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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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(Mark One)

|x | Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
|- | ---------------------------------------------------------------------------------------



For the Quarterly Period Ended September 30, 2005.



or



| ̈ | 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 001-15609



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PATH 1 NETWORK TECHNOLOGIES INC.

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|DELAWARE                                                       |  | 13-3989885                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)



6215 FERRIS SQUARE,
SUITE 140, SAN DIEGO, CALIFORNIA 92121

(858) 450-4220

(Address, including zip code, and telephone number, including area code, of principal executive offices)



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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  x    No ̈



Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes ̈No  x



Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.): Yes ̈No  x



As of November 10, 2005, 6,956,604 shares of the registrants common stock were outstanding.



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##### Table of Contents

PATH 1 NETWORK TECHNOLOGIES INC.



Quarterly Report on Form 10-Q

For the Quarterly Period Ended September 30, 2005



TABLE OF CONTENTS



|                                                                                               |  |   
|---------------------------------------------------------------------------------------------- |  | --
|PART IFINANCIAL INFORMATION                                                                   |  | 3 
|                                                                                               | 
|ITEM 1. 
FINANCIAL STATEMENTS (UNAUDITED)                                                      |  | 3 
|                                                                                               | 
|CONSOLIDATED BALANCE SHEETS                                                                    |  | 3 
|                                                                                               | 
|CONSOLIDATED STATEMENTS OF OPERATIONS                                                          |  | 4 
|                                                                                               | 
|CONSOLIDATED STATEMENTS OF CASH FLOWS                                                          |  | 5 
|                                                                                               | 
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                                                     |  | 6 
|                                                                                               | 
|ITEM 2. 
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |  | 13
|                                                                                               | 
|ITEM 3. 
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                            |  | 31
|                                                                                               | 
|ITEM 4. 
CONTROLS AND PROCEDURES                                                               |  | 31
|                                                                                               | 
|PART IIOTHER INFORMATION                                                                      |  | 31
|                                                                                               | 
|ITEM 1. 
LEGAL PROCEEDINGS                                                                     |  | 31
|                                                                                               | 
|ITEM 2. 
UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS                           |  | 31
|                                                                                               | 
|ITEM 3. 
DEFAULTS UPON SENIOR SECURITIES                                                       |  | 31
|                                                                                               | 
|ITEM 4. 
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                   |  | 31
|                                                                                               | 
|ITEM 5. 
OTHER INFORMATION                                                                     |  | 32
|                                                                                               | 
|ITEM 6. 
EXHIBITS                                                                              |  | 33
|                                                                                               | 
|SIGNATURES                                                                                     |  | 34



2



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##### Table of Contents



PART IFINANCIAL INFORMATION



|ITEM 1. | FINANCIAL STATEMENTS
|------- | --------------------



Path 1 Network Technologies Inc.

Consolidated Balance Sheets

(in thousands, except shares data)



|                                                                                                                                                                                                                                                          |  |                   |         |   |                  |   |         |  
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------- | ------- | - | ---------------- | - | ------- | -
|                                                                                                                                                                                                                                                          |  | September 30,2005 |         |   | December 31,2004 |  
|                                                                                                                                                                                                                                                          |  | (Unaudited)       |         |   |                  |  
|ASSETS                                                                                                                                                                                                                                                    |  |                   |         |   |                  |   |         |  
|Current assets:                                                                                                                                                                                                                                           |  |                   |         |   |                  |   |         |  
|Cash and cash equivalents                                                                                                                                                                                                                                 |  | $                 | 1,362   |   |                  | $ | 929     |  
|Accounts receivables, net                                                                                                                                                                                                                                 |  |                   | 704     |   |                  |   | 810     |  
|Inventory                                                                                                                                                                                                                                                 |  |                   | 536     |   |                  |   | 541     |  
|Other current assets                                                                                                                                                                                                                                      |  |                   | 186     |   |                  |   | 469     |  
|                                                                                                                                                                                                                                                          |  |                   |         |   |                  |   |         |  
|Total current assets                                                                                                                                                                                                                                      |  |                   | 2,788   |   |                  |   | 2,749   |  
|Property and equipment, net                                                                                                                                                                                                                               |  |                   | 284     |   |                  |   | 352     |  
|Issuance costs for mandatorily-redeemable preferred stock, net                                                                                                                                                                                            |  |                   | 500     |   |                  |   | 4       |  
|Other assets                                                                                                                                                                                                                                              |  |                   | 121     |   |                  |   | 59      |  
|                                                                                                                                                                                                                                                          |  |                   |         |   |                  |   |         |  
|Total assets                                                                                                                                                                                                                                              |  | $                 | 3,693   |   |                  | $ | 3,164   |  
|                                                                                                                                                                                                                                                          |  |                   |         |   |                  |   |         |  
|LIABILITIES AND SHAREHOLDERS EQUITY (DEFICIT)                                                                                                                                                                                                            |  |                   |         |   |                  |   |         |  
|Current liabilities:                                                                                                                                                                                                                                      |  |                   |         |   |                  |   |         |  
|Accounts payable and accrued liabilities                                                                                                                                                                                                                  |  | $                 | 1,261   |   |                  | $ | 752     |  
|Accrued compensation and benefits                                                                                                                                                                                                                         |  |                   | 412     |   |                  |   | 176     |  
|Deferred revenue                                                                                                                                                                                                                                          |  |                   | 179     |   |                  |   | 256     |  
|Current portion of leases payable                                                                                                                                                                                                                         |  |                   | 6       |   |                  |   | 21      |  
|Current portion of notes payable, net                                                                                                                                                                                                                     |  |                   |        |   |                  |   | 78      |  
|                                                                                                                                                                                                                                                          |  |                   |         |   |                  |   |         |  
|Total current liabilities                                                                                                                                                                                                                                 |  |                   | 1,858   |   |                  |   | 1,283   |  
|Mandatorily-redeemable preferred shares, net (note 11)                                                                                                                                                                                                    |  |                   | 2,297   |   |                  |   |        |  
|                                                                                                                                                                                                                                                          |  |                   |         |   |                  |   |         |  
|Total liabilities                                                                                                                                                                                                                                         |  |                   | 4,155   |   |                  |   | 1,283   |  
|                                                                                                                                                                                                                                                          |  |                   |         |   |                  |   |         |  
|Shareholders equity (deficit):                                                                                                                                                                                                                           |  |                   |         |   |                  |   |         |  
|Common stock, $0.001 par value; 40,000,000 shares authorized; 6,956,604 and 6,820,606 shares issued and outstanding at September 30, 2005
and December 31, 2004, respectively; 2,777 shares held in treasury at September 30, 2005, and December 31, 2004 |  |                   | 7       |   |                  |   | 7       |  
|Additional paid in capital                                                                                                                                                                                                                                |  |                   | 52,708  |   |                  |   | 48,743  |  
|Deferred compensation                                                                                                                                                                                                                                     |  |                   | (346    | ) |                  |   | (1,357  | )
|Accumulated deficit                                                                                                                                                                                                                                       |  |                   | (52,830 | ) |                  |   | (45,512 | )
|                                                                                                                                                                                                                                                          |  |                   |         |   |                  |   |         |  
|Total shareholders equity (deficit)                                                                                                                                                                                                                      |  |                   | (462    | ) |                  |   | 1,881   |  
|                                                                                                                                                                                                                                                          |  |                   |         |   |                  |   |         |  
|Total liabilities and shareholders equity (deficit)                                                                                                                                                                                                      |  | $                 | 3,693   |   |                  | $ | 3,164   |  
|                                                                                                                                                                                                                                                          |  |                   |         |   |                  |   |         |  



3



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Path 1 Network Technologies Inc.

Consolidated Statements of Operations

(in thousands, except per share amounts)

(unaudited)



|                                                                  |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|----------------------------------------------------------------- |  | --------------------------------------- | ------ | - | -------------------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                                                  |  | For the three monthsended September 30, |        |   | For the nine monthsended September 30, |  
|                                                                  |  | 2005                                    |        |   | 2004                                   |   |        | 2005 |  |   | 2004   |  
|Revenues:                                                         |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Product revenue                                                   |  | $                                       | 384    |   |                                        | $ | 734    |      |  | $ | 2,352  |   |  | $ | 2,593  |  
|License revenue                                                   |  |                                         |       |   |                                        |   |       |      |  |   |       |   |  |   | 20     |  
|Contract revenue                                                  |  |                                         |       |   |                                        |   | 20     |      |  |   | 16     |   |  |   | 21     |  
|Royalty revenue                                                   |  |                                         |       |   |                                        |   |       |      |  |   | 6      |   |  |   |       |  
|Services revenue                                                  |  |                                         | 20     |   |                                        |   |       |      |  |   | 22     |   |  |   |       |  
|Other revenue                                                     |  |                                         |       |   |                                        |   | 2      |      |  |   | 13     |   |  |   | 20     |  
|                                                                  |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Total revenues                                                    |  |                                         | 404    |   |                                        |   | 756    |      |  |   | 2,409  |   |  |   | 2,654  |  
|                                                                  |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Cost of revenues:                                                 |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Cost of product sales                                             |  |                                         | 369    |   |                                        |   | 233    |      |  |   | 1,142  |   |  |   | 1,828  |  
|Cost of contract services                                         |  |                                         |       |   |                                        |   | 7      |      |  |   |       |   |  |   | 7      |  
|                                                                  |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Total cost of revenues                                            |  |                                         | 369    |   |                                        |   | 240    |      |  |   | 1,142  |   |  |   | 1,835  |  
|                                                                  |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Gross profit                                                      |  |                                         | 35     |   |                                        |   | 516    |      |  |   | 1,267  |   |  |   | 819    |  
|                                                                  |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Operating expenses:                                               |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Engineering research and development                              |  |                                         | 1,106  |   |                                        |   | 466    |      |  |   | 3,112  |   |  |   | 1,472  |  
|Sales and marketing                                               |  |                                         | 880    |   |                                        |   | 398    |      |  |   | 2,324  |   |  |   | 2,242  |  
|General and administrative                                        |  |                                         | 615    |   |                                        |   | 636    |      |  |   | 1,369  |   |  |   | 2,545  |  
|Stock-based compensation                                          |  |                                         | 234    |   |                                        |   |       |      |  |   | 1,126  |   |  |   | 272    |  
|                                                                  |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Total operating expenses                                          |  |                                         | 2,835  |   |                                        |   | 1,500  |      |  |   | 7,931  |   |  |   | 6,531  |  
|                                                                  |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Operating loss                                                    |  |                                         | (2,800 | ) |                                        |   | (984   | )    |  |   | (6,664 | ) |  |   | (5,712 | )
|Other income (expense)                                            |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Interest expense, net                                             |  |                                         | (217   | ) |                                        |   | (22    | )    |  |   | (471   | ) |  |   | (72    | )
|Other income (expense)                                            |  |                                         | 7      |   |                                        |   |       |      |  |   | 3      |   |  |   | (3     | )
|                                                                  |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Total other expense                                               |  |                                         | (210   | ) |                                        |   | (22    | )    |  |   | (468   | ) |  |   | (75    | )
|                                                                  |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Net loss                                                          |  |                                         | (3,010 | ) |                                        |   | (1,006 | )    |  |   | (7,132 | ) |  |   | (5,787 | )
|Accumulated preferred dividends                                   |  |                                         | (94    | ) |                                        |   |       |      |  |   | (188   | ) |  |   |       |  
|                                                                  |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Net loss available to common shareholders                         |  | $                                       | (3,104 | ) |                                        | $ | (1,006 | )    |  | $ | (7,320 | ) |  | $ | (5,787 | )
|                                                                  |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Net loss per common share                                         |  | $                                       | (0.45  | ) |                                        | $ | (0.15  | )    |  | $ | (1.06  | ) |  | $ | (0.86  | )
|                                                                  |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Weighted average shares used in loss per common share calculation |  |                                         | 6,941  |   |                                        |   | 6,764  |      |  |   | 6,890  |   |  |   | 6,711  |  



See accompanying notes
to these consolidated financial statements.



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Path 1 Network Technologies Inc.

Consolidated Statements of Cash Flows

(in thousands)

