**United
      States**


**Securities
      and Exchange Commission**


**Washington,
      D.C. 20549**





**FORM
      10-K/A**




x ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15( d )
      OF THE
      SECURITIES EXCHANGE ACT OF 1934




For
      the fiscal year ended December 31, 2006.




OR




o TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15( d )
      OF THE
      SECURITIES EXCHANGE ACT OF 1934




For
      the transition period from _______________ to
      _______________





Commission
      File Number: 000-19828







**SPATIALIGHT,
      INC.**


(Exact
      name of registrant as specified in its Charter)


**New
                  York**
              **16-1363082**(State
                  or other jurisdiction of incorporation or organization)
              (I.R.S.
                  Employer Identification No.)




Five
      Hamilton Landing, Suite 100, Novato, California 94949


(Address
      of principal executive offices)   (zip
      code)





(415)
      883-1693


(Issuer’s
      telephone number including area code)





Securities
      registered pursuant to Section 12(b) of the Exchange Act: None


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





Common
      Shares, $.01 par value


(Title
      of
      Class)





Indicate
      by check mark if the registrant is a well-known seasoned issuer, as defined
      in
      Rule 405 of the Securities Act.


Yes
oNo
x





Indicate
      by check mark if the registrant is not required to file reports pursuant to
      Section 13 or Section 15(d) of the Act.


Yes
oNo
x





Indicate
      by check mark whether the registrant (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      preceding 12 months (or for such shorter period that the registrant was required
      to file such reports), and (2) has been subject to such filing requirements
      for
      the past 90 days:


Yes
xNo
o





Indicate
      by check mark if disclosure of delinquent filers pursuant to Item 405 of
      Regulation S-K (§229.405 of this chapter) is not contained herein, and will not
      be contained, to the best of registrant’s knowledge, in definitive proxy or
      information statements incorporated by reference in Part III of this Form 10-K/A
      or any amendment to this Form 10-K/A. o





Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer. See definition of “accelerated
      filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
      one):


Large
                  accelerated filer  o
              Accelerated
                    filer   x
              Non-accelerated
                  filer   o


Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Act).


Yes
oNo
x





The
      aggregate market value for the registrant’s voting shares held by non-affiliates
      of the registrant, based upon the $2.30 per share closing sale price of the
      common shares on June 30, 2006, as reported on the Nasdaq Capital Market, was
      approximately $74,860,908. Common shares held by each officer and
      employee-directors and by each person who owns 5% or more of the outstanding
      common shares have been excluded because such persons are deemed to be
      affiliates. This determination of affiliate status is not necessarily a
      conclusive determination for other purposes.





As
      of
      August 17, 2007, registrant had 97,388,513 common shares
      outstanding.





DOCUMENTS
      INCORPORATED BY REFERENCE





None.










**Explanatory
      note**





This
      Amendment to our Annual Report on Form 10-K/A is being filed to amend our Annual
      Report on Form 10-K for the year ended December 31, 2006, as filed with the
      Securities and Exchange Commission on March 16, 2007 (“Original Filing”) for the
      purpose of recording a non-cash impairment loss of $1,429,925 against our
      building in South Korea. On July 24, 2007, we received evidence that LG
      Electronics (“LGE”) communicated its intention to terminate our Supply Agreement
      to Mr. Don Suh, in October 2006, in the form of an email to Mr. Suh’s personal
      email account. The mid-October email to Mr. Suh from LGE was first disclosed
      to
      SpatiaLight executives during settlement discussions by LGE’s legal counsel on
      July 24, 2007. At the time of the October 2006 email, Mr. Suh was our Senior
      Vice President for Marketing and Sales. He was later appointed to Chief
      Executive Officer on November 6, 2006, and was subsequently terminated on
      December 12, 2006. As disclosed in our Original Filing, o n
      March
      9, 2007, we received oral notification from LGE of their intent to discontinue
      the production of all rear projection televisions. As a result of the October
      2006 email, we concluded that the asset impairment loss related to our building
      in South Korea should be recorded in the fourth quarter of 2006. We had
      previously recorded the impairment loss in the first quarter of 2007, based
      upon
      the March 9, 2007 notification from LGE.





In
      order
      to correct this error, we are restating our consolidated financial statements
      for the year ended December 31, 2006. See Note 1 to the consolidated financial
      statements for a discussion of the restatement. This Form 10-K/A updates the
      information provided in Part I, Item 1A and Part II, Items 6, 7, and 8 of the
      Original Filing for the effects of the restatement.





In
      addition, we are correcting an error in Part I, Item 1A “Risk Factors” related
      to the amount disclosed as our Federal net operating loss
      carryforward.





Except
      for the items described above, no other information in the Original Filing
      is
      amended hereby, and this amendment does not reflect events occurring after
      the
      Original Filing or modify or update those disclosures affected by subsequent
      events. This Amendment continues to speak as of the date of the Original filing,
      and does not modify or update any other item or disclosures in the Original
      Filing.




2





SPATIALIGHT,
      INC.


FORM
      10-K/A ANNUAL REPORT





TABLE
      OF
      CONTENTS




PagePART
                  IITEM
                  1
              Business
              
              4ITEM
                  1A
              Risk
                Factors
              
              9ITEM
                1B
              Unresolved
                  Staff Comments
              
              19ITEM
                  2
              Properties
              
              19ITEM
                  3
              Legal
                  Proceedings
              
              19ITEM
                  4
              Submission
                of Matters to a Vote Of Security Holders
              
              19PART
                  IIITEM
                  5
              Market
                  for Registrant’s Common Equity, Related Shareholder Matters and Issuer
                  Purchases of Equity Securities
              
              19ITEM
                  6
              Selected
                  Consolidated Financial Data
              
              21ITEM
                  7
              Management’s
                  Discussion and Analysis of Financial Condition and Results of
                  Operations
              
              22ITEM
                  7A
              Quantitative
                  and Qualitative Disclosures About Market Risk
              
              39ITEM
                  8
              Consolidated
                  Financial Statements and Supplementary Data
              
              40ITEM
                  9
              Changes
                  in and Disagreements with Accountants On Accounting and Financial
                  Disclosure
              
              78ITEM
                  9A
              Controls
                  and Procedures
              
              78ITEM
                  9B
              Other
                  Information
              
              81PART
                  IIIITEM
                  10
              Directors,
                  Executive Officers and Corporate Governance
              
              82ITEM
                  11
              Executive
                  Compensation
              
              84ITEM
                  12
              Security
                  Ownership of Certain Beneficial Owners and Management and Related
                  Shareholder Matters
              
              90ITEM
                  13
              Certain
                Relationships and Related Transactions and Director Independence
              
              91ITEM
                  14
              Principal
                Accountant Fees and Services
              
              92PART
                  IVITEM
                  15
              Exhibits
                and Financial Statement Schedules
              
              92




3





**PART
      I**





*This
      annual report on Form 10-K/A contains certain forward-looking statements within
      the meaning of Section 21E of the Securities and Exchange Act of 1934, as
      amended, and is subject to the safe harbor provisions created by that statute.
      In this report, the words “anticipates,” “believes,” “expects,” “future,”
“intends,” and similar expressions identify forward-looking statements. Such
      statements are subject to risks and uncertainties, including, but not limited
      to, those discussed herein which are specific to the Company’s business, and in
      particular, those contained in “Item 1A - Risk Factors” that could cause actual
      results to differ materially from those projected. You are cautioned not to
      place undue reliance on these forward-looking statements, which speak only
      as of
      the date hereof. We undertake no obligation to publicly update or revise these
      forward-looking statements to reflect events or circumstances after the date
      of
      this report or to reflect the occurrence of unanticipated events and thus you
      should not assume that silence by management over time means that actual events
      are bearing out as estimated in such forward-looking
      statements.*





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





**Description
      of Business**





We
      are in
      the business of manufacturing high-resolution liquid crystal on silicon (LCoS)
      microdisplays. Our current customers and prospective customers are original
      equipment manufacturers (OEMs) engaged in the businesses of manufacturing high
      definition televisions or manufacturing light engines for incorporation into
      high definition televisions and 3-dimensional near-to-eye display devices.
      Our
      products are also suitable for incorporation into other potential display
      applications including front projection systems, head mounted devices, rear
      projection computer monitors, wireless communication devices, portable games
      and
      digital assistants. Currently we are working with OEMs of high definition
      televisions, light engines for incorporation into high definition televisions,
      near-to-eye head mounted display devices, and micro-projectors for mobile
      electronics applications.




We
      were
      incorporated under the laws of the State of New York in 1989. Our executive
      offices are located at Five Hamilton Landing, Suite 100, Novato, California
      94949. Our internet address is www.spatialight.com. Our annual reports on Form
      10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and
      amendments to those reports are available at our internet address without charge
      under “Investors - SEC reports” as soon as reasonably practicable after we
      electronically file with or furnish such material to the SEC.




**Technology
      and Products under Development**





Our
      LCoS
      microdisplays are high-resolution liquid crystal displays. They are constructed
      with a silicon chip, a layer of liquid crystals and a glass cover plate in
      contrast to the more common construction of liquid crystals sandwiched between
      two glass plates. Our displays are also known as, and commonly referred to
      as,
      liquid crystal on silicon (LCoS), liquid crystal displays (LCD), active matrix
      liquid crystal displays and spatial light modulators.





We
      currently manufacture our T-3 LCoS Set which consists of three of our
      proprietary SpatiaLight imagEngineTM LCoS microdisplays and has a 1920 pixels by
      1080 pixels configuration. We previously have manufactured and continue to
      have
      in inventory our T-1 LCoS Set model which has a 1280 pixels by 960 pixels
      configuration. Although we believe we can sell our T-1 LCoS Set model, we are
      focusing on manufacturing the T-3 model of our LCoS Sets (as opposed to the
      T-1
      Sets) because we believe that the market demand for that higher resolution
      product will be significantly greater. The following table summarizes our sales
      revenue percentage by product for the past three years




2006
              
              2005
              
              2004LCoS
                  (T-3) sets
              
              
              96
              %
              
              77
              %
              
              5
              %LCoS
                  (T-1) sets
              
              
              -
              
              
              4
              %
              
              42
              %Light
                  engine display units
              
              
              -
              
              
              1
              %
              
              51
              %Other
                  (primarily supporting electronics)
              
              
              4
              %
              
              18
              %
              
              2
              %Total
              
              
              100
              %
              
              100
              %
              
              100
              %


The
      image
      on a microdisplay can be projected onto a screen or other surface for individual
      or group viewing or used in a portable application that is viewed through a
      magnifying device similar to a viewfinder. Potential microdisplay applications
      include:





4


·
            large-screen
                front and rear-projection television systems, in both high definition
                television format and standard television
                formats;




·
            near-to-eye
                display devices for 3-dimensional viewing
                purposes;




·
            large-screen
                rear-projection computer monitors in a variety of
                resolutions;




·
            video
                projectors for applications such as
                presentations;




·
            head-mounted
                displays which are used for virtual reality systems, defense, aerospace
                and gaming applications; and




·
            other
                potential applications such as point of purchase displays, optical
                computing and data storage.





Our
      technology uses liquid crystals and silicon chips. An advantage of these
      materials is that processes for working with them are already known and they
      may
      be produced more quickly than competing technologies that offer comparable
      quality. By using existing manufacturing processes at our manufacturing facility
      in South Korea, which commenced producing products for commercial sale in
      limited quantities in the second quarter of 2005, we believe we will be able
      to
      obtain economies of scale.





A
      typical
      liquid crystal display consists (along with other associated materials and
      processes) of liquid crystal material sandwiched between two pieces of glass,
      polarizers, color filters, a data signal and a light source. As the data signal
      is applied across the sandwich of the liquid crystals, the electric field
      created by this data signal causes the liquid crystals to tilt. This tilting,
      combined with the polarizers, makes each pixel change from opaque to
      transparent, thereby controlling either the transmission or reflection of light
      from each pixel.





Departing
      from typical liquid crystal displays utilizing circuitry on two pieces of glass,
      we design integrated circuits that control individual reflective pixels on
      a
      silicon substrate. This silicon substrate is manufactured using a conventional
      complementary metal oxide semiconductor (CMOS) process. This processed silicon
      substrate, also known as a silicon backplane, then has the liquid crystal
      material and a cover glass applied to it. When the data signal is sent to the
      circuitry in the silicon, the liquid crystals again tilt from opaque to
      transparent states. When polarizers are added and light is reflected from the
      pixels on the silicon, images can be viewed directly or, using standard optical
      techniques, projected into larger images on a screen.





As
      is
      common with all LCDs, the images produced are inherently black and white. The
      varying of the electrical signal to each pixel produces gray scaling (various
      shades of gray going from black to white). Utilizing this gray scaling, there
      are three basic techniques for achieving color displays: (1) optically combining
      different colors of light, (2) sequential color systems and (3) color filters.
      We believe our displays can be adapted for use in all of these types of color
      display processes.




**Customers
      and Potential Customers**





*LG
      Electronics, Inc.*





LG
      Electronics (LGE) has informed us of their intent to discontinue the production
      of rear projection television (RPTV) (both LCoS and DLP). We do not expect
      significant further sales to LGE, are currently in negotiations with LGE related
      to an appropriate exit strategy, and are currently assessing the impact of
      this
      communication on our business.




In
      July
      2004, we entered into an agreement with LGE providing for us to sell our T-3
      LCoS Sets to LGE. There have been a number of subsequent modifications to our
      arrangements with LGE, most significantly with respect to a number of product
      specifications, as well as in timing of deliveries and quantities. The changes
      in the timing of deliveries and quantities to be delivered were, in part, a
      result of our attempts to respond to these product specification change requests
      and agreements.




In
      August
      2005, we received a firm purchase order from LGE for its purchase from us of
      an
      aggregate minimum quantity of 9,300 LCoS Sets for the period July through
      December 2005, thereby reducing the initial purchase commitment set forth in
      our
      July 2004 agreement. We subsequently agreed with LGE, through a series of
      communications, that the initial purchase order for 9,300 LCoS Sets could be
      filled over a period of time that would extend beyond April 2006. While we
      continued to ship product throughout 2006, as noted above we do not expect
      to
      have significant shipments to LGE in 2007.




LGE
      commenced an initial consumer market rollout in Australia of a limited quantity
      of 71-inch LCoS televisions incorporating our LCoS Sets during the first quarter
      of 2006. The LG Electronics 71” LCoS television has received very positive
      feedback in Australia. LGE communicated to its U.S. distributors in the first
      quarter of 2006 that it had postponed its plans to introduce its 71” and 62”
LCoS televisions into the U.S. marketplace. LGE had attributed this postponement
      to uncertainty regarding the timetable for the availability of sufficiently
      large supplies of our LCoS Sets to enable a significant product launch. We
      believe that delays in LGE’s initial product rollouts had been based upon
      revisions to our delivery schedule caused by LGE’s product specification changes
      and our problems in ramping up production that have occurred over time. However,
      our recent production deliveries to LGE have been of acceptable quantity and
      quality starting in the second quarter of 2006. In our manufacturing process
      we
      have recently made a transition from 100% testing of certain characteristics
      to
      sample testing. This removed a bottleneck and facilitates the production ramp
      up. LGE had previously informed us of their intent to expand distribution of
      product to the US and other markets. This has not occurred to date. LGE has
      been
      emphasizing flat panel TV’s and de-emphasizing their projection TV products. As
      noted above we do not expect to have significant shipments to LGE in
      2007.




5




In
      2005
      and 2006, the majority of our product deliveries, which were in small
      quantities, were made to LGE. The loss of LGE as a customer could materially
      harm our future sales and results of operations; and our substantial dependence
      on one customer is subject to risks set forth under “Item 1A Risk Factors”.




*Business
      in Taiwan*




To
      date,
      we have delivered limited quantities of our T-3 LCoS Sets to a Taiwanese
      customer, ThinTek Optronics Corporation. A substantial portion of these product
      deliveries took place in 2005 and the first quarter of 2006. ThinTek has ordered
      quantities sufficient for pilot programs and sample products, but not enough
      to
      enable them to launch mass production of LCoS high definition televisions.
      On
      July 19, 2006, one of the parent organizations of ThinTek, United Microdisplay
      Optronics (UMO), announced that it was acquiring ThinTek. The acquisition was
      effective October 1, 2006. We understand that as part of this acquisition,
      ThinTek’s and UMO’s business models are under evaluation, and may tend to a more
      vertically integrated approach. For this reason, we have chosen to deal directly
      with a TV maker, Jiangxi Greatsource Display Tech Co., Ltd. (KHD) (in China),
      rather than ThinTek going forward.




*Business
      in China*




To
      date,
      we have delivered limited quantities of our microdisplay products to our Chinese
      customers. A substantial portion of these product deliveries occurred in 2004,
      with a smaller quantity delivered in 2005 and none in 2006. The quantities
      of
      our products delivered to our Chinese customers are sufficient only for
      engineering testing and pilot program purposes. To date, our Chinese customers
      have not ordered quantities of our products that would enable them to launch
      commercial sales of LCoS high definition televisions.




We
      have
      continuing business relationships with customers and prospective customers
      in
      China. Current Chinese prospective customers are at different stages in the
      development and product introduction processes, and their efforts are
      progressing at a slower rate than we originally anticipated. One of our original
      Chinese customers, Skyworth Display Limited, is selling televisions utilizing
      our display units incorporating our T-1 LCoS Sets into the Chinese educational
      market. However, we do not intend to sell any additional display units
      incorporating our T-1 LCoS Sets beyond those we currently have in inventory
      to
      Skyworth. Skyworth may, although we have no assurance that it will, elect to
      transition to products incorporating our T-3 LCoS Sets. We cannot provide
      assurance concerning the quantities of our products that we will sell to our
      Chinese customers and prospective customers in the future.




We
      have
      provided sample product to Jiangxi Greatsource Display Tech Co., Ltd. (KHD),
      a
      Chinese manufacturer of LCoS light engines and televisions that has received
      significant financing from the Chinese government. We supported KHD pilot
      evaluation runs with our personnel at their plant in China. Evaluations have
      identified a variety of non-SpatiaLight related product issues, mostly of driver
      board electronics origin, that are being addressed by KHD. KHD sent a delegation
      to review the capabilities of the SpatiaLight Korea, Inc. (SLK) facility, which
      has successfully occurred. KHD demonstrated an 85” commercial product at the
      January 2007 Consumer Electronics Show (CES) show employing our imagers. For
      a
      more detailed discussion of our business in Taiwan and China, see Item 7
“Management’s Discussion and Analysis of Financial Condition and Results of
      Operations.”




*Prospective
      Customers*




We
      are
      currently continuing to develop working relationships with prospective
      customers, located primarily in South Korea, Japan and other parts of the
      Pacific Rim region. These prospective customers fall into the following
      categories: 1) television manufacturers, 2) light engine suppliers, 3) head
      mounted display manufacturers, and 4) mobile electronics display device
      manufacturers. We have provided samples of our LCoS Sets to certain of these
      prospective customers, but we do not have any formal agreements with these
      parties as of December 31, 2006. While we have made significant progress with
      respect to product integration and negotiating purchase orders with certain
      of
      these prospective customers, we cannot provide assurance that we will receive
      any purchase orders that will be binding on any of these companies for their
      purchase of our products in the near future. Even assuming that we receive
      purchase orders that are binding on the prospective customers, these orders
      and
      our sales to these customers and to our existing customers are subject to
      certain contingencies described under “Item 1A Risk Factors”.




6




**Marketing,
      Sales and Distribution**





Our
      primary target for our product development efforts has been for high definition
      rear projection television. More recently we have taken steps to broaden the
      addressed market and have been developing single panel, field sequential color
      operation LCoS displays for applications such as head mounted displays and
      micro-projectors. These efforts have been facilitated by working with end system
      suppliers such as Deocom of South Korea in the case of head mounted displays,
      and with an international consortium of firms on the development of a
      micro-projector product.




*Application
      and Markets*





We
      are
      currently working with a number of OEM customers and prospective customers,
      located primarily in South Korea, Japan, Taiwan and China, to use our
      microdisplay products in their high definition television end product
      applications. We do not believe that designing, selling and distributing end
      products for these diverse markets is in our own best interests. In high volume
      applications, we currently are and expect to continue custom designing our
      microdisplay products to fit a specific manufacturer’s need for a specific
      product. Our LCoS Sets can be incorporated into a wide variety of products
      such
      as high definition televisions, rear-projection computer monitors, video
      projectors and head mounted displays. While our primary emphasis has previously
      been on high definition rear projection televisions (RPTV) we are now working
      with a number of customers who are active in new display market segments other
      than RPTV.





Our
      current strategy is to focus our resources and expertise on original equipment
      design (OED) of LCoS Sets and to work closely with high definition television
      OEMs, light engine OEMs, and OEMs of products such as head mounted displays
      and
      micro-projectors to market end products utilizing our microdisplays. We are
      therefore dependent upon these OEMs for the manufacturing, marketing and selling
      of these end products.





We
      have
      cooperatively worked with Foreal Spectrum (Foreal) of San Jose, California
      to
      develop an LED illumination/LCoS imager based light engine. A prototype of
      this
      engine was jointly demonstrated at the SpatiaLight suite in the MGM Grand during
      the January 2007 CES show. A second generation prototype will be available
      shortly that will address many issues existing in the first prototype. We expect
      that this product with its long life and other positive characteristics will
      be
      of interest to China TV makers as well as other commercial display
      makers.





We
      have
      recently signed a Joint Market Agreement with Foreal for the LCoS/ LED based
      light engine developed by Foreal. Full production volumes amongst the four
      customers targeted by the two companies are expected to be in the vicinity
      of
      twenty thousand sets per month.





We
      have
      also recently signed a Purchase Agreement with Deocom to supply LCoS imagers
      for
      use in head mounted displays (HMD). This agreement anticipates immediate
      shipments of samples for prototype and pre-production runs, followed by mass
      production later this year. We expect this market to grow significantly over
      time.





In
      January 2007, we entered into a Joint Development Agreement between SpatiaLight,
      SI Infocomm, and SCRAM Technologies for the development of a micro-projector
      prototype with the intent to produce this in volume starting in the fourth
      quarter of 2007.





*Segment
      and Geographical Information*





For
      the
      year ended December 31, 2006, 92% of our revenue was derived from LGE, located
      in South Korea. This customer made up 100% of our outstanding accounts
      receivable balance at December 31, 2006. For the year ended December 31, 2005,
      73% and 12% of our revenue was derived from LGE and Thintek Optronics Corp,
      located in Taiwan, respectively. These two customers made up 84% of our
      outstanding accounts receivable balance at December 31, 2005. The remaining
      15%
      of revenue in 2005 was derived from the sales of our LCoS Sets and related
      components to customers located in Hong Kong, China and the United States.
      For
      the year ended December 31, 2004, 47% and 43% of our revenue was derived from
      Skyworth TV Holding, Ltd. and Shanghai China Display Co., Ltd, both located
      in
      China. These two customers made up 90% of our outstanding accounts receivable
      balance at December 31, 2004. The remaining 10% of revenue in 2004 was derived
      from the sales of our LCoS Sets and related components to customers located
      in
      Hong Kong, Taiwan and South Korea.





*Manufacturing
      and Supply*





We
      completed construction of our South Korean manufacturing facility in January
      2005. This facility serves as our central commercial manufacturing base. The
      facility began producing products for commercial sale in limited quantities
      in
      the second quarter of 2005. The facility is designed with the capacity, on
      full
      employment, to produce up to 28,000 LCoS Sets per month. The facility has been
      designed for expansion to a capacity of 120,000 LCoS Sets per month in several
      phases. We believe that the facility can be expanded in an efficient manner
      in
      the event that such expansion becomes necessary based upon increased or
      perceived increased demand for our products from our customers.





7


We
      completed the process of relocation of all of our manufacturing operations
      to
      South Korea in February of 2006. As part of the transition to full-scale
      manufacturing, we experienced a variety of manufacturing problems, most of
      which
      were due to environmental factors at our facility in Petaluma, California such
      as dust particles, temperature and humidity. At our manufacturing facility
      in
      South Korea, it appears that we are no longer experiencing the production
      problems attributable to the environmental issues specified above. However,
      early in the second quarter of 2006, we experienced certain other production
      problems, some of which we believe were principally attributable to flaws in
      the
      silicon wafers used for our backplane that we obtained from our supplier. Our
      supplier has transferred our wafer fabrication production line to a newer
      facility and processes have been slightly modified. Subsequent production
      verified improvement and increased stability.





In
      addition, we had, until recently, been testing all of our microdisplays for
      certain characteristics. We have now obtained solid statistics on a reasonable
      volume of product and have moved, as of July 31, 2006, to a sampling test mode
      for these characteristics. The testing of all of our microdisplays for certain
      characteristics had been providing a bottleneck to our LCoS Set delivery to
      LGE,
      which is now removed. While many issues have been addressed as indicated, the
      manufacturing process of our LCoS Sets is a complex process, and future problems
      could have a material negative impact upon our results of operations as set
      forth under “Risk Factors.”





We
      currently obtain silicon backplanes, a vital component in our LCoS Sets, from
      Taiwan Semiconductor Manufacturing Company, located in Taiwan. We are working
      to
      qualify a second supply source for our silicon backplanes. Historically, the
      supply of silicon backplanes from suppliers fluctuates and we may be subject
      to
      problems of availability, although we have not experienced any such problems
      to
      date.





Other
      key
      components include coated glass and flex circuitry. We currently obtain glass
      from Oerlikon (formerly Unaxis Optics), located in Liechtenstein. Our flex
      circuits are obtained from multiple sources located in Asia and the United
      States. We are subject to some supply fluctuations and there may be availability
      problems that arise. In all cases, we are attempting to find and qualify
      additional supply sources to mitigate supply risk, but this process is not
      complete.





We
      do not
      currently have any long-term agreements with any of our suppliers. Any
      termination of a relationship with one or more of our suppliers could have
      a
      material adverse effect on our ability to meet our anticipated commitments
      to
      customers while we identify and qualify replacement manufacturers or sources
      of
      supply. We could become dependent on a manufacturer for components of our LCoS
      Sets and any termination of our relationship with such a manufacturer could
      adversely affect our ability to manufacture our products.





**Competition**





Microdisplays
      are a subset of the display market (including television and video display).
      This display market subset consists of (1) reflective microdisplays produced
      on
      silicon backplanes, (2) transmissive microdisplays and (3) emissive
      microdisplays. Companies competing in the reflective microdisplay market include
      Sony, JVC, Aurora, Syntax-Brillian, and eLCOS. These companies are all producing
      different forms of a liquid crystal display on a silicon backplane. Sony and
      JVC
      have high definition televisions incorporating the LCoS technology in the
      consumer market. A major competitor in the reflective microdisplay market,
      although not using liquid crystals in the display, is Texas Instruments, which
      is producing a micro-mechanical structure of moving mirrors on a silicon
      backplane, a technology known as digital light processing, or DLP. Texas
      Instruments has had significant success selling its DLP products to its
      customers in the rear projection television market and the business front
      projector market.





In
      the
      market for head mounted displays and microprojectors, and other near-to-eye
      products, current competitors would include LCoS type displays from DisplayTech
      and Kopin as well as micro electrical mechanical systems (MEMS) based displays
      such as those supplied by Texas Instruments or Microvision.





Rapid
      and
      significant technological advances have characterized the microdisplay market.
      There can be no assurance that we will be able to effect any such technological
      advances or that we will have sufficient funds to invest in new technologies,
      products or processes. Although we believe that our displays have specifications
      and capabilities, which equal or exceed that of commercially available LCD,
      cathode ray tube (CRT) and DLP based display products, the manufacturers of
      these products may develop further improvements of their existing technology
      that would eliminate or diminish our anticipated advantage. In addition,
      numerous competitors have substantially greater financial, technical, marketing,
      distribution and other resources than we have. We may also face an aggressive,
      well-financed competitive response that may include misappropriation of our
      intellectual property or predatory pricing.





Our
      ability to compete will depend in part upon many factors, including the quality
      of the display images, manufacturing, capacity, delivery, pricing and technical
      specifications. In addition, there will be factors within and outside of our
      control, including customer support and the success and timing of product
      introduction and distribution by our customers. Our competitors may succeed
      in
      developing technologies and products that are equally or more efficient than
      any
      which we are developing, which will render our technology, displays and other
      products obsolete and non-competitive.





8




**Patents
      and Intellectual Property**





We
      currently have five U.S. patents and we have other U.S. and international patent
      applications pending. The scope of the issued patents includes physical
      structure design of the metal layers used for light blocking in the silicon
      die
      (or backplane), several silicon die (or backplane) circuitry designs, and a
      dual
      panel system design. The applications are in the area of light engine level
      system enhancements and drive circuitry concepts. Our currently issued patents
      will all expire between 2011 and 2017. There can be no assurance respecting
      the
      degree of protection offered by these patents or as to the likelihood that
      pending patents will be issued. Our competitors, in both the United States
      and
      foreign countries, many of which have substantially greater resources and have
      made substantial investments in competing technologies, may seek to apply for
      and obtain patents that will prevent, limit or interfere with our ability to
      make and sell our products or intentionally infringe upon our patents. We may
      undertake to expand our intellectual property portfolio by continuing to file
      new patent applications and/or by purchasing or licensing existing patents
      currently owned by other companies.





The
      defense and prosecution of patent suits is both costly and time-consuming,
      even
      if the outcome is favorable to us. This can be particularly true in foreign
      countries. In addition, there is an inherent unpredictability regarding
      obtaining and enforcing patents in foreign countries. An adverse outcome in
      the
      defense of a patent suit could subject us to significant liabilities to third
      parties, require disputed rights to be licensed from third parties, or require
      us to cease selling our products.





We
      also
      rely on unpatented proprietary technology and there can be no assurance that
      others may not independently develop the same or similar technology or otherwise
      obtain access to our proprietary technology. To protect our rights in these
      areas, we require all employees and technology consultants, advisors and
      collaborators to enter into confidentiality agreements. However, these
      agreements may not provide meaningful protection for our trade secrets, know-how
      or other proprietary information in the event of any unauthorized use,
      misappropriation or disclosure of such trade secrets, know-how or other
      proprietary information. To date, we have no experience in enforcing our
      confidentiality agreements.





**Research
      and Development**





The
      display industry has undergone and continues to undergo rapid and significant
      technological change. We expect display technologies to continue to develop
      rapidly, and our success will depend significantly on our ability to attain
      and
      maintain a competitive position. Rapid technological development may result
      in
      our products or processes becoming obsolete before we recoup a significant
      portion of related research and development, acquisition and commercialization
      costs.





We
      incurred research and development expenses of approximately $1,067,000 in 2006,
      $3,586,000 in 2005, and $2,306,000 in 2004. Research and development expenses
      are those costs incurred for personnel and experimental materials for the design
      and development of new products. We believe that the development of new products
      will be required to allow us to compete effectively and to achieve greater
      revenues than we have derived to date. As of December 31, 2006, we had 11
      employees in the U.S. whose significant duties included research and
      development. We intend to continue our product development programs, focusing
      on
      increasing the display specifications including resolution, color and
      manufacturing processes. We believe that such developments will be required
      to
      exploit future markets.





**Employees**





As
      of
      December 31, 2006, we had 19 full-time employees and one part-time employee
      located in California. Full-time employment is divided among two functional
      areas with 11 in research and development and nine in management/ finance/
      administration. As of December 31, 2006, we had 12 full-time employees
      classified as management/ finance/ administration in South Korea. We have eight
      engineers and 73 employees classified as manufacturing in South Korea. We
      consider our relations with our employees to be good.





**Item
      1A. Risk Factors.**





**We
      are confronted by serious liquidity concerns.**





As
      of the
      date hereof, we have very limited financial resources. Our operations to date
      have consumed substantial amounts of cash and will continue to require
      substantial amounts of cash in the future. In order to remain competitive,
      we
      must continue to make significant investments including further investments
      in
      research and development, equipment, and expansion of our facilities and
      production activities. Our $10,000,000 of Senior Secured Convertible Notes,
      issued in November 2004, are scheduled to mature on November 30, 2007. The
      Senior Secured Convertible Notes are convertible, at the option of their
      holders, into our common shares at the conversion price of $9.72 per share.
      The
      last sale price of our common shares on the NASDAQ Capital Market on March
      14,
      2007, was $0.66 per share and we do not expect the Noteholders to exercise
      their
      conversion rights. As a result, we will be required to repay to the Noteholders
      the entire $10,000,000 principal amount of the notes on that maturity date.





9


Taking
      into account our current financial condition, we will require significant
      additional financing to satisfy our increasing working capital requirements
      in
      2007 and thereafter. The report of our independent registered public accounting
      firm, Odenberg, Ullakko, Muranishi & Co. LLP, dated March 15, 2007 (except
      for the restatement as described in Note 1 under “Restatement” which is as of
      August 20, 2007), included in this Annual Report on Form 10-K/A raises
      substantial doubt with respect to our ability to continue as a going concern.





In
      the
      past, we have maintained our financial condition and liquidity primarily through
      private sales of our common shares (both registered and unregistered),
      convertible note financing, and the payment of exercise prices on our warrants
      and options. We have no assurance that outstanding stock options and warrants
      will be exercised in the future to any significant extent. Reliance on private
      equity purchase agreements and public offerings and exercises of derivative
      securities to finance our current and future operations entails the additional
      risks of our inability to sell our common shares or other securities and an
      insufficient number of derivative securities being exercised owing to the
      prevailing market prices of our underlying common shares. Additionally, any
      additional sales of our common stock may have a dilutive effect on the value
      of
      our outstanding shares. In the event that we are unable to obtain further
      financing on satisfactory terms, or at all, or if we are unable to generate
      sales sufficient to offset our costs, or if our costs of development and
      operations are greater than we anticipate, we may be unable to increase the
      size
      of our business at the rate desired or may be required to delay, reduce, or
      cease certain or all of our operations, any of which could materially harm
      our
      business and financial results.





**Certain
      of the holders of the Senior Secured Convertible Notes issued by us in November
      2004 have made claims of default.**





Holders
      of $9,000,000 principal amount of our Senior Secured Convertible Notes, issued
      in November 2004, have alleged that we have defaulted in the payment of the
      installment of interest due November 30, 2005. One of these holders has also
      alleged that we have defaulted in our failure to maintain the effectiveness
      of
      the registration statement relating to the shares of common stock issuable
      upon
      conversion of the Senior Secured Convertible Notes and that we have defaulted
      under the terms of the Senior Secured Convertible Notes by entering into certain
      types of debt financing transactions. These holders have demanded the immediate
      redemption of the principal amount of their Senior Secured Convertible Notes
      plus a redemption premium and other amounts. We do not believe that we have
      defaulted in the payment of interest on the Senior Secured Convertible Notes.
      We
      also believe that the registration statement has remained effective, that we
      have not entered into any debt financing transactions that would constitute
      a
      breach or failure in any material respect, and that we are otherwise in
      compliance with the relevant provisions of the Senior Secured Convertible Notes.
      At this date, we cannot predict what actions, if any, will be undertaken by
      any
      of the holders of the Senior Secured Convertible Notes, but we will contest
      any
      adverse actions as we believe that these allegations lack merit and would not
      entitle the holders of the Senior Secured Convertible Notes either to call
      such
      notes or to other remedies that they are seeking.





**We
      have experienced significant manufacturing difficulties during the past year
      that have resulted in our manufacturing and shipping LCoS Sets in only limited
      commercial quantities. If we encounter further difficulties in manufacturing
      our
      products in larger quantities we may have difficulty meeting customer demands
      and our operating results could be significantly harmed by such difficulties.**





We
      have
      experienced difficulties in manufacturing LCoS Sets during the past year. See
      “Management’s Discussion and Analysis of Financial Condition and Results of
      Operations - Status of Business with LG Electronics, Inc.” Although we believe
      that we have developed solutions to the past problems that allow us to achieve
      higher production and shipment volumes, because the manufacture of our LCoS
      Sets
      involves highly complex processes, technical problems may continue to arise
      as
      we manufacture our LCoS Sets and we cannot assure satisfactory manufacturing
      yields on a continuing basis or that we will be able to adequately ramp up
      volume production of our LCoS Sets.





Current
      and anticipated future purchase orders, which we cannot assure, will require
      us
      to produce greater quantities of LCoS Sets than we have produced in the past.
      Unanticipated future problems in manufacturing our LCoS Sets could cause
      additional production delays that might lead our current and prospective
      customers to seek other sources, which would negatively affect our operating
      results.





Although
      we believe that we will be able to mass produce our LCoS Sets, other companies,
      including some with substantially greater resources than us, have found great
      difficulty manufacturing LCoS products. We do not have reliable information
      about why other companies have failed to be able to manufacture similar liquid
      crystal microdisplays and can therefore make no assurances that we will not
      encounter similar problems.





10


We
      currently obtain silicon backplanes, a vital component in our microdisplays,
      from a company in Taiwan, which is subject to potential instability because
      of
      Taiwan’s troubled relations with China. Unless we obtain an alternative source,
      any disruption or termination of our silicon backplane manufacturing source’s
      operation in Taiwan could significantly harm our operations. Early in the second
      quarter of 2006, the silicon wafers that we received from our supplier contained
      flaws that have materially harmed our manufacturing yields. See Item 1 “Business
      - Manufacturing and Supply.”





The
      design and manufacture of LCoS Sets are highly complex processes that are
      sensitive to a wide variety of factors, including the level of contaminants
      in
      the manufacturing environment, variations in temperature and humidity,
      impurities in the materials used, and the performance of personnel and
      equipment. We have built and equipped a manufacturing plant in South Korea
      where
      we currently manufacture our LCoS Sets in limited quantities. We believe that
      these arrangements provide us with strong quality controls and effectively
      protect our proprietary technology in our products, but the risks discussed
      above associated with the highly complex processes of manufacturing these liquid
      crystal microdisplays remain applicable.





**Although
      we have commenced producing LCoS Sets in our manufacturing facility in South
      Korea, which serves as our principal facility for manufacturing our LCoS
      imagers, we may encounter difficulties in conducting our manufacturing
      operations and difficulties in maintaining our quality controls over the
      manufacturing and production processes in a foreign country, any of which would
      be likely to cause significant harm to our business.**





Our
      manufacturing operations were completely relocated from California to South
      Korea and the relocation of our manufacturing operations in South Korea may
      cause us to encounter one or more potential problems in our operations that
      could harm our business because of cultural or language differences, problems
      may arise in the training of, or communications with, our employees or the
      general operation of our manufacturing facility. These cultural or language
      differences may also create misunderstandings or the creation of inefficiencies
      in our operations. Furthermore, the geographic separation between our corporate
      offices in the United States and our principal manufacturing operation in South
      Korea could result in managerial or supervisory problems, which could lead
      to
      decreased quality controls and consequently materially harm our business.





**We
      have been largely dependent on one customer, LG Electronics Inc., for our future
      revenues, and failure to expand our customer base or receive additional orders
      from our existing customer base will make us vulnerable to substantial loss
      of
      potential revenues.**





In
      2005
      and 2006, almost all of our revenue has been derived from LG Electronics, Inc.
      (LGE). We have been informed by LGE of their intent to discontinue the
      production of rear projection televisions (both LCoS and DLP). We do not expect
      significant further sales to LGE. If we cannot diversify our customer base
      and
      derive increased revenues through additional purchase orders and product
      deliveries from customers other than LGE, we will be vulnerable to a substantial
      decline in anticipated revenues. Any such events could have a material adverse
      effect on our business, operations and financial condition and the value of
      our
      common shares could decline substantially.





**We
      are the subject of an investigation by the staff of the SEC regarding the
      circumstances surrounding our filing of certain consents of BDO Seidman, LLP
      without requisite authorization and transactions in our securities by our former
      Chief Executive Officer.**





We
      have
      been advised by the staff of the SEC that it is conducting an investigation
      into
      the circumstances surrounding our filing of certain consents of BDO Seidman
      LLP,
      our former independent accountant, without requisite authorization. The consents
      would have allowed us to incorporate by reference the reports of BDO Seidman
      LLP
      on our consolidated financial statements for the years ended December 31, 2002
      and 2003 into two of our registration statements on Form S-3 (File Nos.
      333-122391 and 333-122392) and each of the prospectuses constituting a part
      of
      such registration statements. Our current independent registered accounting
      firm, Odenberg, Ullakko, Muranishi & Co. LLP (OUM), has since provided us
      with a new report with respect to each of the three years ended December 31,
      2004 and we were not requested to amend or restate the financial statements
      contained in our annual reports on Form 10-K for any of the three fiscal years
      ended December 31, 2004 in connection with the issuance of OUM’s new report. We
      have also received notice that the SEC is investigating transactions in our
      securities by Mr. Robert Olins, our former Chief Executive Officer, Secretary,
      Treasurer and a Director. We have been cooperating and intend to continue to
      cooperate with the SEC in connection with these matters. In addition, the audit
      committee of our Board of Directors has concluded a review and investigation
      of
      these matters. As of this date, we cannot determine whether we or our management
      will be adversely affected by these investigations. See “Management’s Discussion
      and Analysis of Financial Condition and Results of Operations - Certain
      Developments” for further information concerning the circumstances underlying
      the SEC investigation and the audit committee investigation and report with
      respect to these matters.





**We
      may be subject to lawsuits relating to our use of a registration statement
      that
      did not contain an authorized consent of BDO Seidman LLP.**





As
      part
      of amendment numbers 5 and 6 to a registration statement (File No. 333-122391)
      registering shares for resale by certain selling shareholders and as part of
      amendment numbers 3 and 4 to a “shelf” registration statement (File No.
      333-122392), we filed a consent of BDO Seidman LLP to incorporate by reference
      their report on our consolidated financial statements for the fiscal years
      ended
      December 31, 2002 and 2003. Although we received the requisite authorized
      consents from BDO Seidman LLP to the incorporation by reference of their report
      on the consolidated financial statements into these registration statements
      when
      initially filed and subsequent amendments thereto (and BDO Seidman LLP has
      not
      withdrawn these consents), we did not receive the requisite authorization from
      BDO Seidman LLP to file its consent as an exhibit to the penultimate and final
      amendments to the registration statement before it was declared effective.
      These
      amendments were filed with the SEC on July 27, 2005. Subsequently, our current
      independent registered public accountants, OUM, re-audited our consolidated
      financial statements for fiscal years 2003 and 2002. OUM has given its consent
      to incorporate by reference into the registration statement its report related
      to the 2002 and 2003 financial statements. See “Management’s Discussion and
      Analysis of Financial Condition and Results of Operations - Certain
      Developments.”





11


Following
      the filing in July 2005 of amendments containing the unauthorized consents
      referred to above, the staff of the SEC declared both of the registration
      statements effective and shares of our common stock were sold. In August 2005,
      we filed post-effective amendment number 1 to both of these registration
      statements (those post-effective amendments were subsequently withdrawn and
      replaced by additional post-effective amendments), which disclosed the filing
      of
      the unauthorized consents.





Because
      both registration statements were used to sell common shares after the Staff
      of
      the SEC declared the registration statements effective, it is conceivable that
      there may be litigation against us or our officers or directors under Section
      11
      of the Securities Act of 1933, as amended (the “Securities Act”). Although we do
      not believe that the filing of an invalid consent constitutes a materially
      misleading statement or an omission to disclose a material fact within the
      meaning of Section 11 of the Securities Act, a contrary determination could
      result in a liability for us.





At
      present, we are unable to ascertain the exact amount of damages, if any, to
      which we could potentially be subject under a Section 11 claim instituted by
      any
      persons who directly purchased shares pursuant to those registration statements.
      Furthermore, at this date, we cannot ascertain the amount of damages, if any,
      for which we could be liable for claims instituted by any subsequent purchasers
      who could trace the shares purchased by them to those registration statements.
      In August 2005, we sold 500,000 common shares to three institutional purchasers
      for $5.40 per share pursuant to the “shelf” registration statement referenced
      herein. Each of those investors has since represented to us in writing, in
      connection with a separate transaction, that they have disposed of all of those
      shares. One of those institutional investors has represented to us that it
      sold
      those shares at a sale price at or higher than its purchase price from us.
      We
      believe, based upon discussions with the other two investors, that they sold
      their shares at a sale price of not lower than $4.25 per share. Therefore,
      we
      believe that the maximum amount of potential damages pursuant to Section 11
      claims from direct purchasers, which we would fully contest, would be $391,000,
      or the difference between the two investors’ purchase price and lowest believed
      resale price, multiplied by the 340,000 shares that they purchased and then
      resold.





In
      addition to any damage claims, which may be material to our financial condition,
      any lawsuit alleging securities law violations could require us to expend
      significant financial and managerial resources **.** Any
      such
      lawsuit could also result in further volatility in the market price of our
      common shares **.** Nothing
      set forth in the foregoing statement constitutes an express or implied admission
      by us of any liability under Section 11 of the Securities Act or otherwise.





**We
      may be subject to lawsuits relating to certain sales of our securities by our
      former Chief Executive Officer.**





Our
      Audit
      Committee determined that Robert A. Olins, our former Chief Executive Officer,
      Secretary, Treasurer and a Director failed to report the sale of an aggregate
      of
      70,556 of our common shares in August 2005 and February 2006 at sales prices
      ranging from $5.30 to $3.00. Pursuant to Section 16 of the Securities Exchange
      Act of 1934, as amended (the “Exchange Act”), Mr. Olins has filed delinquent
      reports and disgorged $22,273 in “short-swing profits” that he realized from the
      sales. We have been advised by the SEC that they are investigating the
      transactions in our securities by Mr. Olins and an entity which he controls,
      and
      have received and responded to a request from the SEC requesting documentation
      relating to all transactions by Mr. Olins and the entity which he controls.
      We
      have no knowledge of any other transactions by Mr. Olins, or this entity, that
      would be a violation of the Securities Act or the Exchange Act. If the SEC
      determines that these or other transactions by Mr. Olins were a violation of
      the
      Securities Act, it is conceivable that such transactions could be imputed to
      us
      and the SEC could seek to impose remedies against us, or private individuals
      could file litigation against us for damages. See “Management’s Discussion and
      Analysis of Financial Condition and Results of Operations - Certain
      Developments”.





We
      are
      unable to estimate the probability of liability or the amount of any penalties
      or damage claims that might arise, which may be material to our financial
      condition. We believe that Mr. Olins will disgorge any “short swing profits” if
      it is determined that he or the entity he controls engaged in transactions
      that
      violated Section 16 of the Exchange Act. Any action by the SEC or lawsuit
      alleging securities law violations could require us to expend significant
      financial and managerial resources and could also result in further volatility
      in the market price of our common shares **.** Nothing
      set forth in the foregoing statement constitutes an express or implied admission
      by us of any liability under the Securities Act, the Exchange Act or otherwise.





12


**The
      obligations arising from our Senior Secured Convertible Notes restrict our
      future financing alternatives and may result in financial difficulties for
      us in
      the future.**





The
      Senior Secured Convertible Notes issued in November 2004 bear a 10% rate of
      interest per annum and are not prepayable, in whole or in part, prior to their
      maturity on November 30, 2007. Therefore, we do not have the ability to
      refinance the 2004 Senior Secured Convertible Notes with debt obligations
      bearing more favorable terms to us or out of the proceeds of an equity financing
      until their maturity date. We do have the right to force the conversion of
      the
      Senior Secured Convertible Notes into our common shares in the event that our
      common shares trade at or above $14.58 (150% of the $9.72 conversion price
      of
      the Senior Secured Convertible Notes) for twenty consecutive trading days.
      The
      last sale price of our common shares on March 14, 2007, was $0.66 per share
      and
      it is not likely that we will be able to exercise our conversion right prior
      to
      the maturity of the Senior Secured Convertible Notes.





