**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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**FORM 10-K**

 

| **(Mark One)**                                        |
|-------------------------------------------------------|
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| **ý**                                            | ** ** | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
|                                                  |   |   |
| **For the  fiscal year ended December 31, 2005** |
|                                                  |   |   |
| **Or**                                                |
|                                                  |   |   |
| **o**                                                 | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |

 

**For thetransition period from        to        **

 

**Commissionfile number: 000-25755**

 

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**WorldGate Communications, Inc.**

(Exact name of registrant as specified in itscharter)

 

| **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, includingarea code)

 

Securities registered pursuant to Section 12(b) ofthe Act: **None**

 

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

 

**CommonStock, $0.01 Par Value**

(Title of Class)

 

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Indicate by check mark whether the registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o   No  ý

 

Indicate by check mark whether the registrant is notrequired to file reports pursuant to Section 13 or Section 15 (d) ofthe Act. o   No  ý

 

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

 

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, andwill not be contained, to the best of registrant’s knowledge, in definitiveproxy or information statements incorporated by reference in Part III ofthis Form 10-K or any amendment to this Form 10-K. Yes ý     No  o

 

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2  of the Exchange Act. 

 

Large accelerated filer o                      Acceleratedfiler ý                      Non-acceleratedfiler o

 

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

 

The aggregate market value of the common stock heldby non-affiliates of the registrant was approximately $90.5 million as of June 30,2005, based on the closing sale price of $3.24 per share of common stock, asreported on the NASDAQ Small Cap Market.

 

The number of shares of the registrant’s commonstock outstanding as of March 13, 2006 was 39,600,823.

 

**DOCUMENTSINCORPORATED BY REFERENCE**

**None**

 

 

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**WORLDGATECOMMUNICATIONS, INC.**

 

**ANNUALREPORT ON FORM 10-K**

**For theFiscal Year Ended December 31, 2005**

 

**TABLE OFCONTENTS**

 
| **PART I**   |   | 1                                                                                                                  |
|-------------------|--------|--------------------------------------------------------------------------------------------------------------------|
| ** **        |   | ** **                                                                                                         |   | ** ** |
| Item 1.           |   | Business                                                                                                           |   | 1 |
|              |   |                                                                                                               |   |   |
| Item 1A.          |   | Risk Factors                                                                                                       |   | 6 |
|              |   |                                                                                                               |   |   |
| Item 1B.          |   | Unresolved Staff Comments                                                                                          |   | 12 |
|              |   |                                                                                                               |   |   |
| Item 2.           |   | Properties                                                                                                         |   | 12 |
|              |   |                                                                                                               |   |   |
| Item 3.           |   | Legal Proceedings                                                                                                  |   | 12 |
|              |   |                                                                                                               |   |   |
| Item 4.           |   | Submission of Matters to a Vote of Security  Holders                                                               |   | 12 |
| ** **        |   | ** **                                                                                                         |   | ** ** |
| **PART II**  |   | 13                                                                                                                 |
|              |   |                                                                                                               |   |   |
| Item 5.           |   | Market for Registrant’s Common Equity,  Related Stockholder Matters and Issuer Purchases of Equity Securities |   | 13 |
|              |   |                                                                                                               |   |   |
| Item 6.           |   | Selected Financial Data                                                                                            |   | 13 |
|              |   |                                                                                                               |   |   |
| Item 7.           |   | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                        |   | 15 |
|              |   |                                                                                                               |   |   |
| Item 7A.          |   | Quantitative and Qualitative Disclosures  About Market Risk                                                        |   | 24 |
|              |   |                                                                                                               |   |   |
| Item  8.          |   | Financial  Statements and Supplementary Data                                                                       |   | F-1 |
|              |   |                                                                                                               |   |   |
| Item  9.          |   | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure                              |   | 25 |
|              |   |                                                                                                               |   |   |
| Item  9A.         |   | Controls  and Procedures                                                                                           |   | 25 |
|              |   |                                                                                                               |   |   |
| Item 9B.          |   | Other  Information                                                                                                 |   | 28 |
| ** **        |   | ** **                                                                                                         |   |   |
| **PART III** |   | 29                                                                                                                 |
| ** **        |   | ** **                                                                                                         |   |   |
| Item  10.         |   | Directors  and Executive Officers of the Registrant                                                                |   | 29 |
|              |   |                                                                                                               |   |   |
| Item  11.         |   | Executive  Compensation                                                                                            |   | 31 |
|              |   |                                                                                                               |   |   |
| Item  12.         |   | Security  Ownership of Certain Beneficial Owners and Management, and Related  Stockholder Matters                  |   | 34 |
|              |   |                                                                                                               |   |   |
| Item  13.         |   | Certain  Relationships and Related Transactions                                                                    |   | 36 |
|              |   |                                                                                                               |   |   |
| Item  14          |   | Principal  Accountants Fees and Services                                                                           |   | 36 |
|              |   |                                                                                                               |   |   |
| **PART IV**  |   | 38                                                                                                                 |
| ** **        |   | ** **                                                                                                         |   |   |
| Item  15.         |   | Exhibits  and Financial Statement Schedules                                                                        |   | 38 |

 

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**WORLDGATECOMMUNICATIONS, INC.**

 

This report contains forward-looking statements thatinvolve risks and uncertainties. These forward-looking statements are based onmanagement’s current expectations and are subject to a number of uncertaintiesand risks that could cause actual results to differ significantly from thoseanticipated in these forward-looking statements. Factors that may causesuch a difference include, but are not limited to, those set forth in the “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” aswell as those discussed elsewhere in this report.

 

**PART I**

 

**Item 1.Business**

 

WorldGate Communications, Inc. was incorporatedin Delaware in 1996 to succeed to the business of our predecessor, WorldGateCommunications, L.L.C., which commenced operations in March 1995. In April 1999,we completed our initial public offering of 5,750,000 shares of our commonstock. Since January 9, 2003 our common stock has been listed on theNASDAQ Small Cap Market. Previously our common stock was traded on the NASDAQNational Market. Our common stock is traded under the symbol “WGAT” since ourinitial public offering, except for the period from November 25, 2005 to February 9,2006 when our symbol was “WGATE”. Our executive offices are located at 3190Tremont Avenue, Suite 100, Trevose, Pennsylvania 19053.

 

**Overview**

 

Since our formation in 1995 and until the firstquarter of 2004, we were in the business of developing and selling interactivetelevision, or ITV, technology, products and services for use in conjunctionwith cable TV broadband networks (the “ITV Business”). Using our solutions,cable TV operators branded, marketed, and offered a wide variety of ITVpackages to consumers. These packages included walled gardens of information,communications solutions complete with Internet-based e-mail and chat, and Websurfing, all presented and engaged on the TV set.

 

During the third quarter of 2003, we completed asale of significant assets, including our ITV intellectual property rights andour membership interest in TVGateway, LLC, for $3,000,000 in cash to TVGateway,LLC, an ITV oriented company we were instrumental in forming. Our transactionwith TVGateway, LLC marked a shift in our business away from the ITV Businessand toward a new video phone product and associated business. Although wecontinued to support our current ITV Business into the first quarter of 2004,the development of our video phone product became a primary business focus. Thefunds we received from the sale of assets to TVGateway, LLC, as well as thefunds we subsequently received as a result of several private placements of oursecurities have permitted us to fund the development of our new business.

 

During 2004, we continued development of a videophone, designed specifically for personal video communication over high speeddata(“HSD”) or broadband networks, that we believe is differentiated, both fromcompetitors and from previous efforts at personal video telephony, byproviding: “true to life” communication (meaning that images and sounds aresynchronized, that there are minimum delays between the two ends of thecommunication, and that the quality of the images is similar to what weperceive with traditional television), 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, (“PSTN”).The design of our first video phone product, branded as Ojo, was substantiallycompleted in late 2004 and field trials were commenced. Commercial distributionof this product commenced in the spring of 2005.

 

On April 28, 2004, we entered into a multi-yearagreement with General Instrument Corporation d/b/a the Connected HomeSolutions Business of Motorola, Inc. (“General Instrument”) for theworldwide development and distribution of the Ojo personal video phone. Thisagreement provided for General Instrument to be WorldGate’s exclusivedistributor of its broadband video phone products and for WorldGate to beGeneral Instrument’s exclusive supplier of its broadband video phone products. OnFebruary 17, 2006, we mutually agreed with General Instrument to end thisagreement. The ending of this agreement immediately terminates exclusivity forboth parties. In addition to its current role for development and manufactureof Ojo, WorldGate will now have direct responsibility and control for theadvertising, marketing, and distribution of its products. Under its agreementwith General Instrument, WorldGate had been active in marketing and promotingits products, and working with General Instrument to distribute Ojo. WorldGateintends to continue the rollout of Ojo using many of the same distributors,retailers and service providers, and plans to expand distribution to serviceproviders and retailers around the world. The two companies will work togetherto ensure a smooth transition for customer accounts. As part of ending itsagreement with General Instrument, and in anticipation of our inventoryrequirements as a result of taking full responsibility for productdistribution, We negotiated the right to buy back about two-thirds of the unitssold to General Instrument, valued at approximately $2,765,000 (based upon theoriginal sales price to General Instrument), for approximately $1,064,000. Thisis less than half of what it would cost us to purchase the same inventory from ourmanufacturing sources. As a result the Company recorded a reserve for returnsand reduced revenue in the amount of approximately $2,310,000

 

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duringthe fourth quarter of 2005. In addition the Company will record no revenue forunits shipped to General Instrument in the first quarter 2006 and will record again on termination of this agreement of approximately $1,331,000 during thefirst quarter 2006 as a result of the lower purchase price of this inventory(net of the cost of rework for rebranding the product).

 

HSD network users provide a large, and we believeconducive, target market for a quality video phone offering. Initial videophone sales are expected to be derived from new technology adopters and regularlong distance communicators such as families and close friends. We also expectthat the business-to-business opportunity will be attractive as a video phoneprovides means to improve interpersonal communication and multi-locationproductivity. Furthermore we expect that the growth in the voice over Internetprotocol market (or “VoIP”) will also help to drive sales of our video phonesince it can also serve as a VoIP endpoint.

 

Our business model is based on the sale of videophones and related products. We expect that our products will be marketed toHSD network operators as well as to consumers through traditional consumerelectronics distribution channels. We believe that HSD operators could realizesignificant recurring revenue streams associated with offering our product toend users. We have also developed this product to require very minimal capitalinvestment or incremental costs by such operators. Our marketing objective isto have our video phones supplement and hopefully replace ordinary home andbusiness phones worldwide.

 

**General Product Description**

 

We have developed a video phone, ergonomicallydesigned specifically for in-home and business, personal video communication.We have identified several issues that have interfered with commercial successand consumer acceptance of video phones and sought to address each of theseissues within the Ojo video phone. The Ojo video phone was designed for use onthe existing HSD network infrastructure. The Ojo phone will, however, alsoconnect to the analog phone line for interoperability with the voice onlycommunications offered by the existing PSTN networks and VoIP networks. Ojo,therefore, can be used for video calls, for ordinary voice only calls as wellas for voice over Internet protocol, or VoIP calls. We believe that Ojo isdifferentiated, both from competitors and from previous efforts at personalvideo telephony, by providing: true to life communication (meaning that imagesand sounds are synchronized, that there are minimum delays between the two endsof the communication, and that the quality of the image is similar to what isexperienced with television), interoperation with the PSTN and VoIP, ease ofdeployment by HSD operators, ease of use by consumers, and a highly styledergonomic design. We believe Ojo uniquely leverages the recent development of astate of the art connectivity infrastructure, as well as the convergence of thelatest improvements in compression technology, processing power and bandwidthavailability, to help ensure, enable and maintain dedicated high qualityend-to-end connections.

 

TheOjo solution consists of two primary components:

 

1. A display unit includes the camera, video screenand external interface ports. The video screen is used to display menus andprovide a user interface as well as to view the images of the local and remoteparties. Considerable effort has been expended in the ergonomic and stylisticdesign of the display unit. For example, it is taller than most conventionalphones to ensure that the user is looking into the unit and not down at theunit. Similarly the camera of the unit is looking at the user at face level,instead of “up the user’s nose.” The display unit can be used as a standardspeaker phone to receive both audio and audio/video calls. The display unit isdesigned to be aesthetically usable in any room. Particular attention was givento the user interface to ensure that Ojo was installable and usable without theneed to refer constantly to a manual. The display contains an RJ-45 jack forconnection to the cable or DSL modem and an RJ-11 jack for connection to thePSTN or VoIP network. The consumer simply plugs the display unit into the high-speedmodem or router and into the standard house power outlet to facilitate accessto the necessary data network. In addition to a connection to the high-speedmodem or router, the display unit also connects to the standard phone line.This connection, while not required for a video phone call, allows the Ojovideo phone to also be used as a standard telephone using the consumers PSTN orVoIP service.

 

2. A cordless handset with an internal speaker andmicrophone, a monochrome graphical display and most of the user controls forthe device (numeric keypad, navigation device, talk, mute and end buttons).Although the handset is discussed as a separate component, it will generally beseated in the lower portion of the display unit where it will serve as the navigationdevice while its batteries are being charged. The handset fits into a cradle onthe display unit. It is designed to be used both as part of a video call,or alone for standard PSTN phone calls. Since the Ojo unit is designed toreceive and make audio calls as well as video calls, the handset functions as atypical cordless phone and has the features a user typically expects for acordless phone. Although video calls can be received at the display unit evenwhen the handset is not present, the handset is intended to be the primarycomponent used to operate the video phone (in a manner similar to a televisionremote control).

 

**Material Developments for WorldGate since December 31,2004**

 

The following is a summary of material developmentsfor us that have occurred since December 31, 2004:

 

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

 

Commercial distribution of this product commenced inthe spring of 2005. 

 

On August 3, 2005, the Company completed aprivate placement of $17,500,000 of its common stock and warrants with severalinstitutional investors. The Company issued 4,666,664 shares of its commonstock at $3.75 per share to the participating investors. The Company alsoissued five-year warrants to purchase a total of 1,671,947 shares of its commonstock: 1,633,333 shares to the investors at an exercise price of $5.00 pershare, and 38,614 shares to the placement agent at an exercise price of $4.53per share. The investors also received an additional investment right, for alimited period of time, to purchase 1,554,000 additional shares of common stockat $4.12 a share. The private placement includes numerous provisions intendedto protect these institutional investors including a cash payment penalty of1.5% per month for the period above 120 days from the effective date of theAgreement that the shares in the transaction fail to be registered. On December 1,2005 the shares under this private placement had not been registered and untilsuch time as the shares become registered the Company is subject to the penaltyprovision under this private placement. As of December 31, 2005 we haverecorded accrued penalties of $525,000.

 

In addition to the private placement discussedabove, from January 2005 through December 2005, we received additionalcash proceeds of approximately $2,295,000 from the exercise of outstandingwarrants issued pursuant to the private placement discussed above and by theexercise of non-executive employees’ and prior employees’ stock options.

 

From January 1, 2005 through January 12,2006, holders of the preferred stock from the June 24, 2004 privateplacement have converted 6,442 of their shares, resulting in the issuance of 2,741,277shares of our common stock based upon the $2.35 conversion price. 

 

On April 28, 2004, we entered into a multi-yearagreement with General Instrument for the worldwide development anddistribution of the Ojo personal video phone. This agreement provided forGeneral Instrument to be WorldGate’s exclusive distributor of its broadbandvideo phone products and for WorldGate to be General Instrument’s exclusivesupplier of its broadband video phone products. On February 17, 2006, wemutually agreed with General Instrument to end this agreement. The ending ofthis agreement immediately terminates the exclusivity for both parties. WorldGatewill now have direct responsibility and control for the advertising, marketing,and distribution of its products. WorldGate intends to continue the rollout ofOjo and plans to expand distribution to service providers and retailers aroundthe world. The two companies will work together to ensure a smooth transitionfor customer accounts. As part of ending its agreement with GeneralInstrument, and in anticipation of our inventory requirements as a result oftaking full responsibility for product distribution, We negotiated the right tobuy back about two-thirds of the units sold to General Instrument, valued atapproximately $2,765,000 (based upon the original sales price to GeneralInstrument), for approximately $1,064,000. This is less than half of what itwould cost us to purchase the same inventory from our manufacturing sources. Asa result the Company recorded a reserve for returns and reduced revenue in theamount of approximately $2,310,000 during the fourth quarter of 2005. Inaddition the Company will record no revenue for units shipped to GeneralInstrument in the first quarter 2006 and will record a gain on termination ofthis agreement of approximately $1,331,000 during the first quarter 2006 as aresult of the lower purchase price of this inventory (net of the cost of reworkfor rebranding the product).

 

**Business Plan**

 

*General.*Our business model is primarily based uponthe sale of Ojo video phones. It is our plan for Ojo video phone to bedistributed through and in partnership with HSD network providers, as well asthrough traditional electronics distribution channels. Video phone service,using the Ojo video phone, is expected to be offered by HSD network providersas a means of attracting new HSD subscribers as well as maintaining existingsubscribers. We believe that HSD network providers could realize potentiallysignificant recurring incremental revenue streams associated with offeringproducts such as our Ojo video phone, and accordingly we believe they willembrace the concept and business model. The suggested consumer offering for avideo phone service follows the traditional HSD model, which may involve asubsidy of the required hardware by the recurring service fee. We anticipatethat video phone service subscribers will be able to either purchase Ojo orlease a unit from the HSD network provider. There is also a parallel market forsales of video phones directly to consumers through the standard consumerelectronic channels. Sales of video phone through this channel still require avideo phone service and the Company is currently offering such a video phoneservice, using the Ojo video phone, for units sold through this channel.

 

*Manufacturing.* Ojo video phones are manufactured inAsia, to take advantage of the base of lower labor, tooling and componentcosting. A formal relationship with Mototech Inc. (“Mototech” not an affiliateof General Instrument or Motorola) has already been established for the volumemanufacture of Ojo. Mototech along with U.S. Robotics and SMC Networks, areaffiliates of the Accton Technology Group, a group of Taiwanese manufacturersthat we believe are well-known in the electronics industry. Mototech’sresponsibilities in this role include:

 

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•product design finalization for manufacturing; 

•component selection and procurement;

•tool sourcing and management;

•coordination of Ojo manufacturing;

•implementation and monitoring of Ojo’s Quality Plan; and

•product cost reduction.

 

Under the agreement, Mototech is required tomanufacture products in response to purchase orders issued by our company. Althoughour company has no obligation to purchase any particular volume of productsunder the agreement, Mototech is generally required to accept all purchaseorders, subject to certain limits described in the agreement. As part ofour agreement with Mototech we retain formal sign-off control over any product,specification, or component changes proposed by Mototech. We also maintain allrights to the Ojo technology and intellectual property, as well as the right tosecond source the Ojo product. Our agreement with Mototech permits Mototech andour company to terminate the agreement at any time by giving 90 days writtennotice to the other party.

 

*Product Sales and Distribution*. Ojo is being marketed domestically and internationally to both theresidential and business sectors through the standard consumer and businesselectronics channels. In addition we plan to market our products through HSDproviders in a manner similar to broadband modems. Prior to February 17,2006 we relied upon General Instrument to provide the marketing anddistribution for our products. As a result of a mutual agreement with GeneralInstrument our development and distribution agreement with them has ended and wehave now assumed full responsibility for product sale and distribution in allchannels. Under our agreement with General Instrument, WorldGate had beenactive in marketing and promoting its products, and working with GeneralInstrument to distribute Ojo. WorldGate intends to continue the rollout of Ojousing many of the same distributors, retailers and service providers, and plansto expand distribution to service providers and retailers around the world. Thetwo companies will work together to ensure a smooth transition for customeraccounts.

 

**Competition**

 

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

 

*Business Phone Products.*Most of these products are targeted forcorporate use and are relatively high priced. Generally, the ergonomic designof 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 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 a TV-basedvideo phone product that is targeted to consumers as a lower cost videoconferencing device. D-Link uses the home television as the display device andutilizes either the TV’s speaker or connection to a standard analog phone forthe audio portion of the call. Although costing only about two hundred dollars,the main disadvantages of this product is that it requires a television to sendand receive calls. In many cases, this would obstruct the ability to watchtelevision while a call is in progress thereby disrupting family televisionwatching for the length of the call. Numerous video conferencing products also existfor the business market. Typically these devices cost $2,000 or more andinvolve complex installations of one or more cameras, monitors, microphones andspeakers within a conference room setting. The videoconference nature ofthese products eliminates the ability to communicate on a private, one-on-onelevel. The main competitors in this sector include Sony, Sorenson Media andPolycom Inc.

 

*Telephone Products.*Vialta, Inc. produces the “Beamer,” anH.324 (POTS) video phone that is designed for connection to a standardtelephone. The product utilizes a standard analog telephone for connection tothe PSTN and as the listening device. Because the unit uses traditionaltelephone lines for connectivity it cannot take advantage of the high-speeddata systems available through cable and DSL modems.

 

*Web Cam Products.*Web cams are different from other competitiveproducts in that they did not arise from either business video phones or videoconferencing. Rather, they began in the early days of the Internet when “techies”were expanding the capabilities of PC-based content and applications withlow-cost attachments to the computer. Currently, web cams are often used todisplay visual information as well 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. Current web cams typically lackthe

 

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qualityof dedicated video phone devices. They also require the utilization of separatepersonal computers which may not be co-located in the same areas whereconvenient video calls would occur. Competitors in this category includeLogitech, Inc., Intel Corporation, 3Com Corporation, and CreativeTechnology, Ltd.

 

*Hybrid Web Cam-Business PhoneProducts.*In recentmonths, Cisco Systems, Inc. introduced a hybrid video phone product thatis designed for the business phone market. The Cisco product consists of a webcam device and host software that enables video phone functionality when usedin conjunction with an IP phone and call processing hardware. We believe thisproduct requires a significant capital investment for implementing the callprocessing hardware and IP phones.

 

**Intellectual Property**

 

We plan to rely on patent, trade secret, trademarkand copyright law to protect our video phone intellectual property. Although wehave filed multiple patent applications for our products and technology, wecurrently only hold one issued patent. Our patent position is subject tocomplex factual and legal issues that may give rise to uncertainty as tothe validity, scope and enforceability of a particular patent. Accordingly,there can be no assurance that additional patents will be issued pursuant toour current or future patent applications or that patents issued pursuant tosuch applications will not be invalidated, circumvented or challenged.Moreover, there can be no assurance that the rights granted under any suchpatents will provide competitive advantages to us or be adequate to safeguardand maintain our proprietary rights. In addition, effective patent, trademark,copyright and trade secret protection may be unavailable, limited or notapplied for in certain foreign countries.

 

**Government Regulation**

 

Our Ojo video phone will be required to comply withvarious laws and government regulations, including Parts 15 and 68 of the FCC’sregulations in the United States, which relate to radio frequency devices andto terminal equipment that is connected to the telephone network. The legal andregulatory environment that pertains to our business is uncertain and changingrapidly. New legislation or regulation, such as that currently being consideredfor limiting the environmentally hazardous substances that are currently foundin most electronic devices, could be introduced that could substantially impactour ability to distribute our Ojo video phone products. Similarly the FCC and othercomparable regulatory commissions could undertake an examination of whether toimpose surcharges or additional regulations upon certain providers of Internetprotocol, or IP, based communication services. The imposition of regulations onIP communications services may negatively impact our business.

 

**Research and Development**

 

To date, our engineering and product development hasbeen a significant focus. The principal focus of our current engineering anddevelopment activities is the continued development and enhancement of our Ojovideo phone. Development of the Ojo video phone has required combiningtechnical experience and knowledge from two historically separate industries,cable and telephony. Our engineering and development expenditures in connectionwith our Ojo video phone were approximately $3,000,000, $4,001,000 and $6,486,000for the years ended December 31, 2003, 2004 and 2005, respectively.

 

**Employees**

 

As of December 31, 2005, on a consolidatedbasis, we had approximately 70 full-time employees. All of our employees arelocated in Trevose, Pennsylvania. None of our employees are represented by alabor union, and we have no collective bargaining agreement. We consider ouremployee relations to be good.

 

**Financial Information Relating to Foreign and DomesticOperations and Export Sales from Continuing Operations (Dollars in Thousands)**

 
| ** **                                                            | ** ** | **2003**   | ** ** | **2004**   | ** ** | **2005**   | ** ** |
|-----------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net revenues from continuing operations by  geographic area:          |       |       |       |       |       |       |       |
| United  States                                                        |       | $          | 0          |       | $          | 231        |       | $ | 1,558 |   |
| Total                                                                 |       | $          | 0          |       | $          | 231        |       | $ | 1,558 |   |
| Loss from continuing operations (all from  United States operations)  |       | $          | (5,797     | )          | $          | (19,461    | )          | $ | (6,851 | ) |
| Identifiable Assets (all within the United  States)                   |       | $          | (5,117     | )          | $          | 13,172     |       | $ | 20,684 |   |
| Identifiable foreign assets (hardware and  tooling for manufacturing) |       | $          | 0          |       | $          | 650        |       | $ | 545 |   |

 

**Available Information**

 

You may access, free of charge, on our website,www.wgate.com, our annual report on Form 10-K, quarterly reports on Form 10-Q,current reports on Form 8-K and amendments to those reports filed or furnishedpursuant to Section 13(a) or 15(d) of the Exchange Act.  We endeavor to post these reports on ourwebsite as soon as reasonably practicable after we file such material with, orfurnish it to, the SEC.

 

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**Item 1A. Risk Factors.**

 

*In addition to other informationin this Form 10-K, the following risk factors should be carefullyconsidered in evaluating our company and our business. Investing in our commonstock involves a high degree of risk, and you should be able to bear thecomplete loss of your investment. We also caution you that this Form 10-Kincludes forward-looking statements that are based on management’s beliefs andassumptions and on information currently available to management. Future eventsand circumstances and our actual results could differ materially from thoseprojected in any forward-looking statements. You should carefully consider therisks described below, the other information in this Form 10-K, thedocuments incorporated by reference herein and the risk factors discussed inour other filings with the Securities and Exchange Commission when evaluatingour company and our business. The risks and uncertainties described below arenot the only ones we face. Additional risks and uncertainties not presentlyknown by us or that we currently deem immaterial also may impair ourbusiness operations. If any of the following risks actually occur, our businesscould be harmed. In such case, the trading price of our common stock coulddecline and investors could lose all or part of the money paid to buy ourcommon stock.*

 

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

 

Since our formation in 1995 and until the firstquarter of 2004, we were in the business of developing and selling interactivetelevision, or ITV, technology products and services for use in conjunctionwith cable television broadband networks. Our ITV business has historicallyaccounted for substantially all of our revenue. Since we have discontinued theITV Business and transitioned to become a developer, manufacturer and seller ofvideo phone products we cannot reliably predict our future revenues, and noassurances can be provided as to the amount of ongoing revenues, if any, or tothe periods in which any such revenues may be received. Our video phonebusiness involves the development of a new product line with no marketpenetration, in an undeveloped market sector. The extent and timing of ourrevenues depends on several factors, including the rate of market acceptance ofour products, and the degree of competition we face from similar products. Wecannot predict to what extent our video phone product will produce revenues, orwhether we will ever reach profitability. If we are unable to achievesignificant levels of recurring revenue from our video phone business, ourlosses will likely continue indefinitely. If this occurs, the market price ofour common stock and our viability as a going concern could suffer.

 

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

 

The report of the independent registered publicaccounting firm for the year ended December 31, 2005 included anexplanatory paragraph stating that our company has losses from operations andhad an accumulated deficit of $229,092,000 that raised substantial doubt aboutour company’s ability to continue as a going concern. No assurances can begiven that the issues that led our independent registered public accountingfirm to this conclusion will be addressed or that our business will continue tooperate as a going concern.

 

**We are subject to complex and changing rules andregulations concerning corporate governance and financial accounting standards,which may affect our reported financial results or the way we conductbusiness, or our ability to ensure proper financial reporting and adequateinternal controls.**

 

The Sarbanes-Oxley Act, which was signed into law inJuly 2002, among other things, mandated that companies adopt new corporategovernance measures and imposed comprehensive reporting and disclosurerequirements. These rules, regulations and requirements increased the scope,complexity, and cost of our corporate governance, reporting, and disclosurepractices. Furthermore, generally accepted accounting principles in the UnitedStates, 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, reviews and interpretations may have asignificant effect on our reported results of operations, including the resultsof transactions entered into before the effective 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 subsequentanalysis the Company elected to file restatements of certain of its financialstatements to correctly account for such 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 materialweakness is a control deficiency, or a combination of control deficiencies,that results in more than a remote likelihood that a material misstatement ofthe annual or interim financial statements will not be prevented or detected. Toaddress this material weakness the Company engaged outside experts to providecounsel and guidance in areas where we cannot economically maintain therequired expertise internally. No assurance can be given, however, that suchcounsel and guidance will be sufficient to remedy this material weakness or toensure that a future material misstatement may not occur within ourfinancial statements.

