reported above were billed to us by Grant Thornton LLP andPricewaterhouseCoopers LLP for assurance and related services that werereasonably related to the performance of their audit or review of our financialstatements, but which are not reported as Audit Fees. These services includeaccounting consultations in connection with the impact of prospectiveaccounting pronouncements and stock based compensation matters.

 

*TaxFees*

 

During thefiscal years reported above, Grant Thornton LLP and PricewaterhouseCoopers LLPrendered professional services to us relating to tax compliance, tax advice, ortax planning.

 

32

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*AllOther Fees*

 

During thefiscal years reported above, Grant Thornton LLP and PricewaterhouseCoopers LLPrendered no professional services to us other than for those relating to audit,audit related and tax matters.

 

*AuditCommittee Pre-approval Policies and Procedures*

 

Our auditcommittee has adopted a policy requiring the pre-approval of all audit andpermissible nonaudit services provided by our independent public auditors.Under the policy, the audit committee is to specifically pre-approve before theend of each fiscal year any recurring audit and audit related services to beprovided during the following fiscal year. The audit committee also maygenerally pre-approve, up to a specified maximum amount, any nonrecurring auditand audit related services for the following fiscal year. All pre-approvedmatters must be detailed as to the particular service or category of servicesto be provided, whether recurring or non-recurring, and reported to the auditcommittee at its next scheduled meeting. Permissible nonaudit services are tobe pre-approved on a case-by-case basis. The audit committee may delegate itspre-approval authority to any of its members, provided that such member reportsall pre-approval decisions to the audit committee at its next scheduledmeeting. Our independent public auditors and members of management are requiredto report periodically to the audit committee the extent of all servicesprovided in accordance with the pre-approval policy, including the amount offees attributable to such services.

 

In accordancewith Section 10A(i)(2) of the Securities Exchange Act of 1934, as amendedby Section 202 of the Sarbanes-Oxley Act of 2002, we are required todisclose the approval by the audit committee of the Board of Directors of non-auditservices to be performed by Grant Thornton LLP, the Company’s independentauditors. Non-audit services are services other than those provided inconnection with an audit or review of the financial statements. During theperiod covered by this filing, the audit committee approved all audit relatedfees, tax fees and all other fees.

 

### **PART IV**

 

**Item 15. Exhibits, Financial Statement Schedules, and Reports onForm 8-K.**

 

**(a)****                                  Documentsfiled as part of this report.**

 

**1.****                                      FinancialStatements**

 

The followingfinancial statements have been included as part of this report:

 
| Report of  Grant Thornton LLP, Independent Registered Public Accounting Firm         |   |
|--------------------------------------------------------------------------------------|--------|
| Report of  PricewaterhouseCoopers LLP, Independent Registered Public Accounting Firm |   |
| Consolidated  Balance Sheets                                                         |   |
| Consolidated  Statements of Operations                                               |   |
| Consolidated  Statements of Stockholders’ Equity                                |   |
| Consolidated  Statements of Cash Flows                                               |   |
| Notes to  Consolidated Financial Statements                                          |   |

 

33

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**2.  Financial Statement Schedule**

 

**WORLDGATE COMMUNICATIONS, INC.**

**SCHEDULE II—VALUATION AND QUALIFYING ACCOUNTS**

** **
| ** **                                    | ** ** | **Balance at  Beginning of  Year** | ** ** | **Additions Charged  to Cost and  Expenses** | ** ** | **Deductions  Credited to  Costs and  Expenses** | ** ** | **Balance at  end of Year** | ** ** |
|-----------------------------------------------|------------|------------------------------------|------------|----------------------------------------------|------------|--------------------------------------------------|------------|-----------------------------|------------|
| ** **                                    | ** ** | **($000 Omitted)**                 | ** ** |
| Allowance for doubtful accounts:              |       |                               |       |                                         |       |                                             |       |                        |       |
| Year ended December 31, 2002                  |       | 996                                |       | 628                                          |       | (28                                              | )          | 1,596                       |       |
| Year ended December 31, 2003                  |       | 1,596                              |       | 651                                          |       | (1,866                                           | )          | 381                         |       |
| Year ended December 31, 2004                  |       | 381                                |       | 0                                            |       | (381                                             | )          | 0                           |       |
| Valuation Allowance for Deferred Tax  Assets: |       |                               |       |                                         |       |                                             |       |                        |       |
| Year ended December 31, 2002                  |       | 61,350                             |       | 8,144                                        |       |                                             |       | 69,494                      |       |
| Year ended December 31, 2003                  |       | 69,494                             |       | 3,407                                        |       |                                             |       | 72,901                      |       |
| Year ended December 31, 2004                  |       | 72,901                             |       | 6,389                                        |       |                                             |       | 79,290                      |       |