The
      Senior Secured Convertible Notes are secured by virtually all of our assets,
      other than those located in South Korea, and it may therefore be difficult
      for
      us to obtain future debt financing. However, the terms of the Senior Secured
      Convertible Notes allow us to subordinate the liens on accounts receivable,
      certain contract rights and inventory (the “Subject Property”) securing the
      Senior Secured Convertible Notes, to liens on the Subject Property securing
      certain other debt permitted, subject to certain conditions, by the Senior
      Secured Convertible Notes.





In
      addition, the issuance of any additional debt securities, except certain types
      of bank debt permitted under the Senior Secured Convertible Notes, will require
      the consent of the holders of a majority in interest of our Senior Secured
      Convertible Notes, to the extent that such notes remain issued and outstanding
      at the time of issuance of any additional debt securities. The prohibition
      against incurring debt may negatively affect our ability to engage in capital
      expenditures and to maintain and expand our manufacturing operations.





If
      we
      default in meeting our obligations under the Senior Secured Convertible Notes,
      the indebtedness which they evidence may become immediately due and payable,
      and
      the holders of the Senior Secured Convertible Notes may be entitled to foreclose
      on any of our assets securing the notes. As noted earlier, certain of the
      holders of our Senior Secured Convertible Notes have alleged that we have
      defaulted in meeting our obligations under the Senior Secured Convertible Notes
      and have demanded the immediate repayment of principal and liquidated damages.
      In the event these holders pursue their claims, and a court determines that
      we
      have defaulted in our obligations, we will have to seek financing from third
      parties to satisfy the holders’ claims. The Senior Secured Convertible Notes are
      convertible into our common shares and the issuance of such shares (including
      any shares issued in payment of interest on such notes) may have a dilutive
      effect on the value of our outstanding common shares.





**We
      have a history of losses and expect to incur losses in the future and therefore
      cannot assure you that we will achieve profitability.**





We
      have
      incurred operating losses to date and have experienced cash shortages. For
      the
      fiscal year ended December 31, 2006 and 2005, we incurred net losses of
      approximately $20 million and $14 million, respectively. In addition, we had
      an
      accumulated deficit of approximately $102 million as of December 31, 2006.
      We
      expect additional losses as we continue spending for commercial scale production
      and other business activities as well as further research and development of
      our
      products. As a result, we will need to generate substantial sales to support
      our
      costs of doing business before we can begin to recoup our operating losses
      and
      accumulated deficit and achieve profitability.





**We
      may be subject to liability if we default on our obligations to raise additional
      capital as required in the purchase documents related to our private placement
      of common shares in August 2006.**





Under
      the
      terms of the Securities Purchase Agreement dated August 9, 2006, as amended
      on
      October 25, 2006 (the “August 2006 Financing”), we must raise an additional
      $4,200,000 before April 15, 2007 (such date being the “Additional Financing
      Deadline”) or commence a subscription rights offering to our stockholders to
      purchase our common shares having an aggregate value of at least $14,200,000
      (which amount may be reduced on a dollar for dollar basis for any financing
      we
      complete before the Additional Financing Deadline). Because of our existing
      covenants with the holders of our Senior Secured Convertible Notes, which
      requires us to seek their consent before we agree to enter into additional
      material indebtedness, we will most likely try to raise the $4,200,000 through
      the sale of additional common shares. We can offer no assurance that we will
      successfully raise $4,200,000 nor can we offer any assurance that we will issue
      subscription rights to our stockholders in the future. In connection with the
      August 2006 Financing, we also agreed, for a period of one year following the
      closing of the August 2006 Financing, to refrain from, directly or indirectly,
      offering or selling any debt security that is, at any time during the life
      of
      the debt security and under any circumstance, convertible into or exchangeable
      for our common shares, unless we receive prior written consent from a majority
      of the purchasers of the August 2006 Financing.





In
      the
      event that we default upon the foregoing obligations, the purchasers of
      securities in our August 2006 Financing are entitled to contractual damages
      and
      may also request that we specifically perform our obligations under the purchase
      agreement giving rise to our obligations. At present, we are unable to quantify
      the amount of contractual damages to which the purchasers would be entitled,
      and
      we are unable to estimate the likelihood that a court would grant any
      purchaser’s application that we specifically perform our obligations.





13




**We
      are subject to lengthy development periods and product acceptance cycles, which
      may significantly harm our business.**





Our
      business model requires us to develop microdisplays that perform better than
      existing technologies, manufacture our LCoS Sets in bulk, and sell the resulting
      LCoS Sets to OEMs who will then incorporate them into their products. OEMs
      make
      the determination during their product development programs whether to
      incorporate our LCoS Sets and/or display units in their products. This requires
      us to invest significant amounts of time and capital in designing our LCoS
      Sets
      before we can be assured that we will generate any significant sales to our
      customers or even recover our investment. If we fail to recover our investment
      in the LCoS Sets, it could seriously harm our financial condition. In addition,
      the acceptance of new technologies developed by our competitors could limit
      the
      time period that our products may be demanded by our customers.





**We
      incur substantial operational and research and development costs in connection
      with products and technologies that may not be successful.**





We
      currently have 11 full-time engineering personnel based in California working
      on
      microdisplays. We currently have eight full-time engineering and 73 full-time
      manufacturing personnel based in South Korea. This staffing creates significant
      operational and research and development costs that may not be recouped. Even
      if
      our current LCoS Sets become accepted and/or successful, we must continue to
      employ, and may increase in number, our engineering and manufacturing personnel
      to develop future generations of our microdisplays because of the rapid
      technological changes in our industry. As a result, we expect to continue
      incurring significant operational and research and development costs.





**Geopolitical
      conditions or potential military conflicts between the United States or South
      Korea and North Korea may negatively impact our business.**





We
      commenced producing products in our principal manufacturing operations in South
      Korea during the second quarter of 2005, and our largest customer, LGE, resides
      in South Korea. South Korea and North Korea are technically at war with each
      other, despite the mutually agreed upon existence of the Demilitarized Zone
      and
      the relative absence of physical conflict for several decades. Any escalation
      in
      the existing conflict between these countries or any commencement, or perceived
      commencement, of a military conflict between the United States or South Korea
      and North Korea, may limit our ability to effectively operate our manufacturing
      facility in South Korea and may also substantially limit our ability to sell
      products into South Korea because of the negative economic, physical or other
      destructive impact that such a conflict could have on our most important
      customer. Any such disruptions to our manufacturing operations and/or ability
      to
      consummate sales to a substantial customer could adversely affect the
      development of our business and our financial condition. The recent escalation
      in tension between the United States and North Korea, as a result of North
      Korea’s attempts to test certain of their missiles and nuclear devices, has not
      impacted our operations in South Korea, but we can provide no assurances that
      continued tension will not negatively affect our operations.





**If
      the high definition projection television market does not continue to develop
      and if other potential markets for our products do not materialize, then our
      business will likely be significantly harmed.**





High
      definition television programming has only recently become available to
      consumers, and widespread market acceptance, although anticipated, is uncertain
      at this time. The market demand for high definition televisions is considered
      contingent upon widespread acceptance of high definition television programming.
      Current trends in cable and satellite programming as well as availability of Blu-ray
      DiscTM and
      HD-DVD high definition pre-recorded media support the transition to high
      definition television. Our current sales and marketing efforts are focused on
      OEMs of high definition televisions and OEMs of light engines designed for
      incorporation into high definition projection televisions. Therefore, if the
      market for high definition televisions continues to grow and develop, but that
      the projection TV format (as opposed to flat panel display formats such as
      LCD
      TV and Plasma TV) does not maintain a large market share, then we will have
      difficulty selling our products for this application, which will have an adverse
      effect on our results of operations.





Various
      potential target markets for our products, including projectors, monitors,
      and
      portable microdisplays, are uncertain and may be slow to develop. In addition,
      companies in those markets could utilize competing technologies. For us to
      succeed in selling our products in these potential markets we must offer
      end-product manufacturers higher quality and less expensive microdisplay
      products than our competitors, and the manufacturers themselves will also have
      to develop commercially successful products using our products. In the event
      that we attempt to market and sell our products in these potential target
      markets, and we are not able to succeed in selling our products into these
      potential markets, then our results of operations and overall business may
      be
      negatively affected.





14




**If
      our products do not become widely accepted by our customers or the end-users,
      our business could be significantly harmed.**





Our
      LCoS
      Sets may not be accepted by a widespread market **.** Even
      if
      we successfully obtain customer orders, our customers may determine not to
      introduce or may terminate products utilizing the technology for a variety
      of
      reasons, including the following:





·
            superior
                technologies developed by our competitors;




·
            price
                considerations; and




·
            lack
                of anticipated or actual market demand for the products.





**We
      cannot assure you that we will obtain additional purchase orders from our
      current or prospective customers, or, if we do, that such orders will generate
      significant revenues.**





Even
      though in the past we have received purchase orders for our LCoS Sets and/or
      display units from LGE and from certain Chinese and Taiwanese OEMs, and may
      receive additional purchase orders from prospective customers, sales to
      manufacturers in the electronics industry are subject to severe competitive
      pressures, rapid technological change and product obsolescence. In addition,
      purchase orders received from our customers other than LGE are for limited
      quantities. Customers may, at any time, cancel purchase orders or commitments
      or
      reduce or delay orders, thereby increasing our inventory and overhead risks.
      Therefore, despite the purchase orders received from current customers and
      other
      purchase orders that we may receive from prospective customers, we cannot assure
      you that these orders will result in significant revenues to us.





**If
      our customers’ products are not successful, our business would be materially
      harmed.**





We
      do not
      currently sell any products to end-users. Instead, we design and manufacture
      various product solutions that our customers may incorporate into their
      products. As a result, our success depends almost entirely upon the widespread
      market acceptance of our customers’ products. Any significant absence of, or
      slowdown in the demand for our customers’ products would materially harm our
      business.





Our
      dependence on the success of the products of our customers exposes us to a
      variety of risks, including our need to:





·
            maintain
                customer satisfaction with our design and manufacturing services;




·
            match
                our design and manufacturing capacity with customer demand and maintain
                satisfactory delivery schedules;




·
            anticipate
                customer order patterns, changes in order mix, and the level and
                timing of
                orders that we can meet; and




·
            adjust
                to the cyclical nature of the industries and markets we serve.





Our
      failure to address these risks may cause us to lose sales or our sales to
      decline.





**The
      high definition television industry is highly competitive, which may result
      in
      lost sales or lower gross margins.**





We
      serve
      the highly competitive high definition television industry that is characterized
      by price erosion, rapid technological change and competition from major domestic
      and international companies. This intense competition could result in downward
      pricing pressures, lower sales, reduced margins and lower market share.





Companies
      competing in the LCoS microdisplay market include Sony Corporation and Victor
      Company of Japan, Limited (“JVC”). A major competitor of ours in the reflective
      microdisplay market is Texas Instruments, which, rather than using liquid
      crystals in the display, is producing a micro-mechanical structure of moving
      mirrors on a silicon backplane, a technology known as digital light processing,
      or DLP. Texas Instruments has had significant success selling its DLP products
      to its customers in the business front projector market and the rear projection
      high definition television market. Some of our competitors, including Texas
      Instruments, Sony, and JVC, have greater market recognition, larger customer
      bases, and substantially greater financial, technical, marketing, distribution
      and other resources than we possess. As a result, they may be able to introduce
      new products and respond to customer requirements more quickly and effectively
      than we can.





Rapid
      and
      significant technological advances have characterized the microdisplay market.
      There can be no assurance that we will be able to effect any significant
      technological advances or that we will have sufficient funds to invest in new
      technologies or products or processes. Although we believe that our displays
      have specifications and capabilities, which equal or exceed that of commercially
      available liquid crystal displays (“LCD”), cathode ray tube (“CRT”) and DLP
      based display products, the manufacturers of these products may develop further
      improvements of their existing technology that would eliminate or diminish
      our
      anticipated advantage. The acceptance of our LCoS Sets and/or display units
      will
      be dependent upon the pricing, quality, reliability and useful life of these
      products compared to competing technologies, as to which there can be no
      assurance.





15




Our
      competitive position also may suffer if one or more of our customers decide
      to
      design and manufacture their own microdisplay products, to contract with our
      competitors, or to use alternative technologies. In addition, customers in
      the
      television manufacturing industry typically develop a second source. Second
      source suppliers may win an increasing share of our customers’ product demands.





Our
      ability to compete successfully depends on a number of factors, both within
      and
      outside our control. These factors include:





·
            our
                success in designing and manufacturing new display technologies;




·
            our
                ability to address the needs of customers;




·
            the
                quality, performance, reliability, features, ease of use, pricing,
                and
                diversity of our display products;




·
            foreign
                currency fluctuations, which may cause a foreign competitor’s products to
                be priced significantly lower than our displays;




·
            the
                quality of our customer services;




·
            the
                efficiency of our production sources; and




·
            the
                rate at which customers incorporate our displays into their own products.





**Fluctuations
      in the exchange rate of the United States dollar and foreign currencies could
      have a material adverse effect on our financial performance and profitability.**





A
      portion
      of our costs is denominated in foreign currencies, including the Korean Won
      and
      the Euro. As a result, changes in the exchange rates of these currencies or
      any
      other applicable currencies to the U.S. Dollar will affect our costs of goods
      sold and operating margins, and could result in exchange losses. We cannot
      fully
      predict the impact of future exchange rate fluctuations on our profitability.
      From time to time, we may engage in exchange rate hedging activities in an
      effort to mitigate the impact of exchange rate fluctuations, although we have
      not engaged in any such hedging activities to date. We cannot offer assurance
      that any hedging technique we may implement will be effective. If it is not
      effective, we may experience reduced operating margins.





16




**Our
      operating results are subject to significant fluctuations.**





Our
      results of operations have varied significantly from quarter-to-quarter and
      are
      likely to vary significantly in the future, making it difficult to predict
      our
      future operating results. Accordingly, we believe that quarter-to-quarter
      comparisons of our operating results are not meaningful and should not be relied
      upon as an indicator of our future performance. Some of the factors that cause
      our operating results to fluctuate include:





·
            introductions
                of displays and market acceptance of new generations of displays;




·
            timing
                of expenditures in anticipation of future orders;




·
            changes
                in our cost structure;




·
            availability
                of labor and components;




·
            pricing
                and availability of competitive products and services;




·
            the
                timing of orders;




·
            the
                volume of orders relative to the capacity we can contract to produce;




·
            evolution
                in the life cycles of customers’ products; and




·
            changes
                or anticipated changes in economic conditions.





**The
      market price of our common stock is highly volatile.**





The
      market price of our common stock has been highly volatile, reflecting among
      other things reported losses, receipts of additional financing and investors'
      perceptions about our business prospects. Some research has shown that similar
      volatility in other companies correlates with initiation of class action
      securities lawsuits although to date we have not been a defendant in any such
      lawsuit. The trading price of our common shares in the future could continue
      to
      be subject to wide fluctuations in response to various factors, including:





·
            quarterly
                variations in our operating results;




·
            actual
                or anticipated announcements of technical innovations or new product
                developments by us or our competitors;




·
            public
                announcements regarding our business developments;




·
            changes
                in analysts' estimates of our financial performance;




·
            sales
                of large numbers of shares of our common stock by our shareholders;




·
            general
                conditions in the electronics industry; and




·
            worldwide
                economic and financial conditions.





17




In
      addition, the stock market has experienced significant price and volume
      fluctuations that have particularly affected the market prices for many
      high-technology companies and that often have been unrelated to the operating
      performance of these companies. These broad market fluctuations and other
      factors may adversely affect the market price of our common stock.





**Future
      offerings of our common stock, or securities convertible into or exercisable
      for
      our common stock, could cause the market price of our common stock to decrease
      significantly, even if our business operations are performing well.**





We
      could
      issue up to 108,134,848 additional shares of common stock under our current
      “Shelf” Registration Statement (Registration Number 333-137100) (subject to the
      number of authorized shares available), based on the price of our common stock
      on March 14, 2007 or $0.66 per share. This is more than double of the total
      number of shares of our common stock that were issued and outstanding as of
      March 14, 2007. Sales of these shares into the public market, or the perception
      that future sales of these shares could occur, might adversely affect the
      prevailing market price of our common stock in the near future. Furthermore,
      market perceptions regarding the likelihood that we will be required to issue
      and sell additional shares of our common stock in the near future to fund our
      ongoing operations, thereby diluting the ownership interests of current owners
      of our common stock, could have a material adverse effect on the market price
      of
      our common stock.





**Our
      common stock may not be liquid.**





Shares
      of
      our common stock are currently traded on The NASDAQ Capital Market. Our
      stockholders may find that it is more difficult to sell shares of our common
      stock than shares that are listed on The NASDAQ Global Market or The New York
      Stock Exchange. The trading volume of our common stock has historically been
      adversely affected by their limited marketability, but such volume has increased
      significantly in recent periods. Nevertheless, any substantial sales of our
      common stock may result in a material reduction in their market price,
      reflecting the volatility of the trading market for shares of our common
      stock.





**If
      we lose our key personnel or are unable to attract and retain additional
      personnel, our ability to compete could be harmed.**





Our
      development and operations depend substantially on the efforts and abilities
      of
      our senior management and qualified technical personnel. Our products require
      sophisticated production, research and development and technical support. The
      competition for qualified management and technical personnel is intense. The
      loss of services of one or more of our key employees or the inability to add
      key
      personnel could have a material adverse affect on us particularly since
      currently we do not have any insurance policies in place to cover that
      contingency. Our success will depend upon our ability to attract and retain
      highly qualified scientific, marketing, manufacturing, financial and other
      key
      management personnel. We face intense competition for the limited number of
      people available with the necessary technical skills and understanding of our
      products and technology. We cannot assure you that we will be able to attract
      or
      retain such personnel or not incur significant costs in order to do so.





**Our
      future success depends on our ability to protect our proprietary technology
      and
      our registered intellectual property.**





We
      believe that our success depends in part on protecting our proprietary
      technology. We rely on a combination of patent, copyright, trademark and trade
      secret laws, as well as confidentiality and assignment of inventions agreements
      from our employees, consultants, advisors and other contractual provisions,
      to
      establish and protect our intellectual property rights. If we are unable to
      protect our intellectual property from use by third parties, our ability to
      compete in the industry will be harmed, however, policing unauthorized use
      of
      our products and technology is difficult. Despite our efforts to protect our
      proprietary rights, we face the following risks:





·
            pending
                patent applications may not be issued;




·
            patents
                issued to us may be challenged, invalidated, or circumvented;




·
            unauthorized
                parties may obtain and use information that we regard as proprietary
                despite our efforts to protect our proprietary rights;




·
            others
                may independently develop similar technology or design around any
                patents
                issued to us;




·
            breach
                of confidentiality agreements;




·
            intellectual
                property laws may not protect our intellectual property; and




·
            effective
                protection of intellectual property rights may be limited or unavailable
                in some foreign countries, such as China, in which we may operate.
                Specifically, although we consider the following unlikely because
                of the
                complex technological structure of our products, one or more of our
                current or prospective Chinese, Korean or Taiwanese customers, or
                their
                respective employees or other persons including our competitors,
                that have
                or gain access to our products for testing purposes, may seek to
                misappropriate or improperly convert to their own use our intellectual
                property and a lack of adequate remedies and impartiality under the
                Chinese, Korean, Taiwanese and other foreign legal systems may adversely
                impact our ability to protect our intellectual property.





18




There
      can
      be no assurance that we will have adequate remedies or the resources to pursue
      those remedies in the event any of the foregoing materializes. Failure to
      protect our intellectual property would limit our ability to produce and market
      our products in the future, which would materially adversely affect our revenues
      generated by the sale of such products.





In
      addition, third parties could assert that our products and technology infringe
      their patents or other intellectual property rights. As a result, we may become
      subject to future patent infringement claims or litigation, the defense of
      which
      is costly, time-consuming and diverts the attention of management and other
      personnel.





**The
      material weaknesses identified by our management and our independent registered
      public accounting firm with respect to our internal controls over financial
      reporting may have a materially negative impact on our business.**





In
      accordance with the rules prescribed by the SEC and the Sarbanes-Oxley Act
      of
      2002, we must periodically assess the effectiveness of our internal controls
      over financial reporting. During our preparation of our Annual Report on Form
      10-K for the fiscal years ended December 31, 2006 and 2005, our management
      and
      our independent registered public accounting firm identified several material
      weaknesses in our internal controls over financial reporting. As of this date,
      the material weaknesses identified include the fact that our Audit Committee
      does not have a member who is deemed a “financial expert” as defined by the
      rules promulgated by the SEC, although a member of our audit committee has
      the
      level of financial sophistication that the rules of the National Association
      of
      Securities Dealers require. We lack qualified financial executive management
      to
      perform independent secondary reviews over complex and non-routine accounting
      matters. Additionally, we did not maintain a formal policy relating to the
      updating of standard costs and reviewing variances with actual costs, which
      affects the accounting for inventory. We may need to incur significant
      additional expenses to achieve compliance and we may incur other costs in
      connection with regulatory enforcement actions, any of which could negatively
      impact our business.





**Political,
      economic and regulatory risks associated with international operations may
      limit
      our ability to do business abroad.**





A
      substantial number of our customers, manufacturers and suppliers are located
      outside of the United States, principally in the Far East. Our international
      operations are subject to political and economic conditions abroad, and
      protectionist trade legislation in either the United States or foreign
      countries, such as a change in the current tariff structures, export or import
      compliance laws, or other trade policies, any of which could adversely affect
      our ability to manufacture or sell displays in foreign markets and to purchase
      materials or equipment from foreign suppliers. Certain of our current purchase
      order agreements with customers are governed by foreign law and therefore are
      subject to uncertainty with regard to their enforceability.





**Although
      we have a 50 year 100% land lease payment exemption from the South Korean
      government for our South Korean facility, we could lose this land lease payment
      exemption in the event we lose our “high technology”
certification.**





In
      September 2004, we entered into a fifty year term lease with the Gyeongnam
      provincial government for 8.3 acres of undeveloped land in Jinsa, Gyeongnam
      province in South Korea. We leased the land for the purpose of constructing
      a
      state-of-the-art manufacturing facility with the anticipated capacity to meet
      mass production-scale demand from our customers and prospective customers.
      We
      have received a 100% land lease payment exemption because the land has been
      designated a “free economic zone” by the South Korean national government and
      the South Korean government also certified us as a “high technology” company.
      Under our agreement with the Gyeongnam provincial government we could lose
      our
      land lease payment exemption in the event that we lose our “high technology”
certification, which could increase the costs of operating the facility and
      negatively impact our business. Additionally, if we were to lose the lease,
      we
      might be required to donate the building to the South Korean
      government.





**We
      have federal net operating losses which may expire before we can utilize
      them.**





At
      December 31, 2006, the Company had a federal net operating loss carryforward
      of
      approximately $79.7 million. Section 382 of the Internal Revenue Code imposes
      an
      annual limitation on the utilization of net operating loss carryforward
      following a “change in ownership.” The amount of the limitation is based on a
      statutory rate of return and the value of the corporation at the time of the
      change of ownership. Private placements and other sales of equity securities
      by
      the Company can cause a change of ownership either individually or in the
      aggregate. If a change of ownership occurs and an annual limitation is imposed,
      a portion of these carryforwards may expire before the Company is able to
      utilize them.





19




**We
      do not pay cash dividends.**





We
      have
      never paid any cash dividends on our common shares and do not anticipate that
      we
      will pay cash dividends in the near future. Moreover, under the terms of our
      November 2004 Financing, we are prohibited from paying cash dividends while
      the
      Senior Secured Convertible Notes issued in the November 2004 Financing remain
      outstanding. Instead, we intend to apply any future earnings, as to which there
      can be no assurances, to the satisfaction of our obligations, and development
      and expansion of our business.





**Item
      1B.**  **Unresolved
      Staff Comments.**





None.





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





Our
      headquarters are located at Five Hamilton Landing, Suite 100, Novato,
      California. Our premises, which were designed and built-out to our
      specifications, encompass our corporate offices, quality assurance and testing
      facilities and optics laboratories. The facility aggregates 14,000 square feet
      and the lease continues through August 2009. We also leased “clean room” space
      in California where we manufactured components of our LCoS Sets in limited
      quantities through the end of 2005. In September 2004, we entered into a fifty
      year term lease with the Gyeongnam provincial government for 8.3 acres of
      undeveloped land in Jinsa, Gyeongnam province in South Korea. We leased the
      land
      for the purpose of constructing a state-of-the-art manufacturing facility with
      the anticipated capacity to meet mass production-scale demand from our customers
      and prospective customers. We have received a 100% land lease payment exemption
      because the land has been designated a “free economic zone” by the South Korean
      national government and the South Korean government also certified us as a
“high
      technology” company. Under our agreement with the Gyeongnam provincial
      government we could lose our land lease payment exemption in the event that
      we
      lose our “high technology” certification. We completed construction of our South
      Korean manufacturing facility in January 2005. The South Korean facility
      (approximately 25,000 sq. feet) has commenced to serve as our central commercial
      manufacturing base. For a more detailed discussion of our South Korean
      manufacturing facility, see Item 7. Management’s Discussion and Analysis of
      Financial Condition and Results of Operations. We believe that our current
      facilities are adequate to fulfill our business commitments for the immediate
      foreseeable future.





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





We
      are
      not currently involved in any material legal proceedings. We are a party to
      routine claims and lawsuits from time to time in the ordinary course of
      business. While the outcome of such ordinary course proceedings cannot be
      predicted with certainty, we believe that the resolution of any such matters
      individually or in the aggregate will not have a material adverse effect on
      our
      business, financial condition or results of operations.





We
      have
      received notices alleging events of default under the terms of the Senior
      Secured Convertible Notes (but for which we are not yet subject to legal
      proceedings) which we are contesting as more fully described under Item 7 -
      “Management’s Discussion and Analysis - Senior Secured Convertible Debt
      Financing” and Note 3 to the Consolidated Financial Statements.





We
      have
      received notice of an investigation by the SEC into the circumstances related
      to
      our filing of an unauthorized consent by BDO Seidman LLP in connection with
      certain registration statements and transactions in our common stock by Mr.
      Robert Olins, our former Chief Executive Officer and a former Director and
      an
      entity he controls. No legal proceeding has been commenced against us and we
      are
      cooperating with the SEC in their investigation. See “Management’s Discussion
      and Analysis of Financial Condition and Results of Operations - Certain
      Developments.”





In
      connection with his departure, Don Suh, our former Chief Executive Officer,
      has
      filed a claim against the Company alleging the Company violated the
      Sarbanes-Oxley Whistleblower laws and is asking for severance of $250,000 plus
      a
      year’s worth of benefits. We do not believe that his assertions have merit but
      cannot predict the ultimate outcome of any potential litigation.





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





There
      were no matters submitted to a vote of our security holders during the fourth
      quarter of fiscal 2006.





**PART
      II**





**Item
      5.**  **Market
      for Registrant’s Common Equity, Related Stockholders Matters and Issuer
      Purchases of Equity Securities.**


Trading
        in our common shares has been conducted on The Nasdaq Capital Market since
        May
        24, 2000, under the symbol “HDTV.” Because we are traded on the Capital Market,
        our securities may be less liquid, receive less coverage by security analysts
        and news media and generate lower prices than might otherwise be obtained.


20





The
      following table sets forth, for the calendar quarters indicated, the range
      of
      high and low quotations for our common shares, as reported by Commodity Systems,
      Inc.




Fiscal
                2006High
            
            LowFirst
                Quarter
            
            $
            3.71
            
            $
            2.09Second
                Quarter
            
            
            3.99
            
            
            2.00Third
                Quarter
            
            
            3.10
            
            
            2.00Fourth
                Quarter
            
            
            2.45
            
            
            1.32




Fiscal
                2005High
            
            LowFirst
                Quarter
            
            $
            9.15
            
            $
            4.45Second
                Quarter
            
            
            6.98
            
            
            4.45Third
                Quarter
            
            
            6.46
            
            
            3.90Fourth
                Quarter
            
            
            4.77
            
            
            3.11




The
      quotations listed above reflect inter-dealer prices, without retail mark-up,
      markdown or commission and may not represent actual transactions.





As
      of
      March 14, 2007, there were approximately 496 holders of record of our common
      shares and the closing price per share was $0.66 as reported on the Nasdaq
      Capital Market. The common shares represent the only class of securities
      outstanding as of the date of this filing.





To
      date,
      we have not paid a dividend on our common shares. The payment of future
      dividends is subject to our earnings and financial position and such other
      factors, including contractual restrictions, as the Board of Directors may
      deem
      relevant. Under the terms of the November 2004 Financing which is more fully
      described under Item 7 “Overview,” we are prohibited from paying cash dividends
      while the 2004 Senior Secured Convertible Notes issued in the November 2004
      Financing remain outstanding. It is therefore unlikely that dividends will
      be
      paid in the foreseeable future.





Performance
      Graph





The
      following graph compares the cumulative 5-year total return to shareholders
      on
      SpatiaLight, Inc.'s common stock relative to the cumulative total returns of
      the
      S & P 500 index, and a customized peer group of four companies that
      includes: Brillian Corp., Kopin Corp., Microvision Inc and Universal Display
      Corp. An investment of $100 (with reinvestment of all dividends) is assumed
      to
      have been made in the company's common stock, in the peer group, and the index
      on December 31, 2001 and its relative performance is tracked through December
      31, 2006.





21









Dec-01
              
              Dec-02
              
              Dec-03
              
              Dec-04
              
              Dec-05
              
              Dec-06SpatiaLight,
                  Inc.
              
              $
              100.00
              
              $
              35.57
              
              $
              76.71
              
              $
              127.86
              
              $
              49.57
              
              $
              19.29S
                  & P 500
              
              
              100.00
              
              
              77.90
              
              
              100.24
              
              
              111.15
              
              
              116.61
              
              
              135.03Peer
                  Group
              
              
              100.00
              
              
              36.63
              
              
              61.45
              
              
              40.68
              
              
              45.07
              
              
              46.69




The
      stock
      price performance included in this graph is not necessarily indicative of future
      stock price performance.





Securities
      Authorized for Issuance under Equity Compensation Plans




The
      following table provides information as of December 31, 2006 regarding
      compensation plans (including individual compensation arrangements) under which
      equity securities are authorized for issuance.




**EQUITY
        COMPENSATION PLAN INFORMATION**
  **Plan
                  Category**
              
              **Number
                  of Securities to Be Issued Upon Exercise of Outstanding Options**
              
              **Weighted-Average
                  Exercise Price of Outstanding Options (Excluding Securities Reflected
                  in
                  Column (a))**
              
              **Number
                  of Securities Remaining Available For Future Issuance Under Equity
                  Compensation Plans (Excluding Securities Reflected in Column
                  (a)**(a)
              
              (b)
              
              (c)Equity
                  Compensation Plans (2006 Incentive Plan and 1999 Stock Option Plan)
                  Approved by Security Holders
              
              
              4,849,894
              
              $
              3.42
              
              
              5,204,166Equity
                  Compensation Plans (Outside the 2006 Incentive Plan and 1999 Stock
                  Option
                  Plan)
              
              
              870,000
              
              $
              1.50
              
              
              0Total
              
              
              5,719,894
              
              
              
              
              
              5,204,166*
                  For more information see Note 6 to the Consolidated Financial
                  Statements.




**Item
      6.**  **Selected
      Condensed Consolidated Financial Data.**





The
      selected consolidated financial data as of, and for the periods ended, December
      31, 2006, 2005, 2004, 2003, and 2002 presented below have been derived from
      the
      audited Consolidated Financial Statements of SpatiaLight. The selected financial
      data should be read in conjunction with our Consolidated Financial Statements
      and notes thereto and Item 7 “Management’s Discussion and Analysis of Financial
      Condition and Results of Operations” included elsewhere herein, in order to
      fully understand factors that may affect the comparability of the financial
      data
      presented below. Certain reclassifications have been made in the prior years
      to
      conform to current year presentation.




22




**Statements
                  of Operations:**
 Year
                    Ended December 31,2006
                
                2005
                
                2004
                
                2003
                
                2002Revenue
                
                $
                474,004
                
                $
                237,724
                
                $
                1,160,978
                
                $
                221,252
                
                $
                -Gross
                    margin
                
                $
                (5,387,640
                )
                $
                (1,519,365
                )
                $
                178,696
                
                $
                (487,068
                )
                $
                (286,000
                )Total
                    operating expenses
                
                $
                11,810,774
                
                $
                11,027,836
                
                $
                9,046,876
                
                $
                8,308,470
                
                $
                6,714,882Net
                    loss before cumulative effect of changein
                    accounting principle
                
                $
                (20,172,994
                )
                $
                (14,024,639
                )
                $
                (9,367,001
                )
                $
                (9,516,377
                )
                $
                (9,027,913
                )Cumulative
                    effect of change in accountingprinciple
                
                $
                (223,993
                )
                $
                -
                
                $
                -
                
                $
                -
                
                $
                -Net
                    loss
                
                $
                (20,396,987
                )
                $
                (14,024,639
                )
                $
                (9,367,001
                )
                $
                (9,516,377
                )
                $
                (9,027,913
                )Net
                    loss per share - basic and diluted:Net
                    loss per share before cumulative effectof
                    change in accounting principle
                
                $
                (0.50
                )
                $
                (0.39
                )
                $
                (0.27
                )
                $
                (0.34
                )
                $
                (0.37
                )Cumulative
                    effect of change in accountingprinciple
                
                $
                (0.01
                )
                $
                -
                
                $
                -
                
                $
                -
                
                $
                -Net
                    loss per share
                
                $
                (0.50
                )
                $
                (0.39
                )
                $
                (0.27
                )
                $
                (0.34
                )
                $
                (0.37
                )Weighted
                    average shares used in computingnet
                    loss per share- basic and diluted
                
                
                40,717,579
                
                
                36,375,068
                
                
                34,154,057
                
                
                28,173,770
                
                
                24,578,226
  **Balance
                    Sheet Data:**December
                    31,2006
                
                2005
                
                2004
                
                2003
                
                2002Cash
                    and cash equivalents
                
                $
                220,256
                
                $
                42,565
                
                $
                9,087,551
                
                $
                6,359,969
                
                $
                575,663Inventory,
                    net
                
                $
                423,075
                
                $
                756,723
                
                $
                1,173,314
                
                $
                779,617
                
                $
                275,959Working
                    capital (deficit)
                
                $
                (12,893,640
                )
                $
                (3,435,696
                )
                $
                7,679,815
                
                $
                6,228,782
                
                $
                (807,891
                )Total
                    assets
                
                $
                6,246,044
                
                $
                8,081,078
                
                $
                15,258,136
                
                $
                8,349,696
                
                $
                2,058,454Secured
                    convertible notes
                
                $
                10,784,087
                
                $
                10,340,113
                
                $
                9,885,140
                
                $
                1,155,000
                
                $
                4,207,232Total
                    stockholders' equity (deficit)
                
                $
                (8,838,593
                )
                $
                (7,915,226
                )
                $
                1,578,182
                
                $
                5,813,275
                
                $
                (4,373,806
                )


**Item
      7.**  **Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations.**





*The
      following discussion and analysis of our financial condition and results of
      operations should be read in conjunction with the consolidated financial
      statements and related notes appearing elsewhere in this Report. This discussion
      and analysis contains forward-looking statements that involve risks,
      uncertainties and assumptions as indicated in the introductory paragraphs to
      Item 1 of this Report. The actual results could differ materially from those
      anticipated in these forward-looking statements as a result of certain factors,
      including but not limited to, customers reception of our products, intensity
      of
      competition, quality control during manufacturing and those set forth under
      Risk
      Factors Item 1A.*




**Overview**





We
      are in
      the business of manufacturing high-resolution LCoS microdisplays. Our current
      customers are original equipment manufacturers (OEMs) engaged in the business
      of
      manufacturing high definition televisions or manufacturing light engines for
      incorporation into high definition televisions. Our products are also suitable
      for incorporation into other potential display applications including front
      projection systems, rear projection computer monitors, head mounted displays,
      micro-projectors, wireless communication devices, portable games and digital
      assistants, and we are now currently working with OEMs on some of these
      products.




23




*Restatement
      of Financial Results*




On
      July
      24, 2007, we received evidence that LG Electronics (“LGE”) communicated its
      intention to terminate our Supply Agreement to Mr. Don Suh, in October 2006,
      in
      the form of an email to Mr. Suh’s personal email account. The mid-October email
      to Mr. Suh from LGE was first disclosed to SpatiaLight executives during
      settlement discussions by LEG’s legal counsel on July 24, 2007. At the time of
      the October 2006 email, Mr. Suh was our Senior Vice President for Marketing
      and
      Sales. He was later appointed to Chief Executive Officer on November 6, 2006,
      and was subsequently terminated on December 12, 2006. O n
      March
      9, 2007, we received oral notification from LGE of their intent to discontinue
      the production of all rear projection televisions. As a result of the October
      2006 email, we concluded that the asset impairment loss related to our building
      in South Korea should be recorded in the fourth quarter of 2006. We had
      previously recorded the impairment loss in the first quarter of 2007, based
      upon
      the March 9, 2007 notification from LGE.




*Status
      of Business with LG Electronics, Inc.*




LG
      Electronics (LGE) has informed us of their intent to discontinue the production
      of rear projection television (RPTV) (both LCoS and DLP). We do not expect
      significant further sales to LGE, are currently in negotiations with LGE related
      to an appropriate exit strategy, and are currently assessing the impact of
      this
      communication on our business.




In
      July
      2004, we entered into an agreement with LG Electronics (LGE) providing for
      us to
      sell our T-3 LCoS Sets to LGE. Our supply agreement with LGE provides that
      we
      will be their exclusive supplier of three-chip LCoS microdisplay products for
      twelve months beginning from the date that we commenced shipments under that
      agreement. Our agreement provides that LGE will have the exclusive right in
      South Korea to purchase microdisplay products based on our T-3 LCoS Sets from
      us
      for the twelve months beginning from the date that we commenced shipments under
      that agreement. In July 2005, we commenced delivering a limited quantity of
      commercial production LCoS Sets to LGE. Under the July 2004 agreement, LGE
      agreed to purchase from us a minimum of 21,000 LCoS Sets during an initial
      six-month delivery period, which was originally scheduled to commence in January
      2005, subject to LGE's completion of pre-production requirements. Our July
      2005
      product delivery to LGE included a smaller quantity of LCoS Sets than was
      originally contemplated under the July 2004 agreement for the first delivery
      month. We delivered those LCoS Sets in July 2005 based upon our expectation
      that
      in the immediate future we would receive a firm purchase order from LGE.





In
      August
      2005, we received a firm purchase order from LGE for its purchase from us of
      an
      aggregate minimum quantity of 9,300 LCoS Sets for the period July through
      December 2005. In October 2005, we publicly announced that we had received
      the
      formal written qualification letter from LGE stating that we have met certain
      agreed upon technical specifications (which had been the subject of prior
      informal approval in July 2005). We later agreed with LGE to move the initial
      six-month delivery period to November 2005 through April 2006. We subsequently
      agreed with LGE, through a series of communications, that the initial purchase
      order for 9,300 LCoS Sets may be filled over a period of time that extended
      beyond April 2006. This revised schedule had been based primarily upon changing
      expectations about our production output capacity and would have allowed us
      to
      conduct a focused ramp up of our LCoS Set production in South Korea.





Although
      we have been have been delivering a limited quantity of production LCoS Sets
      to
      LGE since July 2005, our delivery ramp up has been slower than expected due
      to
      LGE’s product specification changes and problems that we have experienced in
      ramping up our manufacturing volumes. We have addressed our manufacturing
      problems by relocating the final portions of our manufacturing process to our
      production facility in South Korea, where we believe that the combination of
      a
      new facility designed to our specifications and highly qualified personnel
      provides us with more exacting controls over the external variables that can
      impact our manufacturing process.





Our
      entire manufacturing operations are now conducted at the facility in South
      Korea. The transfer of those specific portions of the process caused a delay
      in
      manufacturing operations early in 2006 while production equipment was physically
      transferred from California to South Korea and South Korean employees were
      being
      trained to use that equipment. The final phase of this transition occurred
      during the first quarter of 2006. We believe that having manufacturing take
      place in one location allows us to maintain a higher level of quality controls
      over LCoS Set production, which we expect will improve our ability to produce
      sufficient quantities of LCoS Sets to meet future quantity demands from current
      and prospective customers. The potential negative impact upon our results of
      operations that could be caused by additional difficulties in manufacturing
      our
      LCoS Sets are described under Risk Factors Item 1A.





LGE
      commenced an initial consumer market rollout in Australia of a limited quantity
      of 71-inch LCoS televisions incorporating our LCoS Sets during the first quarter
      of 2006. While we continued to ship product throughout 2006, as noted above,
      LGE
      intends to discontinue production of RPTVs and therefore we do not expect
      significant shipments in 2007 or beyond.




24




In
      2005
      and 2006, the majority of our product deliveries, which were in small
      quantities, were made to LGE. Since the third quarter of 2006, we have been
      in a
      position to supply LGE’s requirements with quality product meeting all agreed
      upon specifications. The loss of LGE as a customer could significantly harm
      our
      future sales and results of operations; and our historical substantial
      dependence on one customer is subject to risks set forth under Item 1A Risk
      Factors.





*Status
      of Business in Taiwan*




To
      date,
      we have delivered limited quantities of our T-3 LCoS Sets to a Taiwanese
      customer, ThinTek. A substantial portion of these product deliveries occurred
      in
      2005. ThinTek has ordered quantities sufficient for pilot programs and sample
      products, but not enough to enable them to launch mass production of LCoS high
      definition televisions. We have continuing business relationships with customers
      and prospective customers in Taiwan, including ThinTek. We made small shipments
      of T-3 LCoS Sets to ThinTek during 2005 and the first quarter of 2006. On July
      19, 2006, one of the parent organizations of ThinTek, United Microdisplay
      Optronics (UMO), announced that it was acquiring ThinTek. The acquisition was
      effective October 1, 2006. We understand that as part of this acquisition,
      ThinTek’s and UMO’s business models are under evaluation, and may tend toward a
      more vertically integrated approach. For this reason, we have chosen to deal
      directly with a TV maker, Jiangxi Greatsource Display Tech Co., Ltd. (KHD)
      (in
      China), rather than ThinTek going forward.




*Status
      of Business in China*




To
      date,
      we have delivered limited quantities of our microdisplay products to our Chinese
      customers. A substantial portion of these product deliveries occurred in 2004,
      with a smaller quantity delivered in 2005 and none in 2006. The quantities
      of
      our products delivered to our Chinese customers are sufficient only for
      engineering testing and pilot program purposes. To date, our Chinese customers
      have not ordered quantities of our products that would enable them to launch
      commercial sales of LCoS high definition televisions.




We
      have
      provided sample product to Jiangxi Greatsource Display Tech Co., Ltd. (KHD),
      a
      Chinese manufacturer of LCoS light engines and televisions that has received
      significant financing from the Chinese government. We supported KHD pilot
      evaluation runs with our personnel at their plant in China. Evaluations have
      identified a variety of non-SpatiaLight related product issues, mostly of driver
      board electronics origin, that are being addressed by KHD. KHD sent a delegation
      to review the capabilities of the SpatiaLight Korea, Inc. (SLK) facility, which
      has successfully occurred. KHD demonstrated an 85” commercial product at the
      January 2007 CES show employing our imagers. At this time, we do not have any
      purchase orders from KHD. We cannot provide assurance concerning the quantities
      of our products that we will sell to our Chinese customers and prospective
      customers in the future.




*Market
      Strategy for Taiwan and China*




Although
      our Chinese and Taiwanese customers' progression from product prototyping to
      mass production has been far slower than we had anticipated, we remain positive
      about our business prospects in China and Taiwan and the potential for China
      and
      Taiwan to become large markets for us. We currently believe that Chinese and
      Taiwanese television manufacturers tend to apply a market strategy of following
      the successful business models of global television manufacturing leaders,
      rather than acting as leaders themselves in terms of introducing new
      technologies to the marketplace. We therefore believe that if the LCoS
      technology gains greater acceptance in the high definition television
      marketplace, and if industry leaders, such as Sony, JVC and LGE, present their
      LCoS based televisions to the worldwide consumer markets in a prominent fashion,
      it will then be more likely that the Chinese and Taiwanese television
      manufacturers will follow these business models and ramp up their own lines
      of
      LCoS high definition televisions. We believe that our present course of
      continuing to transact business with major Chinese and Taiwanese television
      manufacturers is positioning us to be a leading LCoS supplier in China and
      Taiwan in the future.




*Other
      Business Development*




We
      are
      currently continuing to develop working relationships with prospective
      customers, located primarily in South Korea, Japan and other parts of the
      Pacific Rim region. These prospective customers fall into the following
      categories: 1) television manufacturers, 2) light engine suppliers, 3) head
      mounted display manufacturers, and 4) mobile electronics display device
      manufacturers. We have provided samples of our LCoS Sets to certain of these
      prospective customers, but we do not have any formal agreements with these
      parties as of December 31, 2006. While we have made significant progress with
      respect to product integration and negotiating purchase orders with certain
      of
      these prospective customers, we cannot provide assurances that we will receive
      any purchase orders that will be binding on any of these companies for their
      purchase of our products in the near future. Even assuming that we receive
      purchase orders that are binding on the prospective customers, these orders
      and
      our sales to these customers and to our existing customers are subject to
      certain contingencies described under Risk Factors in Item 1A.





25




We
      have
      recently signed a Joint Market Agreement with Foreal for the LCoS/ LED based
      light engine developed by Foreal. Full production volumes amongst the four
      customers targeted by the two companies are expected to be in the vicinity
      of
      twenty thousand sets per month.





We
      have
      also recently signed a Purchase Agreement with Deocom to supply LCoS imagers
      for
      use in head mounted displays (HMD). This agreement anticipates immediate
      shipments of samples for prototype and pre-production runs, followed by mass
      production later this year. We expect this market to grow significantly over
      time.





In
      January 2007, we entered into a Joint Development Agreement between SpatiaLight,
      SI Infocomm, and SCRAM Technologies for the development of a micro-projector
      prototype with the intent to produce this in volume starting in the fourth
      quarter of 2007.





*Manufacturing
      of LCoS Sets*




We
      completed construction of our South Korean manufacturing facility in January
      2005. The South Korean facility has commenced to serve as our central commercial
      manufacturing base. The facility began producing products for commercial sale
      in
      limited quantities in the second quarter of 2005. The facility is designed
      with
      the capacity, on full employment, to produce up to 28,000 LCoS Sets per month.
      The facility has been specially designed for expansion to a capacity of 120,000
      LCoS Sets per month in several expansion phases. We believe that the facility
      can be expanded in an efficient manner in the event that such expansion becomes
      necessary based upon increased or perceived increased demand for our products
      from our customers.