 

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Additionally, section 404 of the Sarbanes-OxleyAct of 2002 requires us to assess the design and effectiveness of our internalcontrol systems. Because we are an accelerated filer for SEC reporting purposesas of December 31, 2005, we were required to make our initial assessmentfor our fiscal year then ended. Our independent registered public accountingfirm rendered an attestation report on management’s assessment of theeffectiveness of our system of internal control over financial reporting whichincluded an adverse opinion on the effectiveness of our internal controls overfinancial reporting because of the existence of a material weakness. If any changesor additions are required to these systems we must complete the documentation,evaluation and any required remediation of our systems of internal control. Thecosts associated with such compliance are likely to be significant and willnegatively impact future financial results. In addition, there is no assurancethat we will be able to conclude that our systems are appropriately designed oreffective, or that a material weakness will not be found in our internalcontrols over financial reporting, which could result in a materialmisstatement in future financial statements.

 

**We are dependent on a single line of business thatcurrently has no significant history of revenues. We cannot predict our futureresults because our video phone business has no operating history.**

 

Our primary line of business has become thedevelopment of video phone products and technology. We began generating revenuefrom commercial shipment of our Ojo product in April 2005. Given that ourvideo phone business involves the development of a new product line with nomarket penetration, in an underdeveloped market sector, no assurances can begiven that sufficient sales, if any, will materialize. Should this businessfail to generate sufficient sales to support ongoing operations there can be noassurance that we will be able to develop alternate business lines. Investorsshould consider the risks and uncertainties that we may encounter as anearly-revenue-stage company in a new, single line of business, and in an unprovenmarket. These uncertainties include:

 

•                  ourability to design, engineer and manufacture products having the technologicalfeatures planned 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;

•                  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;

•                  achanging regulatory environment;

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

•                  globaleconomic conditions.

 

**We will incur increased risks, costs and expenses for marketing anddistributing our products, for collection and accounts receivable issues, andfor inventory as the result of ending our development and distributionagreement with General Instrument.**

 

Under our development and distribution agreementwith General Instrument, General Instrument was responsible for thedistribution of our products and for the direct relationship with thedistributors, dealers, and other resellers ultimately used to sell the products.In addition, General Instrument marketed our products and maintained aninventory of our products. General Instrument also maintained the necessaryinfrastructure to handle the logistics for performing these functions,including customer ordering, inventory warehousing, billing, customer service,credit and accounts receivable functions for multiple customers. In performingthese functions General Instrument carried the associated risks, costs andexpenses. As a result of ending our agreement with General Instrument, we arenow directly assuming these responsibilities and associated risks, costs andexpenses, and this places increased demands on the cash which we have available.We will also be required to develop new, or expand existing, infrastructure tohandle these logistical functions. There can be no assurance that thedevelopment or expansion of capabilities can be accomplished in an efficientand cost effective manner. In addition, General Instrument’s price of ourproduct to its reseller customers included a mark-up from its cost of theproduct from us that was intended to reflect its risks, cost and expenses, plusits profit. We will be charging these reseller customers a lower price and wecannot be assured that the new price will include a sufficient mark-up to coverthe risks, costs and expenses that is now our responsibility going forward. Furthermoreall of our revenue for the sale of our video phones was derived from GeneralInstrument under the development and distribution agreement and there were minimaladministrative costs associated with billing and collecting this revenue. Wewill now have multiple customers and bear the associated increasedadministrative costs and risks of collection.

 

**Our video phone technology and products remain subjectto significant uncertainty.**

 

Our video phone technology and products are in theearly commercialization stage and have not been proven over an extended periodof time. The market for products related to video telephony is characterized byuncertain user and customer requirements, and the emergence of newcommunications standards and practices. Each of these characteristics couldimpact our video phone products, intellectual property and system designs. Thesuccessful development of our products is subject to the risks that:

 

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•  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.

 

Significant undetected errors or delays in newproducts or releases may affect market acceptance of our product. Therecan be no assurance that, despite our testing, errors will not be found in theinitial product or subsequent releases after the commencement of commercialshipments, resulting in loss of customers or failure to achieve marketacceptance. In addition, our video phone technology and product will need to becompatible with a broad array of disparate technologies in order to beinteroperable with other products routinely used in HSD operations such asrouters, switches, network interfaces, operating systems, security protocolsand techniques, communication protocols and protocol servers, and billingsystems software. Without compatibility, we may not achieve marketacceptance or demand for our products within our target base of customersbecause our products will not operate with many of the applications the targetcustomers currently use.

 

**We rely on third parties to provide certain componentsand services for our video phone products. If our vendors fail to deliver theirproducts in a reliable, timely and cost-efficient manner, our business willsuffer.**

 

We depend on relationships with third parties suchas contract manufacturing companies, chip design companies and others who may besole source providers of key components and services critical for the productwe are developing in our video phone business. A formal relationship withMototech has been established for the volume manufacture of Ojo. Our agreementwith Mototech allows either party to terminate the agreement with 90 days priornotice. If Mototech 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, we may haveto delay product delivery, or recall or replace unacceptable products. Inaddition, 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.

 

**We will rely on third parties to provide certainmarketing and distribution services for our video phone products. If ourvendors fail to deliver their services in an appropriate, reliable, timely andcost-efficient manner, our business will suffer.**

 

Prior to February 17, 2006 the Company reliedupon General Instrument to provide the marketing and distribution for itsproducts. As of such date, the Company and General Instrument agreed to endtheir development and distribution agreement and the Company assumed fullresponsibility for product sale and distribution in all channels. In additionto direct sales on our web site, we will continue to rely upon a distributionorganization of dealers, distributors, original equipment manufacturers, valueadded resellers, service providers and other resellers to market and sell ourvideo phone products, many of which will be the same as those used by GeneralInstrument. WorldGate also plans to expand distribution to service providersand retailers around the world. The Company has agreed with General Instrument towork together to ensure a smooth transition for existing customer accounts. Givenour limited experience in dealing with the retail distribution channel, therecan no assurance that we will be able to successfully and expeditiouslyconclude retail distribution agreements with the necessary retailers anddistributors. Additionally the Company does not have the same presence ornegotiation strength as General Instrument and there can be no assurance thatthe agreements we negotiate will be as favorable as those negotiated by a partywith more presence. These resellers are able to set their own policiesregarding the pricing of our products and the advertising, marketing and otherpromotional efforts applicable to our products. In addition they determine howprominently our products are displayed and demonstrated. If our resellers’policies are not effective or if our products are not given adequateprominence, our sales of our products may be negatively impacted and ouroperating results would be adversely affected. In this event our revenue couldbe significantly reduced and we could lose potential customers for ourproducts.

 

**With the end of our development and distribution agreement with GeneralInstrument, we will no longer be able to use the Motorola brand in associationwith our products, or General Instrument’s other resources in marketing anddistributing our products.**

 

TheMotorola brand made available by General Instrument is a widely recognizedbrand that is almost synonymous with cell phone, radios and other widelydistributed electronic products. In addition, General Instrument broughtsignificant resources in the areas of advertising, sponsorship, sales force anddistribution logistics. With the end of our agreement with General Instrument,we are phasing out the Motorola branding and we are no longer eligible tobenefit from the other resources that they offered. This may negativelyimpact the perception of our products and will require increased efforts on ourpart to market and promote our products and efficiently and successfullyto sell and distribute our products, and there can be no assurance that we willbe successful in our efforts. 

 

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

 

Our video phone products are complex and use “stateof the art” technology. Accordingly, our development efforts are inherentlydifficult to manage and keep on schedule and there can be no assurancethat we will be able to meet our development objectives or to meet marketexpectations. In addition to development delays, we may experiencesubstantial cost overruns in completing development of our product. Thetechnological feasibility for some aspects of the product that we envision isnot completely established. The products developed by us may containundetected flaws when introduced. There can be no assurance that, despitetesting by us and by potential customers, flaws will not be found in theproduct, resulting in loss of or delay in market acceptance. We may beunable, for technological or other reasons, to develop and introduce productsin a timely manner in response to changing customer requirements. Further,there can be no assurance that a competitor will not introduce a similarproduct. The introduction by a competitor of either a similar product or asuperior alternative to our product, may diminish our technologicaladvantage, render our product and technologies partially or wholly obsolete, orrequire substantial re-engineering of our product in order to becomecommercially acceptable. Our failure to maintain our product developmentschedules, avoid cost overruns and undetected errors or introduce a productthat is superior to competing products would have a materially adverse effecton our business, financial condition and results of operations.

 

**We may not be able to achieve competitive pricingin the marketplace.**

 

Because video phone products are relatively new tothe marketplace there is no established market pricing. Our pricing for the Ojovideo phone may be considered high for a consumer product offering. Wecannot be assured that we will be able to provide competitive market pricing.

 

**We are highly dependent on our key personnel to manageour business, and because of competition for qualified personnel we may notbe able to recruit or retain necessary personnel.**

 

Our continued growth and success depend to asignificant degree on the continued services of our senior management and otherkey employees and our ability to attract and retain highly skilled andexperienced technical, managerial, sales and marketing personnel. We havehistorically been a developer of products related to ITV. Our video phonebusiness represents an expansion into the development of HSD communicationshardware and software products in which we have limited experience. In our newvideo phone business, we also expect to encounter new product developmentchallenges, new customer requirements, new competitors and other new businesschallenges, with which our existing management may be unfamiliar. Therecan be no assurance that we will be successful in recruiting new personnel orin retaining existing personnel. None of our employees is subject to along-term employment agreement. The loss of one or more key employees or ourinability to attract additional qualified employees could have a materialadverse effect on our business, results of operations and financial condition.In addition, we may experience increased compensation costs in order toattract and retain skilled employees.

 

**We may not be successful in developing ormaintaining strong distribution channels for our video 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 and/or consumer electronic devices to end-users. If we are notsuccessful in creating a strong distribution channel in a timely manner, we may notgain significant sales.

 

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

 

The market for products that utilize HSDcommunications is still developing and there can be no assurance that ourproduct will ever achieve market acceptance. Businesses, cable operators andother HSD network providers as well as the users of such HSD networks must be convincedto buy our video phone product. To the extent we do not achieve growth, it willbe difficult for us to generate meaningful revenue or to achieve profitability.

 

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

 

Failure to protect our intellectual property rights may resultin a loss of our exclusivity or the right to use our video phone technology. Weplan to rely on patent, trade secret, trademark and copyright law to protectour video phone intellectual property. Although we have filed multiple patentapplications for our technology, and we currently only hold one issued patent, ourpatent position is subject to complex factual and legal issues that may giverise to uncertainty as to the validity, scope and enforceability of aparticular patent. Accordingly, there can be no assurance that any patents willbe issued pursuant to our current or future patent applications or that patentsissued pursuant to such applications will not be invalidated, circumvented orchallenged. Moreover, there can be no assurance that the rights granted underany such patents will provide competitive advantages to us or be adequate to

 

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safeguardand maintain our proprietary rights. In addition, effective patent, trademark,copyright and trade secret protection may be unavailable, limited or notapplied for in certain foreign countries.

 

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

 

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

 

**Legal and regulatory developments could have adverseconsequences for our business.**

 

The legal and regulatory environment that pertainsto our business is uncertain and changing rapidly. New legislation orregulations could be introduced that could substantially impact our ability tolaunch and promote the Ojo video phone. For example the Federal Communications Commission(FCC) or a comparable regulatory authority could undertake an examination ofwhether to impose surcharges or additional regulations upon certain providersof Internet protocol, or IP, based communication services. The imposition ofregulations on IP communications services may negatively impact ourbusiness. Similarly the adoption of regulations prohibiting the use of certainsubstances commonly found in electronic components could likewise increase thecosts of our products, delay product introductions and otherwise negativelyimpact our business.

 

**The use of the high speed data infrastructure as acommercial marketplace is at an early stage of development.**

 

Demand and market acceptance for recently introducedproducts and services over the high speed data, or HSD, infrastructure arestill uncertain. We cannot predict whether customers will be willing to shifttheir traditional telephone activities online. The HSD infrastructure may notprove to be a viable commercial marketplace for a number of reasons, including:

 

• concerns about security and varying security techniques and protocols;

• changing and non-uniform standards

• Internet congestion;

• quality of service issues;

• inconsistent service; and

•  lackof cost-effective, high-speed access.

 

If the use of the HSD infrastructure as a commercialmarketplace does not continue to grow, we may not be able to grow ourcustomer base, which may prevent us from achieving profitability.

 

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

 

The extent and timing of our future capitalrequirements will depend upon several factors, including the rate of marketacceptance of our products, the degree of competition for our products, and ourlevel of expenditures, including those for product development, sales andmarketing. If our capital requirements vary materially from those currentlyplanned, we may require additional financing sooner than anticipated. Despitethe receipt of proceeds from several private placements of our securities, we may needto seek additional third party investment in order to provide additionaloperating capital for our video phone business. We cannot be certain thatfinancing from third parties will be available on acceptable terms to us or atall. The levels of funding of early-stage companies generally by both venturefunds and strategic investors have fallen dramatically in the past few years.If we cannot raise funds on acceptable terms, we may not be able todevelop our products and services, take advantage of future opportunities orrespond to competitive pressures or unanticipated requirements, any of whichcould have a material adverse effect on our ability to grow our business. If weare unable to secure such additional financing, we will have to curtail orsuspend our business activities, we may not be able to continue to operateour business as a going concern and we may have to seek protection of thebankruptcy courts. If that happens, you could lose your entire investment.

 

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**If we obtain additional financing, you may suffersignificant dilution.**

 

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

 

**NASDAQ Listing Requirements may limit our abilityto raise additional capital.**

 

Our common stock is listed on the NASDAQ SmallCapMarket. If our common stock is listed on The NASDAQ National Market or TheNASDAQ SmallCap Market at the time of a proposed equity financing resulting in thesale and issuance of twenty percent or more of the outstanding shares of ourcapital stock, we may be required to obtain stockholder approval of suchissuance. There can be no assurance that we will be able to obtain anynecessary stockholder approval, and the failure to obtain such approval couldlimit our ability to obtain needed capital.

 

**In the event that our common stock is delisted fromNASDAQ SmallCap Market, it may be subject to the requirements of the rules relatingto “penny stocks.”**

 

Our common stock is currently listed on the NASDAQSmallCap Market, which has requirements for the continued listing of stock. Ifwe fail to continue to meet these listing requirements we will become subjectto delisting. For example, if our common stock trades below $1.00 for 30consecutive trading days, or if we fail to meet any of the other listingrequirements including the timely filing of our required financial reports orthe market capitalization, minimum stockholders’ equity requirements andkeeping required filings current, our common stock may be delisted fromthe NASDAQ SmallCap Market. If our shares are delisted from the NASDAQ SmallCapMarket, they are likely to become subject to the SEC penny stock rules, whichcould adversely affect the market liquidity of our common stock. These rules imposeadditional sales practice requirements on broker-dealers that sell low-pricedsecurities to persons other than established customers and institutionalaccredited investors; and require the delivery of a disclosure schedule explainingthe nature and risks of the penny stock market. As a result, the ability orwillingness of broker-dealers to sell or make a market in our common stockmight decline, and you could find it more difficult to sell your stock.

 

**Our stock price is volatile.**

 

The trading price for our common stock has beenvolatile, ranging from a sales price of $0.22 in April 2003, to a salesprice of just under $7.00 per share in the first quarter of 2005. Thetrading price for our common stock during the period from January 3, 2006to March 13, 2006 ranged from $1.06 to $2.30. The price has changeddramatically over short periods with changes of over 60% percent in a singleday. An investment in our stock is subject to such volatility and,consequently, is subject to significant risk.

 

**Prior offerings of our common stock may have anadverse impact on the market value of our stock.**

 

During 2003, 2004 and 2005 we issued shares of ourcommon stock as part of various private placements to certaininstitutional investors and as part of these transaction filed multipleregistration statements, which provided for the sale or distribution of theseshares by these institutional investors. When these investors sell their shareswe will not receive any proceeds from the sales. The sale of these blocks ofstock, or even the possibility of their sale, may adversely affect thetrading market for our common stock and reduce the price available in thatmarket.

 

In connection with these private placements, we alsoissued warrants and additional investment rights to purchase shares of commonstock. The existence of such rights to acquire common stock at fixed prices may provea hindrance to our efforts to raise future equity and debt funding, and theexercise of such rights will dilute the percentage ownership interest of ourstockholders and may dilute the value of their ownership. The possiblefuture sale of shares issuable on the exercise of outstanding warrants andadditional investment rights could adversely affect the prevailing market priceof our common stock. Further, the holders of the outstanding warrants andadditional investment rights may exercise them at a time when we wouldotherwise be able to obtain additional equity capital on terms more favorableto us.

 

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

 

We issued shares of our common and preferred stock,as well as warrants and additional rights to acquire our common stock, tocertain institutional investors in private placement transactions in 2003, 2004and 2005. The various agreements providing for these private placementtransactions included numerous provisions intended to protect suchinstitutional investors. For example, the Company is required to continuallymaintain effective registration statements permitting the investors to selltheir shares of common stock. Failure to comply with such requirements may resultin damages to the investors and result in obligations to make cash payments tothe investors. The investors may also be entitled to receive more sharesthan originally allocated in the event the Company subsequently issues sharesto other investors at a lower valuation than that afforded to the investors. Inaddition, the

 

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investorsmay be entitled to receive cash payments instead of shares upon theredemption of certain securities in the event that certain defined events occurincluding a lapse in the registration statement, being delisted on certainspecified exchanges, trading in the Company’s stock is suspended, or a changein control occurs with respect to the Company.

 

**Our board of directors’ right to authorize additionalshares of preferred stock could adversely impact the rights of holders of ourcommon stock.**

 

Our board of directors currently has the right todesignate and authorize the issuance of one or more series of ourpreferred stock with such voting, dividend and other rights as our directors may determine.The board of directors can designate new series of preferred stock withoutthe approval of the holders of our common stock. The rights of holders of ourcommon stock may be adversely affected by the rights of any holders ofshares of preferred stock that may be issued in the future, includingwithout limitation dilution of the equity ownership percentage of our holdersof common stock and their voting power if we issue preferred stock with votingrights. Additionally, the issuance of preferred stock could make it moredifficult for a third party to acquire a majority of our outstanding votingstock.

 

**Item 1B. Unresolved StaffComments.**

 

In the 180 days before the end of our fiscal yearended December 31, 2005, we received written comments from the staff ofthe Securities and Exchange Commission regarding our periodic and currentreports under the Securities Exchange Act of 1934. As of the date hereof, we donot believe that any unresolved comments related to our periodic and currentreports are material.

 

**Item 2. Properties.**

 

Ourcorporate headquarters is located in Trevose, Pennsylvania in a leased facilityconsisting of approximately 42,500 square feet at an annual fee of $11.40 persquare foot, with a 3% increase annually. The current lease has a five yearterm effective September 1, 2005. The lease is cancelable by either partywith eight months notice, with a termination by the tenant including a sixmonths termination fee.

 

**Item 3.Legal Proceedings.**

 

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

 

**Item 4. Submission of Matters to a Vote of SecurityHolders**.

 

At our annual meeting of stockholders held on October 19,2005, our stockholders elected six members to our Board of Directors. Thoseelected to the Board were Hal M. Krisbergh, Steven C. Davidson, Clarence L.Irving, Jr., Martin Jaffe, Jeff Morris and Lemuel Tarshis. 

 

The results of the voting for each member of ourBoard of Directors are as follows:

 
| **Nominee**                  | ** ** | **FOR**    | ** ** | **WITHHELD** | ** ** |
|------------------------------|------------|------------|------------|--------------|------------|
| Steven C. Davidson           |       | 34,089,075 |       | 584,009      |       |
| Martin Jaffe                 |       | 34,038,252 |       | 598,832      |       |
| Clarence L. Irving, Jr. |       | 34,073,019 |       | 564,065      |       |
| Hal M. Krisbergh             |       | 34,008,227 |       | 628,857      |       |
| Jeff Morris                  |       | 34,069,962 |       | 567,122      |       |
| Lemuel Tarshis               |       | 34,033,795 |       | 603,289      |       |

 

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**PART II**

 

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

 

Our common stock, $0.01 par value, has traded on theNASDAQ National Market under the symbol “WGAT” since our initial publicoffering on April 15, 1999, except for the period from November 25,2005 to February 9, 2006 when our symbol was “WGATE.”  We applied for and received permission,effective January 9, 2003, to transfer the listing of our common stock tothe NASDAQ Small Cap Market. The following table shows the high and low salesprice as reported by the NASDAQ Small Cap Market, for each quarter of 2004 and2005.

 
| ** **                            | ** ** | **High** | ** ** | **Low** | ** ** |
|---------------------------------------|------------|----------|------------|---------|------------|
| **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    |       |
| **Year Ended December 31, 2005** |       |     |       |    |       |
| First  Quarter                        |       | $        | 6.89       |    | $          | 3.30 |   |
| Second  Quarter                       |       | 6.03     |       | 2.95    |       |
| Third  Quarter                        |       | 4.60     |       | 2.02    |       |
| Fourth  Quarter                       |       | 3.40     |       | 1.62    |       |

 

As of March 13, 2006, we had 343 holders ofrecord of our common stock.

 

**Dividends**

 

We have never paid or declared any cash dividends onour common stock. We do not anticipate paying any cash dividends in theforeseeable future. We currently expect to retain future earnings, if any, tofinance the growth and development of our business. The terms of our currentlyissued preferred stock impose certain conditions on our ability to declare adividend on our common stock.

 

**Item 6.Selected Financial Data.**

 

The following table sets forth selected consolidatedfinancial information for the five-year period ended December 31, 2005.This data should be read in conjunction with our financial statements and notesthereto and “Management’s Discussion and Analysis of Financial Condition andResults of Operations” included elsewhere in this report.

 

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|                                                                                         |   | **Year ended December 31,**                     |    |
|----------------------------------------------------------------------------------------------|--------|------------------------------------------------------|---------|
|                                                                                         |   | **2001**                                             |    | **2002** |   | **2003** |   | **2004** |   | **2005** |   |
|                                                                                         |   |                                                 |    |   |   |   |   | ** ** |   |   |   |
|                                                                                         |   | **(In thousands, except share and per  share data)** |    |
| Net revenues                                                                                 |   | $                                                    | —  |   | $ | — |   | $ | — |   | $ | 231 |   | $ | 1,558 |   |
| Cost of revenues                                                                             |   | —                                               |    | — |   | — |   | 103 |   | 2,012 |   |
| Gross margins                                                                                |   | $                                                    | —  |   | $ | — |   | $ | — |   | $ | 128 |   | (454 | )  |
| Costs and expenses:                                                                          |   |                                                 |    |   |   |   |   |   |   |   |   |
| Engineering and  development                                                                 |   | —                                               |    | — |   | 3,000 |   | 4,001 |   | 6,486 |   |
| Sales and marketing                                                                          |   | —                                               |    | — |   | 466 |   | 1,362 |   | 3,755 |   |
| General and administrative                                                                   |   | —                                               |    | — |   | 2,331 |   | 4,675 |   | 4,769 |   |
| Depreciation and  amortization                                                               |   | —                                               |    | — |   | — |   | 477 |   | 693 |   |
| Total expenses from  continuing operations                                                   |   | —                                               |    | — |   | 5,797 |   | 10,515 |   | 15,703 |   |
| Loss from operating  activities of continuing operations                                     |   | —                                               |    | — |   | (5,797 | )  | (10,387 | ) | (16,157 | ) |
| Other interest and other  income                                                             |   | —                                               |    | — |   | — |   | 1,023 |   | 718 |   |
| Change in fair value of  warrants and conversion options                                     |   | —                                               |    | — |   | — |   | (10,091 | )  | 8,594 |   |
| Interest and other expense                                                                   |   | —                                               |    | — |   | — |   | (6 | )  | (6 | ) |
| Loss from continuing  operations                                                             |   | —                                               |    | — |   | (5,797 | )  | (19,461 | ) | (6,851 | ) |
|  (Loss) income from discontinued operations                                             |   | (31,346                                              | )       | (19,210 | ) | (2,908 | ) | 36 |   | — |   |
| Net loss                                                                                     |   | (31,346                                              | )       | (19,210 | ) | (8,705 | ) | (19,425 | ) | (6,851 | ) |
| Accretion on preferred  stock, dividends and deemed dividends                                |   | —                                               |    | — |   | — |   | (951 | )  | (3,922 | ) |
| Net loss available to  common stockholders                                                   |   | $                                                    | (31,346 | ) | $ | (19,210 | ) | $ | (8,705 | ) | $ | (20,376 | ) | $ | (10,773 | ) |
| Basic and diluted loss  from continuing operations per common share                          |   | $                                                    | 0.00    |   | $ | 0.00 |   | $ | (0.25 | )  | $ | (0.70 | ) | $ | (0.19 | ) |
| Basic and diluted (loss) income  from discontinued operations per common share               |   | (1.33                                                | )       | (0.81 | ) | (0.12 | ) | (0.00 | ) | 0.00 |   |
| Basic and diluted net loss  per common share                                                 |   | $                                                    | (1.33   | ) | $ | (0.81 | ) | $ | (0.37 | ) | $ | (0.70 | ) | $ | (0.19 | ) |
| Basic and diluted net loss  available to common shareholders per common share (1)            |   | $                                                    | (1.33   | ) | $ | (0.81 | ) | $ | (0.37 | ) | $ | (0.73 | ) | $ | (0.30 | ) |
| Weighted average common  stock Outstanding—basic and diluted                            |   | 23,501,543                                           |    | 23,573,935 |   | 23,259,611 |   | 27,881,347 |   | 35,449,225 |   |
|                                                                                         |   |                                                 |    |   |   |   |   |   |   |   |   |
| As adjusted net loss  available to common stockholders(2)                                    |   | $                                                    | (30,985 | ) | $ | (19,210 | ) | $ | (8,705 | ) | $ | (20,376 | ) | $ | (10,733 | ) |
| As adjusted basic and  diluted net loss available to common shareholders per common share(2) |   | $                                                    | (1.32   | ) | $ | (0.81 | ) | $ | (0.37 | ) | $ | (0.73 | ) | $ | (0.30 | ) |
| Balance sheet data:                                                                          |   |                                                 |    |   |   |   |   |   |   |   |   |
| Cash and cash equivalents                                                                    |   | $                                                    | 14,613  |   | $ | 3,807 |   | $ | 3,365 |   | $ | 11,840 |   | $ | 16,277 |   |
| Total assets                                                                                 |   | 33,792                                               |    | 14,019 |   | 5,117 |   | 13,822 |   | 21,229 |   |
| Long-term obligations,  including current portion                                            |   | 1                                                    |    | — |   | — |   | — |   | — |   |
| Redeemable Preferred Stock                                                                   |   | —                                               |    | — |   | — |   | 2,995 |   | 379 |   |
| Total stockholders’ equity  (deficiency)                                                |   | 25,415                                               |    | 7,295 |   | 3,680 |   | (5,572 | )  | 13,717 |   |
| Other data:                                                                                  |   |                                                 |    |   |   |   |   |   |   |   |   |
| Common shares outstanding                                                                    |   | 23,565,295                                           |    | 23,077,963 |   | 25,706,843 |   | 30,865,777 |   | 39,511,519 |   |

 

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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, dividends and deemeddividends.

 

(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 $361 for the year ended December 31,2001. This amount is presented to comply with SFAS 142 as if this standardhad been adopted at the beginning of the respective period.

 

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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 per share amounts)

 

**FORWARD-LOOKINGAND CAUTIONARY STATEMENTS**

 

We may from time to time make written or oralforward-looking statements, including those contained in the followingManagement’s Discussion and Analysis of Financial Condition and Results ofOperations. The words “estimate,” “project,” “believe,” “intend,” “expect,” andsimilar expressions are intended to identify forward-looking statements,although not all forward-looking statements contain these identifying words. Inorder to take advantage of the “safe harbor” provisions of the PrivateSecurities Litigation Reform Act of 1995, we are hereby identifyingcertain important factors that could cause our actual results, performance orachievement to differ materially from those that may be contained in orimplied by any forward-looking statement made by or on our behalf. The factors,individually or in the aggregate, that could cause such forward-lookingstatements not to be realized include, without limitation, the following: (1) difficultyin developing and implementing marketing and business plans, (2) industrycompetition factors and other uncertainty that a market for our products willdevelop, (3) challenges associated with distribution channels, includingboth the retail distribution channel and HSD operators (e.g., uncertainty thatthey will offer our products, inability to predict the manner in which theywill market and price our products and existence of potential conflicts ofinterests and contractual limitations impeding their ability to offer ourproducts), (4) continued losses, (5) difficulty or inability to raiseadditional financing on terms acceptable to us, (6) departure of one ormore key persons, (7) delisting of our Common Stock from the NASDAQ SmallCap Market, (8) changes in regulatory requirements, and (9) otherrisks identified in our filings with the Securities and Exchange Commission. Wecaution you that the foregoing list of important factors is not intended to be,and is not, exhaustive. We do not undertake to update any forward-lookingstatement that may be made from time to time by or on our behalf.

