**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**AMENDMENTNO. 2 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 the transition periodfrom         to        **

 

**Commission file number: 000-25755**

 

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**WorldGateCommunications, Inc.**

(Exact name of registrant as specified 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 pursuant to Section 12(b) of the Act: **None**

 

Securities registered pursuant to Section 12(g) of the Act:

 

**Common Stock, $0.01 Par Value**

(Title of Class)

 

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Indicateby check mark whether the registrant: (1) has filed all reports requiredto be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes  ý    No  o

 

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to thebest of registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K. Yes ý

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inExchange Act Rule 12b-2) Yes o    No ý

 

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

 

Theaggregate market value of the common stock held by non-affiliates of theregistrant was approximately $46.7 million as of June 30, 2004, based onthe closing sale price of $2.10 per share of common stock, as reported on theNASDAQ Small Cap Market.

 

Thenumber of shares of the registrant’s common stock outstanding as of March 4,2005 was 31,705,489.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

**None**

 

 

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**EXPLANATORY NOTE**

 

WorldGate Communications, Inc. (the “Company”) isfiling this Amendment No. 2 on Form 10-K/A to amend its Annual Reporton Form 10-K for the years ended December 31, 2003 and 2004, as filedwith the Securities and Exchange Commission (the“SEC”) on March 31, 2005 (the “Original Filing”) and asfirst amended on August 30, 2005 (the “Amended Filing”).  The purpose of this Amendment No. 2 isto amend and restate Part I, Item 1, Part II, Item 6,Item 7 and Item 8 and Part III, Item 15 which set forth the accounting for thewarrants and additional investments rights issued in placements of theCompany’s common stock during the fourth quarter of 2003 and the firstand fourth quarters of 2004.  Thesesecurity components were originally treated as non-cash expenses and with thisamendment are being restated as equity transactions. Accordingly, changes havebeen made to the applicable line items associated with additional paid-incapital, accumulated deficit, general and administrative costs, net loss andnet loss per common share.  In addition, Part II,Item 7 and Item 8 have been amended and restated to reflect certainclarifications made in response to the SEC’s comments as raised in its reviewof the Company’s registration statement on Form SB-2/A, as filed with theSEC on August 30, 2005, and annual report on Form 10-K/A for the yearended December 31, 2004, as filed with the SEC on August 30, 2005.Finally the certifications attached as Exhibits 31.1, 31.2, 32.1 and 32.2 havebeen updated to reflect the filing date of this amendment and interim changesin the regulations applicable to these certifications.  Except as described above, no additions ormodifications have been made to this Amendment No. 2 to reflect facts orevents occurring subsequent to the date of the Original Filing or the AmendedFiling. 

 

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**WORLDGATE COMMUNICATIONS, INC.**

 

**ANNUAL REPORT ON FORM 10-K**

**For the Fiscal Year Ended December 31, 2004**

 

**TABLE OF CONTENTS**

 
| **PART I**   | 1                                                                                                                   |
|-------------------|---------------------------------------------------------------------------------------------------------------------|
| ** **        | ** **                                                                                                          | ** ** |
| Item 1.           | Business                                                                                                            | 1 |
|              |                                                                                                                |   |
| Item 2.           | Properties                                                                                                          | 6 |
|              |                                                                                                                |   |
| Item 3.           | Legal Proceedings                                                                                                   | 6 |
|              |                                                                                                                |   |
| Item 4.           | Submission of Matters to a Vote  of Security Holders                                                                | 6 |
| ** **        | ** **                                                                                                          | ** ** |
| **PART II**  | 7                                                                                                                   |
|              |                                                                                                                |   |
| Item 5.           | Market for Registrant’s  Common Equity, Related Stockholder Matters and Issuer Purchases of Equity  Securities | 7 |
|              |                                                                                                                |   |
| Item 6.           | Selected Financial Data                                                                                             | 9 |
|              |                                                                                                                |   |
| Item 7.           | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                         | 10 |
|              |                                                                                                                |   |
| Item 7A.          | Quantitative  and Qualitative Disclosures About Market Risk                                                         | 23 |
|              |                                                                                                                |   |
| Item 8.           | Financial  Statements and Supplementary Data                                                                        | F-1 |
|              |                                                                                                                |   |
| Item 9.           | Changes in  and Disagreements with Accountants on Accounting and Financial Disclosure                               | 24 |
|              |                                                                                                                |   |
| Item 9a.          | Controls and  Procedures                                                                                            | 24 |
|              |                                                                                                                |   |
| Item 9b.          | Other Information                                                                                                   | 24 |
| ** **        | ** **                                                                                                          | ** ** |
| **PART III** | 24                                                                                                                  |
| ** **        | ** **                                                                                                          | ** ** |
| Item 10.          | Directors  and Executive Officers of the Registrant                                                                 | 24 |
|              |                                                                                                                |   |
| Item 11.          | Executive  Compensation                                                                                             | 26 |
|              |                                                                                                                |   |
| Item 12.          | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                    | 30 |
|              |                                                                                                                |   |
| Item 13.          | Certain  Relationships and Related Transactions                                                                     | 32 |
|              |                                                                                                                |   |
| Item 14           | Principal  Accountants Fees and Services                                                                            | 32 |
|              |                                                                                                                |   |
| **PART IV**  | 33                                                                                                                  |
| ** **        | ** **                                                                                                          | ** ** |
| Item 15.          | Exhibits  and Financial Statement Schedules                                                                         | 33 |

 

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**WORLDGATE COMMUNICATIONS, INC.**

 

Thisreport contains forward-looking statements that involve risks and uncertainties.These forward-looking statements are based on management’s current expectationsand are subject to a number of uncertainties and risks that could cause actualresults to differ significantly from those anticipated in these forward-lookingstatements. Factors that may cause such a difference include, but are notlimited to, those set forth in the “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” as well as those discussedelsewhere 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**

 

Sinceour formation in 1995 and until recently, we were in the business of developingand selling interactive television, or ITV, technology, products and servicesfor use in conjunction with cable TV broadband networks (the “ITV Business”).Using our solutions, cable TV operators branded, marketed, and offered a widevariety of ITV packages to consumers. These packages included walled gardens ofinformation, communications solutions complete with Internet-based e-mail andchat, and Web surfing, all presented and engaged on the TV set.

 

Duringthe third quarter of 2003, we completed a sale of significant assets, includingour ITV intellectual property rights and our membership interest in TVGateway,LLC, for $3,000,000 in cash to TVGateway, LLC, an ITV oriented company we wereinstrumental in forming. Our transaction with TVGateway, LLC marked a shift inour business away from the ITV Business and toward a new video phone productand associated business. Although we continued to support our current ITVBusiness into the first quarter of 2004, the development of our video phoneproduct became a primary business focus. The funds we received from the sale ofassets to TVGateway, LLC, as well as the funds we subsequently received as aresult of several private placements of our securities have permitted us tofund the development of our new business.

 

During2004, we continued development of a video phone, designed specifically forpersonal video communication over high speed data, or HSD or broadbandnetworks, that we believe is differentiated, both from competitors and fromprevious efforts at personal video telephony, by providing: “true to life”communication (meaning that images and sounds are synchronized, that there areminimum delays between the two ends of the communication, and that the qualityof the images are improved significantly), ease of deployment by HSD operators,ease of use by residential and business end users, a highly styled ergonomicdesign, and interoperation with the public switched telephone network, orPSTN.  The design of our first video phone product was substantiallycompleted in late 2004 and field trials were commenced. Commercial distributionof this product is expected to commence in the spring 2005 time frame.

 

OnApril 28, 2004, we entered into a multi-year agreement with GeneralInstrument Corporation d/b/a the Broadband Communication Sector of Motorola, Inc.for the worldwide development and distribution of the Ojo personal video phone.Under the terms of the agreement, our video phone will be co-branded with ourtrademark, OjoTM, and Motorola will market the Ojo personal videophone as part of its “connected home” portfolio of consumer HSD solutions.Motorola plans to distribute Ojo worldwide through HSD service providers,retailers, and distributors of telecommunications products.

 

HSDservice users provide a large, and we believe conducive, target market for aquality video phone offering. We believe that Motorola, as a worldwide marketleader in the HSD market is well-positioned to assist us with our video phoneoffering.  Initial video phone sales are expected to be derived from newtechnology adopters and regular long distance communicators such as familiesand close friends. We also expect that the business-to-business opportunitywill be attractive as a video phone provides means to improve interpersonalcommunication and multi-location productivity.  Furthermore we expect thatthe growth in the

 

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voice over Internet protocolmarket (or “VoIP”) will also help to drive sales of our video phone since itcan also serve as a VoIP endpoint.

 

Ourbusiness model is based on the sale of video phones and related products. Weexpect that our products will be marketed to HSD operators as well as toconsumers through traditional consumer electronics distribution channels. Webelieve that HSD operators could realize significant recurring revenue streamsassociated with offering our product to end users. We have also developed thisproduct to require very minimal capital investment or incremental costs by suchoperators. Our marketing objective is to have our video phones supplement andhopefully replace ordinary home and business phones worldwide.

 

**GeneralProduct Description**

 

Wehave developed a video phone, ergonomically designed specifically for in-homeand business, personal video communication. We have identified several issuesthat have interfered with commercial success and consumer acceptance of videophones and sought to address each of these issues within the Ojo video phone.The Ojo video phone was designed for use on the existing HSD infrastructure.The Ojo phone will, however, also connect to the analog phone line forinteroperability with the voice only communications offered by the existingPSTN networks. Ojo, therefore, can be used for video calls, for ordinary voiceonly calls as well as for voice over Internet protocol, or VoIP calls. Webelieve that Ojo is differentiated, both from competitors and from previousefforts at personal video telephony, by providing: true to life communication(meaning that images and sounds are synchronized, that there are minimum delaysbetween the two ends of the communication, and that the quality of the imagesare improved significantly), interoperation with the PSTN, ease of deploymentby HSD operators, ease of use by consumers, and a highly styled ergonomicdesign. We believe Ojo uniquely leverages the recent development of a state ofthe art connectivity infrastructure, as well as the convergence of the latestimprovements in compression technology, processing power and bandwidthavailability, to help ensure, enable and maintain dedicated high qualityend-to-end connections.

 

The Ojo solution consists oftwo 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).

 

**MaterialDevelopments for WorldGate since December 31, 2003**

 

Thefollowing is a summary of material developments for us that have occurred sinceDecember 31, 2003:

 

InJanuary 2004, during the Consumer Electronics Show (CES) we successfullydemonstrated the capability of delivering high quality video telephone over theInternet. Using our Ojo video phone, we demonstrated repeated quality callsbetween our headquarters in suburban Philadelphia and Las Vegas. Using a datarate of 150 kbps, we made video calls with full motion video displayed at 30frames per second, similar to that of broadcast television. The calls providedconsistent, true-to-life,

 

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synchronized, voice andvideo communications during peak Internet usage time periods. We believe thiswas the first successful demonstration of H. 264-based signal processingtechnology in a personal video phone.

 

OnJanuary 21, 2004, we completed a private placement resulting in anissuance of 1,000,000 shares of our common stock at a sale price of $1.50 pershare, five-year warrants to purchase up to 300,000 shares of our common stockat an exercise price of $1.875 per share, and additional investment rights topurchase, for a limited period of time, up to 200,000 shares of our commonstock at an exercise price of $1.50 per share. In addition, we agreed to issuewarrants to purchase up to an additional 10,000 shares of our common stock atan exercise price of $1.875 per share upon the exercise of the additionalinvestment rights. The January 2004 private placement resulted in grossproceeds to us of approximately $1,500,000.

 

OnApril 23, 2004, we completed a private placement of 666,666 shares of ourcommon stock with Mototech Inc. (not an affiliate of Motorola) at a saleprice of $1.50 per share. The private placement resulted in gross proceeds tous of $1,000,000.

 

OnMay 3, 2004, we announced that we had entered into a multi-year agreementwith Motorola, Inc. for the worldwide development and distribution of theOjo video phone. Under the terms of the agreement, Motorola will market the Ojopersonal video phone as part of its “connected home” portfolio of consumer HSDsolutions. Motorola will distribute Ojo worldwide through HSD serviceproviders, retailers, and distributors of telecommunications products.Additionally, Motorola and WorldGate will jointly develop future HSD videotelephony solutions.

 

OnJune 24, 2004, we completed another private placement that resulted in theissuance of 7,550 shares of preferred stock at a sale price of $1000 per share(which preferred stock is convertible into our common stock at a conversionprice of $2.35 per share,) five-year warrants to purchase up to 803,190 sharesof our common stock at an exercise price of $2.69 per share, and five-yearwarrants to purchase up to 803,190 shares of our common stock at an exerciseprice of $3.14 per share. The investors also received an additional investmentright, for a limited period of time, to purchase 1,606,383 additional shares ofcommon stock shares at $3.14 a share. The June 2004 private placementresulted in gross proceeds to our Company of $7,550,000.

 

OnNovember 10, 2004 we announced that the Ojo video phone was awarded a 2005CES Best of Innovations Award from the Consumer Electronics Association (CEA).

 

Atthe 2005 CES Show, held in Las Vegas on January 6 — 9, we formallyintroduced our Ojo video phone. CES is one of the world’s largest annualconsumer technology shows. We conducted live demonstrations to attendees andthe press of the Ojo phone transmitting full-motion video with synchronizedaudio over a HSD internet connection.

 

DuringDecember 2004, and through January 30, 2005, we received cashproceeds of $7,565,000 from the exercise of outstanding warrants issuedpursuant to the private placements discussed above, by the exercise ofnon-executive employees’ and prior employees’ stock options, and by a privateplacement of an additional 208,333 shares of our common stock. In connectionwith this placement, we granted warrants to Mr. K.Y. Chou, President and GeneralManager of Mototech, to purchase up to 62,500 shares of our common stock at anexercise price of $2.88 per share.

 

**BusinessStrategy**

 

*General.*  Our business model, as is typical of a consumer electronicsproduct, is based upon the sale of Ojo video phones and does not rely upon anyservice fees or other recurring revenue stream for WorldGate, although suchrecurring streams may materialize. It is our plan for Ojo video phone to bedistributed through and in partnership with HSD service providers, as well asthrough traditional electronics distribution channels. Video phone service,using the Ojo video phone, is expected to be offered by HSD service providersas a means of attracting new HSD subscribers as well as maintaining existingsubscribers. We believe that HSD service operators could realize potentiallysignificant recurring revenue streams associated with offering products such asour Ojo video phone, and accordingly we believe they will embrace the conceptand business model. The suggested consumer offering for a video phone servicefollows the traditional HSD model. We anticipate that video phone servicesubscribers will be able to either purchase Ojo or lease a unit from the HSDservice provider.

 

*Manufacturing.* Ojo video phones will be manufactured in Asia, to take advantageof the base of lower labor, tooling and component costing. A formalrelationship with Mototech Inc. (not an affiliate of Motorola) has already beenestablished for the volume manufacture of Ojo. Mototech, along with U.S. Roboticsand SMC Networks, are affiliates of the Accton Technology Group, a group ofTaiwanese manufacturers that we believe are well-known in the electronicsindustry. Mototech’s responsibilities in this role include:

 

Productdesign finalization for manufacturing;

 

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Componentselection and procurement;

Toolsourcing and management;

Coordinationof Ojo manufacturing;

Implementationand monitoring of Ojo’s Quality Plan; and

Productcost reduction.

 

Underthe agreement, Mototech is required to manufacture products in response topurchase orders issued by our company.  Although our company has noobligation to purchase any particular volume of products under the agreement,Mototech is generally required to accept all purchase orders, subject tocertain limits described in the agreement.  As part of our agreement withMototech we retain formal sign-off control over any product, specification, orcomponent changes proposed by Mototech. We also maintain all rights to the Ojotechnology and intellectual property, as well as the right to second source theOjo product.  Our agreement with Mototech permits Mototech and our companyto terminate the agreement at any time by giving 90 days written notice to theother party.

 

*Product Sales and Distribution.*  We have entered into an arrangement withan experienced distribution partner, Motorola, Inc. to market anddistribute the Ojo video phone. Such arrangement is intended to reduce ourworking capital requirements by minimizing our sales and inventory costs, andprovide an entree to more extensive and accelerated coverage than would bepermitted 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.

 

Wehave entered into a six-year distribution agreement with Motorola, Inc.for the marketing and distribution of our Ojo video phone. This agreementprovides for Motorola to be WorldGate’s exclusive distributor of its broadbandvideo phone products and for WorldGate to be Motorola’s exclusive supplier ofits broadband video phone products.  After a period of eighteen monthsfollowing the commercial availability of the Ojo video phone this mutualexclusivity will terminate unless Motorola elects to continue the mutualexclusivity after having achieved certain minimum sales targets for the Ojovideo phone**. **Motorola may,however, at its option, elect to terminate this mutual exclusivity at anytime.  In the event mutual exclusivity terminates or is terminated, thenfor a twelve month period thereafter, WorldGate will continue to be Motorola’sexclusive supplier of broadband video phones, but will be free to sell videophone products to customers other than certain defined Motorola accounts. During this twelve month period, Motorola has a right of first refusal toaccept and fill any orders for video phone products that WorldGate obtains fromnon-Motorola accounts, and is obligated to use good faith efforts to solicitand accept product orders from Motorola accounts in a commercially reasonablemanner.  During any period of exclusivity under this agreement we arereliant upon Motorola and its distribution partners, including, for example,wholesalers, retailers and service providers, to provide the worldwide salesand distribution of the Ojo video phone. Although the agreement requiresMotorola to provide for certain marketing and promotional activities for theOjo video phone, there are no required sales quotas for the agreement to remainin effect, and Motorola controls the volume of products being distributed byour company.  Neither party can terminate the agreement except in cases ofuncured breaches of the agreement or as a result of insolvency events sufferedby the other party.  If Motorola and its partners are not successful, orif their activities do not lead to significant sales of our product, ouroperating results will be adversely affected, our revenue could besignificantly reduced and we could lose potential customers.  Inconnection with our agreement with Motorola, our company has issued a warrantto purchase 300,000 shares of WorldGate common stock, which we issuedsimultaneously with the execution of the agreement in April 2004, and asecond warrant for 300,000 shares issued upon the delivery to Motorola ofacceptable prototypes for the product. Additionally, we agreed to issuewarrants to purchase up to an additional 1,650,000 shares of our common stock,upon the achievement of certain sales milestones, at an exercise price basedupon the average closing sales price of our common stock during the 20 dayperiod preceeding the issuance of each warrant.

 

**Competition**

 

Manyof the current video phone manufacturers have focused on twoapplications—business video phones and video conferencing. Business videophones are designed to be located on an executive’s desk and used tocommunicate with colleagues, employees and customers. Video conferencing unitsare designed for conference rooms where multiple people on one end engage withmultiple people on the other end. The following is a brief description of thepotential competitors and their impact on the market.

 

*Business Phone Products.*  Most of these products are targetedfor corporate use and are relatively high priced. Generally, the ergonomicdesign of these units emulates that of a traditional office telephone with theaddition of a camera and display. The products use standard corporate gray orblack material colors, familiar button shapes and designs, traditional stylehandsets for non-speakerphone conversation and often have business featuresets. For connectivity 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.

 

*Video Conference Products.*  D-Link Systems, Inc. produces aTV-based video 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 more and involve complex installations ofone or more cameras, monitors, microphones and speakers within a conferenceroom setting. The videoconference nature of these products eliminates theability to communicate on a private, one-on-one level. The main competitors inthis sector include Sony, D-Link Systems, Inc., Sorenson Media and PolycomInc.

 

*Telephone Products.*  Vialta, Inc. produces the “Beamer”, an H.324 (POTS) videophone that is designed for connection to a standard telephone. The productutilizes a standard analog telephone for connection to the PSTN and as thelistening device. Because the unit uses traditional telephone lines forconnectivity it cannot take advantage of the high-speed data systems availablethrough cable and DSL modems.

 

*Web Cam Products.*  Web cams are different from other competitive products in thatthey did not arise from either business video phones or video conferencing.Rather, they began in the early days of the Internet when “techies” wereexpanding the capabilities of PC-based content and applications with low-costattachments to the computer. Currently, web cams are often used to displayvisual information rather than as a means for personal communication. Manypopular web sites use web cams to show traffic, weather, adult activities andother visually interesting subjects. Software such as Net Meeting, InstantMessenger and MSN messenger are being supported in web cams to enable a videochat option to these Internet-based services. Competitors in this categoryinclude Logitech, Inc., Intel Corporation, 3Com Corporation, and CreativeTechnology, Ltd.

 

*Hybrid Web Cam-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 device and host software thatenables video phone functionality when used in conjunction with an IP phone andcall processing hardware. We believe this product requires a significantcapital investment for implementing the call processing hardware and IP phones.

 

**IntellectualProperty**

 

Weplan to rely on patent, trade secret, trademark and copyright law to protectour video phone intellectual property.** **Althoughwe have filed multiple patent applications for our technology, we do notcurrently hold any granted patents and our patent position is subject tocomplex factual and legal issues that may give rise to uncertainty as to thevalidity, scope and enforceability of a particular patent. Accordingly, therecan be no assurance that any patents will be issued pursuant to our current orfuture patent applications or that patents issued pursuant to such applicationswill not be invalidated, circumvented or challenged. Moreover, there can be noassurance that the rights granted under any such patents will providecompetitive advantages to us or be adequate to safeguard and maintain ourproprietary rights. In addition, effective patent, trademark, copyright andtrade secret protection may be unavailable, limited or not applied for in certainforeign countries.

 

**GovernmentRegulation**

 

OurOjo video phone will be required to comply with various laws and governmentregulations, including Parts 15 and 68 of the FCC’s regulations in the UnitedStates, which relate to radio frequency devices and to terminal equipment thatis connected to the telephone network. The legal and regulatory environmentthat pertains to our business is uncertain and changing rapidly. Newlegislation or regulation could be introduced that could substantially impact ourability to launch and promote the Ojo video phone. For example, in the UnitedStates, the FCC and state regulatory commissions could undertake an examinationof whether to impose surcharges or additional regulations upon certainproviders of Internet protocol, or IP, based communication services. Theimposition of regulations on IP communications services may negatively impactour business.

 

**Researchand Development**

 

Todate, our engineering and product development has been a significant focus. Theprincipal focus of our current engineering and development activities is thecontinued development and enhancement of our Ojo video phone. Development ofthe Ojo video phone has required combining technical experience and knowledgefrom two historically separate industries, cable

 

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

 

**Employees**

 

Asof December 31, 2004, on a consolidated basis, we had approximately 50full-time employees. All of our employees are located in Trevose, Pennsylvania.None of our employees are represented by a labor union, and we have nocollective bargaining agreement. We consider our employee relations to be good.

 

**FinancialInformation Relating to Foreign and Domestic Operations and Export Sales fromContinuing Operations (Dollars in Thousands)**

 
| ** **                                                            | ** ** | **2002**   | ** ** | **2003**          | ** ** | **2004**          | ** ** |
|-----------------------------------------------------------------------|------------|------------|------------|-------------------|------------|-------------------|------------|
| ** **                                                            | ** ** | ** ** | ** ** | **(As restated)** | ** ** | **(As restated)** | ** ** |
| 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          |              | $          | (5,797            | )          | $ | (19,461 | ) |
| 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.**

 

Ourcorporate headquarters is located in Trevose, Pennsylvania in a leased facilityconsisting of approximately 16,000 square feet. Both we and the landlord,however, have the right to terminate this lease at any time on 90 days priorwritten notice to the other party. In March 2005, the property was soldand our lease was transferred to the new owner. We are currently negotiating along term lease with the new owner and we anticipate that this facility will besuitable for our needs for the immediate future.

 

**Item 3.Legal Proceedings.**

 

Althoughfrom time to time we may be involved in litigation as a routine matter inconducting its business, we are not currently involved in any litigation whichwe believe is material to our operations or balance sheet. We comply with therequirements of currently prevailing accounting standards and provides foraccruals where a liability is probable and a reasonable estimate can be made asto the probable amount of such liability.