During
      2006, we installed additional manufacturing and related equipment in the
      facility and trained our operators and supervisors in key processes and
      equipment familiarization. We completed the process of moving all of our
      manufacturing operations to South Korea in the first quarter of 2006, which
      included physically moving all manufacturing equipment that remained in
      California as of the end of 2005. As part of the transition process, we
      experienced some manufacturing problems as the line was set up and restarted
      in
      Korea. The manufacturing problems have occurred during the alignment coating,
      glue application and cell lamination portions of our manufacturing process.
      We
      addressed our manufacturing problems in the transition of these portions of
      our
      manufacturing process to our production facility in South Korea, and we believe
      that the combination of a new facility designed to our specifications and highly
      qualified personnel provides us with more exacting controls over the external
      variables that can impact our manufacturing process. In addition to addressing
      some continuing specification change request issues with LGE, we completed
      the
      transition of these key processes to the South Korean plant. Since the third
      quarter of 2006, we have been in position to manufacture adequate quantities
      of
      high quality product meeting all agreed upon specifications. While we cannot
      provide any assurances against unexpected delays, we believe our manufacturing
      facility in South Korea can now successfully manufacture on a basis consistent
      with the anticipated demand for our products. Potential unexpected difficulties
      with our manufacturing process in South Korea could have a material negative
      impact upon our results of operations as set forth under Risk Factors in Item
      1A.





*Business
      Strategy*




In
      reviewing the risk factors for our business, it is clear that there are some
      overriding concerns and issues. One of these is the high level of focus and
      reliance in recent periods on one customer, LGE. Another factor is that our
      product focus has been on the high definition rear projection television (RPTV)
      application. While we certainly continue to work for success with the RPTV
      product, we also need to manage the risks inherent in this
      situation.




For
      these
      reasons, we have taken the following initiatives:




·
            Find
                additional Tier 1 customers for the RPTV product (strong focus on
                adding
                at least one other customer).




·
            Complete
                an agreement with at least one and preferably two China TV
                manufacturers.




·
            Improve
                the competitiveness of LCoS based microdisplay products by working
                with
                firms involved in LED and laser diode light sources (instead of the
                standard high pressure mercury arc lamp light
                source).




·
            Engage
                in new product development for applications other than RPTV (including
                Near-To-Eye (NTE) displays such as Head Mounted Displays (HMD) and
                micro-projector products).





We
      are
      currently offering one core product, our T-3 LCoS Set, with a 1920 pixels by
      1080 pixels configuration, to our customers and prospective customers, all
      of
      whom are located primarily in Asia. Our LCoS Set is comprised of three of our
      proprietary SpatiaLight imagEngineTM LCoS microdisplays. They are constructed
      with a silicon chip, a layer of liquid crystals and a glass cover plate in
      contrast to the more common construction of liquid crystals sandwiched between
      two glass plates. Our displays are also known as, and commonly referred to
      as,
      liquid crystal on silicon (LCoS), liquid crystal displays (LCD), active matrix
      liquid crystal displays and spatial light modulators. For applications such
      as
      large screen RPTV, the LCoS cell (T3P) is designed for a three panel
      configuration for maximum brightness. We are working to find a solution using
      the LGE light engine platform that will allow other customers quick market
      entry. We are focusing on manufacturing the T-3 model of our LCoS Sets (as
      opposed to our old T-1 LCoS Set with a resolution of 1280 pixels by 960 pixels)
      for projection TV applications because we believe that the market demand for
      the
      higher resolution product will be significantly greater. A new smaller diagonal
      product (T4P) which will still maintain the high resolution of 1920 pixels
      by
      1080 pixels completes development, we will introduce that to allow lower price
      points in conjunction with smaller screen sizes (50” to 60” for T4P as opposed
      to 60” + for T3P).




26




We
      are
      also working cooperatively with firms such as Foreal Spectrum (Foreal) of San
      Jose, California, to jointly provide a solid state light source based LCoS
      light
      engine solution. The long lifetime of these solid state light sources is
      attractive to both the consumer and commercial display maker when compared
      to
      the standard high pressure mercury arc lamp. In the case of laser diode sources,
      the low angular divergence of the light source facilitates the optical system
      design enabling thin cabinets with form factors approaching those of plasma
      TV’s
      at much lower weight.




We
      have
      recently signed a Joint Market Agreement with Foreal for the LCoS/ LED based
      light engine developed by Foreal. Full production volumes amongst the four
      customers targeted by the two companies are expected to be in the vicinity
      of
      twenty thousand sets per month.





We
      have
      previously announced a Memorandum of Understanding (MOU) working with Deocom
      of
      South Korea on Head Mounted Displays using initially our T-3 imager in a full
      HD
      mode. We expect our cooperative efforts to lead to some product sales in the
      short term and a growing commercial and consumer market. We have also recently
      signed a Purchase Agreement with Deocom to supply LCoS imagers for use in head
      mounted displays (HMD). This agreement anticipates immediate shipments of
      samples for prototype and pre-production runs, followed by mass production
      later
      this year. We expect this market to grow significantly over time.





We
      have
      also announced an MOU between SpatiaLight, SI InfoComm and SCRAM Technologies
      for the joint development of a micro-projector, a new category of product
      targeted at mobile electronics driven applications.




We
      believe we have a solid core technology that can be used to meet the needs
      of a
      number of large and potentially high growth market segments. We believe that
      the
      manufacturing competence we have established at SpatiaLight Korea gives us
      a
      base from which to supply our current and future customers. To help us match
      these technical possibilities and capabilities successfully with market needs,
      we have established a new business development function operating out of Seoul,
      South Korea, that has already paid dividends in some of the agreements mentioned
      above.





*Recent
      Equity Financing*




February
      2007 Financing




On
      February 23, 2007, when the price of our common stock was $1.31, we sold to
      five
      institutional buyers that participated in the November 2006 Financing, an
      aggregate of 2,190,477 of our common shares at a purchase price of $1.05 per
      share. In addition, we issued 600,000 common shares, valued at $786,000, as
      a
      fee to obtain a one-time waiver of contractual prohibitions under the November
      2006 Financing against offering shares of our common stock for less than $1.30
      per share. We received aggregate proceeds of $2.3 million, before issuance
      costs, from the sale of these shares, which will be used for working capital
      and
      other corporate purposes. We made the sale pursuant to our “shelf” registration
      statement on Form S-3 (File No. 333-137100), which was declared effective by
      the
      SEC on February 14, 2007.





November
      2006 Financing




On
      November 29, 2006, when the price of our common stock was $1.76, we issued
      and
      sold 2,400,000 of our common shares in a private placement to three
      institutional investors (the “November 2006 Financing”). The transaction
      included the issuance of warrants to purchase 4,872,000 common shares with
      an
      exercise price of $1.75 per share exercisable within five years from the date
      of
      issuance. The purchase price of the common shares was $1.25 per share. The
      common shares and warrants were sold pursuant to an exemption from registration
      under Section 4(2) of the Securities Act of 1933, as amended. We received
      approximately $3.0 million in proceeds, before cash-based issuance costs of
      $180,000, from the sale of these shares, which was used for working capital
      and
      other general corporate purposes, including the repayment of certain short-term
      debt obligations. We have not yet filed a registration statement on Form S-3
      relating to the resale of these shares issued and
      issuance of the shares issuable upon the exercise of the warrants in the
      November 2006 Financing. Since this registration statement will be filed more
      than 30 days after, and will be declared effective more than 90 calendar days
      after November 29, 2006, we may be required to pay partial liquidated damages
      of
      $60,000 per month, subject to a maximum amount of $720,000 from December 29,
      2006 until the registration statement is declared effective. Once
      the
      registration statement is declared effective, we are required to maintain
      effectiveness of the registration statement until all shares covered by it
      have
      been sold or may be sold without volume restrictions pursuant to Rule 144(k).





27


September
      2006 Financing




On
      September 26, 2006, when the price of our common stock was $2.20, we sold
      270,270 of our common shares in a private placement to certain institutional
      investors (the “September 2006 Financing”) that have previously purchased our
      common shares in private transactions on several occasions and are currently
      stockholders of our Company. The purchase price of the common shares was $1.85
      per share. The transaction included the issuance of warrants to purchase 89,189
      common shares with an exercise price of $2.25 per share exercisable within
      five
      years from the date of issuance. We received $500,000 in gross proceeds, before
      cash-based issuance costs of $17,500, from the sale of these shares, which
      were
      used for working capital and other general corporate purposes. We
      have
      not yet filed a registration statement on Form S-3 relating to the resale of
      these shares issued and the issuance of shares issuable upon the exercise of
      the
      warrants in the September 2006 Financing. Since this registration statement
      will
      be filed more than 30 days after, and will be declared effective more than
      90
      calendar days after September 26, 2006, we
      may be
      required to pay partial liquidated damages of $10,000 when each of these dates
      occur and an additional 1% or $5,000 for each month thereafter to a
      contractually defined maximum of 12% of the aggregate purchase price or $60,000
      from October 26, 2006 until the registration statement becomes effective. Once
      the registration statement is declared effective, we are required to maintain
      effectiveness of the registration statement until the shares covered by the
      registration statement have been sold or may be sold without volume restrictions
      pursuant to Rule 144(k).





August
      2006 Financing




On
      August
      9, 2006, when the price of our common stock was $2.60, we issued 761,500 of
      our
      common shares in a private placement to an institutional investor (“August 2006
      Financing”). The purchase price of the common shares was $2.25 per share. We
      received approximately $1.7 million in gross proceeds, before issuance costs,
      from the sale of these shares, which were used for working capital and other
      general corporate purposes. The
      common shares were sold pursuant to an exemption from registration under Section
      4(2) of the Securities Act of 1933, as amended. We
      paid
      $110,000 to our former Executive Vice President of Strategic Planning to
      facilitate this transaction, which were costs directly related to the
      transaction, and recorded as a reduction of the gross proceeds. We are required
      under a registration rights agreement to file a registration statement for
      the
      resale of the shares within 30 calendar days from the closing date and have
      the
      registration statement declared effective no later than 90 calendar days after
      the closing date. The registration rights agreement provides that if we do
      not
      meet the above deadlines, we may be required to pay an amount equal to 1.5%
      of
      the aggregate purchase price or $25,700 as partial liquidated damages when
      each
      of these dates occur and an additional $25,700 for every 30 days thereafter
      for
      up to six months. After six months, the percentage increases to 2.5% or $42,800
      for each additional 30 days with no contractual maximum. Once the registration
      statement is effective, we are required to maintain effectiveness of the
      registration statement until the shares covered by the registration statement
      have been sold or may be sold without volume restrictions pursuant to Rule
      144(k). The institutional investor has waived any claim for liquidated damages
      based on the failure to file a registration statement within the time required
      until a reasonable time after the effectiveness of our universal shelf
      registration statement on Form S-3 (Registration No. 333-137100), which was
      declared effective by the SEC on February 14, 2007.





As
      part
      of the August 2006 Financing, we agreed to file a “shelf” registration
      statement covering subscription rights of at least $20,000,000 (the “Required
      Rights Offering”) to be offered to the holders of our common stock unless we
      raised at least $10,000,000
      in additional financing between August 9, 2006 and 30 days after the effective
      date of the registration statement. On October 25, 2006, these requirements
      were
      amended to (i) extend the Additional Financing Deadline by 30 days if we raised
      at least $1,000,000 in additional financing; (ii) extend the Additional
      Financing Deadline by 30-60 days if we raised between $3,000,000 and $5,000,000
      in additional financing; (iii) extend the Additional Financing Deadline by
      60
      days and reduce the Required Rights Offering pro rata if we raised more than
      $5,000,000 in additional financing. As of March 15, 2007, we have raised
      $5,800,000 in additional financing, the Required Rights Offering has been
      decreased to $14,200,000 and the Additional Financing Deadline has been extended
      to May 15, 2007.




Because
      of our existing covenants with the holders of our Senior Secured Convertible
      Notes, which requires us to seek their consent before we agree to enter into
      additional material indebtedness, we will most likely try to raise the
      above-mentioned monies through the sale of additional common shares. We can
      offer no assurance that we will successfully raise all or any part of the
      $4,200,000 mentioned above, nor can we offer an assurance that we will issue
      subscription rights to our shareholders in the future. At present, we are
      considering all of our options and have not definitively determined how or
      whether we will raise all or a part of the $4,200,000 which would allow us
      to
      avoid our obligation to make an offering of subscription rights to purchase
      our
      common shares. In connection with the August 2006 Financing, we have also
      agreed, for a period of one year following the closing of the August 2006
      Financing, to refrain from, directly or indirectly, offering or selling any
      debt
      security that is, at any time during the life of the debt security and under
      any
      circumstance, convertible into or exchangeable for our common shares, unless
      we
      receive prior written consent from a majority of the purchasers of the August
      2006 Financing.





In
      the
      event we default upon the foregoing obligations, the purchasers of securities
      in
      our August 2006 Financing are entitled to contractual damages and may also
      request that we specifically perform our obligations under the purchase
      agreement giving rise to our obligations. At present, we are unable to quantify
      the amount of contractual damages to which the purchasers would be entitled,
      and
      we are unable to estimate the likelihood that a court would grant any
      purchaser’s application that we specifically perform our
      obligations.




28




June
      2006 Financing




On
      June
      5, 2006, when the price of our common stock was $2.59, we sold to certain
      institutional buyers, each of which is managed by Wellington Management Company,
      LLP, an aggregate of 601,000 of our common shares at a price per share of $2.80,
      for an aggregate purchase price of approximately $1.7 million. We made the
      sale
      pursuant to a Post-effective Amendment to a “shelf” registration statement on
      Form S-3 (File No. 333-122392), which was declared effective by the SEC before
      this transaction, and which was amended by a registration statement on Form
      S-3
      MEF (File No. 333-134626) filed by us on May 31, 2006. These funds were used
      for
      working capital and other general corporate purposes.





April
      2006 Financing




On
      April
      7, 2006, when the price of our common stock was $3.89, we sold 750,000 of our
      common shares at a purchase price of $3.26 per share to three institutional
      purchasers. Those shares were registered in our Post-effective Amendment No.
      6
      to a Form S-3 “shelf” registration statement (File Number 333-122392). The
      purchase price for those common shares was approximately $2.4 million in the
      aggregate. The purchase price was based upon the five-day volume weighted
      average price of our common shares through April 6, 2006, discounted by five
      percent. We paid aggregate fees equal to $89,650 to persons who introduced
      us to
      the investors. These funds were used for working capital and other general
      corporate purposes.





March
      2006 Financing




On
      March
      17, 2006, when the price of our common stock was $2.79, we sold 500,000 of
      our
      common shares at a purchase price of $2.18 per share to certain institutional
      investors. Those shares were included in our Post-effective Amendment No. 6
      to
      Form S-3 "shelf" registration statement (File No. 333-122392). The purchase
      price was based upon the five-day volume weighted average price of our common
      shares through March 16, 2006, discounted by five percent. We received net
      proceeds of approximately $1.1 million, which were used for working capital
      and
      other general corporate purposes.





January
      2006 Financing




In
      mid-January 2006, when the price of our common stock ranged from $2.62 to $2.85,
      we issued and sold 1,300,000 of our common shares in a private placement to
      three institutional investors. The purchase price of the common shares was
      $2.62
      per share. We received approximately $3.3 million in net proceeds from the
      sale
      of these shares, which were used for working capital and other general corporate
      purposes, including the repayment of certain short-term debt obligations. We
      were required under a registration rights agreement, to file a registration
      statement for the resale of the shares within 30 calendar days after January
      12,
      2006 and have the registration statement declared effective no later than 90
      calendar days after January 12, 2006. Once the registration statement is
      declared effective, we
      are
      required to maintain effectiveness of the registration statement until the
      shares covered by the registration statement have been sold or may be sold
      without volume restrictions pursuant to Rule 144(k). As
      the
      registration statement was not filed by February 11, 2006 or declared effective
      prior to April 12, 2006, the registration rights agreement required us to pay
      an
      amount equal to 5% of the aggregate purchase price or $170,300 as partial
      liquidated damages when each of these dates occurred and an additional $170,300
      for every 30 days thereafter up to six months. After six months, the percentage
      increases to 10% or $340,600 for each additional 30 days. We have included
      $329,602 as liquidated damages in non-cash interest expense from inception
      through May 12, 2006. The registration statement related to these shares was
      filed with the SEC on May 5, 2006 and was declared effective on May 12, 2006.
      Concurrent with the effectiveness of the registration statement, the investors
      of the January financing received an aggregate of 122,725 restricted shares
      in
      settlement of any and all liquidated damages. The shares were issued as follows:
      57,725 restricted shares of our common stock were issued on May 18, 2006, when
      the market value of our shares was $3.12, resulting in an intrinsic value of
      $180,102; 65,000 restricted shares of our common stock were issued on June
      30,
      2006, when the market price of our shares was $2.30, resulting in an intrinsic
      value of $149,500. Of these shares, 57,725 were included in our Form S-3 (File
      No. 333-137100) filed with the SEC on November 6, 2006 and declared effective
      by
      the SEC on February 14, 2007.





*Senior
      Secured Convertible Debt Financing*




On
      November 30, 2004, we completed a non-brokered private placement of $10 million
      of our senior secured notes (the Senior Secured Convertible Notes). The Senior
      Secured Convertible Notes accrue interest at 10% per annum, payable quarterly
      in
      cash or our common shares at our option, if certain conditions are met, such
      as
      the availability of an effective registration statement pursuant to which
      resales may be made or the availability of Rule 144(k) for resale of the common
      shares underlying our Senior Secured Convertible Notes. The value of the shares
      for the purposes of calculating interest payments shall be equal to the 10-day
      trailing average of the volume weighted average prices of our common shares
      at
      the end of each quarterly interest period. The Senior Secured Convertible Notes
      are due November 30, 2007.




29




The
      Senior Secured Convertible Notes are convertible, at the option of their
      holders, into our common shares at the conversion price of $9.72 per share.
      The
      Senior Secured Convertible Notes are senior to notes that we issued to Argyle
      Capital Management Corporation, which is wholly owned by Robert A. Olins, our
      former Chief Executive Officer, Secretary, Treasurer and a Director. The holders
      of our Senior Secured Convertible Notes have a senior security interest in
      substantially all of our assets, except those located in South Korea. However
      the holders of our Senior Secured Convertible Notes have a pledge of the issued
      and outstanding shares of SpatiaLight Korea Ltd. In addition, under the terms
      of
      the November 2004 Financing, we are prohibited from using the proceeds from
      the
      financing to repay debt or to pay dividends, and we are prohibited from paying
      dividends while the Senior Secured Convertible Notes are outstanding.





We
      were
      required under an amended registration rights agreement, to file a registration
      statement for resale of the shares issuable upon conversion of the Senior
      Secured Convertible Notes and to maintain its effectiveness to allow the holders
      of our Senior Secured Convertible Notes to convert their notes and sell the
      underlying common shares freely.  We reported in Post-effective Amendment
      No. 2 to our registration statement on Form S-3 relating to the Senior Secured
      Convertible Notes (Reg. No. 333-122391), that in late August 2005 we advised
      the
      holders of our Senior Secured Convertible Notes that until the matter concerning
      the filing of an unauthorized consent of our former auditors, BDO Seidman LLP,
      is resolved, sales using the prospectus which is the subject of that
      registration statement may result in potential liability. One of the holders
      of
      the Senior Secured Convertible Notes, Portside Growth & Opportunity Fund,
      has claimed that the Post-effective Amendment resulted in an obligation for
      the
      Company to pay each Noteholder liquidated damages in cash equal to 1% of the
      purchase price of the notes, and 1% for every 30 days thereafter, until the
      matter concerning the consent is resolved.  That amount would equal
      $534,000 and $683,000 as of December 31, 2005 and February 14, 2006 (when the
      post-effective amendment to the registration statement was declared effective),
      respectively.  We do not believe that we are contractually obligated to
      make those payments and we have not accrued for the alleged liquidated
      damages.  However, should the Noteholders pursue their claim for liquidated
      damages pursuant to the Registration Rights Agreement and prevail on their
      claim
      in a court of law, the alleged liquidated damages would immediately become
      due
      and payable.  In February 2006, Post-effective Amendment No. 6 to the
      registration statement referenced above was declared effective by the
      SEC.





Portside
      Growth & Opportunity Fund has also claimed the following additional events
      of default under the Senior Secured Convertible Notes: (i) failure to make
      an
      interest payment due in November 2005 on a timely basis; (ii) incurrence of
      prohibited indebtedness to our former officers and/or directors of the Company;
      (iii) incurrence of prohibited indebtedness by our South Korean subsidiary
      to
      certain banks in South Korea; (iv) granting of a security interest by our South
      Korean subsidiary in certain assets located in South Korea; and (v) repayment
      by
      us of indebtedness to our officers or directors and by our South Korean
      subsidiary of indebtedness under bank credit facilities. Smithfield Fiduciary
      LLC, joined in the claim that a default occurred as a result of the failure
      to
      make the November 2005 interest payment in a timely fashion. Each of these
      notices call for us to redeem $9.0 million in the aggregate principal amount
      of
      our Senior Secured Convertible Notes, plus payment of a redemption premium
      of
      $675,000 to each of these holders. Furthermore, the Noteholders claim that
      the
      interest rate on the Senior Secured Convertible Notes has increased from 10%
      per
      annum to 12% per annum as a result of the claimed defaults.





We
      believe, after review with outside legal counsel, that these allegations lack
      merit and would not entitle the Noteholders to call the notes and other remedies
      that they are seeking.  We believe that the Noteholders have undertaken to
      make allegations of events of default that lack merit in an attempt to obtain
      an
      amendment to the terms of the Senior Secured Convertible Notes to reduce the
      conversion price, accelerate repayment and increase the interest rate. We have
      rejected offers from the Noteholders in this regard, and plan to vigorously
      defend our position. If the Noteholders prevail in calling the Notes, the entire
      $10 million debt obligation would become due and payable immediately, including
      the redemption premiums of $1.5 million and liquidated damages of
      $683,000.  We have not accrued the above described redemption premiums or
      liquidated damages as of December 31, 2005 or December 31, 2006.





We
      believe the alleged events of default of which Portside and Smithfield have
      given notice lack merit and would not entitle the Noteholders to the remedies
      that they are seeking. Therefore, we believe it is not probable the Noteholders
      would prevail in calling the Notes. As a result, in accordance with FAS 5,
      “ *Accounting
      for Contingencies,”* we have
      continued to classify the Senior Secured Convertible Notes as a long-term
      obligation in our balance sheet at December 31, 2005 and as a short-term
      liability at December 31, 2006, in accordance with the contractual maturity
      date, rather than as a current liability as of December 31, 2005 as FAS 78,
      “ *Classification
      of Obligations That are Callable by the Creditor,”* might
      otherwise require. The redemption premium and liquidated damages of $1.5 million
      and approximately $0.7 million, respectively, have not been accrued in the
      consolidated financial statements as of December 31, 2005 or 2006. We refer
      you
      to Note 1 of our Notes to consolidated financial statements contained in this
      report for additional information regarding the accounting treatment of the
      Senior Secured Convertible Notes.


*Certain
        Developments*
 
 Audit
        Committee Investigations
 
 We
        filed
        an unauthorized consent of BDO Seidman LLP to Amendment Nos. 5 and 6 to our
        registration statement on Form S-3 (File No. 333-122391) and to Amendment
        Nos. 3
        and 4 to our registration statement on Form S-3 (File No. 333-122392) in
        order
        to incorporate by reference their report on our consolidated financial
        statements for the fiscal years ended December 31, 2002 and 2003, respectively.
        Although we received the requisite authorized consents from BDO Seidman LLP
        to
        incorporate by reference their report on the consolidated financial statements
        into the registration statements when initially filed and in subsequent
        amendments thereto (and BDO Seidman LLP has not withdrawn these subsequent
        consents), we did not receive the requisite authorization from BDO Seidman
        LLP
        to file its consent as an exhibit to the penultimate and final pre-effective
        amendments to either the registration statements. The penultimate and final
        pre-effective amendments to both the registration statements were filed with
        the
        SEC on July 27, 2005.


30




The
      Audit
      Committee of our Board of Directors conducted an investigation and review of
      the
      developments pertaining to the BDO Seidman LLP consent issue with the assistance
      of independent counsel.





The
      Audit
      Committee delivered its report, dated October 31, 2005, to our former Chief
      Executive Officer, Robert A. Olins. The Report concluded that the evidence
      does
      not support a finding that any of our employees included the unauthorized BDO
      Seidman LLP consents in the amendments to the Registration Statements referred
      to above with fraudulent intent or with specific knowledge that BDO Seidman
      LLP
      had not authorized the filing of these consents. It concluded that the evidence
      was consistent with our inclusion of the consents due to lack of communication,
      a series of misunderstandings and/or a failure of inquiry. As to Mr. Olins,
      the
      Report concluded that the Audit Committee found no evidence that Mr. Olins
      was
      informed that BDO Seidman LLP had not authorized the filing of these consents.
      However, it also found no evidence that Mr. Olins inquired or determined whether
      BDO Seidman LLP had in fact authorized inclusion of the consents in these
      filings. The Audit Committee Report determined that Mr. Olins, as our Chief
      Executive Officer, did not exercise sufficient diligence in supervising the
      filing of the amendments to the Registration Statements, that this was a
      particularly serious failing in light of the SEC having highlighted the need
      for
      consents from BDO Seidman LLP, and that as CEO he bears responsibility for
      the
      filings. The Audit Committee also stated its belief that, throughout the process
      of preparing and filing the amendments to the registration statements, Mr.
      Olins
      acted with our best interests and the best interests of our shareholders in
      mind, and that his lack of diligence was not motivated by self-interest and
      that
      nothing related to this incident personally benefited him financially.





The
      Audit
      Committee recommended three remedial actions. It concluded that the membership
      of the Board of Directors should be supplemented with a financial expert within
      the meaning of SEC rules. It also concluded that we must improve our corporate
      governance and disclosure controls, including hiring a full-time Chief Financial
      Officer and a Controller (who can be the same person). It further concluded
      that
      by reason of Mr. Olins' responsibility as CEO for supervision of corporate
      filings, he should reimburse us for the sum of $50,000, a portion of the costs
      incurred by us by reason of the unauthorized BDO Seidman LLP consents and the
      resulting inquiries. In compliance with the Audit Committee Report, in December
      2005, Mr. Olins made the $50,000 payment to reimburse the Company. To date,
      our
      Board of Directors has not been supplemented with a financial expert and we
      have
      not hired a fulltime CFO or Controller although on April 28, 2006, we hired
      a
      part-time Director of Accounting and Finance. We have been advised by the Staff
      of the SEC that the Staff is conducting an investigation into matters and events
      pertaining to the filing of the unauthorized BDO Seidman LLP consents. We have
      been cooperating with the Staff with respect to this matter.





Our
      Audit
      Committee, with the assistance of independent legal counsel, conducted an
      investigation and review of transactions in the Company’s shares by Robert A.
      Olins, our former Chief Executive Officer, Secretary, Treasurer and a Director
      and determined that he failed to report the sale of an aggregate of 70,556
      of
      our common shares in August 2005 and February 2006 at sales prices ranging
      from
      $5.30 to $3.00. The Audit Committee determined that there was no indication
      that
      Mr. Olins had access to material undisclosed information at the time of the
      transactions, that there was no intention to engage in the distribution of
      our
      securities without registration, and that the number of shares involved was
      insignificant. Pursuant to Section 16 of the Exchange Act, in July 2006, Mr.
      Olins filed the delinquent reports and disgorged $22,273 in “short-swing
      profits” that he realized from the sales.





SEC
      Investigations





We
      have
      been advised by the Staff of the SEC that the Staff is conducting an
      investigation into matters and events pertaining to the filing of the
      unauthorized BDO Seidman LLP consents and transactions in our securities by
      Mr.
      Olins and an entity he controls. We have received and responded to a request
      for
      all information relating to transactions in our securities by Mr. Olins and
      the
      entity he controls. We have been cooperating with the Staff with respect to
      this
      matter but are not aware of any violations of the securities laws except as
      set
      forth under “Audit Committee Investigations” above. At this date, we cannot
      determine whether we or our management will be adversely affected by these
      investigations.


Other
        matters
 
 Both
        of
        the registration statements containing the unauthorized BDO Seidman LLP consents
        were declared effective in July 2005. In August 2005, we filed Post-effective
        Amendments number 1 to both of these registration statements (those
        post-effective amendments were subsequently withdrawn and replaced by additional
        post-effective amendments), which disclosed the filing of the unauthorized
        consents. Because both registration statements were used to sell common shares
        after the SEC declared the registration statements effective, it is conceivable
        that there may be litigation against us or our officers or directors under
        Section 11 of the Securities Act. Although we do not believe that the filing
        of
        an invalid consent constitutes a materially misleading statement or an omission
        to disclose a material fact within the meaning of Section 11 of the Securities
        Act, a contrary determination could result in a liability for us.


31





At
      present, we are unable to ascertain the exact amount of damages, if any, to
      which we could be subject under a Section 11 claim instituted by any persons
      who
      directly purchased shares pursuant to those registration statements.
      Furthermore, at this date, we cannot ascertain the amount of damages, if any,
      for which we could be liable for claims instituted by any subsequent purchasers
      who could trace the shares purchased by them to those registration statements.
      In August 2005, we sold 500,000 common shares to three institutional purchasers
      for $5.40 per share pursuant to the “shelf” registration statement referenced
      herein. Each of those investors has since represented to us in writing, in
      connection with a separate transaction, that they have disposed of all of those
      shares. One of those institutional investors has represented to us that it
      sold
      those shares at a sale price at or higher than its purchase price from us.
      We
      believe, based upon discussions with the other two investors, that they sold
      their shares at a sale price of not lower than $4.25 per share. Therefore,
      we
      believe that our maximum damages pursuant to Section 11 claims from direct
      purchasers, which we would fully contest, would be $391,000, or the difference
      between the two investor’s purchase price and lowest believed resale price,
      multiplied by the 340,000 shares that they purchased and then
      resold.





In
      addition to any damage claims, which may be material to our financial condition,
      any lawsuit alleging securities law violations could require us to expend
      significant financial and managerial resources.





**Liquidity
      and Capital Resources**





Through
      December 31, 2006, we have sustained recurring net losses from operations and,
      at December 31, 2006, we had a stockholders’ deficit of approximately
      $8,839,000. During 2006, we experienced negative cash flows from operating
      activities of approximately $12,415,000 and a net loss of approximately
      $20,397,000. In the first quarter of 2006, cash was primarily provided by the
      net proceeds of approximately $3.3 million that we received from the sale of
      1,300,000 of our common shares in mid-January 2006 at a purchase price of $2.62
      per share and approximately $1.1 million that we received from the sale of
      500,000 of our common shares on March 17, 2006 at a purchase price of $2.18
      per
      share. Additional contributions came from the exercise of employee stock
      options. Additionally, cash for the three months ended March 31, 2006 was
      provided by a Korean Won 1.5 billion (approximately $1.5 million) short-term
      loan obtained in March 2006 that was repaid in early April 2006. See Note 3
      for
      further details of this loan. In the second quarter of 2006, cash was primarily
      provided by the net proceeds of approximately $2.4 million that we received
      from
      the sale of 750,000 of our common shares on April 7, 2006 at a purchase price
      of
      $3.26 per share and approximately $1.7 million that we received from the sale
      of
      601,000 of our common shares on June 6, 2006 at a purchase price of $2.80 per
      share. The funds from these financings were used to fund our operations for
      the
      second quarter of 2006. In the third quarter of 2006, cash was primarily
      provided by the net proceeds of approximately $1.6 million that we received
      from
      the sale of 761,500 of our common shares on August 9, 2006 at a purchase price
      of $2.25 per share and $0.5 million that we received from the sale of 270,270
      of
      our common shares on September 26, 2006 at a purchase price of $1.85 per share.
      The funds from these financings were used to fund our operations for the third
      quarter of 2006. During the fourth quarter of 2006, cash was provided by net
      proceeds of approximately $2.8 million that we received from the sale of
      2,400,000 of our common shares on November 29, 2006 at a purchase price of
      $1.25
      per share. The funds from these financings were used to fund our operations
      for
      the fourth quarter of 2006.





As
      of
      December 31, 2006, we had approximately $220,000 in cash and cash equivalents,
      an increase of approximately $177,000 from the December 31, 2005 amount of
      $43,000. Our net working capital deficit at December 31, 2006, was approximately
      $12,894,000, compared to a working capital deficit of approximately $3.4 million
      at December 31, 2005.





Net
      cash
      used in operating activities totaled approximately $12.4 million and $9.7
      million in 2006 and 2005, respectively. This increase is due primarily to
      funding the operations in our South Korean subsidiary without commensurate
      revenues, and increased legal fees associated with the SEC investigations and
      2006 financing transactions. Net cash used in investing activities totaled
      approximately $0.5 million and $5.5 million in 2006 and 2005, respectively.
      The
      larger amount in 2005 stemmed from acquiring and building our South Korean
      manufacturing facility during 2005. This facility was operational towards the
      end of 2005. Net cash provided by financing activities was approximately $13.1
      million and $6.2 million in 2006 and 2005, respectively. Net cash provided
      by
      financing activities in 2006 resulted from the aggregate net proceeds of $13.3
      raised in seven separate equity private placement transactions in 2006 and
      repayment of $0.2 million related to short-term loans during 2006. Net cash
      provided by financing activities in 2005 resulted primarily from the aggregate
      net proceeds of $4.6 million raised in two separate equity private placement
      transactions in 2005 and net proceeds of $0.8 million from short-term loans
      during 2005.




32




As
      of
      December 31, 2006, we had an accumulated deficit of approximately $102.1
      million. We have experienced significant losses in the past and expect that
      these losses will continue until we start to generate significant revenues
      from
      the sale of our products. We generated revenue of approximately $474,000 during
      2006. Although we are expecting to generate revenues from the sale of our
      products in 2007, we expect to operate at a loss during 2007. There can be
      no
      assurance that our business will operate on a profitable basis
      thereafter.





Our
      Audit
      Committee determined that Robert A. Olins, our former Chief Executive Officer,
      Secretary, Treasurer and a Director failed to report the sale of an aggregate
      of
      70,556 of our common shares in August 2005 and February 2006 at sales prices
      ranging from $5.30 to $3.00. Pursuant to Section 16 of the Exchange Act, in
      July
      2006, Mr. Olins has filed the delinquent reports and disgorged $22,273 in “short
      swing profits” that he realized from the sales. These funds were recorded as an
      increase in additional paid in capital during the third quarter
      2006.





We
      anticipate that our cash expenditures during the first part of 2007 will
      approximate $600,000 per month, or approximately $7.2 million for the year,
      without regard to any revenue in 2007. This is down from our 2006 levels due
      to
      cost cutting measures such as reduced personnel costs, partially as a result
      of
      natural attrition and partially due to reduction in work force in South Korea
      due to sales less than anticipated. We expect to meet our immediate cash needs
      and fund our immediate working capital requirements with our existing cash
      balances and from additional sources. Those sources include gross proceeds
      of
      approximately $2.3 million that we received from the sale of 2,190,477 of our
      common shares on February 23, 2007, (as more fully described in Note 11 to
      our
      consolidated financial statements);  cash
      payments from our customers; the exercises of stock options and warrants; and
      additional sales of our common shares. There can be no assurances with respect
      to these potential sources. We believe that our current cash and cash
      equivalents as of December 31, 2006, combined with the proceeds from the
      February 2007 Financing will be sufficient to meet our capital and liquidity
      requirements for our operations through March 2007. We will be required to
      raise
      significant amounts of additional capital to continue to fund our operations
      on
      a going forward basis. To raise additional capital, we plan to sell the 108
      million common shares (subject to the number of available authorized shares)
      that we have available for sale under a currently effective “shelf” registration
      statement (based on the share price on March 14, 2007 of $0.66 per share).
      We
      also believe that we will be required to complete additional equity and/or
      debt
      financings in 2007. If we are unable to obtain additional funds on reasonable
      terms, we may be unable to continue our operations at current levels, or at
      all.





**Off
      Balance Sheet Arrangements**





There
      are
      no off balance sheet arrangements as of December 31, 2006.





**Contractual
      Obligations and Contingent Liabilities and Commitments**





We
      have
      long-term contractual obligations and commitments primarily with regards to
      payment of debt and lease arrangements.





The
      following table aggregates our expected contractual obligations and commitments
      subsequent to December 31, 2006:




**Payments
                  Due By Period**Less
                  than 1Contractual
                  obligations
              
              year
              
              1
                  -
                  3 years
              
              3-5
                  years
              
              over
                  5 years
              
              TotalLong-term
                  convertible debt (1)
              
              $
              -
              
              $
              1,188,000
              
              $
              -
              
              $
              -
              
              $
              1,188,000Senior
                  secured convertible notes (3)
              
              
              10,000,000
              
              
              -
              
              
              -
              
              
              -
              
              
              10,000,000Short
                  term loans
              
              
              591,070
              
              
              -
              
              
              -
              
              
              -
              
              
              591,070Interest
                  on senior secured convertible notes (2)
              
              
              916,667
              
              
              -
              
              
              -
              
              
              -
              
              
              916,667Operating
                  lease commitments
              
              
              459,040
              
              
              792,419
              
              
              -
              
              
              -
              
              
              1,251,459Total
                  contractual cash obligations
              
              $
              11,966,777
              
              $
              1,980,419
              
              $
              -
              
              $
              -
              
              $
              13,947,196




(1)
      All
      interest underlying the Notes, at the contractual rate of 6%, has been prepaid
      through the issuance of common shares (See Note 3 to consolidated financial
      statements.)




33




(2)
      Subject to certain conditions, interest is payable in cash or common shares
      at
      the option of the Company. (See Note 3 to the consolidated financial
      statements.)




(3)
      The
      holders of $9,000,000 principal amount of these Notes have alleged certain
      events of default under these Notes. As a consequence of these alleged defaults,
      these holders have demanded their immediate redemption. We strongly dispute
      that
      any events of default have occurred that would allow the Noteholders to call
      their Notes or be entitled to the redemption premiums and liquidated damages
      of
      approximately $1.5 million and $683,000, respectively. See Notes 1 and 3 to
      the
      consolidated financial statements for further information.





**Results
      of Operations**





*Three
      years ended December 31, 2006, 2005 and 2004*





*Revenue.* We
      recognized sales revenue of approximately $474,000, $238,000, and $1,161,000
      for
      the years ended December 31, 2006, 2005 and 2004, respectively. Revenue in
      2004
      was related to deliveries made pursuant to agreements relating to the sale
      of
      our T-1 LCoS Sets and light engines, primarily to customers in China. During
      2005 we changed our focus to the further development, manufacture and sale
      of
      our T-3 LCoS Sets, primarily to LGE. Revenues significantly decreased from
      2004
      to 2005 because of problems that we experienced in the manufacturing of our
      T-3
      LCoS Sets. Revenue in 2006 was related to delivery of our T-3 LCoS Sets,
      primarily to LGE. Revenue during the fourth quarter 2006 decreased from its
      trend earlier in the year because LGE significantly decreased its shipment
      releases against its outstanding purchase order with us during the fourth
      quarter 2006. As mentioned earlier, we have been informed by LGE that they
      are
      intending to discontinue production of RPTV products (both LCoS and DLP) at
      this
      time, continuing their emphasis on flat panel display televisions. As a result,
      we do not expect significant further sales to LGE. See “Status of Business with
      LG Electronics, Inc.”, “Status of Business in Taiwan” and “Status of Business in
      China” under this Item 7 for a more detailed description of the agreements
      relating to the sale of our products.





The
      following table summarizes our sales revenue percentages by product for the
      years ended 2006, 2005 and 2004.




2006
              
              2005
              
              2004LCoS
                  (T-3) sets
              
              
              96
              %
              
              77
              %
              
              5
              %LCoS
                  (T-1) sets
              
              
              -
              
              
              4
              %
              
              42
              %Light
                  engine display units
              
              
              -
              
              
              1
              %
              
              51
              %Other
                  (primarily supporting electronics)
              
              
              4
              %
              
              18
              %
              
              2
              %Total
              
              
              100
              %
              
              100
              %
              
              100
              %





*Gross
      Margin.* Gross
      margin changed from a positive of $179,000 in 2004 to a negative $1,519,000
      in
      2005 to a negative $5,388,000 in 2006. During the fourth quarter of 2005 our
      manufacturing facility in South Korea became operational. Once production began,
      our costs associated with this facility became part of our cost of revenue.
      These costs include a certain level of relatively fixed overhead costs,
      including personnel-related costs, to operate and maintain our manufacturing
      facilities. Once these relatively fixed overhead costs are covered, we expect
      to
      experience a contribution margin on additional sales. When we incur these costs
      without sufficient revenues from the sale of our products to offset them, we
      report negative margins. Our sales have been relatively minor to date, and
      have
      not yet covered the cost of operating our South Korean manufacturing facility.
      The costs of operating our South Korean facility contributed $4.9 million to
      our
      negative gross margin during 2006 versus $0.9 million in 2005, as it became
      operational during the fourth quarter 2005. Due to the addition of these costs,
      there is currently no direct correlation between costs and revenue during 2005
      or 2006. Cost of revenue in 2005 includes a reserve of $351,000, related to
      a
      percentage of our T-1 inventory. Cost of revenue in 2006 includes a reserve
      of
      $444,000 which wrote down the remaining portion of our T-1 inventory and the
      remaining light engine inventory. Sales of our T-1 product were minimal during
      2005 and we have had no sales of either of these products during 2006.





*Cash-based
      selling, general and administrative expenses.* **** Cash-based
      selling, general and administrative expenses were approximately $7,439,000,
      $7,255,000, and $5,810,000 in 2006, 2005 and 2004, respectively, and include
      professional services, salaries and related taxes and benefits, rent,
      depreciation, travel, insurance, and office expenses. Primary elements of the
      changes between the years follow.




2006
              
              2005Increase/
              
              Increase/(decrease)
              
              (decrease)Legal
              
              $
              838,000
              
              $
              456,000Auditing
                  and Accounting
              
              
              (137,000
              )
              
              452,000Consulting
              
              
              78,000
              
              
              250,000Rent
              
              
              (203,000
              )
              
              -Wages
                  and related taxes and benefits
              
              
              (399,000
              )
              
              355,000Recruiting
                  expense
              
              
              100,000
              
              
              -Freight
                  and delivery
              
              
              (73,000
              )
              
              162,000Travel
                  and entertainment
              
              
              (63,000
              )
              
              53,000Public
                  relations
              
              
              83,000
              
              
              -Bad
                  debt expense
              
              
              -
              
              
              (350,000
              )Other
              
              
              (40,000
              )
              
              67,000$
              184,000
              
              $
              1,445,000




34




Legal
      fees increased approximately $838,000 compared to 2005 primarily due to the
      ongoing SEC investigations as well as correspondence related to our filings
      with
      the SEC and increased legal services incurred for various financing arrangements
      entered into during 2006. Increased legal fees in 2005 were due primarily to
      our
      correspondence related to our filings with the SEC as well as increased legal
      services incurred for various financing arrangements entered into during 2005.
      Accounting related services decreased approximately $137,000 compared with
      2005
      due to audit fees for the one year versus re-audits of earlier years as was
      the
      case in 2005. Accounting related services increased during 2005 primarily due
      to
      the re-audit of 2003 and 2002 financial statements by OUM as well as increased
      audit fees to cover compliance with the Sarbanes-Oxley Act of 2002 (SOX) related
      compliance and the audit of our South Korean subsidiary in 2005. Consulting
      services during 2006 increased approximately $78,000 compared to 2005 and
      included $205,000 in consulting fees to our former Executive Vice President
      of
      Strategic Planning, $36,000 increased costs to comply with the Sarbanes-Oxley
      Act of 2002 (SOX), partially offset by $163,000 in reduced costs associated
      with
      the implementation of our Navision software system (in the US) during 2005.
      Consulting services during 2005 included increases related to SOX compliance
      efforts and implementation of our Navision software system (in the US) as
      compared with 2004. Rent declined during 2006 versus 2005 due to the move from
      our rented clean room facilities in California to our South Korean facility.
      This move was completed during the first part of 2006. Wages and related taxes
      and benefits decreased approximately $399,000 between 2006 and 2005 due to
      a
      six-person reduction (approximately 23%) in headcount in our US operations.
      Salaries and related taxes and benefits increased by approximately $326,000
      in
      2005 compared to 2004 and primarily relates to administrative wages in our
      new
      South Korean manufacturing facility. This facility incurred an additional
      $364,000 in general and administrative expenses during 2005. Freight expense
      declined in 2006 versus that in 2005 due to reduced shipping activity from
      California to our South Korean facility. There were significant freight expenses
      incurred during 2005 to ship equipment and inventory from California to South
      Korea as part of the pre-production activities there. Along the same lines,
      travel and entertainment expenses declined in 2006 as compared to 2005 due
      to
      reduced travel to our South Korean facility that was incurred in 2005 and
      related to the pre-production activities there. We engaged a public relations
      firm during 2006 to help us perform our investor relations duties. We did not
      incur these costs during 2005 due to financial constraints. The cost increases
      in 2005 versus 2004 are partially offset by a reduction in bad debt expense
      of
      $350,000 as compared to 2004. This reserve was created in 2004 and was directly
      associated with a particular customer based upon information provided to us
      by
      our Chinese sales representative that this customer was awaiting additional
      pending corporate financing and would likely not be able to pay us for our
      product deliveries prior to receiving that additional financing. The associated
      receivable was written off against this reserve during 2005.





*Stock-based
      general and administrative expenses.* Stock-based
      general and administrative expenses were approximately $1,875,000, $186,000,
      and
      $932,000 in 2006, 2005 and 2004, respectively. We adopted Statement of Financial
      Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” (“SFAS
      123R”) effective January 1, 2006. SFAS 123R requires the recognition of the fair
      value of stock compensation in net income (loss). We recognize the stock
      compensation expense over the requisite service period of the individual
      grantees, which generally equals the vesting period. All of our stock
      compensation is accounted for as an equity instrument. Prior to January 1,
      2006,
      we followed Accounting Principles Board (“APB”) Opinion 25, “Accounting for
      Stock Issued to Employees,” and related interpretations in accounting for our
      stock compensation. We adopted SFAS 123R using the modified prospective method.
      Under this method, the provisions of SFAS 123R apply to all awards granted
      or
      modified after the date of adoption. The unrecognized expense of awards not
      yet
      vested at the January 1, 2006 date of adoption is recognized in net income
      (loss) in the periods after the date of adoption using the same valuation method
      (i.e. Black-Scholes) and assumptions determined under the original provisions
      of
      SFAS 123, “Accounting for Stock-Based Compensation,” as disclosed in our
      previous filings. Following the provisions of the modified prospective method,
      we have not restated our consolidated financial statements for periods prior
      to
      2006 to reflect the adoption of SFAS 123R. Therefore, the results reported
      in
      the consolidated statement of operations for 2006 are not directly comparable
      to
      the results for 2005 and 2004. The amounts incurred relate to common shares,
      options to purchase common shares and warrants issued in exchange for services
      in 2006, 2005 and 2004, and costs of $1,875,000, $186,000, and $332,000,
      respectively, relate primarily to stock and options granted to employees and
      directors, and warrants issued in exchange for services. In addition, the
      amounts incurred in 2004 include a $600,000 reduction in a note receivable
      from
      one of our stockholders in exchange for a commitment to invest an additional
      $6,000,000. (See Note 3 to Consolidated Financial Statements.)




