**United
      States**


**Securities
      and Exchange Commission**


**Washington,
      D.C. 20549**





**FORM
      10-K**





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


For
      the fiscal year ended December 31, 2005.


OR


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


For
      the transition period from  to





Commission
      File Number: 000-19828





**SPATIALIGHT,
      INC.**


(Exact
      name of registrant as specified in its Charter)




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




Five
      Hamilton Landing, Suite 100, Novato, California 94949


(Address
      of principal executive offices)   (zip
      code)





(415)
      883-1693


(Issuer’s
      telephone number including area code)





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


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





Common
      Shares, $.01 par value


(Title
      of
      Class)





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


Yes
o
      No x





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


Yes
o
      No x





Indicate
      by check mark whether the registrant (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      preceding 12 months (or for such shorter period that the registrant was required
      to file such reports), and (2) has been subject to such filing requirements
      for
      the past 90 days:     Yes
      x No o





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





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


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





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





The
      aggregate market value for the registrant’s voting shares held by non-affiliates
      of the registrant, based upon the $2.28 per share closing sale price of the
      common shares on March 10, 2006, as reported on the Nasdaq SmallCap Market,
      was
      approximately $65,694,534. Common shares held by each officer and director
      and
      by each person who owns 5% or more of the outstanding common shares have been
      excluded because such persons are deemed to be affiliates. This determination
      of
      affiliate status is not necessarily a conclusive determination for other
      purposes.





As
      of
      March 10, 2006, registrant had 38,692,500 common shares
      outstanding.





DOCUMENTS
      INCORPORATED BY REFERENCE





None.








SPATIALIGHT,
      INC.


FORM
      10-K
      ANNUAL REPORT





TABLE
      OF
      CONTENTS


PagePART
                  IITEM
                  1
              Business
              3ITEM
                    1A
              Risk
                  Factors
              8ITEM
                  1B
              Unresolved
                  Staff Comments
              16ITEM
                  2
              Description
                  of Property
              16ITEM
                  3
              Legal
                  Proceedings
              17ITEM
                  4
              Submission
                  of Matters to a Vote of
                  Security Holders
              17PART
                  IIITEM
                5
              Market
                  for Common Equity and Related Stockholders Matters
              17ITEM
                  6
              Selected
                  Condensed Consolidated Financial Data
              18ITEM
                  7
              Management’s
                  Discussion and Analysis of Financial Conditionand
                  Results of Operations
              19ITEM
                  7A
              Quantitative
                  and Qualitative Disclosures About Market Risk
              30ITEM
                  8
              Consolidated
                  Financial Statements
              31ITEM
                  9
              Changes
                  in and Disagreements with Accountant on
                  Accounting and Financial Disclosure
              63ITEM
                  9A
              Controls
                  and Procedures
              63ITEM
                  9B
              Other
                  Information
              68PART
                  IIIITEM
                  10
              Directors
                  and Executive Officers
              69ITEM
                  11
              Executive
                  Compensation
              70ITEM
                  12
              Security
                Ownership of Certain Beneficial Owners and Management and
                Related Shareholder Matters
              74ITEM
                  13
              Certain
                Relationships and Related Transactions
              75ITEM
                  14
              Principal
                  Accountant Fees and Services
              77PART
                  IVITEM
                  15
              Exhibits,
                  Consolidated Financial Statement Schedules and
                  Reports on Form 8-K
              77




2




**PART
      I**





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





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





**Description
      of Business**





We
      are in
      the business of manufacturing high-resolution Liquid Crystal on Silicon (LCoS)
      microdisplays. Our current customers and prospective customers are original
      equipment manufacturers (OEMs) engaged in the businesses of manufacturing high
      definition televisions or manufacturing light engines for incorporation into
      high definition televisions. Our products are also suitable for incorporation
      into other potential display applications including rear projection computer
      monitors, wireless communication devices, portable games and digital assistants,
      although we are not currently working with OEMs of any of these products.




We
      were
      incorporated under the laws of the State of New York in 1989. Our executive
      offices are located at Five Hamilton Landing, Suite 100, Novato, California
      94949.




*Business
      with LG Electronics, Inc.*




In
      July
      2004, we entered into an agreement with LG Electronics, providing for us to
      sell
      a specially tailored version of our T-3 LCoS Sets to LG Electronics. (See
“Technology and Products under Development” for a description of our products).
      For a more detailed discussion of our business with LG Electronics, see Item
      7
“Management’s Discussion and Analysis of Financial Condition and Results of
      Operations.” In August 2005, we received a firm purchase order from LG
      Electronics for its purchase from us of an aggregate minimum quantity of 9,300
      LCoS Sets for the period July through December 2005. In October 2005, we
      publicly announced that we had received the formal written qualification letter
      from LG Electronics stating that we have met certain agreed upon technical
      specifications (which had been the subject of prior informal approval in July
      2005). We later agreed with LG Electronics to move the initial six-month
      delivery period to November 2005 through April 2006. We subsequently agreed
      with
      LG Electronics, through a series of communications, that the initial purchase
      order for 9,300 LCoS Sets may be filled over a period of time that will extend
      beyond April 2006. We currently expect that the initial order for 9,300 LCoS
      Sets will be filled during the summer of 2006. This revised schedule has been
      based primarily upon changing expectations about our production output capacity
      and will allow us to conduct a focused ramp up of our LCoS Set production at
      our
      manufacturing facility in South Korea.




In
      November and December 2005, we delivered a limited quantity of production LCoS
      Sets to LG Electronics based upon a revised delivery schedule. Our delivery
      ramp
      up has been slower than expected due to LG Electronics’ product specification
      changes and certain difficulties in ramping up our manufacturing volumes. See
      Item 7 “Management’s Discussion and Analysis” for more discussion of these
      problems. The potential negative impact upon our results of operations that
      could be caused by difficulties in manufacturing our LCoS Sets are described
      under Risk Factors in Item 1A.




In
      2005,
      a substantial percentage of our product deliveries, which were in small
      quantities, were made to LG Electronics. Based upon our agreement with LG
      Electronics, we believe it is likely that a substantial percentage of our
      anticipated future product deliveries in the first half of 2006 will be made
      to
      LG Electronics as well. The loss of LG Electronics as a customer or any further
      delays in our delivery schedule to LG Electronics could significantly harm
      our
      future sales and results of operations; and our substantial dependence on one
      customer is subject to risks set forth under Risk Factors in Item 1A.




*Business
      in Taiwan and China*




To
      date,
      we have delivered limited quantities of our T-3 LCoS Sets to our Taiwanese customer, ThinTek Optronics Corp. The majority of these sales occurred in 2005.
      To date, ThinTek has ordered quantities sufficient for pilot programs and sample
      products, but not enough to enable them to launch mass production of LCoS high
      definition televisions.




3




We
      have
      delivered limited quantities of our microdisplay products to our Chinese
      customers. A substantial portion of these product deliveries occurred in 2004,
      with a smaller quantity delivered in 2005. The quantities of our products
      delivered to our Chinese customers are sufficient only for engineering testing
      and pilot program purposes. One of our original Chinese customers, Skyworth
      Display LTD. (Skyworth), has commenced sales of televisions utilizing our
      display units incorporating our T-1 LCoS Sets into the Chinese educational
      market. To date, however, our Chinese customers have not ordered quantities
      of
      our products that would enable them to launch commercial sales of LCoS high
      definition televisions.




For
      a
      more detailed discussion of our business in Taiwan and China, see Item 7
“Management’s Discussion and Analysis of Financial Condition and Results of
      Operations.”




*Prospective
      Customers*




We
      are
      currently developing working relationships with prospective customers, located
      primarily in Japan and other parts of the Pacific Rim region. While we have
      made
      progress with respect to product integration and negotiating purchase orders
      with certain of these prospective customers, we cannot assure that we will
      receive any purchase orders binding on any of these companies for their purchase
      of our products in the near future. Even assuming that we receive purchase
      orders that are binding on the prospective customers, these orders and our
      sales
      to these customers and to our existing customers are subject to certain
      contingencies described under Risk Factors in Item 1A.




In
      May
      2004, we opened a representative office in Shanghai, China, for the purpose
      of
      conducting, coordinating and supporting our business relations with our Chinese
      customers and prospective customers.




**Technology
      and Products under Development**





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





We
      are
      currently offering one core product to our customers and prospective customers
      who are located primarily in Asia. The featured product is our LCoS Set, which
      is comprised of three of our proprietary SpatiaLight imagEngineTM LCoS
      microdisplays.





We
      currently are focused on manufacturing one model of our LCoS Sets, the T-3
      LCoS
      Set model which has a 1920 pixels by 1080 pixels configuration. We have
      previously manufactured and continue to have in inventory our T-1 LCoS Set
      model
      which has a 1280 pixels by 960 pixels configuration. Although we believe we
      can
      sell our T-1 LCoS Set model, we are exclusively focusing on manufacturing the
      T-3 model of our LCoS Sets because we believe that the market demand for that
      higher resolution product will be significantly greater.





The
      following table summarizes our sales revenue percentage by product for the
      past
      three years





2005
            
            2004
            
            2003LCoS
                (T-3) sets
            
            
            77
            %
            
            5
            %
            
            —
            %LCoS
                (T-1) sets
            
            
            4
            %
            
            42
            %
            
            27
            %Light
                engine display units
            
            
            1
            %
            
            51
            %
            
            73
            %Other
                (primarily supporting electronics)
            
            
            18
            %
            
            2
            %
            
            —
            %Total
            
            
            100
            %
            
            100
            %
            
            100
            %





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





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


formats;


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


·  video
      projectors for applications such as presentations;


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


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





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




4




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





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





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





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





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





**Marketing,
      Sales and Distribution**





*Application
      and Markets*





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





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





*Segment
      and geographical information*





For
      the
      year ended December 31, 2005, 73% and 12% of our revenue was derived from LG
      Electronics, located in South Korea and Thintek Optronics Corp, located in
      Taiwan, respectively. These two customers made up 84% of our outstanding
      accounts receivable balance at December 31, 2005. The remaining 15% of revenue
      in 2005 was derived from the sales of our LCoS Sets and related components
      to
      customers located in Hong Kong, China and the United States. For the year ended
      December 31, 2004, 47% and 43% of our revenue was derived from Skyworth TV
      Holdings, LTD. and Shanghai China Display Co., LTD, both located in China.
      These two customers made up 90% of our outstanding accounts receivable balance
      at December 31, 2004. The remaining 10% of revenue in 2004 was derived from
      the
      sales of our LCoS Sets and related components to customers located in Hong
      Kong,
      Taiwan and South Korea. For the year ended December 31, 2003, 51% and 31% of
      our
      revenue was derived from Skyworth, and China Display, both located in China.
      The
      remaining 18% of revenue in 2003 was derived from the sales of our LCoS Sets
      and
      related components to customers located in China and Hong Kong.





5





*Manufacturing
      and Supply*





Through
      the end of 2005, we manufactured our LCoS Sets in limited commercial quantities
      at our facilities in South Korea and California. Early in 2006, we moved all
      of
      our manufacturing operations to our facility in South Korea and transitioned
      the
      California facility to research and development and special project operations.
      Internal manufacturing is subject to certain risks described under Risk Factors
      in Item 1A.





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





We
      completed construction of our South Korean manufacturing facility in January
      2005. The South Korean facility has commenced to serve as our central commercial
      manufacturing base. The facility began
      producing products for commercial sale in limited quantities in the second
      quarter of 2005. The facility is designed with the capacity, on full employment,
      to produce up to 28,000 LCoS Sets per month. The facility has been specially
      designed for expansion to a capacity of 120,000 LCoS Sets per month in several
      expansion phases. We believe that the facility can be expanded in an efficient manner
      in the event that such expansion becomes necessary based upon increased or
      perceived increased demand for our products from our customers. Our entire
      manufacturing operations are now conducted at our facility in South Korea.
      We
      have recently experienced certain problems in manufacturing our LCoS Sets.
      See
      Item 7 for a more detailed discussion of those problems. We recently transferred
      certain specific portions of our manufacturing process from California to our
      facility in South Korea so that the entire manufacturing operation now occurs
      in
      South Korea. The transfer of those specific portions of the process caused
      a
      delay in manufacturing operations while production equipment was physically
      transferred from California to South Korea and South Korean employees were
      trained to use that equipment. However, we believe that having manufacturing
      take place in one location will allow us to maintain a higher level of quality
      controls over LCoS Set production, which we expect will increase our long-term
      manufacturing yields and improve our ability to produce sufficient quantities
      of
      LCoS Sets to meet future quantity demands from LG Electronics and other
      customers and prospective customers. The potential negative impact upon our
      results of operations that could be caused by continued or additional
      difficulties in manufacturing our LCoS Sets are described under Risk Factors
      in
      Item 1A.





We continued
      to install manufacturing
      and related equipment in the South Korean facility and we actively hired
      personnel throughout 2005. We are currently training our operators and
      supervisors in key processes and equipment familiarization .
      We
      believe that this is
      making our
      overall production transition more efficient and reducing the
      chances of our incurring more unexpected delays in our manufacturing process.
      The process is now substantially complete for the initial production ramp up.
      We
      will continue to hire and train employees as manufacturing volumes increase,
      although we cannot provide any assurances of increases in manufacturing
      volumes.





In
      our
      manufacturing facilities, we perform product testing of our LCoS Sets, analyze
      the results and take actions to refine the manufacturing process and enhance
      product design. We have developed statistical quality control procedures for
      our
      manufacturing process. We believe that these current arrangements provide us
      with strong quality controls and effectively protect our proprietary technology
      in our products.





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





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





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




6




**Competition**





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





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





**Patents
      and Intellectual Property**





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





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





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





**Research
      and Development**





We
      incurred research and development expenses of approximately $3,586,000 in 2005,
      $2,306,000 in 2004 and $2,681,000 in 2003. Research and development expenses
      are
      those costs incurred for personnel and experimental materials for the design
      and
      development of new products. We believe that the development of new products
      will be required to allow us to compete effectively and to achieve greater
      revenues than we have derived to date. As of December 31, 2005, we had nine
      employees in the U.S. whose significant duties included research and
      development. We intend to continue our product development programs, focusing
      on
      increasing the display specifications including resolution, color and
      manufacturing processes. We believe that such developments will be required
      to
      exploit future markets.




7




**Employees**





As
      of
      December 31, 2005, we had thirty-one full-time employees and one part-time
      accounting contractor located in California. Full-time employment is divided
      among three functional areas with nine in research and development, eight in
      manufacturing and fourteen in management/finance/administration. As of December
      31, 2005, we had eight full-time employees classified as
      management/finance/administration in South Korea. We have nine engineers and
      seventy-four employees classified as manufacturing in South Korea. We consider
      our relations with our employees to be good.