 

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

 

Atour annual meeting of stockholders held on October 13, 2004, ourstockholders elected six members to our Board of Directors.  Those electedto the Board were Hal M. Krisbergh, Steven C. Davidson, Clarence L. Irving, Jr.,Martin Jaffe, Jeff Morris and Lemuel Tarshis.  Stockholders also approvedthe issuance of shares pursuant to a private placement made during the year, anamendment in the Company’s Articles of Incorporation to increase the number ofauthorized shares, and the WorldGate Communications, Inc. 2003 EquityIncentive Plan.

 

(1)           Election of 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)           Ratification and approval of our issuance ofcommon stock in accordance with June, 2004 Private Placement.

 

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

 

(3)           Amendment of Certificate of Incorporation toincrease authorized common shares to 80,000,000.

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

 

(4)           Ratification and approval of WorldGateCommunications, 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 RelatedStockholder Matters and Issuer Purchases of Equity Securities**.

 

Ourcommon stock, $0.01 par value, commenced trading on the NASDAQ National Marketunder the symbol “WGAT” since our initial public offering in April 15,1999. We applied for and received permission, effective January 9, 2003 totransfer the listing of our common stock to the NASDAQ Small Cap Market. Thefollowing table shows the high and low sales price as reported by the NASDAQNational Market and the NASDAQ Small Cap Market, as is applicable, for eachquarter 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    |       |

 

OnMarch 4, 2005, the last reported sale price of our common stock asreported on the NASDAQ Small Cap Market was $3.81 per share.

 

Asof March 4, 2005, we had 342 holders of record of our common stock.

 

**Dividends**

 

Wehave never paid or declared any cash dividends on our common stock. We do notanticipate paying any cash dividends in the foreseeable future. We currentlyexpect to retain future earnings, if any, to finance the growth and developmentof our business.

 

**Sale ofUnregistered Securities**

 

(1)                                  In December 2003 we completed a privateplacement of 2,000,000 shares (the “December 2003 Shares”) of our commonstock to certain institutional investors.  The shares were sold for $0.80per share, resulting in gross proceeds from the offering of $1,600,000. 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 issuedwarrants (the “December 2003 Warrants”) to purchase in the aggregate up to720,000 additional shares (including shares available only as a result of theexercise of the above additional investment rights) of common stock at a pershare exercise price of $1.00. In December 2004 one of our investorsexercised its warrants resulting in an additional purchase of 168,750 sharesand an additional $168,750 in gross proceeds. In January 2005 one of theinvestors exercised its warrants resulting in an additional purchase of 382,500shares and an additional $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)                                  In January 2004 we completed a privateplacement of 1,000,000 shares (the “January 2004 Shares”) of our commonstock to certain institutional investors.  The shares were sold for $1.50per share, resulting in gross proceeds from the offering of $1,500,000. Theinvestors also received a right, for a limited period of time, to purchaseadditional shares of up to 20% of the common stock purchased by the investorsin the placement at $1.50 a share. During the second quarter of 2004 theseadditional investment rights were exercised resulting in an additional purchaseof 200,000 shares and an additional $300,000 in gross proceeds.  Theinvestors were also issued warrants (the “January 2004 Warrants”) topurchase 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 Shares and the January 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 Act and Rule 506thereunder. The January 2004 Shares and the January 2004 Warrantsissued in the offering were subsequently registered for resale by the investorson April 19, 2004.

 

(3)                                  In June 2004 we completed a privateplacement of 7,550 shares (the “June 2004 Shares”) of Series AConvertible Preferred stock to certain institutional investors.  Theshares were sold for $1000 per share, resulting in gross proceeds from theoffering of $7,550,000. The preferred stock issued pursuant to this placementis convertible into WorldGate common stock at a conversion price of $2.35 pershare. WorldGate 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. 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 (withstock payments being made at a 10% discount to the then current market price).For the first two quarters for which dividend payments were due, WorldGateexercised its right to make these dividend payments in stock, resulting in theissuance of an additional 87,137 shares of our common stock. The preferredstock has a staged maturity over three years with scheduled payments of onethird due after 18 months, one half of the remainder due after 24 months andthe balance due after 36 months. The preferred stock may be redeemed atmaturity in cash or through the issuance of an indeterminable number of sharesof common stock, at WorldGate’s option (subject to certain conditions). Alldividend and maturity payments made in stock are subject to the satisfaction ofcertain conditions including the listing and availability of an effectiveregistration statement. As part of the transaction, WorldGate issued five-yearwarrants to purchase a total of 1,606,380 shares of WorldGate common stock,with one-half of the warrants having an exercise price of $2.69 per share andthe remaining half having an exercise price of $3.14 per share. In January 2005one of the investors has fully exercised its warrants resulting in the issuanceof an addition 63,830 of our common shares and an additional $186,064 in grossproceeds. The investors also received an additional investment right, for alimited period of time, to purchase 1,606,380 additional common stock shares at$3.14 a share. During December 2004 all but one of the investors exercisedtheir additional investment rights resulting in the issuance of an additional1,499,998 shares and an additional $4,709,994 in gross proceeds. During thefirst quarter of 2005, the remaining investor exercised their additionalinvestment right resulting in the issuance of an additional 106,383 shares andan 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 506 thereunder. The June 2004Shares and the June 2004 Warrants issued in the offering were subsequentlyregistered for resale by the investors on July 30, 2004.

 

In December 2004, WorldGate completed aprivate placement of 208,333 shares of our common stock to K.Y. Chou, Presidentand General Manager of Mototech (not an affiliate of Motorola), at a sales priceof $2.40 per share, which resulted in additional gross proceeds to the Companyof $500,000. In connection with this placement, the Company granted warrants toMr. Chou to purchase up to 62,500 shares of our common stock at anexercise price of $2.88 per share.

 

**Item 6. Selected Financial Data.**

 

Thefollowing table represents selected consolidated financial information for thefive-year period ended December 31, 2004. This data should be read inconjunction with our financial statements and notes thereto and “Management’sDiscussion and Analysis of Financial Condition and Results of Operations”included elsewhere in this report.

 
| ** **                                                                                   | ** ** | **Year ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                   | ** ** | **2000**                         | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** |
| ** **                                                                                   | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | **(As restated)** | ** ** | **(As restated)** | ** ** |
| ** **                                                                                   | ** ** | ** **                       | ** ** | **(In thousands, except share and per share 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                                                                   |       | —                           |       | — |   | — |   | 2,331 |   | 4,675 |   |
| Depreciation and amortization                                                                |       | —                           |       | — |   | — |   | — |   | 477 |   |
| Total costs and expenses                                                                     |       | —                           |       | — |   | — |   | 5,797 |   | 10,515 |   |
| Loss from operating activities of continuing operations                                      |       | —                           |       | — |   | — |   | (5,797 | ) | (10,387 | ) |
| 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                                                              |       | —                           |       | — |   | — |   | (5,797 | ) | (19,461 | ) |
| Income (loss) from discontinued operations                                                   |       | (49,597                          | )          | (31,346 | ) | (19,210 | ) | (2,908 | ) | 36 |   |
| Net loss                                                                                     |       | (49,597                          | )          | (31,346 | ) | (19,210 | ) | (8,705 | ) | (19,425 | ) |
| Accretion on preferred stock and dividends                                                   |       | —                           |       | — |   | — |   | — |   | (951 | ) |
| Net loss available to common Stockholders                                                    |       | $                                | (49,597    | ) | $ | (31,346 | ) | $ | (19,210 | ) | $ | (8,705 | ) | $ | (20,376 | ) |
| Basic and diluted loss from continuing operations per common share                           |       | $                                | 0.00       |   | $ | 0.00 |   | $ | 0.00 |   | $ | (0.25 | ) | $ | (0.70 | ) |
| 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 | ) | $ | (0.37 | ) | $ | (0.70 | ) |
| Basic and diluted net loss available to common shareholders per  common share                |       | $                                | (2.23      | ) | $ | (1.33 | ) | $ | (0.81 | ) | $ | (0.37 | ) | $ | (0.73 | ) |
| 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 | ) | $ | (8,705 | ) | $ | (20,376 | ) |
| As adjusted basic and diluted net loss available to common  shareholders per common share(2) |       | $                                | (2.22      | ) | $ | (1.32 | ) | $ | (0.81 | ) | $ | (0.37 | ) | $ | (0.73 | ) |
| 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)          For purposes of computing the net loss per common share, net loss hasbeen reduced by the accretion on preferred stock.

 

(2)          “As adjusted net loss available to common stockholders” and “Asadjusted basic and diluted net loss per common share” amounts reflect theexclusion of amortization of goodwill of approximately $241 and $361 for theyears ended December 31, 2000 and 2001, respectively. These amounts arepresented to comply with SFAS 142 as if this standard had been adopted atthe beginning of the respective periods.

 

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**Item 7.Management’s Discussion and Analysis of Financial Condition and Results ofOperations.**(Dollaramounts contained in this Item 7 are in thousands, except for share and pershare amounts)

 

**FORWARD-LOOKING AND CAUTIONARY STATEMENTS**

 

Wemay from time to time make written or oral forward-looking statements,including those contained in the following Management’s Discussion and Analysisof Financial Condition and Results of Operations.  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 to take advantage of the “safe harbor”provisions of the Private Securities Litigation Reform Act of 1995, we arehereby identifying certain important factors that could cause our actualresults, performance or achievement to differ materially from those that may becontained in or implied by any forward-looking statement made by or on ourbehalf.  The factors, individually or in the aggregate, that could causesuch forward-looking statements not to be realized include, without limitation,the following: (1) difficulty in developing and implementing marketing andbusiness plans, (2) industry competition factors and other uncertaintythat a market for our products will develop, (3) challenges associatedwith HSD operators (including, uncertainty that they will offer our products,inability to predict the manner in which they will market and price ourproducts 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 theforegoing list of important factors is not intended to be, and is not,exhaustive.  We do not undertake to update any forward-looking statementthat may be made from time to time by or on our behalf.

 

**Results ofOperations:**

 

**General**

 

OurITV business has historically accounted for substantially all of ourrevenue.  In the third quarter of 2003, we completed a sale of significantassets, including our ITV intellectual property rights and our membershipinterest in TVGateway, LLC.  This transaction marked a shift in ourbusiness away from the ITV business and toward a new video phone product andrelated business.  Although we continued to support our remaining ITVbusiness into the first quarter of 2004, the development of our video phoneproduct became a primary business focus.

 

Ourvideo phone business has not produced significant revenues to date.  Theextent and timing of future revenues for our business depends on severalfactors, including the rate of market acceptance of our products and the degreeof competition from similar products.  We cannot predict to what extentour video phone product will produce revenues, or when, or if, we will reachprofitability.

 

**CriticalAccounting Policies and Estimates**

 

Ourconsolidated financial statements have been prepared in accordance withaccounting principles generally accepted in the United States. These generallyaccepted accounting principles require management to make estimates andassumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of net sales and expenses during thereporting period. Actual results could differ from those estimates.

 

Oursignificant accounting policies are described in note 3 to ourconsolidated financial statements included elsewhere in this report. We believethat the following discussion addresses our critical accounting policies, whichare those that are most important to the portrayal of our financial conditionand results and require management’s most difficult, subjective and complexjudgments, often as a result of the need to make estimates about the effect ofmatters that are inherently uncertain.

 

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities, at the date the financialstatements and the reported amount of revenues and expenses during thereporting period.  Actual results could differ from those estimates.

 

*Revenue Recognition*

 

Revenueis recognized when persuasive evidence of an arrangement exists, the price isfixed or determinable, the collectibility is reasonably assured, and thedelivery and acceptance of the equipment has occurred or services have beenrendered.  Management exercises judgmentin evaluating these factors in light of the terms and conditions of itscustomer contracts and other existing facts and circumstances to determineappropriate revenue recognition. Due to our limited commercial sales history,our ability to evaluate the collectibility of customer accounts requiressignificant judgment. The Company evaluates its equipment customer, and servicecustomers’, accounts for collectibility at the date of sale and on an ongoingbasis.

 

Presentlythe Company has only one customer for the purchase of its equipment and theagreement with this customer includes several elements relevant to revenuerecognition including: (a) The customer has no general right to return theproduct.  (b) The customer can earnwarrants upon the purchase of significant video telephony units and the valueof these warrants would result in a reduction of recognized revenue (the valueof these warrants is routinely monitored by the Company and is currently deemedto be insignificant, however, should the value of these warrants becomematerial an offset would be made against revenues). (c) Penalties arepayable to the customer if certain excessive field failure rates areexceeded.  (d) The Company and thecustomer share in the benefit achieved by product cost reductions. (e) Penaltiesare payable to the customer if the Company fails to deliver shipments on atimely basis. (f) The Company extends to the customer a limited productwarranty for a term not to exceed three years (the Company maintains a warrantyreserve based upon the percentage of product sales consistent with industrycomparable failure rates and the warranty period provided by the agreement.)

 

Revenuesare also offset with a reserve for any price refunds and consumer rebatesconsistent with the Emerging Task Force (“EITF”) Issue 01-9, Accounting forConsideration Given by a vendor to a Customer.

 

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*Inventories.*  Our inventory consists primarily of finished goods equipment tobe sold to our customer. The cost is determined on an average cost basis. Aperiodic review of inventory quantities on hand is performed in order todetermine and record a provision for excess and obsolete inventories. Factorsrelated to current inventories such as technological obsolescence and marketconditions are analyzed to determine estimated net realizable values. Aprovision is recorded to reduce the cost of inventories to the estimated netrealizable values. Any significant unanticipated changes in the factors notedabove could have an impact on the value of our inventories and our reportedoperating results. With the current shift in focus to our new video phonebusiness, our inventory balance of $1,668 consisted of $1,622 relating solelyto our ITV business, which was fully reserved for at December 31, 2004,and $46 related solely to our new video phone business.

 

*Long-Lived Assets.*  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.

 

*Accounting for Income Taxes.*  As part of the process of preparingour consolidated financial statements we are required to estimate our incometaxes in each of the jurisdictions in which we operate. This process involvesus estimating 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.

 

Wehave a full valuation allowance against the net deferred tax asset of $78,712as of December 31, 2004, due to our lack of earnings history and theuncertainty as to the reliability of the asset. In the future, if sufficientevidence of our ability to generate sufficient future taxable income becomesapparent, we would be required to reduce our valuation allowance, resulting ina benefit from income tax in the consolidated statement of operations.

 

*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 disclosures of SFAS No. 123, “Accounting forStock-Based Compensation,” as amended by SFAS No. 148, “Accounting forStock-Based Compensation—Transition and Disclosure. At December 31, 2004,the Company had stock-based compensation plans, which are described separatelyin Note 9 to the consolidated financial statements for the year ended December 31,2004. The Company applies Accounting Principles Board Opinion No. 25, “Accountingfor Stock Issued to Employees” and related interpretations in accounting forits plans, and accordingly, no compensation cost has been recognized for theCompany’s fixed stock-based compensation.

 

*Accounting for Preferred Shares.*  The Company accounts for preferredstock in accordance with EITF topic D-98 “Classification and Measurement ofRedeemable Securities”, and the Redeemable Preferred Stock was recorded in thefinancial statements as temporary equity. Additionally, the fair value ofwarrants and preferred stock conversion options were recorded into theconsolidated financial statements as liabilities as a result of their featuresthat require accounting under FAS 133 “Accounting for Derivative Instrumentsand Hedging Activities, as amended.” At each reporting balance sheet date, anevaluation is made of these valuations and marked to market.

 

**2004 (Restated)versus 2003 (Restated)**

 

**Revenues**

 

*Revenues.*Revenues from continuing operations of $231 were realized during thetwelve months ended December 31, 2004. These revenues represent theinitial 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 productsare delivered and accepted.

 

**Costs andExpenses**

 

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

 

*Engineering and Development*. Engineering and development expensesprimarily consist of compensation, and the cost of design, programming,testing, documentation and support of the Company’s video phone product.Engineering and development costs were $4,001 for the twelve months ended 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 shiftof efforts of our engineering staff, and related costs, from our ITV business(discontinued operations) to the continuing development of our video phoneproduct.

 

*Sales and Marketing*. Sales and marketing expenses consist primarily of compensation,attendance at conferences and trade shows, travel costs, promotions and othermarketing programs related to the introduction of our video phone product.Sales and marketing costs were $1,362 for the twelve months ended December 31,2004, compared with $466 for the twelve months ended December 31, 2003.This increase of $896, or 192%, reflects the increased marketing andpromotional expenditures, trade shows attendance, as well as a shift in effortsfrom our ITV business to our video phone product.

 

*General and Administrative – as restated*. General and administrative expenses consistprimarily of expenditures for administration, office and facility operations,finance and general management activities, including legal, accounting andprofessional fees. General and administrative expenses were $4,675 for thetwelve months ended December 31, 2004, compared with $2,331 for the twelvemonths ended December 31, 2003. The increase of $2,344, or 100%, isattributable primarily to our transition of nearly all of our administrativemanagement compensation, facility, legal, finance and professional consultingfees toward the further development of the video phone business, and a non cashcharge of $608 during the twelve months ended December 31, 2004,reflecting a Black Scholes estimate of the value of warrants and options issuedto Motorola in 2004 in conformity with the terms of the agreement signed in April 2004.For the twelve months ended December 31, 2003, video phone related costswere $2,331, or 60% of total General and Administrative expense of $3,889(including $1,558 in discontinued operations).

 

*Interest, Other Income and Interest Expense*. Interest, other income and interest expensefrom continuing operations consisted of interest earned on cash and cashequivalents, and interest expense on short-term debt. Total interest and otherincome increased to $1,023 for the twelve months ended December 31, 2004from $0 for the twelve months ended December 31, 2003. During the twelvemonths ended December 31, 2004, we earned interest income of $86 onaverage cash balances of approximately $6,601, and incurred interest expense of$6 related to insurance financing. In comparison, during the twelve monthsended December 31, 2003, we earned interest on average cash balances thatare included with discontinued operations of approximately $2,222, and incurredinterest expense of $6 related to our insurance financing. Included in totalinterest and other income is $928 which represents deferred rent credits of$143 and cancelled unpaid rent of $785 relating to the amendment of ourfacility lease with an effective date of June 2004. For more details,refer to Note 11 to our consolidated financial statements for the year ended December 31,2004.

 

*Non Cash Change in Fair Value of Warrants and ConversionOptions.* For thetwelve months ended December 31, 2004, the non cash change in fair valueof warrants and conversion option was an expense of $10,091. This expense wasthe result of a marked to market adjustment as of December 31, 2004related to our June 24, 2004 private placement of our Series AConvertible Preferred Stock and Warrants. Over the life of the instruments,these marked to market adjustment of gains and losses will offset and net to$0.

 

*Income Taxes.*  We have incurred net operating losses since inception andaccordingly have had no income taxes and have not recorded any income taxbenefit for those losses.

 

**2003 (Restated)versus 2002**

 

Sinceour formation in 1995 and into January 2004, our company had been in thebusiness of developing and selling interactive television (“ITV”) technology,products and services for use in conjunction with cable TV broadband networks(the “ITV” Business”).  Using our solutions, cable TV operators branded,marketed, and offered a wide variety of ITV packages to consumers.  Thesepackages included walled gardens of information, communications solutionscomplete with Internet-based e-mail

 

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and chat, and Web surfing,all presented and engaged on the TV set.

 

Duringthe third quarter of 2003, we completed a sale of certain assets, including ourITV intellectual property rights and our membership interest in TVGateway, LLC,for $3,000 in cash to TVGateway, LLC, a company we were instrumental informing.  Our transaction with TVGateway, LLC marked a shift in ourbusiness away from the ITV Business and toward a new video phone product andassociated business.  Although we continued to support our current ITVBusiness during the first quarter of 2004, our new video phone product becameour primary product focus. We advised our ITV customers of our de-emphasis ofITV going forward. We informed them that we were willing to continue ourefforts into 2004 as long as we could do so on a profitable basis. In January,with all our customers having taken steps to terminate their ITV service intheir markets, we decided to formally end our ITV business and began to accountfor our ITV business as a discontinued operation. The funds we received fromthe sale of assets to TVGateway, LLC, as well as the funds we received as aresult of private placements of our securities on December 1, 2003 and December 4,2003, have permitted us to fund the development of our new video phone businessand our continuing operations in 2004.

 

## **Revenues**

 

*Revenues. *For the years ended December 31, 2003 and December 2002, ourrevenues from continuing operations were $0. Revenues from discontinuedoperations for the year 2003 were primarily the result of first quarterproducts sales and consulting fees to TVGateway, LLC, a then unconsolidatedentity, subscriber fees from cable operators providing our interactivetelevision products and services, and certain excess inventory and equipmentsold during the year.  Revenues for the twelve months ended December 31,2003 related to the discontinued operations were $3,886, compared to $13,878for 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 andExpenses**

 

*Cost of Revenues.*  Cost of revenues from continuing operations were $0 for thetwelve months ended December 31, 2003 and 2002. Cost of revenues for theyear 2003 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.

 

*Engineering and Development.*  Engineering and development expensesfrom continuing operations primarily consisted of compensation, the cost ofdesign, programming, testing, documentation, and support of the Company’s videophone product. For the twelve months ended December 31, 2003 and 2002,such expenses 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 todiscontinued operations primarily consisted of the cost of design, programming,testing, documentation and support of our ITV related hardware, software andservices. For the twelve months ended December 31, 2003, discontinuedoperation engineering and development costs were $792, a decrease ofapproximately 90% when compared to $7,705 for the twelve months ended December 31,2002. This decrease in expenses of $6,913 is primarily attributable to theshift of efforts and related costs from the discontinued ITV business to thecontinuing video phone business.

 

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

 

*General and Administrative- as restated.*  General and administrative expensesfrom continuing operations were $2,331 and $0 for the twelve months ended December 31,2003 and 2002, respectively. This increase in 2003 over 2002 reflects ourtransition of our administrative management compensation, facility, legal,finance and professional consulting fees toward the further development of thevideo phone business. General and administrative expenses from discontinuedoperations consisted primarily of expenditures for administration, office andfacility operations, finance and general management activities, includinglegal, accounting, insurance and other professional fees. General andadministrative expenses from discontinued operations were $1,558 for the twelvemonths ended December 31, 2003, a decrease of 49% when compared to expensesof $3,069 for the same period in 2002. This decrease in expenses is primarilyattributable to our transition of our management compensation, facility costs,and professional fees from our ITV business to the video phone business.

 

*Goodwill Impairment*.  During the second quarter of 2002, in an effort to cut costsand achieve operational efficiencies, we commenced the termination of allpersonnel of the former DVA, which performed engineering development services.In conjunction with this action, it was determined that the carrying amount ofthe Company’s remaining goodwill, which was originally recorded with ouracquisition of DVA and related to our discontinued operations, exceeded itsfair value. As such, we measured the impairment loss by the amount the carryingvalue exceeded the implied fair value of the goodwill. The amount of thenon-cash impairment loss was $3,006. The fair value of goodwill was estimatedusing the expected present value of future cash flows.

 

*Interest and 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 and investment inTVGateway.*  On September 30,2003, we sold certain intellectual property rights and certain software andequipment related to our discontinued ITV operations to TVGateway, LLC, for$2,400 in cash, pursuant to an Asset Purchase Agreement (the “PurchaseAgreement”), which we executed with TVGateway in August 2003. Pursuant tothe Purchase Agreement we retained a royalty-free license to the intellectualproperty rights that were sold, enabling us to use the intellectual propertyrights to continue to conduct our business as then being conducted.Concurrently with the execution of the Purchase Agreement, we and TVGatewayalso entered into a redemption agreement pursuant to which we redeemed ourequity interest in TVGateway for $600 in cash, paid concurrently with theexecution of the redemption agreement. The intellectual property rights hadpreviously been expensed as incurred. Similarly, we did not carry an equitybalance for our interest in TVGateway. The aggregate effect of thesetransactions was a gain of $3,000, which is reported in the loss fromdiscontinued operations in 2003.