 

All other schedules for which provision ismade in the applicable accounting regulations of the Securities and ExchangeCommission are not required under the related instructions or are inapplicable,and therefore have been omitted.

 

**3.  Exhibits**

 
| **Exhibit** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                             |
|-------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1         |       | Amended and  Restated Certificate of Incorporation (11)                                                                                                                                                                                                                                                                                     |
| 3.2         |       | Amended and  Restated Bylaws (2)                                                                                                                                                                                                                                                                                                            |
| 3.3         |       | Certificate  of Amendment to Certificate of Incorporation, dated October 18, 2004 (11)                                                                                                                                                                                                                                                      |
| 3.4         |       | Certificate  of Designations, Preferences and Rights of the Series A Convertible Preferred  Stock of the Company dated June 24, 2004 (11)                                                                                                                                                                                                   |
| 4.1         |       | Form of  Warrant issued by the Company to the Purchasers (as defined in the Amended  and Restated Securities Agreement dated as of December 4, 2003) (4)                                                                                                                                                                                    |
| 4.2         |       | Form of  Additional Investment Right issued by the Company to the Purchasers (as  defined in the Amended and Restated Securities Agreement dated as of December  4, 2003) (4)                                                                                                                                                               |
| 4.3         |       | Form of  Warrant issued by the Company to the Purchasers (as defined in the Securities  Purchase Agreement dated as of January 20, 2004) (7)                                                                                                                                                                                                |
| 4.4         |       | Form of  Additional Investment Right dated issued by the Company to the Purchasers (as  defined in the Securities Purchase Agreement dated as of January 20, 2004)  (7)                                                                                                                                                                     |
| 4.5         |       | Form of  Series A Warrant issued by the Company to the Investors (as defined in the  Securities Purchase Agreement dated as of June 24, 2004) (8)                                                                                                                                                                                           |
| 4.6         |       | Form of  Series B Warrant issued by the Company to the Investors (as defined in the  Securities Purchase Agreement dated as of June 24, 2004 between the Company  and the Investors) (8)                                                                                                                                                    |
| 4.7         |       | Form of  Series C Warrant issued by the Company to the Investors (as defined in the  Securities Purchase Agreement dated as of June 24, 2004 between the Company  and the Investors) (8)                                                                                                                                                    |
| 4.8         |       | Form of  Warrant issued by the Company to Mr. K.Y.Chou (13)                                                                                                                                                                                                                                                                                 |
| 10.1        |       | Lease  Agreement dated October 7, 1998 between WorldGate and Balanced Capital LLC,  as amended by First Amendment to Lease Agreement dated December 7, 1998  between WorldGate and Balanced Capital LLC, as further amended by Second  Amendment to Lease Agreement dated December 17, 1998 between WorldGate and  Balanced Capital LLC (1) |
| 10.2        |       | Amendment  dated November 18, 2004 to Lease Agreement dated October 7, 1998 between  WorldGate and Balanced Capital LLC (12)                                                                                                                                                                                                                |
| 10.3        |       | Manufacturing  Agreement between WorldGate and Mototech Inc. dated September 9, 2003 (6)                                                                                                                                                                                                                                                    |

 