**Available
      Information**





We
      make
      available on our website www.spatialight.com under “Investors” - “SEC Filings,”
free of charge, our annual reports on Form 10-K, quarterly reports on Form
      10-Q,
      current reports on Form 8-K, and amendments to those reports as soon as
      reasonably practicable after we electronically file with or furnish such
      material to the SEC.





We
      have
      adopted a Code of Business Conduct and Ethics and a written charter for our
      Audit Committee. All employees and members of our Board of Directors including
      the Chief Executive Officer, who is also the Principal Financial and Accounting
      Officer, are expected to adhere to the principles and procedures set forth
      in
      the Code of Business Conduct and Ethics that apply to them. Each of the
      foregoing are available on our website at www.spatialight.com and in print
      to
      any shareholder who requests it, in writing to the Corporate Secretary,
      SpatiaLight, Inc., Five Hamilton Landing, Suite 100, Novato, California 94949.
      In accordance with the SEC rules, we intend to disclose any amendment (other
      than technical, administrative, or other non-substantive amendment) to, or
      any
      waiver from, a provision of the Code of Business Conduct and Ethics on our
      website within four business days following such amendment or
      waiver.





**Item
      1A.**  **Risk
      Factors**





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





As
      of the
      date hereof, we have limited financial resources. Our operations to date have
      consumed substantial amounts of cash and will continue to require substantial
      amounts of capital in the future. In order to remain competitive, we must
      continue to make significant investments essential to our ability to operate
      profitably, including further investments in research and development,
      equipment, facilities and production activities. Taking into account our current
      financial condition, we will require significant additional financing to satisfy
      our increasing working capital requirements in 2006.





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




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





As
      previously disclosed in our Current Report on Form 8-K, filed December 19,
      2005,
      holders of $9,000,000 principal amount of our Senior Secured Convertible Notes
      have alleged that we have defaulted in the payment of the installment of
      interest due November 30, 2005 on these Notes. In addition, one of these
      holders, who holds $4,500,000 principal amount of the Senior Secured Convertible
      Notes, has alleged that we have defaulted in our failure to maintain the
      effectiveness of registration statement on Form S-3 pertaining to the Senior
      Secured Convertible Notes (Registration No. 333-122391) in such manner as to
      permit such holder to sell its shares pursuant to that registration statement.
      That holder of $4,500,000 principal amount of the Senior Secured Convertible
      Notes, as previously disclosed in our Current Report on Form 8-K, filed February
      14, 2006, has also alleged that we have defaulted under the terms of the Senior
      Convertible Notes by entering into certain types of debt financing transactions.
      As a consequence of these alleged defaults, these holders have demanded the
      immediate redemption of the principal amount of their Senior Secured Convertible
      Notes plus a redemption premium of $675,000 to each of them. We do not believe
      that we have defaulted in the payment of interest on the Senior Secured
      Convertible Notes, and we believe that the registration statement has remained
      effective, that we have not entered into any debt financing transactions that
      would constitute a breach or failure in any material respect, and that we are
      otherwise in compliance with the relevant provisions of the Senior Secured
      Convertible Notes. At this date, we cannot predict what actions, if any, will
      be
      undertaken by any of the holders of the Senior Secured Convertible Notes, but
      we
      will contest any adverse actions as we do not believe that we have committed
      any
      defaults under the terms of the Senior Secured Convertible Notes.




8




**We
      are currently manufacturing and shipping our LCoS Sets in limited commercial
      quantities, but difficulties in manufacturing our products in larger quantities
      will make it difficult to meet customer demands and our operating results could
      be significantly harmed by such difficulties.**




We
      have
      recently experienced difficulties in manufacturing our LCoS Sets principally
      due
      to problems that we have experienced in certain specific portions of our
      manufacturing process, which, until January 2006, were being carried out in
      our
      production facility in California. We have relocated these portions of our
      manufacturing process to our production facility in South Korea, where we have
      highly qualified personnel and a new facility designed to our specifications.
      See “Status of Business with LG Electronics, Inc.” contained in Item 7 for a
      more detailed discussion of manufacturing difficulties that we have experienced.
      Furthermore, by having manufacturing take place in one location, we expect
      to be
      able to maintain a higher level of quality controls over our LCoS Set
      production. However, because the manufacture of our LCoS Sets involves highly
      complex processes and technical problems may continue to arise as we manufacture
      our LCoS Sets, we cannot assure satisfactory manufacturing yields or that we
      will be able to adequately ramp up volume production of our LCoS Sets. Current
      purchase orders, including our agreement with LG Electronics, and anticipated
      future purchase orders, which we cannot assure, will require us to produce
      greater quantities of our LCoS Sets than we have produced in the past. If future
      manufacturing yields do not improve or if we incur unanticipated future problems
      in production of our LCoS Sets, it will significantly harm our business and
      operating results because we will have already incurred the costs for the
      materials used in the LCoS Set manufacturing process as well as the costs of
      operating our South Korean manufacturing facility. Unanticipated further
      problems in manufacturing our LCoS Sets could also cause production delays
      that
      could lead our current and prospective customers to seek other sources, which
      would negatively impact our operating results.





In
      addition, the complexity of our manufacturing processes will increase as the
      sophistication of our LCoS Sets increases, and such complexities may lend to
      similar difficulties that could harm our business and operating results.
      Although we believe that we will be able to mass produce our LCoS Sets, other
      companies, including some with substantially greater resources than us, have
      found great difficulty or failed to do so. We do not have reliable information
      about why other companies have failed to manufacture similar liquid crystal
      microdisplays and can therefore make no assurances that we will not encounter
      similar problems.





We
      currently obtain silicon backplanes, a vital component in our microdisplays,
      from the Far East. Some Asian countries are subject to earthquakes, typhoons
      or
      political instability. Unless we obtain an alternative source, any disruption
      or
      termination of our silicon manufacturing source's operation in Taiwan or air
      transportation with the Far East could significantly harm our operations.





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




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





Our
      decision to locate our principal manufacturing operations in South Korea may
      cause us to encounter one or more potential problems that could harm our
      business. These potential problems could arise in connection with conducting
      our
      manufacturing operations at the facility in South Korea. As a result of cultural
      or language differences, problems may arise in the training of, or
      communications with, our employees, such as misunderstandings or the creation
      of
      inefficiencies in our operations. The geographic separation between our
      corporate offices in the United States and our principal manufacturing operation
      in South Korea could result in managerial or supervisory problems, which could
      lead to decreased quality controls and a subsequent material harm to our
      business.





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




In
      2005,
      most of our revenue was derived from LG Electronics. Based upon our agreement
      with LG Electronics, it is likely that a substantial percentage of our
      anticipated future revenues will be derived from LG Electronics as well. If
      we
      cannot diversify our customer base or derive increased revenues through
      additional purchase orders and product deliveries from customers other than
      LG
      Electronics, and therefore remain primarily reliant on only one customer for
      a
      substantial percentage of our revenues, we will be vulnerable to a substantial
      decline in anticipated revenues if we lose LG Electronics as a customer for
      any
      reason or if LG Electronics were to otherwise reduce, delay or cancel its
      orders. Any such events could cause a material adverse effect on our business,
      operations and financial condition and the value of our common shares could
      decline substantially.




9




Our
      ability to retain and receive additional purchase orders from our current
      customers and to attract and receive purchase orders from prospective customers
      may depend upon the acceptance of LG Electronics' products in the consumer
      marketplace. If LG Electronics' television products incorporating our LCoS
      technology are not commercially successful, demand for our products from our
      current and prospective customers may not materialize, which could negatively
      impact our results of operations and our financial condition.





**We
      are the subject of an investigation by the staff of the SEC regarding the
      circumstances surrounding our filing of certain consents of the independent
      registered accounting firm BDO Seidman, LLP without requisite
      authorization.**





We
      have
      been advised by the Staff of the SEC that it is conducting an investigation
      into
      the circumstances surrounding our filing of consents of the independent
      registered accounting firm BDO Seidman, LLP, without requisite authorization,
      which consents were filed as Exhibit 23.1 to amendments to our registration
      statements on Form S-3 (Nos. 333-122391 and 333-122392) filed with the SEC
      on
      July 27, 2005. The consents would have allowed us to incorporate by reference
      in
      each of the prospectuses constituting a part of the above-referenced
      registration statements our consolidated financial statements for the years
      ended December 31, 2002 and 2003. Our current independent registered accounting
      firm, Odenberg, Ullakko, Muranishi & Co. LLP (OUM) has since provided us
      with a new report with respect to each of the three years ended December 31,
      2004 and we were not requested to amend or restate the financial statements
      contained in our annual reports on Form 10-K for any of the three fiscal years
      ended December 31, 2004 in connection with the issuance of OUM's new report.
      We
      have been cooperating and intend to continue to cooperate with the SEC in
      connection with this matter. In addition, the audit committee of our board
      of
      directors has concluded a review and investigation of these matters. As of
      this
      date, we cannot determine whether we or our management will be adversely
      affected by this inquiry. See “Certain Developments” under Item 7 for further
      information concerning the factual circumstances underlying the SEC
      investigation and the audit committee investigation and report with respect
      to
      this matter.





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





As
      disclosed under “Certain Developments” under Item 7, we filed, as part of
      amendment numbers 5 and 6 to a registration statement (File No. 333-122391)
      registering shares for resale by certain selling shareholders (the “Financing
      Registration Statement”) and as part of amendment numbers 3 and 4 to a “shelf”
registration statement (File No. 333-122392), an unauthorized consent of BDO
      Seidman to incorporate by reference their report on our consolidated financial
      statements for the fiscal years ended December 31, 2002 and 2003, respectively.
      Although we received the requisite authorized consents from BDO Seidman to
      the
      incorporation by reference of their report on the consolidated financial
      statements into these registration statements when initially filed and
      subsequent amendments thereto (and BDO Seidman has not withdrawn these
      subsequent consents), we did not receive the requisite authorization from BDO
      Seidman to file its consent as an exhibit to the penultimate and final
      amendments to the registration statement before it was declared effective.
      These
      amendments were filed with the SEC on July 27, 2005. Subsequently, our current
      independent registered public accountants, OUM, re-audited our consolidated
      financial statements for fiscal years 2003 and 2002. OUM has given its consent
      to incorporate by reference into the registration statement the financial
      statements for 2002 and 2003 and its report related to those financial
      statements.




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





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





At
      present, we are unable to ascertain the exact amount of damages, if any, to
      which we could potentially be subject under a Section 11 claim instituted by
      any
      persons who directly purchased shares pursuant to those registration statements.
      Furthermore, at this date, we cannot ascertain the amount of damages, if any,
      for which we could be liable for claims instituted by any subsequent purchasers
      who could trace the shares purchased by them to those registration statements.
      In August 2005, we sold 500,000 common shares to three institutional purchasers
      for $5.40 per share pursuant to the “shelf” registration statement referenced
      herein. Each of those investors has since represented to us in writing, in
      connection with a separate transaction, that they have disposed of all of those
      shares. One of those institutional investors has represented to us that it
      sold
      those shares at a sale price at or higher than its purchase price from us.
      We
      believe, based upon discussions with the other two investors, that they sold
      their shares at a sale price of not lower than $4.25 per share. Therefore,
      we
      believe that our maximum damages pursuant to Section 11 claims from direct
      purchasers, which we would fully contest, would be $385,250, or the difference
      between the two investors’ purchase price and lowest believed resale price,
      multiplied by the 335,000 shares that they purchased and then
      resold.




10




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





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





The
      Senior Secured Convertible Notes issued in November 2004 bear a 10% rate of
      interest per annum and are not prepayable, in whole or in part, prior to their
      maturity on November 30, 2007. Therefore, we do not have the ability to
      refinance the 2004 Senior Secured Convertible Notes with debt obligations
      bearing more favorable terms to us or out of the proceeds of an equity financing
      until their maturity date. Although we do have the right to convert the Senior
      Secured Convertible Notes into our common shares in the event that our common
      shares trade at or above $14.58 (150% of the $9.72 conversion price of the
      Senior Secured Convertible Notes) for twenty consecutive trading days. The
      last
      sale price of our common shares on March 10, 2006, was $2.28 per share.





Furthermore,
      the Senior Secured Convertible Notes are secured by virtually all of our assets,
      other than those located in South Korea, and it may therefore be difficult
      for
      us to obtain future debt financing. However, the terms of the Senior Secured
      Convertible Notes allow us to subordinate these Notes to indebtedness to a
      bank
      or other institution where that indebtedness is secured by accounts receivable,
      contractual rights or inventory or similar financing.





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





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





We
      have
      incurred losses to date and have experienced cash shortages. For the year ended
      December 31, 2005, we incurred net losses of approximately $14 million. In
      addition, we had an accumulated deficit of approximately $82 million as of
      December 31, 2005. We expect additional losses as we continue spending for
      commercial scale production and other business activities as well as further
      research and development of our products. As a result, we will need to generate
      substantial sales to support our costs of doing business before we can begin
      to
      recoup our operating losses and accumulated deficit and achieve profitability.





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





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





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





We
      currently have 9 full-time engineering and 8 full-time manufacturing personnel
      based in California working on microdisplays. We currently have nine full-time
      engineering and 74 full-time manufacturing personnel based in South Korea.
      This
      staffing creates significant operational and research and development costs
      that
      may not be recouped. Even if our current LCoS Sets become accepted and/or
      successful, we must continue to employ and may increase in number, our
      engineering and manufacturing personnel to develop future generations of our
      microdisplays because of the rapid technological changes in our industry. As
      a
      result, we expect to continue incurring significant operational and research
      and
      development costs.




11




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





We
      commenced producing products in our principal manufacturing operations in South
      Korea during the second quarter of 2005, and our largest customer, LG
      Electronics, resides in South Korea. South Korea and North Korea are technically
      at war with each other, despite the mutually agreed upon existence of the
      Demilitarized Zone and the relative absence of physical conflict for several
      decades. Any escalation in the existing conflict between these countries or
      any
      commencement, or perceived commencement of a military conflict between the
      United States and North Korea, may limit our ability to effectively operate
      our
      manufacturing facility in South Korea and also may substantially limit our
      ability to sell products into South Korea because of the negative economic,
      physical or other destructive impact that such a conflict could have on our
      most
      important customer. Any such disruptions to our manufacturing operations and/or
      ability to consummate sales to a substantial customer could adversely affect
      the
      development of our business and our financial condition.





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





High
      definition television programming has only recently become available to
      consumers, and widespread market acceptance, although anticipated, is uncertain
      at this time. The market demand for high definition televisions is considered
      contingent upon widespread acceptance of high definition television programming.
      Our current sales and marketing efforts are focused on OEMs of high definition
      televisions and OEMs of light engines designed for incorporation into high
      definition televisions. Therefore, if the market for high definition televisions
      does not continue to grow and develop, then we will have significant difficulty
      selling our products, which will have a material adverse effect on our results
      of operations.