 

*Income Taxes.*  The Company has incurred net operating losses since inceptionand accordingly had no income taxes and has not recorded any income tax benefitfor those losses.

 

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**Liquidityand Capital Resources**

 

Asof December 31, 2004, our primary source of liquidity consisted of cashand cash equivalents that are highly liquid, are of high quality investmentgrade and have original maturities of less than three months.

 

AtDecember 31, 2004, we had cash and cash equivalents of $11,840 (and noshort-term investments) as compared to cash and equivalents of $3,365 (and noshort-term investments) at December 31, 2003. Net cash used in continuingoperations was $7,084 for the twelve months ended December 31, 2004, ascompared to $3,644 used for the same period in 2003. This increase in net cashused for continuing operations was primarily attributable to our increase inexpenditures during the twelve months ended December 31, 2004, related tothe video phone business. We recorded bad debt expense in the amount of $16from discontinued operations in 2004 to reflect our current assessment of thecollectability of certain receivables.

 

Cashprovided by financing activities from continuing operations through variousprivate placements of our Company’s securities and through the exercise ofnon-executive employees’ and prior employees’ stock options during the twelvemonths ended December 31, 2004, totaled $16,349 compared to $1,490provided during the same period in 2003. 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 $3,000 in cash toTVGateway, LLC, a company we were instrumental in forming.

 

Operations and Liquidity.

 

Todate, we have funded operations primarily through private sales of equitysecurities and through an initial public offering of common stock in April 1999.As of December 31, 2004 the Company had cash and cash equivalents of$11,840. The operating cash usage from continuing operations for the twelvemonths ended December 31, 2004 and 2003 was $7,084 and $3,644,respectively. As of December 31, 2004 we have $37 of outstanding debt andour assets are not pledged as collateral. We continue to evaluate thepossibilities to obtain additional financing through public or private equityor debt offerings, bank debt financing, asset securitizations, or from othersources. Such additional financing would be subject to the risk ofavailability, may be dilutive to our shareholders, or could impose restrictionson operating activities. There can be no assurance that this additionalfinancing will be available on terms acceptable to us, if at all.

 

TheCompany has funded operations through the private placement of our common stockin January 2004, which provided proceeds of $1,500, the private placementof our common stock in April 2004 providing proceeds of $1,000, the June 2004private placement of our redeemable preferred stock providing proceeds of$7,550, the private placement of common stock in December 2004 providing$500, the exercise of additional investment rights and warrants providing$6,200 in January, February and December 2004 and January and February 2005,the exercise by employees and former employees of options throughout 2004 and January andFebruary 2005 providing aggregate proceeds of $900. We do however have anobligation to pay dividends on, as well as to redeem, our outstanding preferredstock upon maturity, or at the earlier option of a holder of these securities.Under certain limited circumstances we may be forced to make such payments andredemptions with cash instead of shares of our common stock. In such event ourability to fund continuing operations would be negatively impacted.

 

The report of the independent registered publicaccounting firm for the year ended December 31, 2004 included an explanatoryparagraph stating that our Company had suffered recurring losses fromoperations and had a net accumulated deficiency of $218,000, and that theseissues raised substantial doubt about our Company’s ability to continue as agoing concern. Our short term cash requirements and obligations includeinventory, accounts payable and capital expenditures from continuingoperations, operating expenses, and the redemption of preferred stock, of which$2,258 is required to be redeemed in December 2005, although thisredemption can be made in common stock if certain conditions are met. Weexpect, based on our internal forecasts and assumptions relating to ouroperations (including among others, assumptions regarding our short term cashrequirements and our projected revenue growth ) that we have sufficient cash onhand to meet our obligations for at least the next twelve months.

 

Our ability to generate cash is dependant upon thesale of our Ojo product and on obtaining cash through capital markets.  We have not generated any revenue fromcommercial shipments of our Ojo product and we do know when or if we will.Given that our video phone business involves the development of a new productline with no market penetration, in an undeveloped market sector, no assurancescan be given that sufficient sales, if any, will materialize.

 

Additionally, as needed, we plan to generate cash byturning to the capital markets for funding. No assurances can be given that, if pursued, additional financingtransactions can be consummated.  Wecontinue to evaluate possibilities to obtain additional financing throughpublic or private equity or debt offerings, bank debt financing, assetsecuritizations, or from other sources, should we need to obtain suchfinancing.  Such additional financingwould be subject to the risk of availability, may be dilutive to ourshareholders, or could impose restrictions on operating activities. There canbe no assurance that this additional financing will be available on termsacceptable to us, if at all.

 

We, however, remain hopeful that sufficient saleswill materialize and/or that sufficient funding can be developed throughongoing operations or additional financings to continue our operations beyondthe next twelve months.

 

Our long term cash requirement obligations areprimarily comprised of the items noted above. We have no long term debt and ourcontractual cash requirements and obligations existing beyond the next twelvemonths are comprised solely of operating lease commitments and redemption ofpreferred stock, which are not considered material.  We have limited capacity to further reduceour workforce and scale back on capital and operational expenditures todecrease our cash usage.

 

InDecember 2003, WorldGate reached agreement with Mototech, Inc. (notan affiliate of Motorola) for the purchase of 625,000 shares of newly issuedcommon stock at $0.80 per share, in return for future design and engineeringservices by Mototech. WorldGate had previously contracted with Mototech toassist the Company with the design and volume manufacture of WorldGate’s Ojopersonal video phone. The purchase price for these shares has been fully paidas of December 31, 2004 by an equivalent reduction in the development andinitial procurement payments that would otherwise be due to Mototech. The valueof this transaction was $600 (based on the closing stock price of $0.96 on thedate of the transaction) of which $200 was recorded as an expense for the yearended December 31, 2003 and $400 was expensed for the year ended December 31,2004. Mototech is an affiliate of Accton Technology Group,a groupof Taiwanese manufacturers that we believe are well-known in the electronicsindustry. Mototech currently manufactures and distributes a fullrange of high performance high speed data and computer networking products,including cable set top boxes, home gateways, wireless LANs, hubs, switches,routers, and other related products. In addition, in April 2004, Mototechinvested $1,000 to purchase 666,666 shares of newly issued common stock at$1.50 per share.

 

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Quantitative and QualitativeDisclosures About Market Risk.

 

InterestRate Risk.  Our exposure to market risk related to changes in interestrates relates primarily to our investment portfolio.  We invest ininstruments that meet high credit quality standards, and we limit the amount ofcredit exposure with respect to any one issue, issuer and type of investment.

 

Asof December 31, 2004, our cash and cash equivalents were $11,840, most ofwhich were securities having a maturity of less than three months.  Due tothe average 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 theaverage yield of our investments decreased by 100 basis points, our interestincome for the twelve months ended December 31, 2004 would have decreasedby approximately $95.  This estimate assumes that the decrease occurred onthe first day of 2004 and reduced the yield of each investment instrument by100 basis points.  The impact on our future interest income of futurechanges in investment yields will depend largely on our total investments.

 

ForeignCurrency Exchange Risk.  Although we transact business in various foreigncountries, the principal portion of our business is in the United States andsubstantially all of our revenues and costs to date have been denominated inU.S. dollars.  Although our agreement with Mototech (not an affiliate of Motorola),our contract manufacturer in Taiwan, is denominated in U.S. dollars, theirmaterial acquisition costs are subject to exchange rate changes that couldimpact our product costs.

 

*Disclosureof Contractual Obligations*

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

 

*RecentAccounting Pronouncements*

 

InJanuary 2003, the FASB issued Interpretation (FIN) No. 46, *Consolidation of Variable Interest Entities*.FIN 46 addresses consolidation by business enterprises of variable interestentities, which are entities that either (a) do not have equity investorswith vesting rights or (b) have equity investors that do not providesufficient financial resources for the entity to support its activities. Theinterpretation is effective immediately for variable interest entities createdafter February 1, 2003. In December 2003, the FASB published FASB FIN46 (R), *Consolidation of Variable InterestEntities*. FIN 46(R), among other things, defers the effective dateof implementation 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 FIN 46 did not have amaterial impact on WorldGate’s results of operations or financial position.

 

InNovember 2004, the FASB issued SFAS No. 151 “Inventory Costs” whichamends the guidance in ARB No. 43, Chapter 4 “Inventory Pricing,” toclarify the accounting for abnormal amounts of idle facility expense, freight,handling costs, and wasted material (spoilage). Paragraph 5 of ARB 43, Chapter4, previously stated that under some circumstances, items such as idle facilityexpense, excessive spoilage, double freight, and rehandling costs may be soabnormal as to require treatment as current period charges.” SFAS No. 151requires that those items be recognized as current-period charges regardless ofwhether they meet the criterion of “so abnormal.” In addition, SFAS No. 151requires that allocation of fixed production overheads to the costs ofconversion be based on the normal capacity of the production facilities. SFAS No. 151shall be effective for inventory costs incurred during fiscal years beginningafter June 15, 2005. Earlier application is permitted for inventory costsincurred during fiscal years beginning after the date SFAS No. 151 wasissued. SFAS No. 151 shall be applied prospectively. The Company does notexpect the adoption of SFAS No. 151 to have a material effect on itsconsolidated financial statements.

 

InDecember 2004, the FASB issued SFAS No. 153 “Exchanges of NonmonetaryAssets” which amends APB Opinion No. 29, “Accounting for NonmonetaryTransactions.” APB No. 29 is based on the principle that exchanges ofnonmonetary assets should be measured based on the fair value of the assetsexchanged. The guidance in that Opinion, however, included certain exceptionsto that principle. SFAS No. 153 amends APB No. 29 to eliminate theexception for nonmonetary exchanges of similar productive assets and replacesit with a general exception for exchanges of nonmonetary assets that do nothave commercial substance. A nonmonetary exchange has commercial substance ifthe future cash flows of the entity are expected to change significantly as aresult of the exchange. SFAS No. 153 shall be effective for nonmonetaryasset exchanges occurring in fiscal periods beginning after June 15, 2005.Earlier application is permitted for nonmonetary asset exchanges occurring infiscal periods beginning after the date SFAS No. 153 was issued. SFAS No. 153shall be applied prospectively. The Company does not expect the adoption ofSFAS No. 153 to have a material effect on its consolidated financialstatements.

 

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InDecember 2004, the FASB issued SFAS No. 123 (R), “Share-Based Payment”that focuses primarily on accounting for transactions in which an entityobtains employee services in share-based payment transactions. This statementreplaces SFAS No. 123, “Accounting for Stock-Based Compensation”, andsupersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.”Beginning with our quarterly period that begins after June 15, 2005, wewill be required to expense the fair value of employee stock options andsimilar awards. As a public company, we are allowed to select from twoalternative transition methods, each having different reporting implications.The impact of SFAS No. 123R has not been determined at this time.

 

**FACTORS AFFECTING OUR BUSINESS CONDITION**

 

*In addition to other information in this Form 10-K, thefollowing risk factors should be carefully considered in evaluating our companyand our business. Investing in our common stock involves a high degree of risk,and you should be able to bear the complete loss of your investment. We alsocaution you that this Form 10-K includes forward-looking statements thatare based on management’s beliefs and assumptions and on information currentlyavailable to management. Future events and circumstances and our actual resultscould differ materially from those projected in any forward-looking statements.You should carefully consider the risks described below, the other informationin this Form 10-K, the documents incorporated by reference herein and therisk factors discussed in our other filings with the Securities and ExchangeCommission when evaluating our company and our business. The risks anduncertainties described below are not the only ones we face. Additional risksand uncertainties not presently known by us or that we currently deem immaterialalso may impair our business operations. If any of the following risks actuallyoccur, our business could be harmed. In such case, the trading price of ourcommon stock would decline.*

 

**Our ITVBusiness has accounted for most of our revenues to date; we cannot reliablyproject our continued revenues, and we expect to incur significant losses foran indefinite period of time.**

 

Sinceour formation in 1995 and until the first quarter of 2004, we were in thebusiness of developing and selling interactive television, or ITV, technologyproducts and services for use in conjunction with cable television broadbandnetworks.  Our ITV business has historically accounted for substantiallyall of our revenue. Since we have discontinued the ITV Business and transitionedto become a developer, manufacturer and seller of video phone products wecannot reliably predict our future revenues, and no assurances can be providedas to the amount of ongoing revenues, if any, or to the periods in which anysuch revenues may be received. Our video phone business involves thedevelopment of a new product line with no market penetration, in an undevelopedmarket sector.  The extent and timing of our revenues depends on severalfactors, including the rate of market acceptance of our products, and thedegree of competition we face from similar products.  We cannot predict towhat extent our video phone product will begin to produce revenues, or whetherwe will ever reach profitability. If we are unable to achieve significant levelsof recurring revenue from our video phone business, our losses will likelycontinue indefinitely. If this occurs, the market price of our common stock andour viability as a going concern could suffer.

 

**Ourauditors have expressed substantial doubt about our company’s ability tocontinue as a going concern.**

 

Thereport of the independent registered public accounting firm for the year ended December 31,2004 included an explanatory paragraph stating that our company has sufferedrecurring losses from operations and had a net accumulated deficiency of$218,000 that raised substantial doubt about our company’s ability to continueas a going concern. No assurances can be given that the issues that led ourauditors to this conclusion will be addressed or that our business willcontinue to operate as a going concern.

 

**We are subject to complex and changing rulesand regulations concerning corporate governance and financial accountingstandards, which may affect our reported financial results or the way weconduct business, or our ability to ensure proper financial reporting andadequate internal controls.**

 

TheSarbanes-Oxley Act, which was signed into law in October 2002, among otherthings, mandates that companies adopt new corporate governance measures andimposes comprehensive reporting and disclosure requirements.  These rules, regulations and requirementshave increased the scope, complexity, and cost of our corporate governance,reporting, and disclosure practices. Furthermore, generally accepted accounting principles in the UnitedSates, including those affecting the accounting for complex financialtransactions, have been the subject of change as well as frequent review andinterpretation by the SEC, as well as by national and international accountingstandards bodies.  Such changes, reviewsand interpretations may have a significant effect on our reported results ofoperations, including the results of transactions entered into before theeffective date of the changes.  Forexample, the Company has previously entered into various private placementtransactions which included multiple types of securities for which the properaccounting treatment was subject to the correct analysis and interpretation ofthe applicable rules regulations and standards. As a result of subsequent analysis the Company elected to filerestatements of certain of its financial statements to correctly account forsuch securities.  The need for suchrestatements also led to the determination that the Company had a materialweakness with respect to the reporting of complex transactions.  A material weakness is a control deficiency,or a combination of control deficiencies, that results in more than a remotelikelihood that a material misstatement of the annual or interim financialstatements will not be prevented or detected. To address this material weakness the Company engaged outside experts toprovide counsel and guidance in areas where we cannot economically maintain therequired expertise internally.  Noassurance can be given, however, that such counsel and guidance will besufficient to remedy this material weakness or to ensure that a future materialmisstatement may not occur within our financial statements.

 

Additionally,section 404 of the Sarbanes-Oxley Act of 2002 requires us to assess the designand effectiveness of our internal control systems effective December 31,2005.  Our independent registered publicaccounting firm is required to render an attestation report on management’sassessment of the effectiveness of our system of internal control overfinancial reporting.  We must completethe documentation, evaluation and remediation of our systems of internalcontrol.  The costs associated with such complianceare likely to be substantial and will negatively impact our financialresults.  In addition, there is noassurance that we will be able to conclude that our systems are appropriatelydesigned or effective, or that a material weakness will not be found in ourinternal controls over financial reporting, which could result in a materialmisstatement in the financial statements.

 

**We expectto be increasingly dependent on a single line of business that currently has nohistory of revenues. We cannot predict our future results because our videophone business has no operating history.**

 

Ourprimary line of business has become the development of video phone products andtechnology. We are still in the process of launching our first product based onthis technology and consequently there are currently no substantial revenuesfrom this line of business. Given the lack of operating history in the videophone business, it is difficult to predict our future results. Investors shouldconsider the risks and uncertainties that we may encounter as apre-revenue-stage company in a new and unproven market. These uncertaintiesinclude:

 

•                  ourability to design and engineer products having the technological featuresplanned for the video phone product line in a cost efficient manner;

•                  ourability to enter into appropriate distribution relationships for the product;

•                  ourability to demonstrate the benefits of our products and services to end users;

 

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•                  ourability to offer our products at competitive prices;

•                  consumerdemand for, and acceptance of, the video phone business products;

•                  ourunproven and evolving business model;

•                  unfavorableeconomic conditions in the technology industry;

•                  decreasedcapital spending on technology due to adverse economic conditions; and

•                  globaleconomic conditions.

 

**Our videophone technology and products remain subject to significant uncertainty.**

 

Ourvideo phone technology and products are in the early commercialization stageand have not been fully proven. The market for products related to videotelephony is characterized by uncertain user and customer requirements, and theemergence of new communications standards and practices. Each of thesecharacteristics could impact our video phone products, intellectual propertyand system designs. The successful development of our products is subject tothe risks that:

 

•                  ourproposed product is found to be ineffective for the intended purposes;

•                  theproposed product is uneconomical to manufacture, or market or does not achievebroad market acceptance; and

•                  thirdparties hold proprietary rights that preclude us from marketing the product.

 

Significantundetected errors or delays in new products or releases may affect marketacceptance of our product. There can be no assurance that, despite our testing,errors will not be found in the initial product or subsequent releases afterthe commencement of commercial shipments, resulting in loss of customers orfailure to achieve market acceptance.  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 onthird parties to provide certain components and services for our video phoneproducts. If our vendors fail to deliver their products in a reliable, timelyand cost-efficient manner, our business will suffer.**

 

Wedepend on relationships with third parties such as contract manufacturingcompanies, chip design companies and others who may be sole source providers ofkey components and services critical for the product we are developing in ourvideo phone business. A formal relationship with Mototech, Inc. (not anaffiliate of Motorola) has been established for the volume manufacture ofOjo.  Our agreement with Mototech allows either party to terminate theagreement with 90 days prior notice.  If Mototech, Inc. or otherproviders of components and/or manufacturing services do not produce thesecomponents or provide their services on a timely basis, if the components orservices do not meet our specifications and quality control standards, or ifthe components or services are otherwise flawed, we may have to delay productdelivery, or recall or replace unacceptable products. In addition, suchfailures could damage our reputation and could adversely affect our operatingresults. As a result, we could lose potential customers and any revenues thatwe may have at that time may decline dramatically.

 

**We willrely on third parties to provide certain marketing and distribution servicesfor our video phone products. If our vendors fail to deliver their services ina reliable, timely and cost-efficient manner, our business will suffer.**

 

We have entered into a sixyear distribution agreement with Motorola, Inc. for the marketing anddistribution of our Ojo video phone. This agreement provides for Motorola to beWorldGate’s exclusive distributor of its broadband video phone products and forWorldGate to be Motorola’s exclusive supplier of its broadband video phoneproducts.  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 the Company’s products being distributed.  Neitherparty can terminate the agreement except in cases of uncured breaches of theagreement or as a result of insolvency events suffered by the otherparty. After a period of 18 months following the commercial availabilityof the Ojo video phone the mutual exclusivity will terminate unless Motorolaelects to continue the mutual exclusivity after having achieved certain minimumsales targets for the Ojo video phone. Motorola may, however, at its option,elect to terminate the exclusivity at any time. In the event mutual exclusivity terminates or is terminated, then for aperiod of twelve months thereafter, WorldGate will continue to be Motorola’sexclusive supplier of broadband video phones but will be free to sell videophones to customers other than certain defined Motorola accounts. During thistwelve month period, Motorola has a right of first refusal to accept and fillany orders for video phone products that WorldGate obtains from non-Motorolaaccounts, and is obligated to use good faith efforts to solicit and acceptproduct orders from Motorola accounts in a commercially reasonable manner.During any period of exclusivity under this agreement we are reliant uponMotorola and its distribution partners, including, for example, wholesalers,retailers and service providers, to provide the worldwide sales anddistribution of the Ojo video phone. If Motorola and its partners are notsuccessful, or if their activities do not lead to significant sales of ourproduct, our operating results will be adversely affected, our revenue could besignificantly reduced and we could lose potential customers.

 

18

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**We may notbe able to meet our product development objectives or market expectations.**

 

Ourvideo phone product development efforts are inherently difficult to manage andkeep on schedule and there can be no assurance that we will be able tomeet our development objectives or to meet market expectations. In addition todevelopment delays, we may experience substantial cost overruns in completingdevelopment of our product. The technological feasibility for some aspects ofthe product that we envision is not completely established. The product beingdeveloped by us may contain undetected flaws when introduced. There can be noassurance that, despite testing by us and by potential customers, flaws willnot be found in the product, resulting in loss of or delay in marketacceptance. We may be unable, for technological or other reasons, to developand introduce the product in a timely manner in response to changing customerrequirements. Further, there can be no assurance that while we are attemptingto finish development of our product, a competitor will not introduce a similarproduct. The introduction by a competitor of either a similar product before weintroduce our product, or a superior alternative to our product, may diminishour technological advantage, render our product and technologies partially orwholly obsolete, or require substantial re-engineering of our product in orderto become commercially acceptable. Our failure to maintain our productdevelopment schedules, avoid cost overruns and undetected errors or introduce aproduct that is superior to competing products would have a materially adverseeffect on our business, financial condition and results of operations.

 

**We may notbe able to achieve competitive pricing in the marketplace.**

 

Becausevideo phone products are relatively new to the marketplace there is noestablished market pricing.  Our pricing for the Ojo video phone may beconsidered high for a consumer product offering. We cannot be assured that we willbe able to provide competitive market pricing.

 

**We arehighly dependent on our key personnel to manage our business, and because ofcompetition for qualified personnel we may not be able to recruit or retainnecessary personnel.**

 

Ourcontinued growth and success depend to a significant degree on the continuedservices of our senior management and other key employees and our ability toattract and retain highly skilled and experienced technical, managerial, salesand marketing personnel. We have historically been a developer of productsrelated to ITV. Our video phone business represents an expansion into thedevelopment of HSD communications hardware and software products in which wehave limited experience. As we enter this new line of business, we also expectto encounter new product development challenges, new customer requirements, newcompetitors and other new business challenges, with which our existingmanagement may be unfamiliar. There can be no assurance that we will besuccessful in recruiting new personnel or in retaining existing personnel. Noneof our employees is subject to a long-term employment agreement. The loss ofone or more key employees or our inability to attract additional qualifiedemployees could have a material adverse effect on our business, results ofoperations and financial condition. In addition, we may experience increasedcompensation costs in order to attract and retain skilled employees.

 

**We may notbe successful in developing or maintaining strong distribution channels for ourvideo phone products.**

 

Thesuccess of the video phone business depends on developing strong relationshipswith service providers such as cable and DSL operators and other HSDcommunications providers and distribution channel partners who are sellingservices to end-users. We plan to rely primarily on Motorola and our HSDoperator and electronics distribution channel relationships to market our videophone products. If we are not successful in creating a strong distributionchannel in a timely manner, we may not gain significant sales.

 

**We may notbe able to compete successfully in the highly competitive and rapidly evolvingHSD communications market.**

 

Themarket for products that utilize HSD communications is still developing andthere can be no assurance that our product will ever achieve market acceptance.Since we have no existing customers for our video phone business, cableoperators and other HSD network providers must be convinced to buy our videophone product. To the extent we do not achieve growth, it will be difficult forus to generate meaningful revenue or to achieve profitability.

 

19

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**We may notbe able to protect intellectual property of our video phone business againstthird-party infringements or claims of infringement.**

 

Failureto protect our intellectual property rights may result in a loss of ourexclusivity or the right to use our video phone technology. We plan to rely onpatent, trade secret, trademark and copyright law to protect our video phoneintellectual property. Although we have filed multiple patent applications forour technology, our patent position is subject to complex factual and legalissues 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.