34

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| 10.4 |   | Development  and Distribution Agreement dated as of April 28, 2004 between the Company,  WorldGate Services, Inc. and General Instrument Corporation d/b/a the  Broadband Communication Sector of Motorola, Inc. (9) (Portions of this  agreement are subject to a confidential treatment request.) |
|------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.5 |   | 1996 Stock  Option Plan (3)                                                                                                                                                                                                                                                                         |
| 10.6 |   | 2003 Equity  Incentive Plan(10)                                                                                                                                                                                                                                                                     |
| 10.7 |   | Amended and  Restated Securities Purchase Agreement dated as of December 4, 2003, by and  between the Company and the Purchasers (as defined therein) (5)                                                                                                                                           |
| 10.8 |   | Securities  Purchase Agreement dated as of January 20, 2004 by and between the Company  and the Purchasers (as defined therein) (7)                                                                                                                                                                 |
| 10.9 |   | Securities  Purchase Agreement dated as of June 24, 2004 by and between the Company and  the Investors (as defined therein) (8)                                                                                                                                                                     |
| 21   |   | Subsidiaries**                                                                                                                                                                                                                                                                                      |
| 23.1 |   | Consent of  PricewaterhouseCoopers LLP*                                                                                                                                                                                                                                                             |
| 23.2 |   | Consent of  Grant Thornton LLP*                                                                                                                                                                                                                                                                     |
| 24   |   | Power of  Attorney**                                                                                                                                                                                                                                                                                |
| 31.1 |   | Certification  of Chief Executive Officer Pursuant to Rule 13a-14(a)*                                                                                                                                                                                                                               |
| 31.2 |   | Certification  of Chief Financial Officer Pursuant to Rule 13a-14(a)*                                                                                                                                                                                                                               |
| 32.1 |   | Certification  of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted by  Section 906 of the Sarbanes-Oxley Act of 2002*                                                                                                                                                         |
| 32.2 |   | Certification  of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted by  Section 906 of the Sarbanes-Oxley Act of 2002*                                                                                                                                                         |

 

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*                      Filedherewith

**               Previouslyfiled

(1)               Incorporatedby reference to the exhibits to our Registration Statement on Form S-1/A asfiled on April 7, 1999 (Registration No. 333-71997).

(2)               Incorporatedby reference to the exhibits to our Form 10-Q Report for the quarter endedMarch 31, 1999.

(3)               Incorporatedby reference to the exhibits to our Form 10-K/A Report for the fiscal yearended December 31, 2000, as filed on August 17, 2001.

(4)               Incorporatedby reference to the exhibits to our Current Report on Form 8-K filedDecember 2, 2003.

(5)               Incorporatedby reference to the exhibits to our Current Report on Form 8-K filedDecember 4, 2003.

(6)               Incorporatedby reference to the exhibits to our Registration Statement on Form SB-2 asfiled on 12/24/03  (RegistrationNo. 333-111571).

(7)               Incorporatedby reference to the exhibits to our Current Report on Form 8-K filedJanuary 21, 2004.

(8)               Incorporatedby reference to the exhibits to our Current Report on Form 8-K filed June25, 2004.

(9)               Incorporatedby reference to the exhibits to our Current Report on Form 8-K filedJuly 13, 2004.

(10)         Incorporatedby reference to the exhibits to the Company’s Proxy Statement to shareholdersfiled September 3, 2004.

(11)         Incorporatedby reference to the exhibits to our Form 10-Q Report for the quarter endedSeptember 30, 2004, as filed on November 17, 2004.

(12)         Incorporatedby reference to the exhibits to our Form 10-K Report for the fiscal yearended December 31, 2003, as filed on March 31, 2005.

(13)         Incorporatedby reference to the exhibits to our Registration Statement on Form SB-2 asfiled on May 24, 2005.

 

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**SIGNATURES**

 

Pursuant tothe requirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.

 
|                  | WorldGate Communications, Inc. |
|-----------------------|-------------------------------------|
|                  |                                |
|                  |                                |
| Date: August 29, 2005 | By:                                 | /s/ Hal M. Krisbergh |
|                  |                                | Hal M. Krisbergh |
|                  |                                | *Chief Executive Officer* |

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.