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





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




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





•  superior
      technologies developed by our competitors;




•  price
      considerations; and




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




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




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





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





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




12




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





•  maintain
      customer satisfaction with our design and manufacturing services;




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





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





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




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




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





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





Companies
      competing in the LCoS microdisplay market include Sony and JVC, although we
      presently believe that Sony has developed LCoS microdisplays for its own use
      and
      not for sale to other OEM's. A major competitor of ours in the reflective
      microdisplay market is Texas Instruments, which, rather than using liquid
      crystals in the display, is producing a micro-mechanical structure of moving
      mirrors on a silicon backplane, a technology known as digital light processing,
      or DLP. Texas Instruments has had significant success selling its DLP products
      to its customers in the business front projector market and the rear projection
      high definition television market. Some of our competitors, including Texas
      Instruments, Sony, and JVC, have greater market recognition, larger customer
      bases, and substantially greater financial, technical, marketing, distribution
      and other resources than we possess. As a result, they may be able to introduce
      new products and respond to customer requirements more quickly and effectively
      than we can.





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





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





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





·
            our
                success in designing and manufacturing new display technologies;





·
            our
                ability to address the needs of customers;





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





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





·
            the
                quality of our customer services;





·
            the
                efficiency of our production sources; and





·
            the
                rate at which customers incorporate our displays into their own products;
                and products or technologies introduced by our competitors.




13




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





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




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





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





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





·
            timing
                of expenditures in anticipation of future orders;





·
            changes
                in our cost structure;





·
            availability
                of labor and components;





·
            pricing
                and availability of competitive products and services;





·
            the
                timing of orders;





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





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





·
            changes
                or anticipated changes in economic
                conditions.





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





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





·
            quarterly
                variations in our operating results;





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





·
            public
                announcements regarding our business developments;





·
            changes
                in analysts' estimates of our financial performance;





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





·
            general
                conditions in the electronics industry; and





·
            worldwide
                economic and financial conditions.





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





**By
      further increasing the number of our common shares that may be sold into the
      market, any future offerings of our common shares, or securities convertible
      into or exercisable for our common shares, could cause the market price of
      our
      common shares to decrease significantly, even if our business operations are
      performing well.**




14




The
      total
      number of common shares included in the Post-Effective Amendment No. 6 to Form
      S-3 Registration Statement that we filed with the SEC on February 14, 2006
      (Registration Number 333-122391), principally relating to the November 2004
      Financing, the 1,500,000 common shares included in the Post-Effective Amendment
      No. 6 to Form S-3 “Shelf” Registration Statement filed by us with the SEC on
      February 14, 2006 (Registration Number 333-122392) and 800,007 common shares
      included the Form S-3 Registration Statement filed by us with the SEC on
      February 27, 2006 (Registration Number 333-132048), represents approximately
      11.01% of the total number of our common shares that were issued and outstanding
      as of December 31, 2005. Sales of these shares into the public market, or the
      perception that future sales of these common shares could occur, might adversely
      affect the prevailing market price of our common shares in the near future.
      Furthermore, market perceptions regarding the likelihood that we will be
      required to issue and sell additional common shares in the near future to fund
      our ongoing operations, thereby diluting the ownership interests of current
      owners of our common shares, could have a material adverse effect on the market
      price of our common shares.





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





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





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





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





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





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





·
            pending
                patent applications may not be issued;





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





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





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





·
            breach
                of confidentiality agreements;





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





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




15




There
      can
      be no assurance that we will have adequate remedies in the event any of the
      foregoing materializes. Failure to protect our intellectual property would
      limit
      our ability to produce and market our products in the future, which would
      materially adversely affect our revenues generated by the sale of such products.
      In addition, third parties could assert that our products and technology
      infringe their patents or other intellectual property rights. As a result,
      we
      may become subject to future patent infringement claims or litigation, the
      defense of which is costly, time-consuming and diverts the attention of
      management and other personnel.





**The
      material weaknesses identified by our management and our independent registered
      public accounting firm with respect to our material internal control systems,
      processes and procedures may have a materially negative impact on our
      business.**





In
      accordance with the rules prescribed by the SEC and the Sarbanes-Oxley Act
      of
      2002, we must periodically review and test our material internal control
      systems, processes and procedures to ensure compliance. During our preparation
      of our Form 10-K Annual Report for the year ended December 31, 2005, our
      management and our independent registered public accounting firm identified
      several material weaknesses in our internal controls over financial reporting.
      Although these material weaknesses did not result in a misstatement of our
      financial results, they relate closely to assuring the fulfillment of critical
      components of the financial reporting functions of our business. As of this
      date, the material weaknesses identified include the fact that our Company
      does
      not have a full-time chief financial officer. The Company does not currently
      have a chief financial officer to work with the chief executive officer and
      chief operating officer in overseeing and monitoring complex and significant
      transactions in order to provide reasonable assurance that such transactions
      are
      reflected accurately and fairly in the financial statements, although we employ
      a part-time controller to assist in the performance of the foregoing functions.
      Furthermore, our Audit Committee does not have a member who is deemed a
      "financial expert" as defined by the rules promulgated by the SEC, although
      a
      member of our Audit Committee has the level of financial sophistication that
      the
      NASDAQ's rules require. Additionally,
      the Company does not have a corporate governance or disclosure committee, has
      inadequate controls and procedures over inventory, lacks information technology
      controls and procedures that would likely prevent unauthorized access to
      accounting and financial systems, does not have effective internal controls
      over
      financial reporting at our wholly owned subsidiary in South Korea, does not
      maintain formal accounting policies and procedures to allow the accounting
      function to adequately analyze transactions and determine correct accounting
      under GAAP, and does not have formal procedures to prevent the filing of
      registration statements with the SEC without the required accountant’s consent.We may therefore need to incur significant additional expenses to achieve
      compliance and we may incur other costs in connection with regulatory
      enforcement actions, any of which could negatively impact our business.





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





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





**We
      do not pay cash dividends.**





We
      have
      never paid any cash dividends on our common shares and do not anticipate that
      we
      will pay cash dividends in the near future. Moreover, under the terms of the
      November 2004 Financing, we are prohibited from paying cash dividends while
      the
      Senior Secured Convertible Notes issued in the November 2004 Financing remain
      outstanding. Instead, we intend to apply any future earnings to the expansion
      and development of our business.





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





None.





**Item
      2.** **Description
      of Property**





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




16




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





We
      are
      not currently involved in any material legal proceedings. We are a party to
      routine claims and lawsuits from time to time in the ordinary course of
      business. While the outcome of such ordinary course proceedings cannot be
      predicted with certainty, we believe that the resolution of any future ordinary
      course matters individually or in the aggregate will not have a material adverse
      effect on our business, financial condition or results of operations. However,
      we have received notices alleging events of default under the terms of the
      Senior Secured Convertible Notes (but for which we are not yet subject to legal
      proceedings) which we are contesting as more fully described under Item 7 -
      “Management’s Discussion and Analysis” and Note 3 to the Consolidated Financial
      Statements.





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





There
      were no matters submitted to a vote of our security holders during the fourth
      quarter of fiscal 2005.





**PART
      II**





**Item
      5.**  **Market
      for Common Equity and Related Stockholders Matters**





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





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





**HDTV
      Common Shares**





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


Fiscal
                2004High
            
            LowFirst
                Quarter
            
            $
            6.32
            
            $
            3.69Second
                Quarter
            
            
            6.16
            
            
            3.26Third
                Quarter
            
            
            6.50
            
            
            4.38Fourth
                Quarter
            
            
            9.21
            
            
            5.20




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





As
      of
      March 10, 2006, there were approximately 479 holders of record of our common
      shares and the closing price per share was $2.28 as reported on the Nasdaq
      SmallCap Market. The common shares represent the only class of securities
      outstanding as of the date of this filing.





To
      date,
      we have not paid a dividend on our common shares. The payment of future
      dividends is subject to our earnings and financial position and such other
      factors, including contractual restrictions, as the Board of Directors may
      deem
      relevant. Under the terms of the financing completed on November 30, 2004
      (November 2004 Financing), which is more fully described under Item 7
“Overview,” we are prohibited from paying cash dividends while the 2004 Senior
      Secured Convertible Notes issued in the November 2004 Financing remain
      outstanding. It is therefore unlikely that dividends will be paid in the
      foreseeable future.





Sales
      of Unregistered Securities





In
      mid-January 2006, we issued and sold 1,300,000 of our common shares in a private
      placement to three institutional investors. The purchase price of the common
      shares was $2.62 per share. We received approximately $3.4 million in gross
      proceeds, before issuance costs, from the sale of these shares.




17




In
      October 2005, we closed a $2.0 million private placement of our common shares
      and warrants to purchase our common shares with certain institutional and other
      investors. This transaction included the sale of 571,431 common shares at a
      purchase price of $3.50 per share and warrants to purchase 228,576 common shares
      with an exercise price of $5.00 per share exercisable within five years from
      the
      date of issuance. We received $2.0 million in gross proceeds from this
      transaction.




On
      November 30, 2004, we issued Senior Secured Convertible Notes totaling
      $10,000,000. The notes are convertible into our common shares at the conversion
      price of $9.72 per share. Interest payable under the notes at 10% per year
      may
      be paid in our common shares, at our option (if certain conditions are met),
      at
      a conversion price that will be calculated at the end of each quarterly interest
      period while the 2004 Senior Secured Convertible Notes are
      outstanding.





In
      October 2004, we issued 125,000 common shares upon the exercise of a warrant.
      The purchase price was $3.50 per share and total cash received was $437,500.





None
      of
      the above securities transactions involved any underwriters.




All
      of
      the purchasers of our securities in the above-described securities transactions
      were “Accredited Investors” within the meaning of Rule 501 under Regulation D of
      the Securities Act of 1933, as amended (the 1933 Act) and, accordingly, all
      of
      these transactions were exempt from registration under the 1933 Act by reason
      of
      Section 4(2) thereof or Regulation D.




We
      have
      used proceeds from the above-described securities transactions to reduce our
      liabilities, for working capital purposes, to fund the construction and
      equipment for our new manufacturing facility in South Korea and for other
      general corporate purposes.




Securities
      Authorized for Issuance under Equity Compensation Plans




The
      following table provides information as of December 31, 2005 regarding
      compensation plans (including individual compensation arrangements) under which
      equity securities are authorized for issuance.




**Plan
                  Category**
              
              **Number
                  of Securities to Be Issued Upon**
                **Exercise
                  of Outstanding Options**
              
              **Weighted-Average
                  Exercise Price of Outstanding Options (Excluding Securities Reflectied
                  in
                  Column (a))**
              
              **Number
                  of Securities Remaining Available For Future Issuance Under Equity
                  Compensation**
                **Plans
                  (Excluding Securities Reflected in Column (a)**(a)
              
              (b)
              
              (c)Equity
                  Compensation Plans (1999 Stock Option Plan)
                Approved
                  by Security Holders
              
              
              4,247,394
              
              $
              3.65
              
              
              806,666Equity
                  Compensation Plans (Outside the 1999 Stock
                Option
                  Plan)
              
              
              1,635,000
              *
              $
              2.91
              
              
              0Total
              
              
              5,882,394
              
              
              
              
              
              806,666*For
                  more information see Note 6 to the Consolidated Financial
                  Statements.




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





The
      selected consolidated financial data as of, and for the periods ended, December
      31, 2005, 2004, 2003, 2002, and 2001 presented below have been derived from
      the
      audited Consolidated Financial Statements of SpatiaLight. The selected financial
      data should be read in conjunction with our Consolidated Financial Statements
      and notes thereto and Item 7 “Management’s Discussion and Analysis of Financial
      Condition and Results of Operations” included elsewhere herein, in order to
      fully understand factors that may affect the comparability of the financial
      data
      presented below.




18




Statements
      of Operations:


Year
                  Ended December 31,2005
              
              2004
              
              2003
              
              2002
              
              2001Revenue
              
              $
              237,724
              
              $
              1,160,978
              
              $
              221,252
              
              $
              —
              
              $
              —Gross
                  margin
              
              $
              (1,519,365
              )
              $
              178,696
              
              $
              (487,068
              )
              $
              (286,000
              )
              $
              —Total
                  operating expenses
              
              $
              11,027,836
              
              $
              9,046,876
              
              $
              8,308,470
              
              $
              6,714,882
              
              $
              7,845,094Net
                  loss
              
              $
              (14,024,639
              )
              $
              (9,367,001
              )
              $
              (9,516,377
              )
              $
              (9,027,913
              )
              $
              (9,911,727
              )Net
                  loss per share - basic and diluted
              
              $
              (0.39
              )
              $
              (0.27
              )
              $
              (0.34
              )
              $
              (0.37
              )
              $
              (0.46
              )Weighted
                    average shares used in computing
                net
                  loss per share- basic and diluted
              
              
              36,375,068
              
              
              34,154,057
              
              
              28,173,770
              
              
              24,578,226
              
              
              21,469,960**Balance
                  Sheet Data:**
              
              December
                  31,2005
              
              
              2004
              
              
              2003
              
              
              2002
              
              
              2001Cash
                  and cash equivalents
              
              $
              42,565
              
              $
              9,087,551
              
              $
              6,359,969
              
              $
              575,663
              
              $
              2,728,134Inventory,
                  net
              
              $
              756,723
              
              $
              1,173,314
              
              $
              779,617
              
              $
              275,959
              
              $
              —Working
                  capital (deficit)
              
              $
              (2,278,563
              )
              $
              8,593,704
              
              $
              6,228,782
              
              $
              (807,891
              )
              $
              (868,056
              )Total
                  assets
              
              $
              11,552,476
              
              $
              19,646,411
              
              $
              8,349,696
              
              $
              2,058,454
              
              $
              3,488,002Secured
                  convertible notes
              
              $
              10,340,113
              
              $
              9,885,140
              
              $
              1,155,000
              
              $
              4,207,232
              
              $
              3,137,284Total
                  stockholders' equity (deficit)
              
              $
              (4,443,828
              )
              $
              5,966,457
              
              $
              5,813,275
              
              $
              (4,373,806
              )
              $
              (213,346
              )




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





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




**Overview**





We
      are in
      the business of manufacturing high-resolution LCoS microdisplays. Our current
      customers and prospective customers are original equipment manufacturers (OEMs)
      engaged in the businesses of manufacturing high definition televisions or
      manufacturing light engines for incorporation into high definition televisions.
      Our products are also suitable for incorporation into other potential display
      applications including rear projection computer monitors, wireless communication
      devices, portable games and digital assistants, although we are not currently
      working with OEMs on any of these products.