 

Wealso seek to protect our proprietary intellectual property, includingintellectual property that may not be patented or patentable, in part byconfidentiality agreements and, if applicable, inventor’s rights agreementswith our current and future strategic partners and employees. We cannot assureyou that these agreements will not be breached, that we will have adequateremedies for any breach or that such persons or institutions will not assertrights to intellectual property arising out of these relationships.

 

Someof our video phone intellectual property includes technologies and processesthat may be similar to the patented technologies and processes of third parties.If we do not adequately secure our freedom to use our video phone technology,we may have to pay others for rights to use their intellectual property, paydamages for infringement or misappropriation or be enjoined from using suchintellectual property. If we are found to be infringing third-party patents, wedo not know whether we will be able to obtain licenses to use such patents onacceptable terms, if at all. While we are not currently engaged in any materialintellectual property disputes or litigation, we could become subject tolawsuits in which it is alleged that we have infringed the intellectualproperty rights of others or commence lawsuits against others who we believeare infringing upon our rights. Our involvement in intellectual propertylitigation could result in significant expense to us, adversely affecting thedevelopment of the challenged product or intellectual property and divertingthe efforts of our technical and management personnel, whether or not suchlitigation concludes favorably for our company.

 

**Legal andregulatory developments could have adverse consequences for our business.**

 

Thelegal and regulatory environment that pertains to our business is uncertain andchanging rapidly. New legislation or regulations could be introduced that couldsubstantially impact our ability to launch and promote the Ojo video phone. Forexample, in the United States, the Federal Communications Commission (FCC)could undertake an examination of whether to impose surcharges or additional regulationsupon certain providers of Internet protocol, or IP, based communicationservices. The imposition of regulations on IP communications services maynegatively impact our business.

 

**The use ofthe high speed data infrastructure as a commercial marketplace is at an earlystage of development.**

 

Demandand market acceptance for recently introduced products and services over thehigh speed data, or HSD, infrastructure are still uncertain. We cannot predictwhether customers will be willing to shift their traditional telephoneactivities online. The HSD infrastructure may not prove to be a viablecommercial marketplace for a number of reasons, including:

 

•                  concernsabout security and varying security techniques and protocols;

•                  changingand non-uniform standards

•                  Internetcongestion;

•                  qualityof service issues;

•                  inconsistentservice; and

•                  lackof cost-effective, high-speed access.

 

Ifthe use of the HSD infrastructure as a commercial marketplace does not continueto grow, we may not be able to grow our customer base, which may prevent usfrom achieving profitability.

 

**We may nothave sufficient working capital to fund our continuing video phone business,and we may be unable to obtain additional capital.**

 

Theextent and timing of our future capital requirements will depend upon severalfactors, including the rate of market

 

20

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acceptance of our products,the degree of competition for our products, and our level of expenditures,including those for product development, sales and marketing.  If ourcapital requirements vary materially from those currently planned, we mayrequire additional financing sooner than anticipated.  Despite the receiptof proceeds from several private placements of our securities, we may need toseek additional third party investment in order to provide additional operatingcapital for our video phone business. We cannot be certain that financing fromthird parties will be available on acceptable terms to us or at all.  Thelevels of funding of early-stage companies generally by both venture funds andstrategic investors have fallen dramatically in the past few years. If wecannot raise funds on acceptable terms, we may not be able to develop ourproducts and services, take advantage of future opportunities or respond tocompetitive pressures or unanticipated requirements, any of which could have amaterial adverse effect on our ability to grow our business. If we are unableto secure such additional financing, we will have to curtail or suspend ourbusiness activities, we may not be able to continue to operate our business asa going concern and we may have to seek protection of the bankruptcy courts. Ifthat happens, you could lose your entire investment.

 

**If weobtain additional financing, you may suffer significant dilution.**

 

Ifwe raise additional capital by issuing equity securities, our stockholders mayexperience severe dilution of their ownership percentage, which may adverselyaffect the value of our common stock.  In addition, the new equitysecurities may have rights, preferences or privileges senior to those of ourcommon stock.

 

**NASDAQListing Requirements may limit our ability to raise additional capital.**

 

Ourcommon stock is listed on the NASDAQ SmallCap Market.  If our common stockis listed on The NASDAQ National Market or The NASDAQ SmallCap Market at thetime of a proposed equity financing resulting in the sale and issuance oftwenty percent or more of the outstanding shares of our capital stock, we maybe required 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 theevent that our common stock is delisted from NASDAQ SmallCap Market, it may besubject to the requirements of the rules relating to “penny stocks.”**

 

Ourcommon stock is currently listed on the NASDAQ SmallCap Market, which hasrequirements for the continued listing of stock. If we fail to continue to meetthese listing requirements we will become subject to delisting. For example, ifour common stock trades below $1.00 for 30 consecutive trading days, or if wefail to meet any of the other listing requirements including the marketcapitalization and minimum stockholders equity requirements, our common stockmay be delisted from the NASDAQ SmallCap Market. If our shares are delistedfrom the NASDAQ SmallCap Market, they are likely to become subject to the SECpenny stock rules, which could adversely affect the market liquidity of ourcommon stock. These rules impose additional sales practice requirements onbroker-dealers that sell low-priced securities to persons other thanestablished customers and institutional accredited investors; and require thedelivery of a disclosure schedule explaining the nature and risks of thepenny stock market. As a result, the ability or willingness of broker-dealersto sell or make a market in our common stock might decline, and you could findit more difficult to sell your stock.

 

**Our stockprice is volatile.**

 

Thetrading price for our common stock has been volatile, ranging from a salesprice of $0.22 in April 2003, to a sales price of over $6.00 per share in December 2004.The price has changed dramatically over short periods with changes of over 60%percent in a single day. An investment in our stock is subject to suchvolatility and, consequently, is subject to significant risk.

 

**Priorofferings of our common stock may have an adverse impact on the market value ofour stock.**

 

During2003 and 2004 we issued shares of our common stock as part of various privateplacements to certain institutional investors and as part of that transactionfiled three registration statements, which provided for the sale ordistribution of these shares by these institutional investors. When theseinvestors sell their shares we will not receive any proceeds from the sales.The sale of these blocks of stock, or even the possibility of its sale, mayadversely affect the trading market for our common stock and reduce the priceavailable in that market.

 

Inconnection with these private placements, we also issued warrants andadditional investment rights to purchase shares of common stock. The existenceof such rights to acquire common stock at fixed prices may prove a hindrance toour efforts to raise future equity and debt funding, and the exercise of suchrights will dilute the percentage ownership interest of our stockholders

 

21

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and may dilute the value oftheir ownership. The possible future sale of shares issuable on the exercise ofoutstanding warrants and additional investment rights could adversely affectthe prevailing market price of our common stock. Further, the holders of theoutstanding warrants and additional investment rights may exercise them at atime when we would otherwise be able to obtain additional equity capital onterms more favorable to us.

 

**The Company’s failure to comply with certain covenants contained inagreements relating to its private placement of securities****may havean adverse impact on the cash available to the Company.**

 

We issued shares of ourcommon and preferred stock, as well as warrants and additional rights toacquire our common stock, to certain institutional investors in privateplacement transactions in 2003 and 2004. The various agreements providing for these private placementtransactions included numerous provisions intended to protect such institutionalinvestors.  For example, the Company isrequired to continually maintain effective registration statements permittingthe investors to sell their shares of common stock.  Failure to comply with such requirements mayresult in damages to the investors and result in obligations to make cashpayments to the investors.  The investorsmay also be entitled to receive more shares than originally allocated in theevent the Company subsequently issues shares to other investors at a lowervaluation than that afforded to the investors. In addition, the investors may be entitled to receive cash paymentsinstead of shares upon the redemption of certain securities in the event thatcertain defined events occur including a lapse in the registration statement,being delisted on certain specified exchanges, trading in the Company’s stockis suspended, or a change in control occurs with respect to the Company.

 

**Our boardof directors’ right to authorize additional shares of preferred stock couldadversely impact the rights of holders of our common stock.**

 

Ourboard of directors currently has the right to designate and authorize theissuance of one or more series of our preferred stock with such voting,dividend and other rights as our directors may determine. The board ofdirectors can designate new series of preferred stock without the approval ofthe holders of our common stock. The rights of holders of our common stock maybe adversely affected by the rights of any holders of shares of preferred stockthat may be issued in the future, including without limitation dilution of theequity ownership percentage of our holders of common stock and their votingpower if we issue preferred stock with voting rights. Additionally, theissuance of preferred stock could make it more difficult for a third party to acquirea majority of our outstanding voting stock.

 

22

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**Item 7A.  Quantitative and Qualitative Disclosures aboutMarket Risk.**

 

Referto Interest Rate Risk and Foreign Currency Exchange Risk on page 16 for adiscussion of this item.

 

23

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**Item 8.  Financial Statements and Supplementary Data.**

 

**WORLDGATE COMMUNICATIONS, INC.**

 

**INDEX TO FINANCIAL STATEMENTS**

 
| Report of Grant Thornton LLP,  Independent Registered Public Accounting Firm                                                  | F-2 |
|-------------------------------------------------------------------------------------------------------------------------------|-----|
| Report of  PricewaterhouseCoopers LLP, Independent Registered Public Accounting Firm                                          | F-3 |
| Consolidated  Balance Sheets as of December 31, 2003 and 2004                                                            | F-4 |
| Consolidated  Statements of Operations for the years ended December 31, 2002, 2003 and  2004                             | F-5 |
| Consolidated  Statements of Stockholders’ (Deficiency) Equity for the years ended  December 31, 2002, 2003 and 2004 | F-6 |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2002, 2003 and  2004                             | F-7 |
| Notes to  Consolidated Financial Statements                                                                                   | F-8 |
| Schedule II  — Valuation and Qualifying Accounts*                                                                   | 34  |

 

----

* All other schedules forwhich provision is made in the applicable accounting regulations of theSecurities and Exchange Commission are not required under the relatedinstructions or are inapplicable, and therefore have been omitted.

 

F-1

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**Report of Independent Registered Public AccountingFirm**

 

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.

 

We conducted our audits inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement. The Company is not required to have, nor were we engagedto perform, an audit of its internal control over financial reporting. Ouraudits included consideration of internal control over financial reporting as abasis for designing audit procedures that are appropriate in the circumstances,but not for the purpose of expressing an opinion on the effectiveness of theCompany’s internal control over financial reporting. Accordingly, we express nosuch opinion. An audit also includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements, assessingthe accounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audits provide a reasonable basis for our opinion.

 

In our opinion, thefinancial statements referred to above present fairly, in all materialrespects, the consolidated financial position of WorldGate Communications, Inc.and subsidiaries as of December 31, 2004 and 2003, and the consolidatedresults of their operations and their cash flows for the years then ended, inconformity with accounting principles generally accepted in the United States.

 

Our audits were conductedfor the purpose of forming an opinion on the basic financial statements takenas a whole. Schedule II is presented for purposes of additional analysisand is not a required part of the basic financial statements. This schedule hasbeen subjected to the auditing procedures applied in the audit of the basicfinancial statements and, in our opinion, is fairly stated in all materialrespects in relation to the basic financial statements taken as a whole.

 

The accompanying financialstatements have been prepared assuming that the Company will continue as agoing concern. As discussed in Note 4 to the financial statements, theCompany has suffered recurring losses from operations and has a net accumulateddeficiency of $218 million that raises substantial doubt about its abilityto continue as a going concern. Management’s plans in regard to these mattersare also described in Note 4. The financial statements do not include anyadjustments that might result from the outcome of this uncertainty.

 

Asdiscussed in Note 2*Restatement No. 1*and Note 3 *Restatement No. 2,*of theconsolidated financial statements, the Company has restated its consolidatedfinancial statements for the years ended December 31, 2004 and 2003.

 
| /s/ Grant  Thornton LLP                                                   |   |
|--------------------------------------------------------------------------------|--------|
|                                                                           |
| Philadelphia,  Pennsylvania                                                    |
| February 24,  2005 (except for Note 2 *Restatement No. 1*            |
| as to which  the date is August 24, 2005 and                              |
| Note 3 *Restatement No. 2*as to which the date is January 10,  2006) |

 

F-2

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**Report of Independent Registered Public Accounting Firm**

 

To the Shareholders andBoard of Directors ofWorldGate Communications, Inc.:

 

In our opinion, theconsolidated statements of operations, stockholders’ (deficiency) equity and ofcash flows for the year ended December 31, 2002 listed in the accompanyingindex present fairly, in all material respects, the results of operations andcash flows of WorldGate Communications, Inc. and its Subsidiaries for theyear ended 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 3 to the financial statements, which appears inthe financial statements included in the Company’s Form 10-K for the yearended December 31, 2002 and not presented herein, the Company has incurredrecurring losses from operations that raise substantial doubt about its abilityto continue as a going concern. Management’s plans in regard to these mattersare also described in Note 3, which appears in the financial statementsincluded 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

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

 
| ** **                                                                                                                                                                                               | ** ** | **As of  December 31** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                               | ** ** | **2003 (Restated)**         | ** ** | **2004 (Restated)** | ** ** |
| ASSETS                                                                                                                                                                                                   |       |                        |       |   |   |
| Current  assets:                                                                                                                                                                                         |       |                        |       |   |   |
| Cash and cash equivalents                                                                                                                                                                                |       | $                           | 3,365      |   | $ | 11,840 |   |
| Trade accounts receivable less allowance  for doubtful accounts of $381 at December 31, 2003 and $0 at  December 31, 2004                                                                 |       | 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                                                                                                                                                                                              |       | 0                           |       | 0 |   |
| 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’ equity (deficiency):                                                                                                                                                           |       |                        |       |   |   |
| 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                                                                                                                                                                              |       | 201,766                     |       | 212,439 |   |
| Unearned  compensation                                                                                                                                                                                   |       | (400                        | )          | 0 |   |
| Accumulated  deficit                                                                                                                                                                                     |       | (197,943                    | )          | (218,319 | ) |
| 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 an integral part of these consolidatedfinancial statements.

 

F-4

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

 
| ** **                                                                                                      | ** ** | **Twelve Months  Ended December  31, 2002** | ** ** | **Twelve Months  Ended December  31, 2003** | ** ** | **Twelve Months  Ended December  31, 2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                      | ** ** | ** **                                  | ** ** | **(Restated)**                              | ** ** | **(Restated)**                              | ** ** |
| 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                                           |       | 2,331                                       |       | 4,675                                       |       |
| Depreciation and amortization                                                                                   |       | 0                                           |       | 0                                           |       | 477                                         |       |
| Total expenses from continuing operations                                                                       |       | 0                                           |       | 5,797                                       |       | 10,515                                      |       |
| Loss from  operating activities of continuing operations                                                        |       | 0                                           |       | (5,797                                      | )          | (10,387                                     | )          |
| 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                                           |       | (5,797                                      | )          | (19,461                                     | )          |
| (Loss)  income from discontinued operations                                                                     |       | (19,210                                     | )          | (2,908                                      | )          | 36                                          |       |
| Net loss                                                                                                        |       | $                                           | (19,210    | )                                           | $          | (8,705                                      | )          | $ | (19,425 | ) |
| Accretion on  preferred stock and dividends                                                                     |       | 0                                           |       | 0                                           |       | (951                                        | )          |
| Net loss  available to common stockholders                                                                      |       | $                                           | (19,210    | )                                           | $          | (8,705                                      | )          | $ | (20,376 | ) |
| Loss from continuing operations per common  share (Basic and Diluted)                                           |       | $                                           | 0.00       |                                        | $          | (0.25                                       | )          | $ | (0.70 | ) |
| (Loss) income 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      | )                                           | $          | (0.37                                       | )          | $ | (0.70 | ) |
| Net loss available to common shareholders  per common share (Basic and Diluted)                                 |       | $                                           | (0.81      | )                                           | $          | (0.37                                       | )          | $ | (0.73 | ) |
| Weighted  average common shares outstanding (Basic and Diluted)                                                 |       | 23,573,935                                  |       | 23,259,611                                  |       | 27,881,347                                  |       |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

F-5

----

 

**WORLDGATE COMMUNICATIONS, 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  (as restated)** | ** ** | **Common  Stock** | ** ** | **Deficit  (as restated)** | ** ** | **Compensation** | ** ** | **Shares**          | ** ** | **Amount** | ** ** | **Equity** | ** ** |
| **Balance  at December 31, 2001**                                    |       | 23,565            |       | $          | 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 (as restated)                          |       |              |       |       |       | 117                        |       |              |       |                       |       |             |       |                |       |   |   | 117 |   |
| 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 (as restated)                                      |       |              |       |       |       |                       |       |              |       | (8,705                     | )          |             |       |                |       |   |   | (8,705 | ) |
| **Balance  at December 31, 2003**(as restated)                       |       | 26,207            |       | 262        |       | 201,766                    |       | 0                 |       | (197,943                   | )          | (400             | )          | (500                | )          | (5 | ) | 3,680 |   |
| Authorization of  earned compensation to vendor                           |       |              |       |       |       |                       |       |              |       |                       |       | 400              |       |                |       |   |   | 400 |   |
| Non-cash stock  based Compensation (as restated)                          |       |              |       |       |       | 608                        |       |              |       |                       |       |             |       |                |       |   |   | 608 |   |
| 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 (as restated)                                      |       |              |       |       |       |                       |       |              |       | (19,425                    | )          |             |       |                |       |   |   | (19,425 | ) |
| **Balance  at December 31, 2004 (as restated)**                      |       | 30,866            |       | $          | 308        |                       | $          | 212,439           |       | $                          | 0          |             | $          | (218,319            | )          | $ | 0 |   | $ | 0 |   | $ | 0 |   | $ | (5,572 | ) |
|                                                                           |            |                   |            |            |            |                            |            |                   |            |                            |            |                  |            |                     |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

F-6

----

 

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

 
| ** **                                                                                        | ** ** | **Twelve Months  Ended December  31, 2002** | ** ** | **Twelve Months  Ended December  31, 2003** | ** ** | **Twelve Months  Ended December  31, 2004** | ** ** |
|---------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                        | ** ** | ** **                                  | ** ** | **(As restated)**                           | ** ** | **(As restated)**                           | ** ** |
| Cash flows  from operating activities:                                                            |       |                                        |       |                                        |       |                                        |       |
| Net loss                                                                                          |       | $                                           | (19,210    | )                                           | $          | (8,705                                      | )          | $ | (19,425 | ) |
| Income (loss) 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                                           |       | 78                                          |       | 608                                         |       |
| 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  (decrease) increase 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 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

F-7

----

 

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

 

**1. Basis of Presentation**

 

Theconsolidated financial statements of WorldGate Communications, Inc. (“WorldGate”or the “Company”) presented herein have been prepared by the Company pursuantto the rules and regulations of the Securities and Exchange Commission forannual reports on Form 10-K. WorldGate was incorporated in Delaware in1996 to succeed to the business of the predecessor company, WorldGateCommunications, L.L.C., which commenced operations in March 1995. WorldGate has 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.

 

Theconsolidated financial statements of the company include the accounts ofWorldGate Communications, Inc. and its wholly owned subsidiaries WorldGateService, Inc., WorldGate Finance, Inc., and WorldGate AcquisitionCorp. All significant intercompany accounts and transactions have beeneliminated in consolidation.

 

**2.**** ****Restatement No. 1**

 

The Company has restated its financialstatements for the year ended December 31, 2004 toinclude certain clarifications made in response to the SEC’s review of theCompany’s registration statement on Form SB-2, as filed with theSEC on May 24, 2005, and annual report on Form 10-Kfor the year ended December 31, 2004, as filed with the SEC onMarch 31,2005.  These restatements includeexpanded explanations in the Notes to Consolidated Financial Statements of theCompany’s accounting method and policy for redeemable preferred stock andwarrants issued by the Company in a private placement in June 2004.

 

**3.**** ****Restatement No. 2**

 

The Company has restated its financial statements for the years ended December 31,2004 and 2003 to amend and restate the accounting for the warrants andadditional investments rights issued in a private placement of the Company’scommon stock during the fourth quarter of 2003, and the first and fourthquarters of 2004.  Thesesecurity components were originally treated as non-cash expenses and with thisrestatement are being restated as equity transactions.  There is no cash impact associated with theserestatements. There were also related adjustments to the Company’s consolidatedstatement of cash flows and consolidated statement of stockholders’ equity.

 

The effect of the restatement on specific amounts provided in theconsolidated financial statements is as follows:

 

| ** **                           | ** ** | **As of December 31, 2004** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|
| **Consolidated  Balance Sheet**      | ** ** | **As previously reported**       | ** ** | **As restated** | ** ** |
|                                 |       |                             |       |   |   |
| Accumulated  deficit                 |       | $                                | (219,743   | ) | $ | (218,319 | ) |
| Additional-paid-in  capital          |       | 213,863                          |       | 212,439 |   |
| Total  stockholders’ deficiency |       | (5,572                           | )          | (5,572 | ) |
|                                      |            |                                  |            |  |  |  |  |

 

| ** **                                                 | ** ** | **For the year ended December 31, 2004** | ** ** |
|------------------------------------------------------------|------------|-----------------------------------------------|------------|
| **Consolidated  Statement of Operations**                  | ** ** | **As previously reported**                    | ** ** | **As restated** | ** ** |
|                                                       |       |                                          |       |   |   |
| General and  Administrative expenses-continuing operations |       | $                                             | 5,399      |   | $ | 4,675 |   |
| Total  expenses-continuing operations                      |       | 11,239                                        |       | 10,515 |   |
| Net loss                                                   |       | (20,149                                       | )          | (19,425 | ) |
| Net loss  applicable to common stockholders                |       | (21,100                                       | )          | (20,376 | ) |
|                                                       |       |                                          |       |   |   |
| Net loss per common share:                                 |       |                                          |       |   |   |
| Basic                                                      |       | $                                             | (0.72      | ) | $ | (0.70 | ) |
| Diluted                                                    |       | (0.72                                         | )          | (0.70 | ) |

 

| ** **                       | ** ** | **As of December 31, 2003** | ** ** |
|----------------------------------|------------|----------------------------------|------------|
| **Consolidated  Balance Sheet**  | ** ** | **As previously reported**       | ** ** | **As restated** | ** ** |
|                             |       |                             |       |   |   |
| Accumulated  deficit             |       | $                                | (198,643   | ) | $ | (197,943 | ) |
| Additional-paid-in  capital      |       | 202,466                          |       | 201,766 |   |
| Total  stockholders’ equity |       | 3,680                            |       | 3,680 |   |
|                                  |            |                                  |            |  |  |  |  |

 

| ** **                                                 | ** ** | **For the year ended December 31, 2003** | ** ** |
|------------------------------------------------------------|------------|-----------------------------------------------|------------|
| **Consolidated  Statement of Operations**                  | ** ** | **As previously reported**                    | ** ** | **As restated** | ** ** |
|                                                       |       |                                          |       |   |   |
| General and  Administrative expenses-continuing operations |       | $                                             | 3,031      |   | $ | 2,331 |   |
| Total  expenses-continuing operations                      |       | 6,497                                         |       | 5,797 |   |
| Net loss                                                   |       | (9,405                                        | )          | (8,705 | ) |
|                                                       |       |                                          |       |   |   |
| Net loss per  share                                        |       |                                          |       |   |   |   |
| Basic                                                      |       |                                          | $          | (0.40 | ) | $ | (0.37 | ) |
| Diluted                                                    |       |                                          | (0.40      | ) | (0.37 | ) |

 

F-8

----

 

In addition, the Company has included restatements toreflect expanded clarifications on the preferred stock transaction the Companycompleted in June of 2004, liquidity and going concern considerations andchanges to the Notes to Consolidated Financial Statements.