(unaudited)



|                                                                                              |  |                                        |        |   |      |   |        |  
|--------------------------------------------------------------------------------------------- |  | -------------------------------------- | ------ | - | ---- | - | ------ | -
|                                                                                              |  | For the nine monthsended September 30, |       
|                                                                                              |  | 2005                                   |        |   | 2004 |  
|Cash flows from operating activities                                                          |  |                                        |        |   |      |   |        |  
|Net loss                                                                                      |  | $                                      | (7,320 | ) |      | $ | (5,787 | )
|Adjustments to reconcile net loss to net cash used in operating activities:                   |  |                                        |        |   |      |   |        |  
|Depreciation & amortization                                                                   |  |                                        | 186    |   |      |   | 233    |  
|Stock-based compensation                                                                      |  |                                        | 1,011  |   |      |   | 272    |  
|Accretion of debt discount & debt conversion expense                                          |  |                                        | 605    |   |      |   | 100    |  
|Bad debt expense                                                                              |  |                                        | (60    | ) |      |   |       |  
|Changes in assets and liabilities                                                             |  |                                        |        |   |      |   |        |  
|Accounts receivable                                                                           |  |                                        | 166    |   |      |   | (326   | )
|Inventory                                                                                     |  |                                        | 5      |   |      |   | 13     |  
|Other current assets                                                                          |  |                                        | 283    |   |      |   | (140   | )
|Other assets                                                                                  |  |                                        | (524   | ) |      |   |       |  
|Accounts payable and accrued liabilities                                                      |  |                                        | 511    |   |      |   | (87    | )
|Accrued compensation and benefits                                                             |  |                                        | 236    |   |      |   | 105    |  
|Deferred revenue                                                                              |  |                                        | (77    | ) |      |   | 214    |  
|                                                                                              |  |                                        |        |   |      |   |        |  
|Cash used in operating activities                                                             |  |                                        | (4,978 | ) |      |   | (5,403 | )
|                                                                                              |  |                                        |        |   |      |   |        |  
|Cash flows from investing activities                                                          |  |                                        |        |   |      |   |        |  
|Capitalized software development - internal use tools                                         |  |                                        | (113   | ) |      |   |       |  
|Purchase of property & equipment                                                              |  |                                        | (96    | ) |      |   | (180   | )
|                                                                                              |  |                                        |        |   |      |   |        |  
|Cash used in investing activities                                                             |  |                                        | (209   | ) |      |   | (180   | )
|                                                                                              |  |                                        |        |   |      |   |        |  
|Cash flows from financing activities                                                          |  |                                        |        |   |      |   |        |  
|Issuance of common stock                                                                      |  |                                        |       |   |      |   | 240    |  
|Repayment of notes payable                                                                    |  |                                        | (15    | ) |      |   | (16    | )
|Proceeds from exercise of options                                                             |  |                                        | 251    |   |      |   |       |  
|Issuance of preferred stock                                                                   |  |                                        | 5,384  |   |      |   |       |  
|                                                                                              |  |                                        |        |   |      |   |        |  
|Cash provided by financing activities                                                         |  |                                        | 5,620  |   |      |   | 224    |  
|                                                                                              |  |                                        |        |   |      |   |        |  
|                                                                                              |  |                                        |       |   |      |   |        |  
|Net increase (decrease) in cash                                                               |  |                                        | 433    |   |      |   | (5,359 | )
|Cash and cash equivalents, beginning of period                                                |  |                                        | 929    |   |      |   | 7,807  |  
|                                                                                              |  |                                        |        |   |      |   |        |  
|Cash and cash equivalents, end of period                                                      |  | $                                      | 1,362  |   |      | $ | 2,448  |  
|                                                                                              |  |                                        |        |   |      |   |        |  
|Non-cash, reconciling items                                                                   |  |                                        |        |   |      |   |        |  
|Conversion of notes and accrued interest to common stock                                      |  | $                                      | 102    |   |      | $ | 331    |  
|                                                                                              |  |                                        |        |   |      |   |        |  
|Capitalized debt issuance costs in connection with beneficial conversion charges and warrants |  | $                                      | 3,333  |   |      | $ |       |  
|                                                                                              |  |                                        |        |   |      |   |        |  
|Purchase of equipment for note payable                                                        |  | $                                      |       |   |      | $ | 23     |  
|                                                                                              |  |                                        |        |   |      |   |        |  
|Issuance of restricted stock to executives                                                    |  | $                                      | 116    |   |      | $ |       |  
|                                                                                              |  |                                        |        |   |      |   |        |  



See accompanying notes
to these consolidated financial statements.



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Path 1 Network Technologies Inc.



Notes to the Unaudited Consolidated Financial Statements



Note 1Basis of Presentation



The accompanying
consolidated balance sheet at September 30, 2005, the consolidated statements of operations for the three-month and nine-month periods ended September 30, 2005 and 2004, and the consolidated statements of cash flows for the nine-month
periods ended September 30, 2005 and 2004, have been prepared by Path 1 Network Technologies Inc. (the Company) and have not been audited. The consolidated balance sheet at December 31, 2004 has been audited. These consolidated
quarterly financial statements, in the opinion of management, include all adjustments, consisting only of normal and recurring adjustments, necessary to state fairly the financial information set forth therein, in accordance with accounting
principles generally accepted in the United States.



These quarterly
consolidated financial statements should be read in conjunction with the financial statements and notes thereto for the year ended December 31, 2004. The interim consolidated financial information contained in this filing is not necessarily
indicative of the results to be expected for any other interim period or for the full year ending December 31, 2005.



Reclassifications



Certain reclassifications have been made to prior periods financial statements to conform to current year presentation.



Recently Issued Accounting Standards



In May 2005, the FASB issued Statement of Financial Accounting Standards No. 154, Accounting Changes and Error Corrections, applying to all voluntary
accounting principle changes as well as the accounting for and reporting of such changes. SFAS No. 154 replaces APB Opinion No. 20, Accounting Changes, and SFAS No. 3, Reporting Accounting Changes in Interim Financial
Statements. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company does not expect SFAS No. 154 to affect the Companys financial
condition or results of operations.



In March 2005, the FASB issued
Interpretation No. 47 (FIN 47), Accounting for Conditional Asset Retirement Obligations. FIN 47 clarifies that an entity must record a liability for a conditional asset retirement obligation if the fair value of the
obligation can be reasonably estimated. The provision is effective no later than the end of fiscal years ending after December 15, 2005. We have not determined what effect, if any, FIN 47 will have on our financial condition or results of
operations.



On December 16, 2004, the FASB issued Statement of Financial
Accounting Standards No. 123 (revised 2004), or SFAS 123(R), Share-Based Payment, which is a revision of SFAS 123. SFAS 123(R) supersedes APB Opinion No. 25, and amends SFAS 95, Statement of Cash Flows. Generally, the
approach in SFAS 123(R) is similar to the approach described in SFAS 123. However, SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair
values and pro forma disclosure will no longer be an alternative. The Company has not yet quantified the impact that adoption of SFAS 123(R) will have on its financial statements, but expects such impact to be material. On April 14, 2005, the
U.S. Securities and Exchange Commission announced, in Staff Accounting Bulletin No. 107, a deferral of the effective date of SFAS 123(R) until the first interim period beginning after December 15, 2005. The Company expects to adopt SFAS
123(R) effective in its first fiscal quarter beginning January 1, 2006. The Company is currently determining how or if the adoption of SFAS 123(R) will impact the magnitude or form of its share-based compensation to employees.



In November 2004, the FASB issued Statement of Financial Accounting Standards No. 151,
Inventory Costs, an Amendment of ARB No. 43, Chapter 4 (SFAS 151). SFAS 151 clarifies that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges
and requires the allocation of fixed production overhead to inventory based on the normal capacity of the production facilities. SFAS 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Adoption of
SFAS 151 is not expected to have a material impact on the Companys financial condition, results of operations or cash flows.



6



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##### Table of Contents

Path 1 Network Technologies Inc.



Notes to the Unaudited Consolidated Financial Statements -(Continued)



In November 2004, the FASB issued Statement of Financial Accounting Standards No. 153, Exchanges of
Non-monetary Assets, an Amendment of APB No. 29 (SFAS 153). SFAS 153 requires that exchanges of productive assets for similar productive assets should be measured based on the fair value of the assets exchanged except in those instances in
which the exchanges of non-monetary assets do not have commercial substance. SFAS 153 is effective prospectively for non-monetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. Adoption of SFAS 153 is not expected to
have a material impact on the Companys financial condition, results of operations or cash flows.



Stock-based Compensation



The Company
currently accounts for stock-based compensation arrangements using the intrinsic value method in accordance with the provisions of Accounting Principles Board Opinion (APB) 25, Accounting for Stock Issued to Employees,SFAS
Interpretation No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans, and SFAS Interpretation No. 38, Determining the Measurement Date for Stock Option, Purchase, and Award Plans
involving Junior Stock. The Company also complies with the disclosure provisions of SFAS 123, Accounting for Stock-Based Compensation.



The Company accounts for equity instruments issued to non-employees using the fair value method in accordance with the provisions of SFAS 123 and Emerging Issues Task
Force Issue No. 96-18, Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring, or in Conjunction with Selling, Goods or Services. In December 2002, the FASB issued Statement of Financial Accounting
Standards No. 148 (SFAS 148), Accounting for Stock-Based CompensationTransition and Disclosure. This statement amends SFAS 123 to provide alternative methods of transition for a voluntary change to the fair value based method of
accounting for stock-based employee compensation. In addition, the statement amends the disclosure requirements of SFAS 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for
stock-based employee compensation and the effect of the method used on reported results. The Company makes the following required disclosure under SFAS 148. The table below provides, on a pro forma basis, the effect employee stock-based compensation
would have had on the Companys operating results had the Company used the fair value method of accounting for stock-based compensation arrangements in conformity with SFAS 123 (in thousands, except per share amounts):



|                                                                                 |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|-------------------------------------------------------------------------------- |  | --------------------------------------- | ------ | - | -------------------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                                                                 |  | For the three monthsended September 30, |        |   | For the nine monthsended September 30, |  
|                                                                                 |  | 2005                                    |        |   | 2004                                   |   |        | 2005 |  |   | 2004   |  
|Net income (loss) attributable to common stock                                   |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|As reported                                                                      |  | $                                       | (3,104 | ) |                                        | $ | (1,006 | )    |  | $ | (7,320 | ) |  | $ | (5,787 | )
|Deduct:                                                                          |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Stock-based employee compensation expense determined under the fair value method |  |                                         | (25    | ) |                                        |   | (14    | )    |  |   | (169   | ) |  |   | (30    | )
|                                                                                 |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Pro forma                                                                        |  | $                                       | (3,179 | ) |                                        | $ | (1,020 | )    |  | $ | (7,489 | ) |  | $ | (5,817 | )
|                                                                                 |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Basic and diluted net loss per share                                             |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|As reported                                                                      |  | $                                       | (0.45  | ) |                                        | $ | (0.15  | )    |  | $ | (1.06  | ) |  | $ | (0.86  | )
|                                                                                 |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Pro forma                                                                        |  | $                                       | (0.45  | ) |                                        | $ | (0.15  | )    |  | $ | (1.09  | ) |  | $ | (0.87  | )
|                                                                                 |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  



Equity instruments
issued to non-employees that are fully vested and non-forfeitable are measured at fair value at the issuance date and expensed in the period over which the benefit is expected to be received. Equity instruments issued to non-employees which are
either unvested or forfeitable, for which counter-party performance is required for the equity instrument to be earned, are measured initially at the fair value and subsequently adjusted for changes in fair value until the earlier of: 1) the date at
which a commitment for performance by the counter-party to earn the equity instrument is reached; or 2) the date on which the counter-partys performance is complete.



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Path 1 Network Technologies Inc.



Notes to the Unaudited Consolidated Financial Statements -(Continued)



During the three and nine-month periods ended September 30, 2005 and 2004, the Company recorded no stock-based
compensation expense related to the amortization of options outstanding to employees and consultants, but during the three and nine-month periods ended September 30, 2005, the Company recorded non-cash compensation related to the vesting of
restricted stock issued to five present and former executives. Stock-based compensation expense may occur in future quarters due to the planned vesting dates for restricted stock awards granted in earlier periods to company executives.



Note 2Going Concern



The accompanying consolidated financial statements have been prepared assuming that the
Company will continue as a going concern. This contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. From January 30, 1998 through September 30, 2005, we incurred losses totaling $52.8
million. We have not yet achieved profitability, and remain a risky enterprise. We believe that our existing capital resources will enable us to fund operations for only a few months. We have taken steps to reduce expenses to help manage our cash.
At September 30, 2005, we had working capital of $930,000 and cash and cash equivalents of $1,362,000. Additionally, as of September 30, 2005 the Company has $160,000 in eligible accounts to borrow against under the $1 million revolving line of
credit with Laurus Master Fund Ltd.



Given our projected cash burn rate, we
will be required to raise additional capital in the very near term. We are currently pursuing efforts to raise additional capital, and urgently need to do so by December 31, 2005. We cannot ensure that financing would be available to us on
acceptable terms, if at all. Our investment bankers, when and if engaged, may not be able to successfully find any financing or other strategic opportunities for us. Our inability to raise capital when needed would seriously harm our business. In
addition, additional equity may dilute our stockholders interest, and debt financing, if available, may involve restrictive covenants and could result in a substantial portion of our operating cash flow being dedicated to the payment of
principal and interest on debt.



Note 3Private Offering



On January 26, 2005, the Company entered into a Securities Purchase
Agreement (the Agreement) and a related Registration Rights Agreement, with certain accredited investors. On January 27, 2005, pursuant to the Agreement, the Company sold to a group of accredited investors 556,538 shares of the
Companys mandatorily-redeemable 7% Convertible Preferred Stock (the Series A Preferred Stock), and issued to those investors warrants to purchase up to 278,268 shares of the Companys Common Stock (the Series A
Warrants). The per share purchase price of the Series A Preferred Stock (with 0.5 Series A Warrant) was initially $3.25, and the Series A Warrants initially carried an exercise price of $4.20 per share. The Companys gross receipts from
the January 27, 2005, sale of Series A Preferred Stock (with Series A Warrants) were $1,808,750. On February 18, 2005, under the Agreement, the Company sold to other accredited investors at a second closing a total of 307,691 shares of
Series A Preferred Stock and 153,847 Series A Warrants, for $1,000,000. In total, under the two closings, the Company sold 864,229 shares of Series A Preferred Stock and 432,115 Series A Warrants, for gross receipts of $2,808,750.



The Series A Preferred Stock accrues dividends at the rate of $0.2275 per share per year, and
dividends are cumulative. The Series A Preferred Stock is convertible at the option of the holder into shares of Common Stock at a conversion price of $3.25 per share, subject to specified anti-dilution adjustments. The preferred stock shall be
automatically redeemed on January 27, 2009 for $3.25 per share plus accumulated but unpaid dividends. The Company has the right to redeem the preferred stock earlier upon certain conditions.



The financing was led by investor Gryphon Master Fund, L.P. The Company paid Gryphon Master
Fund, L.P. a fee of $30,000 to cover its expenses incurred in connection with this financing.



On June 1, 2005, pursuant to a Securities Purchase Agreement dated April 26, 2005, the Company sold to accredited investors led by Castle Creek Technology Partners LLC, for $2,575,000, a total of 792,306
shares of Series B 7% Convertible Preferred Stock (Series B Preferred Stock) and five-year warrants to purchase up to a total of 396,155 shares of the Companys Common Stock. The purchase price for each combination of one share and
0.5 warrants was $3.25 and the warrants carry an exercise price of $3.25 per share.



The Company paid Castle Creek Technology Partners LLC fees totaling $25,000 to cover its expenses.



The Series B Preferred Stock accrues dividends at the rate of $0.2275 per share per year, and dividends are cumulative. The Series B Preferred Stock is convertible at the option of the holder into shares of Common
Stock at a conversion price of $3.25 per share, subject to specified anti-dilution adjustments. The Series B Preferred Stock shall be automatically redeemed by the Company if for 10 consecutive trading days the common stock closes at a price above
$9.04. The holders of the Series B Preferred Stock would be able to convert their shares into shares of common stock at any time before such redemption.