35




*Research
      and development expenses.* Research
      and development expenses (R&D) were approximately $1,067,000, $3,586,000,
      and $2,306,000 in 2006, 2005 and 2004, respectively. The increase in 2005 as
      compared to 2004 is due to the pre-production activities of our South Korean
      manufacturing facility. This includes the cost of operating the manufacturing
      facility prior to commencing production as well as supplies and materials used
      in these efforts. The facility neared completion towards the end of 2005,
      resulting in significantly reduced R&D expenses during 2006.




*Impairment
      loss* . We
      recorded an asset impairment loss of $1,429,925 related to our building in
      South
      Korea in the quarter ended December 31, 2006, in accordance with SFAS 144,
      “ *Accounting
      for the Impairment or Disposal of Long-Lived Assets* ”
based
      upon the estimated fair value of the building. On
      July
      24, 2007, we received evidence that LG Electronics (“LGE”) communicated its
      intention to terminate our Supply Agreement to Mr. Don Suh, in October 2006,
      in
      the form of an email to Mr. Suh’s personal email account. The mid-October email
      to Mr. Suh from LGE was first disclosed to SpatiaLight executives during
      settlement discussions by LGE’s legal counsel on July 24, 2007. At the time of
      the October 2006 email, Mr. Suh was our Senior Vice President for Marketing
      and
      Sales. He was later appointed to Chief Executive Officer on November 6, 2006,
      and was subsequently terminated on December 12, 2006. O n
      March
      9, 2007, we received oral notification from LGE of their intent to discontinue
      the production of all rear projection televisions. As a result of the October
      2006 email, we concluded that the asset impairment loss related to our building
      in South Korea should be recorded in the fourth quarter of 2006.




We
      considered the loss of LGE as a customer a significant change in circumstances
      which indicated the need for an impairment analysis, based on undiscounted
      cash
      flows. While we believe that we will find other customers for our products,
      we
      do not currently have existing customers to support estimated cash flows to
      achieve the recoverability of the asset and our forecast of future revenues,
      at
      this point, is speculative. Further, we receive
      a 100% land lease payment exemption because the facility is located on land
      designated a “free economic zone” by the South Korean national government and
      the South Korean government has certified us as a “high technology” company.
      Under our agreement with the Gyeongnam provincial government we could lose
      our
      land lease payment exemption in the event that we lose our “high technology”
certification. If we were to lose the lease, we might be required to donate
      the
      building to the South Korean government.




In
      determining the fair value of the building, we considered an independent
      appraisal which took into account the building’s overall structure, materials,
      and current condition. Based upon our analysis, the building’s
      estimated fair value was less than the net book value. As a result, the
      carrying value of the building has been reduced by $1,429,925 with a
      corresponding charge to impairment loss on the consolidated statement of
      operations.




*Interest
      expense* .
      Interest expense was approximately $396,000, $1,108,000, and $157,000, in 2006,
      2005, and 2004, respectively. The increase during 2005 is related to the
      November 2004 Senior Secured Convertible Notes of $10,000,000 which bear
      interest at 10% per annum. Approximately $745,000 of the decrease between 2006
      and 2005 is due to issuing our common shares in lieu of cash to the Senior
      Secured Noteholders for the payment of three quarters’ interest during 2006,
      which is included in non-cash interest expense. This decrease is partially
      offset by interest incurred on the short-term South Korean debt facilities.
      No
      comparable facilities existed in 2004 or the first three quarters of
      2005.





*Non-cash
      interest expense.* Non-cash
      interest expense of approximately $2,856,000, $1,431,000, and $791,000 in 2006,
      2005 and 2004, respectively, includes approximately $1,086,000, $846,000 and
      $729,000 for 2006, 2005 and 2004, respectively of expense associated with the
      amortization of the beneficial conversion of shares issued to prepay interest
      on
      the notes payable to Argyle Capital Management Corporation, a company
      wholly-owned by Robert A. Olins, former Chief Executive Officer, Secretary,
      Treasurer and a former Director of SpatiaLight. The beneficial conversion
      interest represents the excess market value of the shares received or receivable
      at the market price on the date of receipt over the $0.50 per share conversion
      price. Also included in non-cash interest expense is approximately $444,000
      in
      2006 and 2005 and approximately $37,000 in 2004 representing the amortization
      of
      note discounts and note financing costs of the Senior Secured Convertible Notes.
      See Note 3 to the Consolidated Financial Statements for further details.
      Approximately $745,000 of the increase between 2005 and 2006 represents expense
      associated with issuing our common shares in lieu of cash to the Senior Secured
      Noteholders for the payment of three quarters’ interest. Additionally, 2006
      includes approximately $518,000 representing liquidated damages related to
      the
      registration rights agreements entered into as part of the October 2005, January
      2006, September 2006 and November 2006 Financings. Please refer to footnote
      2 in
      the consolidated financial statements for further details.




36




*Gain
      from revaluation of note purchase option liability.* The gain
      of approximately $754,000 and $412,000 recorded in 2005 and 2004, respectively,
      arises from the revaluation of the additional investment rights (AIR) issued
      with our Senior Secured Convertible Notes in November 2004, which are being
      treated as a derivative and is recorded on the balance sheet as a note purchase
      option liability. This AIR expired on August 31, 2005. See Note 3 to
      Consolidated Financial Statements. The gain in 2005 also includes an expired
      Investment Right of $94,500 associated with our August 2005 financing. There
      were no corresponding financial instruments during 2006.





*Gain
      on fair value of warrants.* The gain
      of approximately $44,000 and $180,000 arises from the revaluation of the
      warrants issued in connection with the September 2006 and October 2005
      financing. These warrants were being treated as derivatives and were recorded
      on
      the balance sheet at fair value until the shares
      covered by the registration statement have been sold or may be sold without
      volume restrictions pursuant to Rule 144(k) .
      Upon
      our October 1, 2006 adoption of Financial Accounting Standards Board Staff
      Position Emerging Issues Task Force 00-19-2, “Accounting for Registration
      Payment Arrangements”, these warrants have been reclassified to equity and the
      related fair value revaluations have been included in the cumulative effect
      of a
      change in accounting principle (see below).





*Foreign
      currency translation gain.* The gain
      of approximately $91,000 and $59,000 relates to the revaluation of intercompany
      payables recorded in local currency and then revalued at the balance sheet
      date
      to the then-current exchange rate.





*Interest
      and other income.* Interest
      and other income was approximately $145,000, $70,000, and $38,000 in 2006,
      2005,
      and 2004, respectively. Interest was primarily bank interest. Other income
      in
      2006 and 2005 includes approximately $141,000 and $42,000, respectively, of
      subsidies from the South Korean government.





*Loss
      before income taxes* .
      Losses
      before income taxes were approximately $20,397,000, $14,022,000, and $9,366,000
      in 2006, 2005 and 2004, respectively. The increase in losses from 2006 to 2005
      and from 2005 to 2004 is primarily due to costs associated with starting up
      our
      South Korean manufacturing facility coupled with negligible sales, increased
      legal fees related to the SEC investigations and 2006 financings, offset by
      non-cash gains from the revaluation of the note purchase option liability of
      $754,000 and $412,000 in 2005 and 2004, respectively. Additional factors between
      2005 and 2004 include approximately $1,443,000 of increased interest expense
      associated with our $10,000,000 notes ($443,000 of which is non-cash).





*Income
      taxes.* Income
      taxes consist primarily of minimum state tax requirements. See Note 5 to the
      Consolidated Financial Statements under Item 8 of this Report.





*Cumulative
      effect of change in accounting principle* .
      Effective October 1, 2006, we adopted Financial Accounting Standards Board
      (FASB) Staff Positon (FSP) Emerging Issues Task Force (EITF) 00-19-2,
“Accounting for Registration Payment Arrangements”. This FASB staff position
      addresses how to account for registration payment arrangements and clarifies
      that a financial instrument subject to a registration payment arrangement should
      be accounted for in accordance with other generally accepted accounting
      principles (GAAP) without regard to the contingent obligation to transfer
      consideration pursuant to the registration payment arrangement. The cumulative
      effect of this accounting change increased net loss for 2006 by $223,993, or
      $0.01 per share. Please
      see below under Recent
      Accounting Pronouncements and Adoption of New Accounting Pronouncements for
      further details.





*Inflation.* Our
      management currently believes that inflation has not had a material impact
      on
      continuing operations.





**Critical
      Accounting Policies and Estimates**





Management’s
      discussion and analysis of our results of operations and liquidity and capital
      resources are based on our consolidated financial statements. To prepare our
      Consolidated Financial Statements in accordance with accounting principles
      generally accepted in the United States of America, we must make estimates
      and
      assumptions that affect the amounts reported in the consolidated financial
      statements. We regularly evaluate these estimates and assumptions, particularly
      in areas we consider to be critical accounting estimates, where changes in
      the
      estimates and assumptions could have a material impact on our results of
      operations, financial position and, generally to a lesser extent, cash flows.
      Senior management and the Audit Committee of the Board of Directors have
      reviewed the disclosures included herein about our critical accounting
      estimates, and have reviewed the processes to determine those
      estimates.





*Revenue
      Recognition* - We
      evaluate revenue recognition for transactions using the following criteria
      (collectively called the Revenue Recognition Criteria):





·
            Evidence
                of an arrangement: Before revenue is recognized, we must have evidence
                of
                an agreement with the customer reflecting the terms and conditions
                to
                deliver our products.


·
            Delivery:
                For products, delivery is considered to occur when title and risk
                of loss
                have been transferred, which generally occurs upon shipment.




37




·
            Fixed
                or determinable fee: We consider a fee to be fixed or determinable
                if the
                fee is not subject to refund or adjustment. If a portion of the
                arrangement fee is not fixed or determinable, we recognize that amount
                as
                revenue when the amount becomes fixed or determinable. We do not
                consider
                a fee to be fixed and determinable if any amount is due more than
                180 days
                from the delivery date. Payment terms of less than 180 days are evaluated
                based upon the laws or trade practices of the country in which the
                arrangement is entered into to assess whether the fee is fixed and
                determinable.


·
            Collection
                is deemed reasonably assured: Collection is deemed reasonably assured
                if
                we expect the customer to be able to pay amounts under the arrangement
                as
                those amounts become due. We reduce product revenue for customer
                returns
                and sales allowances and record an allowance for doubtful accounts
                should
                collectibility become questionable. If it is determined that an account
                is
                uncollectible, the account is written off against the allowance.





*Inventory
      Valuation -* We
      value
      inventories at the lower of cost (based on the first-in, first-out method)
      or
      market value. We include materials, labor and manufacturing overhead in the
      cost
      of inventories. In determining inventory market values, we give substantial
      consideration to the expected selling price of the product based on historical
      recovery rates. If we assess the market value of our inventory to be less than
      costs we write it down to its replacement cost or its net realizable value.
      Our
      estimates may differ from actual results due to the quantity, quality and mix
      of
      products in inventory, consumer and retailer preferences and economic
      conditions.




*Stock-based
      Payments -* Effective January 1, 2006 we adopted SFAS 123R using the modified prospective
      method and therefore have not restated prior periods’ results for the adoption
      of SFAS 123R. Under the fair value recognition provisions of SFAS 123R, we
      recognize stock-based compensation net of an estimated forfeiture rate and
      therefore only recognize compensation cost for those shares expected to vest
      over the service period of the award. Prior to SFAS 123R adoption, we accounted
      for share-based payments under APB 25 and accordingly, generally recognized
      compensation expense related to stock options with intrinsic value and accounted
      for forfeitures as they occurred.




We
      estimated the fair value of options granted using the Black-Scholes option
      pricing model, except for options granted with a market condition, in which
      case
      a binomial model is used, using the assumptions shown in Note 1, Description
      of
      Business and Summary of Significant Accounting Policies - Stock Based
      Compensation. Calculating stock-based compensation expense under the provisions
      of SFAS 123R requires the input of highly subjective assumptions, including
      the
      expected term of the stock-based awards, stock price volatility, and pre-vesting
      option forfeitures. We estimate the expected life of options granted based
      on
      the simplified method provided in Staff Accounting Bulletin No. 107 for "plain
      vanilla" options, except for options granted with a market condition, in which
      case a binomial model is used. We estimate the volatility of our common stock
      at
      the date of grant based on the historical volatility of our common stock. 
In addition, we are required to estimate the expected forfeiture rate and only
      recognize expense for those shares expected to vest. We estimate the forfeiture
      rate based on historical experience of our stock-based awards that are granted,
      exercised and cancelled. If our actual forfeiture rate is materially different
      from our estimate, the stock-based compensation expense could be significantly
      different from what we have recorded in the current period. The assumptions
      used
      in calculating the fair value of stock-based awards represent our best
      estimates, but these estimates involve inherent uncertainties and the
      application of management judgment. As a result, if factors change and we use
      different assumptions, our stock-based compensation expense could be materially
      different in the future. As required under SFAS 123R, we will review our
      valuation assumptions at each grant date and, as a result, are likely to
      periodically change the valuation assumptions used to value employee stock-based
      awards granted in future periods. The guidance in SFAS 123R is relatively new
      and best practices are not well established. The application of the various
      valuation assumptions may be subject to further interpretation and refinement
      over time. There are significant differences among valuation models and there
      is
      a possibility that we will adopt different valuation models and assumptions
      in
      the future. This may result in a lack of comparability with other companies
      that
      use different models, methods and assumptions and in a lack of consistency
      in
      future periods. See Note 6 - Stockholders’ Equity (Deficit) - Stock Option
      Plans” in the Consolidated Financial Statements for additional
      information.





*Research
      and Development* -
      Research and development costs, including the costs of prototype and
      pre-production LCoS Sets, pre-production display units, and other pre-production
      activities at our South Korean manufacturing facility are charged to expense
      when incurred.





*Income
      Tax Assets and Liabilities -* In
      establishing our deferred income tax assets and liabilities, we make judgments
      and interpretations based on the enacted tax laws and published tax guidance
      that are applicable to our operations. We record deferred tax assets and
      liabilities and evaluate the need for valuation allowances to reduce the
      deferred tax assets to realizable amounts. The likelihood of a material change
      in our expected realization of these assets is dependent on future taxable
      income, our ability to use foreign tax credit carryforwards and carrybacks,
      final U.S. and foreign tax settlements, and the effectiveness of our tax
      planning strategies in the various relevant jurisdictions. Due to our lack
      of
      profitable operating history, potential limitations on usage of operating losses
      and general uncertainty, we provided for a 100% valuation allowance against
      our
      deferred tax assets. We are also subject to examination of our income tax
      returns for multiple years by the Internal Revenue Service and other tax
      authorities. We periodically assess the likelihood of adverse outcomes resulting
      from these examinations to determine the adequacy of our provision for income
      taxes. Changes to our income tax provision or the valuation of the deferred
      tax
      assets and liabilities may affect our annual effective income tax
      rate.




38




*Impairment
      of Long-Lived Assets* -
      We
      account for the impairment of long-lived assets in accordance with SFAS
      No. 144, *Accounting
      for the Impairment or Disposal of Long-Lived Assets* .
      An
      impairment of a long-lived asset exists when the carrying value of an asset
      exceeds its fair value and when the carrying value is not recoverable through
      future undiscounted cash flows from operations. We review the carrying value
      of
      long-lived assets for impairment when events or changes in circumstances
      indicate that the carrying amount of assets may not be recoverable.




Considerable
      management judgment is required in determining if and when a condition would
      trigger an impairment assessment of our long-lived assets and once such a
      determination has been made, considerable management judgment is required to
      determine the fair market value of the long-lived asset. In determining the
      fair
      value of the asset, we consider the associated net present value of estimated
      future cash flows and/or independently performed appraisals. Such
      estimated future cash flows are based on assumptions about our expected future
      operating performance. Our estimates of future cash flows may differ from actual
      cash flows due to, among other things, technological changes, economic
      conditions or changes to our business operations. Impairments would be
      recognized in operating results to the extent that the carrying value exceeds
      this estimated fair value of the long-lived assets.





**Recent
      Accounting Pronouncements and Adoption of New Accounting
      Pronouncements**





In
      September 2006, the Financial Accounting Standards Board (FASB) issued Statement
      No. 157, “Fair Value Measurements” (“FAS 157”). This statement defines fair
      value, establishes a framework for measuring fair value under generally accepted
      accounting principles (GAAP), and expands disclosures about fair value
      measurements. SFAS No. 157 is effective for financial statements issued for
      fiscal years beginning after November 15, 2007, and interim periods within
      those
      fiscal years. The transition adjustment, which is measured as the difference
      between the carrying amount and the fair value of those financial instruments
      at
      the date this statement is initially applied, should be recognized as a
      cumulative effect adjustment to the opening balance of retained earnings for
      the
      fiscal year in which this statement is initially applied. The provisions of
      SFAS
      No. 157 are effective for us beginning January 1, 2008. We are currently
      evaluating the impact of adopting SFAS No. 157 on our consolidated financial
      statements.





In
      September 2006, the Securities and Exchange Commission (SEC) issued Staff
      Accounting Bulletin (SAB) No. 108, “Considering the Effects of Prior Year
      Misstatements when Quantifying Misstatements in Current Year Financial
      Statements.” SAB No. 108 addresses how the effects of prior year uncorrected
      misstatements should be considered when quantifying misstatements in current
      year financial statements and is effective for fiscal years ending after
      November 15, 2006. SAB No. 108 requires companies to quantify misstatements
      using a balance sheet and income statement approach and to evaluate whether
      either approach results in quantifying an error that is material in light of
      relevant quantitative and qualitative factors. SAB No. 108 permits existing
      public companies to initially apply its provisions either by (i) restating
      prior
      financial statements as if the “dual approach” had always been used or (ii)
      recording the cumulative effect of initially applying the “dual approach” as
      adjustments to the carrying value of assets and liabilities as of January 1,
      2006 with an offsetting adjustment recorded to the opening balance of retained
      earnings. The adoption of the provisions of SAB No. 108 on December 31, 2006
      had
      no impact on our consolidated financial statements.





In
      June
      2006, the Financial Accounting Standards Board (FASB) issued Interpretation
      No.
      48, *Accounting
      for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109* (“FIN
      48”). This Interpretation clarifies the accounting for uncertainty in income
      taxes recognized in a company’s financial statements in accordance with FASB
      Statement No. 109, *Accounting
      for Income Taxes.* FIN 48
      prescribes a recognition threshold and measurement attribute for the financial
      statement recognition and measurement of a tax position taken or expected to
      be
      taken in a tax return. This Interpretation also provides guidance on
      derecognition, classification, interest and penalties, accounting in interim
      periods, disclosure, and transition. The evaluation of a tax position in
      accordance with FIN 48 is a two-step process. The first step is recognition:
      The
      Company determines whether it is “more-likely-than-not” that a tax position will
      be sustained upon examination, including resolution of any related appeals
      or
      litigation processes, based on the technical merits of the position. In
      evaluating whether a tax position has met the “more-likely-than-not” recognition
      threshold, the company presumes that the position will be examined by the
      appropriate taxing authority that would have full knowledge of all relevant
      information. The second step is measurement: A tax position that meets the
      “more-likely-than-not” recognition threshold is measured to determine the amount
      of benefit to recognize in the financial statements. The tax position is
      measured at the largest amount of benefit that is greater than 50 percent likely
      to be realized upon ultimate settlement. FIN 48 is effective for fiscal years
      beginning after December 15, 2006. We are in the process of determining the
      impact, if any, of the adoption of FIN 48 on our results of operations or
      financial condition.





In
      June
      2005, the FASB issued Statement No. 154, "Accounting Changes and Error
      Corrections" (SFAS 154), a replacement of APB No. 20, "Accounting Changes"
      and
      FASB Statement No. 3, "Reporting Accounting Changes in Interim Financial
      Statements". FAS 154 applies to all voluntary changes in accounting principle
      and changes the requirements for accounting for and reporting of a change in
      accounting principle. This statement establishes that unless impracticable,
      retrospective application is the required method for reporting a change in
      accounting principle in the absence of explicit transition requirements specific
      to the newly adopted accounting principle. It also requires the reporting of
      an
      error correction which involves adjustments to previously-issued financial
      statements similar to those generally applicable to reporting an accounting
      change retrospectively. FAS 154 became effective for accounting changes and
      corrections of errors made in our fiscal year beginning on January 1, 2006.
      The
      adoption of FAS 154 has not had a material impact on our results of operations
      or financial condition.




39




In
      December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment” to revise
      SFAS No. 123, “Accounting for Stock-Based Compensation” and supersede APB
      Opinion No. 25, “Accounting for Stock Issued to Employees” and its related
      implementation guidance. It requires companies to recognize their compensation
      costs related to share-based payment transactions in financial statements.
      These
      costs are to be measured based on the fair value of the equity or liability
      instruments issued and are recognized over the period during which an employee
      is required to provide services in exchange for the award - the requisite
      service period (usually the vesting period). We have applied
      SFAS No. 123R beginning January 1, 2006 .
      See
      Note 1 - Description of Business and Summary of Significant Accounting Policies
      - Stock Based Compensation for further information.





In
      November 2004, the FASB issued SFAS No. 151, “Inventory Costs, An Amendment Of
      ARB No. 43, Chapter 4” ("SFAS 151"). SFAS 151 amends ARB 43, Chapter 4, to
      clarify that abnormal amounts of idle facility expense, freight, handling costs
      and wasted materials (spoilage) be recognized as current period charges. It
      also
      requires that allocation of fixed production overheads to the costs of
      conversion be based on the normal capacity of the production facilities. SFAS
      151 became effective for the Company beginning in 2006. The adoption of SFAS
      151
      has not had a material impact on our results of operations
      or financial position.





*Adoption
      of New Accounting Pronouncements* -
      Effective October 1, 2006, we adopted Financial Accounting Standards Board
      (FASB) Staff Position (FSP) Emerging Issues Task Force (EITF) 00-19-2,
“Accounting for Registration Payment Arrangements”. This FASB staff position
      addresses how to account for registration payment arrangements and clarifies
      that a financial instrument subject to a registration payment arrangement should
      be accounted for in accordance with other generally accepted accounting
      principles (GAAP) without regard to the contingent obligation to transfer
      consideration pursuant to the registration payment arrangement. This accounting
      pronouncement further clarifies that a liability for liquidated damages
      resulting from registration statement obligations should be recorded in
      accordance with Statement of Financial Accounting Standards No. 5, "Accounting
      for Contingencies *,* " ** when
      the
      payment of liquidated damages becomes probable and can be reasonably estimated.





Prior
      to
      adoption of this FSP, we had classified as temporary equity, and as a warrant
      liability, as applicable, financial instruments issued in conjunction with
      our
      recent financings until the underlying securities were registered with the
      SEC,
      because the maximum potential liquidated damages may be greater than the
      difference in fair values between registered and unregistered shares. Our
      adoption of this accounting pronouncement as of October 1, 2006 resulted
      in a reclassification of $1,947,909 of temporary equity and $129,279 of warrant
      liability to common stock and additional paid in capital as of October 1, 2006. The
      cumulative effect of this accounting change increased our 2006 net loss by
      $223,993, or $0.01 per share.





We
      also
      adopted Statement of Financial Accounting Standard No. 123(R), “Share-Based
      Payment” (“SFAS 123(R)”), and Statement of Financial Accounting Standard No.
      151, “Inventory Costs, an Amendment of ARB No. 43, Chapter 4” (“SFAS No. 151”)
      as of January 1, 2006. The adoption of SFAS 123(R) is discussed above, and
      the
      adoption of SFAS No. 151 did not have a material effect on our results of
      operations or financial position.





**Item
      7A.**  **Quantitative and Qualitative Disclosures About Market Risk**





We
      place
      all of our excess cash and cash equivalents in a checking account or money
      market account in the United States. We do not expect any material losses from
      our placement of such cash balances, and we believe that our interest rate
      exposure is modest. As of December 31, 2006, our cash and cash equivalents
      totaled $220,256. Of this amount, approximately $3,131 was in South
      Korea.





A
      portion
      of our costs is denominated in foreign currencies, including the South Korean
      Won and the Euro. As a result, changes in the exchange rates of these currencies
      or any other applicable currencies to the U.S. dollar will affect our financial
      results, including costs of revenue and operating expenses, and could result
      in
      exchange losses or gains. We cannot fully predict the impact of future exchange
      rate fluctuations on our profitability. From time to time, we may engage in
      exchange rate hedging activities in an effort to mitigate the impact of exchange
      rate fluctuations, although we have not engaged in any such hedging activities
      to date.





The
      November 2006 Financing does not allow us to raise additional capital at less
      than $1.30 per share. Depending on the fluctuations in the price of our common
      stock, this could limit our ability to raise additional capital, or raise the
      costs of obtaining additional capital by paying a fee to obtain a waiver from
      the participants in the November 2006 Financing.




40




**Item
      8.**  **Consolidated
      Financial Statements.**




**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**





To
      the
      Board of Directors and Stockholders of


SpatiaLight,
      Inc.





We
      have
      audited the accompanying consolidated balance sheets of SpatiaLight, Inc. and
      its subsidiaries as of December 31, 2006 and 2005, and the related consolidated
      statements of operations, stockholders' equity (deficit) and cash flows for
      each
      of the three years in the period ended December 31, 2006. These financial
      statements are the responsibility of the Company's management. Our
      responsibility is to express an opinion on these financial statements based
      on
      our audits.





We
      conducted our audits in accordance with standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether the financial
      statements are free of material misstatement. An audit includes examining,
      on a
      test basis, evidence supporting the amounts and disclosures in the financial
      statements. An audit also includes assessing the accounting principles used
      and
      significant estimates made by management, as well as evaluating the overall
      financial statement presentation. We believe that our audits provide a
      reasonable basis for our opinion.





In
      our
      opinion, the consolidated financial statements audited by us present fairly,
      in
      all material respects, the consolidated financial position of SpatiaLight,
      Inc.
      and its subsidiaries at December 31, 2006 and 2005, and the consolidated results
      of their operations and their cash flows for each of the three years in the
      period ended December 31, 2006, in conformity with U.S. generally accepted
      accounting principles.





The
      accompanying consolidated financial statements have been prepared assuming
      that
      the Company will continue as a going concern. As discussed in Note 1 to the
      consolidated financial statements, the Company has suffered recurring operating
      losses and negative cash flows from operations, and has a negative working
      capital position and a stockholders’ deficit. Management believes that the
      Company's cash resources will not be sufficient to sustain its operations beyond
      March 2007 without additional financing. As also described in Notes 1 and 3,
      The
      Company’s Senior Secured Convertible Notes totaling $10 million mature in
      November 2007, and the Company has received notices from certain of its Senior
      Secured Convertible Noteholders calling for immediate redemption of their
      convertible notes based on alleged events of default. Management believes,
      after
      reviewing the alleged events of default with outside legal counsel, the alleged
      events of default lack merit and would not entitle the Noteholders to call
      the
      Senior Secured Convertible Notes and other remedies they are seeking. If the
      Noteholders prevail in calling the convertible notes, the entire debt obligation
      could become due and payable immediately, including the related amounts of
      redemption premium and liquidated damages, and the Company would be forced
      to
      refinance or repay the debt obligations or seek other alternative financing.
      Moreover, the Company will be required to repay or refinance the Senior Secured
      Convertible Notes in November 2007, and will need to obtain additional financing
      to repay the Noteholders. Additionally, as described in Notes 1 and 11, the
      Company, based upon discussions in March 2007 with its major customer, does
      not
      expect significant further sales to this customer. Furthermore, as described
      in
      Note 10, the Company is subject to U.S. Securities and Exchange Commission
      investigations relating to the filing of unauthorized consents of its
      predecessor auditor in certain registration statements, and the sale of the
      Company’s common stock held by its former Chief Executive Officer, and may be
      subject to certain penalties and claims relating thereto. These factors raise
      substantial doubt about the Company's ability to continue as a going concern.
      Management's plans in regard to these matters are also described in Note 1.
      The
      accompanying consolidated financial statements do not include any adjustments
      that might result from the outcome of these uncertainties.





As
      discussed in Note 1 to the consolidated financial statements, the Company
      adopted the provision of Statement of Financial Accounting Standard No. 123(R),
      “Share-Based Payment”, and Statement of Financial Accounting Standard No. 151
“Inventory Costs, an Amendment of ARB No. 43, Chapter 4” as of January 1, 2006.
      Additionally, the Company adopted Financial Accounting Standards Board Staff
      Position EITF 00-19-2, “Accounting for Registration Payment Arrangements” in the
      fourth quarter of 2006.





As
      discussed in Note 1 to the consolidated financial statements, the accompanying
      consolidated financial statements as of and for the year ended December 31,
      2006
      have been restated to correct the Company’s accounting for an asset impairment
      loss on long-lived assets at the Company’s wholly-owned subsidiary in South
      Korea.





41


We
      have
      also audited, in accordance with the standards of the Public Company Accounting
      Oversight Board (United States), the effectiveness of SpatiaLight, Inc.'s
      internal control over financial reporting as of December 31, 2006, based on
      criteria established in Internal Control -- Integrated Framework issued by
      the
      Committee of Sponsoring Organizations of the Treadway Commission and our report
      dated March 15, 2007 expressed an adverse opinion thereon.








*/s/
      ODENBERG, ULLAKKO, MURANISHI & CO. LLP*





*San
      Francisco, California*


*March
      15, 2007 except for the “Restatement” section of Note 1, the "Impairment loss"
      section of Note 4, and Note 5, as to which the date is August 20, 2007*




42




SPATIALIGHT,
      INC.


CONSOLIDATED
      BALANCE SHEETS


DECEMBER
      31, 2006 AND 2005





2006
            
            2005(As
                Restated)See
                Note 1ASSETSCurrent
                assetsCash
                and cash equivalents
            
            $
            220,256
            
            $
            42,565Accounts
                receivable, net of allowance of $0 at December 31,2006
                and 2005
            
            
            52,238
            
            
            139,676Inventory,
                net
            
            
            423,075
            
            
            756,723Prepaids
                and other current assets
            
            
            307,428
            
            
            255,157Total
                current assets
            
            
            1,002,997
            
            
            1,194,121Property
                and equipment, net
            
            
            5,205,926
            
            
            6,813,520Other
                assets
            
            
            37,121
            
            
            73,437Total
                assets
            
            $
            6,246,044
            
            $
            8,081,078LIABILITIES,
                TEMPORARY EQUITY, AND STOCKHOLDERS' EQUITY (DEFICIT)Current
                liabilitiesSenior
                secured convertible notes - current portion
            
            $
            9,596,086
            
            $
            -Unsecured
                short term loans
            
            
            591,070
            
            
            572,025Short
                term loan from a related party
            
            
            -
            
            
            224,384Accounts
                payable
            
            
            1,916,249
            
            
            1,665,711Fair
                value of warrants to purchase common stock
            
            
            -
            
            
            778,270Accrued
                expenses and other current liabilities
            
            
            1,793,232
            
            
            1,389,427Total
                current liabilities
            
            
            13,896,637
            
            
            4,629,817Senior
                secured and related party convertible notes
            
            
            1,188,000
            
            
            10,340,113Total
                liabilities
            
            
            15,084,637
            
            
            14,969,930Commitments
                and contingenciesTemporary
                equity:Common
                stock, subject to registration, $0.01 par value;571,431
                shares issued and outstanding, net of fair value of
                warrantsof
                $958,625 and issuance costs of $15,000 at December 31,
                2005
            
            
            -
            
            
            1,026,374Total
                liabilities and temporary equity
            
            
            15,084,637
            
            
            15,996,304Stockholders'
                equity (deficit):Common
                stock, $.01 par value:100,000,000
                and 50,000,000 shares authorized as of December 31, 2006and
                December 31, 2005, respectively; 44,482,616 and 36,777,069 shares
                issuedand
                outstanding at December 31, 2006 and 2005, respectively
            
            
            444,826
            
            
            367,771Additional
                paid-in capital
            
            
            94,756,700
            
            
            76,631,925Prepaid
                non-cash interest to related party
            
            
            (2,314,266
            )
            
            (3,471,398
            )Other
                comprehensive income
            
            
            336,975
            
            
            222,317Accumulated
                deficit
            
            
            (102,062,828
            )
            
            (81,665,841
            )Total
                stockholders' equity (deficit)
            
            
            (8,838,593
            )
            
            (7,915,226
            )Total
                liabilities, temporary equity, and stockholders' equity
                (deficit)
            
            $
            6,246,044
            
            $
            8,081,078





See
      accompanying notes to consolidated financial statements.




43




SPATIALIGHT,
        INC.
 CONSOLIDATED
        STATEMENTS OF OPERATIONS
 YEARS
        ENDED DECEMBER 31, 2006, 2005 and 2004
 
 2006
              
              2005
              
              2004(As
                  Restated)See
                  Note 1Revenue
              
              $
              474,004
              
              $
              237,724
              
              $
              1,160,978Cost
                  of revenue and manufacturing expenses
              
              
              (5,861,644
              )
              
              (1,757,089
              )
              
              (982,282
              )Gross
                  margin
              
              
              (5,387,640
              )
              
              (1,519,365
              )
              
              178,696Operating
                  expenses:Selling,
                  general and administrative expenses (including stock-basedexpense
                  of $1,875,330, $186,187 and $931,534for
                  the years 2006, 2005, and 2004, respectively)
              
              
              9,313,910
              
              
              7,441,540
              
              
              6,741,226Research
                  and development expenses
              
              
              1,066,939
              
              
              3,586,296
              
              
              2,305,650Impairment
                  loss
              
              
              1,429,925
              
              
              -
              
              
              -Total
                  operating expenses
              
              
              11,810,774
              
              
              11,027,836
              
              
              9,046,876Operating
                  loss
              
              
              (17,198,414
              )
              
              (12,547,201
              )
              
              (8,868,180
              )Other
                  income (expense):Interest
                  expense:Interest
                  expense
              
              
              (396,194
              )
              
              (1,107,812
              )
              
              (156,693
              )Non-cash
                  interest expense
              
              
              (2,856,393
              )
              
              (1,430,506
              )
              
              (791,036
              )Total
                  interest expense
              
              
              (3,252,587
              )
              
              (2,538,318
              )
              
              (947,729
              )Other
                  income:Gain
                  from revaluation of note purchase option andinvestment
                  right liabilities
              
              
              -
              
              
              754,374
              
              
              412,374Gain
                  from revaluation of warrants
              
              
              43,638
              
              
              180,355
              
              
              -Foreign
                  currency translation gain
              
              
              90,880
              
              
              58,531
              
              
              -Interest
                  and other income
              
              
              145,289
              
              
              69,920
              
              
              38,009Total
                  other income
              
              
              279,807
              
              
              1,063,180
              
              
              450,383Total
                  other income (expenses)
              
              
              (2,972,780
              )
              
              (1,475,138
              )
              
              (497,346
              )Loss
                  before income tax expense
              
              
              (20,171,194
              )
              
              (14,022,339
              )
              
              (9,365,526
              )Income
                  tax expense
              
              
              1,800
              
              
              2,300
              
              
              1,475Loss
                  before cumulative effect of change inaccounting
                  principle
              
              
              (20,172,994
              )
              
              (14,024,639
              )
              
              (9,367,001
              )Cumulative
                  effect of change in accounting principle
              
              
              (223,993
              )
              
              -
              
              
              -Net
                  loss
              
              $
              (20,396,987
              )
              $
              (14,024,639
              )
              $
              (9,367,001
              )Net
                  loss per share - basic and dilutedNet
                  loss per share before cumulative change inaccounting
                  principle
              
              $
              (0.50
              )
              $
              (0.39
              )
              $
              (0.27
              )Cumulative
                  effect of change in accounting principle
              
              $
              (0.01
              )
              $
              -
              
              $
              -Net
                  loss per share
              
              $
              (0.50
              )
              $
              (0.39
              )
              $
              (0.27
              )Weighted
                  average shares used in computingnet
                  loss per share - basic and diluted
              
              
              40,717,579
              
              
              36,375,068
              
              
              34,154,057
 
 See
        accompanying notes to consolidated financial statements




44




SPATIALIGHT,
        INC.
 CONSOLIDATED
        STATEMENTS OF EQUITY (DEFICIT)
 YEARS
        ENDED DECEMBER 31, 2006, 2005 AND 2004
 
 **PREPAID**
              
              **NOTES**
              
              
              
              **OTHER****NONCASH**
              
              **RECEIVABLE**
              
              
              
              **COMPRE-**
              
              
              
              **TOTAL****ADDITIONAL**
              
              **INTEREST**
              
              **FROM**
              
              **ACCUM-**
              
              ****HENSIVE****
              
              **COMMON**
              
              **STOCKHOLDERS’****COMMON
                  STOCK**
              
              **PAID-IN**
              
              **RELATED**
              
              **STOCK**
              
              **ULATED**
              
              **INCOME**
              
              **STOCK**
              
              **EQUITY****SHARES**
              
              **AMOUNT**
              
              **CAPITAL**
              
              **PARTY**
              
              **HOLDERS**
              
              **DEFICIT**
              
              **(LOSS)**
              
              **ISSUABLE**
              
              **(DEFICIT)**Balance,
                  January 1, 2004
              
              
              33,229,191
              
              $
              332,292
              
              $
              61,046,425
              
              $
              -
              
              $
              (1,096,926
              )
              $
              (58,274,201
              )
              $
              -
              
              $
              3,805,685
              
              $
              5,813,275Exercise
                    of stock options and warrants, 132,737 shares issued in January
                    2005
              
              
              1,013,127
              
              
              10,131
              
              
              2,484,387
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              394,185
              
              
              2,888,703Issuance
                  of options to employees and directors
              
              
              -
              
              
              -
              
              
              67,674
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              67,674Issuance
                  of warrant for services
              
              
              -
              
              
              -
              
              
              263,850
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              263,850Issuance
                    of shares for prepayment of related party interest
              
              
              264,036
              
              
              2,640
              
              
              1,541,734
              
              
              (1,544,374
              )
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Shares
                    issuable for prepayment of related party interest, 448,768 issued
                    in
                    January 2005
              
              
              -
              
              
              -
              
              
              -
              
              
              (3,643,964
              )
              
              -
              
              
              -
              
              
              -
              
              
              3,643,964
              
              
              -Payments
                  on notes receivable from stockholders
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              269,851
              
              
              -
              
              
              -
              
              
              -
              
              
              269,851Reduction
                    of note receivable in exchange for financing
                    commitment
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              600,000
              
              
              -
              
              
              -
              
              
              -
              
              
              600,000Accrued
                  interest on notes receivable from stockholder
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (14,387
              )
              
              -
              
              
              -
              
              
              -
              
              
              (14,387
              )Beneficial
                    pricing on conversion feature on convertible notes
              
              
              -
              
              
              -
              
              
              156,610
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              156,610Issuance
                  of common shares issuable
              
              
              820,082
              
              
              8,201
              
              
              3,797,484
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (3,805,685
              )
              
              -Amortization
                    of related party prepaid non-cash interest
              
              
              -
              
              
              -
              
              
              -
              
              
              800,063
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              800,063Short
                  swing profit
              
              
              -
              
              
              -
              
              
              25,982
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              25,982Comprehensive
                  loss:Net
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (9,367,001
              )
              
              -
              
              
              -
              
              
              (9,367,001
              )Foreign
                  currency translation adjustments
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              73,562
              
              
              -
              
              
              73,562Total
                  comprehensive loss
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (9,293,439
              )
 
 See
        accompanying notes to consolidated financial statements
  45




SPATIALIGHT,
        INC.
 CONSOLIDATED
        STATEMENTS OF EQUITY (DEFICIT) (con't)
 YEARS
        ENDED DECEMBER 31, 2006, 2005 AND 2004
 
 **PREPAID**
              
              **NOTES**
              
              
              
              **OTHER****NONCASH**
              
              **RECEIVABLE**
              
              
              
              **COMPRE-**
              
              
              
              **TOTAL****ADDITIONAL**
              
              **INTEREST**
              
              **FROM**
              
              **ACCUM-**
              
              **HENSIVE**
              
              **COMMON**
              
              **STOCKHOLDERS'****COMMON
                  STOCK**
              
              **PAID-IN**
              
              **RELATED**
              
              **STOCK**
              
              **ULATED**
              
              **INCOME**
              
              **STOCK**
              
              **EQUITY****SHARES**
              
              **AMOUNT**
              
              **CAPITAL**
              
              **PARTY**
              
              **HOLDERS**
              
              **DEFICIT**
              
              **(LOSS)**
              
              **ISSUABLE**
              
              **(DEFICIT)**Balance,
                  December 31, 2004
              
              
              35,326,436
              
              $
              353,264
              
              $
              69,384,146
              
              $
              (4,388,275
              )
              $
              (241,462
              )
              $
              (67,641,202
              )
              $
              73,562
              
              $
              4,038,149
              
              $
              1,578,182Issuance
                  of options below fair market value to employees
              
              
              -
              
              
              -
              
              
              22,000
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              22,000Exercise
                  of stock options and warrants
              
              
              369,163
              
              
              3,692
              
              
              532,297
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              535,989Issuance
                  of warrant for services
              
              
              -
              
              
              -
              
              
              164,187
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              164,187Issuance
                  of common shares, net of issuance costs of $103,539 and fair value
                  of
                  investment right
              
              
              499,965
              
              
              5,000
              
              
              2,496,961
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              2,501,961Payments
                  on notes receivable from stockholders
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              249,105
              
              
              -
              
              
              -
              
              
              -
              
              
              249,105Accrued
                  interest on notes receivable from stockholder
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (7,643
              )
              
              -
              
              
              -
              
              
              -
              
              
              (7,643
              )Issuance
                  of common shares issuable
              
              
              581,505
              
              
              5,815
              
              
              4,032,334
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (4,038,149
              )
              
              -Amortization
                  of prepaid non-cash interest
              
              
              -
              
              
              -
              
              
              -
              
              
              916,877
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              916,877Comprehensive
                  loss:Net
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (14,024,639
              )
              
              -
              
              
              -
              
              
              (14,024,639
              )Foreign
                  currency translation adjustments
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              148,755
              
              
              -
              
              
              148,755Total
                  comprehensive loss
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (13,875,884
              )
 
 See
        accompanying notes to consolidated financial statements




46


SPATIALIGHT,
        INC.
 CONSOLIDATED
        STATEMENTS OF EQUITY (DEFICIT) (con't)
 YEARS
        ENDED DECEMBER 31, 2006, 2005 AND 2004
 
 **PREPAID**
              
              **NOTES**
              
              
              
              **OTHER**
              
              
              
              **TOTAL****NONCASH**
              
              **RECEIVABLE**
              
              
              
              **COMPRE-**
              
              
              
              **STOCK-****ADDITIONAL**
              
              **INTEREST**
              
              **FROM**
              
              **ACCUM-**
              
              **HENSIVE**
              
              **COMMON**
              
              **HOLDERS'****COMMON
                  STOCK**
              
              **PAID-IN**
              
              **RELATED**
              
              **STOCK**
              
              **ULATED**
              
              **INCOME**
              
              **STOCK**
              
              **EQUITY****SHARES**
              
              **AMOUNT**
              
              **CAPITAL**
              
              **PARTY**
              
              **HOLDERS**
              
              **DEFICIT**
              
              **(LOSS)**
              
              **ISSUABLE**
              
              **(DEFICIT)**Balance,
                  December 31, 2005
              
              
              36,777,069
              
              $
              367,771
              
              $
              76,631,925
              
              $
              (3,471,398
              )
              $
              -
              
              $
              (81,665,841
              )
              
              222,317
              
              $
              -
              
              $
              (7,915,226
              )Reclassification
                  from temporary equity of October 2005 Financing shares upon effectiveness
                  of registration statement, including $743,319 market value of warrants
                  issued
              
              
              571,431
              
              
              5,714
              
              
              1,763,979
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              1,769,693Exercise
                  of stock options
              
              
              50,000
              
              
              500
              
              
              39,745
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              40,245Stock-based
                  compensation expense
              
              
              -
              
              
              -
              
              
              1,875,330
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              1,875,330Issuance
                  of common shares and warrants, net of issuance costs of
                  $650,160
              
              
              6,582,770
              
              
              65,828
              
              
              13,232,076
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              13,297,904Issuance
                  of common shares for interest and liquidated damages
                  charges
              
              
              501,346
              
              
              5,013
              
              
              1,191,372
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              1,196,385Short
                  swing profit
              
              
              -
              
              
              -
              
              
              22,273
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              22,273Amortization
                  of prepaid non-cash interest
              
              
              -
              
              
              -
              
              
              -
              
              
              1,157,132
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              1,157,132Comprehensive
                  loss:Net
                  loss (Restated, See Note 1)
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (20,396,987
              )
              
              -
              
              
              -
              
              
              (20,396,987
              )Foreign
                  currency translation adjustment
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              114,658
              
              
              -
              
              
              114,658Total
                  comprehensive loss
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (20,282,329
              )Balance,
                  December 31, 2006 (Restated, See Note 1)
              
              
              44,482,616
              
              $
              444,826
              
              $
              94,756,700
              
              $
              (2,314,266
              )
              $
              -
              
              $
              (102,062,828
              )
              $
              336,975
              
              $
              -
              
              $
              (8,838,593
              )
 
 See
        accompanying notes to consolidated financial statements




47


SPATIALIGHT,
          INC.
 CONSOLIDATED
          STATEMENTS OF CASH FLOWS
 YEARS
          ENDED DECEMBER 31, 2006, 2005 AND 2004
 
 2006
                
                2005
                
                2004(As
                    Restated)See
                    Note 1Cash
                    flows from operating activities:Net
                    loss
                
                $
                (20,396,987
                )
                $
                (14,024,639
                )
                $
                (9,367,001
                )Adjustments
                    to reconcile net loss to net cash used in operating
                    activities:Allowance
                    for doubtful accounts
                
                
                -
                
                
                -
                
                
                345,030Inventory
                    reserve adjustment
                
                
                444,364
                
                
                351,377
                
                
                (210,000
                )Impairment
                    loss
                
                
                1,429,925
                
                
                -
                
                
                -Depreciation
                    and amortization
                
                
                864,064
                
                
                728,383
                
                
                575,391Stock-based
                    general and administrative expenses
                
                
                1,875,330
                
                
                186,187
                
                
                931,524Non-cash
                    interest expense
                
                
                2,856,393
                
                
                1,430,506
                
                
                791,036Gain
                    from revaluation of note purchase option and investment right
                    liabilities
                
                
                -
                
                
                (754,374
                )
                
                (412,374
                )Gain
                    from revaluation of warrants
                
                
                (43,638
                )
                
                (180,355
                )
                
                -Non-cash
                    foreign currency translation gain
                
                
                (90,880
                )
                
                58,531
                
                
                -Accrued
                    interest on notes receivable from stockholder
                
                
                -
                
                
                (7,643
                )
                
                (14,387
                )Gain
                    on sale of fixed assets
                
                
                (3,375
                )
                
                (1,928
                )
                
                -Changes
                    in operating assets and liabilities:Accounts
                    receivable
                
                
                87,438
                
                
                124,377
                
                
                (491,553
                )Inventory
                
                
                (110,716
                )
                
                65,214
                
                
                (183,697
                )Prepaids
                    and other current assets
                
                
                (44,422
                )
                
                714,901
                
                
                (411,437
                )Other
                    assets
                
                
                36,316
                
                
                50,337
                
                
                (22,711
                )Accounts
                    payable
                
                
                343,646
                
                
                1,005,783
                
                
                (261,890
                )Accrued
                    expenses and other current liabilities
                
                
                337,054
                
                
                577,484
                
                
                214,806Net
                    cash used in operating activities
                
                
                (12,415,488
                )
                
                (9,675,859
                )
                
                (8,517,263
                )Cash
                    flows from investing activities:Purchase
                    of property and equipment
                
                
                (622,623
                )
                
                (5,534,882
                )
                
                (795,173
                )Proceeds
                    from the sale of property and equipment
                
                
                84,166
                
                
                -
                
                
                -Construction
                    in progress
                
                
                -
                
                
                -
                
                
                (950,627
                )Net
                    cash used in investing activities
                
                
                (538,457
                )
                
                (5,534,882
                )
                
                (1,745,800
                )Cash
                    flows from financing actitivies:Proceeds
                    from issuance of short-term notes
                
                
                8,856,697
                
                
                987,316
                
                
                -Payment
                    on short-term notes
                
                
                (9,095,383
                )
                
                (190,907
                )
                
                -Proceeds
                    from the issuance of convertible notes
                
                
                -
                
                
                -
                
                
                10,000,000Payments
                    on notes receivable from stockholders
                
                
                -
                
                
                249,105
                
                
                269,851Financing
                    costs for convertible notes
                
                
                -
                
                
                -
                
                
                (217,162
                )Short
                    swing profits
                
                
                22,274
                
                
                -
                
                
                25,982Proceeds
                    from sales of common shares and warrants, net of fees
                
                
                13,306,590
                
                
                4,581,460
                
                
                -Proceeds
                    from exercise of warrants and options
                
                
                40,245
                
                
                535,989
                
                
                2,888,703Net
                    cash provided by financing activities
                
                
                13,130,423
                
                
                6,162,963
                
                
                12,967,374Net
                    increase (decrease) in cash and cash equivalents
                
                
                176,478
                
                
                (9,047,778
                )
                
                2,704,311Effect
                    of exchange rate changes on cash
                
                
                1,213
                
                
                2,792
                
                
                23,271Cash
                    and cash equivalents at beginning of period
                
                
                42,565
                
                
                9,087,551
                
                
                6,359,969Cash
                    and cash equivalents at end of period
                
                $
                220,256
                
                $
                42,565
                
                $
                9,087,551
 
 See
          accompanying notes to consolidated financial statements.
  48


SPATIALIGHT,
      INC.