** **

**4. Summary of Significant Accounting Policies**

 

*Liquidityand Going Concern Considerations.*

 

Asof December 31, 2004 the Company had cash and cash equivalents of$11,840.  The operating cash usage from continuing operations for thetwelve months ended December 31, 2004 was $7,084. During the third quarterof 2003, 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.

 

InDecember 2003 and January 2004, WorldGate received investmentsaggregating $3,100 by certain institutional investors. These investorspurchased an aggregate of 3,000,000 shares of newly issued common stock. Theinvestors also received a right, for a limited period of time, to purchaseadditional shares of up to 20% of the common stock purchased by the investorsin their investment, at the same price as their investment, and five-yearwarrants to purchase up to 30% of the common stock purchased by the investorsin their investment, at an exercise price equal to a twenty-five percentpremium to their purchase price for the investment. The purchase price for the2,000,000 shares purchased in the December 2003 transactions were $0.80per share, with the warrants having a $1.00 per share exercise price. Thepurchase price for the 1,000,000 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.

 

InDecember 2003, WorldGate reached agreement with Mototech, Inc. (notan affiliate of Motorola) for the purchase of 625,000 shares of newly issuedcommon stock at $0.80 per share, in return for future design and engineeringservices by Mototech. WorldGate had previously contracted with Mototech toassist the Company with the design and volume manufacture of WorldGate’s Ojopersonal video phone. The purchase price for these shares has been fully paidas of December 31, 2004 by an equivalent reduction in the development andinitial procurement payments that would otherwise be due to Mototech.The value of this transaction was $600 (basedon the closing stock price of $0.96 on the date of the transaction) of which$200 was recorded as an expense for the year ended December 31, 2003 and $400was expensed for the year ended December 31, 2004. Mototech is an affiliate ofAccton Technology Group. Mototech currently manufactures and distributes a fullrange of high performance high speed data and computer networking products,including cable set top boxes, home gateways, wireless LANs, hubs, switches,routers, and other related products. In addition, in April 2004, Mototechinvested $1,000 to purchase 666,666 shares of newly issued common stock at$1.50 per share.

 

InJune 2004, WorldGate completed a private placement of 7,550 shares of its preferredstock 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; five-year warrants to purchase up to 803,190 shares of our common stockat an exercise price of $2.69 per share; and five-year warrants to purchase upto 803,190 shares of our common stock at an exercise price of $3.14 per share.The investors also received an additional investment right, for a limitedperiod of time, to purchase 1,606,383 additional shares of common stock sharesat $3.14 a share. In November and December 2004, 775 preferred shareswere converted 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 a private placement of 208,333 shares of our common stockto K. Y. Chou, President and General Manager of Mototech, at a sales price of $2.40per shares, which resulted in additional gross proceeds to the Company of$500.  In connection with this placement the Company granted warrants to Mr. Chouto purchase up to 62,500 shares of our common stock at an exercise price of$2.88 per share.

 

TheCompany has $16,399 of liabilities and its assets are not pledged as collateralas of December 31, 2004. These liabilities include $14,280 related to theCompany’s private placement of preferred stock (refer to Footnote 9), and $369of advanced funds from Motorola for future shipments of video phones inconformity with the Agreement signed in April 2004.

 

F-9

----

OurCompany has suffered recurring losses from operations and had a net accumulateddeficiency of $218,000 as of December 31, 2004, and these issues raisesubstantial doubt about our Company’s ability to continue as a going concern.Our short term cash requirements and obligations include, inventory, accountspayable and capital expenditures from continuing operations, operatingexpenses, and the redemption of preferred stock, of which $2,258 is required tobe redeemed in December 2005, although this redemption can be made incommon stock if certain conditions are met. We expect, based on our internal forecastsand assumptions relating to our operations (including among others, assumptionsregarding our short term cash requirements and our projected revenue growth )that we have sufficient cash on hand to meet our obligations for at least thenext twelve months.

 

Ourability to generate cash is dependant upon the sale of our Ojo product and onobtaining cash through capital markets. We have not generated any revenue from commercial shipments of our Ojoproduct and we do know when or if we will. Given that our video phone businessinvolves the development of a new product line with no market penetration, inan undeveloped market sector, no assurances can be given that sufficient sales,if any, will materialize.

 

Additionally,as needed, we plan to generate cash by turning to the capital markets forfunding.  No assurances can be giventhat, if pursued, additional financing transactions can be consummated.  We continue to evaluate possibilities toobtain additional financing through public or private equity or debt offerings,bank debt financing, asset securitizations, or from other sources, should weneed to obtain such financing.  Suchadditional financing would be subject to the risk of availability, may bedilutive to our shareholders, or could impose restrictions on operatingactivities. There can be no assurance that this additional financing will beavailable on terms acceptable to us, if at all.

 

We,however, remain hopeful that sufficient sales will materialize and/or thatsufficient funding can be developed through ongoing operations or additionalfinancings to continue our operations beyond the next twelve months.

 

Ourlong term cash requirement obligations are primarily comprised of the itemsnoted above. We have no long term debt and our contractual cash requirementsand obligations existing beyond the next twelve months are comprised solely ofoperating lease commitments and redemption of preferred stock, which are notconsidered material.  We have limited capacityto further reduce our workforce and scale back on capital and operationalexpenditures to decrease our cash usage.

 

Use of Estimates

 

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities, at the date the financialstatements and the reported amount of revenues and expenses during thereporting period.  Actual results could differ from those estimates.

 

*Risks and uncertainties*

 

Our primary line of business isthe development of video phone products and technology. We are still in theprocess of launching our first product based on this technology and, althoughwe have realized some revenues for the commercial sale of our product, therevenues to date have not been substantial. Given the early stage of ourproduct and the lack of operating history in the video phone business, it isdifficult to predict our future results.

 

We haveentered into a six year distribution agreement with Motorola, Inc. for themarketing and distribution of our Ojo video phone. This agreement provides forMotorola to be WorldGate’s exclusive distributor of its broadband video phoneproducts and for WorldGate to be Motorola’s exclusive supplier of its broadbandvideo phone products.  Although the agreement requires Motorola to providefor certain marketing and promotional activities for the Ojo video phone, thereare no required sales quotas for the agreement to remain in effect, andMotorola controls the volume of the Company’s products being distributed. Neither party can terminate the agreement except in cases of uncured breachesof the agreement or as a result of insolvency events suffered by the otherparty. After a period of 18 months following the commercial availabilityof the Ojo video phone the mutual exclusivity will terminate unless Motorolaelects to continue the mutual exclusivity after having achieved certain minimumsales targets for the Ojo video phone. Motorola may, however, at its option,elect to terminate the exclusivity at any time. In the event mutual exclusivity terminates or is terminated, then for aperiod of twelve months thereafter, WorldGate will continue to be Motorola’sexclusive supplier of broadband video phones but will be free to sell videophones to customers other than certain defined Motorola accounts. During thistwelve month period, Motorola has a right of first refusal to accept and fillany orders for video phone products that WorldGate obtains from non-Motorolaaccounts, and is obligated to use good faith efforts to solicit and acceptproduct orders from Motorola accounts in a commercially reasonable manner.During any period of exclusivity under this agreement we are reliant uponMotorola and its distribution partners, including, for example, wholesalers,retailers and service providers, to provide the worldwide sales anddistribution of the Ojo video phone. If Motorola and its partners are not successful,or if their activities do not lead to significant sales of our product, ouroperating results will be adversely affected, our revenue could besignificantly reduced and we could lose potential customers.

###### ** **

F-10

----

 

###### **We alsodepend on relationships with third parties such as contract manufacturingcompanies, chip design companies and others who may be sole source providers ofkey components and services critical for the product we are developing in ourvideo phone business. A formal relationship with Mototech, Inc. (notrelated to Motorola) has been established for the volume manufacture of Ojo. Mototechis currently the sole volume manufacturer of Ojo. Our agreement with Mototechallows either party to terminate the agreement with 90 days prior notice. IfMototech, Inc. or other providers of components and/or manufacturingservices do not produce these components or provide their services on a timelybasis, if the components or services do not meet our specifications and qualitycontrol standards, or if the components or services are otherwise flawed, wemay have to delay product delivery, or recall or replace unacceptable products.In addition, such failures could damage our reputation and could adversely affectour operating results. As a result, we could lose potential customers and anyrevenues that we may have at that time may decline dramatically.**

###### *** ***

###### ***Cash and Cash Equivalents***

 

The Company considers allhighly liquid investments with original maturities of three months or less tobe cash equivalents. The Company maintains cash balances at financialinstitutions, which at times exceed the $100 FDIC limit.

* *

*Inventories*

 

Ourinventory consists primarily of finished goods equipment to be sold to ourcustomer. The cost is determined on an average cost basis. A periodic review ofinventory quantities on hand is performed in order to determine and record aprovision for excess and obsolete inventories. Factors related to currentinventories such as technological obsolescence and market conditions areanalyzed to determine estimated net realizable values. A provision is recordedto reduce the cost of inventories to the estimated net realizable values. Anysignificant unanticipated changes in the factors noted above could have animpact on the value of our inventories and our reported operating results. Withthe current shift in focus to our new video phone business, our inventorybalance of $1,668 consisted of $1,622 relating solely to our ITV business,which was fully reserved for at December 31, 2004, and $46 related solelyto our new video phone business.

 

*Propertyand Equipment*

 

Propertyand equipment is carried at original cost. Depreciation is recorded on thestraight-line method over the estimated useful lives of the related assets. TheCompany depreciates furniture and fixtures over seven years; office equipmentover five years; and computer equipment and trade show exhibits over threeyears. Leasehold improvements are capitalized and amortized on thestraight-line basis over the shorter of their useful life or the term of thelease. Maintenance and repairs are expensed as incurred. When the property orequipment is retired or otherwise disposed of, related costs and accumulateddepreciation are removed from the accounts and any resulting gain or loss isincluded in operations.

 

*Goodwill*

 

Goodwillin the amount of $3,608 was recorded in connection with the Company’sacquisition of Digital Video Art, Inc. (“DVA”) and represents the excessof cost over the fair value of net assets acquired. On January 1, 2002,the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 142,“Goodwill and Other Intangible Assets.” This pronouncement changes theaccounting for goodwill and intangible assets with indefinite lives from anamortized method to an impairment approach. SFAS No. 142 requires thatgoodwill and intangible assets be tested annually for impairment using atwo-step process. The first step is to identify a potential impairment and, intransition, this step must be measured as of the beginning of the fiscal year.The second step of the goodwill impairment test measures the amount of theimpairment loss (measured as of the beginning of the year of adoption), if any,and must be completed by the end of the Company’s fiscal year. The Company’stransitional impairment test, measured as of January 1, 2002, did notresult in an impairment loss. However, as described in Note 6, animpairment of our goodwill was recorded in the second quarter of 2002.

 

*Long-livedAssets*

 

TheCompany periodically evaluates the carrying value of long-lived assets whenevents and circumstances warrant such review. The carrying value of along-lived asset is considered impaired when the anticipated undiscounted cashflows 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.

 

OnJanuary 1, 2002, the Company adopted SFAS No. 144, “Accounting forthe Impairment or Disposal of Long-Lived Assets”. SFAS No. 144 providesnew guidance on the recognition of impairment losses on long-lived assets to beheld and used or to be disposed of, and also broadens the definition of whatconstitutes a discontinued operation and how the results of a discontinuedoperation are to be measured and presented.

 

F-11

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*Accountingfor Preferred Shares and Derivative Shares [Restated]*

 

Thefollowing information has been restated to provide a more complete descriptionof the accounting method and policy related to redeemable preferred shares andderivative shares.

 

In June 2004, WorldGate completeda private placement of preferred stock. The Preferred Stock has a dividend rateof 5% per annum, payable quarterly, either by cash or through the issuance ofcommon stock at the Company’s option. The Preferred Stock has a staged maturityover three years with one-third of the Preferred Stock to be redeemed after 18months, one-third after 24 months and one-third after 36 months, and may beredeemed at maturity in cash or, at the Company’s option, subject to certainconditions that may not be solely under the control of the Company, through theissuance of the number of shares of common stock determined by dividing theliquidation preference of the preferred shares by the then current marketprice.  If the effectiveness of theregistration statement lapses, the Company ceases to be listed on certainspecified exchanges and trading in the Company’s stock is suspended or a changein control occurs with respect to the Company, the Company may be required tosettle redemption of the preferred stock with cash instead of its commonshares.  Furthermore, since the marketprice of the Company’s common stock cannot be predicted, the actual number ofshares of the Company’s common stock that will be required if a redemption ismade through the issuance of common stock, can also not be predicted.

 

The Preferred Stock has embedded conversionoptions. Specifically, the holders of the Preferred Stock may convert theirshares into the Company’s common stock at a conversion price of $2.35 pershare. In addition the Company may force conversion of the Preferred Stock intocommon stock if the Company achieves certain price targets for its common stockand satisfaction of certain other conditions, such as the existence of aneffective registration statement. In either event the conversion price issubject to adjustment if, at any time after the date the preferred shares wereissued, the Company issues or sells, or is deemed to have issued or sold, anyshares of the Company’s common stock for per share consideration less than theconversion price of the preferred shares on the date of such issuance orsale.  Accordingly, the number of commonshares issuable upon the conversion of the preferred shares cannot bepredicted.  Furthermore, net-cashsettlement may be required in the event of conversion default under certaincircumstances that may not be solely under the control of the Company.  If the effectiveness of the registrationstatement lapses, the Company ceases to be listed on certain specifiedexchanges and trading in the Company’s stock is suspended or a change incontrol occurs with respect to the Company, the Company may be required tosettle a conversion of the preferred stock with cash instead of its commonshares.

 

Also as part of the private placementthe Company issued five-year warrants to purchase up to 803,190 shares of ourcommon stock at an exercise price of $2.69 per share and five-year warrants topurchase up to 803,190 shares of our common stock at an exercise price of $3.14per share. The investors also received an additional investment right, for alimited period of time, to purchase 1,606,383 additional shares of common stockshares at $3.14 a share. This exercise price of the warrants is subject toadjustment if, at any time after the date the warrants were issued, the Companyissues or sells, or is deemed to have issued or sold, any shares of the Company’scommon stock for per share consideration less than the exercise price of thewarrants on the date of such issuance or sale. Accordingly, the number of common shares that will be issued upon theexercise of the warrants cannot be predicted. As of  December 31, 2004,none of the warrants  had been exercisedand 1,500,000 of the additional investment rights had been exercised.

 

Of the 7,550 preferred shares issuedunder this private placement, 775 shares have been redeemed as of December 31,2004.

 

With respect to the Company’saccounting for the preferred stock, EITF Topic 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 outside of permanentequity. As described above, the terms of the Preferred Stock include certainredemption features that may be triggered by events that are not solely withinthe control of the Company, such as a potential failure in the Company’sability to maintain an effective registration statement. Furthermore, theactual number of shares of common stock required to satisfy redemption is basedupon the  market value of the commonstock at the time of the redemption, which cannot be predicted. Accordingly,the Company has classified the preferred stock as temporary equity and thevalue ascribed to the redeemable preferred stock upon initial issuance, i.e. atJune 23, 2004, was the amount received in the transaction minus the fair valueascribed to the conversion options and warrants. The initial value of theredeemable preferred stock is accreted up to the redemption value (the amountreceived in the transaction) over the future relevant periods using theinterest method.

 

The terms of the preferred stockinclude certain conversion options that represent derivative financialinstruments under paragraph 12 of SFAS No. 133 and thus were separatedfrom the Preferred Stock and valued using the Black-Scholes option pricingmodel.  The conversion options includecertain provisions that could result in a variable number of shares to beissued upon conversion, adjustment to the strike price at which conversionshares will be determined, or the requirement for the Company to settle theconversion options in cash EITF 00-19, “Accounting for Derivative InstrumentsIndexed to, and Potentially Settled in, a Company’s Own Stock”, state that ifthe conversion options require net cash settlement in the event ofcircumstances that are not solely within the Company’s control they should beclassified as a liability measured at fair value on the balance sheet.

 

F-12

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The terms of the five-year warrantsinclude cash penalty provisions in the event that the Company fails to meet itsobligations to deliver registered shares to the warrant holder upon exerciseand an anti-dilution provision that could result in a variable number of sharesto be issued upon warrant exercise. Additionally, the terms and conditions ofthe warrants provide for net settlement via cashless exercise whereby theshares delivered to the warrant holder would be readily convertible to cash. Inaccordance with EITF 00-19 and given the terms and conditions of the warrantsas outlined above, the Company has classified the warrants as a liability onits balance sheet measured at fair value using the Black-Scholes option pricingmodel.

 

The Company accounts for both theconversion options and warrants using the fair value method at the end of each quarter,with the resultant gain or loss recognition recorded against earnings. Both thewarrants and conversion options are valued using the Black-Scholes valuationmodel.

* *

*Revenue Recognition*

 

Revenue is recognized whenpersuasive evidence of an arrangement exists, the price is fixed ordeterminable, the collectibility is reasonably assured, and the delivery andacceptance of the equipment has occurred or services have been rendered.  Management exercises judgment in evaluatingthese factors in light of the terms and conditions of its customer contractsand other existing facts and circumstances to determine appropriate revenuerecognition. Due to our limited commercial sales history, our ability toevaluate the collectibility of customer accounts requires significant judgment.The Company evaluates its equipment customer, and service customers’, accountsfor collectibility at the date of sale and on an ongoing basis.

 

Presently the Company hasonly one customer for the purchase of its equipment and the agreement with thiscustomer includes several elements relevant to revenue recognition including: (a) Thecustomer has no general right to return the product.  (b) The customer can earn warrants uponthe purchase of significant video telephony units and the value of thesewarrants would result in a reduction of recognized revenue (the value of thesewarrants is routinely monitored by the Company and is currently deemed to beinsignificant, however, should the value of these warrants become material anoffset would be made against revenues). (c) Penalties are payable to thecustomer if certain excessive field failure rates are exceeded.  (d) The Company and the customer sharein the benefit achieved by product cost reductions. (e) Penalties arepayable to the customer if the Company fails to deliver shipments on a timelybasis. (f) The Company extends to the customer a limited product warrantyfor a term not to exceed three years (the Company maintains a warranty reservebased upon the percentage of product sales consistent with industry comparablefailure rates and the warranty period provided by the agreement.)

 

Revenues are also offsetwith a reserve for any price refunds and consumer rebates consistent with theEmerging Task Force (“EITF”) Issue 01-9, Accounting for Consideration Given bya vendor to a Customer.

 

*Cost ofRevenues*

 

Costof equipment product revenues reflects the purchase of video phones from theCompany’s supplier Mototech (not an affiliate of Motorola).

 

*Engineeringand Development Costs*

 

Engineeringand development costs are expensed as incurred. Engineering and developmentcosts from continuing operations were $0, $3,000 and $4,001 for the years endedDecember 31, 2002, 2003 and 2004, respectively.

 

*AdvertisingCosts*

 

Advertisingcosts, included in sales and marketing expense, are expensed in the periodincurred. Advertising expenses from continuing operations were $0, $43 and $50for the years ended December 31, 2002, 2003 and 2004, respectively.

 

 

F-13

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*IncomeTaxes*

 

Provisionfor income taxes is determined based on the asset and liability method. Theasset and liability method provides that deferred tax balances are recordedbased on the difference between the tax basis of assets and liabilities andtheir carrying amounts for financial reporting purposes. Deferred taxliabilities or assets at the end of each period are determined using the taxrate enacted under the current tax law. The measurement of net deferred taxassets is reduced by the amount of any tax benefits that, based on availableevidence, are not expected to be realized, and a corresponding valuationallowance is established.

* *

*Stock-BasedCompensation (Restated)*

 

TheCompany accounts for stock-based compensation in accordance with AccountingPrinciples Board Opinion No. 25, “Accounting for Stock Issued toEmployees,” and related interpretations and has presented the required SFAS No. 123,“Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accountingfor Stock-Based Compensation—Transition and Disclosure,” pro forma disclosurein the table below.

 

AtDecember 31, 2004, the Company had stock based compensation plans, whichare described separately in Note 3. The Company applies AccountingPrinciples Board Opinion No. 25, “Accounting for Stock Issued to Employees”and related interpretations in accounting for its plans, and accordingly, nocompensation cost has been recognized for the Company’s fixed stock basedcompensation.  Had compensation cost been determined consistent with SFAS No. 123,as amended by SFAS No. 148, the Company’s net loss would have beenincreased to the following pro forma amounts:

 
| ** **                                                                                                                          | ** ** | **Year Ended December 31** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                          | ** ** | **2002**                        | ** ** | **2003** | ** ** | **2004** | ** ** |
| ** **                                                                                                                          | ** ** | ** **                      | ** ** | **(As restated)** | ** ** | **(As restated)** | ** ** |
| Net loss                                                                                                                            |       | (19,210                         | )          | (8,705 | ) | (19,425 | ) |
| 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    | ) | $ | (14,228 | ) | $ | (21,497 | ) |
|                                                                                                                                |       |                            |       |   |   |   |   |
| Net loss per  share:                                                                                                                |       |                            |       |   |   |   |   |
| Basic and  diluted net loss—as reported                                                                                        |       | $                               | (0.81      | ) | $ | (0.37 | ) | $ | (0.70 | ) |
| Basic and diluted  net—pro forma                                                                                               |       | $                               | (1.00      | ) | $ | (0.61 | ) | $ | (0.77 | ) |

 

Suchpro forma disclosures may not be representative of future compensation expensebecause options vest over several years and additional grants are made eachyear.

 

*Net LossPer Share (Basic and Diluted)*

 

Basicand diluted net loss per common share is computed by dividing the net lossavailable to common stockholders for the period by the weighted average numberof shares of common stock outstanding during the period. The calculation ofdiluted net loss per common share excludes potential common shares if theeffect is antidilutive. Potential common shares are composed of shares ofcommon stock issuable upon the exercise of stock options and warrants. Thenumber of potential common shares which would have been assumed to be convertedin the years ended December 31, 2002, 2003, and 2004 that have a dilutiveeffect if the Company had income from continuing operations is 6,001,324,7,243,403 and 11,295,669, respectively.

 

F-14

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*Fair Valueof Financial Instruments*

 

TheCompany’s financial instruments consist primarily of cash and cash equivalents,embedded derivatives, accounts receivable and accounts payable. The book valueof cash and cash equivalents, accounts receivable, and accounts payable is consideredto be representative of their fair value because of their short maturities. Embeddedderivatives reported on the balance sheet as of December 31, 2004 are presentedas a liability measured at fair value using the Black-Scholes option pricingmodel (refer to Footnote No. 9, “Redeemable Preferred Stock”).

###### *** ***

###### ***Concentration of Credit Risk***

###### ** **

Financialinstruments that potentially subject the Company to a concentration of creditrisk principally consist of cash and cash equivalents and accounts receivable.The Company has its cash and cash equivalents placed with high quality,creditworthy financial institutions. As part of its cash management process,the Company performs periodic evaluation of the relative credit standing ofthese institutions.

 

Accountsreceivables consisted of receivables from cable operators in 2003. In 2004,accounts receivable consists of receivables with our video phone distributionpartner. Due to the credit worthiness of the distribution partner, andits financial payment history with the Company, no allowance for potentialcredit losses was recorded as of December 31, 2004. In 2003, a significant portion of ourrevenues from discontinued operations were generated from outside the U.S. The Company performs ongoingcredit evaluations of its customers’ financial condition and generally requiresno collateral. In 2003, the Company established allowances for potential creditlosses and such losses did not exceed management expectations.