The conversion price of the Series B Preferred Stock is $3.17424, subject to any future weighted average antidilution provisions. This conversion price was established by
a one-time Special Re-Set, calculated by a formula based on Current Market Price at the time of the June 1, 2005 Closing. This also had the effect of reducing the conversion prices of the Series A Preferred Stock to $3.17424 as of June 1,
2005. Also, by private agreements, the exercise price of the 432,115 Series A Warrants was specially reduced from $4.20 to $3.25 upon consummation of the Series B Preferred Stock financing. (See Note 11)



In connection with the sales of Series A Preferred Stock and Series B Preferred Stock, the
Company paid cash fees of approximately $380,000 and approximately 84,000 common stock warrants to the Companys placement agent or the placement agents designees.



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Path 1 Network Technologies Inc.



Notes to the Unaudited Consolidated Financial Statements -(Continued)



Note 4Management Estimates and Assumptions



The preparation of financial statements in conformity with accounting principles generally
accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and reported amounts of expenses during the reporting period.
Actual results could differ from those estimates.



Note 5Inventory



The Company records inventory, which consists primarily of raw materials
used in the production of video gateways and related products and finished goods, at the lower of cost or market. Cost is determined principally on the average cost method. Provisions for potentially obsolete or slow-moving inventory are made based
on an analysis of inventory levels and future sales forecasts. The provision is re-measured at each balance sheet date. At September 30, 2005, the Company had accrued approximately $127,000 for potentially obsolete or slow-moving inventory.



Note 6Revenue Recognition



The Company generates revenue primarily from the sale of its video gateway products. The
Company sells its products through direct sales channels and through distributors or resellers. The Company also derives revenue from contract services and license fees.



Product Revenue



The Company recognizes product revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collection is
reasonably assured. Significant management judgments and estimates must be made in connection with the measurement of revenue in a given period. The Company follows specific and detailed guidelines for determining the timing of revenue recognition.
At the time of the transaction, the Company assesses a number of factors including specific contract and purchase order terms, completion and timing of delivery to the common-carrier, past transaction history with the customer, the creditworthiness
of the customer, evidence of sell-through to the end user, and current payment terms. Based on the results of the assessment, the Company may recognize revenue when the products are shipped or defer recognition until evidence of sell-through occurs
or cash is received; or, if cash has been received, when it is determined there is no reasonable likelihood the Company would accept the return of products which had not been sold through, including sales where there are no return rights. Estimated
warranty costs are calculated based on historical experience and are recorded at the time revenue is recognized. The Companys products generally carry a one-year warranty from the date of purchase.



Contract Service Revenue



Revenue on engineering design contracts, including technology development agreements, is
recognized on a percentage-of-completion method, based on costs incurred to date compared to total estimated costs, subject to acceptance criteria. Billings on uncompleted contracts in excess of incurred costs and accrued profits are classified as
deferred revenue.



License Revenue



Revenues from license fees are recognized when persuasive evidence of a sales arrangement
exists, delivery and acceptance have occurred, the price is fixed or determinable, and collectability is reasonably assured.



Allowances for Doubtful Accounts, Returns and Discounts



The Company performs credit evaluations on all prospective customers, and historically has not required collateral or deposits. The Company establishes allowances for
doubtful accounts based upon current economic trends, contractual terms and conditions and historical customer payment practices, as well as for known or expected events.



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Path 1 Network Technologies Inc.



Notes to the Unaudited Consolidated Financial Statements -(Continued)



Note 7Warranty Reserves, Indemnification Arrangements and Guarantees



In connection with the Companys adoption of FASB Interpretation No. 45 (FIN 45),
Guarantors Accounting and Disclosure Requirements for Guarantees, Including Guarantees of Indebtedness of Others,the following disclosures are made with respect to the Companys product warranties.



The Company provides a limited warranty for its products. A provision for the estimated
warranty cost is recorded at the time revenue is recognized. Liabilities for the estimated future costs of repair or replacement are established and charged to cost of sales at the time the related revenue is recognized. The amount of liability to
be recorded is based on managements best estimate of future warranty costs expected to be incurred for its products still under warranty at the time of measurement. This estimate is derived from analyzing trends in product failure rates and
trends in actual product repair costs incurred. The Companys standard product warranty extends one year from date of sale; however, the Company may warrant products for periods greater than one year under certain circumstances. The following
table summarizes the activity in the liability accrual related to product warranty during the nine months ended September 30, 2005 and the year ended December 31, 2004:



|                                                 |  |                   |    |   |                  |   |     |  
|------------------------------------------------ |  | ----------------- | -- | - | ---------------- | - | --- | -
|                                                 |  | (in thousands)    |   
|                                                 |  | September 30,2005 |    |   | December 31,2004 |  
|                                                 |  | (Unaudited)       |    |   |                  |  
|Warranty reserve beginning balance               |  | $                 | 29 |   |                  | $ | 78  |  
|Warranty expense accrued during the period       |  |                   | 11 |   |                  |   | (11 | )
|Actual warranty costs incurred during the period |  |                   | (9 | ) |                  |   | (38 | )
|                                                 |  |                   |    |   |                  |   |     |  
|Warranty reserve ending balance                  |  | $                 | 31 |   |                  | $ | 29  |  
|                                                 |  |                   |    |   |                  |   |     |  



The Company also undertakes
indemnification obligations in the ordinary course of business related to its products, the licensing of its software, and the issuance of securities. Under these arrangements, the Company may indemnify other parties such as business partners,
customers, and underwriters, for certain losses suffered, claims of intellectual property infringement, negligence and intentional acts in the performance of services, and violations of laws including certain violations of securities laws. The
Companys obligation to provide such indemnification in such circumstances would arise if, for example, a third party sued a customer for intellectual property infringement and the Company agreed to indemnify the customer against such claims.
The Company is unable to estimate with any reasonable accuracy the liability that may be incurred pursuant to its indemnification obligations. Some of the factors that would affect this assessment include, but are not limited to, the nature of the
claim asserted, the relative merits of the claim, the financial ability of the parties, the nature and amount of damages claimed, insurance coverage that the Company may have to cover such claims, and the willingness of the parties to reach
settlement, if any. Because of the uncertainty surrounding these circumstances, the Companys indemnification obligations could range from immaterial to having a material adverse impact on its financial position and its ability to continue in
the ordinary course of business.



Note 8Capitalized Software
Development Costs



The Company capitalizes certain software development
costs in accordance with FASB Statement of Financial Accounting Standards 86 (SFAS 86), Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed and AICPA SOP 98-1 (SOP 98-1), Accounting for the Costs of
Computer Software Developed or Obtained for Internal Use. During the nine months ended September 30, 2005, the Company capitalized approximately $113,000 of engineering costs, consisting of $107,000 related to product development under SFAS
86 and $5,000 for development of internal use software tools under SOP 98-1.



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Path 1 Network Technologies Inc.



Notes to the Unaudited Consolidated Financial Statements -(Continued)



The costs capitalized under SFAS 86 for the period ended September 30, 2005 consisted primarily of the salaries
and employee benefits of the Companys personnel directly involved in the various software development efforts and direct costs associated with third parties hired to assist with these developments. These capitalized costs were costs incurred
to create product masters subsequent to the software product under development achieving technological feasibility as a working model as required by SFAS 86. The Company will capitalize similar future costs incurred to bring this product to general
release to the public at which time capitalization will cease and amortization will begin.



While capitalization of costs under SFAS 86 to date, and for the development of a particular software product to be sold, has been recorded under the working model provisions, SFAS 86 also provides for capitalization
of costs incurred once a product has achieved technological feasibility under a more structured detail program design model. The Company plans to use the detail program design methodology in the future for software development efforts.



At September 30, 2005, the Company had capitalized software development costs
totaling $123,700. The Company has started to amortize capitalized software over an expected twenty-four month period beginning in the second quarter of 2005. The amount of annual expense to be recognized is the greater of the amount that would be
amortized using the straight-line method over the remaining economic life of the product including the period being reported and the amount that would be amortized by the ratio actual period sales of the product bear to the total of current and
anticipated future sales of the product. The following table summarizes activity within the capitalized software and related amortization accounts during the nine months ended September 30, 2005 and the year ended December 31, 2004:



|                                                |  |                   |     |   |                  |   |   
|----------------------------------------------- |  | ----------------- | --- | - | ---------------- | - | --
|                                                |  | (in thousands)   
|                                                |  | September 30,2005 |     |   | December 31,2004
|                                                |  | (Unaudited)       |     |   |                 
|Capitalized software assets:                    |  |                   |     |   |                  |   |   
|Beginning balance                               |  | $                 | 11  |   |                  | $ |  
|Costs capitalized during the period             |  |                   | 113 |   |                  |   | 11
|                                                |  |                   |     |   |                  |   |   
|Ending balance                                  |  | $                 | 124 |   |                  | $ | 11
|Accumulated amortization of capitalized assets  |  |                   |     |   |                  |   |   
|Beginning balance                               |  | $                 |    |   |                  | $ |  
|Amortization expense recorded during the period |  |                   | (22 | ) |                  |   |  
|                                                |  |                   |     |   |                  |   |   
|Ending balance                                  |  | $                 | (22 | ) |                  | $ |  
|                                                |  |                   |     |   |                  |   |   
|Net capitalized software                        |  | $                 | 102 |   |                  | $ | 11
|                                                |  |                   |     |   |                  |   |   



Note 9Off Balance Sheet
Arrangements



The Company does not have off-balance sheet arrangements,
financings, or other relationships with unconsolidated entities or other persons, also known as special purpose entities (SPEs).



Note 10Reportable Operating Segments



The Company does not have more than one reportable operating segment.



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Path 1 Network Technologies Inc.



Notes to the Unaudited Consolidated Financial Statements -(Continued)



Note 11Long-Term Liabilities



Notes Payable



During the nine months ended September 30, 2005, approximately $102,000 of note principal was converted into 26,050 shares of the Companys common stock. The
carrying value of the convertible notes payable, excluding the Companys line of credit, at September 30, 2005 is zero. There was no interest expense for the three months ended September 30, 2005 since the note payable was converted
into the Companys common stock in May 2005. Interest expense related to convertible notes for the nine months ended September 30, 2005, includes coupon interest of approximately $2,533; non-cash interest expense of approximately $2,000
pertaining to the discount related to the warrants; and non-cash interest expense of approximately $7,000 pertaining to the discount related to the beneficial conversion feature. Amortization of debt issuance costs for the nine months ended
September 30, 2005, was $9,000.



The Company maintains a $1 million
revolving line of credit (the LOC) with Laurus Master Fund Ltd. The LOC is secured by the Companys accounts receivables and other assets, and the Company has the ability to draw down advances under the LOC subject to limits. As of
September 30, 2005, the Company had $160,000 of eligible accounts for borrowing. Under the terms of the LOC, Laurus can convert advances made to the Company into common stock at a fixed conversion price of $6.78 per share. The LOC expires in
February 2006. The amount outstanding under the LOC at September 30, 2005 is zero. (See Note 2)



Mandatorily-redeemable convertible preferred shares (see Note 3)



In connection with the sale of the Series A Preferred Stock and Series B Preferred Stock, which are required to be redeemed by the Company if not converted to the Companys common stock, and the issuance of the
warrants as part of the financing transaction, the Company has recorded a long-term liability under FASB Statement of Financial Accounting Standards No. 150 (SFAS 150), Accounting for Certain Financial Instruments with Characteristics of
both Liabilities and Equity. SFAS 150 requires that mandatorily-redeemable stock be characterized as a liability and that all payments to, or accruals for the benefit of, the holders of the stock that are not a return of principal be treated as
interest expense.



The following table shows the carrying value of the
long-term liability related to the Companys convertible preferred shares:



|                                                                                                      |  |                   |        |   |                  |   |  
|----------------------------------------------------------------------------------------------------- |  | ----------------- | ------ | - | ---------------- | - | -
|                                                                                                      |  | (in thousands)   
|                                                                                                      |  | September 30,2005 |        |   | December 31,2004
|                                                                                                      |  | (Unaudited)       |        |   |                 
|Amount payable for mandatorily-redeemable preferred shares (convertible into 1,696,072 common shares) |  | $                 | 5,384  |   |                  | $ | 
|Unamortized discount related to warrants                                                              |  |                   | (625   | ) |                  |   | 
|Unamortized discount related to beneficial conversion feature                                         |  |                   | (2,462 | ) |                  |   | 
|                                                                                                      |  |                   |        |   |                  |   |  
|Carrying value of mandatorily-redeemable convertible preferred shares                                 |  | $                 | 2,297  |   |                  | $ | 
|                                                                                                      |  |                   |        |   |                  |   |  



The convertible preferred shares have
a cumulative 7% dividend rate and are mandatorily-redeemable for cash if not converted at the holders sole discretion into the Companys common stock by January 27, 2009.



Total interest expense related to mandatorily-redeemable convertible preferred shares for the nine months ended September 30, 2005
includes non-cash interest expense of approximately $94,000 pertaining to discounts related to warrants, and non-cash interest expense of approximately $387,000 pertaining to discounts related to the beneficial conversion features which includes
$100,000 of such expense related to the one-time special re-set discussed in Note 3.



Amortization of issuance costs for mandatorily-redeemable preferred stock for the nine months ended September 30, 2005, was approximately $56,000.



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Path 1 Network Technologies Inc.



Notes to the Unaudited Consolidated Financial Statements -(Continued)



|ITEM 2. | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|------- | -------------------------------------------------------------------------------------



Forward Looking Statements



This document may contain forward-looking statements. These statements relate to future events or our future financial performance. In some cases, you can identify
forward-looking statements by terminology such as may, will, should, expect, plan, anticipate, believe, estimate, predict,
potential or continue, the negative of such terms or other comparable terminology. These statements are only predictions. Actual events or results may differ materially.



Although we believe that the expectations reflected in the forward-looking statements are
reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of the forward-looking statements. Except to the
extent required by federal law, we disclaim any duty to update any of the forward-looking statements after the date of this report to conform such statements to actual results or to changes in our expectations.



You are also urged to carefully review and consider the various disclosures made by us which
attempt to advise interested parties of the factors which affect our business, including without limitation the disclosures made in this Item 2 or in our annual report on Form 10-K and other reports and filings made with the Securities and
Exchange Commission.