CONSOLIDATED
      STATEMENTS OF CASH FLOWS (con't)


YEARS
      ENDED DECEMBER 31, 2006, 2005 AND 2004





2006
            
            2005
            
            2004Supplemental
                disclosure of cash flow information:Income
                taxes paid during the period
            
            $
            1,800
            
            $
            2,300
            
            $
            1,475Interest
                paid during the period
            
            $
            323,711
            
            $
            1,002,740
            
            $
            482Non
                cash financing activities:Discount
                on convertible notes due to purchase option liability
            
            $
            -
            
            $
            -
            
            $
            1,072,248Discount
                on convertible notes due to beneficial conversion feature
            
            $
            -
            
            $
            -
            
            $
            156,610Common
                shares issued or issuable for prepaid interest to related
                party
            
            $
            -
            
            $
            -
            
            $
            4,388,275





See
      accompanying notes to consolidated financial statements.




49


SPATIALIGHT,
      INC.


NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
      31, 2006, 2005 AND 2004





**1.**  **Description
      of Business and Summary of Significant Accounting Policies**




*Description
      of Business -* We
      are in
      the business of manufacturing high-resolution liquid crystal on silicon (LCoS)
      microdisplays. We are currently focused on manufacturing our core product,
      our
      T-3 LCoS Set, to our customers and prospective customers, who are located
      primarily in Asia. The T-3 model has a 1920 pixels by 1080 pixels configuration.
      Our previously manufactured T-1 model has a lower resolution of 1280 pixels
      by
      960 pixels configuration. We are exclusively focusing on manufacturing the
      T-3
      model of our LCoS Sets because we believe that the market demand for that higher
      resolution product will be significantly greater. Our current customers and
      current prospective customers are original equipment manufacturers (OEMs)
      engaged in the businesses of manufacturing high definition televisions or
      manufacturing light engines for incorporation into high definition televisions.
      Our products are suitable for incorporation into other potential applications
      including rear projection computer monitors, wireless communication devices,
      portable games and digital assistants. Currently we are working with OEMs of
      high definition televisions, light engines for incorporation into high
      definition televisions, near-to-eye head mounted display devices, and
      micro-projectors for mobile electronics applications.





Our
      principal executive offices are located in Novato, California. We were organized
      under the laws of the State of New York in 1989. Our wholly-owned subsidiary,
      SpatiaLight Korea, Inc., was incorporated in 2004 under the laws of South Korea.
      Our inactive wholly-owned subsidiary, SpatiaLight Technologies, Inc., was
      incorporated in 2003 under the laws of the State of New York.




*Basis
      of Consolidation* - The
      consolidated financial statements incorporate the accounts of SpatiaLight,
      Inc.
      and its wholly-owned subsidiaries, SpatiaLight Technologies, Inc. and
      SpatiaLight Korea, Inc. All significant intercompany business and transactions
      have been eliminated in consolidation.





*Going
      Concern -* The
      accompanying consolidated financial statements have been prepared assuming
      we
      will continue as a going concern. We have suffered recurring operating losses
      and negative cash flows from operations. As of December 31, 2006, we had
      negative net working capital of $12.9 million and an accumulated deficit of
      $102.1 million, with total stockholders’ deficit of $8.8 million.





Our
      total
      cash and cash equivalents at December 31, 2006 was $220,256. As disclosed in
      Note 11 - Subsequent Events after December 31, 2006, we received approximately
      $2.3 million in gross proceeds from the sale of 2,190,477 of our common shares
      in February 2007. We believe these reserves are sufficient to sustain our
      operations and meet our capital and liquidity requirements through March 2007.
      We plan on raising additional funds through anticipated cash payments from
      customers, additional equity financings and exercises of stock options and
      warrants. No assurance can be given that we will receive cash payments from
      customers, that we will be able to raise additional equity, or that there will
      be exercises of stock options and warrants. If we do not receive additional
      funds from these or other sources, we will be required to scale back or
      terminate operations and/or seek protection under applicable bankruptcy laws.





Additionally,
      as more fully described in Note 3, our Senior Secured Convertible Notes,
      maturing in November 2007, are held by four Noteholders. Two of the Noteholders
      have alleged that certain events of default under the Notes have occurred (one
      Noteholder has alleged three events of default, and the other Noteholder has
      alleged one event of default), and they have sent us letters asking for
      immediate redemption of the entire principal of their Notes of $9 million plus
      redemption premiums of approximately $1.35 million and liquidated damages of
      $615,000 and $534,000 at December 31, 2006 and 2005, respectively. We strongly
      dispute that any events of default have occurred that would allow the
      Noteholders to call the Notes, and we plan to vigorously defend our position.
      We
      believe, after review with outside legal counsel, with respect to each of the
      three alleged events of default, that it is not probable that the Noteholders
      would prevail in calling the loans based on any of the alleged events of
      default; therefore, in accordance with SFAS 5 “Accounting for Contingencies,” we
      have classified the Notes as short-term and long-term liabilities at December
      31, 2006 and 2005, respectively, in the accompanying consolidated balance sheet
      in accordance with the original contractual terms rather than as current
      liabilities as SFAS 78, “ *Classification
      of Obligations That are Callable by the Creditor,”* might
      otherwise require, and have not accrued the redemption premiums and liquidated
      damages. However, should the Noteholders pursue their call for immediate
      redemption of the Notes, and prevail on their claim in a court of law, the
      entire $10 million Note obligation would immediately become due and payable
      including redemption premiums of $1.5 million and liquidated damages of $683,000
      at December 31, 2006. Moreover, the Company will be required to repay or
      refinance the Notes at their maturity date in November 2007, and will need
      to
      obtain additional financing to repay the Noteholders.





In
      2006,
      a substantial percentage of our product deliveries, which were in small
      quantities, were made to LGE. We have been informed by LGE of their intent
      to
      discontinue production of RPTVs (both LCoS and DLP). We do not expect
      significant further sales to LGE. We intend to replace the revenues from LGE
      with revenues from sales of our T-3 RPTV model to other customers, as well
      as
      sales of products to manufacturers of head mounted displays and microprojectors.
      Due to the development and ramp up time periods, significant revenue is not
      anticipated until at least the second half of 2007.




50


SPATIALIGHT,
        INC.
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
        31, 2006, 2005 AND 2004


Furthermore,
      we are subject to U.S. Securities and Exchange Commission (SEC) investigations
      relating to the unauthorized filing of consents of BDO Seidman, LLP as an
      exhibit to certain registration statements, as well as an investigation into
      transactions in our securities by our former Chief Executive Officer and may
      be
      subject to penalties and claims relating thereto. These matters are discussed
      in
      Note  10.





These
      matters raise substantial doubt about our ability to continue as a going
      concern. The recoverability of a major portion of the recorded asset amounts
      shown in the accompanying consolidated balance sheet is dependent upon our
      continued operations. Our consolidated financial statements do not include
      any
      adjustments relating to the recoverability and classification of recorded asset
      amounts or amounts and classifications of liabilities that might be necessary
      should we be unable to continue as a going concern.





*Adoption
      of New Accounting Pronouncements* -
      Effective October 1, 2006, we adopted Financial Accounting Standards Board
      (FASB) Staff Position (FSP) Emerging Issues Task Force (EITF) 00-19-2,
“Accounting for Registration Payment Arrangements”. This FASB staff position
      addresses how to account for registration payment arrangements and clarifies
      that a financial instrument subject to a registration payment arrangement should
      be accounted for in accordance with other generally accepted accounting
      principles (GAAP) without regard to the contingent obligation to transfer
      consideration pursuant to the registration payment arrangement. This accounting
      pronouncement further clarifies that a liability for liquidated damages
      resulting from registration statement obligations should be recorded in
      accordance with Statement of Financial Accounting Standards No. 5, "Accounting
      for Contingencies *,* " ** when
      the
      payment of liquidated damages becomes probable and can be reasonably estimated.





Prior
      to
      adoption of this FSP, we had classified as temporary equity, and as a warrant
      liability, as applicable, financial instruments issued in conjunction with
      our
      recent financings until the underlying securities were registered with the
      SEC,
      because the maximum potential liquidated damages may be greater than the
      difference in fair values between registered and unregistered shares. Our
      adoption of this accounting pronouncement as of October 1, 2006 resulted
      in a reclassification of $1,947,909 of temporary equity and $129,279 of warrant
      liability to common stock and additional paid in capital as of October 1, 2006. The
      cumulative effect of this accounting change increased our 2006 net loss by
      $223,993, or $0.01 per share.





We
      also
      adopted Statement of Financial Accounting Standard No. 123(R), “Share-Based
      Payment” (“SFAS 123(R)”), and Statement of Financial Accounting Standard No.
      151, “Inventory Costs, an Amendment of ARB No. 43, Chapter 4” (“SFAS No. 151”)
      as of January 1, 2006. The adoption of SFAS 123(R) is discussed under
“Stock-Based Compensation” below, and the adoption of SFAS No. 151 did not have
      a material effect on our results of operations or financial
      position.





*Estimates* - The
      preparation of financial statements in conformity with U.S. generally accepted
      accounting principles (GAAP) requires that management make estimates and
      assumptions that affect the reported amounts of assets and liabilities and
      disclosure of contingent assets and liabilities at the date of the financial
      statements and the reported amounts of revenues and expenses during the
      reporting period. Actual results could differ from those estimates. Significant
      estimates include those related to accounts receivable reserves and inventory
      reserves and write-downs, which can be affected by a change in the market value
      and replacement cost of materials or a change in market price of products as
      well as the recoverability of long-lived assets and the valuation of stock
      based
      compensation.





*Cash
      and Cash Equivalents* - We
      consider all highly liquid investments purchased with an original maturity
      of
      three months or less to be cash equivalents. At December 31, 2006 and 2005,
      approximately $220,000 and $43,000, respectively, comprised of checking and
      money market accounts, the fair value of which approximates cost, are included
      in cash and cash equivalents. We deposit cash and cash equivalents with high
      credit quality financial institutions.





*Accounts
      Receivable* -
      Accounts receivable are due under negotiated terms. Although we generally do
      not
      require collateral, letters of credit may be required from our customers in
      certain circumstances. Senior management reviews accounts receivable on a
      quarterly basis to determine if any receivables are uncollectible. In the event
      that payment of a customer’s account receivable is doubtful, we would reserve
      the receivable under an allowance for doubtful accounts. If all efforts to
      collect a receivable fail, and the receivable is considered uncollectible,
      the
      receivable would be written off against the allowance reserve.





*Inventories* -
      Inventories are valued at the lower of cost (based on the first-in, first-out
      method) or market value. Materials, labor and manufacturing overhead are
      included in the cost of inventories. In determining inventory market values,
      substantial consideration is given to the expected selling price of the product
      based on historical recovery rates. If the market value of inventory is assessed
      to be less than cost, it is written down to its replacement cost or its net
      realizable value. Estimates may differ from actual results due to the quantity
      and quality and mix of products in inventory, consumer and retailer preferences
      and economic conditions. There was no lower of cost or market provision recorded
      in 2006 or 2005. Inventory reserves are generally recorded when management
      determines that an item is not readily saleable. In 2006 and 2005, we recorded
      a
      provision on our T-1 and light engine inventory of approximately $444,000 and
      $351,000, respectively, as a result of the concentrated focus of our business
      on
      our T-3 LCoS Set model. As of December 31, 2006, we have written off 100% of
      the
      value of our remaining T-1 and light engine inventory.




51


SPATIALIGHT,
          INC.
 NOTES
          TO
          CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
          31, 2006, 2005 AND 2004
 *Property
        and Equipment* -
        Property and equipment are recorded at cost while repairs and maintenance
        costs
        are expensed in the period incurred. Depreciation and amortization is computed
        for financial reporting purposes using the straight-line method over the
        following estimated useful lives.




UsefulLives
                  inCategory
              
              YearsBuildings
              
              
              40Other
                  equipment and instruments
              
              
              3-10Machinery
                  and manufacturing equipment
              
              
              3-10Office
                  furniture and fixtures
              
              
              3-5Tooling
              
              
              1-5Computer
                  software and hardware
              
              
              3-5





Leasehold
      improvements are being amortized over the shorter of eight years or the term
      of
      the lease.





*Debt
      Issuance Costs* -
      Debt
      issuance costs related to the 2004 Senior Secured Convertible Notes are being
      amortized over the term of the notes using the interest method.





*Revenue
      Recognition* - ** We
      evaluate revenue recognition for transactions using the following criteria
      (collectively called the Revenue Recognition Criteria):


·
              Evidence
                  of an arrangement: Before revenue is recognized, we must have evidence
                  of
                  an agreement with the customer reflecting the terms and conditions
                  to
                  deliver our products.
 ·
                Delivery:
                    For products, delivery is considered to occur when title and
                    risk of loss
                    have been transferred, which generally occurs upon shipment.
 ·
                  Fixed
                      or determinable fee: We consider a fee to be fixed or determinable
                      if the
                      fee is not subject to refund or adjustment. If a portion of
                      the
                      arrangement fee is not fixed or determinable, we recognize
                      that amount as
                      revenue when the amount becomes fixed or determinable. We do
                      not consider
                      a fee to be fixed and determinable if any amount is due more
                      than 180 days
                      from the delivery date. Payment terms of less than 180 days
                      are evaluated
                      based upon the laws or trade practices of the country in which
                      the
                      arrangement is entered into to assess whether the fee is fixed
                      and
                      determinable.




·
            Collection
                is deemed reasonably assured: Collection is deemed reasonably assured
                if
                we expect the customer to be able to pay amounts under the arrangement
                as
                those amounts become due. We reduce product revenue for customer
                returns
                and sales allowances and record an allowance for doubtful accounts
                should
                collectibility become questionable. If it is determined that an account
                is
                uncollectible, the account is written off against the
                allowance.





*Warranty
      Reserve* - We
      provide for the estimated cost of product warranties at the time revenue is
      recognized. As we have limited historical experience in selling our products
      to
      our customers in large volumes, we must exercise considerable judgment in
      estimating the expected failure rates. This estimating process is based on
      historical experience of similar products in similar industries, as well as
      various other assumptions that we believe to be reasonable under the
      circumstances. Should actual product failure rates differ from our estimates,
      revisions to the estimated warranty liability would be required. As of December
      31, 2006 and 2005 our warranty reserve represented 1.5% of sales revenue. Our
      warranty is limited to the lesser of the end product warranty (the finished
      HDTV) or two years.





*Shipping
      and Handling Costs* -
      Shipping and handling costs to date have not been charged to our customers.
      These costs have not been material to date. They have been recorded in selling,
      general, and administrative expenses in 2005 and 2004. Beginning in the first
      quarter of 2006, all shipping and handling costs relating to sales of our
      products is recorded in cost of revenue. To the extent that such costs are
      recouped from the customers, such amounts will be included in revenue.





*Income
      Taxes* - We
      utilize the asset and liability method of accounting for income taxes. Deferred
      tax assets and liabilities are recognized for the future tax consequences
      attributable to differences between the financial statement carrying amounts
      of
      existing assets and liabilities and their respective tax bases and operating
      loss and tax credit carryforwards. Deferred tax assets and liabilities are
      measured using enacted tax rates expected to apply to taxable income in the
      years in which those temporary differences are expected to be recovered or
      settled. A valuation allowance is recorded to reduce deferred tax assets to
      an
      amount whose realization is more likely than not. The effect on deferred tax
      assets and liabilities of a change in tax rates is recognized in income in
      the
      period that includes the enactment date.





52




SPATIALIGHT,
      INC.


NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
      31, 2006, 2005 AND 2004




*Research
      and Development* -
      Research and development costs, including the costs of prototype and
      pre-production LCoS Sets, pre-production display units, and other pre-production
      activities at our South Korean manufacturing facility are charged to expense
      when incurred.





*Foreign
      Currency Translation* -
      The
      functional currency of our foreign subsidiary is the local currency, the Korean
      Won. We translate the assets and liabilities of our foreign subsidiary to U.S.
      dollars at the rate of exchange in effect at the end of the reporting period.
      Revenues and expenses are translated at the average rates of exchange for the
      accounting period. Translation adjustments attributable to our foreign
      subsidiary are included in stockholders’ equity (deficit) as a component of
      other comprehensive income (loss).





*Comprehensive
      Loss* -
      Comprehensive loss is comprised of net loss and other comprehensive income.
      The
      only component of other comprehensive income is foreign currency translation
      adjustments in 2006, 2005 and 2004. Other comprehensive income is disclosed
      in
      the statements of stockholders’ equity (deficit).





*Fair
      Value of Financial Instruments* - Our
      financial instruments include cash equivalents, accounts receivable, and debt.
      The carrying value of cash equivalents and accounts receivable approximates
      their fair value. The face amount of the convertible notes approximates their
      fair value and is offset by the calculated value of the beneficial conversion
      feature, additional investment rights or note purchase option embedded in the
      notes, and reimbursement to a noteholder of certain costs.





*Derivative
      Financial Instruments* - Our
      derivative financial instruments consist of a note purchase option (additional
      investment right (AIR)) attached to Senior Secured Convertible Notes and
      warrants issued in connection with our October 2005 financing for the year
      ended
      December 31, 2005 and 2004. The fair value is calculated based on the
      Black-Scholes option-pricing model. We had no derivative financial instruments
      at the end of 2006.




*Stock-Based
      Compensation* - We
      have stock compensation plans for employees and directors which are described
      in
      Note 6 to our consolidated financial statements in this Annual Report. We
      adopted Statement of Financial Accounting Standards No. 123 (revised 2004),
      “ *Share-Based
      Payment* ,”
(“SFAS
      123R”) effective January 1, 2006. SFAS 123R requires the recognition of the fair
      value of stock compensation including stock options in net income (loss). We
      recognize the stock compensation expense over the requisite service period
      of
      the individual grantees, which generally equals the vesting period of the grant
      or, in the case of options granted with a market condition, we use a binomial
      model to calculate a derived service period. All of our stock compensation
      is
      accounted for as an equity instrument. Prior to January 1, 2006, we followed
      Accounting Principles Board Opinion 25, “ *Accounting
      for Stock Issued to Employees,* ”
(“APB
      25”) and related interpretations in accounting for our stock compensation. We
      adopted SFAS 123R using the modified prospective method. Under this method,
      the
      provisions of SFAS 123R apply to all awards granted or modified after the date
      of adoption. The unrecognized expense of awards not yet vested at the January
      1,
      2006 date of adoption is recognized in net income (loss) in the periods after
      the date of adoption using the same valuation method ( *i.e.* Black-Scholes) and assumptions determined under the original provisions of
      SFAS
      123, “ *Accounting
      for Stock-Based Compensation,”* as
      disclosed in our previous filings. Following the provisions of the modified
      prospective method, we have not restated our consolidated financial statements
      for periods prior to 2006 to reflect the adoption of SFAS 123R. Therefore,
      the
      results reported in the Consolidated Statement of Operations for 2006 are not
      directly comparable to the results for the prior year.





Under
      the
      provisions of SFAS 123R, we recorded $1,875,330, or $0.05 per share, of stock
      compensation, net of estimated forfeitures, in selling, general and
      administrative expenses, in our consolidated statement of operations for 2006.
      We utilized the Black-Scholes valuation model for estimating the fair value
      of
      the stock compensation granted after the adoption of SFAS 123R, with the
      following weighted-average assumptions:




Dividend
                  yield
              
              
              -Expected
                  volatility
              
              
              92.8
                  % - 99.02%Risk-free
                  interest rate
              
              
              4.6%
                  - 5.2%Expected
                  lives (in years)
              
              
              5.2
                  - 5.8


The
      dividend yield of zero is based on the fact that we have never paid cash
      dividends and have no present intention to pay cash dividends, and are
      prohibited from paying dividends under the terms of the Senior Secured
      Convertible Notes issued in November 2004 (See Note 3). Expected volatility
      is
      based upon historical volatility of our common stock over the period
      commensurate with the expected life of the options. The risk-free interest
      rate
      is derived from the average U.S. Treasury Constant Maturity Rate during the
      period, which approximates the rate in effect at the time of the grant. The
      expected term is calculated using the simplified method prescribed by the SEC’s
      Staff Accounting Bulletin 107. Our currently unvested options vest over two
      years from the date of grant. Our options generally have a 10-year contractual
      term. Based on the above assumptions, the weighted-average fair values of the
      options granted under the stock option plans for 2006 was $1.95. As required
      by
      SFAS No. 123R, we now estimate forfeitures of employee stock options and
      recognize compensation cost only for those awards expected to vest. Forfeiture
      rates are determined for four groups of employees - CEO, directors, senior
      management and all other employees - based on historical experience. Estimated
      forfeitures are now adjusted to actual forfeiture experience as
      needed.





53


SPATIALIGHT,
        INC.
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
        31, 2006, 2005 AND 2004


During
      the fourth quarter of 2006, we entered into an agreement to grant options to
      purchase 950,000 common shares to our former Executive Vice President of
      Strategic Planning in connection with a consulting contract entered into between
      the Company and him. The options contain market conditions and were valued
      at
      $59,529 using a binomial model. The following assumptions were used for valuing
      this grant: no dividend yields, expected volatility of 81%, risk free rate
      of
      4.74% and expected lives (derived service period) varying from 47 days to 379
      days.




SFAS
      123R
      requires us to present pro forma information for the comparative period prior
      to
      the adoption as if we had accounted for all our employee stock options under
      the
      fair value method of the original SFAS 123. The fair value at date of grant
      for
      options granted has been estimated based on a Black-Scholes pricing model with
      the following weighted average assumptions:


2005
              
              2004Dividend
                  yield
              
              
              -
              
              
              -Expected
                  volatility
              
              
              87
              %
              
              89
              %Risk-free
                  interest rates
              
              
              4.1
              %
              
              2.5
              %Expected
                  lives
              
              
              4.0
                  years
              
              
              3.2
                  years


The
      table
      below shows net loss per share as if the Company had elected the fair value
      method of accounting for stock options.


2005
              
              2004Net
                  loss as reported
              
              $
              (14,024,639
              )
              $
              (9,367,001
              )Add:
                  stock-based employee compensation includedin
                  reported net loss
              
              
              22,000
              
              
              67,674Deduct:
                  total stock-based employee compensationdetermined
                  under fair value method for all awards
              
              
              (3,701,420
              )
              
              (2,723,586
              )Proforma
                  net loss, as adjusted
              
              $
              (17,704,059
              )
              $
              (12,022,913
              )Loss
                  per share:Basic
                  and diluted, as reported
              
              $
              (0.39
              )
              $
              (0.27
              )Basic
                  and diluted, as adjusted
              
              $
              (0.49
              )
              $
              (0.35
              )




If
      the
      tax deduction realized from the exercise of stock options is less than
      recognized compensation expense, the tax shortfall is recognized in equity
      to
      the extent of available windfall tax benefits realized in the prior year, if
      any, otherwise it is recognized within our Consolidated Statements of
      Operations. Under the modified-prospective transition method of
      SFAS No. 123R, we were permitted to calculate a cumulative memo
      balance of windfall tax benefits from post-1995 years for purposes of
      accounting for future tax shortfalls. We elected to apply the long-form method
      for determining the pool of windfall tax benefits and have a pool of windfall
      tax benefits.





*Stock
      Option Acceleration -* ****** On
      December 6, 2005 **,** our
      Compensation Committee of the Board of Directors approved the acceleration
      of
      the vesting of stock options held by all non-executive employees and certain
      officers under its stock option plans effective December 15, 2005. Options
      held
      by directors were excluded from the vesting acceleration. The closing price
      of
      the Company’s common stock on December 14, 2005, the last trading day before
      approval of acceleration, was $3.40 per share. All above-mentioned unvested
      stock options had exercise prices above $3.40 per share. The accelerated options
      are immediately exercisable by employees without any employment-related
      restriction.




The
      primary purpose of the accelerated vesting was to reduce future compensation
      expense associated with the accelerated stock options upon the planned adoption
      of SFAS 123R. We estimate that the acceleration eliminated $0.7 million in
      future compensation charges we would otherwise have taken with respect to the
      accelerated options. Our Board of Directors believes, based on its consideration
      of the expense savings and the current intrinsic and perceived value of the
      accelerated stock options, that the acceleration was in the best interests
      of
      the Company and its shareholders.





54


SPATIALIGHT,
        INC.
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
        31, 2006, 2005 AND 2004


*Impairment
      of Long-Lived Assets* -
      We
      account for the impairment of long-lived assets in accordance with SFAS
      No. 144, *Accounting
      for the Impairment or Disposal of Long-Lived Assets* .
      An
      impairment of a long-lived asset exists when the carrying value of an asset
      exceeds its fair value and when the carrying value is not recoverable through
      future undiscounted cash flows from operations. We review the carrying value
      of
      long-lived assets for impairment when events or changes in circumstances
      indicate that the carrying amount of assets may not be recoverable.




Considerable
      management judgment is required in determining if and when a condition would
      trigger an impairment assessment of our long-lived assets and once such a
      determination has been made, considerable management judgment is required to
      determine the fair market value of the long-lived asset. In
      determining the fair value of the asset, we consider the associated net present
      value of estimated future cash flows and/or independently performed appraisals.
      Such estimated future cash flows are based on assumptions about our expected
      future operating performance. Our estimates of future cash flows may differ
      from
      actual cash flows due to, among other things, technological changes, economic
      conditions or changes to our business operations. Impairments would be
      recognized in operating results to the extent that the carrying value exceeds
      the estimated fair value of the long-lived assets.





*Loss
      per Common Share* - Basic
      loss per common share excludes dilution and is computed by dividing the net
      loss
      by the weighted-average number of common shares outstanding for the period.
      Diluted loss per common share reflects the potential dilution that could occur
      if securities or other contracts to issue common shares were exercised or
      converted into common shares. Common share equivalents are excluded from the
      computation in loss periods, as their effect would be antidilutive.





*Segment
      and Geographical Information* - Our
      chief operating decision-maker is our Chief Executive Officer. The chief
      operating decision-maker reviews only financial information prepared on a basis
      substantially consistent with the accompanying consolidated financial statements
      of operations. Therefore, we have determined that we operate in a single
      business segment. All of our assets are located at our facilities in the United
      States at December 31, 2006, except for the following:


South
                  KoreaCash
              
              $
              3,131Accounts
                  receivable
              
              
              45,899Prepaid
                  expenses
              
              
              94,497Deposits
              
              
              3,566Building,
                  net
              
              
              3,056,036Machinery
                  and manufacturing equipment, net
              
              
              761,781Office
                  furniture and fixtures, net
              
              
              121,225Other
                  equipment and instruments, net
              
              
              753,115Inventory,
                  net
              
              
              393,479$
              5,232,729


The
      following table summarizes our product revenues percentages for the years ended
      December 31, 2006, 2005 and 2004.




2006
              
              2005
              
              2004LCoS
                  (T-3) sets
              
              
              96
              %
              
              77
              %
              
              5
              %LCoS
                  (T-1) sets
              
              
              -
              
              
              4
              %
              
              42
              %Light
                  engine display units
              
              
              -
              
              
              1
              %
              
              51
              %Other
                  (primarily supporting electronics)
              
              
              4
              %
              
              18
              %
              
              2
              %Total
              
              
              100
              %
              
              100
              %
              
              100
              %


For
      the
      year ended December 31, 2006, 92% of our revenue was derived from LGE, located
      in South Korea. LGE made up 100% of our outstanding accounts receivable balance
      at December 31, 2006. For the year ended December 31, 2005, 73% and 12% of
      our
      revenue was derived from LGE and ThinTek Optronics Corp, located in Taiwan,
      respectively. These two customers made up 84% of our outstanding accounts
      receivable balance at December 31, 2005. The remaining 15% of revenue in 2005
      was derived from the sales of our LCoS Sets and related components to customers
      located in Hong Kong, China and the United States. For the year ended December
      31, 2004, 47% and 43% of our revenue was derived from Skyworth TV Holding,
      LTD
      (Skyworth), and Shanghai China Display Co., LTD (China Display), both located
      in
      China. The remaining 10% of revenue in 2004 was derived from the sales of our
      LCoS Sets and related components to customers located in Hong Kong, Taiwan
      and
      South Korea.





55


SPATIALIGHT,
        INC.
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
        31, 2006, 2005 AND 2004




*Restatement*




On
      July
      24, 2007, we received evidence that LG Electronics (“LGE”) communicated its
      intention to terminate our Supply Agreement to Mr. Don Suh, in October 2006,
      in
      the form of an email to Mr. Suh’s personal email account. The mid-October email
      to Mr. Suh from LGE was first disclosed to SpatiaLight executives during
      settlement discussions by LGE’s legal counsel on July 24, 2007. At the time of
      the October 2006 email, Mr. Suh was our Senior Vice President for Marketing
      and
      Sales. He was later appointed to Chief Executive Officer on November 6, 2006,
      and was subsequently terminated on December 12, 2006. O n
      March
      9, 2007, we received oral notification from LGE of their intent to discontinue
      the production of all rear projection televisions. As a result of the October
      2006 email, we concluded that the asset impairment loss related to our building
      in South Korea should be recorded in the fourth quarter of 2006. We had
      previously recorded the impairment loss in the first quarer of 2007, based
      upon
      the March 9, 2007 notification from LGE.





Therefore,
      we have restated our audited consolidated financial statements for the year
      ended December 31, 2006.




The
      following table outlines the effects of the restatement described above for
      the
      period that has been previously reported as of and for the year ended December
      31, 2006.




PreviouslyReported
            
            AsRestated**Consolidated
                Balance sheet:**Property
                and equipment, net
            
            $
            6,635,851
            
            $
            5,205,926Total
                assets
            
            $
            7,675,969
            
            $
            6,246,044Accumulated
                deficit
            
            $
            (100,632,903
            )
            $
            (102,062,828
            )Total
                stockholders’ deficit
            
            $
            (7,408,668
            )
            $
            (8,838,593
            )Total
                liabilities and stockholders’ deficit
            
            $
            7,675,969
            
            $
            6,246,044**Consolidated
                Statement of Operations:**Impairment
                loss
            
            $
            -
            
            $
            1,429,925Total
                operating expenses
            
            $
            10,380,849
            
            $
            11,810,774Operating
                loss
            
            $
            (15,768,489
            )
            $
            (17,198,414
            )Loss
                before income tax
            
            $
            (18,741,269
            )
            $
            (20,171,194
            )Loss
                  before cumulative effect of change in accounting
                  principle
            
            $
            (18,743,069
            )
            $
            (20,172,994
            )Net
                loss
            
            $
            (18,967,062
            )
            $
            (20,396,987
            )Net
                loss per share: basic and dilutedNet
                  loss per share before cumulative change in accounting
                  principle
            
            $
            (0.46
            )
            $
            (0.50
            )Net
                loss per share
            
            $
            (0.47
            )
            $
            (0.50
            )





*Recently
      Issued Accounting Standards -*





In
      September 2006, the Financial Accounting Standards Board (FASB) issued Statement
      No. 157, “Fair Value Measurements” (“FAS 157”). This statement defines fair
      value, establishes a framework for measuring fair value under generally accepted
      accounting principles (GAAP), and expands disclosures about fair value
      measurements. SFAS No. 157 is effective for financial statements issued for
      fiscal years beginning after November 15, 2007, and interim periods within
      those
      fiscal years. The transition adjustment, which is measured as the difference
      between the carrying amount and the fair value of those financial instruments
      at
      the date this statement is initially applied, should be recognized as a
      cumulative effect adjustment to the opening balance of retained earnings for
      the
      fiscal year in which this statement is initially applied. The provisions of
      SFAS
      No. 157 are effective for us beginning January 1, 2008. We are currently
      evaluating the impact of adopting SFAS No. 157 on our consolidated financial
      statements.





In
      September 2006, the Securities and Exchange Commission (SEC) issued Staff
      Accounting Bulletin (SAB) No. 108, “Considering the Effects of Prior Year
      Misstatements when Quantifying Misstatements in Current Year Financial
      Statements.” SAB No. 108 addresses how the effects of prior year uncorrected
      misstatements should be considered when quantifying misstatements in current
      year financial statements and is effective for fiscal years ending after
      November 15, 2006. SAB No. 108 requires companies to quantify misstatements
      using a balance sheet and income statement approach and to evaluate whether
      either approach results in quantifying an error that is material in light of
      relevant quantitative and qualitative factors. SAB No. 108 permits existing
      public companies to initially apply its provisions either by (i) restating
      prior
      financial statements as if the “dual approach” had always been used or (ii)
      recording the cumulative effect of initially applying the “dual approach” as
      adjustments to the carrying value of assets and liabilities as of January 1,
      2006 with an offsetting adjustment recorded to the opening balance of retained
      earnings. The adoption of the provisions of SAB No. 108 on December 31, 2006
      had
      no impact on our consolidated financial statements.





56


SPATIALIGHT,
        INC.
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
        31, 2006, 2005 AND 2004


In
      June
      2006, the Financial Accounting Standards Board (FASB) issued Interpretation
      No.
      48, *Accounting
      for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109* (“FIN
      48”). This Interpretation clarifies the accounting for uncertainty in income
      taxes recognized in a company’s financial statements in accordance with FASB
      Statement No. 109, *Accounting
      for Income Taxes.* FIN 48
      prescribes a recognition threshold and measurement attribute for the financial
      statement recognition and measurement of a tax position taken or expected to
      be
      taken in a tax return. This Interpretation also provides guidance on
      derecognition, classification, interest and penalties, accounting in interim
      periods, disclosure, and transition. The evaluation of a tax position in
      accordance with FIN 48 is a two-step process. The first step is recognition:
      The
      Company determines whether it is “more-likely-than-not” that a tax position will
      be sustained upon examination, including resolution of any related appeals
      or
      litigation processes, based on the technical merits of the position. In
      evaluating whether a tax position has met the “more-likely-than-not” recognition
      threshold, the company presumes that the position will be examined by the
      appropriate taxing authority that would have full knowledge of all relevant
      information. The second step is measurement: A tax position that meets the
      “more-likely-than-not” recognition threshold is measured to determine the amount
      of benefit to recognize in the financial statements. The tax position is
      measured at the largest amount of benefit that is greater than 50 percent likely
      to be realized upon ultimate settlement. FIN 48 is effective for fiscal years
      beginning after December 15, 2006. We are in the process of determining the
      impact, if any, of the adoption of FIN 48 on our results of operations or
      financial condition.





In
      June
      2005, the FASB issued Statement No. 154, "Accounting Changes and Error
      Corrections" (SFAS 154), a replacement of APB No. 20, "Accounting Changes"
      and
      FASB Statement No. 3, "Reporting Accounting Changes in Interim Financial
      Statements". FAS 154 applies to all voluntary changes in accounting principle
      and changes the requirements for accounting for and reporting of a change in
      accounting principle. This statement establishes that unless impracticable,
      retrospective application is the required method for reporting a change in
      accounting principle in the absence of explicit transition requirements specific
      to the newly adopted accounting principle. It also requires the reporting of
      an
      error correction which involves adjustments to previously-issued financial
      statements similar to those generally applicable to reporting an accounting
      change retrospectively. FAS 154 became effective for accounting changes and
      corrections of errors made in our fiscal year beginning on January 1, 2006.
      The
      adoption of FAS 154 has not had a material impact on our results of operations
      or financial condition.





In
      December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment” to revise
      SFAS No. 123, “Accounting for Stock-Based Compensation” and supersede APB
      Opinion No. 25, “Accounting for Stock Issued to Employees” and its related
      implementation guidance. It requires companies to recognize their compensation
      costs related to share-based payment transactions in financial statements.
      These
      costs are to be measured based on the fair value of the equity or liability
      instruments issued and are recognized over the period during which an employee
      is required to provide services in exchange for the award - the requisite
      service period (usually the vesting period). We have applied
      SFAS No. 123R beginning January 1, 2006 .
      See 1 -
      Description of Business and Summary of Significant Accounting Policies - Stock
      Based Compensation for further information.





In
      November 2004, the FASB issued SFAS No. 151, “Inventory Costs, An Amendment Of
      ARB No. 43, Chapter 4” ("SFAS 151"). SFAS 151 amends ARB 43, Chapter 4, to
      clarify that abnormal amounts of idle facility expense, freight, handling costs
      and wasted materials (spoilage) be recognized as current period charges. It
      also
      requires that allocation of fixed production overheads to the costs of
      conversion be based on the normal capacity of the production facilities. SFAS
      151 became effective for the Company beginning with its 2006 fiscal year. The
      adoption of SFAS 151 has not had a material impact on our results of operations
      or financial position.





**2.**
            **Issuance
                of Securities**





Increase
      in Authorized Shares





On
      July
      6, 2006, we filed an Amendment to our Amended and Restated Certificate of
      Incorporation with the Secretary of State of New York that increased the number
      of shares of authorized common stock from 50 million to 100 million. Our
      stockholders approved the Amendment to the Certificate of Incorporation at
      our
      2006 Annual Meeting held on June 28, 2006. A principle purpose for authorizing
      the additional shares was to allow for issuance of the shares pursuant to
      arrangements to fund working capital and other general corporate
      purposes.





Short-Swing
      Profits in 2006 and SEC Investigation





Our
      Audit
      Committee determined that Robert A. Olins, our former Chief Executive Officer,
      Secretary, Treasurer and a Director failed to report the sale of an aggregate
      of
      70,556 of our common shares in August 2005 and February 2006 at sales prices
      ranging from $5.30 to $3.00 per share. Pursuant to Section 16 of the Exchange
      Act, in July 2006, Mr. Olins has filed the delinquent reports and disgorged
      $22,273 in “short swing profits” that he realized from the sales. These funds
      are recorded as an increase in additional paid in capital during the third
      quarter 2006. The Staff of the SEC is conducting an investigation into
      transactions in our securities by Mr. Olins and an entity he controls. See
      Note
      10 - Commitments and Contingencies.





57


SPATIALIGHT,
        INC.
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
        31, 2006, 2005 AND 2004


Exercise
      of Stock Options and Warrants in 2006





During
      2006, 50,000 common shares were issued upon the exercise of employee/director
      stock options. No warrants were exercised during 2006. Total cash received
      from
      option exercises in 2006 was $40,245.





Issuance
      of Shares and Warrants in 2006





On
      November 30, 2006, when the price of our common stock was $1.75, we issued
      143,963 of our common shares in lieu of cash to the Senior Secured Notes for
      the
      payment of one quarter’s interest incurred from these notes. Under the terms of
      the Senior Secured Convertible Notes, we can issue our common shares instead
      of
      making cash payments for interest at our option, as long as certain specified
      conditions are met. All of the specified conditions were met as of November
      30,
      2006.





On
      November 29, 2006, when the price of our common stock was $1.76, we issued
      and
      sold 2,400,000 of our common shares in a private placement to three
      institutional investors. The transaction included the issuance of warrants
      to
      purchase 4,872,000 of common shares with an exercise price of $1.75 per share
      exercisable within five years from the date of issuance. The purchase price
      of
      the common shares was $1.25 per share. The common shares and warrants were
      sold
      pursuant to an exemption from registration under Section 4(2) of the Securities
      Act of 1933, as amended. We received $3.0 million in proceeds, before issuance
      costs of $180,000, from the sale of these shares, which are and will be used
      for
      working capital and other general corporate purposes, including the repayment
      of
      certain short-term debt obligations. We will be required under a registration
      rights agreement to file a registration statement for the resale of the shares
      and shares issuable upon exercise of warrants within 30 calendar days after
      the
      closing date and have the registration statement declared effective no later
      than 90 calendar days after closing. The registration rights agreement provides
      that if we do not meet the above deadlines, we may be required to pay an amount
      equal to 2% of the aggregate purchase price or $60,000 for every thirty days
      thereafter to a maximum of 24% of the aggregate subscription amount or $720,000.
      Once the registration statement is declared effective, we are required to
      maintain effectiveness of the registration statement, including shares issuable
      upon the exercise of the warrants, until the shares covered by the registration
      statement have been sold or may be sold without volume restrictions pursuant
      to
      Rule 144(k). Because we have not filed a registration statement for these shares
      and shares issuable upon exercise of the warrants, we have accrued liquidated
      damages of $60,000 as of December 31, 2006.





On
      September 26, 2006, when the price of our common stock was $2.20, we sold
      270,270 of our common shares in a private placement to certain institutional
      investors that have previously purchased our common shares in private
      transactions on several occasions and are currently stockholders of our Company.
      The purchase price of the common shares was $1.85 per share. The transaction
      included the issuance of warrants to purchase 89,189 common shares with an
      exercise price of $2.25 per share exercisable within five years from the date
      of
      issuance. We received $500,000 in gross proceeds, before issuance costs of
      $17,500, from the sale of these shares, which were used for working capital
      and
      other general corporate purposes. We are required under a registration rights
      agreement to file a registration statement for the resale of the shares and
      shares issuable upon the exercise of the warrants within 30 calendar days from
      the closing date and have the registration statement declared effective no
      later
      than 90 calendar days after the closing date. The registration rights agreement
      provides that if we do not meet the above deadlines, we may be required to
      pay
      an amount equal to 2% of the aggregate purchase price or $10,000 as partial
      liquidated damages when each of these dates occur and an additional 1% for
      each
      month thereafter to a contractually defined maximum of 12% of the aggregate
      purchase price or $60,000. Once the registration statement is declared
      effective, we are required to maintain effectiveness of the registration
      statement until the shares covered by the registration statement have been
      sold
      or may be sold without volume restrictions pursuant to Rule 144(k). Because
      we have not filed a registration statement for these shares and shares issuable
      upon exercise of the warrants, we have accrued liquidated damages of $20,000
      as
      of December 31, 2006. In accordance with EITF 00-19, we classified net stock
      issuance proceeds as temporary equity, and as a warrant liability, because
      shares issued or issuable upon exercise of the warrants were subject to
      registration and potential liquidated damages, which may have been greater
      than
      the difference in fair values between registered and unregistered shares, if
      we
      were unable to have a registration statement declared effective or unable to
      maintain its effectiveness. We recorded the fair value of the warrants at
      issuance of $138,000 as a liability and the remaining net stock proceeds of
      $345,000 as temporary equity. The fair value of the warrants was calculated
      using the Black-Scholes option pricing model, using the following assumptions:
      stock price $2.20, exercise price $2.25, volatility 86%, risk-free interest
      rate
      4.56%, remaining contractual life 5 years, and dividend yield of zero. On
      September 30, 2006, the fair value of the warrants was revalued and calculated
      at $129,000, using the Black-Scholes option pricing model, using the following
      assumptions: stock price $2.09, exercise price $2.25, volatility 86%, risk-free
      interest rate 4.56%, remaining contractual life of five years, and dividend
      yield of zero. The decrease of $9,000 was reflected as a gain from revaluation
      of warrants in the consolidated statement of operations for the year ended
      December 31, 2006. As discussed in Note 1, under Adoption of New Accounting
      Pronouncements, we reclassified the carrying value of the stock from temporary
      equity, and the fair value of the warrant liability, to equity on October 1,
      2006 upon adoption of FSP EITF 00-19-2.





58


SPATIALIGHT,
        INC.
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
        31, 2006, 2005 AND 2004


On
      August
      31, 2006, when the price of our common stock was $2.27, we issued 109,143 of
      our
      common shares in lieu of cash to the Senior Secured Notes for the payment of
      one
      quarter’s interest incurred from these notes. Under the terms of the Senior
      Secured Convertible Notes, we can issue our common shares instead of making
      cash
      payments for interest at our option, as long as certain specified conditions
      are
      met. All of the specified conditions were met as of August 31, 2006.





On
      August
      9, 2006, when the price of our common stock was $2.60, we issued 761,500 of
      our
      common shares in a private placement to an institutional investor (“August 2006
      Financing”). The purchase price of the common shares was $2.25 per share. We
      received approximately $1.7 million in gross proceeds, before issuance costs,
      from the sale of these shares, which were used for working capital and other
      general corporate purposes. We paid $110,000 to our former Executive Vice
      President of Strategic Planning to facilitate this transaction, which were
      costs
      directly related to the transaction, and recorded this amount as a reduction
      of
      the gross proceeds. We are required under a registration rights agreement to
      file a registration statement for the resale of the shares within 30 calendar
      days from the closing date and have the registration statement declared
      effective no later than 90 calendar days after the closing date. The
      registration rights agreement provides that if we do not meet the above
      deadlines, we may be required to pay an amount equal to 1.5% of the aggregate
      purchase price or $25,700 as partial liquidated damages when each of these
      dates
      occur and an additional $25,700 for every 30 days thereafter up to six month.
      After six months, the percentage increases to 2.5% or $42,800 for each
      additional 30 days with no contractual maximum. Once the registration statement
      is effective, we are required to maintain effectiveness of the registration
      statement until the shares covered by the registration statement have been
      sold
      or may be sold without volume restrictions pursuant to Rule 144(k). The
      institutional investor has waived any claim for liquidated damages based on
      the
      failure to file a registration statement within the time required until a
      reasonable time after the effectiveness of our universal shelf registration
      statement on Form S-3 (Registration No. 333-137100). We
      classified the net proceeds from the stock issuance as temporary equity at
      September 30, 2006 in accordance with EITF 00-19, because the shares issued
      were
      subject to registration and potential liquidated damages if we were unable
      to
      have the registration statement declared effective or unable to maintain its
      effectiveness. As discussed in Note 1, under Adoption of New Accounting
      Pronouncements, we reclassified the carrying value of the stock from temporary
      equity to equity on October 1, 2006, upon adoption of FSP EITF
      00-19-2.