 
| **Name**                              | ** ** | **Capacity**                                      | ** ** | **Date**             |
|---------------------------------------|------------|---------------------------------------------------|------------|----------------------|
| ** **                            | ** ** | ** **                                        | ** ** | ** **           |
| /s/ Hal M. Krisbergh                  |       | Chairman of the Board and Chief Executive Officer |       |                 |
| Hal M. Krisbergh                      |       | (principal executive officer)                     |       | August 29, 2005 |
|                                  |       |                                              |       |                 |
| /s/ RANDALL J. GORT, ATTORNEY-IN-FACT |       |                                              |       |                 |
| Joel Boyarski                         |       | Vice President and Chief Financial Officer        |       | August 29, 2005 |
|                                  |       |                                              |       |                 |
| /s/ RANDALL J. GORT, ATTORNEY-IN-FACT |       |                                              |       |                 |
| Steven C. Davidson                    |       | Director                                          |       | August 29, 2005 |
|                                  |       |                                              |       |                 |
| /s/ RANDALL J. GORT, ATTORNEY-IN-FACT |       |                                              |       |                 |
| Martin Jaffe                          |       | Director                                          |       | August 29, 2005 |
|                                  |       |                                              |       |                 |
| /s/ RANDALL J. GORT, ATTORNEY-IN-FACT |       |                                              |       |                 |
| Clarence L. Irving, Jr.               |       | Director                                          |       | August 29, 2005 |

 

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* By Power of Attorney

 

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| ** **                            | ** ** | ** ** | ** ** | ** **           |
|---------------------------------------|------------|------------|------------|----------------------|
| /s/ RANDALL J. GORT, ATTORNEY-IN-FACT |       |       |       |                 |
| Jeff Morris                           |       | Director   |       | August 29, 2005 |
|                                  |       |       |       |                 |
| /s/ RANDALL J. GORT, ATTORNEY-IN-FACT |       |       |       |                 |
| Lemuel Tarshis                        |       | Director   |       | August 29, 2005 |

 

37

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**Exhibit Index**

 
| **Exhibit** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                            |
|-------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1         |       | Amended and Restated Certificate of Incorporation (11)                                                                                                                                                                                                                                                                                     |
| 3.2         |       | Amended and Restated Bylaws (2)                                                                                                                                                                                                                                                                                                            |
| 3.3         |       | Certificate of Amendment to Certificate of Incorporation, dated  October 18, 2004 (11)                                                                                                                                                                                                                                                     |
| 3.4         |       | Certificate of Designations, Preferences and Rights of the Series A  Convertible Preferred Stock of the Company dated June 24, 2004 (11)                                                                                                                                                                                                   |
| 4.1         |       | Form of Warrant issued by the Company to the Purchasers (as defined  in the Amended and Restated Securities Agreement dated as of December 4,  2003) (4)                                                                                                                                                                                   |
| 4.2         |       | Form of Additional Investment Right issued by the Company to the  Purchasers (as defined in the Amended and Restated Securities Agreement dated  as of December 4, 2003) (4)                                                                                                                                                               |
| 4.3         |       | Form of Warrant issued by the Company to the Purchasers (as defined  in the Securities Purchase Agreement dated as of January 20, 2004) (7)                                                                                                                                                                                                |
| 4.4         |       | Form of Additional Investment Right dated issued by the Company to  the Purchasers (as defined in the Securities Purchase Agreement dated as of  January 20, 2004) (7)                                                                                                                                                                     |
| 4.5         |       | Form of Series A Warrant issued by the Company to the Investors (as defined  in the Securities Purchase Agreement dated as of June 24, 2004) (8)                                                                                                                                                                                           |
| 4.6         |       | Form of Series B Warrant issued by the Company to the Investors (as  defined in the Securities Purchase Agreement dated as of June 24, 2004  between the Company and the Investors) (8)                                                                                                                                                    |
| 4.7         |       | Form of Series C Warrant issued by the Company to the Investors (as  defined in the Securities Purchase Agreement dated as of June 24, 2004  between the Company and the Investors) (8)                                                                                                                                                    |
| 4.8         |       | Form of Warrant issued by the Company to Mr. K.Y.Chou (13)                                                                                                                                                                                                                                                                                 |
| 10.1        |       | Lease Agreement dated October 7, 1998 between WorldGate and Balanced  Capital LLC, as amended by First Amendment to Lease Agreement dated December  7, 1998 between WorldGate and Balanced Capital LLC, as further amended by  Second Amendment to Lease Agreement dated December 17, 1998 between WorldGate  and Balanced Capital LLC (1) |
| 10.2        |       | Amendment dated November 18, 2004 to Lease Agreement dated October 7,  1998 between WorldGate and Balanced Capital LLC (12)                                                                                                                                                                                                                |
| 10.3        |       | Manufacturing Agreement between WorldGate and Mototech Inc. dated  September 9, 2003 (6)                                                                                                                                                                                                                                                   |
| 10.4        |       | Development and Distribution Agreement dated as of April 28, 2004  between the Company, WorldGate Services, Inc. and General Instrument  Corporation d/b/a the Broadband Communication Sector of Motorola, Inc. (9)  (Portions of this agreement are subject to a confidential treatment request.)                                         |
| 10.5        |       | 1996 Stock Option Plan (3)                                                                                                                                                                                                                                                                                                                 |
| 10.6        |       | 2003 Equity Incentive Plan(10)                                                                                                                                                                                                                                                                                                             |
| 10.7        |       | Amended and Restated Securities Purchase Agreement dated as of  December 4, 2003, by and between the Company and the Purchasers (as defined  therein) (5)                                                                                                                                                                                  |
| 10.8        |       | Securities Purchase Agreement dated as of January 20, 2004 by and  between the Company and the Purchasers (as defined therein) (7)                                                                                                                                                                                                         |
| 10.9        |       | Securities Purchase Agreement dated as of June 24, 2004 by and  between the Company and the Investors (as defined therein) (8)                                                                                                                                                                                                             |
| 21          |       | Subsidiaries**                                                                                                                                                                                                                                                                                                                             |
| 23.1        |       | Consent of PricewaterhouseCoopers LLP*                                                                                                                                                                                                                                                                                                     |
| 23.2        |       | Consent of Grant Thornton LLP*                                                                                                                                                                                                                                                                                                             |
| 24          |       | Power of Attorney**                                                                                                                                                                                                                                                                                                                        |
| 31.1        |       | Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)*                                                                                                                                                                                                                                                                       |
| 31.2        |       | Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)*                                                                                                                                                                                                                                                                       |
| 32.1        |       | Certification of Chief Executive Officer Pursuant to 18 U.S.C.  Section 1350, as adopted by Section 906 of the Sarbanes-Oxley Act of 2002*                                                                                                                                                                                                 |