OVERVIEW



We are an industry pioneer and leader in designing, developing and supplying products that
enable the adaptation, transportation and delivery of broadcast-quality real-time video over private and public Internet Protocol (IP) networks, such as the networks that comprise the Internet.



We sell two broad categories of products: long haul video gateways and video multiplexers.
Our long haul video gateways are used by many types of customers to transport live, broadcast quality video perfectly over IP networks that span long distancessometimes tens of thousands of miles, and sometimes over multiple IP networks
operated by separate service providers, while our video multiplexer products are used primarily by cable companies or MSOs to offer video on demand.



Our long haul video gateway products operate in many types of IP networks, including those used to transport video to mobile devices. They are used in very high-grade or
clean IP networks (sometimes referred to as 5 nines networks), as well as less reliable networks such as the public Internet. In all cases, our products basically convert video from its many legacy formats into IP packets,
wrap around the packets our proprietary intellectual property or our recently implemented version of the Pro MPEG standards-based Forward Error Correction (FEC) encapsulation designed to ensure that the digitized video packets are
transported perfectly across an IP network, and then re-convert the IP packets to the legacy video formats. In summary, our gateway products serve as a bridge between the worlds of video and networking.



Our long haul product revenues represented nearly 50% of our total product revenues in 2004,
and in the first nine months of 2005 the percentage of revenues from long haul gateway products increased to 64% of total product revenues, reflecting our continuing focus on long haul opportunities across many industry segments.



Although we received private-placement financings in the nine months ended September 30,
2005 which reflect our ongoing progress and provided us with approximately $5.5 million gross proceeds of needed financial support, we are pursuing additional sources of financing.



The performance for the quarter ended September 30, 2005 was disappointing and attributable to ongoing poor execution by the Company. We
have made changes in management and expect significant changes in the coming quarters. John Zavoli, our former CEO, President, Chief Financial Officer and General Counsel, and David Carnevale, our former Vice President of Corporate Development,
separated from the Company in September 2005. Henry Sariowan, our former Vice President of Strategic Technology Planning, separated from the Company in November 2005. Currently directors Frederick Cary and Robert Packer are serving as co-Interim
Principal Executive Officers.



On November 14, 2005 we singed an employment
letter agreement with Thomas Tullie to serve as our Chief Executive Officer beginning November 15, 2005, subject to ratification and formal appointment by our Board of Directors at its scheduled meeting on the afternoon of November 14, 2005.



Also, in August 2005 we hired Jeremy Ferrell as Controller to replace David
Houillion and in November 2005 we promoted Mr. Ferrell to Interim Chief Financial Officer.



In June 2005, we discovered that a clerk in our finance department embezzled from the Company. We immediately fired the clerk and reported the matter to the police. We conducted an internal investigation, and have
determined that this former



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employee acted alone, that no other Path 1 employees were involved in this matter, and that the amount of the embezzlement was approximately $245,000. This
sum is reflected primarily in general and administrative expenses in the first and second quarters of 2005, and in the third and fourth quarters of 2004. Approximately half of the embezzlement occurred in the second quarter of 2005. After the
completion of the internal investigation, stronger controls and procedures have been instituted and we have recommitted to compliance with previously existing procedures. We have also filed suit and are pursuing other legal remedies against this
former employee, an employment agency from which we hired this former employee, and our bank, to recover the amount which was embezzled.



INDUSTRY BACKGROUND



Current technologies for transmitting real-time, high-quality video over long distances require an established and fully dedicated circuit for the duration of a transmission, regardless of whether the circuit is being
used by the end-user. The concept is similar to a traditional telephone networka call is placed, a circuit between two (or multiple) points is established and thereafter remains open for the duration of the call (regardless of whether anyone
is speaking). These technologies typically require that the network be designed to be able to handle twice the expected average capacity in order to prevent congestion during peak usage. These technologies also require procuring expensive, dedicated
bandwidth that remains open at all times regardless of usage. Dedicated bandwidth is often priced on a monthly basis, requiring significant cost regardless of usage.



Cable and satellite companies have historically used technologies that typically require all available packages of programs be broadcast to
every subscriber. As a result, limited bandwidth remains available for video on demand and similar interactive services requiring two-way communication. Because of these factors, such services are currently available only on a limited basis and in
select markets.



The rise of Internet Protocol (IP) and packet-based
networks



The advent of IP and packet-based networks has resulted in a
dramatic increase in the transmission and exchange of data, information and ideas. IP networks have been predominantly used to carry data traffic such as web site pages, e-mail and file transfers. In IP networks, the flow of information (data,
audio, video, etc.) is not continuous, and is not sent as one complete uninterrupted package. Instead, the information is broken into many small pieces called packets before it is sent out. The reason this protocol (Internet Protocol)
was adopted was to make sure that information could travel from one point to another over the best route and not be constrained in case there were bottlenecks along the first path used. In the event a particular pathway on the network
fails, alternate routes to the same destination are available. But because each packet travels independent of the others and possibly by a different pathway, certain packets can be delayed or delivered out of order relative to others, or may not
ever arrive at the intended destination. There is no guarantee that all the packets will get through, so the protocols involved allow for requests to be sent back to the sender to re-send any missing packets until the information is complete and
reassembled in the proper order. While this process does not cause major problems when sending files, web pages or emails, it can make the transmission of video impractical unless it is modified.



Over the past few years, voice traffic has been added to these networks as a replacement for
more expensive circuit-switched telephony networks. The term used to describe voice calls made using this approach is voice over IP (VoIP). Video is the most recent extension of data types that can be transported over IP networks. As a result, IP
networks have become a powerful and flexible platform capable of supporting data, voice, and video, all converged on the same network infrastructure. This push toward converged IP networks is enabling the rollout of new services and new service
providers such as telecommunications carriers offering IP Television, cable companies offering bundled data, voice and video offerings, carriers offering bundled IP video transport services, and mobile providers offering video including live content
to mobile subscribers.



In the case of transmissions that must be delivered
continuously, such as real-time, high-quality video, even a few milliseconds of delay may be noticeable by the viewer. As the majority of video consumers have become accustomed to high-quality delivery, new service offerings must provide quality at
least as good as that to which the target viewing audience has become accustomed. Thus, IP networks have historically not been well-suited for delivery of real-time, high-quality video. While it is currently possible to view video clips (such as
movie trailers) over the public Internet, the inability of current IP networks to deliver real-time, broadcast quality video requires that the clips be downloaded first, and then played. This download-and-play approach has limited application
because, for instance, a 2.5-hour movie may generally take 6 hours to download over T1 or some types of DSL lines. The data rates for a live quality voice call are typically between 64 and 128 kbps, but video is much more problematic, requiring data
rates ranging from 1 Mbps (MPEG-4 Standard Definition TV) to 20 Mbps (MPEG-2 High Definition TV) for acceptable performance.



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THE PATH 1 SOLUTION



We have developed the technologies and products incorporating those technologies that have overcome the above mentioned inherent limitations of IP networks for
transporting live, broadcast quality video, and that enable broadcasters, telcos, carriers, satellite operators and cable companies to transport live video over these types of networks. As a result, they can enjoy significant lower capital and
operating costs of video transport, higher reliability and quality and other benefits over legacy circuit switched networks, satellite, ATM and other platforms. Our products provide significant benefits for both contribution and distribution of
video.



Our products perform four primary functions: First, they process and
prepare multiple video feeds for delivery over an IP network. Second, and perhaps most important, they condition the video data to avoid impairments or disruptions that would otherwise deteriorate the quality of the video signal. Third, they play
out the received video flawlessly. And fourth, depending upon the application, they may combine multiple video streams arriving over the IP network into single multiplexed stream for delivery to the end-viewer.



Our products enable and provide benefits as follows:



| |  |  | FeasibilityIP offers wider bandwidths than are currently available on alternate video transmission methods (such as satellite and DS-3);
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Efficiencyby using bandwidth only when needed, a greater amount of content can be passed over a providers network;
| | - |  | --------------------------------------------------------------------------------------------------------------------



| |  |  | Transparencywe can transport video regardless of the type of encoding at bit rates from under 1 Mbps to 270 Mbps and can accept ASI, SDI or IP inputs and output them in the
same formats;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Decreased capital coststhe extensive installed base of IP networks and the equipment used to support them results in economies of scale and the availability of cost-effective
products;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Decreased operations costsIP networks, designed to be fault-tolerant and self-correcting, reduce the need for redundant back-up networks and significantly reduce maintenance
and support costs;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Customization and flexibilitythe software architecture underpinning our products allows providers to increase the volume of video traffic being delivered simply by the remote
activation of additional ports or features within our products, rather than incurring costs associated with new equipment installation; and
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Content on demandno longer compelled to broadcast content uniformly to all end-users, providers can send specific content to only those requesting it, further reducing
bandwidth constraints (both into the home and within the network).
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



We believe our technology can be used for a wide variety of purposes by all forms of communication service providers.



Product Development



Our product development efforts are based on customer requirements for increased performance, flexibility and functionality. These efforts include upgrades and functional enhancements to current products and
ultimately the development of a new generation of products.



For example, our
most recent new product is the Vx8000, a multi port ASI and IP gateway product capable of handling up to 8 ports of ASI video for long haul IP transport. This product makes use of the latest Pro-MPEG Code of Practice #3 forward error correction and
RTP transport. We have actively participated in the setting of the standard and have led these efforts along with other key vendors. However, our implementation of that standard goes beyond the requirements for interoperability, providing the
broadest envelope of performance available in the market today. Indeed, in a recent interoperability test conducted by a major European broadcaster, our Vx8000 outperformed competing gateways.



We anticipate that our projected next generation products will make use of higher performance
elements including network processors developed by companies like Intel and Broadcom, general purpose processors made by companies like IBM and MIPS, and FPGAs from companies like Xilinx and Altera. The use of higher performance electronics will
increase flexibility of our products, increase capacity to handle uncompressed High Definition video, and increase capacity to handle multiple High Definition and Standard Definition streams. Many of these higher performance elements are being
designed in a building block manner that also enables us to tailor other designs to focused lower performance requirements as well, thus reducing development efforts required to bring products to market.



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COMPETITION



We face competition in each of the target markets for our products, services and products in development. Our competition includes vendors that produce products for
legacy video transport networks such as satellite, circuit switch, Radio Frequency (RF), ATM and other transport platforms. We also compete with vendors that produce products that enable the transport of video over IP networks including, but not
limited to, companies such as Tandberg Television, Thomson, Harris, Aastra, and Scientific-Atlanta. A number of established and development-stage or start-up companies in these markets offer similar or alternative technological solutions for
convergence of real-time data, such as audio and video over IP networks, as well as real-time, high-quality transition (or transmission) of video over IP networks. We anticipate that we will continue to face increased competition in the future as
adoption rates for video over IP transport increase, and as competitors offering video over IP products and solutions continue to enhance their product offerings and new competitors emerge.



The recent adoption of a standard for forward error correction (FEC) known as Pro-MPEG COP-3
may lead potential customers to believe that all products adopting this standard will perform as well as those of Path 1, threatening our position as the acknowledged leader in this market. While we have already released products that exceed this
standard and perform under a much wider range of network conditions, there is no guarantee that our efforts to demonstrate our continued product differentiation will be successful.



Many of our competitors have substantially greater financial, technical and marketing resources, industry clout, larger customer bases,
longer operating histories, greater name recognition and more established relationships in the industry, and could, therefore, threaten the viability of our business. As a result, certain of these competitors may be able to develop products that
directly compete with ours and may be able to succeed with inferior product offerings. These competitors may also be able to adapt to new or emerging technologies and changes in customer requirements more readily, take advantage of acquisition and
other opportunities more effectively, devote greater resources to the marketing and sale of their products and adopt more aggressive pricing policies than we can. In addition, these competitors have entered and will likely continue to enter into
joint ventures or consortiums to provide additional value-added services competitive with those provided by us.



Our product line is relatively narrow, whereas many of our competitors offer a more complete solution, including products that we do not offer. Our limited product line
represents a significant competitive disadvantage for us.



LIQUIDITY AND
CAPITAL RESOURCES



Since our inception on January 30, 1998, we
have financed our operations through a variety of methods including the sale of common equity securities to investors (including our public offering in July/August 2003), sale of common equity to a strategic partner, issuance of convertible notes,
and in 2005, the issuance of convertible preferred stock.



Our cash position at
September 30, 2005, was $1,362,000 and we had working capital of $930,000. Additionally, the Company has $160,000 in eligible accounts to borrow against under the $1 million revolving line of credit with Laurus Master Fund Ltd. Despite our two
private placements in the nine months ended September 30, 2005, in which we raised aggregate proceeds of approximately $5.4 million, given our projected cash burn rate, we need to raise additional capital to sustain our operations at current levels.
From January 30, 1998 through September 30, 2005, we incurred losses totaling $52.8 million. We have not yet achieved profitability, and we remain a risky enterprise. We believe that our existing capital resources will enable us to fund operations
for only a few months. The Company is taking steps to reduce expenses to help manage our cash. (See Note 2)



Given our projected cash burn rate, we will be required to raise additional capital in the very near term. We are currently pursuing efforts to raise additional capital, and urgently need to do so by December 31,
2005. We cannot ensure that financing would be available to us on acceptable terms, if at all. Our investment bankers, when and if engaged, may not be able to successfully find any financing or other strategic opportunities for us. Our inability to
raise capital when needed would seriously harm our business. In addition, additional equity may dilute our stockholders interest, and debt financing, if available, may involve restrictive covenants and could result in a substantial portion of
our operating cash flow being dedicated to the payment of principal and interest on debt. If adequate funds are not available, we would need to curtail our operations significantly and might not be able to continue.



We raised $2,808,750 in the first quarter of 2005 by a private placement of Series
A 7% convertible preferred stock and associated common stock warrants. We raised an additional $2,575,000 in the second quarter by a private placement of Series B 7% convertible preferred stock and associated common stock warrants.
Both Series A and B have similar terms and conditions including mandatory redemption on January 27, 2009, if they have not previously been converted or redeemed.