 

Salesto major customers, in excess of 10% of total revenues and accounts receivables,were as follows for each of the years ended December 31 (years 2002 and2003 percentages were from discontinued operations, there were no continuingoperation sales in 2002 and 2003):

 
| ** **   | ** ** | **Sales** | ** ** | **Accounts Receivable** | ** ** |
|--------------|------------|-----------|------------|-------------------------|------------|
| **Customer** | ** ** | **2002**  | ** ** | **2003**                | ** ** | **2004** | ** ** | **2003** | ** ** | **2004** | ** ** |
|         |       |      |       |                    |       |   |   |   |   |   |   |
| A            |       | 84        | %          | 48                      | %          | 0 |   | 0 |   | 0 |   |
| B            |       | 0         |       | 0                       |       | 100 | % | 0 |   | 0 |   |
| C            |       | 0         |       | 3                       | %          | 0 |   | 36 | % | 0 |   |

 

 

As of December31, 2004, Mototech (not an affiliate of Motorola) is the sole volumemanufacturer of Ojo video phones to the Company.  A formal relationship had been establishedwith Mototech, Inc. in 2003.  Mototech,Inc. is a Taiwanese manufacturer and distributor of high performance, highspeed data and computer networking products. Mototech, Inc. is an affiliate of the Accton Technology Group, a groupof Taiwanese manufactures that we believe are well-known in the electronicsindustry (refer to the “Operations and Liquidity” section of Item 7,“Management’s Discussion and Analysis of Financial Condition and Results ofOperartions”).

 

F-15

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Revenuesfrom continuing operations by geographic area are attributed to the UnitedStates in 2004.

 

AtDecember 31, 2004, all of the Company’s long-lived assets, which total$3,530, are located in the United States, except for $650 located in Taiwan,R.O.C.

 

*RecentAccounting Pronouncements*

 

InJanuary 2003, the FASB issued Interpretation No. 46, *Consolidation of Variable Interest Equities*.Interpretation No. 46 addresses consolidation by business enterprises ofvariable interest entities, which are entities that either (a) do not haveequity investors with vesting rights or (b) have equity investors that donot provide sufficient financial resources for the entity to support itsactivities. The interpretation is effective immediately for variable interestentities created after February 1, 2003. In December 2003, the FASBpublished FASB Interpretation No. 46 (R), *Consolidationof Variable Interest Entities* (FIN 46(R)). FIN 46(R), among otherthings, defers the effective date of implementation for certain entities. Therevised interpretation is effective for the first interim or annual reportingperiod ending after March 15, 2004, with the exception of structures thatare commonly referred to as special-purpose entities, for which the statementis effective for periods ending after December 15, 2003. The adoption ofInterpretation No. 46 did not have a material impact on WorldGate’sresults of operations or financial position.

 

InNovember 2004, the FASB issued SFAS No. 151 “Inventory Costs” whichamends the guidance in ARB No. 43, Chapter 4 “Inventory Pricing,” toclarify the accounting for abnormal amounts of idle facility expense, freight,handling costs, and wasted material (spoilage). Paragraph 5 of ARB 43, Chapter4, previously stated that under some circumstances, items such as idle facilityexpense, excessive spoilage, double freight, and rehandling costs may be soabnormal as to require treatment as current period charges.” SFAS No. 151requires that those items be recognized as current period charges regardless ofwhether they meet the criterion of “so abnormal.” In addition, SFAS No. 151requires that allocation of fixed production overheads to the costs ofconversion be based on the normal capacity of the production facilities. SFAS No. 151shall be effective for inventory costs incurred during fiscal years beginningafter June 15, 2005. Earlier application is permitted for inventory costsincurred during fiscal years beginning after the date SFAS No. 151 wasissued. SFAS No. 151 shall be applied prospectively. The Company does notexpect the adoption of SFAS No. 151 to have a material effect on itsconsolidated financial statements.

 

InDecember 2004, the FASB issued SFAS No. 153 “Exchanges of NonmonetaryAssets” which amends APB Opinion No. 29, “Accounting for NonmonetaryTransactions.” APB No. 29 is based on the principle that exchanges ofnonmonetary assets should be measured based on the fair value of the assetsexchanged. The guidance in that Opinion, however, included certain exceptionsto that principle. SFAS No. 153 amends APB No. 29 to eliminate theexception for nonmonetary exchanges of similar productive assets and replacesit with a general exception for exchanges of nonmonetary assets that do nothave commercial substance. A nonmonetary exchange has commercial substance ifthe future cash flows of the entity are expected to change significantly as aresult of the exchange, SFAS No. 153 shall be effective for nonmonetaryasset exchanges occurring in fiscal periods beginning after June 15, 2005.Earlier application is permitted for nonmonetary asset exchanges occurring infiscal periods beginning after the date SFAS No. 153 was issued. SFAS No. 153shall be applied prospectively. The Company does not expect the adoption ofSFAS No. 153 to have a material effect on its consolidated financialstatements.

 

InDecember 2004, the FASB issued SFAS No. 123 (R), “Share-Based Payment”that focuses primarily on accounting for transactions in which an entityobtains employee services in share-based payment transactions. This statementreplaces SFAS No. 123, “Accounting for Stock-Based Compensation”, andsupersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.”Beginning with our quarterly period that begins after June 15, 2005, wewill be required to expense the fair value of employee stock options andsimilar awards. As a public company, we are allowed to select from twoalternative transition methods, each having different reporting implications.The impact of SFAS No. 123R has not been determined at this time.

 

**5. Inventories**

 

Inventoriesas of December 31, 2003 and 2004 are summarized as follows:

 
| ** **                                   | ** ** | **2003** | ** ** | **2004** | ** ** |
|----------------------------------------------|------------|----------|------------|----------|------------|
| Raw material  (from discontinued operations) |       | $        | 1,622      |     | $          | 1,622 |   |
| Finished  goods (from continuing operations) |       | 0        |       | 46       |       |
| Total  Inventory                             |       | 1,622    |       | 1,668    |       |
| Inventory  Reserve                           |       | (1,622   | )          | (1,622   | )          |
| Inventory,  net                              |       | $        | 0          |     | $          | 46 |   |

 

F-16

----

 

Duringthe year ended December 31, 2003, as a response to the continued sloweconomy, turmoil in the cable industry and the Company’s slower than expecteddeployment of WorldGate’s ITV products and services, the Company periodicallyre-evaluated its inventory and determined that it was in excess of foreseeableneeds and should be resold. The carrying values of the inventory that wereidentified to be used in operations were written down to market value. Totalcharges to reduce the carrying amount of inventory to the lower of cost ofmarket was $3,037 for the year ended December 31, 2003. These charges areincluded in the “Income (loss) from discontinued operations “ line item on theconsolidated statements of operations. There were no further reduction ofinventory values to market values in 2004.

 

**6.  Propertyand Equipment**

 

Propertyand equipment consist of the following 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 |   |

 

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

 

**7. Goodwill**

 

TheCompany had goodwill of $3,608 and accumulated amortization of $602 at December 31,2001. In accordance with SFAS No. 142, no goodwill amortization expensewas recognized during the twelve month period ended December 31, 2002.During the second quarter of 2002, in an effort to cut costs and achieveoperational efficiencies, the Company commenced the termination of allpersonnel of the former Digital Video Art, Inc. (“DVA”) who performedengineering development services. In conjunction with this action, it wasdetermined that the carrying amount of the Company’s remaining goodwillexceeded its fair value. As such, the Company measured the impairment loss bythe amount the carrying value exceeded the implied fair value of the goodwill.The amount of the non-cash impairment loss was $3,006 and is included in theloss from discontinued operations. The fair value of goodwill was estimatedusing the expected present value of future cash flows.

 

**8. Financing Agreements**

 

During2004, the Company financed its Directors and Officers’ Insurance Policy for thepolicy period ending April 15, 2005. At December 31, 2004, theremaining unpaid portion of the note payable totaled $37. This balance was paidsubsequent to year end. The weighted average interest rate on the outstandingnote 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 thepolicy period ending April 15, 2004.

 

**9. Income Taxes (Restated)**

 

Thesignificant components of deferred tax assets at December 31, 2003 and2004 are as follows:

 

| ** **                                               | ** ** | **2003**          | ** ** | **2004**          | ** ** |
|----------------------------------------------------------|------------|-------------------|------------|-------------------|------------|
| ** **                                               | ** ** | **(As restated)** | ** ** | **(As restated)** | ** ** |
| Federal tax  loss carryforward                           |       | $                 | 60,734     |              | $          | 64,993 |   |
| State tax  loss carryforward                             |       | 8,273             |       | 10,354            |       |
| Property and  equipment                                  |       | 688               |       | 157               |       |
| Research and  experimentation credit                     |       | 2,637             |       | 2,739             |       |
| Officers’  compensation, accrued expenses and other |       | 132               |       | 469               |       |
| Bad debt  expense                                        |       | 154               |       | 0                 |       |
|                                                     |       | 72,618            |       | 78,712            |       |
| Less:  valuation allowance                               |       | (72,618           | )          | (78,712           | )          |
|                                                     |       | $                 | 0          |              | $          | 0 |   |

 

F-17

----

 

Avaluation allowance was established against the Company’s net deferred taxasset due to the Company’s lack of earnings history and, accordingly, theuncertainty as to the realization of the asset. A portion of the gross deferredasset and related valuation allowance is attributable to stock option expense.To the extent that such assets are realized in the future, the benefit isapplied to equity.

 

AtDecember 31, 2004, the Company had a net operating loss carryforward ofapproximately $191,154 for federal tax purposes, expiring between 2012 and 2024if not utilized. The net operating loss carryforward for state tax purposes isapproximately $103,640, which will expire in 2024. These carryforwards may beapplied as a reduction to future taxable income of the Company, if any. Thestate net operating loss carryforwards are limited by state tax law to amaximum utilization of $2,000 per year. The Company also has federal and stateresearch and experimentation credit carryforwards of approximately $2,739 and$52, respectively. The federal research and experimentation credit carryforwardsexpire between 2012 and 2024 and the state research and experimentation creditcarryforward expires 2017. The Company’s ability to utilize its net operatingloss carryforwards and credit carryforwards may be subject to annuallimitations as a result of prior or future changes in ownership and tax law asdefined under Section 382 of the Internal Revenue Code of 1986. Suchlimitations are based on the market value of the Company at the time ofownership change multiplied by the long-term exempt note supplied by theInternal Revenue Service.

 

**10. Stockholders’ Equity (Deficiency) (Restated)**

 

*PreferredStock*

 

TheCompany has the authority to issue from time to time up to an aggregate of13,500,000 shares of preferred stock in one or more classes or series and todetermine the designation and the number of shares of any class or series aswell 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 havethe effect of delaying, deferring or preventing a change of control of ourcompany. At December 31, 2004 there were 6,775,000 shares of preferredstock outstanding.

 

*RedeemablePreferred Stock [Restated]*

 

Thefollowing information has been restated to provide a more complete descriptionof the accounting method and policy related to redeemable preferred shares andderivative shares.

 

In June 2004, WorldGate completeda private placement of preferred stock. The Preferred Stock has a dividend rateof 5% per annum, payable quarterly, either by cash or through the issuance ofcommon stock at the Company’s option. The Preferred Stock has a staged maturityover three years with one-third of the Preferred Stock to be redeemed after 18months, one-third after 24 months and one-third after 36 months, and may beredeemed at maturity in cash or, at the Company’s option, subject to certainconditions that may not be solely under the control of the Company, through theissuance of the number of shares of common stock determined by dividing theliquidation preference of the preferred shares by the then current marketprice.  If the effectiveness of theregistration statement lapses, the Company ceases to be listed on certainspecified exchanges and trading in the Company’s stock is suspended or a changein control occurs with respect to the Company, the Company may be required tosettle redemption of the preferred stock with cash instead of its commonshares.  Furthermore, since the marketprice of the Company’s common stock cannot be predicted, the actual number ofshares of the Company’s common stock that will be required if a redemption ismade through the issuance of common stock, can also not be predicted.

 

The Preferred Stock has embeddedconversion options. Specifically, the holders of the Preferred Stock mayconvert their shares into the Company’s common stock at a conversion price of$2.35 per share. In addition the Company may force conversion of the PreferredStock into common stock if the Company achieves certain price targets for itscommon stock and satisfaction of certain other conditions, such as theexistence of an effective registration statement. In either event theconversion price is subject to adjustment if, at any time after the date thepreferred shares were issued, the Company issues or sells, or is deemed to haveissued or sold, any shares of the Company’s common stock for per shareconsideration less than the conversion price of the preferred shares on thedate of such issuance or sale. Accordingly, the number of common shares issuable upon the conversion ofthe preferred shares cannot be predicted. Furthermore, net-cash settlement may be required in the event ofconversion default under certain circumstances that may not be solely under thecontrol of the Company.  If theeffectiveness of the registration statement lapses, the Company ceases to belisted on certain specified exchanges and trading in the Company’s stock issuspended or a change in control occurs with respect to the Company, theCompany may be required to settle a conversion of the preferred stock with cashinstead of its common shares.

 

Also as part of the private placementthe Company issued five-year warrants to purchase up to 803,190 shares of ourcommon stock at an exercise price of $2.69 per share and five-year warrants topurchase up to 803,190 shares of our common stock at an exercise price of $3.14per share. The investors also received an additional investment right, for alimited period of time, to purchase 1,606,383 additional shares of common stockshares at $3.14 a share. This exercise price of the warrants is subject toadjustment if, at any time after the date the warrants were issued, the Companyissues or sells, or is deemed to have issued or sold, any shares of the Company’scommon stock for per share consideration less than the exercise price of thewarrants on the date of such issuance or sale. Accordingly, the number of common shares that will be issued upon theexercise of the warrants cannot be predicted. As of  December 31, 2004,none of the warrants  had been exercisedand 1,500,000 of the additional investment rights had been exercised.

 

InNovember and December 2004, 775 preferred shares were converted tocommon stock, and in December 2004 and February 2005, 1,606,383 additionalinvestment rights were exercised, resulting in an

 

F-18

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incremental investment of$5,044.  Of the 7,550 preferred sharesissued under this private placement, 6,775 shares remain outstanding as of  December 31, 2004..

 

With respect to the Company’saccounting for the preferred stock, EITF Topic 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 outside of permanentequity. As described above, the terms of the Preferred Stock include certainredemption features that may be triggered by events that are not solely withinthe control of the Company, such as a potential failure in the Company’sability to maintain an effective registration statement. Furthermore, theactual number of shares of common stock required to satisfy redemption is basedupon the market value of the common stock at the time of the redemption, whichcannot be predicted. Accordingly, the Company has classified the preferred stockas temporary equity and the value ascribed to the redeemable preferred stockupon initial issuance, i.e. at June 23, 2004, was the amount received inthe transaction minus the fair value ascribed to the conversion options andwarrants. The initial value of the redeemable preferred stock is accreted up tothe redemption value (the amount received in the transaction) over the futurerelevant periods using the interest method. The value of the redeemablepreferred stock at December 31, 2004 was $2,995.

 

The terms of the preferred stockinclude certain conversion options that represent derivative financialinstruments under paragraph 12 of SFAS No. 133 and thus were separatedfrom the Preferred Stock and valued using the Black-Scholes option pricingmodel.   The conversion options includecertain provisions that could result in a variable number of shares to beissued upon conversion, adjustment to the strike price at which conversionshares will be determined, or the requirement for the Company to settle theconversion options in cash EITF 00-19, “Accounting for Derivative InstrumentsIndexed to, and Potentially Settled in, a Company’s Own Stock”, state that ifthe conversion options require net cash settlement in the event ofcircumstances that are not solely within the Company’s control they should beclassified as a liability measured at fair value on the balance sheet.

 

The terms of the five-year warrantsinclude cash penalty provisions in the event that the Company fails to meet itsobligations to deliver registered shares to the warrant holder upon exerciseand an anti-dilution provision that could result in a variable number of sharesto be issued upon warrant exercise. Additionally, the terms and conditions ofthe warrants provide for net settlement via cashless exercise whereby theshares delivered to the warrant holder would be readily convertible to cash  In accordance with EITF 00-19 and given theterms and conditions of the warrants as outlined above, the Company hasclassified the warrants as a liability on its balance sheet measured at fairvalue using the Black-Scholes option pricing model. 

 

The Company accounts for both theconversion options and warrants using the fair value method at the end of eachquarter, with the resultant gain or loss recognition recorded against earnings.Both the warrants and conversion options are valued using the Black-Scholesvaluation model.  Actual period close commonstock prices, applicable volatility rates, and the period close risk-freeinterest rate for the instrument’s expected remaining life (continuouslycompounded), are the key assumptions used in the valuation calculation. TheWorldGate share price changed from $1.67 per share as of September 30,2004 to $4.99 per share at December 31, 2004 making the warrants andpreferred stock conversion elements more valuable, and therefore more costlyrelative to their strike price. The result was a $12,100 non cash loss for thequarter ended December 31, 2004 and a $10,100 gain for the year ended December 31,2004.

 

F-19

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*Warrants-Restated*

 

Inconnection with the issuance of notes payable in March 1999 (that havesince been repaid), the holders of the notes received warrants to purchase upto 331,490 shares of common stock, subject to adjustment, at an exercise priceof $16.50 per share, subject to adjustment. The warrants expired unexercised inMarch 2002.

 

InAugust 2000, the Company issued warrants to the TVGateway partners as partof the TVGateway Joint Venture more fully described in Note 13. Thesewarrants may be exercised to purchase in the aggregate up to 1,500,000 sharesof common stock at an exercise price of $24.78 and up to 500,000 additionalshares of common stock at an exercise price of $12.39. The warrants are subjectto vesting at varying rates based on the deployment of the Company’s InternetTV service on each operator’s digital cable systems. On September 30,2003, 1,000,000 warrants were cancelled. At December 31, 2004, none of theremaining warrants have vested.

 

InNovember 2000, we entered into a deployment agreement with AT&TBroadband to deploy the Company’s interactive services to AT&T digitalcustomers in Cedar Falls and Waterloo, Iowa and Tacoma, Washington. As part ofthis agreement, the Company issued warrants to AT&T to purchase up to1,000,000 shares of the Company’s common stock at a per share exercise price of$16.02. The warrants are subject to vesting at varying rates based on thedeployment of the Company’s Internet TV service on AT&T’s digital cablesystems. At December 31, 2004, none of the warrants have vested.

 

InApril and September 2004 we issued warrants to purchase shares of ourcommon stock, with the April warrants having an exercise price of $1.4375per share and the September warrants having an exercise price of $1.75 pershare. Included with General and Administrative expenses in September 2004were $606 of expenses relating to the valuation of these warrants. This valuationwas determined by using the Black-Scholes fair value option model. Thefollowing assumptions were used: expected volatility of 65%; average risk-freeinterest rate of 3.43 percent; dividend yield of 0%; and an expected life of5.0 years.

 

In connection with the June 2004 privateplacement  the Company issued 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. This exercise price of the warrants is subject to adjustment if, at anytime after the date the warrants were issued, the Company issues or sells, oris deemed to have issued or sold, any shares of the Company’s common stock forper share consideration less than the exercise price of the warrants on the dateof such issuance or sale.  Accordingly,the number of common shares that will be issued upon the exercise of thewarrants cannot be predicted.  As of  December 31, 2004, none of thewarrants  had been exercised and1,500,000 of the additional investment rights had been exercised.

 

Inconnection with the December 2003 and January 2004 privateplacements, we issued warrants and additional investment rights to purchaseshares of common stock. For the December 2003 transactions the warrantshad an exercise price of $1.00 per share and the additional investment rightswere priced at $0.80 per share. For the January 2004 transaction thewarrants had an exercise price of $1.875 per share and the addition investmentrights were priced at $1.50 per share. In addition, if the selling securityholders exercise their additional investment rights, we will be obligated toissue additional warrants to purchase our common stock at an exercise price of$1.00 per share and $1.875 per share, respectively, for the December 2003and the January 2004 transactions.

 

Includedwith General and Administrative expenses in 2003 and 2004 were $117 and $608,respectively, of expenses relating to the valuation of warrants and optionsissued in 2003 and

 

F-20

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2004 for investment adviceand services. These valuations were determined by using the Black-Scholes fairvalue option valuation model. The following assumptions were used for thewarrants: expected volatility of 100% for 2003 and 65% for 2004; averagerisk-free interest rates of 1.0% for 2003 and 3.20% for 2004; dividend yieldsof 0% and 0%; and expected lives of up to 5.0 years for both valuations.  For the twelve months ended December 31,2003, we recorded $77 of expense to continuing operations. Included indiscontinued operations was $40 of non cash expense.

 

InDecember 2004, WorldGate completed a private placement of 208,333 sharesof our common stock to K. Y. Chou, President and General Manager of Mototech,at a sales price of $2.40 per shares, which resulted in additional grossproceeds to the Company of $500.  In connection with this placement theCompany granted warrants to Mr. Chou to purchase up to 62,500 shares ofour common stock at an exercise price of $2.88 per share.

 

*StockOption Plan*

 

InDecember 1996, the Company adopted the 1996 Stock Option Plan (“1996 Plan”).This plan provides for the granting of stock options to officers, directors,employees and consultants. Grants under this plan may consist of optionsintended to qualify as incentive stock options (“ISO s”), or nonqualified stockoptions that are not intended to so qualify (“NQSOs”). The option price of anyISO will not be less than the fair market value on the date the option isgranted (110% of fair value in certain instances). The option price of NQSOsmay be greater than, equal to, or less than the fair market value on the datethe option is granted. The 1996 Plan originally authorized a maximum of 933,333shares of common stock.

 

InMay 1999 and May 2000, the Board increased the total number of sharesof common stock available under the 1996 Plan to 1,600,000 and 3,200,000shares, respectively. In October 2000, the Company’s stockholders approvedthese increases. In February 2001, the Board approved an automatic annualincrease of shares reserved under the 1996 Plan in an amount equal to thelesser of 4% of the then outstanding shares of the Company’s common stock or1,000,000 shares. In October 2001, the Company’s stockholders approvedthis increase.

 

InOctober 2004, the Company’s stockholders approved the 2003 EquityIncentive Plan (“2003 Plan”). This plan is intended to replace the 1996 Planfor new grants. No additional shares were reserved for the new plan but ratherall available shares under the 1996 Plan were made available for the new plan.As with the 1996 Plan, the 2003 Plan includes the same automatic annualincrease in the number of shares reserved for use with the plan equal to thelesser of 4% of the then outstanding shares of the Company’s common stock or1,000,000 shares. In addition to incentive stock options and nonqualified stockoptions, the new plan also provides for performance based awards and restrictedstock.

 

Boththe 1996 Plan and its successor, the 2003 Plan are administered by a committeeof the Board of Directors. The committee determines the term of each award,provided, however, that the exercise period may not exceed ten years from thedate of grant, and for ISOs, in certain instances, may not exceed five years.The options granted under this plan vest ratably over a four-year period fromthe date of grant.

 

Unearnedcompensation expense of approximately $1,133 and $340 was recorded, for certainoptions which were granted to employees in 1998 and 1999, respectively, atbelow the estimated fair value at the time of grant, to acquire 213,343 and39,058 shares of common stock, respectively. The compensation expense is beingrecognized over a four-year vesting period. Compensation expense ofapproximately $396, $388 and $192 was recognized in 2000, 2001 and 2002,respectively, related to these grants. As of December 31, 2003 and 2004,no compensation expense remains to be recognized. No such options were grantedduring the years 2000 through 2004.

 

OnFebruary 15, 2001, the Company’s Board of Directors approved a plan (the “ExchangeOffer”) pursuant to which the Company would offer its employees and directorsthe opportunity to exchange all outstanding options to purchase shares of theCompany’s common stock granted under the Company’s 1996 stock option planhaving an exercise price of $5.00 or more per share (the “eligible options”)together with all options granted to holders of eligible options within the sixmonth period prior to the expiration date of the Exchange Offer, for new optionsto be granted six months and one day after the expiration of the ExchangeOffer. On June 22, 2001, the Company commenced the Exchange Offer andfiled with the SEC a Tender Offer Statement on Schedule TO. The ExchangeOffer expired on July 30, 2001. Pursuant to the Exchange Offer, theCompany accepted for exchange options to purchase 696,359 shares of the Company’scommon stock, representing approximately 21.31% of the options that wereeligible to be tendered in the Exchange Offer. Subject to the terms of theExchange Offer, on January 31, 2002 the Company granted options topurchase an aggregate of 558,742 shares of common stock, in exchange for suchtendered options, having an

 

F-21

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exercise price per shareequal to the closing price of a share of the Company’s common stock as reportedon the NASDAQ National Market on January 31, 2002, which was $1.9297. TheExchange Offer did not result in the recognition of compensation expense by theCompany.