19




*Status
      of Business with LG Electronics, Inc.*




In
      July
      2004, we entered into an agreement with LG Electronics (see Exhibit 10.5 to
      our
      Annual Report on Form 10-K/A filed with the SEC on December 29, 2005), providing
      for us to sell our T-3 LCoS Sets to LG Electronics. Our supply agreement with
      LG
      Electronics provides that we will be their exclusive supplier of three-chip
      LCoS
      microdisplay products for twelve months beginning from the date that we
      commenced shipments under that agreement. Furthermore, our agreement provides
      that LG Electronics will have the exclusive right in South Korea to purchase
      T-3
      microdisplay products from us for the twelve months beginning from the date
      that
      we commenced shipments under that agreement. In July 2005, we commenced
      delivering a limited quantity of commercial production LCoS Sets to LG
      Electronics. Under the July 2004 agreement, LG Electronics agreed to purchase
      from us a minimum of 21,000 LCoS Sets during an initial six-month delivery
      period, which was originally scheduled to commence in January 2005, subject
      to
      LG Electronics' completion of pre-production requirements. Our July 2005 product
      delivery to LG Electronics included a smaller quantity of LCoS Sets than was
      originally contemplated under the July 2004 agreement for the first delivery
      month. We delivered those LCoS Sets in July 2005 based upon our expectation
      that
      in the immediate future we would receive a firm purchase order from LG
      Electronics.





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





Although
      we have been delivering a limited quantity of production LCoS Sets to LG
      Electronics since July 2005, our delivery ramp up has been slower than expected
      due to LG Electronics’ product specification changes and problems that we have
      experienced in ramping up our manufacturing volumes. These manufacturing
      problems have been principally attributable to external variables in the
      manufacturing environment including temperature, humidity and dust particle
      presence. The manufacturing problems have occurred during the alignment coating,
      glue application and cell lamination portions of our manufacturing process,
      which are highly susceptible to those external variables. Until recently, those
      portions of the manufacturing process were being carried out in our production
      facility in California. We have attempted to address our manufacturing problems
      by recently relocating these portions of our manufacturing process to our
      production facility in South Korea, where we believe that the combination of
      a
      new facility designed to our specifications and highly qualified personnel
      provides us with more exacting controls over the external variables that can
      impact our manufacturing process. At our manufacturing facility in South Korea,
      in test and production runs, while we are continuing to experience certain
      of
      the production problems attributable to external variables specified above,
      we
      believe that we will be able to more fully address and alleviate those problems
      in coming months.





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





LG
      Electronics commenced an initial consumer market rollout in Australia of a
      limited quantity of 71-inch LCoS televisions incorporating our LCoS Sets during
      the first quarter of 2006. LG Electronics has also announced that it intends
      LCoS product rollouts into the South Korean consumer market in the near future.
      LG Electronics recently communicated to its distributors that it has postponed
      its plans to introduce its 71” and 62” LCoS televisions into the U.S.
      marketplace. LG has attributed this postponement to uncertainty regarding the
      timetable for the availability of sufficiently large supplies of our LCoS Sets
      to enable a significant product launch. Although LG Electronics has advised
      us
      that it is maintaining future plans for expansion into the United States and
      other markets, there can be no assurances as to the timing of those rollouts.
      We
      believe that delays in LG Electronics' initial product rollouts have been based
      upon revisions to our delivery schedule and our problems in ramping up
      production that have occurred over time.





In
      2005,
      a substantial percentage of our product deliveries, which were in small
      quantities, were made to LG Electronics. Based upon our agreement with LG
      Electronics and our present expectations, it is likely that a substantial
      percentage of our anticipated future product deliveries in the first half of
      2006 will be made to LG Electronics as well. In the event that we are unable
      to
      ramp up our delivery volumes to LG Electronics by the end of July 2006, we
      believe that it is reasonably likely that LG Electronics may discontinue
      actively doing business with us. The loss of LG Electronics as a customer or
      any
      further delays in our delivery schedule to LG Electronics could significantly
      harm our future sales and results of operations; and our substantial dependence
      on one customer is subject to risks set forth under Risk Factors in Item 1A.




20




*Status
      of Business in Taiwan*




To
      date,
      we have delivered limited quantities of our T-3 LCoS Sets to our Taiwanese
      customer, ThinTek. A substantial portion of these product deliveries occurred
      in
      2005. ThinTek has ordered quantities sufficient for pilot programs and sample
      products, but not enough to enable them to launch mass production of LCoS high
      definition televisions. We have continuing business relationships with customers
      and prospective customers in Taiwan, including ThinTek. We made small shipments
      of T-3 LCoS Sets to ThinTek during all four quarters of 2005. We are maintaining
      our plans to ship our products to ThinTek and prospective Taiwanese customers
      in
      2006. We cannot provide assurance concerning the quantities of our products
      that
      we will sell to ThinTek and other prospective customers in the future.




*Status
      of Business in China*




To
      date,
      we have delivered limited quantities of our microdisplay products to our Chinese
      customers. A substantial portion of these product deliveries occurred in 2004,
      with a smaller quantity delivered in 2005. The quantities of our products
      delivered to our Chinese customers are sufficient only for engineering testing
      and pilot program purposes. To date, our Chinese customers have not ordered
      quantities of our products that would enable them to launch commercial sales
      of
      LCoS high definition televisions.




We
      have
      continuing business relationships with customers and prospective customers
      in
      China. Current Chinese prospective customers are at different stages in the
      development and product introduction processes, and their efforts are
      progressing at a slower rate than we originally anticipated. One of our original
      Chinese customers, Skyworth, has commenced sales of televisions utilizing our
      display units incorporating our T-1 LCoS Sets into the Chinese educational
      market. However, we do not intend to sell any additional display units
      incorporating our T-1 LCoS Sets beyond what we currently have in inventory
      to
      Skyworth. They may elect to transition to products incorporating our T-3 LCoS
      Sets. We cannot provide assurance concerning the quantities of our products
      that
      we will sell to our Chinese customers and prospective customers in the
      future.




*Market
      Strategy for Taiwan and China*




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




*Other
      Business Development*




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





*Manufacturing
      of LCoS Sets*




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




21




We
      are
      currently continuing to install additional manufacturing and related equipment
      in the facility. We are currently training our operators and supervisors in
      key
      processes and equipment familiarization. We recently completed the process
      of
      moving all of our manufacturing operations to South Korea, which included
      physically moving all manufacturing equipment that remained in California as
      of
      the end of 2005. As part of the transition process, we experienced some
      manufacturing problems. The manufacturing problems have occurred during the
      alignment coating, glue application and cell lamination portions of our
      manufacturing process, which are highly susceptible to those external variables.
      Until recently, those portions of the manufacturing process were being carried
      out in our production facility in California. We have attempted to address
      our
      manufacturing problems by recently transitioning these portions of our
      manufacturing process to our production facility in South Korea, where we
      believe that the combination of a new facility designed to our specifications
      and highly qualified personnel provides us with more exacting controls over
      the
      external variables that can impact our manufacturing process. At our
      manufacturing facility in South Korea, in test and production runs, we are
      continuing to experience certain of the production problems attributable to
      external variables specified above, but we believe that we will be able to
      more
      fully address and alleviate those problems in coming months. While we cannot
      provide any assurances against unexpected delays, we believe that our transition
      approach constitutes an appropriate plan to deal with mass production readiness
      risks and to prepare ourselves to manage our manufacturing facility in South
      Korea on a basis consistent with the anticipated demand for our products.
      Potential difficulties in transitioning our manufacturing process from
      California to South Korea could have a material negative impact upon our results
      of operations as set forth under Risk Factors in Item 1A.





See
      “Status of Business with LG Electronics, Inc.” for a detailed discussion of
      manufacturing problems that we are experiencing and its effect upon our
      business.





*Business
      Strategy*




We
      are
      currently offering one core product, our T-3 LCoS Set, to our customers and
      prospective customers, all of whom are located primarily in Asia. Our LCoS
      Set
      is comprised of three of our proprietary SpatiaLight imagEngineTM LCoS
      microdisplays. They are constructed with a silicon chip, a layer of liquid
      crystals and a glass cover plate in contrast to the more common construction
      of
      liquid crystals sandwiched between two glass plates. Our displays are also
      known
      as, and commonly referred to as, liquid crystal on silicon (LCoS), liquid
      crystal displays (LCD), active matrix liquid crystal displays and spatial light
      modulators. Another former product that we no longer offer to our customers,
      except out of current inventory, is the display unit, which is comprised of
      an
      LCoS Set fitted onto a light engine.




Our
      T-3
      LCoS Set, which is the only model we currently manufacture, has a 1920 pixels
      by
      1080 pixels configuration. We previously manufactured our T-1 LCoS Set model,
      which had a 1280 pixels by 960 pixels configuration. We are exclusively focusing
      on manufacturing the T-3 model of our LCoS Sets because we believe that the
      market demand for that higher resolution product will be significantly greater.




Since
      we
      commenced delivering our products to our customers in the third quarter of
      2003,
      there has been a significant shift in the type of product that we have delivered
      to our customers based upon their demand. The shift in deliveries has been
      in
      the direction of more LCoS Sets and less display units. We believe that this
      shift is significant because we anticipate that LCoS Sets will be, in the long
      run, a higher margin product line and require less working capital than display
      units. LCoS Sets yield less revenue than display units per unit sold. In the
      beginning of 2005, we made it our short-term strategic objective to operate
      primarily as a seller of LCoS Sets and decrease our supply of display units
      to
      our customers, and our longer-term strategic goal to exclusively sell LCoS
      Sets
      to our customers. Beginning in the first quarter of 2006, we are actively
      offering only LCoS Sets to our customers and prospective customers.




Our
      supply agreement with LG Electronics is exclusively for LCoS Sets, as LG
      Electronics has developed its own light engine designed to incorporate our
      LCoS
      Sets. Our prospective Chinese customers have indicated an interest in one of
      our
      historical products - our display unit. While we currently sell a minor amount
      of these display units, we expect that there will be a shift in products
      demanded by our prospective Chinese customers, over time, from display units
      to
      LCoS Sets. These trends are consistent with our overall product
      strategy.




We
      believe that the T-3 model will become the standard for the next generation
      of
      rear projection display devices and will provide the most cost effective,
      high-resolution microdisplays in the industry and will position us to be a
      potential market leader. We believe that the T-3’s ability to deliver 2
      megapixel resolution in a high performance, reliable, and cost effective manner
      was a key factor in our obtaining the supply agreement with LG Electronics.
      The
      T-3 model is the central component of our ongoing customer acquisition strategy
      described above.




22




*Recent
      Equity Financing*




January
      2006 Financing




In
      mid-January 2006, we issued and sold 1,300,000 of our common shares in a private
      placement to three institutional investors. The purchase price of the common
      shares was $2.62 per share. We received approximately $3.4 million in gross
      proceeds, before issuance costs, from the sale of these shares, which were
      used
      for working capital and other general corporate purposes, including the
      repayment of certain short-term debt obligations. We are required under a
      registration rights agreement, to file a registration statement for the resale
      of the shares within 30 calendar days after January 12, 2006 and have the
      registration statement declared effective no later than 90 calendar days after
      January 12, 2006. The later may be extended to no later than 120 calendar days
      if the registration statement is subject to review, comments or other actions
      by
      the SEC. If the registration statement is not filed by February 11, 2006 or
      not
      declared effective prior to April 12, 2006, we may be required to pay an amount
      equal to 5% of the aggregate purchase price or $170,300 as partial liquidated
      damages when each of these dates occur and an additional $170,300 for every
      30
      days thereafter up to six months. After six months, the percentage increases
      to
      10% or $340,600 for each additional 30 days. We have not filed a registration
      with respect to these shares because of our prior commitment to register first
      the shares sold in our October 2005 Private Placement.





October
      2005 Private Placement





In
      October 2005, we closed a $2.0 million private placement of our common shares
      and warrants to purchase our common shares with certain institutional and other
      investors. This transaction included the sale of 571,431 common shares at a
      purchase price of $3.50 per share and warrants to purchase 228,576 common shares
      with an exercise price of $5.00 per share exercisable within five years from
      the
      date of issuance. We received $2.0 million in gross proceeds from this
      transaction, which has been and will be used for working capital and other
      general corporate purposes. We did not use a placement agent in this
      transaction. Three of the institutional purchasers in this transaction were
      investors in our November 2004 private placement of our Senior Secured
      Convertible Notes. The registration statement registering these shares was
      filed
      on February 27, 2006. Because this statement was not filed by November 12,
      2005,
      we may be required to pay $30,000 as liquidated damages to the investors as
      of
      November 12, 2005 and every thirty days thereafter until the registration
      statement is filed. We have included $79,000 as liquidated damages in non-cash
      interest through December 31, 2005. Additionally, because the registration
      statement was not declared effective by the SEC prior to January 12, 2006,
      we
      may be required to pay $30,000 as liquidated damages to the investors as of
      January 12, 2006 and for every thirty days thereafter until the registration
      statement is declared effective.





August
      2005 Equity Financing




In
      August
      2005, we sold 500,000 of our common shares at a purchase price of $5.40 per
      share to certain institutional investors. Those shares were included in our
      Form
      S-3 "shelf" registration statement (File No. 333-122392), which was declared
      effective by the SEC in July 2005. We received gross proceeds of approximately
      $2.7 million from the transaction, which we used for working capital and other
      general corporate purposes. The purchasers in the August 2005 Equity Financing
      had a 30-day option, which expired without exercise on September 4, 2005, to
      purchase an additional aggregate of 225,000 of our common shares included in
      the
      "shelf" registration statement at a purchase price of $5.50 per share. As of
      the
      date of this filing, 1,500,000 of our common shares included in our currently
      effective "shelf" registration statement have not been sold.





*Senior
      Secured Convertible Debt Financing*




On
      November 30, 2004, we completed a non-brokered private placement of $10 million
      of senior secured notes (the Senior Secured Convertible Notes). The Senior
      Secured Convertible Notes accrue interest at 10% per annum, payable quarterly
      in
      cash or our common shares at our option, if certain conditions are met, such
      as
      the availability of an effective registration statement pursuant to which
      resales may be made or the availability of Rule 144(k) for resale of the common
      shares underlying our Senior Secured Convertible Notes. The value of the shares
      for the purposes of calculating interest payments shall be equal to the 20-day
      trailing average of the volume weighted average prices of our common shares
      at
      the end of each quarterly interest period. The Senior Secured Convertible Notes
      are due November 30, 2007.