The $5.4 million of private placement financing is reflected on our balance sheet as a long-term liability at its net carrying value. The
convertible preferred stock is treated as a liability, rather than equity, for accounting purposes because of its mandatory redemption feature. As a result of the transaction, we recorded a liability equal to the aggregate redemption price and a
discount totaling approximately $1,825,000 that was booked to additional paid-in capital. The discount results from an



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embedded beneficial conversion feature and detachable warrants to purchase common stock with fair values of $2,819,000 and $738,000, respectively. These are
treated as deferred interest charges which will be amortized on an effective yield basis over four years, or sooner if any preferred stock is previously redeemed or converted, resulting in non-cash interest expense each quarter. At
September 30, 2005, the net carrying value of the liability for our mandatorily-redeemable preferred stock was $2,297,000. The remaining unamortized discount related to beneficial conversion feature and detachable warrants was $2,462,000 and
$625,000, respectively.



In February 2003, we entered into a $1 million
revolving line of credit with Laurus. This revolving line of credit (the LOC) is secured by our accounts receivables and other assets, and we have the ability to draw down advances under the LOC subject to limits. As of
September 30, 2005, we had $160,000 of eligible accounts for borrowing. Under the terms of the LOC, Laurus can convert advances made to us into our common stock at a fixed conversion price of $6.78 per share. There was zero balance outstanding
on our LOC as of September 30, 2005.



At September 30, 2005, we had
material commitments related to our obligations under our recent preferred stock financing which could require us to repurchase all our 7% convertible preferred stock for at least $5.4 million in the first quarter of 2009. Our future capital
requirements will depend on many factors, including the timing of research and product development efforts, the possible need to acquire new technology, the expansion of our sales and marketing efforts, and our expansion internationally. We expect
to continue to expend significant amounts in all areas of our operations.



Cash
used in operations was approximately $4,978,000 for the nine months ended September 30, 2005, compared to $5,403,000 for the same period in 2004. The decrease in cash usage was due primarily to a larger portion of our net loss being composed of
non-cash stock-based compensation charges , and the net change in our balance sheet accounts. The $525,000 increase in Other assets in the first nine months of 2005 was due to the capitalized costs associated with the issuance of our
convertible preferred stock.



Cash used in investing activities for the nine
months ended September 30, 2005, was $209,000, compared to $180,000 for the same period ended September 30, 2004. In the nine month period in 2005, we capitalized $113,000 of engineering costs and acquired $96,000 of engineering equipment.



Cash provided by financing activities for the nine-month period ended
September 30, 2005, was $5,620,000 compared to $224,000 for the same period ended September 30, 2004. The cash provided by financing activities in 2005 resulted primarily from the sale of convertible preferred stock while the 2004
provision resulted primarily from the exercise of warrants issued in 2003 in our 7% convertible notes offering.



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RESULTS OF OPERATIONS



Revenues



Revenues

(in thousands)



|                            |  |                                 |     |   |               |   |     |                                |      |     |               |      |   |       |   |  |   |       |   |  |    |  
|--------------------------- |  | ------------------------------- | --- | - | ------------- | - | --- | ------------------------------ | ---- | --- | ------------- | ---- | - | ----- | - |  | - | ----- | - |  | -- | -
|                            |  | Three Months EndedSeptember 30, |     |   | PercentChange |   |     | Nine Months EndedSeptember 30, |      |     | PercentChange |     
|                            |  | 2005                            |     |   | 2004          |   |     |                                | 2005 |     |               | 2004 |   |      
|Product Revenue             |  | $                               | 384 |   |               | $ | 734 |                                |      | -48 | %             |      | $ | 2,352 |   |  | $ | 2,593 |   |  | -9 | %
|Percentage of total revenue |  |                                 | 95  | % |               |   | 97  | %                              |      |     |               |      |   | 98    | % |  |   | 98    | % |  |    |  
|Service/Other Revenue       |  | $                               | 20  |   |               | $ | 22  |                                |      | -9  | %             |      | $ | 57    |   |  | $ | 61    |   |  | -7 | %
|Percentage of total revenue |  |                                 | 5   | % |               |   | 3   | %                              |      |     |               |      |   | 2     | % |  |   | 2     | % |  |    |  
|Total Revenue               |  | $                               | 404 |   |               | $ | 756 |                                |      | -47 | %             |      | $ | 2,409 |   |  | $ | 2,654 |   |  | -9 | %



For the three months ended
September 30, 2005, total revenues declined by $352,000 or 47%, to $404,000 from $756,000 during the three months ended September 30, 2004. Revenues from sales of products in the three months ended September 30, 2005, decreased
$350,000, or 48% to $384,000 from $734,000 in the same period in 2004. The decrease in product sales revenue is due to reduced sales of long-haul products of $483,000 which was partially offset by an increase in cable products sales of $133,000.
Additionally, we had a reduction in sales from partners of $296,000 which is primarily due to Frontiers which accounted for $239,000 of sales in the three months ended September 30, 2004 as compared to no sales in the three months ended
September 30, 2005. The length of time it takes to establish new customer relationships typically ranges from six to twelve months, and as such the timing of sales can fluctuate significantly from quarter to quarter.



For the nine months ended September 30, 2005, total revenues declined by $245,000 or 9%,
to $2,409,000 from $2,654,000 during the nine months ended September 30, 2004. Revenues from sales of products in the nine months ended September 30, 2005, decreased $241,000, or 9% to 2,352,000 from 2,593,000 for the same period in 2004.
The decrease in product revenue is due to reduced sales of cable products of $445,000 which was partially offset by an increase in long-haul products of $204,000. Moreover, revenues for the nine months ended September 30, 2005 include $254,000
recognized for sales made to Frontiers in prior quarters for which we had already been paid and had previously been reported as deferred revenue.



Despite the relatively weak revenue in the three and nine months ended September 30, 2005, we believe that if we are successful in capitalizing on our sales
opportunities, revenue will increase. Our revenues can fluctuate from quarter to quarter, based on timing of customer orders and mix of our product sales.



Cost of Revenues



Cost of Revenues

(in thousands)



|                            |  |                                 |     |   |               |   |     |                                |      |    |               |      |   |       |   |  |   |       |   |  |     |  
|--------------------------- |  | ------------------------------- | --- | - | ------------- | - | --- | ------------------------------ | ---- | -- | ------------- | ---- | - | ----- | - |  | - | ----- | - |  | --- | -
|                            |  | Three Months EndedSeptember 30, |     |   | PercentChange |   |     | Nine Months EndedSeptember 30, |      |    | PercentChange |     
|                            |  | 2005                            |     |   | 2004          |   |     |                                | 2005 |    |               | 2004 |   |      
|Cost of Revenue             |  | $                               | 369 |   |               | $ | 240 |                                |      | 54 | %             |      | $ | 1,142 |   |  | $ | 1,835 |   |  | -38 | %
|Percentage of total revenue |  |                                 | 91  | % |               |   | 32  | %                              |      |    |               |      |   | 47    | % |  |   | 69    | % |  |     |  



Cost of revenues consists of
personnel-related costs in providing support to customers, raw materials costs for the products, and warranty costs as well as an allocation of corporate expenses, such as corporate insurance, facilities, utilities and other.



Cost of revenues increased by $129,000, or 54%, to $369,000 in the three months ended
September 30, 2005 as compared to $240,000 in the three months ended September 30, 2004. During 2005, we adopted a policy to allocate corporate expenses such as corporate insurance, facilities and utilities to each of the functional
departments and to cost of revenues on the basis of headcount. The impact of the allocation to cost of revenues was $87,000 for the three months ended September 30, 2005.



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Additionally, personnel-related costs increased $38,000 in the three months ended September 30, 2005 as compared to the same period in 2004. The 47%
decrease in total revenues combined with a 53% increase in costs of sales resulted in a reduced gross profit percentage to 12% for the three months ended September 30, 2005 as compared to 68% for the same period in 2004.



Cost of revenues decreased by $693,000, or 38%, to $1,142,000 in the nine months ended
September 30, 2005 as compared to $1,835,000 in the nine months ended September 30, 2004. The decrease was due primarily to lower materials costs as compared to the prior year of $892,000 which were partially offset by increased overhead
of $169,000 relating to the new policy adopted in the current year and increased personnel and labor costs of $78,000. The 9% reduction in total revenues combined with the 38% reduction in cost of sales resulted in an improved gross margin
percentage to 53% for the nine months ended September 30, 2005 as compare to 31% for the same period in 2004. We expect the cost of revenues will fluctuate in absolute dollars and as a percentage of total revenue as the related revenue
fluctuates and mix of product sales varies.



Operating Expenses



Engineering, research and development

(in thousands)



|                                      |  |                                 |       |   |               |   |     |                                |      |     |                |      |   |       |   |  |   |       |   |  |     |  
|------------------------------------- |  | ------------------------------- | ----- | - | ------------- | - | --- | ------------------------------ | ---- | --- | -------------- | ---- | - | ----- | - |  | - | ----- | - |  | --- | -
|                                      |  | Three Months EndedSeptember 30, |       |   | PercentChange |   |     | Nine Months EndedSeptember 30, |      |     | Percent Change |     
|                                      |  | 2005                            |       |   | 2004          |   |     |                                | 2005 |     |                | 2004 |   |      
|Engineering, research and development |  | $                               | 1,006 |   |               | $ | 466 |                                |      | 137 | %              |      | $ | 3,112 |   |  | $ | 1,472 |   |  | 111 | %
|Percentage of total revenue           |  |                                 | 274   | % |               |   | 62  | %                              |      |     |                |      |   | 129   | % |  |   | 55    | % |  |     |  



Engineering, research and development
expenses consist of salaries and benefits for engineers and cost of outside consultants as well as the allocation of corporate expenses, calculated on the basis of headcount, such as corporate insurance, facilities, utilities and other.



Engineering, research and development expenses increased $640,000, or 137% from $466,000
to $1,106,000 for the three months ended September 30, 2005 as compared to the same period in 2004. The increase was due primarily to an increase of $434,000 in the allocation of corporate expenses. During 2005, we adopted a policy to allocate
corporate expenses such as corporate insurance, facilities and telephone costs to each of the functional departments on the basis of headcount. In addition, direct consulting and personnel costs increased $146,000 and $57,000, respectively, due to
new product development and product sustaining engineering efforts.



Engineering, research and development expense increased $1,639,000, or 111%, from $1,472,000 to $3,112,000 for the nine months ended September 30, 2005 as compared to the same period in 2004. The increase is due primarily to an
increase of $907,000 in consulting expenses and prototype expenses associated with new product development and an increase in the allocation of corporate expenses of $795,000. We have made the decision, in part due to cost considerations, to
discontinue a development project which had commanded much of the 2005 increase in direct development expenses.



We do not expect engineering, research and development expenses to change significantly in the next several quarters.



Sales and marketing

(in thousands)



|                            |  |                                 |     |   |               |   |     |                                |      |     |                |      |   |       |   |  |   |       |   |  |   |  
|--------------------------- |  | ------------------------------- | --- | - | ------------- | - | --- | ------------------------------ | ---- | --- | -------------- | ---- | - | ----- | - |  | - | ----- | - |  | - | -
|                            |  | Three Months EndedSeptember 30, |     |   | PercentChange |   |     | Nine Months EndedSeptember 30, |      |     | Percent Change |     
|                            |  | 2005                            |     |   | 2004          |   |     |                                | 2005 |     |                | 2004 |   |      
|Sales and marketing         |  | $                               | 880 |   |               | $ | 398 |                                |      | 121 | %              |      | $ | 2,324 |   |  | $ | 2,242 |   |  | 4 | %
|Percentage of total revenue |  |                                 | 218 | % |               |   | 53  | %                              |      |     |                |      |   | 96    | % |  |   | 84    | % |  |   |  



Sales and marketing expenses consist
of salaries, cost of benefits, sales commissions and other expenses related to the direct sales force, as well as allocation of overall corporate expenses, calculated on the basis of headcount, related to such items as corporate insurance,
facilities, utilities, and other.



Sales and marketing expenses increased
$482,000, or 121%, to $880,000 from $398,000 for the three months ended September 30, 2005 as compared to the same period in 2004. The increase was due primarily to an increase of $291,000 in allocated corporate expenses and higher personnel
costs and travel expenses associated with increased headcount.



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Sales and marketing expenses increased $81,000, or 4%, to $2,324,000 from $2,242,000 for the nine months ended
September 30, 2005 as compared to the same period in 2004. The increase was due to an increase of $574,000 in allocated corporate expenses. This increase was partially offset by a one-time charge of $400,000 in the 2004 period for the
repurchase of the exclusive marketing rights to the integrated QAM product we had developed for Aurora Networks and a most-favored-nation pricing which Aurora Networks had as a reseller of our products.



We expect sales and marketing expense to fluctuate as a percentage of revenue based on
changes in revenue.



General and Administrative

(in thousands)



|                            |  |                                 |     |   |               |   |     |                                |      |    |                |      |   |       |   |  |   |       |   |  |     |  
|--------------------------- |  | ------------------------------- | --- | - | ------------- | - | --- | ------------------------------ | ---- | -- | -------------- | ---- | - | ----- | - |  | - | ----- | - |  | --- | -
|                            |  | Three Months EndedSeptember 30, |     |   | PercentChange |   |     | Nine Months EndedSeptember 30, |      |    | Percent Change |     
|                            |  | 2005                            |     |   | 2004          |   |     |                                | 2005 |    |                | 2004 |   |      
|General and administrative  |  | $                               | 615 |   |               | $ | 636 |                                |      | -3 | %              |      | $ | 1,369 |   |  | $ | 2,545 |   |  | -46 | %
|Percentage of total revenue |  |                                 | 152 | % |               |   | 84  | %                              |      |    |                |      |   | 57    | % |  |   | 96    | % |  |     |  



General and administrative expenses
consist primarily of personnel costs for finance, information technology, human resources and general management, as well as outside professional services and an overall allocation of corporate expenses, calculated on the basis of headcount, such as
corporate insurance, facilities, utilities and other.