As
      part
      of the August 2006 Financing, we agreed to file a “shelf” registration
      statement covering subscription rights of at least $20,000,000 (the “Required
      Rights Offering”) to be offered to the holders of our common stock unless we
      raised at least $10,000,000
      in additional financing between August 9, 2006 and 30 days after the effective
      date of the registration statement. On October 25, 2006, these requirements
      were
      amended to (i) extend the Additional Financing Deadline by 30 days if we raised
      at least $1,000,000 in additional financing; (ii) extend the Additional
      Financing Deadline by 30-60 days if we raised between $3,000,000 and $5,000,000
      in additional financing; (iii) extend the Additional Financing Deadline by
      60
      days and reduce the Required Rights Offering pro rata if we raised more than
      $5,000,000 in additional financing. As of March 16, 2007, we have raised
      $5,800,000 in additional financing, the Required Rights Offering has been
      decreased to $14,200,000 and the Additional Financing Deadline has been extended
      to May 15, 2007.





Because
      of our existing covenants with the holders of our Senior Secured Convertible
      Notes, which requires us to seek their consent before we agree to enter into
      additional material indebtedness, we will most likely try to raise the
      above-mentioned monies through the sale of additional common shares. We can
      offer no assurance that we will successfully raise all or any part of the
      $4,200,000 mentioned above, nor can we offer an assurance that we will issue
      subscription rights to our shareholders in the future. At present, we are
      considering all of our options and have not definitively determined how or
      whether we will raise all or a part of the $4,200,000 which would allow us
      to
      avoid our obligation to make an offering of subscription rights to purchase
      our
      common shares. In connection with the August 2006 Financing, we have also
      agreed, for a period of one year following the closing of the August 2006
      Financing, to refrain from, directly or indirectly, offering or selling any
      debt
      security that is, at any time during the life of the debt security and under
      any
      circumstance, convertible into or exchangeable for our common shares, unless
      we
      receive prior written consent from a majority of the purchasers of the August
      2006 Financing.





In
      the
      event we default upon the foregoing obligations, the purchasers of securities
      in
      our August 2006 Financing are entitled to contractual damages and may also
      request that we specifically perform our obligations under the purchase
      agreement giving rise to our obligations. At present, we are unable to quantify
      the amount of contractual damages to which the purchasers would be entitled,
      and
      we are unable to estimate the likelihood that a court would grant any
      purchaser’s application that we specifically perform our
      obligations.





On
      June
      5, 2006, when the price of our common stock was $2.59, we sold to certain
      institutional buyers, each of which is managed by Wellington Management Company,
      LLP, an aggregate of 601,000 of our common shares at a price per share of $2.80,
      for an aggregate purchase price of approximately $1.7 million. We made the
      sale
      pursuant to a post-effective amendment to a “shelf” registration statement on
      Form S-3 (File No. 333-122392), which was declared effective by the SEC before
      this transaction, and which was amended by a registration statement on Form
      S-3
      MEF (File No. 333-134626) filed by us on May 31, 2006. As of the date of this
      filing, 5,150 of our common shares registered under these “shelf” registration
      statements remain unissued. These funds were used for working capital and other
      general corporate purposes.





59


SPATIALIGHT,
        INC.
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
        31, 2006, 2005 AND 2004




On
      May
      31, 2006, when the price of our common stock was $3.06, we issued 81,665 of
      our
      common shares in lieu of cash to the Senior Secured Notes for the payment of
      one
      quarter’s interest incurred from these notes. Under the terms of the Senior
      Secured Convertible Notes, we can issue our common shares instead of making
      cash
      payments for interest at our option, as long as certain specified conditions
      are
      met. All of the specified conditions were met as of May 31, 2006.





On
      April
      7, 2006, when the price of our common stock was $ 3.89, we sold 750,000 of
      our
      common shares at a purchase price of $3.26 per share to three institutional
      purchasers. Those shares were registered in our Post-Effective Amendment No.
      6
      to a Form S-3 “shelf” registration statement (File Number 333-122392), as
      post-effectively amended through February 14, 2006. The purchase price for
      those
      common shares was approximately $2.4 million in the aggregate. The purchase
      price was based upon the five-day volume weighted average price of our common
      shares through April 6, 2006, discounted by five percent. We paid aggregate
      fees
      equal to $89,650 to persons who introduced us to the investors. These funds
      were
      used for working capital and other general corporate purposes.





On
      March
      17, 2006, when the price of our common stock was $2.79, we sold 500,000 of
      our
      common shares at a purchase price of $2.18 per share to certain institutional
      investors. Those shares were included in our Post-Effective Amendment No. 6
      to
      Form S-3 "shelf" registration statement (File No. 333-122392), as
      post-effectively amended through February 14, 2006. The purchase price was
      based
      upon the five-day volume weighted average price of our common shares through
      March 16, 2006, discounted by five percent. We received net proceeds of
      approximately $1.1 million, which were used for working capital and other
      general corporate purposes.





In
      mid-January 2006, when the price of our common stock ranged from $2.62 to $2.85,
      we issued and sold 1,300,000 of our common shares in a private placement to
      three institutional investors. The purchase price of the common shares was
      $2.62
      per share. We received approximately $3.3 million in net proceeds from the
      sale
      of these shares, which were used for working capital and other general corporate
      purposes, including the repayment of certain short-term debt obligations. We
      were required under a registration rights agreement, to file a registration
      statement for the resale of the shares within 30 calendar days after January
      12,
      2006 and have the registration statement declared effective no later than 90
      calendar days after January 12, 2006. The latter may be extended to no later
      than 120 calendar days if the registration statement is subject to review,
      comments or other actions by the SEC. Once the registration statement is
      declared effective, we
      are
      required to maintain effectiveness of the registration statement until the
      shares covered by the registration statement have been sold or may be sold
      without volume restrictions pursuant to Rule 144(k). As
      the
      registration statement was not filed by February 11, 2006 or declared effective
      prior to April 12, 2006, the registration rights agreement required us to pay
      an
      amount equal to 5% of the aggregate purchase price or $170,300 as partial
      liquidated damages when each of these dates occurred and an additional $170,300
      for every 30 days thereafter up to six months. After six months, the percentage
      increases to 10% or $340,600 for each additional 30 days. We have included
      $329,602 as liquidated damages in non-cash interest expense from inception
      through May 12, 2006. The registration statement related to these shares was
      filed with the SEC on May 5, 2006 and was declared effective on May 12, 2006.
      Concurrent with the effectiveness of the registration statement, the investors
      of the January financing received an aggregate of 122,725 restricted shares
      in
      settlement of any and all liquidated damages. The shares were issued as follows:
      57,725 restricted shares of our common stock were issued on May 18, 2006, when
      the market value of our shares was $3.12, resulting in an intrinsic value of
      $180,102; 65,000 restricted shares of our common stock were issued on June
      30,
      2006, when the market price of our shares was $2.30, resulting in an intrinsic
      value of $149,500. Of these shares, 57,725 were included in our Form S-3
      Amendment No. 6 (Registration No. 333-137100) filed with the SEC on February
      13,
      2007. This registration statement was declared effective by the SEC on February
      14, 2007.





Issuance
      of Shares in 2005





In
      October 2005, we closed a $2.0 million private placement of our common shares
      and warrants to purchase our common shares with certain institutional and other
      investors. This transaction included the sale of 571,431 common shares at a
      purchase price of $3.50 per share and warrants to purchase 228,576 common shares
      with an exercise price of $5.00 per share exercisable within five years from
      the
      date of issuance. We received $2.0 million in gross proceeds from this
      transaction, which was used for working capital and other general corporate
      purposes. We did not use a placement agent in this transaction. Three of the
      institutional purchasers in this transaction were investors in our November
      2004
      private placement of our Senior Secured Convertible Notes. We were required
      to
      file a registration statement for resale of the shares and shares issuable
      upon
      exercise of the warrants 30 days after October 12, 2005 and have the
      registration statement declared effective no later than 90 days after October
      12, 2005. We are also required to maintain the effectiveness of the registration
      statement (File No. 333-132048) until the shares covered by the registration
      statement have been sold or may be sold without volume restrictions pursuant
      to
      Rule 144(k).





On
      February 27, 2006, we filed a registration statement (File No. 333-132048)
      registering shares issued in our October 2005 financing. Because this
      registration statement was not filed by November 12, 2005, we may be required
      to
      pay $30,000 as liquidated damages to the investors as of November 12, 2005
      and
      every thirty days thereafter through February 27, 2006. Additionally, since
      the
      registration statement was not declared effective by the SEC prior to January
      12, 2006, we may be required to pay $30,000 as liquidated damages to the
      investors on January 12, 2006 and for every thirty days thereafter until April
      18, 2006, the date of effectiveness for this registration statement. We have
      included $187,215 and $79,000 as liquidated damages in non-cash interest expense
      for the periods ended April 18, 2006 and December 31, 2005, respectively.
      Concurrent with the effectiveness of the registration statement, investors
      accounting for 25% of the invested amount in this transaction have waived their
      rights to any liquidated damages. In addition, in settlement of any and all
      liquidated damages, investors accounting for 50% of the invested amount in
      this
      transaction received an aggregate of 43,850 shares of our common stock on June
      5, 2006, when the market price of our stock was $2.77, resulting in an intrinsic
      value of $121,465. These shares were included in our amended registration
      statement on Form S-3 MEF (File No. 333-134626) filed by us on May 31, 2006.
      We
      continue to maintain an accrual of $65,750 in accrued liabilities on our
      consolidated balance sheet for the investors accounting for the remaining 25%
      of
      the invested amount.





60


SPATIALIGHT,
        INC.
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
        31, 2006, 2005 AND 2004


As
      mentioned above, prior to the issuance of FSP EITF 00-19-2, as further described
      in Note 1, Adoption of New Accounting Pronouncements, in accordance with EITF
      00-19, the fair value of the warrants at inception was accounted for as a
      liability, with an offsetting reduction to the carrying value of the common
      stock. We reclassified the warrant liability to equity upon effectiveness of
      the
      related registration statement, on April 18, 2006. The fair value of the
      warrants at inception, of $958,625, was calculated using the Black-Scholes
      option pricing model, using the following assumptions: stock price $4.26,
      exercise price $5.00, volatility 217%, risk free interest rate 3.00%, remaining
      contractual life 5 years and dividend yield of zero. On December 31, 2005,
      the
      fair value of the warrants was revalued and calculated at $778,270, using the
      Black-Scholes option pricing model, using the following assumptions: stock
      price
      $3.47, exercise price $5.00, volatility 217%, risk free interest rate 3.00%,
      remaining contractual life 4.87 years and dividend yield of zero. The decrease
      of $180,355 is reflected as a gain from revaluation of warrants in the
      consolidated statement of operations during the year ended December 31, 2005.
      On
      April 18, 2006, the fair value of the warrants was revalued and calculated
      at
      $743,319, using the Black-Scholes option pricing model, using the following
      assumptions: stock price $3.48, exercise price $5.00, volatility 178%, risk
      free
      interest rate 3.00%, remaining contractual life 4.52 years and dividend yield
      of
      zero. The decrease of $34,951 is reflected as a gain from revaluation of
      warrants in the consolidated statement of operations during the year ended
      December 31, 2006. In accordance with EITF 00-19, we had classified the
      $1,026,374 value of common stock subject to registration (net of $15,000
      issuance costs and warrants valued at $958,625) as temporary equity as of
      December 31, 2005 related to the October 2005 Financing. The amount had been
      reclassified to equity upon effectiveness of the related registration statement,
      on April 18, 2006.





On
      August
      5, 2005, we sold 500,000 of our common shares at a purchase price of $5.40
      per
      share to certain institutional investors. Those shares were included in our
      Form
      S-3 “shelf” registration statement (File No. 333-122932), which was declared
      effective by the SEC in July 2005. We received gross proceeds of approximately
      $2.7 million from the transaction, which we used for working capital and other
      general corporate purposes. The purchasers in the August 2005 Equity Financing
      had a 30-day right, which expired on September 4, 2005, to purchase an
      additional aggregate of 225,000 of our common shares included in the “shelf”
registration statement at a purchase price of $5.50 per share. On August 23,
      2005, we filed a post-effective amendment to our “shelf” registration statement
      withdrawing exhibit 23.1, the consent of the independent registered accounting
      firm BDO Seidman LLP. We stated in the post-effective amendment that we would
      not make any future sales from the “shelf” registration statement until we
      resolved the matter involving the consent. On August 23, 2005, we reclassified
      the fair value of the Investment Right of $94,500 from equity to a liability
      pursuant to EITF 00-19. The fair value of the Investment Right was calculated
      using the Black-Scholes option pricing model, using the following assumptions:
      stock price $5.24, exercise price $5.50, volatility 138.18%, risk free interest
      rate of 3.33%, remaining contractual term of 12 days and dividend yield of
      zero.  The Investment Right expired, unexercised, on September 4, 2005, and
      the Investment Right liability was recorded in other income. In February 2006,
      the SEC declared our Post-Effective Amendment No. 6 to the Shelf Registration
      Statement effective, and we have sold all but 5,150 the balance of the
      securities remaining on the Shelf Registration Statement in compliance with
      the
      federal securities law, through use of the Shelf Registration Statement as
      noted
      above in the section “Issuance of Shares and Warrants in 2006”.





In
      January 2005, 581,505 common shares with a value of $4,038,149 previously
      recorded as common shares issuable were issued. This included 50,500 shares
      valued at $123,625 issued to employees upon exercise of options at the end
      of
      2004, 448,768 shares valued at $3,643,964 related to the prepayment of interest
      on the Argyle note mentioned below and 82,237 shares valued at $270,560 of
      other
      warrants exercised at the end of 2004.





Exercise
      of Stock Options and Warrants in 2005





During
      2005, employee stock options for 213,606 common shares were exercised for
      $443,989 and warrants for 155,557 common shares were exercised for $92,000.
      Included in the warrant exercise are 105,557 shares issued upon the cashless
      exercise of 250,000 warrants.





61
 
 SPATIALIGHT,
          INC.
 NOTES
          TO
          CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
          31, 2006, 2005 AND 2004


Other
      expenses in 2005 totaling $22,000 relate to the valuation of an employee stock
      option issued with an exercise price lower than the market price on the grant
      date and are included in stock-based general and administrative expenses. This
      expense relates to an option granted in 2003.





Issuance
      of Warrant and Option for Services in 2005





In
      June
      2005, we issued a fully vested warrant to purchase 75,000 of our common shares
      to an unaffiliated investment bank for compensation for services provided
      pursuant to a service agreement. A value of $73,387 was assigned to the warrant
      using the Black-Scholes pricing model and the following assumptions: stock
      price
      $5.71, exercise price $7.50, historical volatility 65%, risk free interest
      rate
      3%, dividend yield of zero and a contractual life of 12 months. This amount
      is
      included in stock-based general and administrative expenses.





In
      February 2005, we issued a fully vested warrant to purchase 75,000 common shares
      as payment to a sales agent. A value of $90,800 was assigned to the warrant
      using the Black-Scholes pricing model and the following assumptions: stock
      price
      $4.66, exercise price $4.50, historical volatility 64%, risk free interest
      rate
      4.28%, dividend yield of zero and a contractual life of 10 months. This amount
      is included in stock-based general and administrative expenses.





Issuance
      of Shares in 2004





In
      December 2003, we completed a private placement of 1,000,000 common shares
      that
      were registered with the SEC in a “shelf” Registration Statement at a price of
      $5.00 per share for net proceeds of $4,955,255 received in December 2003. Prior
      to December 31, 2003, 300,000 of these shares were issued. The remaining 700,000
      shares were reflected in common shares issuable at December 31, 2003 and were
      issued in January 2004. In addition, 120,082 shares were issued in 2004 pursuant
      to a warrant exercised in late 2003. The proceeds of approximately $306,000
      had
      been received and were included in common shares issuable as of December 31,
      2003.





On
      January 7, 2004, we issued 142,360 common shares with a value of $800,063 as
      a
      prepayment of interest on the Argyle notes for the interest due for 2004.
      Prepaid interest was computed using the closing price of the shares on January
      6, 2004 of $5.62. This amount is fully amortized at December 31, 2004. On March
      4, 2004, we issued an additional 71,676 common shares with a value of $338,311
      as a prepayment of interest on the Argyle notes for the period January 1, 2005
      to June 30, 2005 (see Note 3). Prepaid interest was computed using the closing
      price of the shares of $4.72 on March 3, 2004. On December 22, 2004, we issued
      an additional 50,000 shares, and 448,768 shares became issuable (and were issued
      in January 2005) as a prepayment of interest on the Argyle notes for the period
      from July 1, 2005 through December 31, 2008. These shares had a value of
      $4,049,964 based on the closing price of the shares of $8.12 on December 21,
      2004. Prepaid interest of $2,314,266 and $3,471,398, for the year ended December
      31, 2006 and 2005, respectively, is classified as a deduction from stockholders’
equity (deficit).





Exercise
      of Stock Options and Warrants in 2004





During
      2004, employee stock options for 465,083 common shares were exercised for
      $1,158,022 and warrants for 680,781 common shares were exercised for $1,730,681.
      We issued 132,737 of the shares in early January 2005.





Issuance
      of Warrant and Option for services in 2004





In
      April
      2004, we issued a fully vested warrant to purchase 250,000 common shares as
      payment to a sales agent. A value of $210,000 was assigned to the warrant using
      a Black-Scholes pricing model and the following assumptions: stock price $3.58,
      exercise price $3.75, historical volatility 59%, risk free rate 4%, dividend
      yield of 0% and a contractual life of 13 months. This amount is included in
      stock-based general and administrative expenses.




In
      October 2004, we issued a fully vested option to purchase 10,000 common shares
      to a consultant. The option was assigned a value of $53,850 using the
      Black-Scholes option pricing model and the following assumptions: stock price
      $5.75, exercise price $5.75, historical volatility 113%, a risk free rate of
      3%,
      a dividend yield of 0 and a contractual life of 10 years. This amount is
      included in stock-based general and administrative expenses.





Other
      expenses in 2004 totaling $67,674 relate to the valuation of options granted
      to
      employees with an exercise price lower than the market price on the date of
      grant, and options granted to a director for additional services. All of these
      options were issued in years previous to 2004.





Issuance
      of Shares Under Installment Note





In
      November 2002, Greenpark Limited exercised its warrant to purchase 746,268
      common shares at the exercise price of $2.00 per share, for an aggregate
      purchase price of $1,492,536. Under an installment agreement, Greenpark Limited
      was required to make periodic installment payments towards such aggregate
      purchase price. There was a 6% annual interest rate with respect to the balance
      of the share purchase price owed to us and all accrued interest is due with
      the final payment. We issued all of the 746,268 shares to Greenpark Limited
      in
      2003. In consideration for the financing commitment by Greenpark Limited in
      the
      November 2004 Financing, we agreed to reduce by $600,000 the amount owed by
      Greenpark Limited to us under that certain warrant installment agreement, dated
      as of October 14, 2002. This amount was included in stock-based general and
      administrative expenses. We received the remaining outstanding balance, plus
      accrued interest during 2005.





62


SPATIALIGHT,
        INC.
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
        31, 2006, 2005 AND 2004


On
      May
      15, 2001, we sold 600,000 common shares under a private stock purchase
      agreement. The shares were sold at a price of $1.75 per share. Cash received
      was
      $262,500. The balance of $787,500 was to be paid in three equal quarterly
      installments of $262,500. An escrow agent held the certificates for the shares
      being purchased until all three installments were paid in full. At December
      31,
      2004 the remaining balance was paid and the shares were released from
      escrow.





Short-Swing
      Profits in 2004





In
      September 2004, Robert A. Olins, our former Chief Executive Officer, Secretary,
      Treasurer and a Director, disposed of 11,800 of our common shares at a sale
      price of $5.73 per share. Pursuant to the “short-swing profit” provisions of the
      Exchange Act, Mr. Olins subsequently disgorged $25,982 to us for the profit
      that
      he realized from his sale of our common shares. The total aggregate profit
      was
      calculated by using the lowest purchase prices at which Mr. Olins purchased
      11,800 of our common shares during the six months immediately preceding
      September 20, 2004.





Stock-based
      general and administrative expenses discussed above are as follows:


Year-end
                  December 31,2006
              
              2005
              
              2004Financing
                  costs related to reduction of stockholder note
              
              $
              -
              
              $
              -
              
              $
              600,000Stock
                  and options granted to employees and directors
              
              
              1,875,330
              
              
              22,000
              
              
              67,674Common
                  stock and warrants expensed for services
              
              
              -
              
              
              164,187
              
              
              263,850$
              1,875,330
              
              $
              186,187
              
              $
              931,524


3.
            **Short
                Term Loans and Notes Payable**





Short
      Term Loan from a Related Party





During
      March 2006, our wholly-owned subsidiary, SpatiaLight Korea, Inc. borrowed KRW
      85,000,000 (approximately US $86,250) from JeWon Yeun, SpatiaLight Korea’s
      former President. This non-interest bearing, unsecured loan was repaid in early
      April 2006. Between July and December 2006, we borrowed an aggregate of $355,000
      from Herbert Ehrenthal, one of our Directors, and an aggregate of $252,199
      from
      Robert A. Olins, our former Chief Executive Officer, Secretary, Treasurer,
      and a
      Director. The short-term borrowings from Mr. Ehrenthal bear interest at 8%
      per
      annum. The short-term borrowings from Mr. Olins are non-interest bearing. Each
      of the notes was for $100,000 or less and the notes were on average outstanding
      for less than 2 months at a time. All the notes were fully repaid by early
      December 2006.





On
      December 16, 2005, we borrowed $224,384 from Robert A. Olins, our former Chief
      Executive Officer, Secretary, Treasurer and a Director. Mr. Olins obtained
      these
      funds by drawing down on a personal line of credit from a bank, which is the
      same bank that we utilize for our domestic commercial banking requirements.
      Based upon discussions among Mr. Olins and other members of our Board of
      Directors, the Board authorized the repayment of the full principal amount
      of
      the loan plus interest at a rate of 8.25% per annum by February 16, 2006, the
      maturity date. The Board also authorized the reimbursement to Mr. Olins for
      a
      $30,000 fee that he was required to pay to the bank. The interest rate and
      the
      fee are on the same terms that Mr. Olins obtained from the bank. The unsecured
      loan was repaid by the due date and the fee was reimbursed to Mr.
      Olins.





63


SPATIALIGHT,
        INC.
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
        31, 2006, 2005 AND 2004


Short
      Term Loans





Our
      wholly-owned subsidiary SpatiaLight Korea has revolving credit facilities with
      five separate South Korean banks as detailed below (amounts in thousands, Korean
      Won, unless otherwise stated):


Bank
              
              Shinhan
                  Bank
              
              Kyongnam
                  Bank
              
              Korea
                  Exchange Bank
              
              Pusan
                  Bank
              
              Industrial
                  Bank of Korea (4)
              
              TotalInterest
                  rate type
              
              
              Variable
                  (1)
              
              
              Variable
                  (2)
              
              
              Fixed
              
              
              Variable
                  (3)
              
              
              FixedInterest
                  rate at 12/31/06
              
              
              7.05
              %
              
              10.20
              %
              
              13.00
              %
              
              11.14
              %
              
              0.00
              %Maturity
                  date
              
              
              9/22/2007
              
              
              4/28/2007
              
              
              1/10/2007
              
              
              1/10/2007
              
              
              3/23/2007Maximum
                  amount of line
              
              
              200,000
              
              
              200,000
              
              
              200,000
              
              
              100,000
              
              
              -
              
              
              700,000Amount
                  outstanding at 12/31/06
              
              
              199,466
              
              
              198,460
              
              
              57,970
              
              
              99,411
              
              
              -
              
              
              555,308Remaining
                  available
              
              
              534
              
              
              1,540
              
              
              142,030
              
              
              589
              
              
              -
              
              
              144,692Approximate
                  US dollar equivalent
              
              $
              212,312
              
              $
              211,241
              
              $
              61,704
              
              $
              105,813
              
              $
              -
              
              $
              591,070
  (1)
              Yield
                  ratio of annual bank debenture plus
                  1.857%
  (2)
              Yield
                  ratio of annual industrial financial debenture plus
                  4.0%
  (3)
              Pusan
                  Bank's internal market related base rate plus
                  5.56%
  (4)
              The
                  IBK facility was terminated in April 2006. See details
                  below.





Interest
      under each of the credit facilities is payable monthly. We are required to
      repay
      funds on the credit facilities by the maturity dates of each of the respective
      credit facilities as noted in the table above. On April 10, 2006, the Korean
      Exchange Bank extended the expiration date on the line of credit from April
      10,
      2006 to October 10, 2006. In early October 2006, the Korean Exchange Bank
      changed the terms of the line of credit to a loan at the same interest rate
      to
      be repaid in three monthly installments with the final payment due January
      10,
      2007. In late October 2006, the Kyongnam Bank extended the expiration date
      of
      the line of credit from October 28, 2006 to April 28, 2007 in exchange for
      an
      increase in the interest rate by 1%.





On
      March
      24, 2006, the Industrial Bank of Korea (IBK) committed itself to extend a
      secured line of credit (the “March Facility”) of up to 1.5 billion Korean Won
      (or approximately $1.5 million in U.S. dollars) to SpatiaLight Korea. As of
      March 31, 2006, SpatiaLight Korea had drawn down approximately $1.5 million
      on
      the March Facility for working capital purposes and to repay certain of its
      outstanding indebtedness. On April 6, 2006, the March Facility was terminated
      by
      repaying all monies borrowed as well as certain prepayment and finance charges.
      IBK has released its lien on SpatiaLight Korea’s assets securing the March
      Facility and related personal guarantees made by certain officers. We terminated
      this line of credit as some of the terms of the line might have been precluded
      by our other contractual obligations.





We
      have
      not repaid either the Korean Exchange Bank or the Pusan Bank the amount
      outstanding as of the maturity dates noted above and are in the process of
      renegotiating these lines of credit with each of these banks.





Convertible
      Notes





Convertible
      notes at December 31, 2006 consist of the following:





*Argyle
      Notes*





In
      1998,
      we received $1,188,000 in cash in exchange for notes payable in that amount
      to
      Argyle Capital Management Corporation (Argyle), a company owned and controlled
      by Robert A. Olins, our former Chief Executive Officer, Secretary, Treasurer,
      and a former Director. The notes accrue interest at a contractual rate of 6%
      per
      annum, and are secured by substantially all of our assets, although these Notes
      are subordinated to the Senior Secured Convertible Notes described below. Both
      principal and interest are convertible into our common shares at $0.50 per
      share. On May 23, 2001, the due date of the notes was extended until December
      31, 2002. On the extension date, the beneficial conversion effect representing
      the excess aggregate value of the common shares receivable upon conversion
      of
      the notes based on the then-current market price of $1.90 per share, over the
      aggregate conversion price for such common shares (limited to the original
      proceeds of $1,188,000), was recorded as additional paid-in capital. The
      resulting $1,188,000 discount to the debt arising from the beneficial conversion
      feature was originally being amortized through December 31, 2002. The effective
      interest rate for financial statement purposes due to this discount differs
      from
      the actual contractual interest received or receivable in cash or shares by
      Argyle. This discount, along with the contractual 6% interest rate, resulted
      in
      a new effective interest rate of 72% per annum as of the May 23, 2001 extension
      date when compared to the outstanding principal balances. The effective rate
      prior to extension had been the 6% per annum contractual rate.





64


SPATIALIGHT,
        INC.
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
        31, 2006, 2005 AND 2004


On
      September 20, 2002, the due date was extended until March 31, 2004. Accordingly,
      the remaining unamortized discount at the extension date of $198,000 was being
      amortized through March 31, 2004, resulting in a new effective interest rate
      of
      17% per annum when compared to the outstanding principal balances. On December
      31, 2003, the due date was extended until June 30, 2005. Accordingly, the
      remaining unamortized discount of $33,000 at the extension date was being
      amortized through June 30, 2005, resulting in a new effective interest rate
      of
      8% per annum when compared to the outstanding principal balances. On November
      30, 2004, the due date was extended until December 31, 2008. The remaining
      unamortized discount of $11,000 at the extension date was amortized through
      June
      30, 2005.





We
      paid
      interest on the Argyle notes by issuing 142,360 common shares with a market
      value of $354,476 in 2003, and 142,360 common shares with a market value of
      $800,063 in 2004. The market value of the shares was based on the closing price
      of the shares on the day before issuance, and was recorded as interest expense. On
      March
      4, 2004, we issued 71,676 common shares with a market value of $338,311 as
      a
      prepayment of interest on the Argyle notes of $35,640 for the period January
      1,
      2005 to June 30, 2005. Prepaid interest was computed using the closing price
      of
      the shares of $4.72 on March 3, 2004. In December 2004, we issued 50,000 common
      shares, and in January 2005, we issued 448,768 common shares, as a prepayment
      of
      interest on the Argyle notes of $249,480 for the period July 1, 2005 through
      December 31, 2008. These shares had a market value of $4,049,964, based on
      the
      closing price of the shares of $8.12 on December 21, 2004. As of December 31,
      2006, total prepaid interest on the Argyle notes for the period January 1,
      2007
      to December 31, 2008 is $2,314,266, which is classified as a deduction from
      stockholders’ equity (deficit). If Argyle elects to convert the notes prior to
      the maturity date (December 31, 2008), Argyle will return shares representing
      unearned interest on those notes at the time of the conversion.





Interest
      expense includes non-cash interest expense of $728,780 in 2004, $845,957 in
      2005
      and $1,085,583 in 2006. The non-cash interest expense results from the
      beneficial conversion price of interest, which is convertible into common shares
      at $0.50 per share, and was computed as the excess of the market price of the
      shares issued for the interest over the calculated amount of interest due for
      the period.




At
      December 31, 2006, the carrying value of the Argyle notes totaled $1,188,000
      representing the unpaid principal balance *.* In
      December 2006, Argyle, in accordance with the registration rights agreement,
      requested that the shares underlying these notes be registered as soon as
      practicable.





*Senior
      Secured Convertible Debt Financing*





On
      November 30, 2004, we completed a non-brokered private placement of $10 million
      in principal amount of our senior secured notes (the “Senior Secured Convertible
      Notes”). The Senior Secured Convertible Notes accrue interest at 10% per annum,
      payable quarterly, and the interest is payable in cash or common shares, at
      our
      option if certain conditions are met, including the availability of an effective
      registration statement pursuant to which resales may be made or the availability
      of Rule 144(k) for resale of the common shares issued upon conversion. The
      value
      of the shares for the purposes of calculating interest payments is equal to
      the
      10-day trailing average of the volume weighted average prices of our common
      stock at the end of each quarterly interest period. The Secured Convertible
      Notes are due November 30, 2007.





The
      Senior Secured Convertible Notes are convertible, at the option of their
      holders, into shares of our common stock at the conversion price of $9.72 per
      share. The Senior Secured Convertible Notes are senior to notes that we issued
      to Argyle Capital Management Corporation (the “Argyle Notes”), which is wholly
      owned by Robert A. Olins, our former Chief Executive Officer, Secretary,
      Treasurer and a former Director, based upon an Intercreditor Agreement.
 This Intercreditor Agreement precludes us from repaying the Arygle Notes
      in cash or other property until the holders of our Senior Secured Convertible
      Notes have been repaid.  The Intercreditor Agreement does not, however,
      preclude us from paying in either cash or shares, interest on the Argyle Notes
      provided there has not been an event of default under the Senior Secured
      Convertible Notes, as defined in the agreement.  Under the terms of the
      Intercreditor Agreement, Argyle maintains its rights to convert the Argyle
      Notes
      into shares of our common stock under the conversion terms of the Argyle Notes,
      as described above, at any time.  The holders of our Senior Secured
      Convertible Notes have a senior security interest in substantially all of our
      assets, except those located in South Korea.  However, the holders of our
      Senior Secured Convertible Notes have a pledge on SpatiaLight Korea’s shares.
 In addition, under the terms of the November 2004 Financing, we are
      prohibited from using the proceeds from the financing to repay debt or to pay
      dividends, and we are prohibited from paying dividends while the Senior Secured
      Convertible Notes are outstanding.





We
      were
      required under an amended registration rights agreement, to file a registration
      statement for resale of the shares issuable upon conversion of the Senior
      Secured Convertible Notes and to maintain its effectiveness to allow the holders
      of our Senior Secured Convertible Notes to convert their notes and sell the
      underlying common shares freely.  We reported in Post Effective Amendment
      No. 2 to our registration statement on Form S-3 relating to the Senior Secured
      Convertible Notes (Reg. No. 333-122391), that in late August 2005 we advised
      the
      holders of our Senior Secured Convertible Notes that until the matter concerning
      the filing of an unauthorized consent of our former auditors, BDO Seidman LLP,
      is resolved, sales using the prospectus which is the subject of that
      registration statement may result in potential liability. One of the holders
      of
      the Senior Secured Convertible Notes, Portside Growth & Opportunity Fund,
      has claimed that the post-effective amendment resulted in an obligation for
      the
      Company to pay each Noteholder liquidated damages in cash equal to 1% of the
      purchase price of the notes, and 1% for every 30 days thereafter, until the
      matter concerning the consent is resolved.  That amount would equal
      $534,000 and $615,000 as of December 31, 2005 and February 14, 2006 (when the
      post-effective amendment to the registration statement was declared effective),
      respectively.  We do not believe that we are contractually obligated to
      make those payments and therefore we have not accrued for the alleged liquidated
      damages.  However, should the Noteholders pursue their claim for liquidated
      damages pursuant to the registration rights agreement and prevail on their
      claim
      in a court of law, the alleged liquidated damages would immediately become
      due
      and payable.  In February 2006, Post-Effective Amendment No. 6 to the
      registration statement referenced above was declared effective by the
      SEC.





65
 
 SPATIALIGHT,
          INC.
 NOTES
          TO
          CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
          31, 2006, 2005 AND 2004


Portside
      Growth & Opportunity Fund has also claimed the following additional events
      of default under the Senior Secured Convertible Notes: (i) failure to make
      an
      interest payment due in November 2005 on a timely basis; (ii) incurrence of
      prohibited indebtedness to our former officers and/or directors of the Company;
      (iii) incurrence of prohibited indebtedness by our South Korean subsidiary
      to
      certain banks in South Korea; (iv) granting of a security interest by our South
      Korean subsidiary in certain assets located in South Korea; (v) repayment by
      us
      of indebtedness to our officers or directors and by our South Korean subsidiary
      of indebtedness under bank credit facilities. Smithfield Fiduciary LLC, joined
      in the claim that a default occurred as a result of certain indebtedness
      incurred as a result of the failure to make the November 2005 interest payment
      in a timely fashion. Each of these notices call for us to redeem $9.0 million
      in
      the aggregate principal amount of our Senior Secured Convertible Notes, plus
      payment of a redemption premium of $675,000 to each of these holders.
      Furthermore, the Noteholders claim that the interest rate on the Senior Secured
      Convertible Notes has increased from 10% per annum to 12% per annum as a result
      of the claimed defaults.





We
      believe, after review with outside legal counsel, that these allegations lack
      merit and would not entitle the Noteholders to call the notes and other remedies
      that they are seeking.  We believe that the Noteholders have undertaken to
      make allegations of events of default that lack merit in an attempt to obtain
      an
      amendment to the terms of the Senior Secured Convertible Notes to reduce the
      conversion price, accelerate repayment and increase the interest rate.  We
      have rejected offers from the Noteholders in this regard, and plan to vigorously
      defend our position. If the Noteholders prevail in calling the Notes, the entire
      $10 million debt obligation would become due and payable immediately, including
      the redemption premiums of $1.5 million and liquidated damages of $683000. 
We have not accrued the above described redemption premiums or liquidated
      damages as of December 31, 2005 or December 31, 2006.





In
      consideration for Argyle entering into the Intercreditor Agreement, our Board
      of
      Directors authorized us to enter into an extension and modification agreement
      with Argyle with respect to the Argyle Notes (the Extension Agreement) under
      which the due date of the Argyle Notes was extended to December 31,
      2008.





Under
      the
      terms of the November 2004 Financing, Robert A. Olins and Greenpark Limited,
      an
      unaffiliated stockholder, jointly and severally committed, in the event that
      the
      Board of Directors determines that such financing is necessary, to provide
      us
      with up to an additional $6 million in future financing on terms and conditions
      to be determined at the time of any such transaction. That financing commitment
      shall be reduced by any funds that we receive from future sales or exercises
      of
      our equity, debt or derivative securities, including the sale of our common
      shares under the prospectus that we filed with the SEC on January 28, 2005,
      as a
      part of a “shelf” registration process. As of the date of this filing, taking
      into account the October 2005 Private Placement and stock option exercises,
      we
      had received an aggregate total of greater than $6 million, thereby fulfilling
      the commitment by Mr. Olins and Greenpark Limited.





Under
      the
      terms of the November 2004 Financing, the purchasers received the right
      (additional investment rights or AIR) to purchase up to an additional $5 million
      of senior secured convertible notes subject to the same terms and conditions,
      including the same conversion price as the notes issued in the November 2004
      Financing. The AIR originally expired on November 30, 2005, but was amended
      on
      December 21, 2004 to expire on August 31, 2005. The fair value of the AIR was
      calculated on the November 30, 2004 issuance date at $1,072,248 using the
      Black-Scholes option pricing model (see table below.) This AIR is being treated
      as a derivative and has been recorded as a note purchase option liability and
      as
      a discount on the 2004 Senior Secured Convertible Notes. The AIR is not a
      hedging derivative. The fair value of the derivative has been recalculated
      on a
      quarterly basis until exercise or expiration to reflect the changing market
      price of the stock, the remaining contractual term, and the changing volatility.
      The objective in entering into the agreement for the AIR was that it was
      required by the lenders in order to complete the financing agreement. Below
      is a
      table reflecting the fair value of the AIR at each period end date and the
      Black-Scholes assumptions used to calculate the fair value. The assumptions
      changed from the November 2004 valuation date in that the market price of our
      common shares had changed, the contractual life had changed due to the December
      21, 2004 amendment, and the volatility changed as a result of the changes in
      market price and contractual life. Any reduction in the note purchase option
      liability due to the revaluation of the AIR is recorded as a gain from the
      revaluation of the note purchase option liability and is included in other
      income. The remaining value of the note purchase option liability was written
      off upon expiration on August 31, 2005.





66
 
 SPATIALIGHT,
          INC.
 NOTES
          TO
          CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
          31, 2006, 2005 AND 2004


**Fair
                  Value Date***
              
              **Fair
                  Value**
              
              **Gain
                  Recognized for Quarter**
              
              **Cumulative
                  Gain**
              
              **Current
                  Stock Price**
              
              **Volatility**
              
              **Risk-Free
                  Interest Rate**
              
              **Contractual
                  Term**November
                  30, 2004
              
              $
              1,072,248
              
              $
              -
              
              $
              -
              
              $
              8.83
              
              
              67
              %
              
              2.50
              %
              
              1
                  yearDecember
                  31, 2004
              
              $
              659,874
              
              $
              412,374
              
              $
              412,374
              
              $
              8.95
              
              
              52
              %
              
              2.50
              %
              
              8
                  monthsMarch
                  31, 2005
              
              $
              8,639
              
              $
              651,235
              
              $
              1,063,609
              
              $
              5.05
              
              
              49
              %
              
              2.50
              %
              
              5
                  monthsJune
                  30, 2005
              
              $
              2,102
              
              $
              6,537
              
              $
              1,070,146
              
              $
              5.67
              
              
              54
              %
              
              3.00
              %
              
              2
                  monthsSeptember
                  30, 2005
              
              $
              -
              
              $
              2,102
              
              $
              1,072,248
              
              $
              -
              
              
              -
              
              
              -
              
              
              expired
 * 
          Exercise price for all dates is $9.72 per share and dividend yield for
          all dates
          is zero.


The
      $1,072,248 discount applied to the 2004 Senior Secured Convertible Notes gave
      rise to a beneficial conversion feature of $156,610 resulting from the excess
      aggregate value of the common shares issuable upon conversion of the 2004 Senior
      Secured Convertible Notes into common shares over the discounted carrying value
      of the 2004 Senior Secured Convertible Notes at the issuance date. The resulting
      beneficial conversion feature is treated as an additional discount to the 2004
      Senior Secured Convertible Notes and an increase in additional paid-in capital,
      and is being amortized, along with the original discount related to the value
      of
      the AIR, over the life of the 2004 Senior Secured Convertible Notes. In
      addition, $100,000 of legal fees reimbursed to one of the lenders was recorded
      as a note discount and is being amortized over the life of the notes. Additional
      financing costs of $117,162 were recorded as prepaid expenses and are being
      amortized over the life of the notes. The effective interest rate for financial
      statement purposes due to the discount related to the AIR and beneficial
      conversion feature mentioned above differs from the actual contractual interest
      paid or payable in cash or shares to the noteholders. These discounts, along
      with the contractual 10% interest rate, results in an effective rate of 14.4%
      per annum.





67


SPATIALIGHT,
        INC.
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
        31, 2006, 2005 AND 2004


Activity
      in convertible notes payable for 2006 and 2005 is as follows:


**Balance
                  at December 31, 2005**
              
              **Addition
                  or New Discount**
              
              **(Payment)
                  or Discount Amortization**
              
              **Conversion
                  to Equity**
              
              **Balance
                  at**
                **December
                  31,**
                **2006****Debt
                  Principal:**Argyle
              
              $
              1,188,000
              
              $
              -
              
              $
              -
              
              $
              -
              
              $
              1,188,000November
                  financing
              
              
              10,000,000
              
              
              -
              
              
              -
              
              
              -
              
              
              10,000,000November
                  financing discounts for:Beneficial
                  conversion feature
              
              
              (100,060
              )
              
              -
              
              
              52,200
              
              
              -
              
              
              (47,860
              )Reimbursement
                  of investor's legal fees
              
              
              (63,889
              )
              
              -
              
              
              33,333
              
              
              -
              
              
              (30,556
              )AIR
                  or note purchase option
              
              
              (683,938
              )
              
              -
              
              
              358,440
              
              
              -
              
              
              (325,498
              )**Total
                  Convertible Notes**
              
              $
              10,340,113
              
              $
              -
              
              $
              443,973
              
              $
              -
              
              $
              10,784,086**Accrued
                  Interest:**Accrued
                  Argyle 6%
              
              $
              -
              
              $
              71,280
              
              $
              -
              
              $
              (71,280
              )
              $
              -Beneficial
                  interest
              
              
              -
              
              
              1,085,853
              
              
              -
              
              
              (1,085,853
              )
              
              -November
                  financing
              
              
              84,932
              
              
              992,663
              
              
              (247,923
              )
              
              (745,319
              )
              
              84,353**Total
                  Accrued Interest**
              
              $
              84,932
              
              $
              2,149,796
              
              $
              (247,923
              )
              $
              (1,902,452
              )
              $
              84,353**Balance
                  at December 31,**
                **2004**
              
              
              **Addition
                  or New Discount**
              
              
              **(Payment)
                  or Discount Amortization**
              
              
              **Conversion
                  to Equity**
              
              
              **Balance
                  at December 31,**
                **2005****Debt
                  Principal:**Argyle
              
              $
              1,188,000
              
              $
              -
              
              $
              -
              
              $
              -
              
              $
              1,188,000Argyle
                  discount
              
              
              (11,000
              )
              
              -
              
              
              11,000
              
              
              -
              
              
              -November
                  financing
              
              
              10,000,000
              
              
              -
              
              
              -
              
              
              -
              
              
              10,000,000November
                  financing discounts for:Beneficial
                  conversion feature
              
              
              (152,260
              )
              
              -
              
              
              52,200
              
              
              -
              
              
              (100,060
              )Reimbursement
                  of investor's legal fees
              
              
              (97,222
              )
              
              -
              
              
              33,333
              
              
              -
              
              
              (63,889
              )AIR
                  or note purchase option
              
              
              (1,042,378
              )
              
              -
              
              
              358,440
              
              
              -
              
              
              (683,938
              )**Total
                  Convertible Notes**
              
              $
              9,885,140
              
              $
              -
              
              $
              454,973
              
              $
              -
              
              $
              10,340,113**Accrued
                  Interest:**Accrued
                  Argyle 6%
              
              $
              -
              
              $
              71,280
              
              $
              -
              
              $
              (71,280
              )
              $
              -Beneficial
                  interest
              
              
              -
              
              
              845,597
              
              
              -
              
              
              (845,597
              )
              
              -November
                  financing
              
              
              84,932
              
              
              1,002,740
              
              
              (1,002,740
              )
              
              -
              
              
              84,932**Total
                  Accrued Interest**
              
              $
              84,932
              
              $
              1,919,617
              
              $
              (1,002,740
              )
              $
              (916,877
              )
              $
              84,932




The
      maturity date of the Senior Secured Convertible Notes is November 2007.
      Consequently, we have classified the balance related to these notes, of
      $9,596,086 at December 31, 2006 as a current debt in the consolidated balance
      sheet. The $1,188,000 outstanding balance of the Argyle notes continues to
      be
      classified as long-term debt at December 31, 2006 as they are due on December
      31, 2008.