 

**Results of Operations:**

 

**General**

 

Our ITV business has historically accounted forsubstantially all of our revenue. In the third quarter of 2003, we completed asale of significant assets, including our ITV intellectual property rights andour membership interest in TVGateway, LLC. This transaction marked a shift inour business away from the ITV business and toward a new video phone productand related business. Although we continued to support our remaining ITVbusiness into the first quarter of 2004, the development of our video phoneproduct became a primary business focus.

 

Our video phone business has not producedsignificant revenues to date. The extent and timing of future revenues for ourbusiness depends on several factors, including the rate of market acceptance ofour products and the degree of competition from similar products. We cannotpredict to what extent our video phone product will produce revenues, or when,or if, we will reach profitability.

 

 On April 28, 2004, we entered into amulti-year agreement with General Instrument Corporation d/b/a the ConnectedHome Solutions Business of Motorola, Inc. (“General Instrument”) for theworldwide development and distribution of the Ojo personal video phone. Thisagreement provided for General Instrument to be WorldGate’s exclusivedistributor of its broadband video phone products and for WorldGate to beGeneral Instrument’s exclusive supplier of its broadband video phone products. OnFebruary 17, 2006, we mutually agreed with General Instrument to end thisagreement. The ending of this agreement immediately terminates exclusivity forboth parties. In addition to its current role for development and manufactureof Ojo, WorldGate will now have direct responsibility and control for theadvertising, marketing, and distribution of its products.

 

Under our development and distribution agreementwith General Instrument, General Instrument was responsible for thedistribution of our products and for the direct relationship with the distributors,dealers, and other resellers ultimately used to sell the products. In addition,General Instrument marketed our products and maintained an inventory of ourproducts. In performing these functions General Instrument carried theassociated risks, costs and expenses. As a result of ending our agreement withGeneral Instrument, we are now directly assuming these responsibilities and theassociated risks, costs and expenses, and this places increased demands on thecash which we have available. Although General Instrument’s price of ourproduct to its reseller customers included a mark-up from its cost of theproduct from us that was intended to reflect its risks, cost and expenses, plusits profit, we will be charging these reseller customers a lower price and wecannot be assured that the new price will include a sufficient mark-up to coverthe risks, costs and expenses that is now our responsibility going forward.

 

Underits agreement with General Instrument, WorldGate had been active in marketingand promoting its products, and working with General Instrument to distributeOjo. WorldGate intends to continue the rollout of Ojo using many of the samedistributors, retailers and service providers and plans to expand distributionto service providers and retailers around the world. The Company and General

 

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Instrumentwill work together to ensure a smooth transition for existing customer accounts.In addition to direct sales on our web site, we will continue to rely upon adistribution organization of dealers, distributors, original equipmentmanufacturers, value added resellers, service providers and other resellers tomarket and sell our video phone products, many of which will be the same asthose used by General Instrument. To enable our own retail distribution effortswe have hired an experienced retail consumer electronics executive to directour efforts in this area. To create retail and consumer interest and builddemand for the product, the Company plans to lower the wholesale and suggestedmanufacturer suggested retail prices. In addition, the Company will offer timelimited rebates to further spur interest and sales. Under its agreement withGeneral Instrument, WorldGate’s video phone products were required to beco-branded with the Ojo brand (which WorldGate continued to own) and theMotorola brand. As the result of ending our agreement with General Instrument,we will now be dropping the Motorola brand.

 

General Instrument also maintained the necessaryinfrastructure to handle distribution logistics, including customer ordering,inventory warehousing, billing, customer service, credit and accountsreceivable functions multiple customers. All of our revenue for the sale of ourvideo phones was derived from General Instrument, a single customer, and therewere minimal administrative costs associated with billing and collecting thisrevenue. The Company will now have multiple customers and bear the associatedincreased administrative costs and risks of collection. WorldGate will alsoneed to develop the necessary infrastructure to handle multiple customers andthese other logistical functions.

 

As part of ending our agreement with GeneralInstrument, and in anticipation of WorldGate inventory requirements as a resultof taking full responsibility for product distribution, WorldGate negotiatedthe right to buy back about two-thirds of the units sold to General Instrument,valued at approximately $2,765 (based upon the original sales price to GeneralInstrument), for approximately $1,064. This is less than half of what it wouldcost the Company to purchase the same inventory from its manufacturing sources.For more details, refer to Note 5 to our consolidated financial statements forthe year ended December 31, 2005.

 

**Critical Accounting Policies and Estimates**

 

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

 

Our significant accounting policies are described inNote 5 to our consolidated financial statements included elsewhere in thisreport. We believe that the following discussion addresses our criticalaccounting policies, which are those that are most important to the portrayalof our financial condition and results and require management’s most difficult,subjective and complex judgments.

 

*Revenue Recognition*

 

Revenue is recognized when persuasive evidence of anarrangement exists, the price is fixed or determinable, the collectibility isreasonably assured, and the delivery and acceptance of the equipment hasoccurred or services have been rendered. Management exercises judgment inevaluating these factors in light of the terms and conditions of its customercontracts and other existing facts and circumstances to determine appropriaterevenue recognition. Due to our limited commercial sales history, our abilityto evaluate the collectibility of customer accounts requires significantjudgment. The Company evaluates its equipment customer and service customeraccounts for collectibility at the date of sale and on an ongoing basis.

 

Until mid February 2006, the Company had onlyone customer for the purchase of its product and the agreement with thiscustomer included several elements relevant to revenue recognition including: (a) thecustomer had no general right to return the product;  (b) thecustomer earned warrants upon the purchase of significant video telephony unitsand the value of these warrants would result in a reduction of recognizedrevenue (the value of these warrants has been routinely monitored by theCompany and is currently deemed to be insignificant, however, should the valueof these warrants become material an offset would be made against revenues); (c) penaltieswere payable to the customer if certain excessive field failure rates wereexceeded;  (d) the Company and the customer shared in the benefitachieved by product cost reductions; (e) penalties were payable to thecustomer if the Company failed to deliver shipments on a timely basis; (f) theCompany extended to the customer a limited product warranty for a term not toexceed three years (the Company maintains a warranty reserve based upon thepercentage of product sales consistent with industry comparable failure ratesand the warranty period provided by the agreement.)  Beginning in mid February 2006, theCompany began selling its products to multiple customers and some of the abovefactors may change and need to be re-evaluated.

 

Revenues are also offset with a reserve for anyprice refunds and consumer rebates consistent with the Emerging Task Force (“EITF”)Issue 01-9, Accounting for Consideration Given by a Vendor to a Customer.

 

 As an incentive to promote delivery of theunits, a special product launch discount was provided by the Company to its solecustomer as a quantity restricted reduction to the unit contract based price ineffect. For the twelve months ended December 31, 2005, this discount was $398.In addition, the Company offered a forward pricing program to this customer anda rebate program to

 

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consumers,as further incentives for the holiday season. These incentive programs begin inthe fourth quarter of 2005 and terminated during the first quarter of 2006.Consistent with the EITF Issue 01-9, Accounting for Consideration Given by a Vendorto a Customer, the Company has offset the December 31, 2005 revenue by $212with a reserve for the total estimated liability for the forward pricingprogram. The liability associated with the rebate, $91, has been recorded inthe twelve months ending December 31, 2005. The total of the “Productlaunch discount, rebate and refunds for the twelve months ended December 31,2005 was $701.

 

As part of ending our agreement with GeneralInstrument, and in anticipation of our inventory requirements as a result oftaking full responsibility for product distribution, we negotiated the right tobuy back about two-thirds of the units sold to General Instrument, valued atapproximately $2,765 (based upon the original sales price to GeneralInstrument), for approximately $1,064. This is less than half of what it wouldcost us to purchase the same inventory from our manufacturing sources. As aresult we recorded a reserve for returns and reduced revenue in the amount ofapproximately $2,310 during the fourth quarter of 2005. In addition we willrecord no revenue for units shipped to General Instrument in the first quarter2006 and will record a gain on termination of this agreement of approximately$1,331 during the first quarter 2006 as a result of the lower purchase price ofthis inventory (net of the cost of rework for rebranding the product).

 

*Inventories.*Our inventory consists primarily offinished goods equipment.. 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. Our inventory balance as of December 31, 2005 was $2,878and related solely to our video phone business. This balance includes $2,006 ofinventory related to the accounting for product purchased in connection withthe ending of the General Instrument agreement which is being recorded as areserve for returns.

 

*Long-Lived Assets.*Our long-lived assets consist of property andequipment. These long-lived assets are recorded at cost and are depreciated oramortized using the straight-line method over their estimated useful lives. Thecarrying value of a long-lived asset is considered impaired when theanticipated undiscounted cash flows from such assets are separatelyidentifiable and are less than the carrying value. In that event, a loss isrecognized based on the amount by which the carrying value exceeds the fairmarket value of the long-lived asset. Fair market value is determined by usingthe anticipated cash flows discounted at a rate commensurate with the riskinvolved. Measurement of the impairment, if any, will be based upon thedifference between carrying value and the fair value of the asset. If usefullife estimates or anticipated cash flows change in the future, we may berequired to record an impairment charge.

 

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

 

We have a full valuation allowance against the netdeferred tax asset of $85,298 as of December 31, 2005, due to our lack ofearnings history and the uncertainty as to the reliability of the asset. In thefuture, if sufficient evidence of our ability to generate sufficient futuretaxable income becomes apparent, we would be required to reduce our valuationallowance, resulting in a benefit from income tax in the consolidated statementof 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, 2005,the Company had stock-based compensation plans, which are described separatelyin Note 11 to the consolidated financial statements for the year ended December 31,2005. 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.

 

In December 2004, the FASB issued SFAS No. 123(R), “Share-Based Payment” that focuses primarily on accounting fortransactions in which an entity obtains employee services in share-basedpayment transactions. This statement replaces SFAS No. 123, “Accountingfor Stock-Based Compensation”, and supersedes APB Opinion No. 25, “Accountingfor Stock Issued to Employees.” Beginning with our interim period that begins onJanuary 1, 2006, we will be required to expense the fair value of employeestock options and similar awards. We have elected to utilize the modifiedprospective transitional method in accounting for share-based employee paymenttransactions.

 

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

 

*Restatement of the Financial Statements*. The Company has restated its financial statementsfor the year ended December 31, 2004 to include certain clarificationsmade in response to the SEC’s review of the Company’s registration statement onForm SB-2 (Registration No. 333-125205),  and annual report on Form 10-K for theyear ended December 31, 2004. These restatements include expandedexplanations in the Notes to Consolidated Financial Statements of the Company’saccounting method and policy for redeemable preferred stock and warrants issuedby the Company in a private placement in June 2004. In addition, theCompany 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 private placements of the Company’scommon stock during the fourth quarter of 2003, and the first and fourthquarters of 2004. These security components were originally treated as non-cashexpenses and with this restatement are being restated as equity transactions. Thereis no cash impact associated with these restatements. There were also relatedadjustments to the Company’s consolidated statement of cash flows andconsolidated statement of stockholders’ equity.

 

The effect of the restatement on specific amountsprovided in the consolidated 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 | ) |

 

In addition, the Company has included restatementsto reflect expanded clarifications on the preferred stock transaction theCompany completed in June of 2004, liquidity and going concernconsiderations and changes to the Notes to Consolidated Financial Statements.

 

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**2005 versus 2004**

** **

**Revenues**

 

*Revenues.*Revenues from continuing operations of $1,558were realized during the twelve months ended December 31, 2005. Theserevenues represent the initial commercial deliveries of Ojo video phones. Revenuesfrom continuing operations for the twelve months ended December 31, 2004were $231, primarily associated with units sold for pre-market testing. Revenuefrom the sale of equipment is recognized by the Company when the products aredelivered and accepted.

 

 As an incentive to promote delivery of theunits, a special product launch discount was provided to our sole customer as aquantity restricted reduction to the unit contract based price in effect. Forthe twelve months ended December 31, 2005, this discount was $398. Inaddition, we offered a forward pricing program to this customer and a rebateprogram to consumers, as further incentives for the holiday season. Theseincentive programs begin in the fourth quarter of 2005 and terminated duringthe first quarter of 2006. Consistent with the EITF Issue 01-9, Accounting forConsideration Given by a Vendor to a Customer, we offset the December 31,2005 revenue by $212 with a reserve for the total estimated liability for theforward pricing program. The liability associated with the rebate, $91, hasbeen recorded in the twelve months ending December 31, 2005. The total ofthe “Product launch discount, rebate and refunds for the twelve months ended December 31,2005 was $701. As a result we had a negative gross margin of $454 for the yearended December 31, 2005. In the first quarter of 2006 we announced that wewere going to offer a new consumer rebate program during the second quarter of2006.

 

As part of ending our agreement with GeneralInstrument, and in anticipation of our inventory requirements as a result oftaking full responsibility for product distribution, we negotiated the right tobuy back about two-thirds of the units sold to General Instrument, valued atapproximately $2,765 (based upon the original sales price to GeneralInstrument), for approximately $1,064. This is less than half of what it wouldcost us to purchase the same inventory from its manufacturing sources. As aresult we recorded a reserve for returns and reduced revenue in the amount ofapproximately $2,310 during the fourth quarter of 2005. In addition we willrecord no revenue for units shipped to General Instrument in the first quarter2006 and will record a gain on termination of this agreement of approximately$1,331 during the first quarter 2006 as a result of the lower purchase price ofthis inventory (net of the cost of rework for rebranding the product).

 

**Costs and Expenses**

 

*Cost of revenues.*The cost of revenues from continuingoperations relating to the initial commercial deliveries of Ojo video phoneswas $2,012 for the twelve months ended December 31, 2005. Cost of revenuesfrom continuing operations for the twelve months ended December 31, 2004was $103 related to product sold for pre-market testing. The cost of revenueswas reduced by $2,006 for inventory related to the accounting for productpurchased in connection with the ending of the General Instrument agreementwhich is being recorded as a reserve for returns.

 

*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 $6,486 for the twelve months ended December 31,2005, compared with $4,001 for the twelve months ended December 31, 2004.This increase in 2005 over 2004 of $2,485, or 62%, reflects our increasedengineering and support staffing, and related costs, related to the continuingdevelopment and enhancements of our video phone product.

 

*Sales, Marketing and Service*. Sales, marketing and service expensesconsist primarily of compensation, attendance at conferences and trade shows,travel costs, advertising, promotions and other marketing programs related tothe introduction of our video phone product as well as costs related to ourservice business infrastructure and customer support. Sales, marketing, andservice costs were $3,755 for the twelve months ended December 31, 2005,compared with $1,362 for the twelve months ended December 31, 2004. Thisincrease of $2,393, or 176%, reflects the increased marketing and promotionalexpenditures, trade shows attendance, and service business costs related to thecommercial launch and continued support of our video phone product in themarket place.

 

*General and Administrative*. 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 $4,769 for thetwelve months ended December 31, 2005, a slight, increase of $94, or 2%, comparedwith $4,675 for the twelve months ended December 31, 2004

 

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*Interest, Other Income andInterest Expense*.Interest, other income and interest expense from continuing operationsconsisted of interest earned on cash and cash equivalents, and interest expenseon short-term debt. Total interest and other income was $718 for the twelvemonths ended December 31, 2005 a decrease of $305 from $1,023 total forthe twelve months ended December 31, 2004. During the twelve months ended December 31,2005, we earned interest income of $442 on average cash balances ofapproximately $13,423, and incurred interest expense of $6 related to insurancefinancing. In comparison, during the twelve months ended December 31, 2004,we earned interest of $86 on average cash balances that are included withdiscontinued operations of approximately $6,601, and incurred interest expenseof $6 related to our insurance financing. Included in total interest and otherincome for the period ended December 31, 2004 is $928 which representsdeferred rent credits of $143 and cancelled unpaid rent of $785 relating to theamendment of our facility lease with an effective date of June 2004. Formore details, refer to Note 12 to our consolidated financial statements for theyear ended December 31, 2005.

 

*Non Cash Change in Fair Value ofWarrants and Conversion Options.* For the twelve months ended December 31, 2005, the non cashchange in fair value of warrants and conversion option was an income of $8,594.This income was the result of a marked to market adjustment primarily related toour common stock price decline as of December 31, 2005 compared to December 31,2004 as it related to our June 24, 2004 private placement of our Series AConvertible Preferred Stock and Warrants.

 

**2004 versus 2003**

 

**Revenues**

 

*Revenues.*Revenues from continuing operations of $231were realized during the twelve months ended December 31, 2004. Theserevenues represent the initial deliveries of video phones for pre-markettesting. There were no revenues from continuing operations for the twelvemonths ended December 31, 2003. Revenue from the sale of equipment isrecognized by the Company when the products are delivered and accepted.

 

**Costs and Expenses**

 

*Cost of revenues.*The cost of revenues from continuingoperations relating to the initial deliveries of video phones was $103 for thetwelve months ended December 31, 2004. There were no costs of revenuesfrom continuing operations for the twelve months 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 consistprimarily of compensation, attendance at conferences and trade shows, travelcosts, promotions and other marketing programs related to the introduction ofour video phone product. Sales and marketing costs were $1,362 for the twelvemonths ended December 31, 2004, compared with $466 for the twelve monthsended December 31, 2003. This increase of $896, or 192%, reflects theincreased marketing and promotional expenditures, trade shows attendance, aswell as a shift in efforts from our ITV business to our video phone product.

 

*General and Administrative*. 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 General Instrument in 2004 in conformity with the terms of the agreementsigned in April 2004. For the twelve months ended December 31, 2003,video phone related costs were $2,331, or 60% of total General andAdministrative expense of $3,889 (including $1,558 in discontinued operations).

 

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

 

20

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aneffective date of June 2004. For more details, refer to Note 12 to ourconsolidated financial statements for the year ended December 31, 2005.

 

*Non Cash Change in Fair Value ofWarrants and Conversion Options.* For the twelve months ended December 31, 2004, the non cashchange in fair value of warrants and conversion option was an expense of$10,091. This expense was the result of a marked to market adjustment as of December 31,2004 related to our June 24, 2004 private placement of our Series AConvertible Preferred Stock and Warrants.

 

*Income Taxes.*We have incurred net operating losses sinceinception and accordingly have had no income taxes and have not recorded anyincome tax benefit for those losses.

 

**Liquidity and Capital Resources**

 

As of December 31, 2005, our primary source ofliquidity consisted of cash and cash equivalents that are highly liquid, are ofhigh quality investment grade and have original maturities of less than threemonths.

 

At December 31, 2005, we had cash and cashequivalents of $16,277 as compared to cash and equivalents of $11,840 at December 31,2004. Net cash used in continuing operations was $13,616 for the twelve monthsended December 31, 2005, as compared to $7,084 used for the same period in2004. This increase in net cash used for continuing operations was primarilyattributable to our increase in expenditures during the twelve months ended December 31,2005, related primarily to the increased launch and marketing of our videophone business. We recorded bad debt expense in the amount of $16 from discontinuedoperations in 2004 to reflect our current assessment of the collectibility ofcertain receivables. No bad debt expense was recorded in 2005.

 

Cash used for investing activities from continuingoperations were primarily a result of investments in equipment for productdevelopment and manufacture as well as for general administrative purposes. Forthe twelve month periods ending December 31, 2005 and 2004, suchinvestments were $554 and $925, respectively.

 

Cash provided by financing activities fromcontinuing operations primarily through various private placements of ourCompany’s securities, through the exercise of warrants and through the exerciseof non-executive employees’ and prior employees’ stock options during thetwelve months ended December 31, 2005, totaled $18,607 compared to $16,349provided during the same period in 2004.

 

Operationsand Liquidity.

 

To date, we have funded operations primarily throughmultiple private sales of equity securities and through an initial publicoffering of common stock in April 1999. As of December 31, 2005 wehave no outstanding debt and our assets are not pledged as collateral. Wecontinue to evaluate the possibilities to obtain additional financing throughpublic or private equity or debt offerings, bank debt financing, assetsecuritizations, or from other sources. Such additional financing would besubject to the risk of availability, may be dilutive to our shareholders,or could impose restrictions on operating activities. There can be no assurancethat this additional financing will be available on terms acceptable to us, ifat all.

 

The report of the independent registered publicaccounting firm for the year ended December 31, 2005 included anexplanatory paragraph stating that our Company had suffered recurring lossesfrom operations and had an accumulated deficit of $229,092, and that theseissues raised substantial doubt about our Company’s ability to continue as a goingconcern. Our short term cash requirements and obligations include inventory,accounts payable and capital expenditures from continuing operations, operatingexpenses, and the redemption of preferred stock, of which $167 is required tobe redeemed in June 2006, although this redemption can be made in commonstock if certain conditions are met. In addition, the August 2005 privateplacement includes cash payment penalties of 1.5% per month for the period thatthe shares in the transaction fail to be registered. On December 31, 2005the shares under this private placement had not been registered and until suchtime as the shares become registered the Company is subject to the penaltyprovision under this private placement. As of December 31, 2005 theCompany has recorded accrued penalties of $525,000. The ending of the GeneralInstrument agreement on February 17, 2006 places additional cash burdenson the Company and this could impact our cash requirements and usage. As part ofending its agreement with General Instrument, and in anticipation of WorldGateinventory requirements as a result of taking full responsibility for productdistribution, WorldGate negotiated the right to buy back about two-thirds ofthe units sold to General Instrument, valued at approximately $2,765 (basedupon the original sales price to General Instrument), for approximately $1,064.This is less than half of what it would cost the Company to purchase the sameinventory from its manufacturing sources. For more details, refer to Note 5 toour consolidated financial statements for the year ended December 31,2005.

 

We expect, based on our internal forecasts andassumptions 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 into the fourthquarter of 2006.

 

21

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Our ability to generate cash is dependant upon thesale of our Ojo product and on obtaining cash through capital markets. We begangenerating revenue from commercial shipment of our Ojo product in April, 2005and we expect revenues to increase as the product continues to roll out to themarketplace. Depending on the ramp up of sales, the increased level of salesactivity is projected to have a positive impact on our cash flows fromoperations, which will support our ability to meet our obligations beyond 2006.Given that our video phone business involves the development of a new productline with no market penetration, in an underdeveloped market sector, noassurances can be given that sufficient sales, if any, will materialize.

 

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 beyond 2006.

 

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 toreduce our workforce and scale back on capital and operational expenditures todecrease our cash usage.

 

Quantitativeand Qualitative Disclosures About Market Risk.

 

Interest Rate Risk. Our exposure to market riskrelated to changes in interest rates relates primarily to our investmentportfolio. We invest in instruments that meet high credit quality standards,and we limit the amount of credit exposure with respect to any one issue,issuer and type of investment.

 

As of December 31, 2005, our cash and cashequivalents were $16,277, which were securities having a maturity of less thanthree months. Due to the average maturity and conservative nature of ourinvestment portfolio, management believes a sudden change in interest rateswould not have a material effect on the value of the portfolio. Managementestimates that had the average yield of our investments decreased by 100 basispoints, our interest income for the twelve months ended December 31, 2005would have decreased by approximately $176. This estimate assumes that thedecrease occurred on the first day of 2005 and reduced the yield of eachinvestment instrument by 100 basis points. The impact on our future interestincome of future changes in investment yields will depend largely on our totalinvestments.

 

Foreign Currency Exchange Risk. Although we transactbusiness in various foreign countries, the principal portion of our business isin the United States and substantially all of our revenues and costs to datehave been denominated in U.S. dollars. Although our agreement with MototechInc. (not an affiliate of General Instruments or Motorola), our contractmanufacturer in Taiwan, is denominated in U.S. dollars, their materialacquisition costs are subject to exchange rate changes that could impact ourproduct costs.

 

*Disclosure of Contractual Obligations*

 

**Payments due by Period:**

 
| ** **       | ** ** | **Total** | ** ** | **Less than 1  year** | ** ** | **1 — 3 years** | ** ** | **3 — 5 years** | ** ** | **Over 5 years** | ** ** |
|------------------|------------|-----------|------------|-----------------------|------------|----------------------|------------|----------------------|------------|------------------|------------|
|             |       |      |       |                  |       |                 |       |                 |       |             |       |
| Operating leases |       | $         | 2,448      |                  | $          | 503                  |       | $                    | 1,047      |             | $          | 898 |   | $ | — |   |
|                  |            |           |            |                       |            |                      |            |                      |            |                  |            |  |  |  |  |  |

 

*Recent Accounting Pronouncements*

 

In November 2004, the Financial AccountingStandards Board (“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 beso abnormal 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.

 

In December 2004, the FASB issued SFAS No. 153“Exchanges of Nonmonetary Assets” which amends APB Opinion No. 29, “Accountingfor Nonmonetary Transactions.” APB No. 29 is based on the principle thatexchanges of nonmonetary assets

 

22

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shouldbe measured based on the fair value of the assets exchanged. The guidance inthat Opinion, however, included certain exceptions to that principle. SFAS No. 153amends APB No. 29 to eliminate the exception for nonmonetary exchanges ofsimilar productive assets and replaces it with a general exception forexchanges of nonmonetary assets that do not have commercial substance. Anonmonetary exchange has commercial substance if the future cash flows of theentity are expected to change significantly as a result of the exchange. SFAS No. 153shall be effective for nonmonetary asset exchanges occurring in fiscal periodsbeginning after June 15, 2005. Earlier application is permitted fornonmonetary asset exchanges occurring in fiscal periods beginning after thedate SFAS No. 153 was issued. SFAS No. 153 shall be appliedprospectively. The Company does not expect the adoption of SFAS No. 153 tohave a material effect on its consolidated financial statements.

 

In December 2004, the FASB issued SFAS No. 123(R), “Share-Based Payment” that focuses primarily on accounting fortransactions in which an entity obtains employee services in share-basedpayment transactions. This statement replaces SFAS No. 123, “Accountingfor Stock-Based Compensation”, and supersedes APB Opinion No. 25, “Accountingfor Stock Issued to Employees.”  In March 2005,the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107(“SAB 107”) relating to the adoption of SFAS 123R. SAB 107 primarily interpretshow the implementation of SFAS 123R is to be applied under SEC rules andregulations. Beginning with our quarterly period that begins after January 1,2006, we will be required to expense the fair value of employee stock optionsand similar awards. We have elected to utilize the modified prospectivetransitional method in accounting for share-based employee paymenttransactions. Based upon the employee options outstanding as of December 31,2005, and the transitional provisions of SFAS No. 123R and SAB 107, thereis approximately $1,853 of future costs, utilizing the fair value method thatwill be expensed over a four year period from 2006 through 2009. In March 2005,the FASB issued Interpretation No. 47 (FIN 47) to clarify the guidanceincluded in SFAS No. 143, “Accounting for Asset Retirement Obligations.” FIN 47 requires companies to recognize a liability for the fair value of alegal obligation to perform asset retirement activities that areconditional on a future event if the amount can be reasonably estimated. Ifamounts cannot be reasonably estimated, certain disclosures will be requiredabout the unrecognized asset retirement obligations. The interpretation isrequired to be adopted in the first quarter of 2006. The Company does notexpect the adoption of FIN 47 to have a material effect on the consolidatedfinancial statements.

 

In May 2005, SFAS No. 154, “AccountingChanges and Error Corrections – replacement of APB Opinion No. 20 and FASBStatement No. 3,” (SFAS No. 154) was issued. SFAS No. 154 changesthe accounting for and reporting of a change in accounting principle byrequiring retrospective application to prior periods’ financial statements ofchanges in accounting principle unless impracticable. SFAS No. 154 iseffective for accounting changes made in fiscal years beginning after December 15,2005. The Company does not expect the adoption of SFAS No. 154 to have amaterial impact on its results of operations, financial position or cash flows.

 

In June 2005, the EITF reached consensus on IssueNo. 05-2, “The Meaning of ‘Conventional Convertible Debt Instrument’ inEITF Issue No. 00-19, “Accounting for Derivative Financial InstrumentsIndexed to, and Potentially Settled in, a Company’s Own Stock.” Issue 00-19 isused to evaluate whether embedded derivatives should be bifurcated under FASBStatement No. 133, Accounting For Derivative Instruments And Hedging Activities,as amended. Specifically, Statement 133 provides guidance as to when an issueris required to bifurcate a conversion option that is embedded in convertibledebt. However, Issue 00-19 does not define “conventional convertible debtinstrument.” Given the development of numerous contractual terms that may beincluded in a convertible debt instrument, it is not clear when a convertibledebt instrument is “conventional.”  We donot believe that our redeemable preferred stock and related warrants meet the definitionof conventional convertible debt and as a result Issue No. 00-19 appliesto the liability treatment of these instruments. The Company is evaluating theeffect that adoption of the Issue will have on its financial position orresults of operations in future periods.