General and
administrative expenses decreased $21,000, or 3%, to $615,000 from $636,000 for the three months ended September 30, 2005 as compared to the same period in 2004. The decrease is due primarily to a reallocation of corporate expenses of $721,000
due to the adoption of the policy during 2005 to allocate corporate expenses from general and administrative to the other functional departments based on headcount. This decrease was offset by an increase in legal fees associated with several
lawsuits we were engaged in during the quarter. Personnel costs increased by $200,000 primarily due to a one-time charge of $250,000 for the severance to be paid to John Zavoli, our former CEO, as provided in his employment contract. In addition,
audit fees increased by $72,000 due to the correction of the recording of the current year audit fee and additional fees associated with work related to the employee embezzlement discovered during the quarter ended June 30, 2005. Also,
consulting fees increased by $145,000 due to the turnover in the finance department.



General and administrative expenses decreased $1,175,000, or 46%, to $1,369,000 from $2,545,000 for the nine months ended September 30, 2005, as compared to the same period in 2004. The decrease is due primarily to a reallocation of
corporate expenses of $1,466,000 associated with the adoption of the policy during 2005 to allocate corporate expenses from general and administrative to the other functional departments based on headcount. This decrease was partially offset by an
increase in legal fees of $212,000 associated with several lawsuits we were engaged in during the first nine months. In addition, consulting expenses increased $128,000 due to the need for outside assistance to mitigate the turnover in the finance
department. The expenses for the nine months ended September 30, 2005 include $190,000 embezzled by an employee, whom we immediately terminated on June 17, 2005 when we discovered the scheme. The corresponding amount for embezzlement for
the same period of last year was approximately $54,000.



We expect general and
administrative expenses to stabilize or decline in the next several quarters in absolute dollar amounts due to the resolution of lawsuits and the non reoccurrence of severance and embezzlement-related costs.



Stock-based Compensation

(in thousands)



|                            |  |                                 |     |   |               |   |                                |   |      |                |  |      |       |   |  |   |     |   |  |     |  
|--------------------------- |  | ------------------------------- | --- | - | ------------- | - | ------------------------------ | - | ---- | -------------- |  | ---- | ----- | - |  | - | --- | - |  | --- | -
|                            |  | Three Months EndedSeptember 30, |     |   | PercentChange |   | Nine Months EndedSeptember 30, |   |      | Percent Change | 
|                            |  | 2005                            |     |   | 2004          |   |                                |   | 2005 |                |  | 2004 |       |  
|Stock-based compensation    |  | $                               | 234 |   |               | $ |                               |   |      | N/A            |  | $    | 1,126 |   |  | $ | 272 |   |  | 314 | %
|Percentage of total revenue |  |                                 | 58  | % |               |   | 0                              | % |      |                |  |      | 47    | % |  |   | 10  | % |  |     |  



Stock-based compensation is a non-cash
expense item that is recognized as a result of vesting of restricted stock issued to employees. We have also historically recognized compensation expense related to outstanding options or stock awards to consultants and some employees for the amount
of options or awards that vest in that period.



Stock-based compensation
expense increased $234,000, for the three months ended September 30, 2005 to $234,000 as compared to none in the same period of 2004. The increase is due primarily to accelerated vesting of restricted stock in connection with the separation of
three former officers of the Company.



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Stock-based compensation expense increased $854,000, or 314% for the nine months ended September 30, 2005 to
$1,126,000 as compared to $272,000 in the same period of 2004. The increase is due primarily to vesting of restricted stock in favor of five former officers of the Company.



Interest Expense



Net interest expense consists primarily of interest obligations on our outstanding debt and equity instruments. Interest expense was $217,000 and $471,000 for the three
and nine months ended September 30, 2005, respectively, as compared to $22,000 and $72,000 for the comparable periods in 2004. The increase is due primarily to non-cash charges, characterized as interest for accounting purposes,
related to the issuance of mandatorily-redeemable convertible preferred shares during the first six months of 2005.



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RISK FACTORS



You should carefully consider the following risks and uncertainties before you invest in our common stock. Investing in our common stock involves risk. If any of the
following risks or uncertainties actually occurs, our business, financial condition or results of operations could be materially adversely affected. The following are not the only risks and uncertainties we face. Additional risks and uncertainties
of which we are unaware or which we currently believe are immaterial could also materially adversely affect our business, financial condition or results of operations. In any case, the trading price of our common stock could decline, and you could
lose all or part of your investment. See also, Special Note Regarding Forward-Looking Statements.



We need to raise additional capital in the very near future.



Our cash position at September 30, 2005, was $1,362,000. Despite our two private placements in the nine months ended September 30, 2005, in which we raised aggregate proceeds of approximately $5.4
million, given our projected cash burn rate, we need to raise additional capital to sustain our operations at current levels. We believe that our existing capital resources will enable us to fund operations for only a few months. We cannot
ensure that financing will be available to us on acceptable terms, if at all. Our inability to raise capital when needed would severely harm our business. In addition, additional equity financing may dilute our stockholders interest, and debt
financing, if available, may involve restrictive covenants and could result in a substantial portion of our operating cash flow being dedicated to the payment of principal and interest on debt. If adequate funds are not available, we would need to
curtail our operations significantly and might not be able to continue.



Our
window of opportunity may be shrinking.



It is difficult for companies
like us, with small mass and limited resources, to compete in the video transport equipment industry against larger businesses. Our disadvantages have been heightened by our recent failures of execution in many aspects of our business. Although we
believe our products remain technologically superior, our margin of superiority over certain large competitors may diminish as we presently do not offer an integrated solution: we have a narrow product offering. Moreover, our industry is now
adopting international standards for forward error correction (FEC) and other technologies that today are proprietary. While we believe that our implementation of these standards is unique, and while an initial comparison test conducted
by a major European broadcaster showed that our Vx8000 operating our implementation of the Pro-MPEG Code of Practice (COP) # 3 FEC performed best, the movement toward industry standards-based products may result in commoditization and may reduce our
technological advantages, thereby resulting in lower selling prices and reduced gross margins, and thus negatively impact the results of our operations. For these and other reasons, our industry has been experiencing consolidation.



We have incurred losses since inception and will likely not be profitable at least for the
next several quarters.



We have incurred operating losses since our
inception in January 1998. As of September 30, 2005, our accumulated deficit was approximately $52.8 million. We have never been profitable. We expect to continue to incur significant operating, sales, marketing, research and development and
general and administrative expenses and, as a result, we will need to generate significant revenues to achieve profitability. Even if we do achieve profitability, we cannot assure you that we can sustain or increase profitability on a quarterly or
annual basis in the future.



Changes in senior management may result in
difficulties



John Zavoli, our former CEO, President, Chief Financial
Officer and General Counsel, and David Carnevale, our former Vice President of Corporate Development, separated from the Company in September 2005. Henry Sariowan, our former Vice President of Strategic Technology Planning, separated from the
Company in November 2005. Currently directors Frederick Cary and Robert Packer are serving as co-Interim Principal Executive Officers while we seek a new CEO. Also, in August 2005 we hired Jeremy Ferrell as Controller to replace David Houillion.
Mr. Ferrell was recently promoted to Interim Chief Financial Officer. We expect further changes in management. Changes in senior management of small companies are inherently disruptive, and efforts to implement any new strategic or operating
goals may also prove to be disruptive.



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We face competition from established and developing companies, many of which have significantly greater resources, and
we expect such competition to grow.



The markets for our products, future
products and services are competitive. We face direct and indirect competition from a number of established companies, including Tandberg Television, Thomson, Harris, Aastra and Scientific-Atlanta, as well as development stage companies, and we
anticipate that we will face increased competition in the future as existing competitors seek to enhance their product offerings and new competitors emerge. Many of our competitors have greater resources, sell a more complete product line or
solution, have higher name recognition, have more established reputations within the industry and maintain stronger marketing, manufacturing, distribution, sales and customer service capabilities than we do.



The technologies that our competitors and we offer are expensive to design, develop,
manufacture and distribute. Competitive technologies may be owned and commercialized by established companies that possess substantially greater financial, marketing, technical and other resources than we do and, as a result, such companies may be
able to develop their products more rapidly and market their products more extensively than we can.



Competitive technologies that offer a similar or superior capacity to converge and transmit audio, video and telephonic data on a real-time basis over existing networks may currently exist or may be developed in the
future. We cannot assure you that any technology currently being developed by us is not being developed by others or that our technology development efforts will result in products that are competitive in terms of price or performance. If our
competitors develop products or services that offer significant price or performance advantages as compared to our current and proposed products and services, or if we are unable to improve our technology or develop or acquire more competitive
technology, we may find ourselves at a competitive disadvantage and our business could be adversely affected. In addition, competitors with greater financial, marketing, distribution and other resources than we have may be able to leverage such
resources to gain wide acceptance of products inferior to ours.



Our product
line is relatively narrow, whereas many of our competitors can offer customers a complete solution that includes products that we do not manufacture or technologies which we have not developed. Our limited product line represents a significant
competitive disadvantage for us.



We need to develop and introduce new and
enhanced products in a timely manner to remain competitive.



Broadband
communications markets are characterized by continuing technological advancement, changes in customer requirements and evolving industry standards. To compete successfully, we must on a timely basis design, develop, manufacture and sell new or
enhanced products that provide increasingly higher levels of performance and reliability. However, in addition to the technological and managerial risks inherent in any product development effort, we may not be able to develop these products on a
timely basis if the development effort requires more financial resources than we are able to bring to bear, and we may not be able to introduce successfully any new products if our products:



| |  |  | are not cost effective,
| | - |  | -----------------------



| |  |  | are not brought to market in a timely manner,
| | - |  | ---------------------------------------------



| |  |  | are not in accordance with evolving industry standards and architectures, or
| | - |  | ----------------------------------------------------------------------------



| |  |  | fail to achieve market acceptance.
| | - |  | ----------------------------------



Technologies are changing rapidly, and we will be required to spend significant sums on research and developmentparticularly for new hardware designs and software
developmentto produce these next generation products. Our existing products may soon become difficult to produce because of end-of life components, because of emerging governmental restrictions on the manufacture and sale of electronic
products containing lead parts and components, and because of increasing demand in the market for new standards-based products.



In order to develop and market successfully certain of our planned products for digital applications, we may be required to enter into technology development or licensing
agreements with third parties. We cannot assure you that we will be able to enter into any necessary technology development or licensing agreement on terms acceptable to us, or at all. The failure to enter into technology development or licensing
agreements when necessary could limit our ability to develop and market new products and, accordingly, could materially and adversely affect our business and operating results.



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We must re-engineer our current platform and products to comply with environmental laws and regulations.



Our products are not currently in compliance with the RoHS
(Reduction of certain Hazardous Substances) directive of the European Union which will require electronic components shipped into Europe after June 30, 2006 to be essentially lead-free. Various states and other countries are contemplating
adopting this type of legislation and/or similar WEEE (Waste from Electrical Electronic Equipment) legislation designed to reduce the potential damage from hazardous substances contained in electronic components and parts. We will need
to expend significant engineering resources to conform our existing products to this directive, as we believe noncompliant products will no longer be viable in some markets after June 30, 2006. In addition, we will continue to need significant
engineering resources for sustaining-development work (bug fixes, needed upgrades for specific customer bids, etc.). In view of these needs and our finite resources, we are being compelled to scale back certain development toward next-generation
products.



Delivery of real-time, broadcast-quality video via IP networks is
a new market and subject to evolving standards.



Delivery of real-time,
broadcast-quality video over IP networks is novel and evolving, and it is possible that communication service providers or their suppliers will adopt alternative architectures and technologies for delivering real-time, broadcast-quality video over
IP networks or other types of networks that are incompatible with our current or future products. In addition to competing with video over IP vendors, we compete with existing or incumbent alternative technologies and architectures for transporting
live broadcast video that have existed for many years such as satellite, circuit switched networks and ATM, and our customers may not be willing to move to using an IP network for transporting live video.



If we are unable to design, develop, manufacture and sell products that incorporate or are
compatible with these new or existing architectures or technologies, our business could suffer. Moreover, our industry is rapidly adopting technical standards for transporting video over IP networks, and many customers appear to prefer
standards-based or open standards products such as those operating the Pro-MPEG COP (Code of Practice). Our Vx8000, launched in April 2005, is our first product that is Pro-MPEG standards-based. This move towards offering standards-based
products for transporting video over IP networks may result in increased competition, adversely affect our ability to offer differentiated products incorporating our proprietary technology, and cause negative impact to our gross profit margins.



Pricing pressure on our products has placed us at a competitive
disadvantage.



We have experienced significant pricing pressure in some of
the markets for our products, predominantly the cable market. Due to competitive factors, cable customers have been willing to pay only reduced amounts for our products. This has placed us at a competitive disadvantage with our competitors which
have the financial strength to withstand pricing pressures. Most of our competitors in the cable market sell a broader array of products as a bundled solution to cable customers, and these competitors can offer substantial discounts to cable
customers on products that compete directly with ours, sometimes even as loss leaders. If we are unable to regain larger margins on such products, we may be forced to exit certain market segments and our results of operations and profitability will
be negatively affected.



Our quarterly financial results are likely to
fluctuate significantly.



Our quarterly operating results are difficult to
predict and may fluctuate significantly from period to period, particularly because our sales prospects are uncertain and our sales are made on a purchase order basis. In addition, we have not proven our ability to execute our business strategy with
respect to establishing and expanding sales and distribution channels. Fluctuations may result from:



| |  |  | decreased spending on new products by our customers,
| | - |  | ----------------------------------------------------



| |  |  | the timing of new product offerings, acquisitions, licenses or other significant events by us or our competitors,
| | - |  | -----------------------------------------------------------------------------------------------------------------



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| |  |  | problems in our execution of key functions such as engineering, manufacturing, marketing and/or sales,
| | - |  | ------------------------------------------------------------------------------------------------------



| |  |  | our ability to establish a productive sales force or partner with communication service providers or their suppliers,
| | - |  | ---------------------------------------------------------------------------------------------------------------------



| |  |  | demand and pricing of the products we offer,
| | - |  | --------------------------------------------



| |  |  | purchases of our products by communication service providers in large, infrequent amounts consistent with past practice,
| | - |  | ------------------------------------------------------------------------------------------------------------------------



| |  |  | customer acceptance of the services our products enable,
| | - |  | --------------------------------------------------------



| |  |  | interruption in the manufacturing or distribution of our products,
| | - |  | ------------------------------------------------------------------



| |  |  | the willingness and ability of customers to conduct necessary trials and tests of our products prior to sale, and
| | - |  | -----------------------------------------------------------------------------------------------------------------



| |  |  | general economic and market conditions, including war, acts of terrorism, and other conditions specific to the telecommunications industry.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------



As a result, we may experience significant, unanticipated or unexpectedly large quarterly
losses.