Non-cash
      interest expense is as follows:


2006
              
              2005
              
              2004Amortization
                  of Senior Secured Convertible Notes
              
              $
              443,973
              
              $
              443,973
              
              $
              36,998Senior
                  Secured Convertible Notes 10% interest paid in common
                  stock
              
              
              745,319
              
              
              -
              
              
              -Amortization
                  of Argyle note discount
              
              
              -
              
              
              11,000
              
              
              22,000Liquidated
                  damages on the October 2005, January 2006,September
                  2006 and November 2006 financing
              
              
              517,817
              
              
              79,000
              
              
              -Beneficial
                  conversion privileges of interest on Argyle note
              
              
              1,085,853
              
              
              845,597
              
              
              728,780Amortization
                  of prepaid financing costs
              
              
              63,431
              
              
              50,936
              
              
              3,258Total
                  non-cash interest expense
              
              $
              2,856,393
              
              $
              1,430,506
              
              $
              791,036
  68
 
 SPATIALIGHT,
            INC.
 NOTES
            TO
            CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
            31, 2006, 2005 AND 2004


**4.**
            **Balance
                Sheet Components**




Inventory
      as of December 31 consists of the following:


2006
              
              2005Raw
                  materials
              
              $
              531,114
              
              $
              796,770Work-in-progress
              
              
              26,088
              
              
              17,043Finished
                  goods
              
              
              161,285
              
              
              294,287718,487
              
              
              1,108,100Inventory
                  reserve
              
              
              (295,412
              )
              
              (351,377
              )Total
                  inventory
              
              $
              423,075
              
              $
              756,723





Property
      and equipment as of December 31, consists of the following:


2006
              
              2005(RestatedSee
                  Note 1)Building
              
              $
              3,305,102
              
              $
              4,360,663Other
                  equipment and instruments
              
              
              2,332,603
              
              
              2,659,653Machinery
                  and manufacturing equipment
              
              
              1,688,943
              
              
              1,141,726Office
                  furniture and equipment
              
              
              463,414
              
              
              590,696Tooling
              
              
              371,700
              
              
              371,700Leasehold
                  improvements
              
              
              165,937
              
              
              175,654Computer
                  software and hardware
              
              
              352,825
              
              
              215,109Total
                  property, plant and equipment
              
              
              8,680,524
              
              
              9,515,201Accumulated
                  depreciation
              
              
              (3,474,598
              )
              
              (2,701,681
              )Property,
                  plant and equipment, net
              
              $
              5,205,926
              
              $
              6,813,520





*Impairment
      loss* . We
      recorded an asset impairment loss of $1,429,925 related to our building in
      South
      Korea in the quarter ended December 31, 2006, in accordance with SFAS 144,
      “ *Accounting
      for the Impairment or Disposal of Long-Lived Assets* ”
based
      upon the estimated fair value of the building. On
      July
      24, 2007, we received evidence that LG Electronics (“LGE”) communicated its
      intention to terminate our Supply Agreement to Mr. Don Suh, in October 2006,
      in
      the form of an email to Mr. Suh’s personal email account. The mid-October email
      to Mr. Suh from LGE was first disclosed to SpatiaLight executives during
      settlement discussions by LGE’s legal counsel on July 24, 2007. At the time of
      the October 2006 email, Mr. Suh was our Senior Vice President for Marketing
      and
      Sales. He was later appointed to Chief Executive Officer on November 6, 2006,
      and was subsequently terminated on December 12, 2006. O n
      March
      9, 2007, we received oral notification from LGE of their intent to discontinue
      the production of all rear projection televisions. As a result of the October
      2006 email, we concluded that the asset impairment loss related to our building
      in South Korea should be recorded in the fourth quarter of 2006.





We
      considered the loss of LGE as a customer a significant change in circumstances
      which indicated the need for an impairment analysis, based on undiscounted
      cash
      flows. While we believe that we will find other customers for our products,
      we
      do not currently have existing customers to support estimated cash flows to
      achieve the recoverability of the asset and our forecast of future revenues,
      at
      this point, is speculative. Further, we receive
      a 100% land lease payment exemption because the facility is located on land
      designated a “free economic zone” by the South Korean national government and
      the South Korean government has certified us as a “high technology” company.
      Under our agreement with the Gyeongnam provincial government we could lose
      our
      land lease payment exemption in the event that we lose our “high technology”
certification. If we were to lose the lease, we might be required to donate
      the
      building to the South Korean government.




In
      determining the fair value of the building, we considered an independent
      appraisal which took into account the building’s overall structure, materials,
      and current condition. Based upon our analysis, the building’s estimated fair
      value was less than the net book value. As a result, the carrying value of
      the
      building has been reduced by $1,429,925 with a corresponding charge to
      impairment loss on the consolidated statement of operations.




69




SPATIALIGHT,
        INC.
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
        31, 2006, 2005 AND 2004


Accrued
      expenses and other current liabilities as of December 31, consist of the
      following:


2006
              
              2005Deferred
                  rent
              
              $
              212,886
              
              $
              269,843Accrued
                  compensation
              
              
              446,438
              
              
              184,283Accrued
                  interest on senior secured convertible notes
              
              
              84,932
              
              
              84,932Accrued
                  financing fee
              
              
              149,353
              
              
              -Liquidated
                  damages
              
              
              145,750
              
              
              79,000Accrued
                  legal, accounting and consulting related services
              
              
              706,643
              
              
              741,855Other
              
              
              47,230
              
              
              29,514Total
                  accrued expenses and other current liabilities
              
              $
              1,793,232
              
              $
              1,389,427


Depreciation
      and amortization expense was $864,064, $728,383, and $575,391 for the years
      ended December 31, 2006, 2005 and 2004, respectively.





Rent
      expense related to operating leases was $557,576, $675,339, and $585,897 for
      the
      years ended December 31, 2006, 2005 and 2004, respectively.





We
      lease
      our office space under a non-cancelable operating lease. The lease expires
      in
      August 2009 and is subject to escalations in rent. Rent expense is recorded
      evenly over the lease term. Deferred rent of $212,886, $269,843 and $314,611
      was
      recorded as of December 31, 2006, 2005, and 2004, respectively.





Future
      lease obligations under non-cancelable operating leases as of December 31,
      2006
      are as follows:


**Year**
              
              **Amount**2007
              
              $
              459,0402008
              
              
              471,7682009
              
              
              320,651Total
              
              $
              1,251,459




In
      September 2004, we entered into a fifty year term lease with the Gyeongnam
      provincial government for 8.3 acres of undeveloped land in Jinsa, Gyeongnam
      province in South Korea. We leased the land for the purpose of constructing
      a
      state-of-the-art manufacturing facility with the anticipated capacity to meet
      mass production-scale demand from our customers and prospective customers.
      We
      have received a 100% land lease payment exemption because the land has been
      designated a “free economic zone” by the South Korean national government and
      the South Korean government also certified us as a “high technology” company.
      Under our agreement with the Gyeongnam provincial government we could lose
      our
      land lease payment exemption in the event that we lose our “high technology”
certification.





**5.**
            **Income
                Taxes**





Income
      taxes consist primarily of state minimum taxes. Income tax expense (benefit)
      differed from the amounts computed by applying the U.S. federal income tax
      rate
      of 34% to pretax losses from operations as a result of the
      following:




70


SPATIALIGHT,
        INC.
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
        31, 2006, 2005 AND 2004
  2006
              
              2005
              
              2004(Restated
                  -See
                  Note 1)Computed
                  tax benefit at federal statutory rate
              
              $
              (6,935,000
              )
              $
              (4,768,000
              )
              $
              (3,185,000
              )Federal
                  research and development credit
              
              
              (51,000
              )
              
              (81,000
              )
              
              (91,000
              )Permanent
                  differences:Nondeductible
                  interest
              
              
              971,000
              
              
              486,000
              
              
              269,000Nondeductible
                  SFAS123R stock option expense
              
              
              638,000
              
              
              -
              
              
              -Foreign
                  earnings taxed at different rates, net ofunbenefitted
                  foreign losses
              
              
              (290,000
              )
              
              870,000
              
              
              -Other
              
              
              75,000
              
              
              (306,000
              )
              
              132,000Changes
                  in valuation allowances
              
              
              5,445,000
              
              
              4,967,000
              
              
              3,869,000State
                  tax benefit, net of effect on federal income taxes
              
              
              (94,000
              )
              
              (670,000
              )
              
              (252,000
              )Other,
                  net
              
              
              242,800
              
              
              (495,700
              )
              
              (740,525
              )Total
                  tax expense
              
              $
              1,800
              
              $
              2,300
              
              $
              1,475


The
      tax
      effect of temporary differences that give rise to significant portions of the
      deferred tax assets at December 31, is presented below:


2006
              
              2005(Restated
                  -Deferred
                  tax assets:
              
              See
                  Note 1)Federal
                  net operating loss carryforwards
              
              $
              27,106,000
              
              $
              24,168,000State
                  income tax effects and credits
              
              
              5,245,000
              
              
              5,186,000Korean
                  income tax effects
              
              
              2,664,000
              
              
              -Accrued
                  expenses
              
              
              17,000
              
              
              28,000Federal
                  research and development credits
              
              
              1,086,000
              
              
              1,031,000Options
                  and warrants
              
              
              806,000
              
              
              883,000Other
              
              
              178,000
              
              
              361,000Gross
                  deferred tax assets
              
              
              37,102,000
              
              
              31,657,000Valuation
                  allowance
              
              
              (37,102,000
              )
              
              (31,657,000
              )Net
                  deferred tax assets
              
              $
              -
              
              $
              -




The
      provision for income taxes attributable to pretax loss from operations follows,
      for the years ended December 31, 2006, 2005 and 2004.


2006
              
              2005
              
              2004(Restated
                  -See
                  Note 1)Loss
                  before income taxes:Domestic
              
              $
              13,413,834
              
              $
              11,485,540
              
              $
              9,228,446International
              
              
              6,983,153
              
              
              2,539,099
              
              
              138,555Total
              
              $
              20,396,987
              
              $
              14,024,639
              
              $
              9,367,001





The
      net
      change in the total valuation allowance was $5,445,000, $4,967,000 and
      $3,869,000 in 2006, 2005 and 2004, respectively. As of December 31, 2006, we
      had
      net operating loss carryforwards of approximately $79.7 million for federal,
      $66.1 million for state tax purposes and $2.7 million for South Korean purposes,
      respectively, which expire in varying amounts from 2007 through 2026 for federal
      purposes and through 2016 for state purposes, and 2009 through 2011 for South
      Korean purposes. In addition, as of December 31, 2006, we had research and
      development carryforwards of approximately $1,086,000 for federal tax purposes,
      which will begin to expire in 2008 and $1,212,000 for state tax purposes, which
      do not expire.





71
 
 SPATIALIGHT,
          INC.
 NOTES
          TO
          CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
          31, 2006, 2005 AND 2004


The
      Company analyzes its deferred tax assets with regard to potential realization.
      The Company has established a full valuation allowance on its deferred tax
      assets because management could not conclude that it was more likely than not
      that such deferred tax assets would be realized.





Under
      the
      provisions of the Internal Revenue Code, should substantial changes in our
      ownership occur, the utilization of net operating loss carryforwards might
      be
      limited.





Included
      in the net operating loss carryforwards are tax benefits created resulting
      from
      tax deductions in excess of share-based compensation expense recognized under
      the fair value recognition provisions of SFAS 123R (windfall tax benefits).
      Although these windfall tax benefits are reflected in the total net operating
      tax loss carryforwards, pursuant to SFAS 123R, deferred tax assets associated
      with these deductions are only recognized to the extent that they reduce taxes
      payable. Further, these recognized deductions are treated as direct increases
      to
      stockholders’ equity (deficit) and as a result do not impact the Consolidated
      Statement of Operations. To the extent stock-option related deductions are
      not
      recognized pursuant to SFAS 123R, the unrecognized benefit is not reflected
      on
      the Consolidated Balance Sheet. We
      have
      elected to continue to reflect our gross net operating loss carryforward
      deferred tax assets and related valuation allowance for the accumulated stock
      award tax benefits determined under Accounting Principles Board (“APB”) Opinion
      No. 25, “ Accounting for Stock Issued to Employees ” (“APB 25”). We will track
      these stock award attributes separately and will only realize these attributes
      in accordance with SFAS 123(R). These additional tax benefits of net operating
      loss carryforwards related to the tax benefit from the exercise of stock awards
      were $1.6 million in both 2006 and 2005.





**6.**
            **Stockholders’
                Equity (Deficit)**





*Stock
      Option Plans* - In
      2006 the Stockholders approved the 2006 Incentive Plan (the 2006 Plan). In
      1999
      the Stockholders approved the 1999 Stock Option Plan (the 1999 Plan), which
      in
      turn replaced our 1993 Non-Statutory Employee Stock Option Plan, the 1993
      Non-Statutory Director Stock Option Plan, and the 1991 Stock Option Plan. The
      2006 Plan authorizes the issuance of options to purchase up to 5,000,000 shares
      of our common shares. The 2006 Plan provides for the grant of incentive stock
      options, within the meaning of Section 422 of the Internal Revenue Code,
      nonqualified stock options, share appreciation rights, share purchase awards,
      restricted shares, restricted stock units, performance units, and other
      share-based awards. Key employees, directors, and third party service providers
      who are selected by the designated committee are eligible to participate in
      the
      plan. Third party providers include any consultant, agent, advisor, or
      independent contractor who renders services to us, or to any of our subsidiaries
      or affiliates, that are not in connection with the offer and sale of our
      securities in a capital raising transaction and do not directly or indirectly
      promote or maintain a market for our securities. The 1999 Plan authorized the
      issuance of options to purchase up to 4,000,000 shares of our common shares.
      It
      also provided for options which may be issued as nonqualified or qualified
      incentive stock options under Section 422A of the Internal Revenue Code of
      1986,
      as amended.





In
      June
      2002, the Stockholders approved an amendment to the 1999 Stock Option Plan
      to
      increase the maximum number of shares that can be issued pursuant to award
      grants made under the Plan by 1,000,000 common shares, raising the total number
      of common shares reserved for issuance thereunder to 5,000,000.





In
      July
      2004, the Stockholders approved an amendment to the 1999 Stock Option Plan
      to
      increase the maximum number of shares that can be issued pursuant to award
      grants made under the Plan by 2,000,000 common shares, raising the total number
      of common shares reserved for issuance thereunder to 7,000,000.





Under
      the
      1999 Plan, we may grant options to employees at prices not less than 85% of
      fair
      market value for non-statutory stock options, and to directors at the fair
      market value at the date of grant.





Options
      under the 1999 Plan are granted to Executive Officers at the discretion of
      the
      Board of Directors/Compensation Committee. Options granted to employees and
      consultants are at the discretion of the CEO. Options under the 2006 Plan are
      granted at the discretion of the Board of Directors/Compensation Committee.
      Options under both plans generally expire 10 years from the date of grant and,
      in general, vest and become exercisable 50% at the end of year one and 50%
      at
      the end of year two. Changes to the vesting period may be made at the discretion
      of the Board of Directors/Compensation Committee.





Stock
      option grants to employees are generally issued with an exercise price equal
      to
      the market price on the day before the grant date. To the extent that the market
      price of the common stock exceeds the exercise price of the options, the Company
      recognizes deferred compensation for the intrinsic value in accordance with
      APB
      25 and FIN 44. The Company amortizes deferred compensation on a straight-line
      basis over the vesting period of the option.





Option
      grants to non-employees are valued at the date of grant using the Black-Scholes
      option-pricing model in accordance with FAS 123. Option grants that do not
      include sufficient disincentive for non-performance are accounted for in
      accordance with EITFs 96-18 and 00-18. In such instances, the deferred
      compensation is amortized over the term of the agreement on a straight-line
      basis. Until the awards are fully vested or a measurement date is achieved,
      the
      Company records an adjustment to deferred compensation and consultant expense
      to
      reflect the impact of the fair value, as re-measured at quarter-end, of the
      options based on changes to the Company's stock price.





72
 
 SPATIALIGHT,
          INC.
 NOTES
          TO
          CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
          31, 2006, 2005 AND 2004


The
      following is a status of the options under the Plans and outside of the Plans
      and a summary of the changes in options outstanding during 2006, 2005 and 2004:


**Number
                  of Shares**
              
              **Weighted
                  Average Exercise Price**
              
              **Weighted
                  Average Remaining Contractual Term (in Years)**
              
              **Aggregate
                  Intrinsic Value at**
                **December
                  31,**
                **2006**Outstanding
                  January 1, 2004
              
              
              4,962,333
              
              $
              3.26Options
                  granted under the plan
              
              
              1,122,500
              
              $
              5.39Options
                  exercised
              
              
              (465,083
              )
              $
              2.49Options
                  cancelled
              
              
              (161,250
              )
              $
              4.43Outstanding
                  December 31, 2004
              
              
              5,458,500
              
              $
              3.89Options
                  granted under the plan
              
              
              735,000
              
              $
              5.03Options
                  exercised
              
              
              (213,606
              )
              $
              2.08Options
                  cancelled
              
              
              (97,500
              )
              $
              5.90Outstanding
                  December 31, 2005
              
              
              5,882,394
              
              $
              4.06
              
              
              5.79Options
                  granted under the plan
              
              
              900,000
              
              $
              2.57Options
                  exercised
              
              
              (50,000
              )
              $
              0.80Options
                  cancelled
              
              
              (1,012,500
              )
              $
              8.10Outstanding
                  December 31, 2006
              
              
              5,719,894
              
              $
              3.15
              
              
              5.80
              
              $
              162,270Options
                  vested and exercisableat
                  December 31, 2006
              
              
              5,657,394
              
              $
              3.14
              
              
              5.77
              
              $
              162,270





At
      December 31, 2006, 870,000 of the options outstanding were granted outside
      of
      the 2006 and 1999 Plans. Options exercisable as of December 31, 2006 and 2005
      totaled 5,657,394 and 5,302,394 options, respectively, at a weighted average
      exercise price of $3.14 and $3.55 per share, respectively. Of the options
      exercisable as of December 31, 2006, 870,000 options were issued outside of
      the
      2006 and 1999 Plans at a weighted average exercise price of $1.50.





Aggregate
      intrinsic value is the sum of the amounts by which the quoted market price
      of
      our stock at December 29, 2006 (the last trading day of 2006), $1.35 per share,
      exceeded the exercise price of the options, for those options for which the
      quoted market price was in excess of the exercise price
      (“in-the-money-options”). The aggregated intrinsic value of options exercised on
      the dates the options were exercised was $112,865 and $1,512,567 for the year
      ended December 31, 2006 and 2005, respectively.




As
      of
      December 31, 2006, total expected compensation cost of options outstanding
      but
      not yet vested is approximately $57,593. This cost is expected to be recognized
      through June 2008. We recorded no income tax benefits for stock-based
      compensation expense arrangements for the years ended December 31, 2006, 2005
      and 2004, as we have cumulative operating losses, for which a full valuation
      allowance has been established.




The
      weighted average exercise price of options granted during 2006, 2005 and 2004
      are as follows:


2006
              
              2005
              
              2004Exercise
                  price equals market price
              
              $
              2.57
              
              $
              5.03
              
              $
              2.18Exercise
                  price is less than market price
              
              
              -
              
              
              -
              
              
              -Exercise
                  price is more than market price
              
              
              -
              
              
              -
              
              
              -
  73


SPATIALIGHT,
        INC.
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
        31, 2006, 2005 AND 2004


Additional
      information regarding options outstanding as of December 31, 2006 is as follows:


**Options
                  Outstanding**
              
              **Options
                  Exercisable**Range
                  of Exercise Prices
              
              Outstanding
                  at December 31, 2006
              
              Weighted
                  Average Remaining Contractual Life (Yrs.)
              
              Weighted
                  Average Exercise Price
              
              Number
                  Exercisable
              
              Weighted
                  Average Exercise Price$6.01
                  - 9.00
              
              
              10,000
              
              
              8.0
              
              $
              8.35
              
              
              10,000
              
              $
              8.35$5.01
                  - 6.00
              
              
              952,500
              
              
              7.1
              
              $
              5.43
              
              
              952,500
              
              $
              5.43$4.01
                  - 5.00
              
              
              745,000
              
              
              7.8
              
              $
              4.93
              
              
              707,500
              
              $
              4.93$3.01
                  - 4.00
              
              
              489,444
              
              
              5.1
              
              $
              3.60
              
              
              489,444
              
              $
              3.60$2.01
                  - 3.00
              
              
              2,333,750
              
              
              6.9
              
              $
              2.45
              
              
              2,308,750
              
              $
              2.45$1.01
                  - 2.00
              
              
              945,000
              
              
              4.5
              
              $
              1.52
              
              
              945,000
              
              $
              1.52$0.25
                  - 1.00
              
              
              244,200
              
              
              1.4
              
              $
              0.69
              
              
              244,200
              
              $
              0.695,719,894
              
              
              
              
              
              
              
              
              5,657,394


At
      December 31, 2006, 5,204,166 options were available for future grants under
      the
      2006 and 1999 Plans.





*Warrants
      outstanding and exercisable*





Additional
      information regarding warrants outstanding as of December 31, 2006 is as
      follows:





**Warrants
                  Outstanding and Exercisable**Exercise
                  Price
              
              Outstanding
                  at December 31, 2006
              
              Remaining
                  Contractual Life (Yrs.)$
                  1.75
              
              
              4,872,000
              
              
              4.9$
                  2.25
              
              
              89,189
              
              
              4.7$
                  2.65
              
              
              323,296
              
              
              1.4$
                  3.29
              
              
              123,465
              
              
              1.6$
                  5.00
              
              
              228,576
              
              
              3.85,636,526


*Diluted
      net loss per share*




Diluted
      net loss per share does not include the effect of the following potential common
      shares at December 31:




2006
              
              2005
              
              2004Shares
                  issuableunder
                  stock options
              
              
              5,719,894
              
              
              5,882,394
              
              
              5,458,500Shares
                  issuable pursuant to warrants to purchase common shares
              
              
              5,636,526
              
              
              750,337
              
              
              746,761Shares
                  of convertible notes on an "as if converted" basis
              
              
              3,404,807
              
              
              3,404,807
              
              
              3,404,807


The
      weighted average exercise price of stock options outstanding was $3.15, $4.06,
      and $3.89 as of December 31, 2006, 2005, and 2004 respectively. The weighted
      average exercise price of warrants was $1.98, $3.96, and $3.12, per share as
      of
      December 31, 2006, 2005 and 2004, respectively.





74
 
 SPATIALIGHT,
            INC.
 NOTES
            TO
            CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
            31, 2006, 2005 AND 2004


**7.**
            **Quarterly
                Results (Unaudited)**





Summarized
        unaudited results of operations for each quarter of the years ended December
        31,
        2006 and
        December 31, 2005 are as follows:
  First
                  Quarter
              
              Second
                  Quarter
              
              Third
                  Quarter
              
              Fourth
                  QuarterYear
                  EndedDecember
                  31, 2006Revenue
              
              $
              85,694
              
              $
              59,148
              
              $
              298,046
              
              $
              31,116Gross
                  margin
              
              $
              (1,462,636
              )
              $
              (1,542,866
              )
              $
              (1,367,278
              )
              $
              (1,014,860
              )Loss
                  before cumulativeeffect
                  of change inaccounting
                  principle
              
              $
              5,632,669
              
              $
              5,304,581
              
              $
              4,173,985
              
              $
              5,061,759Cumulative
                  effect of changein
                  accounting principle
              
              $
              -
              
              $
              -
              
              $
              -
              
              $
              (223,993
              )Net
                  loss
              
              $
              5,632,669
              
              $
              5,304,581
              
              $
              4,173,985
              
              $
              5,285,752Net
                  loss per share - basic and diluted:Loss
                  per share beforecumulative
                  effect of changein
                  accounting principle
              
              $
              (0.15
              )
              $
              (0.13
              )
              $
              (0.10
              )
              $
              (0.12
              )Cumulative
                  effect of changein
                  accounting principle
              
              $
              -
              
              $
              -
              
              $
              -
              
              $
              (0.01
              )Net
                  loss per share
              
              $
              (0.15
              )
              $
              (0.13
              )
              $
              (0.10
              )
              $
              (0.12
              )First
                  Quarter
              
              
              Second
                  Quarter
              
              
              Third
                  Quarter
              
              
              Fourth
                  QuarterYear
                  EndedDecember
                  31, 2005Revenue
              
              $
              97,759
              
              $
              41,149
              
              $
              58,457
              
              $
              40,359Gross
                  margin
              
              $
              27,915
              
              $
              (47,895
              )
              $
              965
              
              $
              (1,500,350
              )Net
                  loss
              
              $
              2,148,535
              
              $
              3,524,447
              
              $
              3,620,751
              
              $
              4,730,906Basic
                  and diluted loss per share
              
              $
              (0.06
              )
              $
              (0.10
              )
              $
              (0.10
              )
              $
              (0.13
              )


**8.**
            **Inventory
                Reserves**


Balance
                  at Beginning of Period
              
              Additions
                  - Charged to Expense
              
              Deductions
                  - and Writeoffs Charged to Reserves
              
              Balance
                  at End of PeriodYear
                  ended December 31, 2006Inventory
                  allowance
              
              $
              351,377
              
              $
              444,364
              
              $
              (500,329
              )
              $
              295,412Year
                  ended December 31, 2005Inventory
                  allowance
              
              $
              -
              
              $
              351,377
              
              $
              -
              
              $
              351,377Year
                  ended December 31, 2004Inventory
                  allowance
              
              $
              210,000
              
              $
              -
              
              $
              (210,000
              )
              $
              -




**9.**
            **Management
                Changes**





On
      June
      13, 2006, Theodore H. Banzhaf resigned as our Executive Vice President of
      Strategic Planning and as President and Chief Executive Officer of SpatiaLight
      Technologies, Inc., a non-active wholly owned subsidiary, effective immediately.
      Mr. Banzhaf’s vested options to purchase 265,000 common shares of the Company
      awarded pursuant to his Time Accelerated Restricted Stock Award Plan expired
      on
      September 13, 2006. Pursuant to a General Release contract between Mr. Banzhaf
      and us, Mr. Banzhaf received his current salary through September 9, 2006.





JeWon
      Yeun resigned as our President of SpatiaLight Korea, effective May 31,
      2006.





75


SPATIALIGHT,
      INC.


NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
      31, 2006, 2005 AND 2004





On
      November 3, 2006, Robert A. Olins resigned as our Chief Executive Officer,
      Secretary, Treasurer and a Director, effective immediately. In accordance with
      a
      severance agreement dated December 12, 2006, Mr. Olins will continue to work
      with us on a consultant basis, for $1,500 per week for a period of 13 months.
      We
      may also, upon approval of the stockholders at our 2007 Annual Meeting, exchange
      all outstanding stock options granted to Mr. Olins for a number of shares of
      our
      common stock that is equal to the value of the outstanding options as of the
      date of stockholder approval of the option exchange. The value of the options
      will be determined in accordance with the Black-Scholes valuation method, based
      on the assumptions used in valuing our stock options under SFAS
      123R.





On
      November 3, 2006, the Company’s Board of Directors elected Don S. Suh, 49, as
      the Company’s Chief Executive Officer, replacing Robert A. Olins. On December
      12, 2006, Mr. Suh’s employment was terminated and his non-vested options were
      cancelled as of that date.





On
      November 3, 2006, the Company’s Board of Directors appointed David F. Hakala, 54
      to be the Chairman of the Board of Directors, replacing Lawrence Matteson who
      remained on the Board through December 31, 2006. Dr. Hakala was also appointed
      as the Principal Accounting Officer. Dr. Hakala continues in the capacity as
      Chief Operating Officer. On December 12, 2006 Dr. Hakala was appointed our
      Chief
      Executive Officer in addition to his other responsibilities.





On
      December 31, 2006, Lawrence Matteson resigned from the Board of
      Directors.





**10.**
            **Commitments
                and Contingencies**





*Lease
      Commitments*





Our
      lease
      commitments are described in Note 4. As discussed in Note 4, in September 2004,
      we entered into a fifty year term lease with the Gyeongnam provincial government
      for 8.3 acres of undeveloped land in Jinsa, Gyeongnam province in South Korea.
      We have received a 100% land lease payment exemption because the land has been
      designated a “free economic zone” by the South Korean national government and
      the South Korean government also certified us as a “high technology” company.
      Under our agreement with the Gyeongnam provincial government we could lose
      our
      land lease payment exemption in the event that we lose our “high technology”
certification, which could increase the costs of operating the facility and
      negatively impact our business. Additionally, if we were to lose the lease,
      we
      might be required to donate the building to the South Korean
      government.





*Alleged
      Events of Default on Senior Secured Convertible Notes*





Certain
      allegations of events of default related to the November 30, 2004 Financing
      have
      been communicated to us as more fully described in Note 3.




*Guarantees
      and Indemnifications*




As
      permitted under New York law and in accordance with our Bylaws, we indemnify
      our
      officers and directors for certain events or occurrences while the officer
      or
      director is or was serving at the Company’s request in such capacity. The term
      of the indemnification period is for the officer’s or director’s lifetime. The
      maximum amount of potential future indemnification is unlimited. We are unable
      to estimate the fair value of these indemnification agreements and accordingly,
      we have not recorded any liabilities for these agreements as of
      December 31, 2006.





*Other*





In
      connection with his departure, Don Suh, our former Chief Executive Officer,
      has
      filed a claim against the Company alleging the Company violated the
      Sarbanes-Oxley Whistleblower laws and is asking for severance of $250,000 plus
      a
      year’s worth of benefits. We do not believe that his assertions have merit but
      cannot predict the ultimate outcome of any potential litigation.





We
      are
      not currently involved in any other material legal proceedings. We are a party
      to routine claims and lawsuits from time to time in the ordinary course of
      business. While the outcome of such ordinary course proceedings cannot be
      predicted with certainty, we believe that the resolution of any future ordinary
      course matters individually or in the aggregate will not have a material adverse
      effect on our business, financial condition or results of operations.





*U.S.
      Securities and Exchange Commission Investigations*





As
      previously reported in our post-effective amendments to the Form S-3
      Registration Statement registering the common shares underlying the Senior
      Secured Convertible Notes (the “Financing Registration Statement”) (File No.
      333-122391) and the Form S-3 Registration Statement registering common shares
      on
      a “shelf” (the “Shelf Registration Statement”) (File No. 333-122392), we filed
      an unauthorized consent of BDO Siedman LLP to Amendment Nos. 5 and 6 to the
      Financing Registration Statement and to Amendment Nos. 3 and 4 to the Shelf
      Registration Statement in order to incorporate by reference their report on
      our
      consolidated financial statements for the fiscal years ended December 31, 2002
      and 2003, respectively. Although we received the requisite authorized consents
      from BDO Seidman LLP to incorporate by reference their report on the
      consolidated financing statements into the Financing Registration Statement
      and
      the Shelf Registration Statement when initially filed and in subsequent
      amendments thereto (and BDO Seidman LLP has not withdrawn these subsequent
      consents), we did not receive the requisite authorization from BDO Seidman
      LLP
      to file its consent as an exhibit to the penultimate and final pre-effective
      amendments to either the Financing Registration Statement or the Shelf
      Registration Statement (i.e. Amendment Nos. 5 and 6 and Amendment Nos. 3 and
      4
      to the respective registration statements). The penultimate and final
      pre-effective amendments to both the Financing Registration Statement and the
      Shelf Registration Statement were filed with the SEC on July 27, 2005.




76


SPATIALIGHT,
        INC.
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
        31, 2006, 2005 AND 2004




The
      Audit
      Committee of our Board of Directors conducted an investigation and review of
      the
      developments pertaining to the BDO Seidman LLP consent issue with the assistance
      of independent counsel.





The
      Audit
      Committee delivered its draft report, dated October 31, 2005, to our then-Chief
      Executive Officer, Robert A. Olins. The Report concluded that the evidence
      does
      not support a finding that any of our employees included the unauthorized BDO
      Seidman LLPconsents in the amendments to the Registration Statements referred
      to
      above with fraudulent intent or with specific knowledge that BDO Seidman LLP
      had
      not authorized the filing of these consents. It concluded that the evidence
      was
      consistent with our inclusion of the consents due to lack of communication,
      a
      series of misunderstandings and/or a failure of inquiry. As to Mr. Olins, the
      Report concluded that the Audit Committee found no evidence that Mr. Olins
      was
      informed that BDO Seidman LLP had not authorized the filing of these consents.
      However, it also found no evidence that Mr. Olins inquired or determined whether
      BDO Seidman LLP had in fact authorized inclusion of the consents in these
      filings. The Audit Committee Report determined that Mr. Olins, as our Chief
      Executive Officer, did not exercise sufficient diligence in supervising the
      filing of the amendments to the Registration Statements, that this was a
      particularly serious failing in light of the SEC having highlighted the need
      for
      consents from BDO Seidman LLP, and that as CEO he bears responsibility for
      the
      filings. The Audit Committee also stated its belief that, throughout the process
      of preparing and filing the amendments to the Registration Statements, Mr.
      Olins
      acted with our best interests and the best interests of our stockholders in
      mind, and that his lack of diligence was not motivated by self-interest and
      that
      nothing related to this incident personally benefited him financially.





The
      Audit
      Committee recommended three remedial actions. It concluded that the membership
      of the Board of Directors should be supplemented with a financial expert within
      the meaning of SEC rules. It also concluded that we must improve our corporate
      governance and disclosure controls, including hiring a full-time Chief Financial
      Officer and a Controller (who can be the same person). It further concluded
      that
      by reason of Mr. Olins' responsibility as CEO for supervision of corporate
      filings, he should reimburse us for the sum of $50,000, a portion of the costs
      incurred by us by reason of the unauthorized BDO Seidman LLP consents and the
      resulting inquiries. In compliance with the Audit Committee Report, in December
      2005, Mr. Olins made the $50,000 payment to reimburse the Company. To date,
      our
      Board of Directors has not been supplemented with a financial expert and
      although we have not hired a fulltime CFO or Controller, we have hired a
      Director of Accounting and Finance.





We
      have
      been advised by the Staff of the SEC that the Staff is conducting an
      investigation into matters and events pertaining to the filing of the
      unauthorized BDO consents. We have been cooperating fully with the Staff with
      respect to this matter.





As
      discussed in Note 2 - Short Swing Profits and SEC Investigation, the Staff
      of
      the SEC is conducting an investigation into transactions in our securities
      by
      Mr. Olins and an entity he controls. We have been cooperating fully with the
      Staff with respect to this matter.





*Other
      matters*





Following
      the filing in July 2005 of amendment number 6 to the Financing Registration
      Statement and amendment number 4 to the “shelf” registration statement, which
      contained the unauthorized consents referred to above, the Staff of the SEC
      declared both of the registration statements effective. In August 2005, we
      filed
      post-effective amendments number 1 to both of these registration statements
      (those post-effective amendments were subsequently withdrawn and replaced by
      additional post-effective amendments), which disclosed the filing of the
      unauthorized consents.





Because
      both registration statements were used to sell common shares after the Staff
      of
      the SEC declared the registration statements effective, it is conceivable that
      there may be litigation against us or our officers or directors under Section
      11
      of the Securities Act. Although we do not believe that the filing of an invalid
      consent constitutes a materially misleading statement or an omission to disclose
      a material fact within the meaning of Section 11 of the Securities Act, a
      contrary determination could result in a liability for us.




77




At
      present, we are unable to ascertain the exact amount of damages, if any, to
      which we could potentially be subject under a Section 11 claim instituted by
      any
      persons who directly purchased shares pursuant to those registration statements.
      Furthermore, at this date, we cannot ascertain the amount of damages, if any,
      for which we could be liable for claims instituted by any subsequent purchasers
      who could trace the shares purchased by them to those registration statements.
      In August 2005, we sold 500,000 common shares to three institutional purchasers
      for $5.40 per share pursuant to the “shelf” registration statement referenced
      herein. Each of those investors has since represented to us in writing, in
      connection with a separate transaction, that they have disposed of all of those
      shares. One of those institutional investors has represented to us that it
      sold
      those shares at a sale price at or higher than its purchase price from us.
      We
      believe, based upon discussions with the other two investors, that they sold
      their shares at a sale price of not lower than $4.25 per share. Therefore,
      we
      believe that our maximum damages pursuant to Section 11 claims from direct
      purchasers, which we would fully contest, would be $391,000, or the difference
      between the two investor’s purchase price and lowest believed resale price,
      multiplied by the 340,000 shares that they purchased and then
      resold.





In
      addition to any damage claims, which may be material to our financial condition,
      any lawsuit alleging securities law violations could require us to expend
      significant financial and managerial resources.




**11.**
            **Subsequent
                Events after December 31,
                2006**





On
      February 14, 2007, our $75,000,000 Shelf registration statement (333-137100)
      was
      declared effective.





On
      February 23, 2007, when the price of our common stock was $1.31, we sold to
      five
      institutional buyers that participated in the November 2006 Financing, an
      aggregate of 2,190,477 of our common shares at a purchase price of $1.05 per
      share. In addition, we issued 600,000 shares of our common stock, valued at
      $786,000, as a fee to obtain a one-time waiver of contractual prohibitions
      under
      the November 2006 Financing against offering shares of our common stock for
      less
      than $1.30 per share. We received aggregate proceeds of $2.3 million, before
      issuance costs, from the sale of these shares, which will be used for working
      capital and other corporate purposes. We made the sale pursuant to our “shelf”
registration statement on Form S-3 (File No. 333-137100), which was declared
      effective by the SEC on February 14, 2007.





On
      March
      6, 2007, we entered into First Amendments to Registration Rights Agreement
      amending the Registration Rights Agreements dated September 26, 2006 between
      the
      Company and each of Bluegrass Growth Fund, L.P. and Bluegrass Growth Fund,
      LTD.
      In exchange for the forgiveness of accrued liquidated damages under the
      Registration Rights Agreement in the amount of $30,806 and the rescission of
      an
      obligation to issue 250,000 warrants to purchase Common Shares, the Company
      issued to Bluegrass Growth Fund, L.P. and Bluegrass Growth Fund, LTD. an
      aggregate of 500,000 Common Shares. The Common Shares, valued at $545,000 were
      issued on March 6, 2007, when the price of our common stock was $1.09, were
      issued pursuant to the Company’s Registration Statement on Form S-3 (File No.
      333-137100), which was declared effective by the U.S. Securities and Exchange
      Commission on February 14, 2007.




78


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





None.





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





*Disclosure
      Controls and Internal Controls.* **** As
      of
      December 31, 2006, under the supervision of our principal executive and
      financial officer (CEO), we evaluated the effectiveness of the design and
      operation of our "disclosure controls and procedures", as such term is defined
      under Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934,
      as
      amended (Disclosure Controls), and our "internal controls and procedures for
      financial reporting" (Internal Controls).




*Limitations
      on the Effectiveness of Controls.* Our CEO
      does not expect that our Disclosure Controls or our internal control over
      financial reporting will prevent all error and all fraud. A control system,
      no
      matter how well conceived and operated, can provide only reasonable, not
      absolute, assurance that the control system’s objectives will be met. Further,
      the design of a control system must reflect the fact that there are resource
      constraints, and the benefits of controls must be considered relative to their
      costs. We have only had limited revenue derived from the sale of our
      microdisplay products in the current reporting period and since we commenced
      operations. While the evaluation of our Disclosure Controls and Procedures
      and
      Internal Controls has accounted for such limited sales and revenue, new or
      additional controls may or may not be required once we begin selling our
      microdisplay products in increased volume in the ordinary course of business.
      Because of the inherent limitations in all control systems, no evaluation of
      controls can provide absolute assurance that all control issues and instances
      of
      fraud, if any, within the Company have been detected. These inherent limitations
      include the realities that judgments in decision-making can be faulty, and
      that
      breakdowns can occur because of simple error or honest mistake. Additionally,
      controls can be circumvented by the individual acts of some persons, by
      collusion of two or more persons, or by management override of the controls.
      The
      design of any system of controls also is based in part upon certain assumptions
      about the likelihood of future events, and there can be no assurance that any
      design will succeed in achieving its stated goals under all potential future
      conditions. Over time, specific controls may or may not become inadequate (e.g.,
      when we commence to sell our products in increased volume in the ordinary course
      of business) because of changes in conditions or deterioration in the degree
      of
      compliance with policies or procedures. Because of the inherent limitations
      in a
      cost-effective control system, misstatements due to error or fraud may occur
      and
      not be detected.




**Conclusion
      regarding the Effectiveness of Disclosure Controls and
      Procedures**




As
      of
      December 31, 2006, the end of the period covered by this Annual Report, our
      Chief Executive and Financial Officer (the “Certifying Officer”) conducted
      evaluations of our Disclosure Controls and Procedures. As defined under Sections
      13a-15(e) and 15d-15(e) of the Exchange Act, the term “Disclosure Controls and
      Procedures” means controls and other procedures of an issuer that are designed
      to ensure that information required to be disclosed by the issuer in the reports
      that it files or submits under the Exchange Act is recorded, processed,
      summarized and reported, within the time periods specified in the SEC’s rules
      and forms. Disclosure Controls and Procedures include, without limitation,
      controls and procedures designed to ensure that information required to be
      disclosed by an issuer in the reports that it files or submits under the
      Exchange Act is accumulated and communicated to our management, including our
      chief executive and financial officer, to allow timely decisions regarding
      required disclosure. Based on his evaluation, for the reasons set forth below,
      the Certifying Officer has concluded that our Disclosure Controls and Procedures
      were not effective to ensure that material information is recorded, processed,
      summarized and reported by management on a timely basis in order to comply
      with
      our disclosure obligations under the Exchange Act, and the rules and regulations
      promulgated thereunder.




**Management’s
      Report on Internal Control Over Financial Reporting**




Our
      management, under the supervision of the Certifying Officer, is responsible
      for
      establishing and maintaining adequate internal control over financial reporting
      as defined in Rule 13a-15(f) under the Exchange Act. An internal control system
      is designed to provide reasonable assurance regarding the preparation and fair
      presentation of published financial statements. Management has assessed the
      effectiveness of our internal control over financial reporting as of December
      31, 2006. In making its assessment of internal control over financial reporting,
      management used the criteria set forth by the Committee of Sponsoring
      Organizations (“COSO”) of the Treadway Commission in its report entitled
“Internal Control—Integrated Framework.”





Internal
      control over financial reporting is a process designed to provide reasonable
      assurance regarding the reliability of financial reporting and the preparation
      of financial statements for external purposes in accordance with GAAP. Internal
      control over financial reporting includes those policies and procedures
      that:





·
            pertain
                to the maintenance of records that, in reasonable detail, accurately
                and
                fairly reflect our transactions and dispositions of the
                assets;




79




·
            provide
                reasonable assurance that transactions are recorded as necessary
                to permit
                preparation of financial statements in accordance with GAAP, and
                that our
                receipts and expenditures are being made only in accordance with
                authorizations of our management and Board of Directors;
                and




·
            provide
                reasonable assurance regarding prevention or timely detection of
                unauthorized acquisition, use, or disposition of our assets that
                could
                have a material effect on the financial
                statements.





A
      material weakness in internal control over financial reporting is a control
      deficiency (within the meaning of the Public Company Accounting Oversight Board
      Auditing Standard No. 2), or combination of control deficiencies, that results
      in there being more than a remote likelihood that a material misstatement of
      the
      annual or interim financial statements will not be prevented or
      detected.





Because
      of its inherent limitations, internal control over financial reporting may
      not
      prevent or detect misstatements. It is also a process that involves human
      diligence and compliance and may be subject to lapses in judgment and breakdowns
      resulting from human judgments. Internal control over financial reporting can
      also be circumvented by collusion or improper management override. Furthermore,
      projections of any evaluation of effectiveness to future periods are subject
      to
      the risks that controls may become inadequate because of changes in condition,
      or that the degree of compliance with the policies or procedures may
      deteriorate.





As
      a
      result of our assessment, performed on the basis of the COSO criteria,
      management has identified the material weaknesses in annual financial reporting
      set forth below, and has concluded that, based on the specified criteria, we
      did
      not maintain effective internal control
      over financial reporting as of December 31, 2006.





The
      material weaknesses identified were:





·
            Our
                Audit Committee does not have a financial expert (as defined by SEC
                rules).


·
            We
                lack a qualified financial executive to perform independent secondary
                reviews over complex and non-routine accounting matters to ensure
                they are
                reported in accordance with GAAP.


·
            We
                lack information technology controls and procedures that would likely
                prevent unauthorized access to the accounting and financial systems,
                and
                ensure that the accounting and financial records are recoverable
                in the
                event of a disaster.


·
            We
                do not maintain formal accounting policies and procedures related
                to the
                updating of standard costs and reviewing variances with actual costs
                to
                ensure the accuracy and appropriateness of the valuation of
                inventory.




**Remediation
      Plans**





Management
      has reported to the Audit Committee the identification of the material
      weaknesses identified in its assessment. We intend to pursue the following
      corrective actions during fiscal year 2007 to address the material weaknesses
      we
      have identified. Our remediation plans include:





Corporate
      governance - We have not taken any steps, as of the date of this filing, to
      address the material weaknesses relating to the facts that the audit committee
      does not have a financial expert, as defined by SEC rules. We do not presently
      have specific plans with respect to adding a director who would constitute
      a
      financial expert, nor for the addition of financial executive management to
      perform independent secondary reviews over complex and non-routine accounting
      matters, though we may engage a third party provider to provide such a service
      on a consultant basis.





We
      will
      institute formal accounting policies and procedures relating to Information
      Technology and to the updating of standard costs and reviewing of variances
      with
      actual costs during 2007.





SpatiaLight,
      Inc.'s independent auditors have issued an attestation report on management's
      assessment of the company's internal control over financial reporting. Such
      report immediately follows this report.





80




**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING**


**FIRM
      ON INTERNAL CONTROL OVER FINANCIAL REPORTING**





To
      the
      Board of Directors and Stockholders of


SpatiaLight,
      Inc.





We
      have
      audited management's assessment, included in the accompanying Management's
      Report on Internal Control Over Financial Reporting, that SpatiaLight, Inc.
      (“Company”) did not maintain effective internal control over financial reporting
      as of December 31, 2006, because of the effect of material weaknesses identified
      in management's assessment, based on criteria established in Internal Control
      -
      Integrated Framework issued by the Committee of Sponsoring Organizations of
      the
      Treadway Commission (the COSO criteria). SpatiaLight, Inc.'s management is
      responsible for maintaining effective internal control over financial reporting
      and for its assessment of the effectiveness of internal control over financial
      reporting. Our responsibility is to express an opinion on management's
      assessment and an opinion on the effectiveness of the Company's internal control
      over financial reporting based on our audit.





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





A
      company's internal control over financial reporting is a process designed to
      provide reasonable assurance regarding the reliability of financial reporting
      and the preparation of financial statements for external purposes in accordance
      with generally accepted accounting principles. A company's internal control
      over
      financial reporting includes those policies and procedures that (1) pertain
      to
      the maintenance of records that, in reasonable detail, accurately and fairly
      reflect the transactions and dispositions of the assets of the company; (2)
      provide reasonable assurance that transactions are recorded as necessary to
      permit preparation of financial statements in accordance with generally accepted
      accounting principles, and that receipts and expenditures of the company are
      being made only in accordance with authorizations of management and directors
      of
      the company; and (3) provide reasonable assurance regarding prevention or timely
      detection of unauthorized acquisition, use, or disposition of the company's
      assets that could have a material effect on the financial
      statements.





Because
      of its inherent limitations, internal control over financial reporting may
      not
      prevent or detect misstatements. Also, projections of any evaluation of
      effectiveness to future periods are subject to the risk that controls may become
      inadequate because of changes in conditions, or that the degree of compliance
      with the policies or procedures may deteriorate.





A
      material weakness is a control deficiency, or combination of control
      deficiencies, that results in more than a remote likelihood that a material
      misstatement of the annual or interim financial statements will not be prevented
      or detected. The following material weaknesses have been identified and included
      in management's assessment:





·
            The
                Audit Committee does not have a financial expert (as defined by SEC
                rules).




·
            The
                Company does not currently have a qualified financial executive to
                perform
                independent secondary reviews over complex and non-routine accounting
                matters to ensure they are reported in accordance with
                GAAP.




·
            The
                Company lacks information technology controls and procedures that
                would
                likely prevent unauthorized access to the accounting and financial
                systems, and ensure that the accounting and financial records are
                recoverable in the event of a
                disaster.




·
            The
                Company does not maintain formal accounting policies and procedures
                related to the updating of standard costs and reviewing variances
                with
                actual costs to ensure the accuracy and appropriateness of the valuation
                of inventory.