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





In
      a
      letter that we received on December 12, 2005, one of the holders of our 2004
      notes, Portside Growth & Opportunity Fund, an affiliate of Ramius Capital
      Group, LLC, notified us of two alleged events of default under their note set
      forth below. In a letter that we received on December 13, 2005, another holder
      of our 2004 notes, Smithfield Fiduciary LLC, an affiliate of Highbridge Capital
      Management, LLC, notified us only with respect to the second alleged event
      of
      default, set forth below. In a letter that we received on February 9, 2006,
      Portside notified us of a third alleged event of default under their note,
      as
      set forth below. Each of these notices call for us to redeem the entire $4.5
      million principal amount of the Portside and Smithfield 2004 notes, or $9.0
      million in the aggregate, plus a redemption premium of $675,000 plus liquidated
      damages to each of these holders of the 2004 notes pursuant to Section
      12(a) of their notes.




23




The
      following are the alleged defaults: (i) Registration Statement Failure pursuant
      to Section 4(a)(i) of their Note - Based upon our filing of a Post-Effective
      Amendment to the registration statement on Form S-3 relating to the underlying
      common shares of the Senior Secured Convertible Notes (Reg. No. 333-122391);
      (ii) Failure to Make Interest Payment pursuant to Section 4(a)(v) of their
      Note
      - Based upon a claim that we did not make a November 2005 interest payment;
      and
      (iii) Entering into unpermitted debt financing transactions prohibited pursuant
      to Section 4(a) (xi) of their Note - Based upon a claim that certain debt
      financing transactions that we have entered into are not permitted under the
      Note.





We
      believe after review with outside legal counsel, that these allegations lack
      merit and would not entitle the Noteholders to call the notes and
      other remedies that they are seeking. With respect to the first
      alleged event of default concerning the alleged registration maintenance
      failure, we contend that the filing of our post-effective amendments to the
      registration statements registering the underlying common shares did not and
      does not constitute an event of default under Section 4(a)(i) of the Portside
      Note. We contend that the second allegation of default is incorrect because
      on
      November 30, 2005 (the interest due date), we tendered payment by forwarding
      checks payable to Portside, Smithfield and the other holders of the 2004 notes
      by overnight courier to an attorney representing the holders for the full
      amounts of the relevant quarterly interest payments. That attorney did not
      distribute the checks to the four holders (although located in the same city),
      but instead returned the checks to us in California. We have since tendered
      payment of the full interest amount owing to all of the holders via federal
      funds wire into designated accounts for each of these parties. We contend that
      the third allegation of default lacks merit because we believe that
      the debt financing transactions that we have entered into are permitted under
      their Note and, even if deemed not permitted, do not constitute a breach or
      failure in any material respect under the Note.





We
      believe that Portside has undertaken to make allegations of events of default
      that lack merit in an attempt to achieve its objective of amending the terms
      of
      its Note to their advantage, including a reduction in the conversion price
      of
      the Notes or an acceleration in repayment of principal on its Note, although
      that principal is not due and payable until the note's maturity date, which
      is
      November 30, 2007. We have rejected its offers in this regard. We will continue
      to take appropriate actions that we believe are in the best interests of our
      Company and our shareholders.





If
      the
      Noteholders prevail in calling the Senior Secured Convertible Notes, the entire
      $10 million debt obligation can become due and payable immediately, including
      the redemption premiums and liquidated damages. We
      believe the alleged events of default of which Portside and Smithfield have
      given notice lack merit and would not entitle the Noteholders to the remedies
      that they are seeking. Therefore, we believe it is not probable the Noteholders
      would prevail in calling the Notes. As a result, in accordance with FAS 5,
      *“Accounting
      for Contingencies,”*we
      have continued to classify the Senior Secured Convertible Notes as a long-term
      obligation in our balance sheet at December 31, 2005,rather
      than as a current liability as FAS 78, “*Classification
      of Obligations That are Callable by the Creditor,”*might
      otherwise require.The redemption premium and liquidated damages of $1.5
      million and approximately $0.6 million, respectively, have not been accrued
      in
      the consolidated financial statements as of December 31, 2005. We refer you
      to
      Note 1 of our Notes to consolidated financial statements contained in this
      report for additional information regarding the accounting treatment of the
      Senior Secured Convertible Notes.





*Certain
      Developments*





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


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


24




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





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





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





On
      December 6, 2005, we filed Post-Effective Amendment No. 2 to the Financing
      Registration Statement and the Shelf Registration Statement for the purpose
      of
      filing an amended Exhibit 23.2, which included the consent of the independent
      registered public accounting firm, Odenberg, Ullakko, Muranishi & Co., LLP
      (OUM). That consent allows us to incorporate by reference into that registration
      statement the consolidated financial statements appearing in our 2004 Annual
      Report on Form 10-K/A filed on December 29, 2005, for each of the three years
      ended December 31, 2004.





In
      February 2006, we were advised by the Staff of the SEC that Post-Effective
      Amendment No. 6 to both the Financing Registration Statement and the Shelf
      Registration Statement were declared effective by the SEC.





**Liquidity
      and Capital Resources**





Through
      December 31, 2005, we have sustained recurring net losses from operations and,
      at December 31, 2005, we had a stockholders’ deficit of approximately
      $4,444,000. During 2005, we experienced negative cash flows from operating
      activities of approximately $9,676,000 and a net loss of approximately
      $14,025,000. Our operations were primarily funded in 2005 by the proceeds
      derived from exercises of warrants and options of approximately $536,000,
      proceeds of approximately $2.0 million that we received from the sale of 571,431
      of our common shares on October 12, 2005, proceeds of approximately $2.6 million
      from the sale of 499,965 of our common shares in August 2005, and the remaining
      proceeds from the sale of $10,000,000 of Senior Secured Convertible Notes in
      November 2004.





As
      of
      December 31, 2005, we had approximately $43,000 in cash and cash equivalents,
      a
      decrease of approximately $9,045,000 from the December 31, 2004 amount of
      $9,088,000. Our net working capital deficit at December 31, 2005, was
      approximately $2,279,000, compared to a net positive working capital of
      approximately $8,594,000 at December 31, 2004.





Net
      cash
      used in operating activities totaled approximately $9,676,000 and $8,517,000
      in
      2005 and 2004, respectively. This increase is due primarily to increased
      pre-production activities in our South Korean subsidiary. Net cash used in
      investing activities totaled approximately $5.5 million and $1.7 million in
      2005
      and 2004, respectively. This increase stemmed from acquiring and building our
      South Korean manufacturing facility. Net cash provided by financing activities
      was approximately $6.2 million and $13.0 million in 2005 and 2004, respectively.
      This resulted from the aggregate net proceeds of $4.6 million raised in two
      separate equity private placement transactions in 2005 and net proceeds of
      $0.8
      million from short-term loans during 2005. Net cash provided by financing
      activities in 2004 resulted primarily from the issuance of the 2004 Senior
      Secured Convertible Notes totaling $10,000,000.





As
      of
      December 31, 2005, we had an accumulated deficit of approximately $81,666,000.
      We have experienced significant losses in the past and expect that these losses
      will continue until we start to generate significant revenues from the sale
      of
      our products. We generated revenue of approximately $238,000 during 2005.
      Although we are expecting to generate revenues from the sale of our products
      in
      2006, we may continue to operate at a loss during 2006. There can be no
      assurance that our business will operate on a profitable basis
      thereafter.





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




25




We
      anticipate that our cash expenditures during 2006 will approximate $700,000
      per
      month, or approximately $8.4 million for the year, without regard to any revenue
      in 2006. We expect to meet our immediate cash needs and fund our immediate
      working capital requirements with our existing cash balances and from additional
      sources. Those sources include proceeds of approximately $3.4 million that
      we
      received from the sale of 1,300,000 of our common shares on January 12, 2006,
      (as more fully described in Note 10 to our consolidated financial statements);
      cash payments from our customers; the exercises of stock options and warrants;
      and additional sales of our common shares. We also have approximately $0.2
      million available under revolving credit facilities that we established in
      September and October 2005 and January 2006 in South Korea. There can be no
      assurances with respect to these potential sources. We believe that our current
      cash and cash equivalents as of December 31, 2005, combined with the proceeds
      from the January 2006 Financing and available draw downs on South Korean credit
      facilities will be sufficient to meet our capital and liquidity requirements
      for
      our operations through mid-March 2006. We will be required to raise significant
      amounts of additional capital to continue to fund our operations on a going
      forward basis. To raise additional capital, we plan to sell the 1.5 million
      common shares that we have available for sale under a currently effective
“shelf” registration statement. We also believe that we will be required to
      complete additional equity and/or debt financings in 2006. If we are unable
      to
      obtain additional funds on reasonable terms, we may be unable to continue our
      operations at current levels, or at all.





**Off
      Balance Sheet Arrangements**





There
      are
      no off balance sheet arrangements as of December 31, 2005.





**Contractual
      Obligations and Contingent Liabilities and Commitments**





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





The
      following table aggregates our expected contractual obligations and commitments
      subsequent to December 31, 2005:





Payments
      Due By
      Period


Contractual
                  obligations
              
              Less
                  than 1 year
              
              1
                  -
                  3 years
              
              3-5
                  years
              
              over
                  5 years
              
              TotalLong-term
                  convertible debt (1)
              
              $
              —
              
              $
              1,188,000
              
              $
              —
              
              $
              —
              
              $
              1,188,000Senior
                  secured convertible notes (3)
              
              
              —
              
              
              10,000,000
              
              
              —
              
              
              —
              
              
              10,000,000Short
                  term loans
              
              
              796,000
              
              
              —
              
              
              —
              
              
              —
              
              
              796,000Interest
                  on senior secured convertible notes (2)
              
              
              1,000,000
              
              
              1,000,000
              
              
              —
              
              
              —
              
              
              2,000,000Operating
                  lease commitments
              
              
              501,000
              
              
              1,270,000
              
              
              —
              
              
              —
              
              
              1,771,000Total
                  contractual cash obligations
              
              $
              2,297,000
              
              
              13,458,000
              
              $
              —
              
              $
              —
              
              $
              15,755,000




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


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


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





**Results
      of Operations**





*Three
      years ended December 31, 2005, 2004 and 2003*





*Revenue.* We
      recognized sales revenue of approximately $238,000, $1,161,000 and $221,000
      for
      the years ended December 31, 2005, 2004 and 2003, respectively. Revenue in
      2004
      was related to deliveries made pursuant to agreements relating to the sale
      of
      our T-1 LCoS Sets and light engines, primarily to customers in China. During
      2005 we changed our focus to the further development, manufacture and sale
      of
      our T-3 LCoS Sets, primarily to LG Electronics. Revenue in 2003 was related
      to
      initial shipments against purchase orders signed in 2003. See “Status of
      Business with LG Electronics”, “Status of Business in Taiwan” and “Status of
      Business in China” under this Item 7 for a more detailed description of the
      agreements relating to the sale of our products.




26




The
      following table summarizes our sales revenue percentages by product for the
      years ended 2005, 2004 and 2003.





2005
            
            2004
            
            2003LCoS
                (T-3) sets
            
            
            77
            %
            
            5
            %
            
            -
            %LCoS
                (T-1) sets
            
            
            4
            %
            
            42
            %
            
            27
            %Light
                engine display units
            
            
            1
            %
            
            51
            %
            
            73
            %Other
                (primarily supporting electronics)
            
            
            18
            %
            
            2
            %
            
            -
            %Total
            
            
            100
            %
            
            100
            %
            
            100
            %





Revenues
      significantly decreased from 2004 to 2005 because of problems that we
      experienced in the manufacturing of our T-3 LCoS Sets. These problems, and
      their
      resolution, are discussed in greater detail under Item 7 - “Management’s
      Discussion and Analysis - Status of Business with LG Electronics,
      Inc.”





*Gross
      Margin.* Gross
      margin changed from a negative $487,068 in 2003 to a positive of $178,696 in
      2004 to a negative $1,519,365 in 2005. Gross margin increased in 2004 compared
      to 2003 due to the higher percentage of LCoS Sets sales, as their margins are
      greater than those on display units. During 2005 our manufacturing facility
      in
      South Korea became operational. Once production began, our costs associated
      with
      this facility became part of our cost of revenue. These costs include a certain
      level of relatively fixed overhead costs, including personnel-related costs,
      to
      operate and maintain our manufacturing facilities. Once these relatively fixed
      overhead costs are covered, we expect to enjoy a contribution margin on
      additional sales. When we incur these costs without sufficient revenues from
      the
      sale of our products to offset them, we report negative margins. Our sales
      have
      been relatively minor to date, and have not yet covered the cost of operating
      our South Korean manufacturing facility. Due to the addition of these costs,
      there is currently no direct correlation between costs and revenue during 2005.
      Cost of revenue in 2005 includes a reserve of $351,000 related to a percentage
      of our T-1 inventory. While we believe we can sell this inventory, we have
      shifted our focus to the manufacture and sale of our T-3 product and are not
      currently manufacturing our T-1 product. Sales of our T-1 product were minimal
      during 2005.





*Selling,
      general and administrative expenses.* **** Selling,
      general and administrative expenses were approximately $7,255,000, $5,810,000
      and $3,641,000 in 2005, 2004 and 2003, respectively, and include professional
      services, salaries and related taxes and benefits, rent, depreciation, travel,
      insurance, and office expenses. Accounting, consulting and legal services
      increased by $452,000, $250,000, and $456,000, respectively in 2005 compared
      to
      2004. Accounting related services increased primarily due to the re-audit of
      2003 and 2002 financial statements by OUM as well as increased audit fees to
      cover compliance with the Sarbanes-Oxley Act of 2002 (SOX) related compliance
      and the audit of our South Korean subsidiary in 2005. Consulting services
      included increases related to SOX compliance efforts and implementation of
      our
      Navision software system. Legal fees increased due primarily to our
      correspondence related to our filings with the SEC as well as increased legal
      services incurred for various financing arrangements entered into during 2005.
      Salaries and related taxes and benefits increased by approximately $326,000
      in
      2005 compared to 2004 and primarily relates to administrative wages in our
      new
      South Korean manufacturing facility. This facility incurred an additional
      $364,000 in general and administrative expenses during 2005. These increases
      are
      partially offset by a reduction in bad debt expense of $350,000 (see below).
      This reserve was created in 2004 and was directly associated with a particular
      customer. The associated receivable was written off against this reserve during
      2005. Salaries and related taxes and benefits increased approximately $1,600,000
      in 2004 over 2003 as a result **** of
      the
      reassignment of employees from research and development to general and
      administrative and an additional **** increase
      in the number of general and administrative and sales staff. The increase in
      the
      amount of salary and related costs was approximately $1,500,000. In addition,
      travel and entertainment increased by approximately $300,000 between 2004 and
      2003 due to travel by our sales and marketing team as well as by management
      to
      generate new business. In addition, in 2004 we recorded an allowance for
      doubtful accounts of approximately $350,000 to reserve a receivable from one
      of
      our Chinese customers. We reserved this receivable based upon information
      provided to us by our Chinese sales representative that this customer was
      awaiting additional pending corporate financing and would likely not be able
      to
      pay us for our product deliveries prior to receiving that additional financing.