The sales cycle for certain of our products is lengthy, which makes
forecasting of our customer orders and revenues difficult.



The sales
cycle for certain of our products is lengthy, often lasting six months to more than a year. Our customers generally conduct significant technical evaluations and trials of our products as well as competing products prior to making a purchasing
decision, even in cases where they may have previously purchased our products for use in one region of their operations and later seek to deploy our products in another. In addition, purchasing decisions may also be delayed because of a
customers internal budget approval processes. Because of the lengthy sales cycle and the size of customer orders, if orders forecasted for a specific customer for a particular period do not occur in that period, our revenues and operating
results for that particular quarter could suffer. Moreover, a portion of our expenses related to an anticipated order is fixed and difficult to reduce or change, affecting results for a particular period.



The rate of market adoption of our technology is uncertain and we could experience long
and unpredictable sales cycles.



Our products are based on new technology
and, as a result, it is extremely difficult to predict the timing and rate of market adoption of our products or the rate of market adoption of applications enhanced by our products such as video-on-demand. Accordingly, we have limited visibility
into when we might realize substantial revenue from product sales.



We are
providing new and highly technical products and services to enable new applications. Thus, the duration of our sales efforts with prospective customers in all market segments is likely to be lengthy as we seek to educate them on the uses and
benefits of our products. This sales cycle could be lengthened even further by potential delays related to product implementation as well as delays over which we have little or no control, including:



| |  |  | the length or total dollar amount of our prospective customers planned purchasing programs contemplating our products;
| | - |  | -----------------------------------------------------------------------------------------------------------------------



| |  |  | changes in prospective customers capital equipment budgets or purchasing priorities;
| | - |  | -------------------------------------------------------------------------------------



| |  |  | prospective customers internal acceptance reviews; and
| | - |  | -------------------------------------------------------



| |  |  | the complexity of prospective customers technical needs.
| | - |  | ---------------------------------------------------------



These uncertainties, combined with many potential customers measured approaches to corporate spending on technology generally as well as new technologies such as
ours, substantially complicate our planning and may reduce prospects for sales of our products. If our prospective customers curtail or eliminate their purchasing programs, decrease their budgets or reduce their purchasing priority, our results of
operations could be adversely affected.



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Our customer base is concentrated and the loss of one or more of our key customers would harm our business.



Historically, a significant majority of our sales have been to relatively
few customers. We expect that sales to relatively few customers will continue to account for a significant percentage of our net sales for the foreseeable future. Almost all of our sales are made on a purchase order basis, and none of our customers
has entered into a long-term agreement requiring it to purchase our products. The loss of, or any reduction in orders from, a significant customer would harm our business.



The success of our business is dependent on establishing and expanding sales and distribution channels for our products.



Third-Party Collaborations. Although we intend to establish strategic
relationships with leading suppliers, integrators and resellers to promote and distribute our products, we may not succeed. We may not be able to identify adequate partners, and even if identified, we may not be able to enter into agreements with
these entities on commercially reasonable terms, or at all. To the extent that we enter into any such agreements with third parties, any revenues we receive from sales of our products in those markets will depend upon the efforts of such third
parties, which in most instances will not be within our control. If we are unable to leverage effectively a partner to market our products more broadly than we can through our internal sales force, our business could be adversely affected.



Internal Sales Force. We have limited experience in marketing and
selling our products. We intend to expand our direct and indirect sales force and independent channel partners domestically and internationally for the promotion of our product lines and other future products to suppliers and communication service
providers of all kinds. Competition for quality sales and marketing personnel and channel partners is intense. In addition, new employees, particularly new sales and marketing employees, will require training and education concerning our products
and will also increase our operating expenses. There can be no assurance that we will be successful in attracting or retaining qualified sales and marketing personnel and partners. As a result, there can be no assurance that the sales force we are
able to build will be of a sufficient size or quality to effectively market our products.



We may not be able to profit from growth if we are unable to manage the growth effectively.



We anticipate that we will need to grow in the future. This anticipated growth will place strain on our managerial, financial and personnel resources. The pace of our
anticipated expansion, together with the complexity of the technology involved in our products and the level of expertise and technological sophistication incorporated into the provision of our design, engineering, implementation and support
services, demands an unusual amount of focus on the operational needs of our future customers for quality and reliability, as well as timely delivery and post-installation and post-consultation field and remote support. In addition, new customers,
especially customers that purchase novel and technologically sophisticated products such as ours, generally require significant engineering support. Therefore, adoption of our platforms and products by customers would increase the strain on our
resources.



To reach our goals, we may need to hire rapidly, while at the same
time investing in our infrastructure. We expect that we will also have to expand our facilities. In addition, we will need to successfully train, motivate and manage new employees; expand our sales and support organization; integrate new management
and employees into our overall operations; and establish improved financial and accounting systems. Indeed, even without consideration of future needs imposed by any future growth of our business, we need to upgrade several of these areas even to
support our present levels of business.



We may not succeed in anticipating all
of the changing demands that growth would impose on our systems, procedures and structure. If we fail to effectively manage our expansion, if any, our business may suffer.



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We will depend on broadcasting, cable and satellite industry spending for a substantial portion of our revenue and any
decrease or delay in spending in these industries would negatively impact our resources, operating results and financial condition.



Demand for our products will depend on the magnitude and timing of spending by cable television operators, broadcasters, satellite operators and carriers for adopting new
products for installation with their networks.



Spending by
customers in these sectors is dependent on a variety of factors, including:



| |  |  | overall demand for communication services and the acceptance of new video, voice and data services;
| | - |  | ---------------------------------------------------------------------------------------------------



| |  |  | annual budget cycles;
| | - |  | ---------------------



| |  |  | the status of federal, local and foreign government regulation of telecommunications and television broadcasting;
| | - |  | -----------------------------------------------------------------------------------------------------------------



| |  |  | access to financing;
| | - |  | --------------------



| |  |  | evolving industry standards and network architectures;
| | - |  | ------------------------------------------------------



| |  |  | competitive pressures;
| | - |  | ----------------------



| |  |  | discretionary customer spending patterns;
| | - |  | -----------------------------------------



| |  |  | general economic conditions.
| | - |  | ----------------------------



Recent developments in capital markets have reduced access to funding for potential and existing customers causing delays in the timing and scale of deployments of our equipment, as well as the postponement of certain
projects by our customers. The timing of deployment of our equipment can be subject to a number of other risks, including the availability of skilled engineering and technical personnel.



Product quality problems may negatively affect our revenues and results from operations, as well as disrupt our research and development
efforts.



We produce highly complex products that incorporate leading edge
technology including hardware, software and embedded firmware. In addition to problems relating to the physical quality of manufacturing, our software and other technology may contain bugs that can prevent our products from performing as
intended. There can be no assurance that our pre-shipment testing programs will be adequate to detect all defects either in individual products or which could affect numerous shipments that, in turn, could create customer dissatisfaction, reduce
sales opportunities, or affect gross margins if the cost of remedying the problems exceed our reserves established for this purpose. Our inability to cure a product defect may result in the failure of a product line, serious damage to our
reputation, and increased engineering and product re-engineering costs that individually or collectively would have a material adverse impact on our revenues and operating results.



We rely on several key suppliers of components, sub-assemblies and modules that we use to manufacture our products, and we are subject to
manufacturing and product supply chain risks.



We purchase components,
sub-assemblies and modules from a limited number of vendors and suppliers that we use to manufacture and test our products. Our reliance on these vendors and suppliers involves several risks including, but not limited to, the inability to purchase
or obtain delivery of adequate supplies of such components, sub-assemblies or modules, increases in the prices of such items, quality, and overall reliability of our vendors and suppliers. Although in many cases we use standard parts and components
for our products, certain components are presently available only from a single source or limited sources. Some of the materials used to produce our products are purchased from foreign suppliers. We do not generally maintain long-term agreements
with any of our vendors or suppliers. Thus we may thus be unable to procure necessary components, sub-assemblies or modules in time to manufacture and ship our products, thereby harming our business.



We operate under an agreement with a leading parts vendor to provide turnkey outsourced
manufacturing services. To reduce manufacturing lead times and to ensure adequate component supply, we have instructed our vendor to procure inventory based on criteria and forecasts as defined by us. If we fail to anticipate customer demand
properly, an oversupply of parts, obsolete components or finished goods could result, thereby adversely affecting our gross margins and results of operations.



We may also be subject to disruptions in our manufacturing and product-testing operations that could have a material adverse affect on our operating results.



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We may not be able to hire and assimilate key employees.



Our future success will depend, in part, on our ability to attract and retain highly skilled
employees, including management, technical and sales personnel. Significant competition exists for employees in our industry and in our geographic region. We may be unable to identify and attract highly qualified employees in the future. In
addition, we may not be able to assimilate successfully these employees or hire qualified personnel to replace them. The loss of services of any of our key personnel, the inability to attract or retain key personnel in the future, or delays in
hiring required personnel, particularly engineering and sales personnel, could make it difficult to meet key objectives such as timely and effective product introductions.



Changes in the mix of product sales, product distribution model or customer base could negatively impact our sales and margins.



We may encounter a shift in the mix of the various products that we
sellproducts that have varying selling prices based in part on the type of product sold, competitive conditions in the particular market into which the product is sold, applicable sales discounts, licensed product feature sets, whether we sell
our products as an OEM, and whether the sale is a direct sale or an indirect channel sale through our VARs and resellers. Any change in any of these variables could result in a material adverse impact on our gross sales, gross margins and operating
results.



We may be unable to obtain full patent protection for our core
technology and there is a risk of infringement.



Since 2001, we have
submitted several patent applications and provisional patent applications on topics surrounding our core technologies to supplement our existing patent portfolio. There can be no assurance that these or other patents will be issued to us, or, if
additional patents are issued, that they or our three existing patents will be broad enough to prevent significant competition or that third parties will not infringe upon or design around such patents to develop competing products. There is no
assurance that these or any future patent applications will be granted, or if granted, that they will not be challenged, invalidated or circumvented.



In addition to seeking patent protection for our products, we intend to rely upon a combination of trade secret, copyright and trademark laws and contractual provisions
to protect our proprietary rights in our products.



There has been a trend
toward litigation regarding patent and other intellectual property rights in the telecommunications industry. Although there are currently no lawsuits pending against us regarding possible infringement claims, there can be no assurance such claims
will not be asserted in the future or that such assertions will not materially adversely affect our business, financial conditions and results of operations. Any such suit, whether or not it has merit, would be costly to us in terms of employee time
and defense costs and could materially adversely affect our business.



If an
infringement or misappropriation claim is successfully asserted against us, we may need to obtain a license from the claimant to use the intellectual property rights. There can be no assurance that such a license will be available on reasonable
terms if at all.



We are subject to local, state and federal regulation.



Legislation affecting us (or the markets in which we compete) could
adversely impact our ability to implement our business plan on a going-forward basis. The telecommunications industry in which we operate is heavily regulated and these regulations are subject to frequent change. Future changes in local, state,
federal or foreign regulations and legislation pertaining to the telecommunications field may adversely affect prospective purchasers of telecommunications equipment, which in turn would adversely affect our business.



The market price of our common stock could be volatile and your investment could suffer a
decline in value.



The market prices for our common stock is likely to be
volatile and could be susceptible to wide price fluctuations due to a number of internal and external factors, many of which are beyond our control, including:



| |  |  | quarterly variations in operating results and overall financial condition;
| | - |  | --------------------------------------------------------------------------



| |  |  | economic and political developments affecting technology spending generally and adoption of new technologies and products such as ours;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------



| |  |  | customer demand or acceptance of our products and solutions;
| | - |  | ------------------------------------------------------------



| |  |  | short-selling programs;
| | - |  | -----------------------



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| |  |  | stock selling by persons to whom we sold securities in one or more private placements at below-market prices;
| | - |  | -------------------------------------------------------------------------------------------------------------



| |  |  | changes in IT spending patterns and the rate of consumer acceptance of video-on-demand;
| | - |  | ---------------------------------------------------------------------------------------



| |  |  | product sales progress, both positive and negative;
| | - |  | ---------------------------------------------------



| |  |  | the stock markets perception of the telecommunications equipment industry as a whole;
| | - |  | --------------------------------------------------------------------------------------



| |  |  | technological innovations by others;
| | - |  | ------------------------------------



| |  |  | cost or availability of components, sub-assemblies and modules used in our products;
| | - |  | ------------------------------------------------------------------------------------



| |  |  | the introduction of new products or changes in product pricing policies by us or our competitors;
| | - |  | -------------------------------------------------------------------------------------------------



| |  |  | proprietary rights disputes or litigation;
| | - |  | ------------------------------------------



| |  |  | initiation of or changes in earnings estimates by analysts;
| | - |  | -----------------------------------------------------------



| |  |  | additions or departures of key personnel; and
| | - |  | ---------------------------------------------



| |  |  | sales of substantial numbers of shares of our common stock or securities convertible into or exercisable for our common stock.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------



In addition, stock prices for many technology companies, especially early-stage companies
such as ours, fluctuate widely for reasons that may be unrelated to operating results. These fluctuations, as well as general economic, market and political conditions such as interest rate increases, recessions or military or political conflicts,
may materially and adversely affect the market price of our common stock, thereby causing you to lose some or all of your investment.



In addition, if the average daily trading volume in our common stock is low, the resulting illiquidity could magnify the effect of any of the above factors on our stock
price.



Newly adopted accounting regulations requiring companies to expense
stock options will result in a decrease in our earnings, or an increase in our losses, and our stock price may decline.



The Financial Accounting Standards Board recently adopted the previously proposed regulations that will eliminate the ability to account for share-based compensation
transactions using the intrinsic method that we currently use and generally would require that such transactions be accounted for using a fair-value-based method and recognized as an expense in our consolidated statement of operations. We will be
required to expense stock options vested after December 31, 2005. Currently, we generally only disclose such expenses on a pro forma basis in the notes to our consolidated financial statements in accordance with accounting principles generally
accepted in the United States. The adoption of this new accounting regulation will have a significant impact on our results of operations when or if we issue stock options after December 31, 2005, and our stock price could decline accordingly.