These
      material weaknesses were considered in determining the nature, timing, and
      extent of audit tests applied in our audit of the 2006 consolidated financial
      statements, and this report does not affect our report dated March 15, 2007
      on
      those consolidated financial statements.





In
      our
      opinion, management's assessment that SpatiaLight, Inc. did not maintain
      effective internal control over financial reporting as of December 31, 2006
      is
      fairly stated, in all material respects, based on the COSO criteria. Also,
      in
      our opinion, because of the effect of the material weaknesses described above
      on
      the achievement of the objectives of the control criteria, SpatiaLight, Inc.
      has
      not maintained effective internal controls over financial reporting as of
      December 31, 2006 based on the COSO criteria.




81




We
      have
      also audited, in accordance with the standards of the Public Company Accounting
      Oversight Board (United States), the consolidated balance sheets of SpatiaLight,
      Inc. and its subsidiaries as of December 31, 2006 and 2005, and the related
      consolidated statements of operations, stockholders’ equity (deficit) and cash
      flows for each of the three years in the period ended December 31, 2006 and
      our
      report dated March 15, 2007 (which includes a matter of emphasis paragraph
      relating to SpatiaLight, Inc.’s ability to continue as a going concern),
      expressed an unqualified opinion thereon.







/s/
      ODENBERG, ULLAKKO, MURANISHI & CO. LLP





San
      Francisco, California


March
      15,
      2007




**Item
      9B.**  **Other
      Information.**




None




82


**PART
      III**





**Item
      10.**  **Directors,
      Executive Officers and Corporate Governance.**





**DIRECTORS
      AND EXECUTIVE OFFICERS OF THE COMPANY**





**Name**
            
            **Age**
            
            **Position(s)**David
                F. Hakala
            
            54
            
            Chief
                Executive Officer, Chief Operating Officer, Principle Financial and
                Accounting Officer, Chairman of Board of DirectorsMichael
                S. Jin
            
            43
            
            Chief
                Technology OfficerClaude
                Piaget
            
            65
            
            DirectorJerilyn
                Kessel
            
            47
            
            DirectorHerbert
                Ehrenthal
            
            69
            
            DirectorRobert
                C. Munro
            
            79
            
            Director





All
      Directors serve for terms of one year and until their successors are duly
      elected. All officers serve at the pleasure of the Board of Directors. There
      are
      no family relationships between any of our directors and officers.





**David
      F. Hakala** ,
      Chief
      Operating Officer since September 2002. Dr. Hakala was elected to the Board
      of
      Directors in June 2006. On November 3, 2006, Dr. Hakala became our Principal
      Financial and Accounting Officer as well as the Chairman of our Board of
      Directors in addition to his former duties. On December 12, 2006, Dr. Hakala
      became our Chief Executive Officer, in addition to his former duties. During
      the
      course of his career, Dr. Hakala has been directly responsible for the
      manufacturing startup and ramp-up of numerous products, and their associated
      manufacturing facilities, including several models of HDTV and of HDTV-ready
      televisions, the DTC-100 HD TV/DBS decoder box, the decoder box for the DirecTV
      DBS satellite system as well as 31” and 35” Very Large Screen (VLS) direct view
      CRTs. Prior to joining SpatiaLight, from 1994 to 2001, Dr. Hakala served in
      various senior management positions with Thomson Multimedia, including Vice
      President of Manufacturing Operations, and most recently as Vice President,
      Product Development, Americas, in which he was responsible for the design and
      development of television and video systems, including digital television with
      integrated HDTV decoders, projection systems and other advanced display systems,
      including the Thomson RCA L50000 LCoS project.





**Michael
      S. Jin** ,
      Chief
      Technology Officer since July 7, 2004, joined SpatiaLight in April 2000, and
      has
      directed SpatiaLight’s efforts to develop and enhance LCoS cell structure,
      processing technologies and overall product performance. Dr. Jin has also served
      as a leader on the technical front in growing our relationships with television
      OEMs throughout Asia. Prior to joining SpatiaLight, Dr. Jin served as a Vice
      President and the Principal Investigator for New Interconnect and Packaging
      Technology, Inc., based in San Diego, CA, working on numerous DARPA, STTR and
      SBIR programs in the areas of Optoelectronic Interconnects, Volumetric 3-D
      Displays Based on 2-Photon Transition Materials, MEMS Laser Beam Steering
      Devices, 3-D Optoelectronic and IC Packaging Technologies and Phase-Shift Masks
      for High-Resolution Lithography. Previously, Dr. Jin was engaged in developing
      thin film devices for laser fusion research at the University of Rochester
      Laboratory for Laser Energetics. Dr. Jin received his Bachelor’s and Master’s
      degrees in Optics from the University of Rochester and his Ph.D. in Applied
      Physics from the University of California at San Diego.





**Claude
      Piaget** ,
      director since June 2001, served as Chief Executive Officer and Senior Vice
      President, International Relations of Digital Video Broadcasting, a global
      consortium involved in the promotion of unified worldwide standards for digital
      television. Dr. Piaget’s broad industry experience includes several executive
      positions with Philips Electronics, including market development manager from
      1995 to 1997, company strategy expert from 1994 to 1995 and development manager
      from 1986 to 1994. Previously, he was involved in researching semiconductor
      physics, components, devices and systems. He has participated in the development
      of information and communication technologies and consortiums in Europe, Asia
      and Latin America. He holds a Masters degree in Physics Engineering and a Ph.D.
      in Physics from the University of Paris.





**Jerilyn
      Kessel** ,
      elected
      to the Board of Directors in June 2006 is a Strategic Marketing and Consumer
      Research and Business Development Consultant with an expansive list of A-list
      clients in the Media, Filmed Entertainment and Telecommunication Industries
      including leading television networks, film studios, internet companies and
      telecom businesses.  Ms.  Kessel is best known for her analytic
      insights into consumers’ adoption of new technology formats and audiences’
changing viewing habits across expanding media options.  Ms. Kessel teamed
      with ICR Survey Research in 1997 to create CENTRIS sm ,
      a
      leading media research service.  In October 2005, Ms. Kessel left CENTRIS
      to return to her consulting practice full time.  In March 2003, Ms. Kessel
      became a principle in Brand Advisors, LLC (a subsidiary of The Salter Group,
      a
      company that provides financial forecasts and valuations for television and
      film).   From September 1999 through February 2002, she was a Founding
      Partner in Global Media Ventures, LLC.  Beginning in 1996, Ms. Kessel was a
      founding partner of WebFeat, Inc., which was then acquired by American
      Interactive Media, Inc. in 1997.  In 1993, Ms. Kessel joined Entertainment
      Made Convenient (Emc 3 )
      as part
      of its founding management team, serving as Senior Vice President Program
      Planning & Marketing.   Ms. Kessel served as Managing Director of
      Video Flash, which she co-founded, from 1987 through 1990 and a Senior
      Consultant at the New York based management consulting firm of Alexander and
      Associates.  Ms. Kessel is a graduate of The Wharton School at the
      University of Pennsylvania where she majored in Finance and Entrepreneurial
      Management.




83




**Herbert
      Ehrenthal** ,
      elected
      to the Board of Directors in June 2006, is currently Vice President Global
      Advertising and Marketing at Schering-Plough Corporation, the global
      research-based pharmaceutical company, where he has been since 2003. Mr.
      Ehrenthal is responsible for directing the creation of all consumer
      communication programs and initiatives on a worldwide basis across all
      Schering-Plough pharmaceutical brands. Prior to joining Shering-Plough, Mr.
      Ehrenthal was an Executive Director at Pharmacia Corporation (now Pfizer),
      responsible for all overseas consumer activities. In 1987, Mr. Ehrenthal founded
      Rubin Ehrenthal and Associates. He pioneered one of the first successful Direct
      to Consumer marketing programs in the United States. That agency merged in
      1991
      and was renamed Healthworld. Mr. Ehrenthal became President and COO when
      Healthworld went public in November 1997, where he continued his career at
      the
      agency through 2001 when it was purchased by a conglomerate, at which time
      he
      retired from his positions as President and COO and a member of the Board.
      Mr.
      Ehrenthal is a graduate of City College in New York where he majored in
      History.





**Robert
      C. Munro** ,
      director since February 2004, has served as a private business consultant in
      the
      finance, banking and retail industries in the United States, the United Kingdom
      and throughout Europe since 1985. He currently sits on the board of directors
      of
      UNET 2 Corporation, a privately held electronic publishing company based in
      New
      York. Mr. Munro is a Fellow of the Institute of Directors in the United Kingdom.
      He has extensive global business experience in the banking, real estate and
      shipping industries. Mr. Munro received a Master’s degree from Edinburgh
      University in Scotland.





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




Section
      16(a) of the Securities Exchange Act of 1934, as amended, requires directors,
      executive officers and persons who beneficially own more than 10% of our common
      shares to file with the SEC initial reports of ownership and reports of changes
      in ownership of common shares and other equity securities. Executive officers,
      directors and greater than 10% shareholders are required by SEC regulations
      to
      furnish us with copies of all Section 16(a) reports they file. Except as set
      forth below, to our knowledge, based solely on a review of the copies of such
      reports furnished to the Corporation for fiscal 2005, executive officers,
      directors and greater than 10% shareholders filed the required Section 16(a)
      reports of material transactions in a timely manner in 2006.





Robert
      A.
      Olins, our former Chief Executive Officer, Secretary, Treasurer and a Director
      failed to report the sale of an aggregate of 70,556 of our common shares in
      August 2005 and February 2006 at sales prices ranging from $5.30 to $3.00.
      Pursuant to Section 16 of the Exchange Act, in July 2006, Mr. Olins has filed
      the delinquent reports and disgorged $22,273 in “short swing profits” that he
      realized from the sales. These funds are recorded as an increase in additional
      paid in capital during the third quarter 2006.





**Code
      of Ethics**





We
      have a
      Code of Business Conduct and Ethics which is applicable to all of our employees
      including the principal executive officer, the principal financial officer
      and
      the principal accounting officer or Controller. The Code of Business Conduct
      and
      Ethics and any amendments or waivers are available on our website
      www.spatialight.com under Corporate Governance.





**Audit
      Committee**





The
      Audit
      Committee of the Board of Directors (which is formed in compliance with section
      3(a)(58)(A) of the Securities and Exchange Act of 1934) bears primary
      responsibility for our financial statements and for our reporting process,
      including our system of internal controls. The primary purpose of our Audit
      Committee is to monitor: (1) the integrity of our financial statements; (2)
      our
      compliance with legal and regulatory requirements; (3) the independence and
      performance of our external auditors; and (4) the adequacy of our internal
      controls. The Audit Committee consists of three directors that meet the
      independence standards of the SEC and NASD and met 13 times during last fiscal
      year. From January 1, 2006 through June 30, 2006, the members of the Audit
      Committee were Messrs. Matteson, Munro (Chair), and Piaget. From July 1, 2006
      through December 31, 2006, the members of the Audit Committee were Messrs.
      Matteson and Piaget and Ms. Kessel (Chair). After December 31, 2006, the members
      of the Audit Committee were Dr. Piaget and Ms. Kessel. Mr. Munro was elected
      to
      the Audit Committee on February 2, 2007. The Audit Committee is responsible
      for
      the appointment, retention and termination of a firm of independent registered
      public accountants and monitoring the effectiveness of the audit effort, our
      financial and accounting organization and our system of internal accounting
      and
      disclosure controls. However, none of the members of the Audit Committee qualify
      as an Audit Committee Financial Expert, as defined by SEC rules. The Audit
      Committee has reviewed and discussed the audited financial statements with
      management and has discussed with Odenberg, Ullakko, Muranishi & Co., LLP
      their independence and the matters required under Auditing Standard No. 61.
      The
      Audit Committee has recommended to the Board of Directors that the audited
      financial statements be included in our annual report on Form 10-K for 2006.
      Our
      limited resources have made it difficult to recruit an individual with the
      necessary qualifications to serve as a financial expert. The Audit Committee
      Charter is available on our website.




84




**Item
      11.**  **Executive
      Compensation.**





The
      following Compensation Discussion and Analysis describes the material elements
      of compensation for the executive officers identified in the Summary
      Compensation Table (“Named Executive Officers”). As more fully described below,
      the Compensation Committee of the Board of Directors (the “Committee”) makes all
      decisions for the total direct compensation, including the amount of base
      salaries and bonuses, and timing and terms of equity based compensation award
      for the Executive Officers of the Company. The Committee’s recommendations for
      the total direct compensation of the Company’s Chief Executive Officer are
      subject to approval of the Board of Directors.





**Compensation
      Program Discussion and Analysis**





Our
      compensation and benefits programs are intended to attract, retain and motivate
      individuals with the necessary scientific, engineering and business knowledge
      and experience to accomplish our overall business objectives and to motivate
      these individuals to devote their time and energy for the benefit of our
      stockholders. Consequently, the guiding principles of our compensation programs
      are:





·
            simplicity,
                clarity, and fairness to both the employee and the
                Company;


·
            preservation
                of Company resources;


·
            delivery
                of sufficient current cash compensation to attract and retain accomplished
                individuals in a highly competitive market;
                and


·
            opportunity
                to receive significant compensation if the Company is
                successful.




Each
      element of our compensation program contributes to these overall goals in a
      different way.





·
            Base
                Salary and Benefits are designed to provide a minimum threshold to
                attract
                and retain employees identified as necessary for our
                success.


·
            Cash
                Bonuses are designed to reward employees for accomplishment of annual
                goals or performance criteria that have been determined by the Board
                of
                Directors to support our long-term operational
                goals.


·
            Stock
                and option awards and individual incentive arrangements are designed
                to
                provide a long-term incentive to individuals that are critical to
                our
                success as reflected in the market price of our common
                stock.




*Base
      Salaries*





Executive
      officer base salaries are based on job responsibilities and individual
      contribution, with reference to base salary levels of executives at peer
      developmental electronic components companies. The goal of the Committee is
      to
      maintain base salaries at sufficient levels to prevent the loss of key
      executives without providing an industry-leading salary structure. The Committee
      proposes base salaries for the executive officers listed in “Summary of
      Compensation” (the “Named Executive Officers”) for approval by the Board of
      Directors every year based on information provided by the Company’s Chief
      Executive Officer. Mr. Olins was not paid a base salary during 2005 and the
      Compensation Committee did not authorize a salary for Mr. Olins during 2006
      because it was believed that Mr. Olins’ long-term incentives were sufficient to
      reward him for his services to the Company. The Compensation Committee
      recommended and the Board of Directors approved the payment of a housing and
      automobile allowance of $100,372 during 2006. Mr. Olins, our former Chief
      Executive Officer, proposed, the Committee recommended, and the Board of
      Directors approved, a 10% increase in the base salary of Mr. Hakala on the
      basis
      of the increased responsibility assigned to the Chief Operating Officer and
      the
      compensation paid to other executives in similar positions. There were no
      changes to the salaries paid to the other Named Executive Officers during
      2006.




*Cash
      Bonuses*





Cash
      bonuses are awarded on the proposal of the Chief Executive Officer, the
      recommendation of the Compensation Committee and the approval of the Board
      of
      Directors when it is determined that an individual has accomplished a
      significant short-term goal identified as supporting the long-term performance
      or profitability of the Company, or when necessary to correct inconsistencies
      between the salary paid to a Named Executive Officer and other executives of
      the
      Company or of other companies that are similarly situated. No cash bonuses
      were
      awarded during 2006.




85




*Stock
      and Option Awards*





Awards
      under the Company’s 2006 Incentive Plan, the 1999 Stock Option Plan (the
“Plans”) or under individual incentive agreements are used to encourage Named
      Executive Officers to have a strategic outlook and to conform their economic
      incentives with the interests of our stockholders. The type and amount of award
      is based upon job responsibilities, potential for individual contribution to
      Company performance, total cash compensation in the form of base salary and
      bonuses, and the number of previous awards then outstanding or exercisable.
      The
      Compensation Committee is authorized to grant Awards under the Company’s Plans
      on its own without proposal from the Chief Executive Officer or the approval
      of
      the Board of Directors. However, in most cases, the awards are initiated by
      the
      Chief Executive Officer. The Compensation Committee does not have a regular
      schedule for awarding equity-based compensation and the timing of such awards
      is
      subject to the discretion of the Compensation Committee. On February 2, 2006,
      as
      part of the general review of competitive salary structures within the Company,
      the Compensation Committee awarded options to purchase 500,000 shares of common
      stock at $2.60 per share to Mr. Olins and options to purchase 150,000 shares
      of
      common stock at $2.60 per share to Mr. Suh. The difference between the number
      of
      options awarded reflects the different responsibilities of the individuals
      and
      that no base salary is paid to Mr. Olins. The Compensation Committee believes
      that the level of awards made to the Named Executive Officers in 2006 is
      consistent with the level of responsibility, other compensation paid, and
      company performance that is within such individual’s control.





Stock
      options provide for financial gain derived from the potential appreciation
      in
      stock price from the date that the option is granted until the date that the
      option is exercised. The exercise price of stock option grants is set at fair
      market value on grant date. Under the Plans, the Compensation Committee may
      not
      grant stock options at a discount to fair market value or reduce the exercise
      price of outstanding stock options except in the case of a stock split or other
      similar event. The Company’s long-term performance ultimately determines the
      value of stock options, because gains from stock option exercises are entirely
      dependent on the long-term appreciation of the Company’s stock price. Because a
      financial gain from stock options is only possible after the price of our common
      stock has increased, we believe grants encourage executives and other employees
      to focus on behaviors and initiatives that should lead to an increase in the
      price of our common stock, which benefits all our stockholders.





We
      do not
      backdate options or grant options retroactively or stock options with a
      so-called “reload” feature. In addition, we do not plan to coordinate grants of
      options so that they are made before announcement of favorable information,
      or
      after announcement of unfavorable information.





*Impact
      of Section 162(m) of the Code*





The
      Compensation Committee has considered the potential impact of Section 162(m)
      of
      the Code, adopted under the Revenue Reconciliation Act of 1993. This section
      disallows a tax deduction for any publicly held corporation, for individual
      compensation exceeding $1,000,000 in any taxable year paid the Named Executive
      Officers unless (1) the compensation is payable solely on account of the
      attainment of performance goals, (ii) the performance goals are determined
      by a
      committee of two or more outside directors, (iii) the material terms under
      which
      compensation is to be paid are disclosed to and approved by shareholders and
      (iv) the committee certifies that the performance goals were met. Our 1999
      Stock
      Option Plan and 2006 Incentive Plan were approved by our Shareholders so that
      compensation attributable to stock options and certain other awards granted
      under such plans may be excluded from the $1,000,000 threshold.





The
      Compensation Committee continues to consider other steps which might be in
      the
      Company’s best interest to comply with Section 162(m), while reserving the right
      to award future compensation which would not comply with the Section 162(m)
      requirements for non-deductibility if the Compensation Committee concluded
      that
      this was in the Company’s best interests.




86




The
      following table sets forth the compensation paid by us for the fiscal year
      ended
      December 31, 2006, to our Chief Executive Officer and all of the other executive
      officers as of December 31, 2006.




**SUMMARY
        COMPENSATION TABLE - 2006**
 
 Name
                  and Principal Position
              
              Year
              
              Salary
                  ($)
              
              Stock
                  Awards ($)
              
              
              
              All
                  Other Compensation
              
              Total
                  ($)(a)
              
              (b)
              
              (c
                  )
              
              (e)
              
              (f)
              
              (i)
              
              (j)Robert
                  A. Olins, former Chief Executive Officer, Treasurer, Secretary
                  and
                  Principal Financial and Accounting Officer
              
              
              2006
              
              $
              -
              
              $
              966,500
              
              
              (2)
              
              $
              100,372
              (1)
              $
              1,066,872David
                  F. Hakala, Chief Executive Officer effective December 12, 2006,
                  Chief
                  Operating Officer and Principal Financial and Accounting
                  Officer
              
              
              2006
              
              $
              256,154
              
              $
              -
              
              
              
              
              $
              -
              
              $
              256,154Michael
                  S. Jin, Chief Technology Officer
              
              
              2006
              
              $
              200,000
              
              $
              -
              
              
              
              
              $
              -
              
              $
              200,000Don
                  S. Suh, Chief Executive Officer from November 3, 2006 to December
                  12,
                  2006, former Senior Vice President, Marketing & Sales
              
              
              2006
              
              $
              200,250
              
              $
              152,250
              
              
              (2)
              
              $
              -
              
              $
              352,500





(1)
            Represents
                (a) $75,179 paid by the Company for housing for Robert Olins and
                (b)
                $25,193 paid by the Company for a car for
              Mr.
                Olins.


(2)
            The
                assumptions used to derive the fair value of the stock option awards
                noted
                above are discussed in Footnote 1 to the Consolidated Financial
                Statements.




**Grants
      of Plan Based Awards**





The
      following table sets forth certain information for the year ended December
      31,
      2006, with respect to plan based awards granted to the individuals named in
      the
      Summary Compensation Table.


**GRANTS
        OF PLAN-BASED AWARDS - 2006**
 
 Name
              
              Grant
                  Date
              
              All
                  Other Option Awards: Number of Securities Underlying
                  Options
              
              Exercise
                  of Base Price of Option Awards ($/Sh)
              
              Grant
                  Date Fair Value of Stock and Option Awards(a)
              
              (b)
              
              (j)
              
              (k)
              
              (l)Robert
                  A. Olins
              
              
              2/6/2006
              
              
              500,000
              
              $
              2.60
              
              $
              966,500Don
                  S. Suh
              
              
              2/6/2006
              
              
              150,000
              
              $
              2.60
              
              $
              297,936




87




The
      following table sets forth total outstanding equity awards at year-end for
      the
      individuals names in the Summary Compensation Table.




**OUTSTANDING
        EQUITY AWARDS AT FISCAL YEAR END - 2006**
 
 Name
              
              Number
                  of Securities Underlying Unexercised Options (#)
                  Exercisable
              
              Option
                  Exercise Price ($)
              
              Option
                  Expiration Date(a)
              
              (b)
              
              (e)
              
              (f)Robert
                  A. Olins
              
              
              750,000
              
              $
              1.50
              
              
              6/5/2011Robert
                  A. Olins
              
              
              500,000
              
              $
              2.15
              
              
              8/22/2011Robert
                  A. Olins
              
              
              489,444
              
              $
              3.60
              
              
              1/27/2012Robert
                  A. Olins
              
              
              300,000
              
              $
              2.49
              
              
              12/30/2012Robert
                  A. Olins
              
              
              200,000
              
              $
              2.10
              
              
              5/21/2013Robert
                  A. Olins
              
              
              285,417
              
              $
              5.21
              
              
              1/4/2014Robert
                  A. Olins
              
              
              179,583
              
              $
              5.60
              
              
              7/6/2014Robert
                  A. Olins
              
              
              500,000
              
              $
              4.97
              
              
              1/17/2015Robert
                  A. Olins
              
              
              500,000
              
              $
              2.60
              
              
              2/5/2016Total
                  Mr. Olins
              
              
              3,704,444David
                  F. Hakala
              
              
              335,000
              
              $
              2.66
              
              
              9/3/2012Michael
                  S. Jin
              
              
              20,000
              
              $
              4.94
              
              
              4/23/2010Michael
                  S. Jin
              
              
              5,000
              
              $
              1.25
              
              
              12/28/2010Michael
                  S. Jin
              
              
              15,000
              
              $
              1.93
              
              
              4/22/2011Michael
                  S. Jin
              
              
              35,000
              
              $
              5.10
              
              
              4/22/2012Michael
                  S. Jin
              
              
              125,000
              
              $
              5.60
              
              
              7/6/2014Michael
                  S. Jin
              
              
              100,000
              
              $
              4.97
              
              
              1/17/2015Total
                  Mr. Jin
              
              
              300,000Don
                  S. Suh
              
              
              150,000
              
              $
              5.55
              
              
              3/12/2007Don
                  S. Suh
              
              
              75,000
              
              $
              2.60
              
              
              3/12/2007Total
                  Mr. Suh
              
              
              225,000




The
      following table sets forth total options exercised and stock vested during
      2006
      for the individuals names in the Summary Compensation Table.




**OPTIONS
        EXERCISES AND STOCK VESTED - 2006**
 
 Option
                  AwardsName
              
              Number
                  of Shares Acquired on Exercise (#)
              
              Value
                  Realized on Exercise ($)(a)
              
              (b)
              
              (c
                  )Robert
                  A. Olins
              
              
              25,000
              
              $
              69,500




88




The
      following table sets forth Director compensation for 2006.


**DIRECTOR
        COMPENSATION - 2006**
 
 Name
              
              Option
                  Awards ($)
              
              Total
                  ($)(a)
              
              (d)
              
              (h)Lawrence
                  J. Matteson
              
              $
              85,112
              
              $
              85,112Claude
                  Piaget
              
              $
              85,112
              
              $
              85,112Robert
                  C. Munro
              
              $
              85,112
              
              $
              85,112Herbert
                  Ehrenthal
              
              $
              9,599
              
              $
              9,599Jerilyn
                  Kessel
              
              $
              9,599
              
              $
              9,599




The
      assumptions used to derive the fair value of the stock option awards noted
      above
      are discussed in Footnote 1 to the Consolidated Financial Statements. As of
      December 31, 2006 Mr. Matteson, who resigned from the Board of Directors as
      of
      December 31, 2006, had an aggregate of 279,500 options outstanding, Dr. Piaget
      had an aggregate of 175,000 options outstanding, Mr. Munro had an aggregate
      of
      75,000 options outstanding, and Mr. Ehrenthal and Ms. Kessel each had 25,000
      options outstanding.




**Employment
      Arrangements and Agreements**




Robert
      A.
      Olins served as one of our directors from 1998 to November 2006 and has also
      served as our Chief Executive Officer, Secretary and Treasurer of the
      Corporation from July 2000 to November 2006. Mr. Olins did not have an
      employment agreement. In accordance with a severance agreement dated December
      12, 2006, Mr. Olins will continue to work with us on a consultant basis, for
      $1,500 per week for a period of 13 months. In addition, subject to the approval
      by our shareholders, the severance agreement provides for the exchange of all
      outstanding options under Plans for Common Shares having a value on date of
      exchange equal to the fair market value of the options. The exchange will
      require approval by our shareholders at the next annual meeting. The value
      of
      the options will be determined in accordance with the Black-Scholes valuation
      method, based on the assumptions used in valuing our stock options under SFAS
      123R.




Don
      S.
      Suh served as our Senior Vice President - Marketing and Sales from July 19,
      2004
      and as our Chief Executive Officer from November 3, 2006 to December 12, 2006.
      We do not have an employment or separation agreement with Mr. Suh.




David
      F.
      Hakala has served as our Chief Operating Officer since September 3, 2002. On
      November 3, 2006, Dr. Hakala became our Principal Financial and Accounting
      Officer as well as the Chairman of our Board of Directors. On December 12,
      2006,
      Dr. Hakala became our Chief Executive Officer. We do not have an employment
      agreement with Dr. Hakala. We have extended Dr. Hakala’s employment by one-year
      extensions on the anniversary of his employment.




Michael
      S. Jin was promoted to Chief Technology Officer on July 7, 2004. We do not
      have
      an employment agreement with Dr. Jin.




**Compensation
      Committee Interlocks and Insider Participation**




No
      member
      of the Compensation Committee was an officer or former officer of the Company
      or
      had any material relationship or transactions with the Company and no officer
      of
      the Company sits on the compensation committee or other body that has the power
      to establish the compensation of any member of the Compensation
      Committee.




89




**Compensation
      Committee Report**





The
      Compensation Committee reviewed and discussed with the Company’s management the
      Compensation Discussion and Analysis for the year ended December 31, 2006.
      Based
      upon such review and Discussion, the members of the Compensation Committee
      recommended to the Board of Directors that the Compensation Discussion and
      Analysis for the year ended December 31, 2006 be included in the Company’s
      Annual Report on Form 10-K filed with the SEC.


Herbert
        Ehrenthal
 Claude
        Piaget




90




**Item
      12.**  **Security
      Ownership of Certain Beneficial Owners and Management and Related Shareholder
      Matters.**





The
      following table sets forth information regarding beneficial ownership of common
      shares as of March 14, 2007, by each person known by us to own beneficially
      more
      than five percent of our outstanding common shares, by each of our directors,
      and by each of our executive officers named in the Summary Compensation Table
      contained in “Executive Compensation,” and by all of our directors and executive
      officers as a group. Except as otherwise noted, each person named in the table
      has sole voting and investment power with respect to all common shares shown
      as
      beneficially owned by him, her or it.




**Name
                  and Address**
                **Beneficial
                  Owner**
              
              **Amount
                  and**
                **Nature
                  of Beneficial Ownership**
              
              
              
              **Percent
                  of Class**Robert
                  A. Olins
                Argyle
                  Capital Management Corp.
                27
                  De Silva Island, Mill Valley, CA 94941
              
              
              9,410,066
              
              
              (1
              )
              
              18.3
              %Wellington
                  Management Company, LLP
                75
                  State Street
                Boston,
                  Massachusetts 02109
              
              
              3,185,914
              
              
              (2
              )
              
              6.7
              %Adele
                  Becker
                215
                  E 68th Street
                New
                  York, NY 10021
              
              
              2,779,333
              
              
              (3
              )
              
              5.8
              %Herbert
                  Ehrenthal
                Five
                  Hamilton Landing, Suite 100
                Novato,
                  CA 94949
              
              
              531,275
              
              
              (4
              )
              
              *Lawrence
                  J. Matteson
                5
                  Hogan Ct.
                Pittsford,
                  NY 14534
              
              
              274,000
              
              
              (5
              )
              
              *Claude
                  Piaget
                Five
                  Hamilton Landing, Suite 100
                Novato,
                  CA 94949
              
              
              162,500
              
              
              (6
              )
              
              *Robert
                  C. Munro
                Five
                  Hamilton Landing, Suite 100
                Novato,
                  CA 94949
              
              
              62,500
              
              
              (7
              )
              
              *Jerilyn
                  Kessel
                Five
                  Hamilton Landing, Suite 100
                Novato,
                  CA 94949
              
              
              12,500
              
              
              (8
              )
              
              *David
                  F. Hakala
                Five
                  Hamilton Landing, Suite 100
                Novato,
                  CA 94949
              
              
              336,000
              
              
              (9
              )
              
              *Michael
                  S. Jin
                Five
                  Hamilton Landing, Suite 100
                Novato,
                  CA 94949
              
              
              315,255
              
              
              (10
              )
              
              *Don
                  S. Suh
                Five
                  Hamilton Landing, Suite 100
                Novato,
                  CA 94949
              
              
              230,000
              
              
              (11
              )
              
              *All
                  directors and officers as a group (7 persons)
              
              
              1,694,030
              
              
              
              
              
              3.5
              %





(1)
            Based
                solely upon information contained in Section 16 filings made by named
                shareholder, includes 2,376,000 Shares beneficially owned subject
                to
                conversion of principal of convertible notes held by Argyle Capital
                Management Corporation (Argyle), of which Mr. Olins is President
                and over
                which Mr. Olins exercises voting control, and 1,678,597 Shares owned
                by
                Argyle. Also includes 1,411,870 common shares and Warrants to purchase
                239,360 common shares held by Mr. Olins and 3,704,444 Shares subject
                to
                outstanding stock options held by Mr. Olins that are exercisable
                on or
                before May 13, 2007.




91




(2)
            Based
                solely upon information filed in a Schedule 13G by named
                stockholder.





(3)
            Based
                solely upon information provided by named
                stockholder.





(4)
            Includes
                518,775 Shares based on information filed in a Form 3 by named
                stockholder, 12,500 Shares subject to options exercisable on or before
                May
                13, 2007.





(5)
            Includes
                7,000 Shares based on information filed in a Form 3 by named stockholder,
                254,200 Shares subject to options exercisable on or before May 13,
                2007.





(6)
            Includes
                162,500 Shares subject to options exercisable on or before May 13,
                2007.





(7)
            Includes
                62,500 Shares subject to options exercisable on or before May 13,
                2007.





(8)
            12,500
                Shares subject to options exercisable on or before May 13,
                2007.





(9)
            Includes
                335,000 Shares subject to options exercisable on or before May 13,
                2007.





(10)
            Includes
                300,000 Shares subject to options exercisable on or before May 13,
                2007.





(11)
            Includes
                225,000 Shares subject to options exercisable on or before May 13,
                2007.





We
      pledged substantially all of our assets to the purchasers of our Senior Secured
      Convertible Notes in November 2004.  This pledge of assets could result in
      a change of control of our Company in the future.  Two holders of our
      Senior Secured Convertible Notes have alleged certain events of default under
      their Notes.  Although we believe that these allegations are not correct
      and are without foundation, this matter could potentially result in a change
      of
      control of the Company in the future.





Argyle
      Capital Management Corporation, a company owned and controlled by Robert A.
      Olins, our former Chief Executive Officer, Secretary, Treasurer and a former
      director, has a subordinated security interest in all assets, which could result
      in a change of control of the Company in the future.





**Item
      13.**  **Certain
      Relationships and Related Transactions, and Director
      Independence.**





The
      Company’s Code of Business Conduct and Ethics (the “Code”), which is available
      on the Company’s website (www.spatialight.com), prohibits all conflicts of
      interest. Under the Code, conflicts of interest occur when private or family
      interests interfere in any way, or even appear to interfere, with the interests
      of the Company. The Company’s prohibition on conflicts of interest under the
      Code includes any related person transaction. Any employee with knowledge of
      a
      conflict of interest, including a related party transaction, must notify the
      Chairman of our Audit Committee, who will undertake such review of the
      transaction as is appropriate. Any transaction between the Company and an
      officer or director of the Company must be approved by the Audit Committee
      or
      the Board of Directors. During the year ended December 31, 2006, the following
      related party transactions occurred with the approval of the Board of Directors.





*Argyle
      Notes:*





During
      the year ended December 31, 2006, the Company was indebted to Argyle Capital
      Management Corporation (Argyle), a company owned and controlled by Robert A.
      Olins, our former Chief Executive Officer, Secretary, Treasurer, and Director,
      in the amount of $1,188,000 pursuant to a series of promissory notes bearing
      interest at 6%, due December 31, 2008. Both principal and interest are
      convertible into our Common Shares at $0.50 per share and are secured by
      substantially all of our assets. Interest on these notes has been prepaid
      through December 31, 2008. At December 31, 2006, the carrying value of the
      Argyle notes was $1,188,000.





*Additional
      Financing Commitment*





In
      November 2004, Robert A. Olins, the Chief Executive Officer and a director
      of
      SpatiaLight, and Greenpark Limited, an unaffiliated shareholder of SpatiaLight,
      jointly and severally committed, in the event that the Board determines that
      such financing is necessary, to provide us with up to $6,000,000 in future
      financing on terms and conditions to be determined at the time of any such
      transaction. That financing commitment shall be reduced by any funds that
      SpatiaLight receives from future sales or exercises of its equity, debt or
      derivative securities, including the sale of our common shares under the
      Prospectus that we filed with the SEC on January 31, 2005, as part of a “shelf”
registration process. As of the date of this filing we have received an
      aggregate total of greater than $6 million and Mr. Olins and Greenpark Ltd.
      have
      no obligation under this commitment.




*Short-term
      Financing*




On
      December 16, 2005, we borrowed $224,384 from Robert A. Olins, our Chief
      Executive Officer and a director. Mr. Olins obtained these funds by drawing
      down
      on a personal line of credit from a bank, which is the same bank that we utilize
      for our domestic commercial banking requirements. Based upon discussions among
      Mr. Olins and other members of our Board of Directors, we have agreed to repay
      the borrowed funds to Mr. Olins on the same terms that he agreed to with the
      bank. Therefore, we were required to repay the full principal amount of the
      loan
      plus interest at a rate of 8.25% per annum on February 16, 2006, the maturity
      date. We have also agreed to reimburse Mr. Olins for a $30,000 fee that he
      was
      required to pay to the bank. We repaid the loan in and the fee was reimbursed
      to
      Mr. Olins in January 2006. Between September and November 2006, we borrowed
      an
      aggregate of $252,199 from Mr. Olins. These short-term loans were non-interest
      bearing, with a term of three months or less, and were completely paid off
      by
      the end of November 2006.




92




Between
      September and November 2006, we borrowed an aggregate of $355,000 from Mr.
      Herbert Ehrenthal, a director of our company. These notes bore interest at
      8%,
      with a term of three months or less, and were completely paid off by December
      1,
      2006.





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





The
      following table contains the fees billed to us for the last two fiscal years
      by
      Odenberg, Ullakko, Muranishi & Co., LLP, our current independent registered
      public accountants for the two years ended December 31, 2006.




2006
              
              2005Audit
                  Fees
              
              $
              435,937
              (1)
              $
              350,467
              (1)Audit-Related
                  Fees
              
              
              2,250
              (2)
              
              -Tax
                  Fees
              
              
              11,860
              (3)
              
              -All
                  Other Fees
              
              
              9,128





(1)
            Includes
                fees associated with the annual audit of consolidated financial statements
                and internal control over financial reporting in compliance with
                regulatory requirements under Sarbanes-Oxley Act of 2002, review
                of our
                quarterly reports on Form 10-Q, annual report on Form 10-K, and consents
                issued in connection with our Form S-3 filings, assistance and review
                of
                other documents with the SEC.


(2)
            Includes
                accounting consultations


(3)
            Includes
                fees for tax compliance (tax return preparation assistance) and general
                tax planning.




Our
      Audit
      Committee adopted a policy for engaging our independent registered public
      accountants, for audit and non-audit services that includes requirements for
      the
      Audit Committee to pre-approve audit and non-audit services provided by the
      independent auditor. All of the audit and audit related fees provided by
      Odenberg, Ullakko, Muranishi & Co., LLP (described in the footnotes to the
      table above) and related fees were approved in advance by our Audit
      Committee.





**PART
      IV**





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





(a).  The
      following documents are filed as part of this Report under Item 8
      herein:








1.
            Consolidated
                Financial Statements





PageReport
                of Independent Registered Public Accounting Firm
            
            40Consolidated
                Balance Sheets at December 31, 2006 and 2005
            
            42Consolidated
                Statements of Operations for years ended December 31, 2006, 2005
                and
                2004
            
            43Consolidated
                Statements of Stockholders’ Equity (Deficit) for years
                endedDecember
                31, 2006, 2005 and 2004
            
            44Statements
                of Cash Flows for years ended December 31, 2006, 2005 and
                2004
            
            47Notes
                To Consolidated Financial Statements
            
            49





2.
            Consolidated
                Financial Statement Schedules





All
      schedules are omitted because the required information is inapplicable or the
      information is presented in the Consolidated Financial Statements and/or the
      Notes thereto in Item 8 herein.





93


(b).  Exhibits





**Exhibit
                #**
            
            **Description**3.1
            
            Certificate
                of Incorporation, as amended (Amendments to document filed as Exhibit
                3.1
                to the Company’s Amendment No. 1 to Form S-3 Registration Statement filed
                November 18, 1999).3.2
            
            Bylaws
                (incorporated by reference to Exhibit B to the Company’s Form 8-K filed
                February 7, 1995).10.1
            
            1999
                Stock Option Plan (incorporated by reference to Exhibit 10.4 to the
                Company’s Amendment No. 1 to Form S-3 Registration Statement filed on
                November 18, 1999).10.2
            
            Employment
                Amendment No. 1 between the Company and Theodore H. Banzhaf date
                July 6,
                2005 (the original Employment Agreement was filed as Exhibit 10.1
                to the
                Company’s quarterly report on Form 10-Q filed with the SEC on August 14.
                2003).10.3
            
            Amendment
                No. 2 to Time Accelerated Restricted Stock Award Plan (TARSAP) between
                SpatiaLight, Inc. and Theodore Banzhaf, dated as of July 6, 2005
                (the
                Amended and Restated TARSAP Agreement was filed as Exhibit 10.1 to
                the
                Company’s quarterly report on Form 10-Q filed with the SEC on May 13,
                2004).10.4
            
            Amendment
                to Lease Agreement between the Company and Hamilton Marin, LLC, dated
                May
                17, 2002 (Lease Agreement filed as exhibit 10.18 in Form 10-QSB filed
                on
                August 14, 2002).10.5
            
            LCoS
                Supply Agreement dated as of July 1, 2004, between SpatiaLight, Inc.
                and
                LG Electronics Inc.* (filed as Exhibit 10.5 to the Company’s Annual Report
                on Form 10-K/A filed with SEC on December 29, 2005).10.6
            
            Securities
                Purchase Agreement-Private Placement on January 13, 2006 (the original
                Securities Purchase Agreement was filed as Exhibit 10.1 to the Company’s
                current report on Form 8-K filed with SEC on January 19,
                2006).10.7
            
            Registration
                Rights Agreement-Private Placement on January 13, 2006 (the original
                Registration Rights Agreement was filed as Exhibit 10.2 to the Company’s
                current report on Form 8-K filed with SEC on January 19,
                2006).10.8
            
            Securities
                Purchase Agreement-Private Placement on October 12, 2005 (the original
                Securities Purchase Agreement was filed as Exhibit 10.1 to the Company’s
                current report on Form 8-K filed with SEC on October 13,
                2005).10.9
            
            Registration
                Rights Agreement-Private Placement on October 12, 2005 (the original
                Registration Rights Agreement was filed as Exhibit 10.2 to the Company’s
                current report on Form 8-K filed with SEC on October 13,
                2005).10.10
            
            Warrant
                issued to Portside Growth and Opportunity Fund in connection with
                the
                Private Placement-October 12, 2005 (the original Warrant was filed
                as
                Exhibit 10.4 to the Company’s current report on Form 8-K filed with SEC on
                October 13, 2005).10.11
            
            Warrant
                issued to Smithfield Fiduciary LLC in connection with the Private
                Placement-October 12, 2005 (the original Warrant was filed as Exhibit
                10.5
                to the Company’s current report on Form 8-K filed with SEC on October 13,
                2005).10.12
            
            Warrant
                issued to Bluegrass Growth Fund LP in connection with the Private
                Placement-October 12, 2005 (the original Warrant was filed as Exhibit
                10.6
                to the Company’s current report on Form 8-K filed with SEC on October 13,
                2005).10.13
            
            Warrant
                issued to Greenpark Limited in connection with the Private
                Placement-October 12, 2005 (the original Warrant was filed as Exhibit
                10.7
                to the Company’s current report on Form 8-K filed with SEC on October 13,
                2005).10.14
            
            Warrant
                issued to Steven F. Tripp in connection with the Private Placement-October
                12, 2005 (the original Warrant was filed as Exhibit 10.8 to the Company’s
                current report on Form 8-K filed with SEC on October 13,
                2005).10.15
            
            Warrant
                issued to Robert Woods in connection with the Private Placement-October
                12, 2005 (the original Warrant was filed as Exhibit 10.9 to the Company’s
                current report on Form 8-K filed with SEC on October 13,
                2005).10.16
            
            Form
                of Replacement Note - November 2004 Financing (original filed as
                Exhibit
                10.1 to the Company’s current report on Form 8-K filed with the SEC on
                December 22, 2004).10.17
            
            Form
                of Replacement and Exchange Agreement - November 2004 Financing (original
                filed as Exhibit 10.3 to the Company’s current report on Form 8-K filed
                with the SEC on December 22, 2004).10.18
            
            Securities
                Purchase Agreement-November 2004 Financing (the original Securities
                Purchase Agreement was filed as Exhibit 10.1 to the Company’s current
                report on Form 8-K filed with SEC on December 6,
                2004).





94





10.19
            
            Registration
                Rights Agreement-November 2004 Financing (the original Registration
                Rights
                Agreement was filed as Exhibit 10.10 to the Company’s current report on
                Form 8-K filed with SEC on December 6, 2004).10.20
            
            Intercreditor
                and Subordination Agreement-November 2004 Financing (the original
                Intercreditor and Subordination Agreement was filed as Exhibit 10.11
                to
                the Company’s current report on Form 8-K filed with SEC on December 6,
                2004).10.21
            
            Korean
                Pledge Agreement-November 2004 Financing (the original Korean Pledge
                Agreement was filed as Exhibit 10.13 to the Company’s current report on
                Form 8-K filed with SEC on December 6, 2004).10.22
            
            Pledge
                and Security Agreement-November 2004 Financing (the original Pledge
                and
                Security Agreement was filed as Exhibit 10.14 to the Company’s current
                report on Form 8-K filed with SEC on December 6, 2004).10.23
            
            Negative
                Pledge Agreement-November 2004 Financing (the original Negative Pledge
                Agreement was filed as Exhibit 10.15 to the Company’s current report on
                Form 8-K filed with SEC on December 6, 2004).10.24
            
            Extension
                and Modification Agreement-November 2004 Financing (the original
                Extension
                and Modification Agreement was filed as Exhibit 10.16 to the Company’s
                current report on Form 8-K filed with SEC on December 6,
                2004).10.25
            
            Resident
                Agreement (Lease) between SpatiaLight, Inc. and Korea Industrial
                Complex
                Corporation (original Resident Agreement (Lease) was filed as Exhibit
                10.1
                to the Company’s current report on Form 8-K filed with SEC on November 15,
                2004).14.1
            
            Code
                of Business Conduct and Ethics†16.1
            
            Letter
                from BDO Seidman LLP dated December 6, 2004 (original letter filed
                as
                Exhibit 16.1 to the Company’s current report on Form 8-K filed with the
                SEC on December 10, 2004).21.1
            
            Principal
                subsidiaries of the Company.23.1
            
            Consent
                of Odenberg, Ullakko, Muranishi & Co. LLP24.1
            
            Power
                of Attorney.31.1
            
            Certification
                of Chief Executive Officer and Principal Financial and Accounting
                Officer
                Pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange
                Act of
                1934, as amended.32.1
            
            Certification
                of Chief Executive Officer and Principal Financial and Accounting
                Officer
                Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section
                906 of
                the Sarbanes-Oxley Act of 2002.





*Confidential
      Treatment has been requested with respect to certain portions of this exhibit.
      Omitted portions have been filed separately with the Securities and Exchange
      Commission.




† Previously filed.




95




**SIGNATURES**





Pursuant
      to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
      1934, the Registrant has duly caused this report to be signed on its behalf
      by
      the undersigned, thereunto duly authorized, on the 20th day of August 2007.




SPATIALIGHT,
              INC.By:
            /s/
              David F. HakalaDavid
              F. HakalaChief
                Executive Officer, Chief Operating
              Officer,
                Principal
                Financial and
                Accounting Officer




Pursuant
      to the requirements of the Securities Exchange Act of 1934, this report has
      been
      signed below by the following persons on behalf of the Registrant and in the
      capacities and on the dates indicated.




Signature
            
            Title
            
            Date/s/
              DAVID F.
              HAKALA
            
            Chief
              Executive
              Officer, Chief Operating Officer
            
            August 20, 2007David
              F. Hakala*/s/VOLKAN H. OZGUZ
            
            Director
            
            August 20, 2007Volkan
              H. Ozguz*/s/YOUNG HWAN KIM
            
            Director
            
            August 20, 2007Young
              Hwan Kim*/s/MICHAEL S. JIN
            
            Director
            
            August 20, 2007Michael
              S. JinPursuant to Power of Attorney
              filed as Exhibit 24.1/s/ DAVID F. HAKALA
            
            
            
            August 20, 2007David F. Hakala
              (Attorney-in-fact)




96