 

In June 2005, the EITF reached consensus on IssueNo. 05-6, Determining the Amortization Period for Leasehold Improvements (“EITF05-6”). EITF 05-6 provides guidance on determining the amortization period forleasehold improvements acquired in a business combination or acquiredsubsequent to lease inception. The guidance in EITF 05-6 will be appliedprospectively and is effective for periods beginning after June 29, 2005.EITF 05-6 is not expected to have a material impact on the Company’s condensedfinancial position or results of operations.

 

In September 2005, the EITF reached consensuson Issue No. 04-13, “*Accounting forPurchases and Sales of Inventory with the Same Counterparty,”* that inventory purchases and salestransactions with the same counterparty that are entered into in contemplationof one another should be combined for purposes of applying APB Opinion No. 29,“*Accounting for Nonmonetary Transactions.”* The effect reduces reported revenues and costof sales for affected transactions. The consensus on this issue would apply tosuch transactions beginning in the second quarter 2006. The Company isevaluating the effect of EITF 04-13 on its consolidated financial statements.

 

In September 2005, the FASB ratified the EITFIssue No. 05-7, “Accounting for Modifications to Conversion OptionsEmbedded in Debt Instruments and Related Issues.”, which addresses whether amodification to a conversion option that changes its fair value effects therecognition of interest expense for the associated debt instrument after themodification, and whether a borrower should recognize a beneficial conversionfeature, not a debt extinguishment, if a debt modification increases theintrinsic value of the

 

23

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debt(for example, the modification reduces the conversion price of the debt). Theadoption of the Issue may have a material effect on our consolidatedfinancial position or results of operations in future periods.

 

In September 2005, the FASB also ratified theEITF’s Issue No. 05-8, “Income Tax Consequences of Issuing ConvertibleDebt with a Beneficial Conversion Feature”, which discusses whether theissuance of convertible debt with a beneficial conversion feature results in abasis difference arising from the intrinsic value of the beneficial conversionfeature on the commitment date (which is treated recorded in the shareholder’sequity for book purposes, but as a liability for income tax purposes) and, ifso, whether that basis difference is a temporary difference under FASBStatement No. 109, Accounting for Income Taxes. The adoption of the Issue may havea material effect on our consolidated financial position or results ofoperations in future periods.

 

In March 2006, the FASB issued SFAS No. 156,“Accounting for Servicing of Financial Assets” (“SFAS 156”), whichamends SFAS 140, “Accounting for Transfers and Servicing of Financial Assetsand Extinguishments of Liabilities”, with respect to the accounting forseparately recognized servicing assets and servicing liabilities. SFAS 156 permits the choice of the amortization method or the fairvalue measurement method, with changes in fair value recorded in income, forthe subsequent measurement for each class of separately recognizedservicing assets and servicing liabilities. The statement is effective foryears beginning after September 15, 2006, with earlier adoptionpermitted. The Company is currently evaluating the effect thatadopting this statement will have on the Company’s financialposition and results of operations.

 

**Item 7A. Quantitative and Qualitative Disclosuresabout Market Risk.**

 

Refer to Interest Rate Risk and Foreign CurrencyExchange Risk on page 22 for a discussion of this item.

 

24

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

 

**WORLDGATE COMMUNICATIONS, INC.**

 

**INDEX TO FINANCIAL STATEMENTS**

 
| Report of Marcum &  Kliegman LLP, Independent Registered Public Accounting Firm                                      | F-2 |
|-------------------------------------------------------------------------------------------------------------------------------|-----|
| Report of Grant  Thornton LLP, Independent Registered Public Accounting Firm                                                  | F-3 |
| Consolidated  Balance Sheets as of December 31, 2004 and 2005                                                            | F-4 |
| Consolidated  Statements of Operations for the years ended December 31, 2003, 2004 and  2005                             | F-5 |
| Consolidated Statements  of Stockholders’ (Deficiency) Equity for the years ended December 31,  2003, 2004 and 2005 | F-6 |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2003, 2004 and  2005                             | F-7 |
| Notes to  Consolidated Financial Statements                                                                                   | F-8 |
| Schedule II  — Valuation and Qualifying Accounts*                                                                   | 39  |

 

----

*All other schedules for which provision is made in the applicable accountingregulations of the Securities and Exchange Commission are not required underthe related instructions or are inapplicable, and therefore have been omitted.

 

F-1

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**Report of Independent Registered Public Accounting Firm**

 

Tothe Audit Committee of the

Boardof Directors and Stockholders

WorldGateCommunications, Inc.

 

Wehave audited the accompanying consolidated balance sheet of WorldGateCommunications, Inc. and subsidiaries (the “Company”) as of December 31,2005, and the related consolidated statements of operations, stockholders’(deficiency) equity, and cash flows for the year ended December 31, 2005. Ouraudit also included the Financial Statement Schedule II – Valuation andQualifying Accounts for the Company as of December 31, 2005 and for theyear then ended. These consolidated financial statements and financialstatement schedule are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these consolidated financialstatements and financial statement schedule based on our audit.

 

Weconducted our audit in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that weplan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation. We believe that our auditprovides a reasonable basis for our opinion.

 

Inour opinion, the 2005 consolidated financial statements referred to abovepresent fairly, in all material respects, the financial position of WorldGateCommunications, Inc. and its subsidiaries as of December 31, 2005 andthe results of their operations and cash flows for the year ended December 31,2005, in conformity with accounting principles generally accepted in the UnitedStates of America. Also, in our opinion, the related financial statement schedule,when considered in relation to the basic consolidated financial statementstaken as a whole, presents fairly, in all material respects, the informationcontained therein.

 

Theaccompanying financial statements have been prepared assuming that the Companywill continue as a going concern. As discussed in Note 5 to the consolidatedfinancial statements, the Company has suffered recurring losses from operationsand had an accumulated deficit of $229 million which raises substantial doubtabout its ability to continue as a going concern. The financial statements donot include any adjustments that might result from the outcome of thisuncertainty.

 

Wehave also audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the effectiveness of the Company’sinternal control over financial reporting as of December 31, 2005, basedon the criteria established in Internal Control—Integrated Framework issued bythe Committee of Sponsoring Organizations of the Treadway Commission and ourreport dated March 23, 2006 expressed an unqualified opinion on management’sassessment of the effectiveness of the Company’s internal control overfinancial reporting and an adverse opinion on the effectiveness of the Company’sinternal control over financial reporting because of the existence of amaterial weakness.

 

 
| /s/ Marcum & Kliegman LLP |   |
|------------------------------------|--------|

 

 

Marcum &Kliegman LLP

Melville,New York

March 23,2006

 

F-2

----

 

**Report of Independent Registered Public Accounting Firm**

 

Tothe Shareholders and Board of Directors

WorldGateCommunications, Inc. and Subsidiaries

 

We have audited the accompanying consolidatedbalance sheet of WorldGate Communications, Inc. and subsidiaries as of December 31,2004, and the related consolidated statements of operations, stockholders’deficiency, and cash flows for the years ended December 31, 2004 and 2003.These financial statements are the responsibility of the Company’s management.Our responsibility is to express an opinion on these financial statements basedon our audits.

 

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. The Company is not required to have, nor were we engaged toperform, an audit of its internal control over financial reporting. Our auditsincluded consideration of internal control over financial reporting as a basisfor designing audit procedures that are appropriate in the circumstances, butnot for the purpose of expressing an opinion on the effectiveness of theCompany’s internal 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, the financial statements referred toabove present fairly, in all material respects, the consolidated financialposition of WorldGate Communications, Inc. and subsidiaries as of December 31,2004, and the consolidated results of their operations and their cash flows forthe years ended December 31, 2004 and 2003, in conformity with accountingprinciples generally accepted in the United States.

 

Our audits were conducted for the purpose of formingan opinion on the basic financial statements taken as a whole. Schedule IIis presented for purposes of additional analysis and is not a required part ofthe basic financial statements. This schedule has been subjected to theauditing procedures applied in the audits of the basic financial statementsand, in our opinion, is fairly stated in all material respects in relation tothe basic financial statements taken as a whole.

 

The accompanying financial statements have beenprepared assuming that the Company will continue as a going concern. TheCompany has suffered recurring losses from operations and has a net accumulateddeficiency of $218 million as of December 31, 2004 that raises substantialdoubt about its ability to continue as a going concern. Management’s plans inregard to these matters are also described in Note 4. The financialstatements do not include any adjustments that might result from the outcome ofthis uncertainty.

 
| /s/ Grant Thornton LLP                      |   |
|--------------------------------------------------|--------|
|                                             |
| Philadelphia, Pennsylvania                       |
| February 24, 2005 (except for Note 2        |
| as to which the date is August 24, 2005 and      |
| Note 3 as to which the date is January 10, 2006) |

 

F-3

----

 

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

 
| ** **                                                                                                                                                                                               | ** ** | **As of  December 31** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                               | ** ** | **2004**                    | ** ** | **2005** | ** ** |
| ASSETS                                                                                                                                                                                                   |       |                        |       |   |   |
| Current  assets:                                                                                                                                                                                         |       |                        |       |   |   |
| Cash and  cash equivalents                                                                                                                                                                               |       | $                           | 11,840     |   | $ | 16,277 |   |
| Trade accounts  receivable less allowance for doubtful accounts of $0 at December 31,  2004 and 2005                                                                                           |       | 0                           |       | 133 |   |
| Other  receivables                                                                                                                                                                                       |       | 28                          |       | 26 |   |
| Inventory                                                                                                                                                                                                |       | 46                          |       | 2,878 |   |
| Prepaid and  other assets                                                                                                                                                                                |       | 184                         |       | 209 |   |
| Total  current assets                                                                                                                                                                                    |       | 12,098                      |       | 19,523 |   |
| Property and  equipment                                                                                                                                                                                  |       | 3,530                       |       | 4,084 |   |
| Less:  accumulated depreciation and amortization                                                                                                                                                         |       | (1,815                      | )          | (2,508 | ) |
| Property and  equipment, net                                                                                                                                                                             |       | 1,715                       |       | 1,576 |   |
| Deposits and  other assets                                                                                                                                                                               |       | 9                           |       | 130 |   |
| Total assets                                                                                                                                                                                             |       | $                           | 13,822     |   | $ | 21,229 |   |
|                                                                                                                                                                                                     |       |                        |       |   |   |
| LIABILITIES  AND STOCKHOLDERS’  (DEFICIENCY) EQUITY                                                                                                                                            |       |                        |       |   |   |
| Current  liabilities:                                                                                                                                                                                    |       |                        |       |   |   |
| Accounts  payable                                                                                                                                                                                        |       | $                           | 222        |   | $ | 1,695 |   |
| Accrued  expenses                                                                                                                                                                                        |       | 951                         |       | 1,333 |   |
| Accrued  compensation and benefits                                                                                                                                                                       |       | 540                         |       | 36 |   |
| Dividend  payable on Preferred Stock                                                                                                                                                                     |       | 85                          |       | 6 |   |
| Detachable  Warrants                                                                                                                                                                                     |       | 5,583                       |       | 1,038 |   |
| Notes  payable                                                                                                                                                                                           |       | 37                          |       | 0 |   |
| Conversion  option on Preferred Stock                                                                                                                                                                    |       | 8,612                       |       | 57 |   |
| Incentive  sale claims liability                                                                                                                                                                         |       | 0                           |       | 278 |   |
| Warranty  reserve                                                                                                                                                                                        |       | 0                           |       | 336 |   |
| Deferred  revenues                                                                                                                                                                                       |       | 369                         |       | 44 |   |
| Returns  reserve                                                                                                                                                                                         |       | 0                           |       | 2,310 |   |
| Total  current liabilities                                                                                                                                                                               |       | 16,399                      |       | 7,133 |   |
|                                                                                                                                                                                                     |       |                        |       |   |   |
| Commitments                                                                                                                                                                                              |       |                        |       |   |   |
| Redeemable  Preferred Stock; 7,550 shares authorized, 6,775 shares issued and outstanding  at December 31, 2004, and 500 issued and outstanding at December 31,  2005                          |       | 2,995                       |       | 379 |   |
|                                                                                                                                                                                                     |       |                        |       |   |   |
| Total  Stockholders’  (deficiency) equity:                                                                                                                                                     |       |                        |       |   |   |
| Preferred  Stock, $.01 par value, 13,492,450 shares authorized, and 0 shares issued at December 31,  2004 and December 31, 2005                                                                |       | 0                           |       | 0 |   |
| Common  Stock, $.01 par value; 80,000,000 shares authorized, 30,865,777 shares issued  and outstanding at December 31, 2004 and 39,511,519 shares issued and  outstanding at December 31, 2005 |       | 308                         |       | 395 |   |
| Additional  paid-in capital                                                                                                                                                                              |       | 212,439                     |       | 242,414 |   |
| Accumulated  deficit                                                                                                                                                                                     |       | (218,319                    | )          | (229,092 | ) |
| Total  stockholders’ (deficiency) equity                                                                                                                                                            |       | (5,572                      | )          | 13,717 |   |
| Total  liabilities and stockholders’ (deficiency) equity                                                                                                                                            |       | $                           | 13,822     |   | $ | 21,229 |   |

 

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

 

F-4

----

 

**WORLDGATE COMMUNICATIONS, INC.CONSOLIDATED STATEMENTS OF OPERATIONS(DOLLARS IN THOUSANDS, AND PER SHARE AMOUNTS)**

 
| ** **                                                                                                         | ** ** | **Twelve Months  Ended  December  31, 2003** | ** ** | **Twelve Months  Ended  December  31, 2004** | ** ** | **Twelve Months  Ended  December  31, 2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                                                         | ** ** | ** **                                   | ** ** | ** **                                   | ** ** | ** **                                   | ** ** |
| Gross  revenues                                                                                                    |       | $                                            | 0          |                                         | $          | 231                                          |       | $ | 2,259 |   |
| Less:  Product launch discount and refunds                                                                         |       | 0                                            |       | 0                                            |       | (701                                         | )          |
| Net revenues                                                                                                       |       | 0                                            |       | 231                                          |       | 1,558                                        |       |
| Cost of  revenues                                                                                                  |       | 0                                            |       | 103                                          |       | 2,012                                        |       |
| Gross  margins                                                                                                     |       | 0                                            |       | 128                                          |       | (454                                         | )          |
| Engineering  and development (excluding depreciation and amortization amounts of $0, $64,  and $303, respectively) |       | 3,000                                        |       | 4,001                                        |       | 6,486                                        |       |
| Sales and  marketing (excluding depreciation and amortization amounts of $0, $13 and  $46, respectively)           |       | 466                                          |       | 1,362                                        |       | 3,755                                        |       |
| General and  administrative (excluding depreciation and amortization amounts of $0, $400  and $344, respectively)  |       | 2,331                                        |       | 4,675                                        |       | 4,769                                        |       |
| Depreciation  and amortization                                                                                     |       | 0                                            |       | 477                                          |       | 693                                          |       |
| Total  expenses from continuing operations                                                                         |       | 5,797                                        |       | 10,515                                       |       | 15,703                                       |       |
| Loss from  operating activities of continuing operations                                                           |       | (5,797                                       | )          | (10,387                                      | )          | (16,157                                      | )          |
| Interest and  other income                                                                                         |       | 0                                            |       | 1,023                                        |       | 718                                          |       |
| Change in  fair value of warrants and conversion options                                                           |       | 0                                            |       | (10,091                                      | )          | 8,594                                        |       |
| Interest and  other expense                                                                                        |       | 0                                            |       | (6                                           | )          | (6                                           | )          |
| Loss from  continuing operations                                                                                   |       | (5,797                                       | )          | (19,461                                      | )          | (6,851                                       | )          |
| (Loss)  income from discontinued operations                                                                        |       | (2,908                                       | )          | 36                                           |       | 0                                            |       |
| Net loss                                                                                                           |       | $                                            | (8,705     | )                                            | $          | (19,425                                      | )          | $ | (6,851 | ) |
| Accretion on  preferred stock,dividends and deemed dividends                                                       |       | 0                                            |       | (951                                         | )          | (3,922                                       | )          |
| Net loss  available to common stockholders                                                                         |       | $                                            | (8,705     | )                                            | $          | (20,376                                      | )          | $ | (10,773 | ) |
| Loss from  continuing operations per common share (Basic and Diluted)                                              |       | $                                            | (0.25      | )                                            | $          | (0.70                                        | )          | $ | (0.19 | ) |
| (Loss)  income from discontinued operations per common share (Basic and Diluted)                                   |       | (0.12                                        | )          | 0.00                                         |       | 0.00                                         |       |
| Net loss per  common share (Basic and Diluted)                                                                     |       | $                                            | (0.37      | )                                            | $          | (0.70                                        | )          | $ | (0.19 | ) |
| Net loss  available to common stockholders per common share (Basic and Diluted)                                    |       | $                                            | (0.37      | )                                            | $          | (0.73                                        | )          | $ | (0.30 | ) |
| Weighted  average common shares outstanding (Basic and Diluted)                                                    |       | 23,259,611                                   |       | 27,881,347                                   |       | 35,449,225                                   |       |

 

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

 

F-5

----

 

**WORLDGATE COMMUNICATIONS, INC.CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ (DEFICIENCY) EQUITY(DOLLARS AND SHARES IN THOUSANDS)**

 
| ** **                                                                | ** ** | ** **       | ** ** | ** **  | ** ** | ** **     | ** ** | **Warrants**     | ** ** | ** **  | ** ** | ** **         | ** ** | ** **       | ** ** | ** ** | ** ** | ** **             | ** ** |
|---------------------------------------------------------------------------|------------|------------------|------------|-------------|------------|----------------|------------|------------------|------------|-------------|------------|--------------------|------------|------------------|------------|------------|------------|------------------------|------------|
| ** **                                                                | ** ** | ** **       | ** ** | ** **  | ** ** | ** **     | ** ** | **for**          | ** ** | ** **  | ** ** | **Unearned**       | ** ** | ** **       | ** ** | ** ** | ** ** | **Total**              | ** ** |
| ** **                                                                | ** ** | ** **       | ** ** | ** **  | ** ** | **Additional** | ** ** | **Class A** | ** ** | ** **  | ** ** | **Stock-**         | ** ** | ** **       | ** ** | ** ** | ** ** | **Stockholders’** | ** ** |
| ** **                                                                | ** ** | **Common Stock** | ** ** | **Paid-In** | ** ** | **Common**     | ** ** | **Accumulated**  | ** ** | **based**   | ** ** | **Treasury Stock** | ** ** | **(Deficiency)** | ** ** |
| ** **                                                                | ** ** | **Shares**       | ** ** | **Amount**  | ** ** | **Capital**    | ** ** | **Stock**        | ** ** | **Deficit** | ** ** | **Compensation**   | ** ** | **Shares**       | ** ** | **Amount** | ** ** | **Equity**             | ** ** |
| **Balance at January 1, 2003**                                       |       | 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                                         |       |             |       |        |       | 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                                                     |       |             |       |        |       |           |       |             |       | (8,705      | )          |               |       |             |       |       |       | (8,705                 | )          |
| **Balance at December 31, 2003**                                     |       | 26,207           |       | 262         |       | 201,766        |       | 0                |       | (197,943    | )          | (400               | )          | (500             | )          | (5         | )          | 3,680                  |       |
| Amortization of earned compensation to vendor                             |       |             |       |        |       |           |       |             |       |        |       | 400                |       |             |       |       |       | 400                    |       |
| Non-cash stock based Compensation                                         |       |             |       |        |       | 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                                                     |       |             |       |        |       |           |       |             |       | (19,425     | )          |               |       |             |       |       |       | (19,425                | )          |
| **Balance at December 31, 2004**                                     |       | 30,866           |       | 308         |       | 212,439        |       | 0                |       | (218,319    | )          | 0                  |       | 0                |       | 0          |       | (5,572                 | )          |
| Issuance of Common Stock                                                  |       | 4,683            |       | 47          |       | 16,596         |       |             |       |        |       |               |       |             |       |       |       | 16,643                 |       |
| Issuance of Common Stock upon conversion of preferred  stock              |       | 2,720            |       | 27          |       | 6,248          |       |             |       |        |       |               |       |             |       |       |       | 6,275                  |       |
| Reclassification of conversion option liability                           |       |             |       |        |       | 4,632          |       |             |       |        |       |               |       |             |       |       |       | 4,632                  |       |
| Deemed dividend upon conversion                                           |       |             |       |        |       |           |       |             |       | (3,102      | )          |               |       |             |       |       |       | (3,102                 | )          |
| Issuance of common stock to settle accrued preferred  stock dividends     |       | 64               |       | 1           |       | 216            |       |             |       |        |       |               |       |             |       |       |       | 217                    |       |
| Exercise of Stock Options                                                 |       | 373              |       | 4           |       | 814            |       |             |       |        |       |               |       |             |       |       |       | 818                    |       |
| Exercise of Warrants                                                      |       | 805              |       | 8           |       | 1,469          |       |             |       |        |       |               |       |             |       |       |       | 1,477                  |       |
| Accretion on preferred stock and dividends                                |       |             |       |        |       |           |       |             |       | (820        | )          |               |       |             |       |       |       | (820                   | )          |
| Net Loss for the year                                                     |       |             |       |        |       |           |       |             |       | (6,851      | )          |               |       |             |       |       |       | (6,851                 | )          |
| **Balance at December 31, 2005**                                     |       | 39,511           |       | $           | 395        |           | $          | 242,414          |       | $           | 0          |               | $          | (229,092         | )          | $          | 0          |                   | 0          |   | $ | 0 |   | $ | 13,717 |   |

 

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

 

F-6

----

 

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

 
| ** **                                                                                         | ** ** | **Twelve Months  Ended  December  31, 2003** | ** ** | **Twelve Months  Ended  December  31, 2004** | ** ** | **Twelve Months  Ended  December  31, 2005** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                                         | ** ** | ** **                                   | ** ** | ** **                                   | ** ** | ** **                                   | ** ** |
| Cash flows  from operating activities:                                                             |       |                                         |       |                                         |       |                                         |       |
| Net loss                                                                                           |       | $                                            | (8,705     | )                                            | $          | (19,425                                      | )          | $ | (6,851 | ) |
| Loss  (income) from discontinued operations                                                        |       | 2,908                                        |       | (36                                          | )          | 0                                            |       |
| Adjustments  to reconcile net loss to cash used in operating activities of continuing  operations: |       |                                         |       |                                         |       |                                         |       |
| Depreciation  and amortization                                                                     |       | 0                                            |       | 477                                          |       | 693                                          |       |
| Non-cash  stock based compensation to product development vendor                                   |       | 200                                          |       | 400                                          |       | 0                                            |       |
| Change in  fair value of warrants and conversion options                                           |       | 0                                            |       | 10,091                                       |       | (8,594                                       | )          |
| Non-cash  stock based compensation                                                                 |       | 78                                           |       | 608                                          |       | 3                                            |       |
| Changes in  operating assets and liabilities:                                                      |       |                                         |       |                                         |       |                                         |       |
| Trade  accounts receivable                                                                         |       | 0                                            |       | 0                                            |       | (133                                         | )          |
| Other  receivables                                                                                 |       | 0                                            |       | (17                                          | )          | 2                                            |       |
| Inventory                                                                                          |       | 0                                            |       | (46                                          | )          | (2,832                                       | )          |
| Prepaid and  other assets                                                                          |       | 816                                          |       | 219                                          |       | 146                                          |       |
| Accounts  payable                                                                                  |       | 184                                          |       | (218                                         | )          | 1,473                                        |       |
| Accrued  expenses                                                                                  |       | 374                                          |       | 357                                          |       | 660                                          |       |
| Accrued  compensation and benefits                                                                 |       | 501                                          |       | 302                                          |       | (504                                         | )          |
| Warranty  reserve                                                                                  |       | 0                                            |       | 0                                            |       | 336                                          |       |
| Deferred  revenue                                                                                  |       | 0                                            |       | 204                                          |       | (325                                         | )          |
| Returns  Reserve                                                                                   |       | 0                                            |       | 0                                            |       | 2,310                                        |       |
| Net  operating cash flow used in continuing operations                                             |       | (3,644                                       | )          | (7,084                                       | )          | (13,616                                      | )          |
| Net  operating cash flow (used in) provided by discontinued operations                             |       | (1,248                                       | )          | 135                                          |       | 0                                            |       |
| Net cash  used in operating activities                                                             |       | (4,892                                       | )          | (6,949                                       | )          | (13,616                                      | )          |
|                                                                                               |       |                                         |       |                                         |       |                                         |       |
| Cash flows  from investing activities of continuing operations:                                    |       |                                         |       |                                         |       |                                         |       |
| Capital  expenditures from continuing operations                                                   |       | 0                                            |       | (925                                         | )          | (554                                         | )          |
| Net  investing cash flow from discontinued operations                                              |       | 6,788                                        |       | 0                                            |       | 0                                            |       |
| Net cash  provided by (used in) investing activities                                               |       | 6,788                                        |       | (925                                         | )          | (554                                         | )          |
|                                                                                               |       |                                         |       |                                         |       |                                         |       |
| Cash flows  from financing activities of continuing operations:                                    |       |                                         |       |                                         |       |                                         |       |
| Payment of  note payable                                                                           |       | 0                                            |       | 0                                            |       | (331                                         | )          |
| Proceeds  from issuance of common stock                                                            |       | 1,490                                        |       | 2,813                                        |       | 16,643                                       |       |
| Proceeds  from the issuance of redeemable preferred stock                                          |       | 0                                            |       | 7,111                                        |       | 0                                            |       |
| Proceeds  from the exercise of stock options                                                       |       | 0                                            |       | 813                                          |       | 818                                          |       |
| Proceeds  from the exercise of warrants                                                            |       | 0                                            |       | 5,612                                        |       | 1,477                                        |       |
| Net cash  provided by financing activities from continuing operations                              |       | 1,490                                        |       | 16,349                                       |       | 18,607                                       |       |
| Net  financing cash flow from discontinued operations                                              |       | (610                                         | )          | 0                                            |       | 0                                            |       |
| Net cash  provided by financing activities                                                         |       | 880                                          |       | 16,349                                       |       | 18,607                                       |       |
| **Net  increase in cash and equivalents**                                                          |       | 2,776                                        |       | 8,475                                        |       | 4,437                                        |       |
| **Cash and  cash equivalents, beginning of year**                                                  |       | 589                                          |       | 3,365                                        |       | 11,840                                       |       |
| **Cash and  cash equivalents, end of year**                                                        |       | $                                            | 3,365      |                                         | $          | 11,840                                       |       | $ | 16,277 |   |

 

The accompanying notes are an integral part ofthese consolidated financial statements.

 

F-7

----

 

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

 

**1. Basis of Presentation**

 

The consolidated financial statements of WorldGateCommunications, Inc. (“WorldGate”, “We”, “Our” or the “Company”) presentedherein have been prepared by the Company pursuant to the rules andregulations of the Securities and Exchange Commission (“SEC”) for annualreports on Form 10-K. WorldGate was incorporated in Delaware in 1996 tosucceed to the business of the predecessor company, WorldGate Communications,L.L.C., which commenced operations in March 1995. WorldGate has developeda video phone designed specifically for personal video communication, and isdifferentiated, both from competitors and from previous efforts at personalvideo telephony, by providing: true-to-life communication; ease of deploymentby high-speed data, or HSD, operators as well as businesses; a highly styledergonomic design; and interoperation with the public switched telephonenetwork, or PSTN.

 

The consolidated financial statements of the Companyinclude the accounts of WorldGate Communications, Inc. and its whollyowned subsidiaries WorldGate Service, Inc., WorldGate Finance, Inc.,Ojo Services LLC and WorldGate Acquisition Corp. All significant intercompanyaccounts and transactions have been eliminated in consolidation.

 

**2.Restatement in August 2005**

 

The Companypreviously restated its consolidated financial statements for the year endedDecember 31, 2004 with regard to expanded explanations in the Notes to theConsolidated Financial Statements of the Company’s accounting method and policyfor redeemable preferred stock and warrants issued by the Company in a privateplacement in June 2004.

 

**3.Restatement in January 2006**

 

The Companypreviously restated its consolidated financial statements for the year endedDecember 31, 2004 and 2003 with regard to the accounting for the warrants andadditional investment rights issued in private placements of the Company’scommon stock during the fourth quarter of 2003 and the first and fourthquarters 2004.