 

Theweighted-average fair value of the options granted was $1.85, $0.50 and $1.16per option during the years ended December 31, 2002, 2003 and 2004,respectively. The fair value of each option grant is estimated on the date ofgrant using the Black-Scholes fair value option valuation model. The followingweighted-average assumptions were used for grants in 2002, 2003 and 2004,respectively: expected volatility of 100%, 100% and 90%; average risk-freeinterest rates of 4.69%, 2.96% and 2.97%; dividend yield of 0%; and expectedlives of 5.8, 3.8 and 4.0 years.

 

Asummary of the Company’s stock plan is presented 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       |   |

 

Thefollowing table summarizes information about 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 |   | 2,021,630 |   | $ | 2.67 |   |

 

Fora period of approximately three (3) weeks in May 2001, executives(including the Chief Executive Officer) were granted four options, which vestin equal installments over a three-year period, for each share of common stockthey purchased. The 4-for-1 matching grant was capped at the point that theaggregate purchase price of shares bought by an executive reached one hundredthousand dollars.

 

F-22

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*EmployeeStock Purchase Plan*

 

InOctober 2001, our shareholders approved the WorldGate 2001 Employee StockPurchase Plan that provides eligible participants with the opportunity toperiodically acquire shares of our common stock through payroll deductions.Eligible participants may contribute up to fifteen percent of theircompensation towards the purchase of our common stock. At the end of eachcalendar quarter, the contributions of the participants are used to purchaseshares of the Company’s common stock at the lower of eighty-five percent of themarket price of our common stock: (i) at the beginning of each calendarquarter or (ii) at the end of each calendar quarter. A maximum of 750,000shares of the Company’s common stock (plus an annual increase of 375,000shares) may be purchased in the aggregate by participants in the Stock PurchasePlan.

 

During2003 and 2004, the Company sold 3,880 and 48,832 shares of common stock underthe Stock Purchase Plan for proceeds of $1 and $45, respectively.

 

**11. Net Loss Per Share (Restated)**

 

Thefollowing table is a reconciliation of the numerators and denominators of thebasic and diluted per share computations:

 
| ** **                                            | ** ** | **Years Ended December 31** | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                            | ** ** | **2002**                         | ** ** | **2003** | ** ** | **2004** | ** ** |
| ** **                                            | ** ** | ** **                       | ** ** | **(as restated)** | ** ** | **(as restated)** | ** ** |
| Loss from  continuing operations                      |       | $                                | 0          |   | $ | (5,797 | ) | $ | (19,461 | ) |
| (Loss)  income from discontinued operations           |       | (19,210                          | )          | (2,908 | ) | 36 |   |
| Net loss                                              |       | (19,210                          | )          | (8,705 | ) | (19,425 | ) |
| Accretion on  preferred stock and dividends           |       | 0                                |       | 0 |   | (951 | ) |
| Net loss  available to common shareholders            |       | $                                | (19,210    | ) | $ | (8,705 | ) | $ | (20,376 | ) |
|                                                  |       |                             |       |   |   |   |   |
| **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       |   | $ | (0.25 | ) | $ | (0.70 | ) |
| (Loss)  income from discontinued operations           |       | (0.81                            | )          | (0.12 | ) | 0.00 |   |
| Net loss                                              |       | $                                | (0.81      | ) | $ | (0.37 | ) | $ | (0.70 | ) |
| Net loss  available to common shareholders            |       | $                                | (0.81      | ) | $ | (0.37 | ) | $ | (0.73 | ) |

 

**12. Commitments and Contingencies**

 

*Leases*

 

In1998 the Company entered into a leasing arrangement for a building with anentity formed by non-employee investors. The Company stopped paying rent onthis lease in May 2003, and in lieu of rent payments the Company’slandlord, 3190 T General, Inc. (an entity formed by non-employee investorsin the Company), began drawing down the security deposit for the facility.Prior to stopping rent payments, the Company had commenced negotiations withits landlord for an amendment of its lease to reduce the space commitment andthe rent payable. These negotiations were not successful, and in September 2003,the Company’s landlord filed an action in the Court of Common Pleas, BucksCounty Pennsylvania to perfect its interest to take possession of the Company’sfacility, and to establish damages for past rent and expenses. Although ajudgment was granted allowing the Company’s landlord to regain possession ofthe facility, the Company remained in the facility and continued negotiationswith its landlord. During 2004, the landlord deeded the facility to itsmortgage holders and negotiations commenced with GMAC as representative for themortgage holders. These negotiations were successful and in June 2004 theCompany’s lease was amended to reduce the lease obligation in line with theCompany’s current space requirements, and to bring the Company current withrespect to all outstanding back rent.  The current lease permits both theCompany and the landlord to terminate the lease at any time on 90 days writtennotice to the other party.  In November 2003, the Company enteredinto a 60 month lease for office equipment. As of December 31, 2004 thereremains a total of $23 to be paid over the remaining period of the lease.

 

*Disclosureof Contractual Obligations*

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

 

F-23

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Totalrent expense resulting from this lease for the years ended December 31,2002, 2003 and 2004, respectively, amounted to approximately $1,442, $957 and$1,027, respectively. The rent expense for 2004 of $1,027 includes $785 ofunpaid rent that was cancelled as a result of a lease amendment entered into November 2004with an effective date of June 2004. This cancellation is included intotal interest and other income in our consolidated financial statements.

 

**13. Significant Agreements and Transactions**

 

In1997, the Company entered into agreements with certain customers who areinvestors. Revenues recognized from such investors were approximately, $0, $0and $231, respectively, for the twelve months ended December 31, 2002,2003 and 2004. One of these investors accounted for 100% of the revenues forthe twelve months ended December 31, 2004. Advances received from thisinvestor were $396 and as of December 31, 2004 and are included indeferred revenue in the accompanying balance sheet.

 

Revenuesfrom discontinued operations recognized from such investors were approximately$11,991, $2,153 and $0 (included in discontinued operations), respectively, forthe twelve months ended December 31, 2002, 2003 and 2004. Accountsreceivable from such investors amounted to approximately $1,185, $53 and $0,respectively, as of December 31, 2002, 2003 and 2004.

 

TheCompany has a current two year agreement with an investor, and previously hadagreements with certain other investors, to provide the Company withengineering and development support. As a result of those agreements, theCompany has expensed approximately $1,837, $557 and $0 (included indiscontinued operations), respectively, for the twelve months ended December 31,2002, 2003 and 2004. Accounts payable to these investors amounted to $117 and$170 at December 31, 2004 and December 31, 2003, respectively. Someof these stockholders were suppliers of technology and components for theCompany’s discontinued ITV products and services. These agreements provided forlicensing of technology, as well as contracted services, including hardware andsoftware development, product testing and certification, and the creation anddevelopment of tools and systems to facilitate the Company’s engineeringefforts. These agreements did not provide for ongoing royalties, purchaseprovisions, or for any requirement to provide additional funding to theCompany.

 

On April 28, 2004, we entered into a six-yeardistribution agreement with Motorola, Inc. for the marketing anddistribution of our Ojo video phone. This agreement provides for Motorola to beWorldGate’s exclusive distributor of its broadband video phone products and forWorldGate to be Motorola’s exclusive supplier of its broadband video phoneproducts.  After a period of eighteen months following the commercialavailability of the Ojo video phone this mutual exclusivity will terminateunless Motorola elects to continue the mutual exclusivity after having achievedcertain minimum sales targets for the Ojo video phone**. **Motorola may, however, at its option, elect toterminate this mutual exclusivity at any time.  In the event mutualexclusivity terminates or is terminated, then for a twelve month periodthereafter, WorldGate will continue to be Motorola’s exclusive supplier of broadbandvideo phones, but will be free to sell video phone products to customers otherthan certain defined Motorola accounts.  During this twelve month period,Motorola has a right of first refusal to accept and fill any orders for videophone products that WorldGate obtains from non-Motorola accounts, and isobligated to use good faith efforts to solicit and accept product orders fromMotorola accounts in a commercially reasonable manner.  During any periodof exclusivity 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 certain marketingand promotional activities for the Ojo video phone, there are no required salesquotas for the agreement to remain in effect, and Motorola controls the volumeof products being distributed by our company.  Neither party can terminatethe agreement except in cases of uncured breaches of the agreement or as aresult of insolvency events suffered by the other party.  If Motorola andits partners are not successful, or if their activities do not lead tosignificant sales of our product, our operating results will be adverselyaffected, our revenue could be significantly reduced and we could losepotential customers.  In connection with our agreement with Motorola, ourcompany has issued a warrant to purchase 300,000 shares of WorldGate commonstock, which we issued simultaneously with the execution of the agreement in April 2004,and a second warrant for 300,000 shares issued upon the delivery to Motorola ofacceptable prototypes for the product. Additionally, we agreed to issuewarrants to purchase up to an additional 1,650,000 shares of our common stock,upon the achievement of certain sales milestones, at an exercise price basedupon the average closing sales price of our common stock during the 20 dayperiod preceeding the issuance of each warrant.

 

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

 

*TVGatewayJoint Venture*

 

OnJuly 24, 2000, the Company formed a separate 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.  In addition to providing for theterms and conditions under which such services were to be provided, themanagement agreement provided for WorldGate and TVGateway to cooperate totransition to TVGateway some or all of the support services being provided byWorldGate and/or the employees providing these services.  In addition,this provision required WorldGate to remain available to provide support servicesuntil July 24, 2005.  During 2002 WorldGate and TVGateway agreed tocommence the transition of services pursuant to this provision.  Inaddition, the parties agreed that the management agreement would be of nofurther force and effect with respect to the services that are transferred asof the date of completion of the 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.

 

Revenuesfor such services, which are included in service fee revenue, totaled $11,484,$794 and $0, for the twelve months ended December 31, 2002, 2003 and 2004(included in discontinued operations), respectively. In addition, product salesto TVGateway totaled $92, $1,078 and $0 for the twelve months ended December 31,2002, 2003 and 2004, respectively (included in discontinued operations).Accounts receivable from TVGateway amounted to $0 at December 31, 2004 and$0 at December 31, 2003.  WorldGate was accounting for its 18%investment in the TVGateway joint venture, which was previously reduced to acarrying value of $0 due to prior losses, under the equity method.

 

F-24

----

 

On September 30, 2003 the Company announced that it had sold toTVGateway, LLC certain ITV intellectual property rights and certain softwareand equipment related to the ITV business, which TVGateway was currently using,for $2, 400.  In addition, on August 7, 2003, WorldGate and TVGatewayentered into a redemption agreement pursuant to which TVGateway redeemedWorldGate’s equity interest in TVGateway for $600 in cash. The purchase pricefor these assets in the aggregate was $3,000 and was used by the Company tofund continuing operations, as well as to develop and distribute its new Ojovideo telephony product. As part of this transaction WorldGate retained aroyalty-free license to certain of the transferred intellectual propertyrights and software. At this time the Company has completely exited from theinteractive television (ITV) business.

 

Inconnection with the Asset Purchase Agreement we entered into with TVGateway forthe sale of certain ITV Business assets, we have an obligation to indemnifyTVGateway for any losses from breaches of our representations or warranties inthe Asset Purchase Agreement that occur within twelve months after the closingdate of the TVGateway transaction or within the applicable statute oflimitations period for claims relating to our ownership of our assets, paymentof our taxes, and our compliance with applicable laws, if longer. Ourindemnification obligations are limited by an overall cap of $500 on the amountof the indemnification. Although we know of no breaches of our representationsor warranties and the initial twelve-month period has expired, the payment ofany such indemnification obligations would adversely impact our cash resourcesand our ability to pursue our video phone business.

 

**15. Employee Benefit Plan**

 

In2000, the Company established a Retirement Savings Plan that is funded by theparticipant’s salary reduction contributions. All employees of the Company areeligible to participate in the plan upon joining the Company. The plan isintended to permit any eligible employee who wishes to participate tocontribute up to 12% of the employee’s compensation on a before-tax basis underSection 401(k) of the Internal Revenue Code. The plan provides for discretionaryCompany matching contributions and discretionary Company profit-sharingcontributions. Contributions are invested, in such proportions as the employeemay elect in any of 10 mutual investment funds. In 2002 and 2003, the Companymade no discretionary profit-sharing contributions to the plan.  On May 28,2003, this Retirement Savings Plan was terminated by the Company.

 

InJanuary of 2005 the Company established a new Retirement Savings Plan thatis funded by the participant’s salary reduction contributions. All employees ofthe Company are eligible to participate in the plan upon joining the Company.The plan is intended to permit any eligible employee who wishes to participateto contribute up to 12% of the employee’s compensation on a before-tax basisunder Section 401(k) of the Internal Revenue Code. The plan provides fordiscretionary Company matching contributions and discretionary Companyprofit-sharing contributions. Contributions are invested, in such proportionsas the employee may elect in a variety 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**

 

Wefiled a registration statement with the Securities and Exchange Commission in April 2004relating to a private

 

F-25

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placement of our commonstock to certain institutional investors and the resulting proposed resale bysuch investors of up to 3,105,345 shares of our common stock. This registrationstatement was declared effective in April, 2004.

 

Wefiled a registration statement with the Securities and Exchange Commission in July 2004relating to a private placement of our common stock to certain institutionalinvestors and the resulting proposed resale by such investors of up to10,343,997 shares of its common stock. This registration statement was declaredeffective in July, 2004.

 

**18. Discontinued Operations**

 

Duringthe first quarter of 2004, the Company decided to transition from the businessof developing and selling interactive television, or ITV, technology, productsand services for use in conjunction with cable TV broadband networks (the “ITVbusiness”) to the development of videophone products. In accordance withStatement of Financial Accounting Standards 144, Accounting for the Impairmentor Disposal of Long-Lived Assets, all assets related to the ITV business havebeen written down to their net realizable value. Related operating results ofthe ITV business have been reported as discontinued operations for all yearspresented.

 

Revenue and net income(loss) before income taxes from discontinued operations 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 |   |
|                                    |            |                                                          |            |  |  |  |  |  |  |  |

 

**SupplementalQuarterly Data (unaudited) - Restated**

 

The Companyhas restated its financial statements for the years ended December 31,2004 and 2003 to amend and restate the accounting for the warrants andadditional investments rights issued in a private placement of the Company’scommon stock during the fourth quarter of 2003, and the first and fourthquarters of 2004.  Thesesecurity components were originally treated as non-cash expenses and with thisrestatement are being restated as equity transactions.

 
| ** **                                                                     | ** ** | **First**                                                | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|------------|------------|-----------|------------|------------|------------|
| ** **                                                                     | ** ** | **(dollars in thousands  other than per share amounts)** | ** ** |
|                                                                           |       |                                                     |       |       |       |      |       |       |       |
| 2004                                                                           |       |                                                     |       |       |       |      |       |       |       |
| Net revenues                                                                   |       | $                                                        | 0          |       | $          | 0         |       | $          | 106        |   | $ | 125 |   |
| Loss from  continuing operations                                               |       | (2,130                                                   | )          | (1,951     | )          | (1,517    | )          | (13,863    | )          |
| Income from  discontinued operations                                           |       | 22                                                       |       | 7          |       | 7         |       | 0          |       |
| Net loss                                                                       |       | (2,108                                                   | )          | (1,944     | )          | (1,510    | )          | (13,863    | )          |
| Accretion on  preferred stock and dividends                                    |       | 0                                                        |       | (31        | )          | (400      | )          | (520       | )          |
| Net loss  available to common shareholders                                     |       | (2,108                                                   | )          | (1,975     | )          | (1,910    | )          | (14,383    | )          |
| Basic and diluted loss from continuing  operations per common share            |       | (0.08                                                    | )          | (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                                   |       | (0.08                                                    | )          | (0.07      | )          | (0.06     | )          | (0.49      | )          |
| Basic and diluted net loss available to  common shareholders per common share  |       | (0. 08                                                   | )          | (0.07      | )          | (0.07     | )          | (0.51      | )          |
|                                                                           |       |                                                     |       |       |       |      |       |       |       |
| 2003                                                                           |       |                                                     |       |       |       |      |       |       |       |
| Net revenues                                                                   |       | $                                                        | 0          |       | $          | 0         |       | $          | 0          |   | $ | 0 |   |
| Loss from  continuing operations                                               |       | (813                                                     | )          | (1,372     | )          | (1,652    | )          | (1,959     | )          |
| (Loss)  income from discontinued operations                                    |       | (1,072                                                   | )          | (1,627     | )          | 1,755     |       | (1,965     | )          |
| Net (loss)  income                                                             |       | (1,885                                                   | )          | (2,999     | )          | 103       |       | (3,924     | )          |
| Net (loss)  income available to common shareholders                            |       | (1,885                                                   | )          | (2,999     | )          | 103       |       | (3,924     | )          |
| Basic and diluted loss from continuing  operations per common share            |       | (0.03                                                    | )          | (0.06      | )          | (0.07     | )          | (0.08      | )          |
| 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      |       | (0.16      | )          |
| Basic and diluted net (loss) income  available to common                       |       |                                                     |       |       |       |      |       |       |       |
| shareholders per common share                                                  |       | (0.08                                                    | )          | (0.13      | )          | 0.00      |       | (0.16      | )          |

 

F-26

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**Item 9. Changes in and Disagreements With Accountantson Accounting and Financial Disclosure.**

 

None

 

**Item 9A.  Controls and Procedures.**

 

As of the end of the periodcovered by this Form 10-K, our management, with the participation of ourchief executive officer and chief financial officer, conducted an evaluation ofthe effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and15d -15(e) under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”)).

 

Based on that evaluation,our chief executive officer and chief financial officer determined that we havea material weakness (as defined under the standards established by the AmericanInstitute of Certified Public Accountants) that exists with respect to ourreporting of complex transactions. As a result of this material weakness, onNovember 17, 2004 we restated  ourfinancial statements in our quarterly reports for 2004 and this annual report.

 

To address this materialweakness, we have engaged outside experts to provide counsel and guidance inareas where we cannot economically maintain the required expertise internally(e.g., with the appropriate classifications and treatments of complex andnon-routine transactions).

 

As a result of the materialweakness identified with respect to our reporting of complex transactions, thechief 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’s rules andforms.  Except as identified above, there have been no changes in ourinternal control over financial reporting that occurred during the quarterended December 31, 2004, that have materially affected, or are reasonablylikely to materially affect, our internal control over financial reporting.

 

**Item 9B.  Other Information.**

 

None

 

**PART III**

 

**Item 10. Directors and Executive Officers of theRegistrant.**

 

We have adopted a Code ofConduct that applies to all of our directors and employees, including, withoutlimitation, our principal executive officer, our principal financial andaccounting officer, and all of our employees performing financial or accountingfunctions.  We have posted our Code of Conduct on our website,www.wgate.com, under the “Investors” section. We intend to satisfy thedisclosure requirements under Item 10 of Form 8-K regarding an amendmentto, or waiver from, any provisions of our Code of Conduct by posting suchinformation on our website at the location specified above.

 

As of December 31, 2004our 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)           Member of Compensation Committee

(2)           Member of Audit Committee

(3)           Resigned from Compensation Committee in August 2004

 

24

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Hal M. Krisbergh has servedas our Chairman and Chief Executive Officer since our inception in March 1995.From September 1981 to September 1994, Mr. Krisbergh was anexecutive officer of General Instrument (now a part of Motorola, Inc.). Mr. Krisberghserved as President of General Instrument’s Communications Division and, forthe past 17 years, has been a well-known figure in the cable industry. He is arecognized leader in the development of addressable cable boxes, impulsepay-per-view, opto-electronics and digital audio technologies. In 1991, Mr. Krisberghreceived cable television’s prestigious Vanguard award. Prior to joiningGeneral Instrument, Mr. Krisbergh was employed by W. R. Grace &Co., Deloitte & Touche and Raytheon Company.

 

Joel I. Boyarski joined ourcompany in October 1999 and was named Vice President and Chief FinancialOfficer in September 2002. Prior to becoming Vice President and ChiefFinancial Officer, Mr. Boyarski served as General Manager of TVGateway,LLC from December 2001 until September 2002 and as Vice President ofBusiness Development for TVGateway, LLC from June 2000 until December 2001.From October 1999 to June 2000, he served as a consultant for ourcompany. Prior to joining us, Mr. Boyarski was a business and financialconsultant from June 1998 to October 1999, and for 23 years prior to June 1998,he held a variety of management positions at Joseph E. Seagram and Sons, Inc.,including Vice President of Finance and Business Planning for several ofSeagram’s Domestic and International divisions including North America, AsiaPacific and Global Duty Free.

 

Randall J. Gort joined ourcompany in August 1997 as Vice President, Legal and Corporate Affairs,General Counsel and Secretary. In January 2003 Mr. Gort became theCompany’s Chief Legal Officer. From July 1995 to August 1997, Mr. Gortwas General Counsel, Secretary, and Director of Legal and Corporate Affairs forIntegrated Circuit Systems, Inc. Mr. Gort was in private practicefrom August 1994 through June 1995. Prior to that time, from May 1987through July 1994, he was an Associate General Counsel for CommodoreInternational Ltd. Mr. Gort was with Schlumberger Ltd. from October 1982through early 1987, originally as Senior Attorney and then as General Counsel,FACTRON Division. From April 1979 through October 1982, Mr. Gortwas Counsel for various divisions of the 3M Company, including Medical andSurgical Products Divisions, Orthopedic Products Division, Electro-MechanicalResources Division and 3M’s four tape divisions.

 

James E. McLoughlin joinedour company in February 2001 and in January 2002 was named VicePresident, Marketing, Business and Account Development. Prior to this position,Mr. McLoughlin served as Vice President, Sales and Marketing. From February 1981through February 2001, Mr. McLoughlin was Vice President, AffiliateOperations for Home Box Office, where he was responsible for sales andmarketing of premium television services to affiliated cable televisioncompanies.

 

Richard Westerfer joined ourcompany in February 2000 as Vice President of Engineering. In December 2000,Mr. Westerfer became Senior Vice President of Operations. He served inthis position until April 2002, when he became Chief Operations Officer ofWorldGate. Prior to joining us, from 1979 to February 2000, Mr. Westerferserved as the Senior Director of Engineering for General Instruments (now apart of Motorola, Inc.).

 

Steven C. Davidson has beena member of our board of directors since April 2002. From 1979 until hisretirement in April 2002, Mr. Davidson held various executivepositions with HBO, Inc., most recently serving as Senior Vice Presidentand General Manager of Affiliate Operations. In February 2004 Mr. Davidsonreturned to HBO, Inc. as Executive Vice President of Affiliate Sales. Mr. Davidsonis also 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 has beenPresident and Chief Executive Officer of Irving Information Group, a consultingservices firm, since October 1999 and has served as a director of CovadCommunications Group, Inc. since April 1999. On August 15, 2002,Covad Communications Group, Inc. filed a voluntary petition for reliefunder Chapter 11 of the Federal bankruptcy code in the United States BankruptcyCourt for the District of Delaware. Mr. Irving served as AssistantSecretary of Commerce to the United States Department of Commerce from June 1993to October 1999.

 

Martin Jaffe has been amember of our board of directors since April 2002. Since January 2002,Mr. Jaffe has been the Chief Operating Officer, Managing Director andCo-Founder of Silvercrest Asset Management Group LLC. From November 2000until September 2001, Mr. Jaffe was Chief Financial Officer of CreditSuisse Asset Management Group LLC, and from 1981 until

 

25

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November 2000, Mr. Jaffe was ChiefOperating Officer of Donaldson, Lufkin & Jenrette Asset ManagementGroup.