Our outstanding convertible preferred stock and warrants and the stock
options and bonus stock we offer to our employees, non-employee directors, consultants and advisors could result in ongoing dilution to all stockholders.



We maintain three equity compensation plans: (i) the 2000 Stock Option/Stock Issuance Plan (the 2000 Plan), pursuant to which we may issue an
aggregate of 710,000 options and shares of common stock to employees, officers, directors, consultants and advisors, (ii) the 2001 Employee Stock Purchase Plan (the Purchase Plan), pursuant to which our employees are provided the
opportunity to purchase our stock through payroll deductions, and (iii) the 2004 Equity Incentive Plan (the 2004 Plan), pursuant to which we may issue a total of 900,000 options and shares of common stock to employees, officers,
directors, consultants and advisors. As of September 30, 2005, 435,000 shares of stock had been granted directly to current and former executives of the Company and there were options outstanding to purchase 274,342 shares of common stock under
our 2000 Plan; 70,658 shares of common stock remained available for issuance under the 2000 Plan. A maximum of 710,000 shares of common stock have been authorized for issuance under the Purchase Plan. As of September 30, 2005, there were
options outstanding to purchase 430,935 shares of common stock and 20,000 shares of stock had been granted directly to current executives of the Company under our 2004 Plan; 469,065 shares of common stock remained available for issuance under the
2004 Plan.



In addition, as of September 30, 2005, there were 59,840
shares of common stock subject to outstanding options granted other than under the 2004 Plan, the 2000 Plan or the Purchase Plan. These non-plan options were granted in prior years to various employees, directors, consultants and advisors before the
creation of any stock option plan.



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We plan to continue to provide our employees opportunities to participate in the Purchase Plan. We also plan to issue
options to purchase sizable numbers of shares of common stock to new and existing employees, officers, directors, advisors, consultants or other individuals as we deem appropriate and in our best interests. This could result in substantial dilution
to all stockholders and increased control by management.



As of
September 30, 2005, there were outstanding warrants to purchase up to 4,047,559 shares of our common stock with a weighted average exercise price of $4.70 per share. The weighted average remaining life for all of the currently outstanding
warrants is 2.82 years from September 30, 2005.



In addition, at
September 30, 2005, there were 864,229 shares of Series A 7% convertible preferred stock and 792,306 shares of Series B 7% Convertible Preferred Stock outstanding. These shares are convertible into shares of common stock.



Our common stock is subject to the rights and preferences of our
mandatorily-redeemable convertible preferred stock.



In January and
February 2005, we issued 864,229 shares of 7% Convertible Preferred Stock in a Series A private placement. These shares have an aggregate liquidation preference of $2,808,750 above the common stock, have an aggregate cumulative dividend of
approximately $200,000 per year, must be redeemable in four years, and are convertible into common stock (with favorable anti-dilution adjustments if we issue stock below fair market value). Also, without approval of a majority of the 7% Convertible
Preferred Stock, we cannot repurchase or redeem common stock (except pursuant to repurchase agreements with service providers) or borrow money or issue debt securities other than in a strategic transaction, in connection with an acquisition of
another entity, or pursuant to an independent-directors-approved commercial borrowing transaction, secured lending transaction or lease financing transaction.



In the second quarter of 2005, we issued 792,306 shares of Series B 7% Convertible Preferred Stock, with rights and preferences substantially similar to those of
Series A.



We do not intend to pay cash dividends.



We have never paid cash dividends on our capital stock and do not anticipate paying any cash
dividends in the foreseeable future.



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##### Table of Contents

|ITEM 3. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
|------- | ----------------------------------------------------------



We would be exposed to changes in interest rates primarily from any marketable securities and investments in certain available-for-sale securities. Under our current policies, we do not use interest rate derivative
instruments to manage exposure to interest rate changes. At September 30, 2005, we did not have any marketable securities or investments in available-for-sale securities, nor did we have any sales denominated in a currency other than the United
States dollar. Our cash equivalents principal would not be materially changed by changes in interest rates, but as the short term instruments mature and roll over, we would be able to earn more interest in the future if interest rates rise. A
one percentage point (100 basis point) increase in interest rates would result in approximately a $17,000 annual increase in our income from cash equivalents, assuming our cash equivalents principal balance remained at its September 30, 2005
level. Our $1 million revolving line of credit from Laurus has a floating interest rate and currently has zero outstanding balance.



|ITEM 4. | CONTROLS AND PROCEDURES
|------- | -----------------------



Frederick
Cary and Robert Packer, our co-interim principal executive officers, and Jeremy Ferrell, our interim principal financial officer, after evaluating the effectiveness of our disclosure controls and procedures (as defined in Securities
Exchange Act of 1934 Rule 13a15(e)), concluded that as of September 30, 2005, our disclosure controls and procedures were effective.



PART IIOTHER INFORMATION



|ITEM 1. | LEGAL PROCEEDINGS
|------- | -----------------



We are not a
defendant in any material legal proceedings.



|ITEM 2. | UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
|------- | -----------------------------------------------------------



None.



|ITEM 3. | DEFAULTS UPON SENIOR SECURITIES
|------- | -------------------------------



Not applicable.



|ITEM 4. | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
|------- | ---------------------------------------------------



The Annual Meeting of Shareholders was held on July 18, 2005. At the meeting, the shareholders approved two proposals. The shareholders approved a proposal to ratify the appointment of Swenson Advisors, LLP
as independent registered public accountants of the Company for the fiscal year ending December 31, 2005. The proposal was approved with 6,150,380 voting for, 1,233 voting against and 1,000 abstaining. The shareholders also approved
the election of the following individuals as directors who will hold office until their successors are duly elected: James Bixby with 6,124,954 voting for and 27,659 votes withheld, Mark Buckner with 6,124,954 voting for and 27,659 withheld,
Frederick Cary with 6,122,454 voting for and 30,159 withheld, Robert Clasen with 6,124,954 voting for and 27,659 withheld, Robert Packer with 6,124,954 voting for and 27,659 withheld and John Zavoli with 6,122,454 voting for and 30,159 withheld.



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##### Table of Contents

|ITEM 5. | OTHER INFORMATION
|------- | -----------------



On July 18,
2005 we increased the base salary rate of Henry Sariowan, then our Vice President of Strategic Technology Planning, to $165,000 per annum, effective July 18, 2005.



On August 11, 2005 we entered into the third amendment of the restricted stock award agreement between us and John Zavoli, our former Chief
Executive Officer to change the vesting period of restricted stock to one-tenth a month starting on October 13, 2005 and the same day of each of the nine succeeding calendar months. In consideration for the Companys amendment to his agreement
Mr. Zavoli was required to enter into a Rule 10b5-1 stock selling plan which would sell Restricted Stock to generate gross proceeds equal to 40% of the gross taxable income recognized by the vesting of Restricted Shares and remit payment to the
Company to cover the Federal and California tax withholding amounts. In addition Mr. Zavoli agreed not to sell, assign or transfer shares in an amount equal to 30% of the Restricted Stock vested, unless the Company is acquired, the Participant
leaves the service of the Company, or written permission was granted by the Companys Compensation Committee.



On September 23, 2005 we entered into an employment letter agreement amendment between us and John Zavoli, our former Chief Executive Officer, to provide if any
post-termination payment to Mr. Zavoli that constituted deferred compensation if payable later than March 15 of the calendar year after the calendar year in which employment was terminated must to the extent not already paid shall be due and
payable in full on March 15.



On September 23, 2005 we entered into
the third amendment of the restricted stock award agreement between us and David Carnevale, our former Vice President of Corporate Development to immediately vest all the shares of Restricted Stock which were not fully vested as of
September 23, 2005 in anticipation of Mr. Carnevales resignation as Vice President and an employee.



On September 23, 2005 we entered into the fourth amendment of the restricted stock award agreement between us and John Zavoli, our form Chief Executive Officer to
vest 10,000 shares of restricted stock as of September 23, 2005 and the remaining 55,000 shares of restricted stock to vest as of the second business day after our third quarter 2005 earnings announcement provided that Mr. Zavoli serves
Path 1 as an unpaid consultant through this period.



On July 29, 2005 we
entered into a separation, consulting and general release agreement between us and David Houillion, our former Chief Accounting Officer to provide two months salary as severance in exchange for availability of Mr. Houillion for sixty hours per
month to consult with us for a period of sixty days.



On July 15, 2005 we
entered into a financial advisory agreement between us and Merriman Curhan Ford and Company to provide us with investment banking services, identify strategic partners and partnering opportunities and evaluate and negotiate proposals to purchase the
Company.



On August 1, 2005 we entered into an employment letter agreement
between us and Jeremy Ferrell for the position of Controller.



On
August 30, 2005 we entered into a restricted stock award agreement between us and Jeremy Ferrell, our Controller to provide 10,000 shares of restricted stock which will vest one-half on August 29, 2006 and the remaining one half restricted
shares will vest over four quarterly installments from August 30, 2006 through August 29, 2007.



32



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##### Table of Contents

|ITEM 6. | EXHIBITS
|------- | --------



|               |  |                                                                                                                
|-------------- |  | ---------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Description                                                                                                    
|10.70.1 * #    |  | Employment Letter Agreement Amendment between us and John Zavoli, dated September 23, 2005.                    
|               | 
|10.72.1 * #    |  | Third Amendment of Restricted Stock Award Agreements between us and David Carnevale, as of September 23, 2005. 
|               | 
|10.78.1 * #    |  | Third Amendment of Restricted Stock Award Agreement between us and John Zavoli, as of August 11, 2005.         
|               | 
|10.78.2 * #    |  | Fourth Amendment of Restricted Stock Award Agreement between us and John Zavoli, dated September 23, 2005.     
|               | 
|10.89 * #      |  | Separation, Consulting and General Release Agreement between us and David Houillion dated July 19, 2005.       
|               | 
|10.90 *        |  | Financial Advisory Agreement between us and Merriman Curhan Ford & Company dated July 15, 2005.                
|               | 
|10.91 * #      |  | Jeremy Ferrell employment letter agreement dated August 1, 2005.                                               
|               | 
|10.92 * #      |  | Restricted Stock Award Agreement between us and Jeremy Ferrell, dated August 30, 2005.                         
|               | 
|31.1*          |  | Certifications under Section 302 of the Sarbanes-Oxley Act of 2002 / SEC Rule 13a14(a).                       
|               | 
|31.2*          |  | Certifications under Section 302 of the Sarbanes-Oxley Act of 2002 / SEC Rule 13a14(a).                       
|               | 
|31.3*          |  | Certifications under Section 302 of the Sarbanes-Oxley Act of 2002 / SEC Rule 13a14(a).                       
|               | 
|32.1*          |  | Certification under Section 906 of the Sarbanes-Oxley Act of 2002 / 18 U.S.C. Section 1350/ SEC Rule 13a-14(b).
|               | 
|32.2*          |  | Certification under Section 906 of the Sarbanes-Oxley Act of 2002 / 18 U.S.C. Section 1350/ SEC Rule 13a-14(b).
|               | 
|32.3*          |  | Certification under Section 906 of the Sarbanes-Oxley Act of 2002 / 18 U.S.C. Section 1350/ SEC Rule 13a-14(b).

---

|* | Filed Herewith
|- | --------------



|# | Indicates management contract or compensatory plan or arrangement.
|- | ------------------------------------------------------------------



33



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##### Table of Contents

SIGNATURES



Pursuant to the
requirements 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.



|                                 |  |                                                      
|-------------------------------- |  | -----------------------------------------------------
|Path 1 Network Technologies Inc.
|                                 | 
|By:                              |  | /s/ Frederick Cary                                   
|                                 |  | Frederick Cary Co-Interim Principal Executive Officer



Date:
November 14, 2005



34



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##### Table of Contents

INDEX OF EXHIBITS



|               |  |                                                                                                                
|-------------- |  | ---------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Description                                                                                                    
|10.70.1 * #    |  | Employment Letter Agreement Amendment between us and John Zavoli, dated September 23, 2005.                    
|               | 
|10.72.1 * #    |  | Third Amendment of Restricted Stock Award Agreements between us and David Carnevale, as of September 23, 2005. 
|               | 
|10.78.1 * #    |  | Third Amendment of Restricted Stock Award Agreement between us and John Zavoli, as of August 11, 2005.         
|               | 
|10.78.2 * #    |  | Fourth Amendment of Restricted Stock Award Agreement between us and John Zavoli, dated September 23, 2005.     
|               | 
|10.89 * #      |  | Separation, Consulting and General Release Agreement between us and David Houillion dated July 19, 2005.       
|               | 
|10.90 *        |  | Financial Advisory Agreement between us and Merriman Curhan Ford & Company dated July 15, 2005.                
|               | 
|10.91 * #      |  | Jeremy Ferrell employment letter agreement dated August 1, 2005.                                               
|               | 
|10.92 * #      |  | Restricted Stock Award Agreement between us and Jeremy Ferrell, dated August 30, 2005.                         
|               | 
|31.1*          |  | Certifications under Section 302 of the Sarbanes-Oxley Act of 2002 / SEC Rule 13a14(a).                       
|               | 
|31.2*          |  | Certifications under Section 302 of the Sarbanes-Oxley Act of 2002 / SEC Rule 13a14(a).                       
|               | 
|31.3*          |  | Certifications under Section 302 of the Sarbanes-Oxley Act of 2002 / SEC Rule 13a14(a).                       
|               | 
|32.1*          |  | Certification under Section 906 of the Sarbanes-Oxley Act of 2002 / 18 U.S.C. Section 1350/ SEC Rule 13a-14(b).
|               | 
|32.2*          |  | Certification under Section 906 of the Sarbanes-Oxley Act of 2002 / 18 U.S.C. Section 1350/ SEC Rule 13a-14(b).
|               | 
|32.3*          |  | Certification under Section 906 of the Sarbanes-Oxley Act of 2002 / 18 U.S.C. Section 1350/ SEC Rule 13a-14(b).

---

|* | Filed Herewith
|- | --------------



|# | Indicates management contract or compensatory plan or arrangement.
|- | ------------------------------------------------------------------



35