 

F-8

----

 

 

**4. Restatement in March 2006**

 

TheCompany has restated its financial statements for the quarters ended June 30,2005 and September 30, 2005 to correct the accounting for certainconversions of preferred stock related to its June 2004 private placementof 7,550 shares of Series A Convertible Preferred stock to certaininstitutional investors. The corrected accounting reclassifies the convertedpreferred stock and the associated conversion options liability to equity basedon a ratio of the shares converted during the quarter to the total preferredshares outstanding, whereas previously the ratio used for the reclassificationof preferred stock and conversion options was based on the percentage of theseinstruments to each other and applied to the amount converted. In addition,both the fair value of the conversion option and any unaccreted discountassociated with the conversion are being applied to equity with the discountbeing accounted for as a deemed dividend which is also presented in thestatement of operations. We previously did not reflect the discount on thepreferred stock as a deemed dividend. There is no cash impact associated withthese restatements.

 

The effect of therestatement on specific amounts provided in the consolidated financialstatements is as follows:

 
| ** **                          | ** ** | **June 30, 2005**      | ** ** |
|-------------------------------------|------------|-----------------------------|------------|
| **Consolidated Balance Sheet**      | ** ** | **As previously  reported** | ** ** | **As restated** | ** ** |
|                                |       |                        |       |   |   |
| Redeemable Preferred Stock          |       | $                           | 1,858      |   | $ | 1,460 |   |
|                                |       |                        |       |   |   |
| Accumulated deficit                 |       | $                           | (216,726   | ) | $ | (219,595 | ) |
| Additional-paid-in capital          |       | 218,888                     |       | 222,155 |   |
| Total stockholders’ deficiency |       | 2,500                       |       | 2,898 |   |

 

F-9

----

 
| ** **                                                            | ** ** | **Three Months Ended  June 30, 2005** | ** ** | **Six Months Ended  June 30, 2005** | ** ** |
|-----------------------------------------------------------------------|------------|--------------------------------------------|------------|------------------------------------------|------------|
| **Consolidated Statement of  Operations**                             | ** ** | **As previously  reported**                | ** ** | **As restated**                          | ** ** | **As previously  reported** | ** ** | **As restated** | ** ** |
|                                                                  |       |                                       |       |                                     |       |   |   |   |   |
| Change in  fair value of warrants and conversion options              |       | $                                          | 2,466      |                                     | $          | 1,633 |   | $ | 7,642 |   | $ | 6,809 |   |
| Loss from  continuing operations                                      |       | (366                                       | )          | (1,199                                   | )          | 2,228 |   | 1,395 |   |
| Net loss                                                              |       | (366                                       | )          | (1,199                                   | )          | 2,228 |   | 1,395 |   |
| Accretion  preferred stock and dividends                              |       | (139                                       | )          | (2,175                                   | )          | (635 | ) | (2,671 | ) |
| Net loss  available to common stockholders                            |       | (505                                       | )          | (3,374                                   | )          | 1,593 |   | (1,276 | ) |
|                                                                  |       |                                       |       |                                     |       |   |   |   |   |
| Net (loss)  income per common share:                                  |       |                                       |       |                                     |       |   |   |   |   |
| Basic                                                                 |       | $                                          | (0.01      | )                                        | $          | (0.04 | ) | $ | 0.07 |   | $ | 0.04 |   |
| Diluted                                                               |       | (0.01                                      | )          | (0.04                                    | )          | 0.06 |   | 0.04 |   |
| Net (loss)  income available to common shareholders per common share: |       |                                       |       |                                     |       |   |   |   |   |
| Basic                                                                 |       | $                                          | (0.02      | )                                        | $          | (0.10 | ) | $ | 0.05 |   | $ | (0.04 | ) |
| Diluted                                                               |       | (0.02                                      | )          | (0.10                                    | )          | 0.06 |   | (0.04 | ) |

 
| ** **                          | ** ** | **September 30, 2005** | ** ** |
|-------------------------------------|------------|-----------------------------|------------|
| **Consolidated Balance Sheet**      | ** ** | **As previously  reported** | ** ** | **As restated** | ** ** |
|                                |       |                        |       |   |   |
| Redeemable Preferred Stock          |       | $                           | 702        |   | $ | 678 |   |
|                                |       |                        |       |   |   |
| Accumulated deficit                 |       | $                           | (218,207   | ) | $ | (219,372 | ) |
| Additional-paid-in capital          |       | 237,256                     |       | 238,445 |   |
| Total stockholders’ deficiency |       | 19,442                      |       | 19,466 |   |

 
| ** **                                                            | ** ** | **Three Months Ended  September 30, 2005** | ** ** | **Nine Months Ended  September 30, 2005** | ** ** |
|-----------------------------------------------------------------------|------------|-------------------------------------------------|------------|------------------------------------------------|------------|
| **Consolidated Statement of  Operations**                             | ** ** | **As previously  reported**                     | ** ** | **As restated**                                | ** ** | **As previously  reported** | ** ** | **As restated** | ** ** |
|                                                                  |       |                                            |       |                                           |       |   |   |   |   |
| Change in  fair value of warrants and conversion options              |       | $                                               | 1,759      |                                           | $          | 1,165 |   | $ | 9,401 |   | $ | 7,974 |   |
| Loss from  continuing operations                                      |       | (1,397                                          | )          | (1,991                                         | )          | 831 |   | (596 | ) |
| Net loss                                                              |       | (1,397                                          | )          | (1,991                                         | )          | 831 |   | (596 | ) |
| Accretion  preferred stock and dividends                              |       | (85                                             | )          | (656                                           | )          | (719 | ) | (3,326 | ) |
| Net loss  available to common stockholders                            |       | (1,482                                          | )          | (2,647                                         | )          | 112 |   | (3,922 | ) |
|                                                                  |       |                                            |       |                                           |       |   |   |   |   |
| Net (loss)  income per common share:                                  |       |                                            |       |                                           |       |   |   |   |   |
| Basic                                                                 |       | $                                               | (0.04      | )                                              | $          | (0.04 | ) | $ | 0.02 |   | $ | (0.02 | ) |
| Diluted                                                               |       | (0.04                                           | )          | (0.04                                          | )          | 0.02 |   | (0.02 | ) |
| Net (loss)  income available to common shareholders per common share: |       |                                            |       |                                           |       |   |   |   |   |
| Basic                                                                 |       | $                                               | (0.04      | )                                              | $          | (0.07 | ) | $ | 0.00 |   | $ | (0.11 | ) |
| Diluted                                                               |       | (0.04                                           | )          | (0.07                                          | )          | 0.00 |   | (0.11 | ) |

 

F-10

----

 

**5. Summaryof Significant Accounting Policies**

 

*Liquidityand Going Concern Considerations.*

 

Asof December 31, 2005 the Company had cash and cash equivalents of $16,277.The operating cash usage from continuing operations for the twelve months endedDecember 31, 2005 was $13,616. During the third quarter of 2003, wecompleted a sale of certain assets, including our interactive television (“ITV”)intellectual property rights and our membership interest in TVGateway, LLC, for$3,000 in cash to TVGateway, LLC, a company we were instrumental in forming.Our transaction with TVGateway, LLC marked a shift in our business away fromthe ITV business and toward a new video phone product and associated business.The funds 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, December 15, 2004 and August 3, 2005, have permitted us to fundthe development of our new business.

 

InDecember 2003 and January 2004, WorldGate received investmentsaggregating $3,100 from 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 and January 2005,resulting in an incremental investment of $925.

 

InDecember 2003, WorldGate reached agreement with Mototech, Inc. (“Mototech”is not an affiliate of General Instruments or Motorola) for the purchase of625,000 shares of newly issued common stock at $0.80 per share, in return forfuture design and engineering services by Mototech. WorldGate had previouslycontracted with Mototech to assist the Company with the design and volumemanufacture of WorldGate’s Ojo personal video phone. The purchase price forthese shares has been fully paid as of December 31, 2004 by an equivalentreduction in the development and initial procurement payments that wouldotherwise be due to Mototech. The value of this transaction was $600 (based onthe closing stock price of $0.96 on the date of the transaction) of which $200was recorded as an expense for the year ended December 31, 2003 and $400was expensed for the year ended December 31, 2004. In addition, in April 2004,Mototech invested $1,000 to purchase 666,666 shares of newly issued commonstock at $1.50 per share.

 

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 In June 2004 we completed a privateplacement of 7,550 shares (the “June 2004 Shares”) of Series AConvertible Preferred stock to certain institutional investors. The shares weresold for $1,000 per share, resulting in gross proceeds from the offering of$7,550. The preferred stock issued pursuant to this placement is convertibleinto WorldGate common stock at a conversion price of $2.35 per share. WorldGatehas the right to require conversion of the preferred stock into common stockupon achieving certain price targets with respect to its common stock and thesatisfaction of certain other conditions. Of the 7,550 convertible preferredissued 500 shares remained outstanding as of December 31, 2005 and 333shares remain outstanding as of January 12, 2006. Between November 2004and January 2006 all but one of the investors have fully converted theirpreferred shares resulting in the issuance of 3,071,064 of our common shares.The preferred stock has a dividend rate of 5% per annum, payable quarterly,which may be paid either by cash or through the issuance of common stockat WorldGate’s option (with stock payments being made at a 10% discount to thethen current market price). Through January 12, 2006, for all quarterlydividend payments due, WorldGate exercised its right to make these dividendpayments in stock, resulting in the issuance of an additional 136,623 shares ofour common stock. The preferred stock has a staged maturity over three years withscheduled payments of one third due after 18 months, one half of the remainderdue after 24 months and the balance due after 36 months. The preferred stock may beredeemed at maturity in cash or through the issuance of an indeterminate numberof shares of common stock, at WorldGate’s option (subject to certainconditions). All dividend and maturity payments made in stock are subject tothe satisfaction of certain conditions including the listing and availabilityof an effective registration statement. As part of the transaction,WorldGate issued five-year warrants to purchase a total of 1,606,380 shares ofWorldGate common stock, with one-half of the warrants having an exercise priceof $2.69 per share and the remaining half having an exercise price of $3.14 pershare. Through December 2005 125,000 of $2.69 warrants have been exercisedresulting in the issuance of an addition 125,000 of our common shares and anadditional $336 in gross proceeds and 51,915 of $3.14 warrants have beenexercised resulting in the issuance of an addition 51,915 of our common sharesand an additional $163 in gross proceeds. The investors also received anadditional investment right, for a limited period of time, to purchase1,606,380 additional common stock shares at $3.14 a share. During December 2004all but one of the investors exercised their additional investment rightsresulting in the issuance of an additional 1,500,000 shares and an additional$4,710 in gross proceeds. During the first quarter of 2005, the remaininginvestor exercised their additional investment right resulting in the issuanceof an additional 106,383 shares and an additional $334 in gross proceeds. Theprivate placement includes numerous provisions intended to protect theseinstitutional investors including a cash payment penalty of 1.0% per month forunredeemed preferred shares once registration of the shares lapse and until theregistration again becomes effective.

 

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$2.40 per 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.

 

 In August 2005,the Company completed a private placement of $17,500 of its common stock andwarrants with several institutional investors. The Company issued 4,666,664 sharesof its common stock at $3.75 per share to the participating investors. TheCompany also issued five-year warrants to purchase a total of 1,671,947 sharesof its common stock: 1,633,333 shares to the investors at an exercise price of$5.00 per share, and 38,614 shares to the placement agent at an exercise priceof $4.53 per share. The investors also received an additional investmentright, for a period of 60 days from the time the shares become registered, topurchase 1,554,000 additional shares of common stock at $4.12 per share. Theaccounting for these warrants and investment rights is established by analogyto Accounting Principle Board Opinion (“APB”) No. 14 “Accounting forConvertible Debt and Debt Issued with Stock Purchase Warrants,” which addressesdetachable stock purchase warrants issued in conjunction with convertible debtand prescribes that such warrants be accounted for as additional paid incapital measured at fair value. The private placement includes numerousprovisions intended to protect these institutional investors including a cashpayment penalty of 1.5% per month for the period above 120 days from theeffective date of the Agreement that the shares in the transaction fail to beregistered. On December 31, 2005 the shares under this private placementhad not been registered and until such time as the shares become registered theCompany is subject to the penalty provision under this private placement. As ofDecember 31, 2005 the Company has recorded accrued penalties of $525,000.

 

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Registration statements for the securities soldpursuant to the June 2004, December 2004 and August 2005 privateplacements were originally filed containing financial statements that werecurrent at the time of the filing. Subsequently the Company initiated a processto amend, restate and re-file certain of its 2003, 2004 and 2005 financialstatements to correct an error in the accounting treatment for various securitycomponents of our private placements. As a result the registration statementsthen on file also needed to be amended to reflect these changes in ourfinancial statements. Amended registration statements were subsequently filedwith the SEC to reflect the amended and restated financial statements, andthese amended registration statements are currently awaiting SEC review. It ishowever likely that as part of the standard review process with the SEC wewill need to file subsequent amendments to these registration statements toupdate the financial statements contained therein to reflect our fiscal 2005,year end financials.

 

On April 28, 2004, we entered into a multi-yearagreement with General Instrument Corporation d/b/a the Connected HomeSolutions Business of Motorola, Inc. (“General Instrument”) for theworldwide development and distribution of the Ojo personal video phone. Thisagreement provided for General Instrument to be WorldGate’s exclusivedistributor of its broadband video phone products and for WorldGate to beGeneral Instrument’s exclusive supplier of its broadband video phone products. OnFebruary 17, 2006, we mutually agreed with General Instrument to end thisagreement. The ending of this agreement immediately terminates exclusivity forboth parties. In addition to its current role for development and manufactureof Ojo, WorldGate will now have direct responsibility and control for theadvertising, marketing, and distribution of its products. Under its agreementwith General Instrument, WorldGate had been active in marketing and promotingits products, and working with General Instrument to distribute Ojo. WorldGateintends to continue the rollout of Ojo using many of the same distributors,retailers and service providers, and plans to expand distribution to serviceproviders and retailers around the world. The two companies will work togetherto ensure a smooth transition for customer accounts. As part of ending itsagreement with General Instrument, and in anticipation of WorldGate inventoryrequirements as a result of taking full responsibility for productdistribution, WorldGate negotiated the right to buy back about two-thirds ofthe units sold to General Instrument, valued at approximately $2,765 (basedupon the original sales price to General Instrument), for approximately $1,064.This is less than half of what it would cost the Company to purchase the sameinventory from its manufacturing sources. As a result the Company recorded areserve for returns and reduced revenue in the amount of approximately $2,310during the fourth quarter of 2005. In addition the Company will record norevenue for units shipped to General Instrument in the first quarter 2006 andwill record a gain on termination of this agreement of approximately $1,331during the first quarter 2006 as a result of the lower purchase price of thisinventory (net of the cost of rework for rebranding the product).

 

The Company had $7,133 of liabilities and its assetsare not pledged as collateral as of December 31, 2005. These liabilitiesinclude $1,101 of dividends, detachable warrants and conversion options relatedto the Company’s private placement of Preferred Stock.

 

Our Company has sufferedrecurring losses from operations and had an accumulated deficit of $229,092 asof December 31, 2005, and these issues raise substantial doubt about ourCompany’s ability to continue as a going concern. Our short term cashrequirements and obligations include, inventory, accounts payable and capitalexpenditures from continuing operations, operating expenses, and the redemptionof preferred stock, of which $167 is required to be redeemed in June 2006,although this redemption can be made in common stock if certain conditions aremet. In addition, the August 2005 private placement includes cash paymentpenalties of 1.5% per month for the period that the shares in the transactionfail to be registered. On December 31, 2005 the shares under this privateplacement had not been registered and until such time as the shares becomeregistered the Company is subject to the penalty provision under this privateplacement. As of December 31, 2005 the Company has recorded accruedpenalties of $525,000. The ending of the General Instrument agreement placesadditional cash burdens on the Company and this could impact our cashrequirements and usage.

 

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 into the fourth quarter of 2006.

 

Our ability to generate cashis dependant upon the sale of our Ojo product and on obtaining cash throughcapital markets. We began generating revenue from commercial shipment ofour Ojo product in April, 2005 and we expect revenues to increase as theproduct continues to roll out to the marketplace. Depending on the ramp up of

 

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sales, the increased level of sales activity isprojected to have a positive impact on our cash flows from operations, whichwill support our ability to meet our obligations beyond 2006. Given that ourvideo phone business involves the development of a new product line with nomarket penetration, in an underdeveloped market sector, no assurances can begiven 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 given that, if pursued, additional financingtransactions 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. Such additional financing would be subject tothe risk of availability, may be dilutive to our stockholders, or couldimpose restrictions on operating activities. There can be no assurance thatthis additional financing will be available on terms acceptable to us, if atall.

 

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 capacity to reduce our workforce and scaleback on capital and operational expenditures 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 of the financialstatements and the reported amount of revenues and expenses during thereporting period. Actual results could differ from those estimates.

 

*Risks and uncertainties*

 

Ourprimary line of business is the development of video phone products andtechnology. We are still in the process of launching our first product based onthis technology and, although we have realized some revenues for the commercialsale of our product, the revenues to date have not been substantial. Given theearly stage of our product and the lack of operating history in the video phonebusiness, it is difficult to predict our future results.

 

OnApril 28, 2004, we entered into a multi-year agreement with GeneralInstrument Corporation d/b/a the Broadband Communication Sector of Motorola, Inc.(“General Instrument”) for the worldwide development and distribution of theOjo personal video phone. This agreement provided for General Instrument to beWorldGate’s exclusive distributor of its broadband video phone products and forWorldGate to be General Instrument’s exclusive supplier of its broadband videophone products. On February 17, 2006, we mutually agreed with GeneralInstrument to end this agreement. The ending of this agreement immediatelyterminated this exclusivity for both parties, and accordingly enabled WorldGateto expand its focus in bringing Ojo to the marketplace. In addition to itscurrent role for development and manufacture of Ojo, WorldGate became directlyresponsible for the advertising, marketing, and distribution of its products. Subsequentto the ending of the agreement with General Instrument we will depend upondistribution partners, including, for example, wholesalers, retailers andservice providers, to provide the worldwide sales and distribution of the Ojovideo phone. If our partners are not successful, or if their activities do notlead to significant sales of our product, our operating results will beadversely affected, our revenue could be significantly reduced and we couldlose potential customers.

 

###### **We also depend on relationshipswith third parties such as contract manufacturing companies, chip designcompanies and others who may be sole source providers of key componentsand services critical for the product we are developing in our video phonebusiness. A formal relationship with Mototech has been established for thevolume manufacture of Ojo. Mototech is currently the sole volume manufacturerof Ojo. Our agreement with**

 

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###### **Mototech allows either party to terminate the agreementwith 90 days prior notice. If Mototech or other providers of components and/ormanufacturing services do not produce these components or provide theirservices on a timely basis, if the components or services do not meet ourspecifications and quality control standards, or if the components or servicesare otherwise flawed, we may have to delay product delivery, or recall orreplace unacceptable products. In addition, such failures could damage ourreputation and could adversely affect our operating results. As a result, wecould lose potential customers and any revenues that we may have at thattime may decline dramatically.**

###### ** **

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

###### ** **

TheCompany considers all highly liquid investments with original maturities of threemonths or less to be cash equivalents. The Company maintains cash balances atfinancial institutions, which at times exceed the $100 FDIC limit.

 

*Inventories*

 

Our inventory consistsprimarily of finished goods equipment to be sold to our customer. The cost isdetermined on an average cost basis. A periodic review of inventory quantitieson hand is performed in order to determine and record a provision for excessand obsolete inventories. Factors related to current inventories such astechnological obsolescence and market conditions are analyzed to determineestimated net realizable values. A provision is recorded to reduce the cost ofinventories to the estimated net realizable values. Any significantunanticipated changes in the factors noted above could have an impact on thevalue of our inventories and our reported operating results. Our December 31,2004 inventory balance of $1,668 consisted of $1,622 relating solely to our ITVbusiness, which was fully reserved for at December 31, 2004, and $46related solely to our new video phone business. At December 31, 2005, ourinventory balance of $2,878 related solely to our video phone business. Thisbalance includes $2,006 of inventory related to the accounting for productpurchased in connection with the ending of the General Instrument agreementwhich is being recorded as a reserve for returns.

 

*Propertyand Equipment*

 

Propertyand equipment is carried at original cost. Depreciation is recorded on astraight-line basis 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 a straight-linebasis over the shorter of their useful life or the term of the lease.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.

 

*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.

 

Statementof Financial Accounting Standards (“SFAS”) No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets” provides guidance on therecognition of impairment losses on long-lived assets to be held and used or tobe disposed of, and also broadens the definition of what constitutes adiscontinued operation and how the results of a discontinued operation are tobe measured and presented.

 

F-15

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*Accountingfor Preferred Shares and Derivative Shares*

 

In June 2004, WorldGatecompleted a private placement of preferred stock. The Preferred Stock has adividend rate of 5% per annum, payable quarterly, either by cash or through theissuance of common stock at the Company’s option. The Preferred Stock has astaged maturity over three years with one-third of the Preferred Stock to beredeemed after 18 months, one-third after 24 months and one-third after 36months, and may be redeemed at maturity in cash or, at the Company’s option,subject to certain conditions that may not be solely under the control ofthe Company, through the issuance of the number of shares of common stockdetermined by dividing the liquidation preference of the preferred shares bythe then current market price. 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 redemption of the preferred stock with cash instead of its common shares.Furthermore, since the market price of the Company’s common stock cannot bepredicted, the actual number of shares of the Company’s common stock that willbe required if a redemption is made through the issuance of common stock, canalso not be predicted. The private placement includes numerous provisionsintended to protect these institutional investors including a cash paymentpenalty of 1.0% per month for unredeemed preferred shares once registration ofthe shares lapse and until the registration again becomes effective. Similarlythe amount of the cash penalties may not be determinable until such timeas the event triggering the cash payment is cured or removed.

 

 The Preferred Stockhas embedded conversion options. Specifically, the holders of the PreferredStock may convert their shares into the Company’s common stock at aconversion price of $2.35 per share. In addition the Company may forceconversion of the Preferred Stock into common stock if the Company achievescertain price targets for its common stock and satisfaction of certain otherconditions, such as the existence of an effective registration statement. Ineither event the conversion price is subject to adjustment if, at any timeafter the date the preferred shares were issued, the Company issues or sells,or is deemed to have issued or sold, any shares of the Company’s common stockfor per share consideration less than the conversion price of the preferredshares on the date of such issuance or sale. Accordingly, the number of commonshares issuable upon the conversion of the preferred shares cannot be predicted.Furthermore, net-cash settlement may be required in the event ofconversion default under certain circumstances that may not be solelyunder 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 theprivate placement the Company issued five-year warrants to purchase up to 803,190shares of our common stock at an exercise price of $2.69 per share andfive-year warrants to purchase up to 803,190 shares of our common stock at anexercise price of $3.14 per share. The investors also received an additionalinvestment right, for a limited period of time, to purchase 1,606,383additional shares of common stock shares at $3.14 a share. This exercise priceof the warrants is subject to adjustment if, at any time after the date thewarrants were issued, the Company issues or sells, or is deemed to have issuedor sold, any shares of the Company’s common stock for per share considerationless than the exercise price of the warrants on the date of such issuance orsale. Accordingly, the number of common shares that will be issued upon theexercise of the warrants cannot be predicted. As of December 31, 2005,125,000 warrants exercisable at $2.69 had been exercised and 51,915 warrantsexercisable at $3.14 had been exercised. All of the additional investmentrights had been exercised as of December 31, 2005.

 

Of the 7,550 preferred shares issuedunder this private placement, 7,050 shares have been redeemed as of December 31,2005. In January 2006 an additional 167 shares were redeemed.

 

With respect to the Company’saccounting for the preferred stock, Emerging Issues Task Force (“EITF”) Topic D-98,paragraph 4, states that Rule 5-02.28 of Regulation S-X requiressecurities with redemption features that are not solely within the control ofthe issuer to be recorded outside of permanent equity. As described above, theterms of the Preferred Stock include certain redemption features that may betriggered by events that are not solely within the control of the Company, suchas a potential failure in the Company’s ability to maintain an effective registrationstatement. Furthermore, the actual number of shares of common stock required tosatisfy redemption is based upon the market value of the common stock at thetime of the redemption, which cannot be predicted. Accordingly, the Company hasclassified the preferred stock as temporary equity and the value ascribed tothe redeemable preferred stock upon initial issuance, i.e. at June 24,2004, was the amount received in the

 

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transaction minus the fair value ascribed to theconversion options and warrants. The initial value of the redeemable preferredstock is accreted up to the redemption value (the amount received in thetransaction) over the future relevant periods using the interest method.The value of the redeemablepreferred stock at December 31, 2005 was $379.

 

The terms of the preferredstock include 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 include certain provisions that could result in avariable number of shares to be issued upon conversion, adjustment to thestrike price at which conversion shares will be determined, or the requirementfor the Company to settle the conversion options in cash. EITF 00-19, “Accountingfor Derivative Instruments Indexed to, and Potentially Settled in, a Company’sOwn Stock”, states that if the conversion options require net cash settlementin the event of circumstances that are not solely within the Company’s controlthey should be classified as a liability measured at fair value on the balancesheet.

 

The terms of the five-yearwarrants include cash penalty provisions in the event that the Company fails tomeet its obligations to deliver registered shares to the warrant holder uponexercise and an anti-dilution provision that could result in a variable numberof shares to be issued upon warrant exercise. Additionally, the terms andconditions of the warrants provide for net settlement via cashless exercisewhereby the shares delivered to the warrant holder would be readily convertibleto cash. In accordance with EITF 00-19 and given the terms and conditions ofthe warrants as outlined above, the Company has classified the warrants as aliability on its balance sheet measured at fair value using the Black-Scholesoption pricing model.

 

The Company accounts forboth the conversion options and warrants using the fair value method at the endof each quarter, with the resultant gain or loss recognition recorded againstearnings. Both the warrants and conversion options are valued using theBlack-Scholes valuation model. Actual period close common stock prices,applicable volatility rates, and the period close risk-free interest rate forthe instrument’s expected remaining life (continuously compounded), are the keyassumptions used in the valuation calculation. The WorldGate share pricechanged from $4.99 per share as of December 31, 2004 to $2.06 per share atDecember 31, 2005, making the warrants and preferred stock conversionelements less valuable, and therefore less costly, relative to their strikeprice. The result was a $8,594 non cash gain for the year ended December 31,2005.

 

*RevenueRecognition*

 

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. Managementexercises judgment in evaluating these factors in light of the terms andconditions of its customer contracts and other existing facts and circumstancesto determine appropriate revenue recognition. Due to our limited commercialsales history, our ability to evaluate the collectibility of customer accountsrequires significant judgment. The Company evaluates its equipment customer,and service customers’, accounts for collectibility at the date of sale and onan ongoing basis.

 

For the years ended December 31, 2004 and 2005,and through mid February 2006, the Company had only one customer for thepurchase of its product and the agreement with this customer included severalelements relevant to revenue recognition including: (a) the customer hadno general right to return the product;  (b) the customer earnedwarrants 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 has been routinely monitored by the Company and is currentlydeemed to 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 the customer share in the benefitachieved by product cost reductions; (e) penalties are payable to thecustomer if the Company fails to deliver shipments on a timely basis; (f) theCompany extends to the customer a limited product warranty for a term not toexceed three years (the Company maintains a warranty reserve based upon thepercentage of product sales consistent with industry comparable failure ratesand the warranty period provided by the agreement). Beginning in mid February 2006the Company began selling its products to multiple customers and some of theabove factors may change and may need to be re-evaluated.

 

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Revenues are also offset bya reserve for any price refunds and consumer rebates consistent with the EITFIssue 01-9, “Accounting for Consideration Given by a Vendor to a Customer”.

 

As an incentive to promotedelivery of the units, a special product launch discount was provided by theCompany to our distributor as a quantity restricted reduction to the unitcontract based price in effect. For the year ended December 31, 2005, thisdiscount was $398. In addition, the Company has offered a forward pricingprogram to our distributor and a rebate program to consumers, as furtherincentives for the holiday season. These incentive programs began in the fourthquarter of 2005 and terminated during the first quarter of 2006. Consistentwith the EITF Issue 01-9, Accounting for Consideration Given by a vendor to aCustomer, the Company has offset its revenues for the year ended December 31,2005 by $212 for a reserve for the total estimated liability for the forwardpricing program, and $91 as an estimated liability associated with the rebate program.The total of the product launch discount, refunds and rebates for the yearended December 31, 2005 was $701. There were no product launch discounts,refunds or rebates for the years ended December 31, 2003 and 2004. In thefirst quarter of 2006 the Company announced that we were going to offer a newconsumer rebate program during the second quarter of 2006.

 

As part of ending itsagreement with General Instrument, and in anticipation of WorldGate inventoryrequirements as a result of taking full responsibility for productdistribution, WorldGate negotiated the right to buy back about two-thirds ofthe units sold to General Instrument, valued at approximately $2,765 (basedupon the original sales price to General Instrument), for approximately $1,064,.This is less than half of what it would cost the Company to purchase the sameinventory from its manufacturing sources. As a result the Company recorded areserve for returns and reduced revenue in the amount of approximately $2,310,during the fourth quarter of 2005. In addition the Company will record norevenue for units shipped to General Instrument in the first quarter 2006 andwill record a gain on termination of this agreement of approximately $1,331during the first quarter 2006 as a result of the lower purchase price of thisinventory (net of the cost of rework for rebranding the product).