 

Jeff Morris has been amember of our board of directors since April 2001. Since April 2001, Mr. Morrishas been the President of Digital Media Consulting, a new media consultingcompany. From July 2000 to April 2001, he was President and ChiefExecutive Officer of Yack, Inc., an Internet events and program guide. Mr. Morrisis a veteran of the cable television industry, including a fifteen-year tenurefrom 1984 through 2000 at Showtime Networks, Inc., where his last positionwas Senior Vice President of New Media and Technology Development.

 

Lemuel Tarshis has been amember of our board of directors since April 2001. Since August 1991,Dr. Tarshis has been a director for the Alliance for Technology Managementat the Stevens Institute of Technology. In addition, he has recently worked asa management consultant for Lucent Technologies Inc., Bell Atlantic, GTECHCorporation, AT&T Corporation, Aequus Technologies, LLC and VerizonCommunications, Inc.

 

**Audit Committee**

 

The Audit Committee isresponsible for providing general oversight with respect to the accountingprinciples employed in our financial reporting and operates in accordance witha written charter adopted by our Board of Directors. The Audit Committeemonitors our financial reporting process and internal control system, reviewsand appraises the audit efforts of our independent accountants and provides anavenue of communication among the independent accountants, financial and seniormanagement and the Board of Directors. The Audit Committee meets at least threetimes annually, and meets at least once annually with our management andindependent public accountants to review the scope of auditing procedures, ourpolicies relating to internal auditing and accounting procedures and controls,and to discuss results of the annual audit of our financial statements. TheAudit Committee is currently composed of Dr. Tarshis, Mr. Davidsonand Mr. Jaffe, each of whom is “independent” as such term is defined underRule 4200(a)(15) of the NASDAQ listing standards. The Audit Committee alsocomplies with the financial sophistication requirement under the NASDAQ listingstandards. In addition, the Board has determined that Mr. Jaffe is anaudit committee financial expert as defined by SEC rules.

 

**Section 16(a) BeneficialOwnership Reporting Compliance**

 

Section 16(a) ofthe 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, webelieve that all filings required to be made by the reporting persons forfiscal year 2004 were made on a timely basis.

 

**Item 11. Executive Compensation.**

 

**Compensation Committee Interlocksand Insider Participation**

 

The Compensation and StockOption Committee (the “Compensation Committee”) is currently composed of Messrs. Morrisand Irving. The Compensation Committee is responsible for determining thegeneral compensation and benefits philosophy for the Company, includingadministering the Company’s equity compensation programs, and for setting cashand long-term incentive compensation for executive officers and other keyemployees of the Company. No member of the Compensation Committee is an officeror employee of the Company.

 

**Report of Compensation and StockOption Committee on Executive Compensation**

 

This report by theCompensation Committee of the Board of Directors (the “Committee”) discussesthe Committee’s compensation objectives and policies applicable to the Company.The report reviews the Committee’s policy generally with respect to thecompensation 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**

 

Our compensation policiesare intended to create a direct relationship between the level of compensationpaid to employees and our current and long-term level of performance. TheCommittee believes that this relationship is best implemented by providing a compensationpackage of separate components, all of which are designed to enhance ouroverall performance. The components are base salary, short-term compensation inthe form of annual bonuses and long-term incentive compensation in the form ofstock options.

 

The base salaries, targetedbonus amounts and number of stock options established for or granted to ourexecutive 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 base salaries for oursenior executive officers for 2004 were established subjectively by theCommittee based on the market environment and our need to attract and retainkey personnel for whom we must compete against larger, more establishedcompanies. Also considered was the absence of a general salary increase during2003 in light of our need to conserve cash.

 

Short-Term Annual Bonuses

 

Annual bonuses establishedfor the executive officers are intended to provide an incentive for improvedperformance in the short term. Normally the Committee would establish targetbonus levels at the beginning of the year based on predetermined goals withrespect to individual, department and Company performance, however, given theCompany’s need to conserve cash, no bonuses were provided during 2004.

 

Long-Term Incentive Compensation

 

Our long-term incentivecompensation plan for its senior executive officers, administered through theCompany’s stock option plan, promotes ownership of the our Common Stock, which,in turn, provides a common interest between our shareholders and our executiveofficers. Options granted to executive officers under the plan have an exerciseprice equal to the fair market value of the shares on the date of grant, anexercise period of ten years and generally vest over four years. The number ofoptions granted to executive officers is determined by the Committee, which ischarged with administering the stock option plan. During 2003 the Committeeanalyzed various equity incentive programs provided by peer group companies anddetermined that it was advisable to include equity alternatives other thantraditional stock options within its compensation strategy. Accordingly, in November 2003,the Committee, as well as the other members of the board of directors,unanimously approved a new equity compensation plan (the “2003 Plan”) andrequested that this plan be submitted for shareholder approval at our nextshareholder meeting. This plan was approved by our shareholders at the October 2004annual shareholders’ meeting. The plan as approved by the board and ourshareholders does not authorize any incremental shares for issuance thereunder,but rather transfers the balance available for issuance under its predecessor,the 1996 Plan, after all issuances thereunder. The 1996 Plan will continue tobe in effect for the grants which are currently outstanding under that plan,however, new grants will be issued under the 2003 Plan.

 

**Summary Compensation Table**

 

The following table setsforth information concerning compensation paid with respect to our chiefexecutive officer and four other most highly compensated officers who wereserving 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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**SUMMARYCOMPENSATION TABLEFISCAL 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    |   | — |   |

 

The Compensation Committeehas the authority to administer the long term incentive plans and to exerciseall the powers and authorities either specifically granted to it under, ornecessary or advisable in the administration of the plans, including, withoutlimitation, the authority to grant awards; to determine the persons to whom andthe time or times at which awards shall be granted; to determine the type andnumber of awards to be granted, the number of shares of common stock to whichan award may relate and the terms, conditions, restrictions and performancegoals relating to any award; to determine whether, to what extent, and underwhat circumstances an award may be settled, canceled, forfeited, exchanged, orsurrendered; to make adjustments in the performance goals in recognition ofunusual or non-recurring events affecting us or our financial statements ofWorldGate (to the extent not inconsistent with Section 162(m) of the Code,if applicable), or in response to changes in applicable laws, regulations, oraccounting principles; to construe and interpret the plans and any award; toprescribe, amend and rescind rules and regulations relating to the plans;to determine the terms and provisions of agreements evidencing awards; and tomake all other determinations deemed necessary or advisable for theadministration of the plans. Generally, outstanding awards vest in equalinstallments over a four-year period. However, in no event may a stock optionbe exercised more than ten years following the date of its grant, subject toacceleration in the event of some changes of control of WorldGate.

 

The purchase price per sharepayable upon the exercise of an option (the “option exercise price”) will beestablished by the Compensation Committee, provided, however, that incentivestock options may not have an option exercise price less than the fair marketvalue of a share of common stock on the date of grant. The option exerciseprice is payable by any one of the following methods or a combination thereof,to the extent permitted by the Compensation Committee:

 
| • | in cash or by check or wire transfer,                                                                                                                                                                                                     |
|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                      |
| • | subject to the approval of the Compensation  Committee, in common stock owned by the participant for at least six months  prior to the date of exercise and valued at their fair market value on the  effective date of such exercise, or |
|   |                                                                                                                                                                                                                                      |
| • | subject to the approval of the Compensation  Committee, by such other provision as the Compensation Committee may from  time to time authorize.                                                                                           |

 

Our board of directors orthe Compensation Committee may suspend, revise, terminate or amend the equityincentive plans at any time, provided, however, that:

 
| • | stockholder approval will be obtained if and to  the extent required under Rule 16b-3 promulgated under the Exchange Act  or if and to the extent the board determines that such approval is required  for purposes of satisfying Section 162(m) or Section 422 of the  Code, and |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                             |
| • | no such suspension, revision, termination or  amendment may, without the consent of a participant, reduce the part icipant’s  rights under any outstanding award.                                                                                                                           |

 

On October 5, 2001, ourshareholders approved the WorldGate 2001 Employee Stock Purchase Plan (the “StockPurchase Plan”). The Stock Purchase Plan provides our eligible employees withthe opportunity to periodically acquire shares of our

 

28

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

 
| • | each employee who has completed six months of  continuous employment with us is eligible to participate in the Stock  Purchase Plan so long as the employee customarily works at least  20 hours per week and 5 months per year;                                                                       |
|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                             |
| • | participants in the Stock Purchase Plan are  permitted to contribute up to fifteen percent of their compensation towards  the purchase of our common stock;                                                                                                                                                      |
|   |                                                                                                                                                                                                                                                                                                             |
| • | at the end of each calendar quarter, the  contributions of the participants are used to purchase shares of our common  stock at the lower of eighty-five percent of the market price of our common  stock: (i) at the beginning of each calendar quarter or (ii) at the  end of each calendar quarter; |
|   |                                                                                                                                                                                                                                                                                                             |
| • | shares of our common stock that are purchased  under the Stock Purchase Plan are not transferable by the participant until  at least nine months has elapsed from the acquisition of the shares;                                                                                                                 |
|   |                                                                                                                                                                                                                                                                                                             |
| • | a maximum of 750,000 shares of our common stock  (plus an annual increase of 375,000 shares) may be purchased in the aggregate  by participants in the Stock Purchase Plan; and                                                                                                                                  |
|   |                                                                                                                                                                                                                                                                                                             |
| • | our Board of Directors has the power and authority  to administer the Stock Purchase Plan and may, subject to certain limitations  suspend, revise, terminate or amend the Stock Purchase Plan.                                                                                                                  |

 

The following table presentsinformation regarding options granted to our named executive officers duringfiscal 2004 to purchase shares of our common stock. In accordance with SECrules, the table shows the hypothetical “gains” or “option spreads” that wouldexist for the respective options based on assumed rates of annual compoundstock price of 5% and 10% from the date the options were granted over the fulloption term.

 

**Options/SARGrants 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 following table showsthe number of shares of common stock subject to exercisable and unexercisablestock options held by each of the named executive officers as of December 31,2004. The table also reflects the values of such options based on the positivespread between the exercise price of such options and $4.99, which was the pershare closing sales price reported on the NASDAQ Small Cap Market on December 31,2004.

 

29

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**AggregatedOption/SAR Exercises in Last Fiscal 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 to our 2003 EquityIncentive Plan, non-employee directors, currently Messrs. Davidson, Jaffe,Irving, Morris and Tarshis, will receive an annual stock grant of 10,000 shares,vesting in equal amounts over four years, issued at the fair market value onthe date of grant, a stipend of $1,000 for each board or committee meeting thedirector attends in person, and $250 for each meeting attended telephonically.Furthermore, we paid an annual stipend of $5,000 for 2004 and will pay $10,000for each year thereafter, as well as an initial stock grant of 30,000 sharesupon becoming a non-employee director.  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 following table setsforth information as of December 31, 2004 regarding securities authorizedfor issuance under the Company’s equity compensation plans:

 

##### **EquityCompensation 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)           In October 2004 our shareholders approved a new Equity IncentivePlan.  The Equity Incentive Plan as approved does not authorize anyincremental shares for issuance thereunder, but rather transfers the balanceavailable for issuance under the 1996 Stock Option Plan after all issuancesthereunder. Although our 1996 Stock Option Plan remains in effect for anyoutstanding options issued under that plan we do not intend to issue new grantsunder that plan.  Both the 1996 Stock Option Plan and its successor, theEquity Incentive Plan contain a provision that automatically increases thenumber of shares available for future issuances as of January 1st of eachcalendar year.  The increase is equal to the lesser of (i) four (4) percentof the issued and outstanding shares of company stock (determined as of thefirst day of each such year), or

 

30

----

 

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

 

The following table setsforth information as of March 10, 2004 regarding beneficial ownership ofour common stock by the following persons:

 

•              each person who is known to us to ownbeneficially more than 5% of the outstanding shares of common stock,

 

•              each director,

 

•              each executive officer named in the executivecompensation table above, and

 

•              all directors and executive officers as agroup.

 

Unless otherwise indicated below, to our knowledge,all persons listed below have sole voting and investment power with respect totheir shares of common stock, except to the extent authority is shared byspouses under applicable law. Beneficial ownership is determined in accordancewith the rules of the SEC, based on factors including voting andinvestment power with respect to shares, subject to applicable communityproperty laws. Shares of common stock subject to options or warrantsexercisable within 60 days of March 5, 2005 are deemed outstandingfor the purpose of computing the percentage ownership of the person holdingsuch options or warrants, but are not deemed outstanding for computing thepercentage ownership of any other person. Unless otherwise indicated, themailing address of the beneficial owners is 3190 Tremont 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 to purchase 220,000 shares of common stock. Alsoincludes 3,488,670 shares of common stock held directly, 1,700,000 shares ofcommon stock held within grantor retained trusts in which either Mr. Krisberghor his spouse are trustees, 299,938 shares of common stock held by Mr. Krisbergh’sspouse and 300,000 shares of common stock held by the Krisbergh FamilyFoundation, with Mr. Krisbergh acting as the custodian for these shares.

 

(2)           Includes options to purchase 254,583 shares of common stock.  Alsoincludes 106,063 shares of common stock held directly and 68,879 shares ofcommon stock held by Mr. Gort as custodian for his minor children.

 

(3)           Includes options to purchase 307,000 shares of common stock and 241shares of common stock held by Mr. Westerfer’s minor son.

 

(4)           Includes options to purchase 181,238 shares of common stock. Alsoincludes 2,000 shares of common stock held directly.

 

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

 

(6)           Includes options to purchase 18,250 shares of common stock. Alsoincludes 10,000 shares of common stock held directly.

 

31

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(7)           Includes options to purchase 18,250 shares of common stock. Alsoincludes 15,000 shares of common stock held directly.

 

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

 

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

 

(10)         Includes options to purchase 44,791 shares of common stock.  Alsoincludes 5,200 shares of common stock held directly and 12,000 shares of commonstock held by Mr. Tarshis’ spouse.

 

**Item 13. Certain Relationships and RelatedTransactions**

 

None.

 

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

 

The aggregate fees forprofessional 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 December 31,2004, 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)           Of this amount $83,430 was attributable to Grant Thornton and $29,350was attributable to PricewaterhouseCoopers LLP.

(2)           Of this amount $0 was attributable to Grant Thornton and $22,650 wasattributable to PricewaterhouseCoopers LLP.

(3)           Of this amount $0 was attributable to Grant Thornton and $27,000 wasattributable to PricewaterhouseCoopers LLP.

 

###### ***Audit Fees***

###### ** **

The“audit fees” reported above were billed to us by Grant Thornton LLP andPricewaterhouseCoopers LLP for professional services rendered in connectionwith their audit of our consolidated financial statements and their limitedreviews of our unaudited consolidated financial statements and our unauditedconsolidated interim financial statements included in our quarterly reports,and for services normally provided by Grant Thornton LLP andPricewaterhouseCoopers LLP in connection with other statutory and regulatory filingsor engagements, including audit consultations and SEC comment letters.

 

*AuditRelated Fees*

 

The “audit related fees”reported above were billed to us by Grant Thornton LLP andPricewaterhouseCoopers LLP for assurance and related services that were reasonablyrelated 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.

 

*Tax Fees*

 

During the fiscal yearsreported above, Grant Thornton LLP and PricewaterhouseCoopers LLP renderedprofessional services to us relating to tax compliance, tax advice, or taxplanning.

 

32

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*All OtherFees*

 

During the fiscal yearsreported above, Grant Thornton LLP and PricewaterhouseCoopers LLP rendered noprofessional services to us other than for those relating to audit, auditrelated and tax matters.

 

*AuditCommittee Pre-approval Policies and Procedures*

 

Our audit committee hasadopted a policy requiring the pre-approval of all audit and permissiblenonaudit services provided by our independent public auditors. Under thepolicy, the audit committee is to specifically pre-approve before the end ofeach fiscal year any recurring audit and audit related services to be providedduring the following fiscal year. The audit committee also may generallypre-approve, up to a specified maximum amount, any nonrecurring audit and auditrelated services for the following fiscal year. All pre-approved matters mustbe detailed as to the particular service or category of services to beprovided, 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 of feesattributable to such services.

 

In accordance with Section 10A(i)(2) ofthe Securities Exchange Act of 1934, as amended by Section 202 of theSarbanes-Oxley Act of 2002, we are required to disclose the approval by theaudit committee of the Board of Directors of non-audit services to be performedby Grant Thornton LLP, the Company’s independent auditors. Non-audit servicesare services other than those provided in connection with an audit or review ofthe financial statements. During the period covered by this filing, the auditcommittee approved all audit related fees, tax fees and all other fees.

 

### **PART IV**

### ** **

**Item 15. Exhibits, Financial Statement Schedules, andReports on Form 8-K.**

 

**(a)****          ****Documents filed as part ofthis report.**

 

**1.****            ****Financial Statements**

 

The following financialstatements 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

----

 

**2. Financial Statement Schedule**

 

**WORLDGATECOMMUNICATIONS, 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 (as  restated) |       | 69,494                             |       | 3,124                                        |       |                                             |       | 72,618                      |       |
| Year ended December 31, 2004 (as  restated) |       | 72,618                             |       | 7,094                                        |       |                                             |       | 78,712                      |       |

 

All other schedules for which provision is made in the applicableaccounting regulations of the Securities and Exchange Commission are notrequired under the related instructions or are inapplicable, and therefore havebeen 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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| **   | Previously filed                                                                                                                                               |
|------|----------------------------------------------------------------------------------------------------------------------------------------------------------------|
| *    | Filed herewith                                                                                                                                                 |
| (1)  | Incorporated by reference to the exhibits to our  Registration Statement on Form S-1/A as filed on April 7, 1999  (Registration No. 333-71997). |
| (2)  | Incorporated by reference to the exhibits to our  Form 10-Q Report for the quarter ended March 31, 1999.                                             |
| (3)  | Incorporated by reference to the exhibits to our  Form 10-K/A Report for the fiscal year ended December 31, 2000, as  filed on August 17, 2001. |
| (4)  | Incorporated by reference to the exhibits to our  Current Report on Form 8-K filed December 2, 2003.                                                 |
| (5)  | Incorporated by reference to the exhibits to our  Current Report on Form 8-K filed December 4, 2003.                                                 |
| (6)  | Incorporated by reference to the exhibits to our  Registration Statement on Form SB-2 as filed on 12/24/03 (Registration   No. 333-111571).          |
| (7)  | Incorporated by reference to the exhibits to our  Current Report on Form 8-K filed January 21, 2004.                                                 |
| (8)  | Incorporated by reference to the exhibits to our  Current Report on Form 8-K filed June 25, 2004.                                                    |
| (9)  | Incorporated by reference to the exhibits to our  Current Report on Form 8-K filed July 13, 2004.                                                    |
| (10) | Incorporated by reference to the exhibits to the  Company’s Proxy Statement to shareholders filed September 3, 2004.                                 |
| (11) | Incorporated by reference to the exhibits to our  Form 10-Q Report for the quarter ended September 30, 2004, as filed  on November 17, 2004.    |
| (12) | Incorporated by reference to the exhibits to our  Form 10-K Report for the fiscal year ended December 31, 2003, as  filed on March 31, 2005.    |
| (13) | Incorporated by reference to the exhibits to our  Registration Statement on Form SB-2 as filed on May 24, 2005.                                      |

 

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**SIGNATURES**

 

Pursuant to the requirementsof Section 13 or 15(d) of the Securities Exchange Act of 1934, theregistrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 
|                   | WORLDGATE COMMUNICATIONS, INC. |
|------------------------|-------------------------------------|
|                   |                                |   |
|                   |                                |   |
| Date: January 23, 2006 | By:                                 | /s/ HAL M. KRISBERGH |
|                   |                                | Hal M. Krisbergh |
|                   |                                | Chief  Executive Officer |

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, this report has been signed below bythe following persons on behalf of the registrant and in the capacities and onthe dates indicated.

 
| **Name**                               | ** ** | **Capacity**                                      | ** ** | **Date**         |
|----------------------------------------|------------|---------------------------------------------------|------------|------------------|
| ** **                             | ** ** | ** **                                        | ** ** | ** **       |
| /s/ HAL M. KRISBERGH                   |       | Chairman of the Board and Chief Executive Officer |       |             |
| Hal M. Krisbergh                       |       | (Principal Executive Officer)                     |       | January 23, 2006 |
|                                   |       |                                              |       |             |
|                                   |       |                                              |       |             |
| /s/ RANDALL J. GORT,  ATTORNEY-IN-FACT |       |                                              |       |             |
| Joel Boyarski                          |       | Vice President and Chief Financial Officer        |       | January 23, 2006 |
|                                   |       | (Principal Financial and Accounting Officer)      |       |             |
|                                   |       |                                              |       |             |
| /s/ RANDALL J. GORT,  ATTORNEY-IN-FACT |       |                                              |       |             |
| Steven C. Davidson                     |       | Director                                          |       | January 23, 2006 |
|                                   |       |                                              |       |             |
|                                   |       |                                              |       |             |
| /s/ RANDALL J. GORT,  ATTORNEY-IN-FACT |       |                                              |       |             |
| Martin Jaffe                           |       | Director                                          |       | January 23, 2006 |
|                                   |       |                                              |       |             |
|                                   |       |                                              |       |             |
| /s/ RANDALL J. GORT,  ATTORNEY-IN-FACT |       |                                              |       |             |
| Clarence L.  Irving, Jr.          |       | Director                                          |       | January 23, 2006 |

 

36

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| /s/ RANDALL J. GORT,  ATTORNEY-IN-FACT |   |     |   |             |
|----------------------------------------|--------|----------|--------|------------------|
| Jeff Morris                            |   | Director |   | January 23, 2006 |
|                                   |   |     |   |             |
|                                   |   |     |   |             |
| /s/ RANDALL J. GORT, ATTORNEY-IN-FACT  |   |     |   | January 23, 2006 |
| Lemuel Tarshis                         |   | Director |   |             |

 

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* |
|------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------|

 

----

| **   | Previously filed                                                                                                                                               |
|------|----------------------------------------------------------------------------------------------------------------------------------------------------------------|
| *    | Filed herewith                                                                                                                                                 |
| (1)  | Incorporated by reference to the exhibits to our  Registration Statement on Form S-1/A as filed on April 7, 1999  (Registration No. 333-71997). |
| (2)  | Incorporated by reference to the exhibits to our  Form 10-Q Report for the quarter ended March 31, 1999.                                             |
| (3)  | Incorporated by reference to the exhibits to our  Form 10-K/A Report for the fiscal year ended December 31, 2000, as  filed on August 17, 2001. |
| (4)  | Incorporated by reference to the exhibits to our  Current Report on Form 8-K filed December 2, 2003.                                                 |
| (5)  | Incorporated by reference to the exhibits to our  Current Report on Form 8-K filed December 4, 2003.                                                 |
| (6)  | Incorporated by reference to the exhibits to our  Registration Statement on Form SB-2 as filed on 12/24/03 (Registration   No. 333-111571).          |
| (7)  | Incorporated by reference to the exhibits to our  Current Report on Form 8-K filed January 21, 2004.                                                 |
| (8)  | Incorporated by reference to the exhibits to our  Current Report on Form 8-K filed June 25, 2004.                                                    |
| (9)  | Incorporated by reference to the exhibits to our  Current Report on Form 8-K filed July 13, 2004.                                                    |
| (10) | Incorporated by reference to the exhibits to the  Company’s Proxy Statement to shareholders filed September 3, 2004.                                 |
| (11) | Incorporated by reference to the exhibits to our  Form 10-Q Report for the quarter ended September 30, 2004, as filed  on November 17, 2004.    |
| (12) | Incorporated by reference to the exhibits to our  Form 10-K Report for the fiscal year ended December 31, 2003, as  filed on March 31, 2005.    |
| (13) | Incorporated by reference to the exhibits to our  Registration Statement on Form SB-2 as filed on May 24, 2005.                                      |

 

39

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