*Stock-based
      general and administrative expenses.* Stock-based
      general and administrative expenses were approximately $186,000, $932,000 and
      $1,986,000 in 2005, 2004 and 2003, respectively. The amounts incurred relate
      to
      common shares, options to purchase common shares and warrants issued in exchange
      for services in 2005, 2004 and 2003, costs of $186,000, $332,000 and $581,000,
      respectively, relate primarily to stock and options granted to employees and
      directors, and warrants issued in exchange for services. In addition, the
      amounts incurred in 2004 include a $600,000 reduction in a note receivable
      from
      one of our shareholders in exchange for a commitment to invest an additional
      $6,000,000. (See Note 3 to Consolidated Financial Statements.) The amounts
      incurred in 2003 relate primarily to stock-based expense of approximately
      $1,300,000 associated with the May 2003 private financing transaction. Of this
      amount, $959,000 related to the deemed beneficial pricing of shares and warrants
      purchased by Robert A. Olins, Chief Executive Officer, Secretary,
      Treasurer and a Director of SpatiaLight. For more information concerning
      the foregoing, see Note 2 to the Consolidated Financial Statements under Item
      8
      of this Report.




27




*Research
      and development expenses.* Research
      and development expenses were approximately $3,586,000, $2,306,000 and
      $2,681,000 in 2005, 2004 and 2003, respectively. The increase in 2005 as
      compared to 2004 is due to the pre-production activities of our South Korean
      manufacturing facility. This includes the cost of operating the manufacturing
      facility prior to commencing production as well as supplies and materials used
      in these efforts. The decrease in 2004 as compared to 2003 was due to the
      reclassification of existing employees to general and administrative duties,
      offset by an increase in consulting services related to our integrated circuit
      design.




*Interest
      expense* .
      Interest expense was approximately $1,108,000, $157,000, and $213,000 in 2005,
      2004, and 2003, respectively. These amounts are consistent with the balances
      in
      notes payable. The increase during 2005 is related to the November 2004 Senior
      Secured Convertible Notes of $10,000,000 which bear interest at 10% per
      annum.





*Non-cash
      interest expense.* Non-cash
      interest expense of approximately $1,431,000, $791,000 and $584,000 in 2005,
      2004 and 2003, respectively, primarily relates to the valuation of the
      beneficial conversion feature of interest converted and convertible into equity
      on the notes payable to Argyle Capital Management Corporation, a company
      wholly-owned by Robert A. Olins, Chief Executive Officer, Secretary,
      Treasurer and a Director of SpatiaLight, based on the intrinsic value of
      the conversion feature. The beneficial conversion interest represents the excess
      market value of the shares issued or issuable at current market prices over
      accrued interest payable. In November 2004, these notes were extended until
      December 31, 2008. Amortization of the discount on the Argyle notes is included
      in non-cash interest expense.





Also
      included in non-cash interest expense in 2005 is the amortization of note
      discounts related to the November 2004 Financing. The note discounts primarily
      resulted from the valuation of the additional investment rights or note purchase
      option, and beneficial conversion feature. See Note 3 to the Consolidated
      Financial Statements.





*Gain
      from revaluation of note purchase option liability.* The gain
      of approximately $754,000 and $412,000 recorded in 2005 and 2004, respectively,
      arises from the revaluation of the additional investment rights (AIR), which
      is
      being treated as a derivative and is recorded on the balance sheet as a note
      purchase option liability. This AIR expired on August 31, 2005. See Note 3
      to
      Consolidated Financial Statements. The gain in 2005 also includes an expired
      Investment Right of $94,500 associated with our August 2005
      financing.





*Gain
      on fair value of warrants.* The gain
      of approximately $180,000 arises from the revaluation of the warrants issued
      in
      connection with the October 2005 financing. These warrants are being treated
      as
      derivatives and are recorded on the balance sheet at fair value until the
      registration statement underlying the associated shares is declared effective
      by
      the SEC.





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





*Interest
      and other income.* Interest
      and other income was approximately $70,000, $38,000, and $76,000 in 2005, 2004,
      and 2003, respectively. The increase in interest income in 2003 was due to
      interest earned on a stock subscription receivable from a shareholder. See
      Note
      2 to the Consolidated Financial Statements under Item 8 of this Report. Interest
      in 2005 and 2004 was primarily bank interest. Other income in 2005 includes
      approximately $42,000 of subsidies from the South Korean
      government.





*Loss
      before income taxes* .
      Losses
      before income taxes were approximately $14,022,000, $9,366,000, and $9,516,000
      in 2005, 2004 and 2003, respectively. The increase in losses from 2005 to 2004
      is primarily due to costs associated with starting up our South Korean
      manufacturing facility coupled with negligible sales. Additional factors include
      approximately $1,443,000 of increased interest expense associated with our
      $10,000,000 notes ($443,000 of which is non-cash). The decrease in these losses
      from 2003 to 2004 is due to an increase in gross margin of approximately
      $666,000 as well as a decrease in stock-based compensation of approximately
      $1,055,000, offset by an increase in selling, general and administrative
      expense.





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





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





**Critical
      Accounting Policies and Estimates**





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




28




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





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


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


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


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





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




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





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





**Recent
      Accounting Pronouncements**





In
      February 2006, the Financial Accounting Standards Board (FASB) issued
      SFAS No. 155,*“Accounting
      for Certain Hybrid Financial Instruments — an amendment of FASB Statements
      No. 133 and 140*”
      (SFAS 155).
      SFAS 155amends
      SFAS No. 133,*“Accounting
      for Derivative Instruments and Hedging Activities”*(SFAS 133),
      and SFAS No. 140,*“Accounting
      for Transfers and Servicing of Financial Assets and Extinguishments of
      Liabilities”*(SFAS 140).
      This statement also resolves issues addressed in Statement No. 133
      Implementation Issue No. D1,*“Application
      of Statement 133 to Beneficial Interests in Securitized Financial Assets.”*SFAS 155permits
      fair value remeasurement for any hybrid financial instrument that contains
      an
      embedded derivative that otherwise would require bifurcation and clarifies
      which
      interest-only strips and principal-only strips are not subject to the
      requirements of SFAS 133. SFAS 140 is amended to eliminate the
      prohibition on a qualifying special-purpose entity from holding a derivative
      financial instrument that pertains to a beneficial interest other than another
      derivative financial instrument. SFAS 155is
      effective for all financial instruments acquired or issued during fiscal years
      beginning after September 15, 2006 (January 1, 2007 for the Company).
      The Companydoes not
      expect this statement to have a material impact on its consolidated financial
      statements.




29




In
      June
      2005, the Financial Accounting Standards Board (FASB) issued Statement No.
      154,
“Accounting Changes and Error Corrections” (FAS 154), a replacement of APB No.
      20, “Accounting Changes” and FASB Statement No. 3, “Reporting Accounting Changes
      in Interim Financial Statements.” FAS 154 applies to all voluntary changes in
      accounting principle and changes the requirements for accounting for and
      reporting of a change in accounting principle. This statement establishes that,
      unless impracticable, retrospective application is the required method for
      reporting a change in accounting principle in the absence of explicit transition
      requirements specific to the newly adopted accounting principle. It also
      requires the reporting of an error correction which involves adjustments to
      previously issued financial statements similar to those generally applicable
      to
      reporting an accounting change retrospectively. FAS 154 is effective for
      accounting changes and corrections of errors made in fiscal years beginning
      after December 15, 2005. We do not expect the adoption of FAS 154 will have
      a
      material impact on our results of operations or financial condition.





In
      March 2005, the FASB issued Interpretation No. 47, “Accounting for
      Conditional Asset Retirement Obligations.” Interpretation No. 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.
      Interpretation No. 47 also clarifies when an entity would have sufficient
      information to reasonably estimate the fair value of an asset retirement
      obligation. Interpretation No. 47 is effective no later than the end of the
      fiscal year ending after December 15, 2005. The adoption of Interpretation
      No. 47 did not have a material impact on our results of operations or
      financial condition.





In
      December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment” to revise
      SFAS No. 123, “Accounting for Stock-Based Compensation” and supersede APB
      Opinion No. 25, “Accounting for Stock Issued to Employees” and its related
      implementation guidance. It requires companies to recognize their compensation
      costs related to share-based payment transactions in financial statements.
      These
      costs are to be measured based on the fair value of the equity or liability
      instruments issued and are recognized over the period during which an employee
      is required to provide services in exchange for the award - the requisite
      service period (usually the vesting period). We will apply
      SFAS No. 123R in the first quarter of 2006. We expect the adoption of
      this statement to result in a pretax expense of $555,000 in 2006. This does
      not include the expense impact of future grants of options.





In
      December 2004, the FASB issued SFAS No. 153, “Exchanges of
      Non-monetary Assets — an Amendment of APB Opinion No. 29,” which
      eliminates the exception for non-monetary exchanges of similar productive assets
      and replaces it with a general exception for exchanges of non-monetary assets
      that do not have commercial substance. A non-monetary exchange has commercial
      substance if the future cash flows of the entity are expected to change
      significantly as a result of the exchange. SFAS No. 153 will be
      effective for non-monetary asset exchanges occurring in fiscal periods beginning
      after June 15, 2005. We do not expect that the adoption of SFAS No. 153
      will have a material impact on our results of operations or financial condition.





In
      November 2004, the FASB issued SFAS No. 151, “Inventory Costs —
an Amendment of ARB No. 43, Chapter 4,” which clarifies that abnormal
      amounts of idle facility expense, freight, handling costs and wasted material
      (spoilage) be recognized as current period charges. In addition,
      SFAS No. 151 requires that allocation of fixed production overheads to
      the costs of conversion be based on the normal capacity of the production
      facilities. SFAS No. 151 will be effective for inventory costs
      incurred in fiscal years beginning after June 15, 2005. We do not expect
      that the adoption of SFAS No. 151 will have a material impact on our results
      of
      operations or financial condition.





In
      March
      2004, the Financial Accounting Standards Board (FASB) approved the consensus
      reached by the Emerging Issues Task Force (EITF) Issue No. 03-1, "The Meaning
      of
      Other-Than-Temporary Impairment and Its application to Certain Investments"
      ("EITF 03-1"). The objective of EITF 03-1 was to provide guidance for
      identifying impaired investments. EITF 03-1 also provided new disclosure
      requirements for investments that are deemed to be temporarily impaired. The
      accounting provisions of EITF 03-1 were effective for all reporting periods
      beginning after June 15, 2004, while the disclosure requirements were effective
      only for annual periods ending after June 15, 2004. In September 2004, the
      FASB
      deferred the requirement to record impairment losses caused by the effect of
      increases in "risk-free" interest rates and "sector spreads" on debt securities
      subject to paragraph 16 of EITF 03-1 and excludes minor impairments from the
      requirement until new guidance becomes effective. We have evaluated the impact
      of the adoption of EITF 03-1 and do not believe the impact is significant to
      the
      Company's overall results of operations or financial position.





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





We
      place
      all of our excess cash and cash equivalents in a checking account or money
      market account in the United States. We do not expect any material losses from
      our placement of such cash balances, and we believe that our interest rate
      exposure is modest. As of December 31, 2005, our cash and cash equivalents
      totaled $42,565. Of this amount, approximately $41,000 was in South
      Korea.


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


30




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





**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**





To
      the
      Board of Directors and Stockholders of


SpatiaLight,
      Inc.





We
      have
      audited the accompanying consolidated balance sheets of SpatiaLight, Inc. and
      its subsidiaries as of December 31, 2005 and 2004, and the related consolidated
      statements of operations, stockholders' equity (deficit) and cash flows for
      each
      of the three years in the period ended December 31, 2005. These financial
      statements are the responsibility of the Company's management. Our
      responsibility is to express an opinion on these financial statements based
      on
      our audits.





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





In
      our
      opinion, the consolidated financial statements audited by us present fairly,
      in
      all material respects, the consolidated financial position of SpatiaLight,
      Inc.
      and its subsidiaries at December 31, 2005 and 2004, and the consolidated results
      of their operations and their cash flows for each of the three years in the
      period ended December 31, 2005, in conformity with U.S. generally accepted
      accounting principles.





The
      accompanying consolidated financial statements have been prepared assuming
      that
      the Company will continue as a going concern. As discussed in Note 1 to the
      consolidated financial statements, the Company has suffered recurring operating
      losses and negative cash flows from operations, and has a negative working
      capital position and a stockholder deficit. Management believes that the
      Company's cash resources will not be sufficient to sustain its
      operations beyond mid March 2006 without additional financing. As also
      described in Notes 1 and 3, t he
      Company has received notices from certain of its Senior Secured Convertible
      Noteholders calling for immediate redemption of their convertible notes based
      on
      alleged events of default. Management believes, after reviewing the alleged
      events of default with outside legal counsel, the alleged events of default
      lack
      merit and would not entitle the Noteholders to call the Senior Secured
      Convertible Notes and other remedies they are seeking. If the Noteholders
      prevail in calling the convertible notes, the entire debt obligation could
      become due and payable immediately, including the related amounts of redemption
      premium and liquidated damages, and the Company would be forced to refinance
      or
      repay the debt obligations or seek other alternative financing. Additionally,
      as
      described in Note 1, in the event the Company is unable to ramp up delivery
      volumes to their major customer by the end of July 2006, management believes
      that it is reasonably likely that the major customer may discontinue actively
      doing business with the Company. Furthermore, the Company is subject to a U.S.
      Securities and Exchange Commission investigation relating to the filing of
      unauthorized consents of its predecessor auditor in certain
      registration statements, and may be subject to certain penalties and claims
      relating thereto. These factors raise substantial doubt about the Company's
      ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 1.
      The
      accompanying consolidated financial statements do not include any adjustments
      that might result from the outcome of these uncertainties.





We
      have
      also audited, in accordance with the standards of the Public Company Accounting
      Oversight Board (United States), the effectiveness of SpatiaLight, Inc.'s
      internal control over financial reporting as of December 31, 2005, based on
      criteria established in Internal Control -- Integrated Framework issued by
      the
      Committee of Sponsoring Organizations of the Treadway Commission and our report
      dated March 6, 2006 expressed an adverse opinion thereon.