 

*Cost ofRevenues*

 

Costof equipment product revenues reflects the purchase of video phones from theCompany’s supplier Mototech.

 

*Engineeringand Development Costs*

 

Engineering and developmentcosts are expensed as incurred. Engineering and development costs fromcontinuing operations were $3,000, $4,001 and $6,486 for the years ended December 31,2003, 2004 and 2005, respectively.

 

*AdvertisingCosts*

 

Advertising costs, includedin sales and marketing expense, are expensed in the period incurred.Advertising expenses from continuing operations were $43, $50 and $1,743 forthe years ended December 31, 2003, 2004 and 2005, respectively.

 

*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.

 

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*Stock-BasedCompensation*

 

AtDecember 31, 2005, the Company had stock based compensation plans, whichare described separately in Note 11. The Company applies APB 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. Had compensation cost been determinedconsistent with SFAS No. 123, as amended by SFAS No. 148, the Company’snet loss would have been increased to the following pro forma amounts:

 
| ** **                                                                                                                  | ** ** | **Year Ended December 31** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                  | ** ** | **2003**                        | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                                                                                                  | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net loss                                                                                                                    |       | $                               | (8,705     | ) | $ | (19,425 | ) | $ | (6,851 | ) |
| Stock-based  employee compensation expense included in reported net loss, net of related  tax effects                       |       | 0                               |       | 0 |   | 0 |   |
| Total  stock-based employee compensation expense determined under fair value based  method for all awards, net of tax of $0 |       | (5,523                          | )          | (2,072 | ) | (833 | ) |
| Pro forma  net loss                                                                                                         |       | $                               | (14,228    | ) | $ | (21,497 | ) | $ | (7,684 | ) |
|                                                                                                                        |       |                            |       |   |   |   |   |
| Net loss per  share:                                                                                                        |       |                            |       |   |   |   |   |
| Basic and  diluted net loss—as reported                                                                                |       | $                               | (0.37      | ) | $ | (0.70 | ) | $ | (0.19 | ) |
| Basic and  diluted net—pro forma                                                                                       |       | $                               | (0.61      | ) | $ | (0.77 | ) | $ | (0.22 | ) |

 

Suchpro forma disclosures may not be representative of future compensationexpense because options vest over several years and additional grants are madeeach year.

 

*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, 2003, 2004, and 2005 that have a dilutiveeffect if the Company had income from continuing operations is 7,243,403,11,295,669 and 10,990,946, respectively.

 

*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 isconsidered to be representative of their fair value because of their short termmaturities. Embedded derivatives reported on the balance sheet as of December 31,2005 are presented as a liability measured at fair value using theBlack-Scholes option pricing model (refer to Note 9, “Redeemable PreferredStock”).

 

###### ***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 managementprocess, the Company performs periodic evaluation of the relative creditstanding of these institutions.

 

 In2004 and 2005, accounts receivable consisted of receivables with our videophone distribution partner. Due to the credit worthiness of the distributionpartner, and its financial payment history with the Company, no allowance forpotential credit losses was recorded as of December 31, 2004 and 2005. In2003, a significant portion of our revenues from discontinued operations weregenerated from outside the U.S. The Company performed

 

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ongoing credit evaluationsof its customers’ financial condition and generally requires no collateral. In2003, the Company established allowances for potential credit losses and suchlosses did not exceed management expectations.

 

Salesto major customers, in excess of 10% of total revenues and accountsreceivables, were as follows for each of the years ended December 31(years 2003 percentages were from discontinued operations, there were nocontinuing operation sales in 2003):

 
| ** **   | ** ** | **Sales** | ** ** | **Accounts Receivable** | ** ** |
|--------------|------------|-----------|------------|-------------------------|------------|
| **Customer** | ** ** | **2003**  | ** ** | **2004**                | ** ** | **2005** | ** ** | **2004** | ** ** | **2005** | ** ** |
|         |       |      |       |                    |       |   |   |   |   |   |   |
| A            |       | 48        | %          | 0                       |       | 0 |   | 0 |   | 0 |   |
| B            |       | 0         |       | 100                     | %          | 99 | % | 0 |   | 92 | % |
| C            |       | 3         | %          | 0                       |       | 0 |   | 0 |   | 0 |   |

 

As of December 31,2005, Mototech is the sole volume manufacturer of Ojo video phones to theCompany. A formal relationship had been established with Mototech in 2003. Mototech.isa Taiwanese manufacturer and distributor of high performance, high speed dataand computer networking products.

 

Revenuesfrom continuing operations by geographic area are currently attributed to theUnited States.

 

AtDecember 31, 2005, the Company has long-lived assets, with a net bookvalue total of $1,031, located in the United States, and $545 located inTaiwan, R.O.C.

 

*RecentAccounting Pronouncements*

 

InNovember 2004, the Financial Accounting Standards Board (“FASB”) issuedSFAS No. 151 “Inventory Costs” which amends the guidance in ARB No. 43,Chapter 4 “Inventory Pricing,” to clarify the accounting for abnormal amountsof idle facility expense, freight, handling costs, and wasted material(spoilage). ARB 43 previously stated that under some circumstances, items suchas idle facility expense, excessive spoilage, double freight, and rehandlingcosts may be so abnormal as to require treatment as current periodcharges.” SFAS No. 151 requires that those items be recognized as currentperiod charges regardless of whether they meet the criterion of “so abnormal.”In addition, SFAS No. 151 requires that allocation of fixed productionoverheads to the costs of conversion be based on the normal capacity of theproduction facilities. SFAS No. 151 shall be effective for inventory costsincurred during fiscal years beginning after June 15, 2005. Earlierapplication is permitted for inventory costs incurred during fiscal yearsbeginning after the date SFAS No. 151 was issued. SFAS No. 151 shallbe applied prospectively. The Company does not expect the adoption of SFAS No. 151to have a material effect on its consolidated 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.

 

In December 2004, the FASB issued SFAS No. 123(R), “Share-Based Payment” that focuses primarily on accounting fortransactions in which an entity obtains employee services in share-basedpayment transactions. This statement replaces SFAS No. 123, “Accountingfor Stock-Based Compensation”, and supersedes APB Opinion No. 25, “Accountingfor Stock Issued to Employees.”  In March 2005,the Securities and Exchange Commission

 

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issuedStaff Accounting Bulletin No. 107 (“SAB 107”) relating to the adoption ofSFAS 123R. SAB 107 primarily interprets how the implementation of SFAS 123R isto be applied under SEC rules and regulations. Beginning with ourquarterly period that begins after January 1, 2006, we will be required toexpense the fair value of employee stock options and similar awards. TheCompany has elected to utilize the modified prospective transitional method inaccounting for share-based employee payment transactions. Based upon theemployee options outstanding as of December 31, 2005, and the transitionalprovisions of SFAS No. 123R and SAB 107, there is approximately $1,853 offuture costs, utilizing the fair value method that will be expensed over a fouryear period from 2006 through 2009. Additionally, the Company will utilize thefair value method for any future instruments issued after January 1, 2006.

 

In March 2005, the FASBissued Interpretation No. 47 (FIN 47) to clarify the guidance included inSFAS No. 143, “Accounting for Asset Retirement Obligations”. FIN 47requires companies to recognize a liability for the fair value of a legalobligation to perform asset retirement activities that are conditional ona future event if the amount can be reasonably estimated. If amounts cannot bereasonably estimated, certain disclosures will be required about theunrecognized asset retirement obligations. The interpretation is required to beadopted in the first quarter of 2006. The Company does not expect the adoptionof FIN 47 to have a material effect on the consolidated financial statements.

 

In May 2005, SFAS No. 154,“Accounting Changes and Error Corrections – replacement of APB Opinion No. 20and FASB Statement No. 3,” was issued. SFAS No. 154 changes theaccounting for and reporting of a change in accounting principle by requiringretrospective application to prior periods’ financial statements of changes inaccounting principle unless impracticable. SFAS No. 154 is effective foraccounting changes made in fiscal years beginning after December 15, 2005.The Company does not expect the adoption of SFAS No. 154 to have amaterial impact on its results of operations, financial position or cash flows.

 

In June 2005, the EITFreached consensus on Issue No. 05-2, “The Meaning of ‘ConventionalConvertible Debt Instrument’ in EITF Issue No. 00-19, ‘Accounting forDerivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock.’” Issue 00-19 is used to evaluate whether embeddedderivatives should be bifurcated under SFAS No. 133, “Accounting ForDerivative Instruments And Hedging Activities”, as amended. Specifically, SFAS133 provides guidance as to when an issuer is required to bifurcate aconversion option that is embedded in convertible debt. However, Issue 00-19does not define “conventional convertible debt instrument.” Given thedevelopment of numerous contractual terms that may be included in aconvertible debt instrument, it is not clear when a convertible debt instrumentis “conventional.”  We do not believethat our redeemable preferred stock and related warrants meet the definition ofconventional convertible debt and as a result Issue No. 00-19 applies tothe liability treatment of these instruments. The Company is evaluating theeffect that adoption of the Issue will have on its financial position orresults of operations in future periods.

 

In June 2005, the EITFreached consensus on Issue No. 05-6, “Determining the Amortization Periodfor Leasehold Improvements.”  EITF 05-6provides guidance on determining the amortization period for leaseholdimprovements acquired in a business combination or acquired subsequent to leaseinception. The guidance in EITF 05-6 will be applied prospectively and is effectivefor periods beginning after June 29, 2005. EITF 05-6 did not have to havea material impact on the Company’s financial position or results of operations.

 

In September 2005, the EITF reached consensuson Issue No. 04-13, “*Accounting forPurchases and Sales of Inventory with the Same Counterparty,”* that inventory purchases and salestransactions with the same counterparty that are entered into in contemplationof one another should be combined for purposes of applying APB Opinion No. 29,“*Accounting for Nonmonetary Transactions.”* The effect reduces reported revenues and costof sales for affected transactions. The consensus on this issue would apply tosuch transactions beginning in the second quarter 2006. The Company isevaluating the effect of EITF 04-13 on its consolidated financial statements.

 

In September 2005, theFASB ratified the EITF Issue No. 05-7, “Accounting for Modifications toConversion Options Embedded in Debt Instruments and Related Issues,” whichaddresses whether a modification to a conversion option that changes its fairvalue effects the recognition of interest expense for the associated debtinstrument after the modification, and whether a borrower should recognize abeneficial conversion feature, not a debt extinguishment, if a debtmodification increases the intrinsic value of the debt (for example, themodification

 

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reduces the conversion price of the debt). Theadoption of the Issue may have a material effect on our consolidatedfinancial position or results of operations in future periods.

 

In September 2005, theFASB also ratified the EITF’s Issue No. 05-8, “Income Tax Consequences ofIssuing Convertible Debt with a Beneficial Conversion Feature,” which discusseswhether the issuance of convertible debt with a beneficial conversion featureresults in a basis difference arising from the intrinsic value of thebeneficial conversion feature on the commitment date (which is treated recordedin the stockholder’s equity for book purposes, but as a liability for incometax purposes) and, if so, whether that basis difference is a temporarydifference under SFAS No. 109, “Accounting for Income Taxes.”  The adoption of the Issue is not expected tohave a material effect on our consolidated financial position or results ofoperations in future periods.

 

InFebruary 2006, the FASB issued SFAS No. 155 “Accounting for CertainHybrid Financial Instruments, an amendment of FASB Statements No. 133 and140” (“SFAS 155”). SFAS 155 clarifies certain issues relating to embeddedderivatives and beneficial interests in securitized financial assets. Theprovisions of SFAS 155 are effective for all financial instruments acquired orissued after fiscal years beginning after September 15, 2006. The Companyis currently assessing the impact that the adoption of SFAS 155 will have onits results of operations and financial position.

 

In March 2006, the FASB issued SFAS No. 156,“Accounting for Servicing of Financial Assets” (“SFAS 156”), whichamends SFAS 140, “Accounting for Transfers and Servicing of Financial Assetsand Extinguishments of Liabilities”, with respect to the accounting forseparately recognized servicing assets and servicing liabilities. SFAS 156 permits the choice of the amortization method or the fairvalue measurement method, with changes in fair value recorded in income, forthe subsequent measurement for each class of separately recognizedservicing assets and servicing liabilities. The statement is effective foryears beginning after September 15, 2006, with earlier adoptionpermitted. The Company is currently evaluating the effect thatadopting this statement will have on the Company’s financialposition and results of operations.

 

**6. Inventories**

 

Inventories as of December 31,2004 and 2005 are summarized as follows:

 
| ** **                                        | ** ** | **2004** | ** ** | **2005** | ** ** |
|---------------------------------------------------|------------|----------|------------|----------|------------|
| Raw material (from discontinued operations)       |       | $        | 1,622      |     | $          | 0 |   |
| Finished goods (from continuing operations)       |       | 46       |       | 2,878    |       |
| Total Inventory                                   |       | 1,668    |       | 2,878    |       |
| Inventory Reserve (from discontinued  operations) |       | (1,622   | )          | 0        |       |
| Inventory, net                                    |       | $        | 46         |     | $          | 2,878 |   |

 

**7. Propertyand Equipment**

 

Propertyand equipment consist of the following at December 31, 2004 and 2005:

 
| ** **                                      | ** ** | **2004** | ** ** | **2005** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
| Computer equipment and system packages          |       | $        | 1,034      |     | $          | 1,079 |   |
| Office equipment                                |       | 211      |       | 225      |       |
| Furniture and fixtures                          |       | 625      |       | 714      |       |
| Hardware, software and tooling                  |       | 856      |       | 1,160    |       |
| Leasehold improvements                          |       | 804      |       | 906      |       |
|                                            |       | 3,530    |       | 4,084    |       |
| Less accumulated depreciation and  amortization |       | (1,815   | )          | (2,508   | )          |
| Property and equipment, net                     |       | $        | 1,715      |     | $          | 1,576 |   |

 

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Depreciationand amortization on property and equipment in the amount of $742, $477 and $693was recorded for each of the three years ended December 31, 2003, 2004 and2005, respectively.

 

**8. WarrantyReserve**

 

Weprovide a warranty covering defects arising from the sales of our video phoneproduct. This warranty is limited to a specific time period. The Companyestablished an initial reserve of $336 that is based on a percentage of productsales. As of December 31, 2005, the Company has not incurred any materialwarranty costs related to our product. Warranty costs are charged to cost ofrevenues when they are probable and reasonably estimable. While we believe ourestimate at December 31, 2005 is reasonable and adequate, it is subject tochange based on our future sales and experience, which may require anincrease or decrease in our reserve.

 

**9. FinancingAgreements**

 

During2005, the Company financed its Directors and Officers’ Insurance Policy for thepolicy period ending April 15, 2006. As of December 31, 2005, theremaining unpaid portion of the note payable had been paid in full. Theweighted average interest rate on this financing was 5.99%. At December 31,2004, the Directors and Officers’ Insurance Policy for the policy period ended April 15,2005 was also financed. At December 31, 2004 the remaining unpaid portionof that note payable totaled $37. This balance was paid subsequent to that yearend. The weighted average interest rate on the outstanding note payable for theyear ended December 31, 2004 was 4.25%.

 

**10. IncomeTaxes**

 

Thesignificant components of deferred tax assets at December 31, 2004 and2005 are as follows:

 

| ** **                                               | ** ** | **2004**   | ** ** | **2005**   | ** ** |
|----------------------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Federal tax loss carryforward                            |       | $          | 64,993     |       | $          | 69,713 |   |
| State tax loss carryforward                              |       | 10,354     |       | 11,961     |       |
| Property and equipment                                   |       | 157        |       | (188       | )          |
| Research and experimentation credit                      |       | 2,739      |       | 3,019      |       |
| Officers’ compensation, accrued expenses  and other |       | 469        |       | 627        |       |
| Inventory                                                |       | 0          |       | 166        |       |
|                                                     |       | 78,712     |       | 85,298     |       |
| Less: valuation allowance                                |       | (78,712    | )          | (85,298    | )          |
|                                                     |       | $          | 0          |       | $          | 0 |   |

 

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, 2005, the Company had a net operating loss carryforward ofapproximately $205,039 for federal tax purposes, expiring between 2012 and 2025if not utilized. The net operating loss carryforward for state tax purposes isapproximately $119,724, which will expire through 2025. 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 $3,019 and$52, respectively. The federal research and experimentation creditcarryforwards expire between 2012 and 2025 and the state research andexperimentation credit carryforward expires 2017. The Company’s ability toutilize its net operating loss carryforwards and credit carryforwards may besubject to annual limitations as a result of prior or future changes inownership and tax law as defined under Section 382 of the Internal RevenueCode of 1986. Such limitations are based on the market value of the Company atthe time of ownership change multiplied by the long-term exempt note suppliedby the Internal Revenue Service

 

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

 

*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 andto determine 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 theCompany. At December 31, 2005 there were 500 shares of redeemablepreferred stock outstanding.

 

*RedeemablePreferred Stock*

 

In June 2004, WorldGatecompleted a private placement of preferred stock. The Preferred Stock has adividend rate of 5% per annum, payable quarterly, either by cash or through theissuance of common stock at the Company’s option. The Preferred Stock has astaged maturity over three years with one-third of the Preferred Stock to beredeemed after 18 months, one-third after 24 months and one-third after 36months, and may be redeemed at maturity in cash or, at the Company’soption, subject to certain conditions that may not be solely under thecontrol of the Company, through the issuance of the number of shares of commonstock determined by dividing the liquidation preference of the preferred sharesby the then current market price. 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 redemption of the preferred stock with cash instead of its common shares.Furthermore, since the market price of the Company’s common stock cannot bepredicted, the actual number of shares of the Company’s common stock that willbe required if a redemption is made through the issuance of common stock, canalso not be predicted. The private placement includes numerous provisionsintended to protect these institutional investors including a cash paymentpenalty of 1.0% per month for unredeemed preferred shares once registration ofthe shares lapse and until the registration again becomes effective. Aregistration statement for these securities was originally filed containingfiscal 2003 financial statements, and an amendment to this registrationstatement which would include fiscal 2005 financial statements has not yet beenfiled. Similarly the amount of the cash penalties may not be determinableuntil such time as the event triggering the cash payment is cured or removed.

 

The Preferred Stock hasembedded conversion options. Specifically, the holders of the Preferred Stock may converttheir shares into the Company’s common stock at a conversion price of $2.35 pershare. In addition the Company may force conversion of the Preferred Stockinto common stock if the Company achieves certain price targets for its commonstock and 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 or sale. Accordingly,the number of common shares issuable upon the conversion of the preferredshares cannot be predicted. Furthermore, net-cash settlement may berequired in the event of conversion default under certain circumstances that may notbe solely under the control of the Company. 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 requiredto settle a conversion of the preferred stock with cash instead of its commonshares.

 

 Also as part ofthe private placement the Company issued five-year warrants to purchase up to803,190 shares of our common stock at an exercise price of $2.69 per share andfive-year warrants to purchase up to 803,190 shares of our common stock at anexercise price of $3.14 per share. The investors also received an additionalinvestment right, for a limited period of time, to purchase 1,606,383additional shares of common stock shares at $3.14 a share. This exercise priceof the warrants is subject to adjustment if, at any time after the date thewarrants were issued, the Company issues or sells, or is deemed to have issuedor sold, any shares of the Company’s common stock for per share considerationless than the exercise price of the warrants on the date of such issuance orsale. Accordingly, the number of common shares that will be issued upon theexercise of the warrants cannot be predicted. As of December 31, 2005,125,000 warrants exercisable at $2.69 had been exercised and 51,915 warrants

 

F-24

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exercisable at $3.14 had been exercised. All of theadditional investment rights had been exercised as of December 31, 2005.

 

Of the 7,550 preferredshares issued under this private placement, 6,275 shares were converted intocommon stock during the year ended December 31, 2005 and all but 500shares have been redeemed as of December 31, 2005.In January 2006 an additional 167 shareswere converted.

 

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 certain redemptionfeatures that may be triggered by events that are not solely within thecontrol of the Company, such as a potential failure in the Company’s ability tomaintain an effective registration statement. Furthermore, the actual number ofshares of common stock required to satisfy redemption is based upon the marketvalue of the common stock at the time of the redemption, which cannot bepredicted. Accordingly, the Company has classified the preferred stock astemporary equity and the value ascribed to the redeemable preferred stock uponinitial issuance, i.e. at June 24, 2004, was the amount received in thetransaction 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, 2005 was $379.

 

The terms of the preferredstock include 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 include certain provisions that could result in avariable number of shares to be issued upon conversion, adjustment to thestrike price at which conversion shares will be determined, or the requirementfor the Company to settle the conversion options in cash. EITF 00-19, “Accountingfor Derivative Instruments Indexed to, and Potentially Settled in, a Company’sOwn Stock”, states that if the conversion options require net cash settlementin the event of circumstances that are not solely within the Company’s controlthey should be classified as a liability measured at fair value on the balancesheet.

 

The terms of the five-yearwarrants include cash penalty provisions in the event that the Company fails tomeet its obligations to deliver registered shares to the warrant holder uponexercise and an anti-dilution provision that could result in a variable numberof shares to be issued upon warrant exercise. Additionally, the terms andconditions of the warrants provide for net settlement via cashless exercisewhereby the shares delivered to the warrant holder would be readily convertibleto cash. In accordance with EITF 00-19 and given the terms and conditions ofthe warrants as outlined above, the Company has classified the warrants as aliability on its balance sheet measured at fair value using the Black-Scholesoption 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 common stock prices, applicable volatilityrates, and the period close risk-free interest rate for the instrument’sexpected remaining life (continuously compounded), are the key assumptions usedin the valuation calculation. The WorldGate share price changed from $4.99 pershare as of December 31, 2004 to $2.06 per share at December 31, 2005making the warrants and preferred stock conversion elements less valuable, andtherefore less costly relative to their strike price. The result was a $8,594gain for the year ended December 31, 2005.

 

*Warrants*

 

InAugust 2000, the Company issued warrants to the TVGateway partners as part ofthe TVGateway Joint Venture more fully described in Note 14. Thesewarrants may be exercised to purchase in the aggregate up to 1,500,000shares of common stock at an exercise price of $24.78 and up to 500,000additional shares of common stock at an exercise price of $12.39. The warrantswere subject to vesting at varying rates based on the deployment of the Company’sdiscontinued Internet TV service on each operator’s digital cable systems. On September 30,2003, 1,000,000 warrants were cancelled. At December 31, 2005, none of theremaining warrants have vested.

 

F-25

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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, 2005, 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.

 

Inconnection with the June 2004 private placement the Company issuedfive-year warrants to purchase up to 803,190 shares of our common stock at anexercise price of $2.69 per share and five-year warrants to purchase up to803,190 shares of our common stock at an exercise price of $3.14 per share. Theinvestors also received an additional investment right, for a limited period oftime, to purchase 1,606,383 additional shares of common stock shares at $3.14 ashare. 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 beissued upon the exercise of the warrants cannot be predicted. As of December 31,2005, 125,000 warrants exercisable at $2.69 had been exercised and 51,915warrants exercisable at $3.14 had been exercised. All of the additionalinvestment rights had been exercised as of December 31, 2005.

 

Inconnection with the December 2003 and January 2004 privateplacements, we issued 1,020,000 warrants and 10,000 additional investment rightsto purchase shares of common stock. For the December 2003 transactions thewarrants had an exercise price of $1.00 per share and the additional investmentrights were priced at $0.80 per share. For the January 2004 transactionthe warrants had an exercise price of $1.875 per share and the additioninvestment rights were priced at $1.50 per share. In addition, if the sellingsecurity holders exercise their additional investment rights, we will beobligated to issue additional warrants to purchase our common stock at anexercise price of $1.00 per share and $1.875 per share, respectively, for the December 2003and the January 2004 transactions.

 

Included with general andadministrative expenses in 2003 and 2004 were $117 and $608, respectively, ofexpenses relating to the valuation of warrants and options issued in 2003 and2004 for investment advice and services. These valuations were determined byusing the Black-Scholes fair value option valuation model. The followingassumptions were used for the warrants: expected volatility of 100% for 2003and 65% for 2004; average risk-free interest rates of 1.0% for 2003 and 3.20%for 2004; dividend yields of 0% and 0%; and expected lives of up to 5.0 yearsfor both valuations. For the twelve months ended December 31, 2003, werecorded $77 of expense to continuing operations. Included in discontinuedoperations 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 ata sales price of $2.40 per shares, which resulted in additional gross proceedsto the Company of $500. In connection with this placement the Company grantedwarrants to Mr. Chou to purchase up to 62,500 shares of our common stockat an exercise price of $2.88 per share.

 

 In August 2005, the Company completed aprivate placement for $17,500 of its common stock and warrants with severalinstitutional investors. The Company issued 4,666,664 shares of its commonstock at $3.75 per share to the participating investors. The Company alsoissued five-year warrants to purchase a total of 1,671,947 shares of its commonstock: 1,633,333 shares to the investors at an exercise price of $5.00 pershare, and 38,614 shares to the placement agent at an exercise price of $4.53per share. The investors also received an additional investment right, fora period of 60 days from the time the shares become registered, to purchase1,554,000 additional shares of common stock at $4.12 per share. The accountingfor these warrants and investment rights is established by analogy to APB No. 14“Accounting for Convertible Debt and Debt Issued with Stock Purchase

 

F-26

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Warrants,”which addresses detachable stock purchase warrants issued in conjunction withconvertible debt and prescribes that such warrants be accounted for asadditional paid in capital measured at fair value.

 

Asof December 31, 2004 and 2005, respectively, there were a total of4,427,266 and 6,297,195 warrants outstanding.

 

*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 is granted(110% of fair value in certain instances). The option price of NQSOs may begreater than, equal to, or less than the fair market value on the date theoption 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 ISOs and NQSOs, the new plan also provides forperformance based awards and restricted stock.

 

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 fromthe date of grant, and for ISOs, in certain instances, may not exceed fiveyears. The options granted under this plan vest ratably over a four-year periodfrom the date of grant. As of December 31, 2005 there were 1,974,667shares available to grant under the Plan.

 

The weighted-average fairvalues of the options granted were $0.50, $1.16 and $1.56 per option during theyears ended December 31, 2003, 2004 and 2005, respectively. The fair valueof each option grant is estimated on the date of grant using the Black-Scholesfair value option valuation model. The following weighted-average assumptionswere used for grants in 2003, 2004 and 2005, respectively: expected volatilityof 100%, 90% and 58%; average risk-free interest rates of 2.96%, 2.97% and4.23%; dividend yield of 0%; and expected lives of 3.8, 4.0 and 4.0 years.

 

Asummary of the Company’s stock plan is presented below:

 
| ** **                          | ** ** | **Stock Options** | ** ** | **Weighted-  Average  Exercise Price** | ** ** |
|-------------------------------------|------------|-------------------|------------|----------------------------------------|------------|
|                                |       |              |       |                                   |       |
| 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       |   |
|                                |       |              |       |                                   |       |
| Granted                             |       | 494,292           |       | $                                      | 3.21       |   |
| Exercised                           |       | (373,352          | )          | $                                      | 2.20       |   |
| Cancelled/forfeited                 |       | (176,602          | )          | $                                      | 4.55       |   |
| Outstanding, December 31, 2005 |       | 4,481,015         |       | $                                      | 1.94       |   |

 

F-27

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Thefollowing table summarizes information about stock options outstanding at December 31,2005:

 
| ** **                   | ** ** | **Stock Options Outstanding** | ** ** | ** **                                        | ** ** |
|------------------------------|------------|-------------------------------|------------|---------------------------------------------------|------------|
| ** **                   | ** ** | ** **                    | ** ** | **Weighted-**                                     | ** ** | ** ** | ** ** | **Stock Options Exercisable** | ** ** |
| **Range of Exercise Prices** | ** ** | **Shares**                    | ** ** | **Average  Remaining  Contractual  Life (Years)** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** |
| $0.24 - $0.39                |       | 306,525                       |       | 7.17                                              |       | $ | 0.37 |   | 148,271 |   | $ | 0.37 |   |
| $0.40 - $0.59                |       | 1,288,142                     |       | 7.74                                              |       | 0.54 |   | 713,892 |   | 0.54 |   |
| $0.60 - $0.89                |       | 29,749                        |       | 3.37                                              |       | 0.71 |   | 24,749 |   | 0.72 |   |
| $0.90 - $1.34                |       | 779,250                       |       | 7.97                                              |       | 1.06 |   | 204,375 |   | 1.07 |   |
| $.1.35 - $2.01               |       | 395,378                       |       | 6.27                                              |       | 1.73 |   | 314,238 |   | 1.76 |   |
| $2.02 - $3.02                |       | 1,052,832                     |       | 7.10                                              |       | 2.59 |   | 637,330 |   | 2.63 |   |
| $3.03 - $4.53                |       | 437,960                       |       | 8.37                                              |       | 4.23 |   | 114,171 |   | 4.42 |   |
| $4.54 - $6.80                |       | 116,077                       |       | 6.90                                              |       | 5.91 |   | 63,677 |   | 6.34 |   |
| $6.81 - $10.20               |       | 40,000                        |       | 5.13                                              |       | 8.25 |   | 40,000 |   | 8.25 |   |
| $10.21 - $15.30              |       | 0                             |       | 0                                                 |       | 0 |   | 0 |   | 0 |   |
| $15.31 - $22.95              |       | 31,046                        |       | 4.10                                              |       | 20.43 |   | 31,046 |   | 20.43 |   |
| $22.96 - $34.43              |       | 4,056                         |       | 4.51                                              |       | 28.61 |   | 4,056 |   | 28.61 |   |
|                         |       | 4,481,015                     |       | 7.42                                              |       | $ | 1.94 |   | 2,295,805 |   | $ | 2.13 |   |

 

*EmployeeStock Purchase Plan*

 

InOctober 2001, our stockholders 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 StockPurchase Plan.