 

38

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| 32.2 |   | Certification of Chief Financial Officer Pursuant to 18 U.S.C.  Section 1350, as adopted by Section 906 of the Sarbanes-Oxley Act of 2002* |
|------|--------|--------------------------------------------------------------------------------------------------------------------------------------------|

 

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*                      Filedherewith

**               Previouslyfiled

(1)               Incorporatedby reference to the exhibits to our Registration Statement on Form S-1/A asfiled on April 7, 1999 (Registration No. 333-71997).

(2)               Incorporatedby reference to the exhibits to our Form 10-Q Report for the quarter endedMarch 31, 1999.

(3)               Incorporatedby reference to the exhibits to our Form 10-K/A Report for the fiscal yearended December 31, 2000, as filed on August 17, 2001.

(4)               Incorporatedby reference to the exhibits to our Current Report on Form 8-K filedDecember 2, 2003.

(5)               Incorporatedby reference to the exhibits to our Current Report on Form 8-K filedDecember 4, 2003.

(6)               Incorporatedby reference to the exhibits to our Registration Statement on Form SB-2 asfiled on 12/24/03  (RegistrationNo. 333-111571).

(7)               Incorporatedby reference to the exhibits to our Current Report on Form 8-K filedJanuary 21, 2004.

(8)               Incorporatedby reference to the exhibits to our Current Report on Form 8-K filed June25, 2004.

(9)               Incorporatedby reference to the exhibits to our Current Report on Form 8-K filedJuly 13, 2004.

(10)         Incorporatedby reference to the exhibits to the Company’s Proxy Statement to shareholdersfiled September 3, 2004.

(11)         Incorporatedby reference to the exhibits to our Form 10-Q Report for the quarter endedSeptember 30, 2004, as filed on November 17, 2004.

(12)         Incorporatedby reference to the exhibits to our Form 10-K Report for the fiscal yearended December 31, 2003, as filed on March 31, 2005.

(13)         Incorporatedby reference to the exhibits to our Registration Statement on Form SB-2 asfiled on May 24, 2005.

 

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