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





*San
      Francisco, California*


*March
      6, 2006*





31




SPATIALIGHT,
                INC.CONSOLIDATED
                  BALANCE SHEETSDECEMBER
                  31, 2005 AND 20042005
              
              2004ASSETSCurrent
                  assetsCash
                  and cash equivalents
              
              $
              42,565
              
              $
              9,087,551Accounts
                    receivable, net of allowance of $0 and $345,030at
                    December 31, 2005
                  and
                    2004, respectively
              
              
              139,676
              
              
              264,053Inventory,
                  net
              
              
              756,723
              
              
              1,173,314Prepaids
                  and other current assets
              
              
              255,157
              
              
              949,711Prepaid
                  current non-cash interest to related party
              
              
              1,157,133
              
              
              913,889Total
                  current assets
              
              
              2,351,254
              
              
              12,388,518Property
                  and equipment, net
              
              
              6,813,520
              
              
              858,212Construction
                  in progress
              
              
              —
              
              
              2,801,521Prepaid
                  non-cash interest to related party
              
              
              2,314,265
              
              
              3,474,386Other
                  assets
              
              
              73,437
              
              
              123,774Total
                  assets
              
              $
              11,552,476
              
              $
              19,646,411LIABILITIES,
                  TEMPORARY EQUITY, AND STOCKHOLDERS' EQUITY (DEFICIT)Current
                  liabilitiesShort
                  term loans
              
              $
              572,025
              
              $
              —Short
                  term loan from a related party
              
              
              224,384
              
              
              —Accounts
                  payable
              
              
              1,665,711
              
              
              601,394Note
                  purchase option liability
              
              
              —
              
              
              659,874Fair
                  value of warrants to purchase common stock
              
              
              778,270Accrued
                  expenses and other current liabilities
              
              
              1,389,427
              
              
              2,533,546Total
                  current liabilities
              
              
              4,629,817
              
              
              3,794,814Senior
                  secured and related party convertible notes
              
              
              10,340,113
              
              
              9,885,140Total
                  liabilities
              
              
              14,969,930
              
              
              13,679,954Commitments
                  and contingenciesTemporary
                  equity:Common
                    stock, subject to registration, $0.01 par value;571,431
                    shares issued and outstanding,
                  net
                    of fair value ofwarrants
                    of $958,625 and issuance costs of $15,000
              
              
              1,026,374
              
              
              —Total
                  liabilities and temporary equity
              
              
              15,996,304
              
              
              13,679,954Stockholders'
                  equity (deficit):Common
                  stock, $.01 par value:50,000,000
                    shares authorized;36,777,069
                    and 35,326,436 shares issued and outstanding,
                at
                  December 31, 2005 and 2004, respectively
              
              
              367,771
              
              
              353,264Additional
                  paid-in capital
              
              
              76,631,925
              
              
              69,384,146Notes
                  receivable from stockholders
              
              
              —
              
              
              (241,462
              )Common stock
                  issuable
              
              
              —
              
              
              4,038,149Other
                  comprehensive income
              
              
              222,317
              
              
              73,562Accumulated
                  deficit
              
              
              (81,665,841
              )
              
              (67,641,202
              )Total
                  stockholders' equity (deficit)
              
              
              (4,443,828
              )
              
              5,966,457Total
                  liabilities, temporary equity, and stockholders' equity
                  (deficit)
              
              $
              11,552,476
              
              $
              19,646,411


See
      accompanying notes to consolidated financial statements.




32




SPATIALIGHT,
                INC.CONSOLIDATED
                  STATEMENTS OF OPERATIONSYEARS
                  ENDED DECEMBER 31, 2005, 2004 and 20032005
              
              2004
              
              2003Revenue
              
              $
              237,724
              
              $
              1,160,978
              
              $
              221,252Cost
                  of revenue
              
              
              (1,757,089
              )
              
              (982,282
              )
              
              (708,320
              )Gross
                  margin
              
              
              (1,519,365
              )
              
              178,696
              
              
              (487,068
              )Selling,
                  general and administrative expenses:Selling,
                  general and administrative expenses
              
              
              7,255,353
              
              
              5,809,702
              
              
              3,641,422Stock-based
                  general and administrative expenses
              
              
              186,187
              
              
              931,524
              
              
              1,985,720Total
                  selling, general and administrative expenses
              
              
              7,441,540
              
              
              6,741,226
              
              
              5,627,142Research
                  and development expenses
              
              
              3,586,296
              
              
              2,305,650
              
              
              2,681,328Total
                  operating expenses
              
              
              11,027,836
              
              
              9,046,876
              
              
              8,308,470Operating
                  loss
              
              
              (12,547,201
              )
              
              (8,868,180
              )
              
              (8,795,538
              )Other
                  income (expense):Interest
                  expense:Interest
                  expense
              
              
              (1,107,812
              )
              
              (156,693
              )
              
              (213,362
              )Non-cash
                  interest expense
              
              
              (1,430,506
              )
              
              (791,036
              )
              
              (583,672
              )Total
                  interest expense
              
              
              (2,538,318
              )
              
              (947,729
              )
              
              (797,034
              )Other
                  income:Gain
                  from revaluation of note purchase option and investment right
                  liabilities
              
              
              754,374
              
              
              412,374
              
              
              —Gain
                  from revaluation of warrants
              
              
              180,355
              
              
              —
              
              
              —Foreign
                  currency translation gain
              
              
              58,531
              
              
              —
              
              
              —Interest
                  and other income
              
              
              69,920
              
              
              38,009
              
              
              76,195Total
                  other income
              
              
              1,063,180
              
              
              450,383
              
              
              76,195Total
                  other income (expenses)
              
              
              (1,475,138
              )
              
              (497,346
              )
              
              (720,839
              )Loss
                  before income tax expense
              
              
              (14,022,339
              )
              
              (9,365,526
              )
              
              (9,516,377
              )Income
                  tax expense
              
              
              2,300
              
              
              1,475
              
              
              —Net
                  loss
              
              $
              (14,024,639
              )
              $
              (9,367,001
              )
              $
              (9,516,377
              )Net
                  loss per share - basic and diluted
              
              $
              (0.39
              )
              $
              (0.27
              )
              $
              (0.34
              )Weighted
                    average shares used in computingnet
                    loss per share- basic and diluted
              
              
              36,375,068
              
              
              34,154,057
              
              
              28,173,770




See
        accompanying notes to consolidated financial statements




33




SPATIALIGHT,
                  INC.
                CONSOLIDATED
                  STATEMENTS OFSTOCKHOLDERS'
                EQUITY (DEFICIT)
              
              
              
              
              
              
              
              **NOTES**YEARS
                  ENDED DECEMBER 31, 2005, 2004 AND 2003
              
              
              
              **ADDITIONAL**
              
              **RECEIVABLE**
              
              
              
              **OTHER**
              
              **COMMON**
              
              **TOTAL****COMMON
                  STOCK**
              
              **PAID-IN**
              
              **FROM**
              
              **ACCUMULATED**
              
              **COMPREHEN-**
              
              **STOCK**
              
              **STOCKHOLDERS'****SHARES**
              
              **AMOUNT**
              
              **CAPITAL**
              
              **STOCKHOLDERS**
              
              **DEFICIT**
              
              **SIVE
                  INCOME**
              
              **ISSUABLE**
              
              **EQUITY
                  (DEFICIT)**Balance,
                  January 1, 2003
              
              
              26,018,658
              
              $
              260,188
              
              $
              45,550,830
              
              $
              (1,426,999
              )
              $
              (48,757,824
              )
              $
              —
              
              $
              —
              
              $
              (4,373,805
              )Exercise
                  of stock options and warrants, 120,082 shares issued in January
                  2004
              
              
              365,624
              
              
              3,657
              
              
              541,124
              
              
              —
              
              
              —
              
              
              —
              
              
              305,685
              
              
              850,466Payments
                  on notes receivable from stockholders
              
              
              —
              
              
              —
              
              
              —
              
              
              402,500
              
              
              —
              
              
              —
              
              
              —
              
              
              402,500Accrued
                  interest on notes receivable from stockholders
              
              
              —
              
              
              —
              
              
              —
              
              
              (72,427
              )
              
              —
              
              
              —
              
              
              —
              
              
              (72,427
              )Issuance
                  of stock, stock options, and warrants for services
              
              
              79,000
              
              
              790
              
              
              569,937
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              570,727Issuance
                  of options to employees and directors
              
              
              —
              
              
              —
              
              
              195,387
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              195,387Conversion
                  of debt and accrued interest
              
              
              1,580,820
              
              
              15,807
              
              
              3,929,439
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              3,945,246Warrants
                  issued in lieu of interest on short term borrowings
              
              
              —
              
              
              —
              
              
              6,647
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              6,647Shares
                  issued on exercise of warrant under 2002 installment note
              
              
              746,268
              
              
              7,463
              
              
              (7,463
              )
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              —May
                  Private placement, net of issuance cost of $175,065
              
              
              2,796,325
              
              
              27,963
              
              
              4,946,972
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              4,974,935Issuance
                  of shares to third party for finder's fee in conjunction with May
                  Private
                  placement
              
              
              130,435
              
              
              1,304
              
              
              375,653
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              376,957August
                  Private placement, net of issuance cost of $224,648
              
              
              1,212,061
              
              
              12,120
              
              
              2,526,731
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              2,538,851December
                  private placement, 300,000 issued, 700,000 issuable in
                  January
              
              
              300,000
              
              
              3,000
              
              
              1,452,255
              
              
              —
              
              
              —
              
              
              —
              
              
              3,500,000
              
              
              4,955,255Beneficial
                    pricing on stock and warrants acquired in
                  private
                    placement
              
              
              —
              
              
              —
              
              
              958,913
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              958,913Net
                  loss
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              (9,516,377
              )
              
              —
              
              
              —
              
              
              (9,516,377
              )




See
        accompanying notes to consolidated financial statements




34




SPATIALIGHT,
                    INC.
                CONSOLIDATED
                  STATEMENTS OF
                STOCKHOLDERS'
                  EQUITY (DEFICIT) (con't)
              
              
              
              
              
              **NOTES**YEARS
                  ENDED DECEMBER 31, 2005, 2004 AND 2003
              
              
              
              **ADDITIONAL**
              
              **RECEIVABLE**
              
              
              
              **OTHER**
              
              **COMMON**
              
              **TOTAL****COMMON
                  STOCK**
              
              **PAID-IN**
              
              **FROM**
              
              **ACCUMULATED**
              
              **COMPREHEN-**
              
              **STOCK**
              
              **STOCKHOLDERS'****SHARES**
              
              **AMOUNT**
              
              **CAPITAL**
              
              **STOCKHOLDERS**
              
              **DEFICIT**
              
              **SIVE
                  INCOME**
              
              **ISSUABLE**
              
              **EQUITY
                  (DEFICIT)**Balance,
                  December 31, 2003
              
              
              33,229,191
              
              
              332,292
              
              
              61,046,425
              
              
              (1,096,926
              )
              
              (58,274,201
              )
              
              —
              
              
              3,805,685
              
              
              5,813,275Exercise
                  of stock options and warrants, 132,737 shares issued in January
                  2005
              
              
              1,013,127
              
              
              10,131
              
              
              2,484,387
              
              
              —
              
              
              —
              
              
              —
              
              
              394,185
              
              
              2,888,703Issuance
                  of options to employees and directors
              
              
              —
              
              
              —
              
              
              67,674
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              67,674Issuance
                  of warrant for services
              
              
              —
              
              
              —
              
              
              263,850
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              263,850Issuance
                  of shares for prepayment of related party interest
              
              
              264,036
              
              
              2,640
              
              
              1,541,734
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              1,544,374Shares
                  issuable for prepayment of related party interest, 448,768 issued
                  in
                  January 2005
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              3,643,964
              
              
              3,643,964Payments
                  on notes receivable from stockholders
              
              
              —
              
              
              —
              
              
              —
              
              
              269,851
              
              
              —
              
              
              —
              
              
              —
              
              
              269,851Reduction
                  of note receivable in exchange for financing commitment
              
              
              —
              
              
              —
              
              
              —
              
              
              600,000
              
              
              —
              
              
              —
              
              
              —
              
              
              600,000Accrued
                  interest on notes receivable from stockholder
              
              
              —
              
              
              —
              
              
              —
              
              
              (14,387
              )
              
              —
              
              
              —
              
              
              —
              
              
              (14,387
              )Beneficial
                  pricing on conversion feature on convertible notes
              
              
              —
              
              
              —
              
              
              156,610
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              156,610Issuance
                  of common shares issuable
              
              
              820,082
              
              
              8,201
              
              
              3,797,484
              
              
              —
              
              
              —
              
              
              —
              
              
              (3,805,685
              )
              
              —Short
                  swing profit
              
              
              —
              
              
              —
              
              
              25,982
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              25,982Comprehensive
                  loss:Net
                  loss
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              (9,367,001
              )
              
              —
              
              
              —
              
              
              (9,367,001
              )Foreign
                  currency translation adjustments
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              73,562
              
              
              —
              
              
              73,562Total
                  comprehensive loss
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              (9,293,439
              )




See
        accompanying notes to consolidated financial statements




35




SPATIALIGHT,
                    INC.
                CONSOLIDATED
                  STATEMENTS OF
                STOCKHOLDERS'
                  EQUITY (DEFICIT) (con't)YEARS
                  ENDED DECEMBER 31, 2005, 2004 AND 2003
              
              **NOTES****ADDITIONAL**
              
              **RECEIVABLE**
              
              
              
              **OTHER**
              
              **COMMON**
              
              **TOTAL****COMMON
                  STOCK**
              
              **PAID-IN**
              
              **FROM**
              
              **ACCUMULATED**
              
              **COMPREHEN-**
              
              **STOCK**
              
              **STOCKHOLDERS'****SHARES**
              
              **AMOUNT**
              
              **CAPITAL**
              
              **STOCKHOLDERS**
              
              **DEFICIT**
              
              **SIVE
                  INCOME**
              
              **ISSUABLE**
              
              **EQUITY
                  (DEFICIT)**Balance,
                  December 31, 2004
              
              
              35,326,436
              
              
              353,264
              
              
              69,384,146
              
              
              (241,462
              )
              
              (67,641,202
              )
              
              73,562
              
              
              4,038,149
              
              
              5,966,457Issuance
                  of options below fair market value to employees
              
              
              —
              
              
              —
              
              
              22,000
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              22,000Exercise
                  of stock options and warrants
              
              
              369,163
              
              
              3,692
              
              
              532,297
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              535,989Issuance
                  of warrant for services
              
              
              —
              
              
              —
              
              
              164,187
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              164,187Issuance
                  of common shares, net of issuance costs of $103,539 and fair value
                  of
                  investment right of $94,500
              
              
              499,965
              
              
              5,000
              
              
              2,496,961
              
              
              —
              
              
              —
              
              
              —
              
              
              