 

During 2004 and 2005, theCompany sold 48,832 and 16,639 shares of common stock under the Stock PurchasePlan for proceeds of $45 and $35, respectively

 

**12. Commitmentsand 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 November 2004the

 

F-28

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Company’s lease was amendedwith an effective date of June 2004 to reduce the lease obligation in linewith the Company’s then current space requirements, and to bring the Companycurrent with respect to all outstanding back rent. Total rent expense resultingfrom this lease obligation for the years ended December 31, 2003, 2004 and2005, amounted to approximately $957, $1,027 and $218, respectively. The rentexpense for 2004 of $1,027 includes $785 of unpaid rent that was cancelled as aresult of a lease amendment entered into November 2004 with an effectivedate of June 2004. This cancellation is included in total interest andother income in our consolidated financial statements. Subsequently, GMAC soldthe building and we have negotiated a new lease with the new owner on September 1,2005. The current lease covers 42,500 square feet at an annual rate of $11.40per square foot with a 3% increase annually, cancelable by either party with 8months notice, with a termination by tenant also including six monthstermination fee. Total rent expense resulting from this lease for the yearended December 31, 2005 amounted to approximately $212.

 

InNovember 2003, the Company entered into a 60 month lease for officeequipment. As of December 31, 2005 there remains a total of $14 to be paidover the remaining period of this lease. In October 2005, the Companyentered into a 36 month lease for office equipment. As of December 31,2005 there remains a total of $21 to be paid over the remaining period of thislease.

 

*Disclosureof Contractual Obligations*

 

The future minimum contractual rental commitmentsunder non-cancelable leases for each of the fiscal years ending December 31are as follows:

 
| ** ** | ** ** | **(Dollars in  Thousands)** | ** ** |
|------------|------------|-----------------------------|------------|
| 2006       |       | $                           | 503        |   |
| 2007       |       | 517                         |       |
| 2008       |       | 530                         |       |
| 2009       |       | 535                         |       |
| 2010       |       | 363                         |       |
| Total      |       | $                           | 2,448      |   |

 

**13. SignificantAgreements and Transactions**

 

Netrevenues from continuing operations recognized from General Instrument, aninvestor, were approximately $0, $231 and $3,815, respectively, for the yearsended December 31, 2003, 2004 and 2005, respectively. This investoraccounted for approximately 0%, 100% and 99% of the revenues for the yearsended December 31, 2003, 2004 and 2005, respectively. This investorpreviously provided a cash advance against product shipments. The balance ofthis advance received from this investor was $369 and $0 as of December 31,2004 and 2005, respectively. Accounts receivable from this investor were $0 asof December 31, 2004 and $123 at December 31, 2005. In April andSeptember 2004, we issued to this investor warrants to purchase shares ofour common stock, with the April warrants having an exercise price of$1.4375 per share and the September warrants having an exercise price of$1.75 per share. Included with General and Administrative expenses in September 2004were $606 of expenses relating to the valuation of these warrants. Thisvaluation was determined by using the Black-Scholes fair value option model.The following assumptions were used: expected volatility of 65%; averagerisk-free interest rate of 3.43 percent; dividend yield of 0%; and an expectedlife of 5.0 years.

 

OnApril 28, 2004, we entered into a six-year distribution agreement withGeneral Instrument for the marketing and distribution of our Ojo video phone.This agreement provides for General Instrument to be WorldGate’s exclusivedistributor of its broadband video phone products and for WorldGate to beGeneral Instrument ‘s exclusive supplier of its broadband video phone products.After a period of eighteen months following the commercial availability of theOjo video phone this mutual exclusivity will terminate unless GeneralInstrument elects to continue the mutual exclusivity after having achieved certainminimum sales targets for the Ojo video

 

F-29

----

 

phone. General Instrumentmay, however, at its option, elect to terminate this mutual exclusivity at anytime. In the event mutual exclusivity terminates or is terminated, then for atwelve month period thereafter, WorldGate will continue to be GeneralInstrument’s exclusive supplier of broadband video phones, but will be free tosell video phone products to customers other than certain defined GeneralInstrument accounts. During this twelve month period, General Instrument has aright of first refusal to accept and fill any orders for video phone productsthat WorldGate obtains from non- General Instrument accounts, and is obligatedto use good faith efforts to solicit and accept product orders from GeneralInstrument accounts in a commercially reasonable manner. During any period ofexclusivity under this agreement we are reliant upon General Instrument 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 General Instrument to provide forcertain marketing and promotional activities for the Ojo video phone, there areno required sales quotas for the agreement to remain in effect, and GeneralInstrument controls the volume of products being distributed by our Company.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. If General Instrument and its partners are not successful, or if theiractivities do not lead to significant sales of our product, our operatingresults will be adversely affected, our revenue could be significantly reducedand we could lose potential customers. In connection with the Development andDistribution Agreement with General Instrument, we issued warrants to GeneralInstrument to purchase 600,000 shares of our common stock, 300,000 at anexercise price of $1.4375 per share with the execution of the agreement in April 2004,and 300,000 at an exercise price of $1.75 upon the delivery to GeneralInstrument of acceptable prototypes for the product. Additionally, we agreed toissue warrants to purchase up to an additional 1,650,000 shares of our commonstock, upon the achievement of certain sales milestones, at an exercise pricebased upon the average closing sales price of our common stock during the 20day period preceding the issuance of each warrant.

 

On February 17, 2006, we mutually agreed withGeneral Instrument to end our mutually exclusive distribution agreement. Theending of this agreement immediately terminated this exclusivity for bothparties, and accordingly enabled WorldGate to expand its focus in bringing Ojoto the marketplace. In addition to its current role for development andmanufacture of Ojo, WorldGate became directly responsible for the advertising,marketing, and distribution of its products.

 

TheCompany has a current two year agreement with Mototech, an investor, to providethe Company with engineering and development support. As a result of thisagreement, the Company has expensed approximately $100, $59 and $427,respectively for the twelve months ended December 31, 2003, 2004 and 2005.Accounts payable to this investor amounted to $117 and $1,173 at December 31,2004 and December 31, 2005, respectively. This agreement provided forcontracted services, including hardware and software development, and thecreation and development of tools to facilitate the Company’s engineeringefforts. This agreement does not provide for ongoing royalties, purchaseprovisions, or for any requirement to provide additional funding to theCompany.

 

InJune 2004, WorldGate completed a private placement of 7,550 shares ofPreferred Stock at a stated value of $1,000 per share. The Preferred Stock hasattached warrants and conversion options. Specifically, the holders of thePreferred Stock may convert their shares into our common stock at a conversionprice of $2.35 per share. The private placement includes numerous provisionsintended to protect these institutional investors including a cash paymentpenalty of 1.0% per month for unredeemed preferred shares once registration ofthe shares lapse and until the registration again becomes effective. Aregistration statement for these securities was originally filed containingfiscal 2003 financial statements, and an amendment to this registrationstatement which would include fiscal 2005 financial statements has not beenregistered and until such time as the shares become registered the Company issubject to the penalty provision under this private placement.

 

In August 2005, theCompany completed a private placement for $17,500 of its common stock andwarrants with several institutional investors. The Company issued 4,666,664shares of its common stock at $3.75 per share to the participating investors.The Company also issued five-year warrants to purchase a total of 1,671,947shares of its common stock: 1,633,333 shares to the investors at an exerciseprice of $5.00 per share, and 38,614 shares to the placement agent at anexercise price of $4.53 per share. The investors also received an additionalinvestment right, for a limited period of time, to purchase 1,554,000additional shares of common stock at $4.12 per share. The private placementincludes numerous provisions intended to protect these institutional investorsincluding a cash payment penalty of 1.5% per month for the period above120 days from the effective date of the Agreement that the shares inthe transaction fail to be registered. On December 31, 2005 the sharesunder this

 

F-30

----

 

private placement had not been registered and untilsuch time as the shares become registered the Company is subject to the penaltyprovision under this private placement. As of December 31, 2005 theCompany has recorded accrued penalties of $525,000.

 

**14. TVGatewayJoint 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, operations andadministrative support services. In addition to providing for the terms andconditions under which such services were to be provided, the managementagreement provided for WorldGate and TVGateway to cooperate to transition toTVGateway some or all of the support services being provided by WorldGateand/or the employees providing these services. In addition, this provisionrequired WorldGate to remain available to provide support services until July 24,2005. During 2002 WorldGate and TVGateway agreed to commence the transition ofservices pursuant to this provision. In addition, the parties agreed that themanagement agreement would be of no further force and effect with respect tothe services that are transferred as of the date of completion of the specifictransfers. The companies completed this transition in first quarter 2003, andaccordingly, WorldGate has now been relieved of any continuing obligation toprovide such transitioned services. WorldGate no longer receives revenues fromthe management agreement with TVGateway.

 

Revenuesfor such services, which are included in service fee revenue, totaled $794 and$0, for the twelve months ended December 31, 2003 and 2004 (included indiscontinued operations), respectively. In addition, product sales to TVGatewaytotaled $1,078 and $0 for the twelve months ended December 31, 2003 and2004, respectively (included in discontinued operations). Accounts receivablefrom TVGateway amounted to $0 at December 31, 2004 and $0 at December 31,2003. WorldGate was accounting for its 18% investment in the TVGateway jointventure, which was previously reduced to a carrying value of $0 due to priorlosses, under the equity method.

 

OnSeptember 30, 2003 the Company announced that it had sold to TVGateway,LLC certain ITV intellectual property rights and certain software and equipmentrelated to the ITV business, which TVGateway was currently using, for $2,400. Inaddition, on August 7, 2003, WorldGate and TVGateway entered into aredemption agreement pursuant to which TVGateway redeemed WorldGate’s equityinterest in TVGateway for $600 in cash. The purchase price for these assets inthe aggregate was $3,000 and was used by the Company to fund continuingoperations, as well as to develop and distribute its new Ojo video telephonyproduct. As part of this transaction WorldGate retained a royalty-freelicense to certain of the transferred intellectual property rights andsoftware. At this time the Company has completely exited from the 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. Our indemnificationobligations are limited by an overall cap of $500 on the amount of theindemnification. Although we know of no breaches of our representations orwarranties and the initial twelve-month period has expired, the payment of anysuch indemnification obligations would adversely impact our cash resources andour ability to pursue our video phone business.

 

**15. EmployeeBenefit 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 fordiscretionary Company matching contributions and discretionary Companyprofit-sharing contributions. Contributions are invested, in such proportionsas the employee may elect in any of 10 mutual investment funds. In

 

F-31

----

 

2003, the Company made nodiscretionary 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. As of December 31,2005, the Company has made no matching or discretionary profit-sharing contributionsto the plan.

 

**16. Supplementaldisclosure of cash flow information**

 
| ** **                                                                   | ** ** | **Year ended December 31,** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                   | ** ** | **2003**                         | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                                                   | ** ** | **(dollars in thousands)**       | ** ** |
| Cash paid for interest                                                       |       | $                                | 15         |   | $ | 6 |   | $ | 6 |   |
|                                                                         |       |                             |       |   |   |   |   |
| **Non-cash  investing and financing activities:**                            |       |                             |       |   |   |   |   |
| Settlement  of contractual obligation related to equity financing            |       | 3,283                            |       | 0 |   | 0 |   |
| Issuance of  common stock in payment for product development                 |       | 600                              |       | 0 |   | 0 |   |
| Issuance of  notes payable for Directors and Officers’ insurance policy |       | 560                              |       | 328 |   | 294 |   |
| Accretion on  preferred stock                                                |       | 0                                |       | 763 |   | 682 |   |
| Conversion  of preferred stock to common                                     |       | 0                                |       | 775 |   | 6,275 |   |
| Dividends  accrued on preferred stock                                        |       | 0                                |       | 85 |   | 137 |   |
| Deemed  dividend on conversion of preferred stock                            |       | 0                                |       | 0 |   | 3,102 |   |
| Common stock  issued for accrued dividends                                   |       | 0                                |       | 103 |   | 217 |   |
| Cancellation  of treasury stock shares                                       |       | 0                                |       | 5 |   | 0 |   |
|                                                                              |            |                                  |            |  |  |  |  |  |  |  |

 

**17. DiscontinuedOperations**

 

Duringthe first quarter of 2004, the Company decided to transition from the businessof developing and selling ITV technology, products and services for use inconjunction with cable TV broadband networks (the “ITV business”) to thedevelopment of videophone products. In accordance with SFAS No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets”, all assets related to theITV business have been written down to their net realizable value. Relatedoperating results of the ITV business have been reported as discontinuedoperations for all years presented.

 

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

 
| ** **                        | ** ** | **For the Twelve-Month Period  ended  December 31,** | ** ** |
|-----------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                        | ** ** | **2003**                                                  | ** ** | **2004** | ** ** | **2005** | ** ** |
| Revenues                          |       | $                                                         | 3,886      |   | $ | 82 |   | $ | 0 |   |
| (Loss) income before income taxes |       | (2,908                                                    | )          | 36 |   | 0 |   |
|                                   |            |                                                           |            |  |  |  |  |  |  |  |

 

F-32

----

 

**18. SupplementalQuarterly Data (unaudited)**

 
| ** **                                                                     | ** ** | **First**                                                | ** ** | **Second**     | ** ** | **Third**      | ** ** | **Fourth** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|----------------|------------|----------------|------------|------------|------------|
| ** **                                                                     | ** ** | **(dollars in thousands  other than per share amounts)** | ** ** |
| ** **                                                                     | ** ** | ** **                                               | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** | ** ** | ** ** |
| 2005                                                                           |       |                                                     |       |           |       |           |       |       |       |
| Net revenues                                                                   |       | $                                                        | 179        |           | $          | 1,399          |       | $          | 2,290      |   | $ | (2,310 | ) |
| Loss from  operating activities of continuing operations                       |       | (2,648                                                   | )          | (2,938         | )          | (3,444         | )          | (7,127     | )          |
| Change in  fair value of warrants and conversion options                       |       | 5,176                                                    |       | 1,633          |       | 1,165          |       | 620        |       |
| Other income  (expense) - net                                                  |       | 66                                                       |       | 106            |       | 288            |       | 252        |       |
| Income  (loss) from continuing operations                                      |       | 2,594                                                    |       | (1,199         | )          | (1,991         | )          | (6,255     | )          |
| Income from  discontinued operations                                           |       | 0                                                        |       | 0              |       | 0              |       | 0          |       |
| Net income  (loss)                                                             |       | 2,594                                                    |       | (1,199         | )          | (1,991         | )          | (6,255     | )          |
| Accretion on  preferred stock, dividends and deemed dividends                  |       | (495                                                     | )          | (2,175         | )          | (656           | )          | (596       | )          |
| Net income  (loss) available to common stockholders                            |       | 2,099                                                    |       | (3,374         | )          | (2,647         | )          | (6,851     | )          |
| Income  (loss) from continuing operations per common share:                    |       |                                                     |       |           |       |           |       |       |       |
| Basic                                                                          |       | 0.08                                                     |       | (0.04          | )          | (0.05          | )          | (0.16      | )          |
| Fully  Diluted                                                                 |       | 0.07                                                     |       | (0.04          | )          | (0.05          | )          | (0.16      | )          |
| Income  (loss) from discontinued operations per share:                         |       |                                                     |       |           |       |           |       |       |       |
| Basic                                                                          |       | 0.00                                                     |       | 0.00           |       | 0.00           |       | 0.00       |       |
| Fully  Diluted                                                                 |       | 0.00                                                     |       | 0.00           |       | 0.00           |       | 0.00       |       |
| Net income  (loss) per common share:                                           |       |                                                     |       |           |       |           |       |       |       |
| Basic                                                                          |       | 0.08                                                     |       | (0.04          | )          | (0.05          | )          | (0.16      | )          |
| Fully  Diluted                                                                 |       | 0.07                                                     |       | (0.04          | )          | (0.05          | )          | (0.16      | )          |
| Income (loss)  available to common stockholders per common share:              |       |                                                     |       |           |       |           |       |       |       |
| Basic                                                                          |       | 0.07                                                     |       | (0.10          | )          | (0.07          | )          | (0.17      | )          |
| Fully  Diluted                                                                 |       | 0.05                                                     |       | (0.10          | )          | (0.07          | )          | (0.17      | )          |
|                                                                           |       |                                                     |       |           |       |           |       |       |       |
| 2004                                                                           |       |                                                     |       |           |       |           |       |       |       |
| Net revenues                                                                   |       | $                                                        | 0          |           | $          | 0              |       | $          | 106        |   | $ | 125 |   |
| Loss from  operating activities of continuing operations                       |       | (2,137                                                   | )          | (2,310         | )          | (3,175         | )          | (2,765     | )          |
| Change in  fair value of warrants and conversion options                       |       | 0                                                        |       | 348            |       | 1,623          |       | (12,062    | )          |
| Other income  (expense) - net                                                  |       | 6                                                        |       | 11             |       | 35             |       | 964        |       |
| Loss from  continuing operations                                               |       | (2,131                                                   | )          | (1,951         | )          | (1,517         | )          | (13,863    | )          |
| Income from  discontinued operations                                           |       | 23                                                       |       | 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 stockholders                                     |       | (2,108                                                   | )          | (1,975         | )          | (1,910         | )          | (14,383    | )          |
| Basic and  diluted loss from continuing operations per common share            |       | (0.08                                                    | )          | (0.07          | )          | (0.07          | )          | (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          | )          | (0.07          | )          | (0.49      | )          |
| Basic and  diluted net loss available to common stockholders per common share  |       | (0. 08                                                   | )          | (0.07          | )          | (0.07          | )          | (0.51      | )          |

 

F-33

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

 

On November 17, 2005,Grant Thornton LLP (Grant Thornton), our independent registered publicaccounting firm, advised the Company that it would not stand for re-appointmentfor the audit of the year ending December 31, 2005 and that it would beresigning as the Company’s independent auditor effective upon the completion ofits engagement which ended with the audit of the restatement described belowand the review of the Company’s financial statements included in its QuarterlyReport on Form 10-Q for the quarter ended September 30, 2005. Asstated in the Company’s Proxy Statement pursuant to Section 14(a) ofthe Securities Exchange Act of 1934, as filed on September 9, 2005 withthe SEC, the Company had withheld any decision as to the retention of anindependent registered public accounting firm for fiscal year 2005. The Companyhas elected to not seek the re-engagement of Grant Thornton.

 

On January 24, 2006,the Company filed amendments to and restatements of its financial statementsfor the years ended December 31, 2003 and 2004 as included in the Company’sAnnual Report on Form 10-K/A for the fiscal year ended December 31,2004, and the interim financial statements for the periods ended March 31,2004 through June 30, 2005 included in the Company’s Quarterly Reports on Form 10-Q.The report of independent registered public accounting firm issued by GrantThornton dated February 24, 2005 (except for Note 2 *Restatement No. 1* as to which thedate is August 24, 2005 and Note 3 *RestatementNo. 2* as to which the date is January 10, 2006 included inthe Company’s Annual Report on Form 10-K/A for the fiscal year ended December 31,2004 filed on January 24, 2006) contained no adverse opinion or disclaimerof opinion, and was not qualified or modified as to uncertainty, audit scope,or accounting principles, except for a modification related to an uncertaintyregarding the Company’s ability to continue as a going concern, and anexplanatory paragraph regarding two restatements of the Company’s consolidatedfinancial statements for the years ended December 31, 2003 and 2004.

 

During the fiscal yearsended December 31, 2003 and 2004, and any subsequent interim periodthrough the date hereof, there were no disagreements between the Company andGrant Thornton on any matter of accounting principles or practices, financialstatement disclosure or auditing scope or procedure, which disagreement(s), ifnot resolved to the satisfaction of Grant Thornton, would have caused it tomake reference to the subject matter of the disagreement(s) in connection withits reports.

 

On January 5, 2006, theAudit Committee of the Company’s Board of Directors engaged the firm of Marcum &Kliegman LLP (M&K) as the new independent registered public accountants toaudit the Company’s financial statements as of and for the period ended December 31,2005. During the Company’s two most recent fiscal years, and through January 5,2006, the Company has not consulted with M&K regarding the application ofaccounting principles to a specified transaction, either completed or proposed,or the type of audit opinion that might be rendered on the Company’s financialstatements nor has it consulted with M&K regarding any matter that waseither the subject of a disagreement, as that term is defined in Item 304(a)(1)(iv) of Regulation S-K and the related instructions to Item 304of Regulation S-K, or a reportable event, as that term is defined in Item304 (a)(1)(v) of Regulation S-K.

 

**Item 9A. Controls and Procedures**

 

(a) Disclosure Controls and Procedures. Wemaintain disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e) and15d-15(e)) that are designed to ensure that information required to be disclosedin reports that we file or submit under the Securities Exchange Act of 1934 isrecorded, processed, summarized, and reported within the time periods specifiedin the Securities and Exchange Commission’s rules and forms, and that suchinformation is accumulated and communicated to our management, including ourChief Executive Officer and Chief Financial Officer, as appropriate to allowtimely decisions regarding the required disclosures. In designing andevaluating the disclosure controls and procedures, we recognize that anycontrols and procedures, no matter how well designed and operated, can provideonly reasonable assurance of achieving the desired control objectives.

 

We carried out anevaluation, under the supervision and with the participation of management,including our Chief Executive Officer and Chief Financial Officer, of theeffectiveness of the design and operation of our disclosure controls andprocedures as of December 31, 2005. As discussed more fully in Management’sAnnual Report on Internal Control Over Financial Reporting set out below, basedon that evaluation, our Chief Executive Officer and Chief Financial Officerdetermined that we have a material weakness (as defined under the standards 

 

25

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established by the Public Company AccountingOversight Board) that exists with respect to our control procedure for theaccounting and reporting of complex financial transactions.

 

As previously reported inour Form 10-Q for the quarterly period ended September 30, 2005, weidentified material weaknesses in our control procedure for the accounting andreporting of complex financial transactions. These material weaknessescontributed to restatements of our financial statements in our annual andquarterly reports from the quarter ended March 31, 2004 through September 30,2005.

 

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 control procedures for the accountingand reporting of complex transactions, the Chief Executive Officer and ChiefFinancial Officer concluded that our disclosure controls and procedures are notdesigned and are not effective in ensuring that the information required to bedisclosed by our Company in the reports that we file and submit under theExchange Act is recorded, processed, summarized and reported within the timeperiods specified in the Commission’s rules and forms. Except asidentified above, there have been no changes in our internal control overfinancial reporting that occurred during the quarter ended December 31,2005, that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

 

(b) Management’s Annual Report on InternalControl Over Financial Reporting. Our management is responsible forestablishing and maintaining adequate internal control over financial reportingas defined in Rules 13a-15(f) under the Securities Exchange Act of1934. Our internal control over financial reporting is designed to providereasonable regarding the reliability of financial reporting and preparation offinancial statements for external purposes in accordance with generallyaccepted accounting principles.

 

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Therefore, even those systems determined to be effectivecan provide only reasonable assurance with respect to financial statementpreparation and presentation.

 

Management assessed theeffectiveness of our internal control over financial reporting as of December 31,2005. In making this assessment, management used the criteria set forth by theCommittee of Sponsoring Organizations of the Treadway Commission (“COSO”) inInternal Control - Integrated Framework. The assessment identified a materialweakness in that we did not have sufficient expertise in the accounting andreporting of complex transactions. A material weakness is a control deficiency,or 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.

 

During the period 2003through 2005 the Company secured capital through private sales of equitysecurities. These transactions involved security instruments and conditionscontaining intricate considerations. The accounting for these transactions iscomplex and requires the understanding of recent accounting pronouncements. Dueto the limited resources the Company has relied on, and continues to rely on,external consulting sources to provide accounting treatment guidance for thesetransactions. Given the nature and continuing evolvement of the accountingregulations governing these financial transactions there is no assurance thatthe external guidance provided to us by consultants on these transactions willbe correctly interpreted.

 

Based on management’sassessment, management concluded that, as of December 31, 2005, due solelyto the material weakness related our control procedure for the accounting andreporting of complex financial transactions, our internal control overfinancial reporting was not effective.

 

Management’s assessment ofthe effectiveness of internal control over financial reporting as of December 31,2005, has been audited by Marcum & Kliegman LLP (“M&K LLP”), theindependent registered public accounting firm who also audited our consolidatedfinancial statements. M&K LLP’s attestation report on management’sassessment of our internal control over financial reporting is contained below.

 

26

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(c) Attestation Report of IndependentRegistered Public Accounting Firm on Internal Control over Financial Reporting.

 

Report of IndependentRegistered Public Accounting Firm on Internal Control Over Financial Reporting

 

Tothe Audit Committee of

theBoard of Directors and Stockholders

WorldGateCommunications, Inc.

 

We have audited management’sassessment, included in the accompanying “Management’s Annual Report on InternalControl Over Financial Reporting”, that WorldGate Communications, Inc. andsubsidiaries (the “Company”) did not maintain effective internal control overfinancial reporting as of December 31, 2005, because of the effect of amaterial weakness in the Company’s internal control relating to reporting ofcomplex transactions, based on criteria established in Internal Control –Integrated Framework issued by the Committee of Sponsoring Organizations of theTreadway Commission (the “COSO” criteria). The Company’s management isresponsible for maintaining effective internal control over financial reportingand for its assessment of the effectiveness of internal control over financialreporting. Our responsibility is to express an opinion on management’s assessmentand an opinion on the effectiveness of the Company’s internal control overfinancial reporting based on our audit.

 

We conducted our audit inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform theaudit to obtain reasonable assurance about whether effective internal controlover financial reporting was maintained in all material respects. Our auditincluded obtaining an understanding of internal control over financialreporting, evaluating management’s assessment, testing and evaluating thedesign and operating effectiveness of internal control, and performing suchother procedures as we considered necessary in the circumstances. We believethat our audit provides a reasonable basis for our opinion.

 

A company’s internal controlover financial reporting is a process designed to provide reasonable assuranceregarding the reliability of financial reporting and the preparation offinancial statements for external purposes in accordance with generallyaccepted accounting principles. A company’s internal control over financialreporting includes those policies and procedures that (1) pertain to themaintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the company; (2) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made only in accordance with authorizations of management and directorsof the company; and (3) provide reasonable assurance regarding preventionor timely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

 

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Also, projections of any evaluation of effectiveness tofuture periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

 

27

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A material weakness is acontrol deficiency, or combination of control deficiencies, that results inmore than a remote likelihood that a material misstatement of the annual orinterim financial statements will not be prevented or detected. The followingmaterial weakness has been identified and included in management’sassessment:  management does not have thesufficient expertise in the accounting and reporting of complex transactions.This material weakness was considered in determining the nature, timing, andextent of audit tests applied in our audit of the 2005 consolidated financialstatements and financial statement schedule. Our report dated March 23,2006 on those consolidated financial statements and financial statementschedule, expressed an unqualified opinion, and also contains an explanatoryparagraph as to the Company’s ability to continue as a going concern.

 

In our opinion, management’sassessment that WorldGate Communications, Inc. and subsidiaries did notmaintain effective internal control over financial reporting as of December 31,2005, is fairly stated, in all material respects, based on the COSO criteria.Also, in our opinion, because of the effect of the material weakness describedabove on the achievement of the objectives of the control criteria, WorldGateCommunications, Inc. and subsidiaries have not maintained effectiveinternal control over financial reporting as of December 31, 2005, basedon the COSO criteria.

 

We do not express an opinionor any other form of assurance on management’s statements included in thefourth paragraph of the accompanying Management’s Annual Report on InternalControl Over Financial Reporting.

 
|   | /s/ Marcum & Kliegman LLP |   |
|--------|------------------------------------|--------|

 

Marcum & Kliegman LLP

Melville, New York

March 23, 2006

 

**Item 9B. Other Information.**

 

None

 

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**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 the disclosure requirementsunder Item 10 of Form 8-K regarding an amendment to, or waiver from, anyprovisions of our Code of Conduct by posting such information on our website atthe location specified above.

 

As of December 31, 2005our executive officers and directors are as follows:

 
| **Name**                        | ** ** | **Age** | ** ** | **Position**                                                    |
|---------------------------------|------------|---------|------------|-----------------------------------------------------------------|
| Hal M. Krisbergh                |       | 58      |       | Chairman of the Board of Directors and Chief  Executive Officer |
| Joel Boyarski                   |       | 59      |       | Vice President and Chief Financial Officer                      |
| Randall J. Gort                 |       | 56      |       | Vice President, Chief Legal Officer and Secretary               |
| James E. McLoughlin             |       | 53      |       | Vice President, Account Development and Marketing               |
| Richard Westerfer               |       | 47      |       | Vice President and Chief Operations Officer                     |
| Steven C. Davidson(2)           |       | 57      |       | Director                                                        |
| Clarence L. Irving, Jr.(1) |       | 50      |       | Director                                                        |
| Martin Jaffe(2)                 |       | 59      |       | Director                                                        |
| Jeff Morris(1)                  |       | 55      |       | Director                                                        |
| Lemuel Tarshis(2)               |       | 65      |       | Director                                                        |

 

----

(1)           Member of Compensation Committee

(2)           Member of Audit Committee

 

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. Krisbergh served as President of General Instrument’s CommunicationsDivision and, for the past 25 years, has been a well-known figure in the cableindustry. He is a recognized leader in the development of addressable cableboxes, impulse pay-per-view, opto-electronics and digital audio technologies.In 1991, Mr. Krisbergh received cable television’s prestigious Vanguardaward. Prior to joining General Instrument, Mr. Krisbergh was employed byW. 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 

 

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various divisions of the 3M Company, includingMedical and Surgical Products Divisions, Orthopedic Products Division,Electro-Mechanical Resources 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 Instrument (now a part ofMotorola, 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 November 2000,Mr. Jaffe was Chief Operating Officer of Donaldson, Lufkin &Jenrette Asset Management Group.

 

Jeff Morris has been amember of our board of directors since April 2001. Mr. Morris iscurrently Senior Vice President of Long Term Strategy & TechnologyDevelopment at Showtime Networks Inc. He has been in his current position sinceAugust 2005. Previously, Mr. Morris headed up Digital MediaConsulting, a new media consulting company. Prior to that Mr. Morris wasPresident and Chief Executive Officer of Yack, Inc., an Internet eventsand program guide. Mr. Morris is a veteran of the cable televisionindustry, including a previous tenure from 1984 through 1999 at ShowtimeNetworks, Inc., where his last position was Senior Vice President of NewMedia 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 eachquarter and at least once annually with our management and independent publicaccountants to review the scope of auditing procedures, our policies relatingto internal auditing and accounting 

 

30

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procedures and controls, and to discuss results ofthe annual audit of our financial statements. The Audit Committee is currentlycomposed of Dr. Tarshis, Mr. Davidson and Mr. Jaffe, each ofwhom is “independent” as such term is defined under Rule 4200(a)(15) ofthe NASDAQ listing standards. The Audit Committee also complies with thefinancial sophistication requirement under the NASDAQ listing standards. Inaddition, the Board has determined that Mr. Jaffe is an audit committeefinancial 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 2005 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.

 

**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, 2005, each of whose aggregatecompensation for fiscal 2005 exceeded $100,000, for services rendered in allcapacities for us and our subsidiaries.

 

**SummaryCompensation TableFiscal Years 2005, 2004 and 2003**

 
| ** **                                                           | ** ** | ** **       | ** ** | ** **                   | ** **               | ** **     | ** **             | **Long Term Compensation Awards** | ** **               |
|----------------------------------------------------------------------|------------|------------------|------------|------------------------------|--------------------------|----------------|------------------------|--------------------------------------------------|--------------------------|
| ** **                                                           | ** ** | ** **       | ** ** | ** **                   | ** **               | **Securities** | ** **             | ** **                                       | ** **               |
| ** **                                                           | ** ** | ** **       | ** ** | **Annual Compensation** | ** **               | **Underlying** | ** **             | **All Other**                               | ** **               |
| **Name and Principal Position**                       | ** ** | **Year**         | ** ** | **Salary**                   | ** **               | **Bonus**      | ** **             | **Options (#)**                             | ** **               | **Compensation** | ** ** |
|                                                                 |       |             |       |                         |                     |           |                   |                                             |                     |   |   |
| Hal M. Krisbergh  Chairman and Chief Executive Officer               |       | 2003  2004  2005 |       | $  $  $                      | 337,080  349,497 376,209 |           | —  —  81,512 |                                             | —  —  50,000   |   | —  —  — |   |
|                                                                 |       |             |       |                         |                     |           |                   |                                             |                     |   |   |
| Richard Westerfer  Vice President, Chief Operations Officer          |       | 2003  2004  2005 |       | $  $  $                      | 209,192  219,531 242,977 |           | $                      | —

 —  40,425                     |                     | 200,000  225,000  25,000 |   | —  —  — |   |
|                                                                 |       |             |       |                         |                     |           |                   |                                             |                     |   |   |
| Randall J. Gort  Vice President, Chief Legal Officer                 |       | 2003  2004  2005 |       | $  $  $                      | 200,000  207,385 226,147 |           | $                      | —  —  37,625                           |                     | 200,000  222,250  22,500 |   | —  —  — |   |
|                                                                 |       |             |       |                         |                     |           |                   |                                             |                     |   |   |   |   |
| Joel Boyarski  Vice President, Chief Financial Officer               |       | 2003  2004  2005 |       | $  $  $                      | 195,570  202,791 221,138 |           | —  —  36,792 |                                             | 200,000  195,000  20,000 |   | —  —  — |   |
|                                                                 |       |             |       |                         |                     |           |                   |                                             |                     |   |   |
| James McLoughlin

Vice  President, Account Development and Marketing |       | 2003  2004  2005 |       | $  $  $                      | 190,800 197,845  215,745 |           | $                      | —  —  35,894                           |                     | 161,500  195,000  20,000 |   | —  —  — |   |

 

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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 andperformance goals relating to any award; to determine whether, to what extent,and under what circumstances an award may be settled, canceled, forfeited,exchanged, or surrendered; to make adjustments in the performance goals inrecognition of unusual or non-recurring events affecting us or our financialstatements of WorldGate (to the extent not inconsistent with Section 162(m)of the Code, if applicable), or in response to changes in applicable laws,regulations, or accounting principles; to construe and interpret the plans andany award; to prescribe, amend and rescind rules and regulations relatingto the plans; to determine the terms and provisions of agreements evidencingawards; and to make all other determinations deemed necessary or advisable forthe administration of the plans. Generally, outstanding awards vest in equalinstallments over a four-year period. However, in no event may a stockoption be exercised more than ten years following the date of its grant,subject to acceleration 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 theincentive stock options may not have an option exercise price less thanthe fair market value of a share of common stock on the date of grant. Theoption exercise price is payable by any one of the following methods or acombination thereof, to the extent permitted by the Compensation Committee:

 

•                                          in cash or by check or wire transfer,

 

•                                          subject to the approval of the CompensationCommittee, in common stock owned by the participant for at least six monthsprior to the date of exercise and valued at their fair market value on theeffective date of such exercise, or

 

•                                          subject to the approval of the CompensationCommittee, by such other provision as the Compensation Committee may fromtime to time authorize.

 

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

 

•                                          stockholder approval will be obtained if andto the extent required under Rule 16b-3 promulgated under the Exchange Actor if and to the extent the board determines that such approval is required forpurposes of satisfying Section 162(m) or Section 422 of the Code, and

 

•                                          no such suspension, revision, termination oramendment may, without the consent of a participant, reduce the participant’srights 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 common stock throughpayroll deductions. In general, the Stock Purchase Plan provides that:

 

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•                                          each employee who has completed six months ofcontinuous employment with us is eligible to participate in the Stock PurchasePlan so long as the employee customarily works at least 20 hours per weekand 5 months per year;

 

•                                          participants in the Stock Purchase Plan arepermitted to contribute up to fifteen percent of their compensation towards thepurchase of our common stock;

 

•                                          at the end of each calendar quarter, thecontributions of the participants are used to purchase shares of our commonstock at the lower of eighty-five percent of the market price of our commonstock: (i) at the beginning of each calendar quarter or (ii) at theend of each calendar quarter;

 

•                                          shares of our common stock that are purchasedunder the Stock Purchase Plan are not transferable by the participant until atleast nine months has elapsed from the acquisition of the shares;

 

•                                          a maximum of 750,000 shares of our commonstock (plus an annual increase of 375,000 shares) may be purchased in theaggregate by participants in the Stock Purchase Plan; and

 

•                                          our Board of Directors has the power andauthority to administer the Stock Purchase Plan and may, subject to certainlimitations suspend, revise, terminate or amend the Stock Purchase Plan.

 

The following table presentsinformation regarding options granted to our named executive officers duringfiscal 2005 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  |       | 50,000                                                              |       | 26.7                                                                         |       | 3.95                              |       | 3/8/15 |   | 124,364 |   | 315,253 |   |
| Richard Westerfer |       | 25,000                                                              |       | 13.3                                                                         |       | 2.63                              |       | 11/9/15 |   | 41,402 |   | 104,951 |   |
|              |       |                                                                |       |                                                                         |       |                              |       |   |   |   |   |   |   |
| Randall J. Gort   |       | 22,500                                                              |       | 12.0                                                                         |       | 2.63                              |       | 11/9/15 |   | 37,262 |   | 94,456 |   |
|              |       |                                                                |       |                                                                         |       |                              |       |   |   |   |   |   |   |
| Joel Boyarski     |       | 20,000                                                              |       | 10.7                                                                         |       | 2.63                              |       | 11/9/15 |   | 33,122 |   | 83,961 |   |
|              |       |                                                                |       |                                                                         |       |                              |       |   |   |   |   |   |   |
| James McLoughlin  |       | 20,000                                                              |       | 10.7                                                                         |       | 2.63                              |       | 11/9/15 |   | 33,122 |   | 83,961 |   |

 

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 31,2005. The table also reflects the values of such options based on the positivespread between the exercise price of such options and $2.06, which was the pershare closing sales price reported on the NASDAQ Small Cap Market on December 30,2005.

 

33

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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  |       | —                                                        |       | —                             |       | 240,000/70,000                                                                                                                                                     |       | 28,224/9,408                                                                                                                          |       |
|              |       |                                                          |       |                               |       |                                                                                                                                                               |       |                                                                                                                                  |       |
| Richard Westerfer |       | —                                                        |       | —                             |       | 354,000/306,000                                                                                                                                                    |       | 206,590/306,590                                                                                                                       |       |
|              |       |                                                          |       |                               |       |                                                                                                                                                               |       |                                                                                                                                  |       |
| Randall J. Gort   |       | —                                                        |       | —                             |       | 300,958/295,375                                                                                                                                                    |       | 206,590/306,590                                                                                                                       |       |
|              |       |                                                          |       |                               |       |                                                                                                                                                               |       |                                                                                                                                  |       |
| Joel Boyarski     |       | —                                                        |       | —                             |       | 221,988/273,750                                                                                                                                                    |       | 215,254/291,790                                                                                                                       |       |
|              |       |                                                          |       |                               |       |                                                                                                                                                               |       |                                                                                                                                  |       |
| James McLoughlin  |       | —                                                        |       | —                             |       | 183,300/251,600                                                                                                                                                    |       | 169,400/256,900                                                                                                                       |       |

 

**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 10,000shares, vesting in equal amounts over four years, issued at the fair marketvalue on the date of grant, a stipend of $1,000 for each board or committeemeeting the director attends in person, and $250 for each meeting attendedtelephonically. Furthermore, we paid an annual stipend of $5,000 for 2005 andwill pay $10,000 for each year thereafter, as well as an initial stock grant of30,000 shares upon becoming a non-employee director. We will continue toreimburse non-employee directors for reasonable travel expenses for attendingboard or committee meetings.

 

**Item 12. Security Ownership of Certain BeneficialOwners and Management, and Related Stockholder Matters.**

 

The following table setsforth information as of December 31, 2005 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     |       | 4,481,015                                                                                                                                                 |       | $                                                                                                            | 1.94       |                                                                                                                                                                                                             | 1,974,667  | (1) |
| Equity compensation plans not approved by security  holders |       | —                                                                                                                                                    |       | —                                                                                                       |       | —                                                                                                                                                                                                           |       |
| Total                                                       |       | 4,481,015                                                                                                                                                 |       |                                                                                                         |       | 1,974,667                                                                                                                                                                                                        |       |
|                                                        |       |                                                                                                                                                      |       |                                                                                                         |       |                                                                                                                                                                                                             |       |   |

 

----

(1)                                  In October 2004 our shareholdersapproved a new Equity Incentive Plan. The Equity Incentive Plan as approveddoes not authorize any incremental shares for issuance thereunder, but rathertransfers the balance available for issuance under the 1996 Stock Option Planafter all issuances thereunder. Although our 1996 Stock Option Plan remains ineffect for any outstanding options issued under that plan we do not intend toissue new grants under that plan. Both the 1996 Stock Option Plan and itssuccessor, the Equity Incentive Plan contain a 

 

34

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provision that automatically increases the number ofshares available for future issuances as of January 1st of each calendaryear. The increase is equal to the lesser of (i) four (4) percent ofthe issued and outstanding shares of company stock (determined as of the firstday of each such year), or (ii)   1,000,000 shares of commonstock.

 

The following table setsforth information as of March 13, 2006 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 warrants exercisablewithin 60 days of March 13, 2006 are deemed outstanding for thepurpose of computing the percentage ownership of the person holding suchoptions 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)                                                   |       | 5,941,113                                                                                      |       | 15.1                                 | %          |
| Randall J. Gort(2)                                                    |       | 541,150                                                                                        |       | 1.4                                  | %          |
| Richard Westerfer (3)                                                 |       | 425,741                                                                                        |       | 1.1                                  | %          |
| Joel Boyarski(4)                                                      |       | 296,859                                                                                        |       | *                                    |       |
| James McLoughlin(5)                                                   |       | 236,275                                                                                        |       | *                                    |       |
| Steven C. Davidson(6)                                                 |       | 39,875                                                                                         |       | *                                    |       |
| Martin Jaffe(7)                                                       |       | 44,875                                                                                         |       | *                                    |       |
| Clarence L. Irving, Jr.(8)                                       |       | 44,625                                                                                         |       | *                                    |       |
| Jeff Morris(9)                                                        |       | 40,375                                                                                         |       | *                                    |       |
| Lem Tarshis(10)                                                       |       | 70,241                                                                                         |       | *                                    |       |
| All current directors and executive officers as a  group (10 persons) |       | 7,681,129                                                                                      |       | 19.5                                 | %          |

 

----

*                                         Less than 1% of the outstanding Common Stock.

 

(1)                                  Includes options to purchase 252,500 sharesof common stock. Also includes 3,654,246 shares of common stock held directly,1,434,429 shares of common stock held within grantor retained trusts in whicheither Mr. Krisbergh or his spouse are trustees, 299,938 shares of commonstock held by Mr. Krisbergh’s spouse and 300,000 shares of common stockheld by the Krisbergh Family Foundation, with Mr. Krisbergh acting as thecustodian for these shares.

 

35

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(2)                                  Includes options to purchase 366,208 sharesof common stock. Also includes 106,063 shares of common stock held directly and68,879 shares of common stock held by Mr. Gort as custodian for his minorchildren.

 

(3)                                  Includes options to purchase 425,500 sharesof common stock and 241 shares of common stock held by Mr. Westerfer’sminor son.

 

(4)                                  Includes options to purchase 287,488 sharesof common stock. Also includes 9,371 shares of common stock held directly.

 

(5)                                  Includes options to purchase 236,275 sharesof common stock.

 

(6)                                  Includes options to purchase 29,875 shares ofcommon stock. Also includes 10,000 shares of common stock held directly.

 

(7)                                  Includes options to purchase 29,875 shares ofcommon stock. Also includes 15,000 shares of common stock held directly.

 

(8)                                  Includes options to purchase 44,625 shares ofcommon stock.

 

(9)                                  Includes options to purchase 40,375 shares ofcommon stock.

 

(10)                            Includes options to purchase 53,041 shares ofcommon stock. Also includes 5,200 shares of common stock held directly and12,000 shares of common stock held by Mr. Tarshis’ spouse.

 

**Item 13. Certain Relationships and RelatedTransactions**

 

None.

 

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

 

On November 17, 2005,Grant Thornton LLP (Grant Thornton), our independent registered publicaccounting firm, advised the Company that it would not stand for re-appointmentfor the audit of the year ending December 31, 2005 and that it would beresigning as the Company’s independent auditor effective upon the completion ofits engagement which ended with the audit of the restatement described belowand the review of the Company’s financial statements included in its QuarterlyReport on Form 10-Q for the quarter ended September 30, 2005. Asstated in the Company’s Proxy Statement pursuant to Section 14(a) ofthe Securities Exchange Act of 1934, as filed on September 9, 2005 withthe SEC, the Company had withheld any decision as to the retention of anindependent registered public accounting firm for fiscal year 2005. The Companyhas elected to not seek the re-engagement of Grant Thornton.

 

On January 24, 2006,the Company filed amendments to and restatements of its financial statementsfor the years ended December 31, 2003 and 2004 as included in the Company’sAnnual Report on Form 10-K/A for the fiscal year ended December 31,2004, and the interim financial statements for the periods ended March 31,2004 through June 30, 2005 included in the Company’s Quarterly Reports on Form 10-Q.The report of independent registered public accounting firm issued by GrantThornton dated February 24, 2005 (except for Note 2 *Restatement No. 1* as to which thedate is August 24, 2005 and Note 3 *RestatementNo. 2* as to which the date is January 10, 2006 included inthe Company’s Annual Report on Form 10-K/A for the fiscal year ended December 31,2004 filed on January 24, 2006) contained no adverse opinion or disclaimerof opinion, and was not qualified or modified as to uncertainty, audit scope,or accounting principles, except for a modification related to an uncertaintyregarding the Company’s ability to continue as a going concern, and anexplanatory paragraph regarding two restatements of the Company’s consolidatedfinancial statements for the years ended December 31, 2004 and 2003.

 

During the fiscal yearsended December 31, 2003 and 2004, and any subsequent interim periodthrough the date hereof, there were no disagreements between the Company andGrant Thornton on any matter of accounting 

 

36

----

 

principles or practices, financial statementdisclosure or auditing scope or procedure, which disagreement(s), if notresolved to the satisfaction of Grant Thornton, would have caused it to makereference to the subject matter of the disagreement(s) in connection with itsreports.

 

On January 5, 2006, theAudit Committee of the Company’s Board of Directors engaged the firm of Marcum &Kliegman, LLP (M&K) as the new independent registered public accountants toaudit the Company’s financial statements as of and for the period ended December 31,2005. During the Company’s two most recent fiscal years, and through January 5,2006, the Company has not consulted with M&K regarding the application ofaccounting principles to a specified transaction, either completed or proposed,or the type of audit opinion that might be rendered on the Company’s financialstatements nor has it consulted with M&K regarding any matter that waseither the subject of a disagreement, as that term is defined in Item 304(a)(1)(iv) of Regulation S-K and the related instructions to Item 304of Regulation S-K, or a reportable event, as that term is defined in Item304 (a)(1)(v) of Regulation S-K.

 

The aggregate fees forprofessional services rendered to us by Grant Thornton LLP, our independentregistered public accounting firm for the fiscal year ended December 31,2004, and Marcum & Kliegman LLP, our independent registered publicaccounting firm for the fiscal year ended December 31 2005, are as follows(in whole dollars):

 
| ** **         | ** ** | **Fiscal Years Ended  December 31** | ** ** |
|--------------------|------------|----------------------------------------------------|------------|
| ** **         | ** ** | **2004**                                           | ** ** | **2005** | ** ** |
|               |       |                                               |       |   |   |
| Audit fees         |       | $                                                  | 93,320     |   | $ | 121,500 |   |
| Audit related fees |       | 45,328                                             |       | 0 |   |
| Tax fees           |       | 36,401                                             |       | 0 |   |
| All other fees     |       | 0                                                  |       | 0 |   |
|               |       |                                               |       |   |   |
| Total              |       | $                                                  | 175,049    |   | $ | 121,500 |   |

 

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

###### ** **

The“audit fees” reported above were billed to us by Grant Thornton LLP and Marcum &Kliegman LLP for professional services rendered in connection with their auditof our consolidated financial statements and their limited reviews of ourunaudited consolidated financial statements and our unaudited consolidatedinterim financial statements included in our quarterly reports, and forservices normally provided by Grant Thornton LLP and Marcum & KliegmanLLP in connection with other statutory and regulatory filings or engagements,including audit consultations and SEC comment letters.

 

*AuditRelated Fees*

 

The “audit related fees”reported above were billed to us by Grant Thornton LLP for assurance andrelated services that were reasonably related to the performance of their auditor review of our financial statements, but which are not reported as AuditFees. These services include accounting consultations in connection with theimpact of prospective accounting pronouncements and stock based compensationmatters.

 

*Tax Fees*

 

During the fiscal yearsreported above, Grant Thornton LLP rendered professional services to usrelating to tax compliance, tax advice, or tax planning.

 

37

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*All OtherFees*

 

During the fiscal yearsreported above, Grant Thornton LLP and Marcum & Kliegman LLP renderedno professional 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 delegateits pre-approval authority to any of its members, provided that such memberreports all pre-approval decisions to the audit committee at its next scheduledmeeting. Our independent public auditors and members of management are requiredto report periodically to the audit committee the extent of all servicesprovided in accordance with the pre-approval policy, including the amount offees attributable to such services.

 

In 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 and Marcum and Kliegman LLP, the Company’s independentauditors. Non-audit services are services other than those provided inconnection with an audit or review of the financial statements. During theperiod covered by this filing, the audit committee approved all audit relatedfees, tax fees and all other fees.

 

### **PART IV**

### ** **

**Item 15. Exhibits and Financial Statement Schedules.**

 

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

 

**1.             Financial Statements**

 

The following financialstatements have been included as part of this report:

 
| Report of  Marcum & Kliegman LLP, Independent Registered Public Accounting Firm |   |
|------------------------------------------------------------------------------------------|--------|
| Report of  Grant Thornton 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                                               |   |

 

38

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**2. FinancialStatement 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,  2003            |       | 1,596                                        |       | 651                                                         |       | (1,866                                                     | )          | 381                                        |       |
| Year ended December 31,  2004            |       | 381                                          |       | 0                                                           |       | (381                                                       | )          | 0                                          |       |
| Year ended December 31,  2005            |       | 0                                            |       | 0                                                           |       | 0                                                          |       | 0                                          |       |
| Valuation  Allowance for Deferred Tax Assets: |       |                                         |       |                                                        |       |                                                       |       |                                       |       |
| Year ended December 31,  2003            |       | 69,494                                       |       | 3,124                                                       |       |                                                       |       | 72,618                                     |       |
| Year ended December 31,  2004            |       | 72,618                                       |       | 7,094                                                       |       |                                                       |       | 78,712                                     |       |
| Year ended December 31,  2005            |       | 78,712                                       |       | 6,586                                                       |       |                                                       |       | 85,298                                     |       |

 

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)                                                                                                                                          |
| 4.9         |   | Form of Warrant dated August 3, 2005  issued by the Company to the Investors (as defined in the Securities Purchase  Agreement dated August 3, 2005 amoung the Company and the Investors)  (14) |
| 4.10        |   | Form of Warrant dated August 3, 2005  issued by the Company to the Investors (as defined in the Securities Purchase  Agreement dated August 3, 2005 amoung the Company and the Investors)  (14) |
| 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   |

 

39

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|   |   | 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)                                                                                                                                                                                     |
| 10.10  |   | Securities Purchase Agreement dated August 3,  2005 among the Company and the Investors (as defined therein) (14)                                                                                                                                                                                                  |
| 16     |   | Letter on Change in Certifying Accountant (15)                                                                                                                                                                                                                                                                          |
| 21     |   | Subsidiaries*                                                                                                                                                                                                                                                                                                           |
| 23.1   |   | Consent of Marcum & Kliegman LLP*                                                                                                                                                                                                                                                                              |
| 23.2   |   | Consent of Grant Thornton LLP*                                                                                                                                                                                                                                                                                          |
| 24     |   | Power of Attorney (included in signature page)                                                                                                                                                                                                                                                                          |
| 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*                                                                                                                                                                   |

 

----

| *    | 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 December 24, 2003  (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, 2004, 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.                                            |
| (14) | Incorporated by reference to the exhibits to our  Current Report on Form 8-K filed August 8, 2005.                                                         |
| (15) | Incorporated by reference to the exhibits to our  Current Report on Form 8-K filed November 23, 2005.                                                      |

 

40

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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: March 31, 2006 | By:                                 | /s/ HAL M. KRISBERGH |
|                      |                                | Hal M. Krisbergh |
|                      |                                | Chief Executive Officer |

 

**Power ofAttorney**

 

Each person whose signature appears belowhereby constitutes and appoints Hal M. Krisbergh and Randall J. Gort the trueand lawful attorneys-in-fact and agents of the undersigned, with full power ofsubstitution and resubstitution, for and in the name, place and stead of theundersigned, in any and all capacities, to sign any and all amendments to thisreport, and to file the same, with all exhibits thereto, and other documents inconnection therewith, with the Securities and Exchange Commission, and herebygrants to such attorneys-in-fact and agents full power and authority to do andperform each and every act and thing requisite and necessary to be done,as fully to all intents and purposes as the undersigned might or could do inperson, hereby ratifying and confirming all that said attorneys-in-fact andagents, or their substitute or substitutes, may lawfully do or cause to bedone by virtue hereof.

 

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)                     |   | March 31, 2006 |
|                             |   |                                              |   |                |
| /s/ JOEL BOYARSKI                |   |                                              |   |                |
| Joel Boyarski                    |   | Senior Vice President and Chief Financial Officer |   |                |
|                             |   | (Principal Financial and Accounting Officer)      |   | March 31, 2006 |
|                             |   |                                              |   |                |
| /s/ STEVEN C. DAVIDSON           |   |                                              |   |                |
| Steven C. Davidson               |   | Director                                          |   | March 31, 2006 |
|                             |   |                                              |   |                |
| /s/ MARTIN JAFFE                 |   |                                              |   |                |
| Martin Jaffe                     |   | Director                                          |   | March 31, 2006 |
|                             |   |                                              |   |                |
| /s/ CLARENCE L. IRVING, JR. |   |                                              |   |                |
| Clarence L. Irving, Jr.     |   | Director                                          |   | March 31, 2006 |
|                             |   |                                              |   |                |
| /s/ JEFF MORRIS                  |   |                                              |   |                |
| Jeff Morris                      |   | Director                                          |   | March 31, 2006 |
|                             |   |                                              |   |                |
| /s/ LEMUEL TARSHIS               |   |                                              |   |                |
| Lemuel Tarshis                   |   | Director                                          |   | March 31, 2006 |

 

41

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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)                                                                                                                                                                                                                                                                                     |
| 4.9         |   | Form of Warrant dated August 3, 2005  issued by the Company to the Investors (as defined in the Securities Purchase  Agreement dated August 3, 2005 among the Company and the Investors) (14)                                                                                                                                              |
| 4.10        |   | Form of Warrant dated August 3, 2005  issued by the Company to the Investors (as defined in the Securities Purchase  Agreement dated August 3, 2005 among the Company and the Investors) (14)                                                                                                                                              |
|  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)                                                                                                                                                                                                                     |
| 10.10       |   | Securities Purchase Agreement dated August 3,  2005 among the Company and the Investors (as defined therein) (14)                                                                                                                                                                                                                                    |
| 16          |   | Letter on Change in Certifying Accountant (15)                                                                                                                                                                                                                                                                                                            |
| 21          |   | Subsidiaries*                                                                                                                                                                                                                                                                                                                                             |
| 23.1        |   | Consent of Marcum & Kliegman LLP*                                                                                                                                                                                                                                                                                                                |
| 23.2        |   | Consent of Grant Thornton LLP*                                                                                                                                                                                                                                                                                                                            |
| 24          |   | Power of Attorney (included in signature page)                                                                                                                                                                                                                                                                                                            |
| 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)*                                                                                                                                                                                                                                                                                |

 

42

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| 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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| *    | 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 December 24, 2003  (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.                                            |
| (14) | Incorporated by reference to the exhibits to our  Current Report on Form 8-K filed August 8, 2005.                                                         |
| (15) | Incorporated by reference to the exhibits to our  Current Report on Form 8-K filed November 23, 2005.                                                      |

 

43

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