              
              
              2,501,961Payments
                  on notes receivable from stockholders
              
              
              —
              
              
              —
              
              
              —
              
              
              249,105
              
              
              —
              
              
              —
              
              
              —
              
              
              249,105Accrued
                  interest on notes receivable from stockholder
              
              
              —
              
              
              —
              
              
              —
              
              
              (7,643
              )
              
              —
              
              
              —
              
              
              —
              
              
              (7,643
              )Issuance
                  of common shares issuable
              
              
              581,505
              
              
              5,815
              
              
              4,032,334
              
              
              —
              
              
              —
              
              
              —
              
              
              (4,038,149
              )
              
              —Comprehensive
                  loss:Net
                  loss
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              (14,024,639
              )
              
              —
              
              
              —
              
              
              (14,024,639
              )Foreign
                  currency translation adjustments
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              148,755
              
              
              —
              
              
              148,755Total
                  comprehensive loss
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              (13,875,884
              )Balance,
                  December 31, 2005
              
              
              36,777,069
              
              $
              367,771
              
              $
              76,631,925
              
              $
              —
              
              $
              (81,665,841
              )
              $
              222,317
              
              $
              —
              
              $
              (4,443,828
              )




See
        accompanying notes to consolidated financial statements




36




SPATIALIGHT,
                  INC.
                CONSOLIDATED
                  STATEMENTS OF CASH FLOWSYEARS
                  ENDED DECEMBER 31, 2005, 2004 AND 20032005
              
              2004
              
              2003Cash
                  flows from operating activities:Net
                  loss
              
              $
              (14,024,639
              )
              $
              (9,367,001
              )
              $
              (9,516,377
              )Adjustments
                  to reconcile net loss to net cash used in operating
                  activities:Allowance
                  for doubtful accounts
              
              
              —
              
              
              345,030
              
              
              —Inventory
                  reserve adjustment
              
              
              351,377
              
              
              (210,000
              )
              
              516,382Depreciation
                  and amortization
              
              
              728,383
              
              
              575,391
              
              
              393,302Stock-based
                  general and administrative expenses
              
              
              186,187
              
              
              931,524
              
              
              1,985,720Non-cash
                  interest expense
              
              
              1,430,506
              
              
              791,036
              
              
              583,672Gain
                  from revaluation of note purchase option and investment right
                  liabilities
              
              
              (754,374
              )
              
              (412,374
              )
              
              —Gain
                  from revaluation of warrants
              
              
              (180,355
              )
              
              —
              
              
              —Non-cash
                  foreign currency translation gain
              
              
              58,531
              
              
              —
              
              
              —Accrued
                  interest on notes receivable from stockholders
              
              
              (7,643
              )
              
              (14,387
              )
              
              (72,427
              )Gain
                  on sale of fixed assets
              
              
              (1,928
              )
              
              —
              
              
              —Changes
                  in operating assets and liabilities:Accounts
                  receivable
              
              
              124,377
              
              
              (491,553
              )
              
              (117,530
              )Inventory
              
              
              65,214
              
              
              (183,697
              )
              
              (1,020,040
              )Prepaids
                  and other current assets
              
              
              714,901
              
              
              (411,437
              )
              
              212,428Other
                  assets
              
              
              50,337
              
              
              (22,711
              )
              
              156,079Accounts
                  payable
              
              
              1,005,783
              
              
              (261,890
              )
              
              (1,154,946
              )Accrued
                  expenses and other current liabilities
              
              
              577,484
              
              
              214,806
              
              
              470,799Net
                  cash used in operating activities
              
              
              (9,675,859
              )
              
              (8,517,263
              )
              
              (7,562,938
              )Cash
                  flows from investing activities:Purchase
                  of property and equipment
              
              
              (5,534,882
              )
              
              (795,173
              )
              
              (524,764
              )Construction
                  in progress
              
              
              —
              
              
              (950,627
              )
              
              —Net
                  cash used in investing activities
              
              
              (5,534,882
              )
              
              (1,745,800
              )
              
              (524,764
              )Cash
                  flows from financing actitivies:Proceeds
                  from issuance of short-term notes
              
              
              987,316
              
              
              —
              
              
              792,500Payment
                  on short-term notes
              
              
              (190,907
              )
              
              —
              
              
              (542,500
              )Proceeds
                  from the issuance of convertible notes
              
              
              —
              
              
              10,000,000
              
              
              —Payments
                  on notes receivable from stockholders
              
              
              249,105
              
              
              269,851
              
              
              402,500Payments
                  on convertible notes
              
              
              —
              
              
              —
              
              
              (100,000
              )Financing
                  costs for convertible notes
              
              
              —
              
              
              (217,162
              )
              
              —Short
                  swing profits
              
              
              —
              
              
              25,982
              
              
              —Proceeds
                  from sales of common shares and warrants, net of fees
              
              
              4,581,460
              
              
              —
              
              
              12,469,042Proceeds
                  from exercise of warrants and options
              
              
              535,989
              
              
              2,888,703
              
              
              850,466Net
                  cash provided by financing activities
              
              
              6,162,963
              
              
              12,967,374
              
              
              13,872,008Net
                  increase (decrease) in cash and cash equivalents
              
              
              (9,047,778
              )
              
              2,704,311
              
              
              5,784,306Effect
                  of exchange rate changes on cash
              
              
              2,792
              
              
              23,271
              
              
              —Cash
                  and cash equivalents at beginning of period
              
              
              9,087,551
              
              
              6,359,969
              
              
              575,663Cash
                  and cash equivalents at end of period
              
              $
              42,565
              
              $
              9,087,551
              
              $
              6,359,969






37




SPATIALIGHT,
                  INC.
                CONSOLIDATED
                  STATEMENTS
                  OF CASH FLOWS (Cont.)YEARS
                  ENDED DECEMBER 31, 2005, 2004 AND 20032005
              
              2004
              
              2003Supplemental
                  disclosure of cash flow information:Income
                  taxes paid during the period
              
              $
              2,300
              
              $
              1,475
              
              $
              —Interest
                  paid during the period
              
              $
              1,002,740
              
              $
              482
              
              $
              45,319Non
                  cash financing activities:Common
                  shares issued upon conversion of interest and notes
              
              $
              —
              
              $
              —
              
              $
              3,945,246Discount
                  on convertible notes due to purchase option liability
              
              $
              —
              
              $
              1,072,248
              
              $
              —Discount
                  on convertible notes due to beneficial conversion feature
              
              $
              —
              
              $
              156,610
              
              $
              —Common
                  shares issued or issuable for prepaid interest to related
                  party
              
              $
              —
              
              $
              4,388,275
              
              $
              —




See
        accompanying notes to consolidated financial statements.




38




SPATIALIGHT,
        INC.
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
        31, 2005, 2004 AND 2003




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




*Description
      of Business -* We
      are in
      the business of manufacturing high-resolution liquid crystal on silicon (LCoS)
      microdisplays. We are currently focused on manufacturing one core product,
      our
      T-3 LCoS Set, to our customers and prospective customers, who are located
      primarily in Asia. The T-3 model has a 1920 pixels by 1080 pixels configuration.
      Our previously manufactured T-1 model has a lower resolution of 1280 pixels
      by
      960 pixels configuration. We are exclusively focusing on manufacturing the
      T-3
      model of our LCoS Sets because we believe that the market demand for that higher
      resolution product will be significantly greater. Our current customers and
      current prospective customers are original equipment manufacturers (OEMs)
      engaged in the businesses of manufacturing high definition televisions or
      manufacturing light engines for incorporation into high definition televisions.
      Our products are suitable for incorporation into other potential applications
      including rear projection computer monitors, wireless communication devices,
      portable games and digital assistants, although we are not currently working
      with OEMs of these products.





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




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





*Going
      Concern -* The
      accompanying consolidated financial statements have been prepared assuming
      we
      will continue as a going concern. We have suffered recurring operating losses
      and negative cash flows from operations. As of December 31, 2005, we had
      negative net working capital of $2,278,563 and an accumulated deficit of
      $81,665,841, with total stockholders’ deficit of $4,443,828.





Our
      total
      cash and cash equivalents at December 31, 2005 was $42,565. As disclosed in
      Note
      10, we received approximately $3.4 million from the sale of 1,300,000 of our
      common shares in January 2006, and have available cash of approximately $130,000
      as of December 31, 2005 under revolving credit facilities established in South
      Korea. We believe these reserves are sufficient to sustain our operations and
      meet our capital and liquidity requirements through mid-March 2006. We plan
      on
      raising additional capital, including through anticipated cash payments from
      customers, additional equity and/or debt financings and exercises of stock
      options and warrants. No assurance can be given that we will receive cash
      payments from customers, that we will be able to close additional equity or
      debt
      offerings, or that there will be exercises of stock options and warrants. If
      we
      do not receive additional funds from these or other sources, we will be required
      to scale back or terminate operations and/or seek protection under applicable
      bankruptcy laws.





Additionally,
      as more fully described in Note 3, our Senior Secured Convertible Notes,
      maturing in November 2007, are held by four Noteholders. Two of the Noteholders
      have alleged that certain events of default under the Notes have occurred (one
      Noteholder has alleged three events of default, and the other Noteholder has
      alleged one event of default), and they have sent us letters asking for
      immediate redemption of the entire principal of their Notes of $9 million plus
      redemption premiums and liquidated damages, which would be approximately
      $1.35 million and $534,000, respectively. We strongly dispute that any events
      of
      default have occurred that would allow the Noteholders to call the Notes, and
      we
      plan to vigorously defend our position. We believe, after review with outside
      legal counsel, with respect to each of the three alleged events of default,
      that
      it is not probable that the Noteholders would prevail in calling the loans
      based
      on any of the alleged events of default; therefore, in accordance with FAS
      5,
“*Accounting for Contingencies,*” we have continued classifying the Notes
      as long-term liabilities in the accompanying consolidated balance sheet rather
      than as current liabilities as FAS 78, “*Classification
      of Obligations That are Callable by the Creditor,”*might
      otherwise require, and have not accrued the redemption premiums and
      liquidated damages. However, should the Noteholders pursue their call for
      immediate redemption of the Notes, and prevail on their claim in a court of
      law,
      the entire $10 million Note obligation would immediately become due and payable
      including redemption premiums of $1.5 million and liquidated damages of
      approximately $605,000.




In
        2005,
        a substantial percentage of our product deliveries, which were in small
        quantities, were made to LG Electronics. Based on our agreement with LG
        Electronics, and our present expectations, it is likely that a substantial
        percentage of our anticipated future product deliveries in the first half
        of
        2006 will be made to LG Electronics as well. Although
        we have been delivering a limited quantity of production LCoS set to LG
        Electronics since July 2005, our delivery ramp-up has been slower than expected
        due to LG Electronics product specification changes and problems that we
        have
        experienced in ramping up our manufacturing volumes. In the event we are
        unable
        to ramp up our delivery volumes to LG Electronics by the end of July 2006,
        we
        believe that it is reasonably likely that LG Electronics may discontinue
        actively doing business with us. The loss of LG Electronics as a customer
        or any
        further delays in our delivery schedule to LG Electronics could significantly
        harm our future sales and results of operations.
 
 Furthermore,
        we are subject to a U.S. Securities and Exchange Commission (SEC)
        investigation relating to the unauthorized filing of consents of BDO Seidman
        as
        an exhibit to certain registration statements and may be subject to penalties
        and claims relating thereto. These matters are discussed in Note 9.


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






39




**SPATIALIGHT,
        INC.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2005, 2004 AND 2003**


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





*Cash
      and Cash Equivalents* - We
      consider all highly liquid investments purchased with an original maturity
      of
      three months or less to be cash equivalents. At December 31, 2005 and 2004,
      approximately $43,000 and $9,088,000, respectively, comprised of checking and
      money market accounts, the fair value of which approximates cost, are included
      in cash and cash equivalents. We deposit cash and cash equivalents with high
      credit quality financial institutions.





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





*Inventories.* Inventories are valued at the lower of cost (based on the first-in, first-out
      method) or market value. Materials, labor and manufacturing overhead are
      included in the cost of inventories. In determining inventory market values,
      substantial consideration is given to the expected selling price of the product
      based on historical recovery rates. If the market value of inventory is assessed
      to be less than cost, it is written down to its replacement cost or its net
      realizable value. Estimates may differ from actual results due to the quantity
      and quality and mix of products in inventory, consumer and retailer preferences
      and economic conditions. The adjustment to record inventory at lower of cost
      or
      market value was $311,000 in 2003. There was no lower of cost or market
      provision recorded in 2005 or 2004. Inventory reserves are generally recorded
      when management determines that an item is not readily saleable. In 2005, we
      recorded a provision on our T-1 inventory of approximately $351,000 in line
      with
      the concentrated focus of our business on our T-3 LCoS Set model. While we
      believe there continues to be a market for our T-1 model, we are focusing our
      resources on the manufacture and sale of our T-3 model.





*Property
      and Equipment* -
      Property and equipment are recorded at cost while repairs and maintenance costs
      are expensed in the period incurred. Depreciation and amortization is computed
      for financial reporting purposes using the straight-line method over the
      following estimated useful lives.




Category
              
              
              Useful
                  Lives in YearsBuildings
              
              
              40Other
                  equipment and instruments
              
              
              3-10Machinery
                  and manufacturing equipment
              
              
              3-10Office
                  furniture and fixtures
              
              
              3-5Tooling
              
              
              1.5Computer
                  software and hardware
              
              
              3-5




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





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




40




**SPATIALIGHT,
        INC.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2005, 2004 AND 2003**




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




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


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


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


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




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





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





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





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





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





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





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





41




**SPATIALIGHT,
        INC.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2005, 2004 AND 2003**




*Derivative
      Financial Instruments* - Our
      derivative financial instruments consist of a note purchase option attached
      to
      Senior Secured Convertible Notes and warrants issued in connection with our
      October 2005 financing. The fair value is calculated based on the Black-Scholes
      option-pricing model.





*Stock-Based
      Compensation* - We
      account for our stock-based compensation arrangements for employees and
      directors using the intrinsic value method pursuant to Accounting Principles
      Board Opinion (APB) No. 25, “Accounting for Stock Issued to Employees,” as
      clarified by Financial Accounting Standards Board (FASB) Interpretation No.
      44
“Accounting for Certain Transactions Involving Stock Compensation.” As such,
      compensation expense is recorded when, on the date of grant, the fair value
      of
      the underlying common stock exceeds the exercise price for stock options or
      the
      purchase price for issuances or sales of common shares. Pursuant to Statement
      of
      Financial Accounting Standard (SFAS) No. 123 “Accounting for Stock-Based
      Compensation”, we disclose the proforma effects of using the fair value method
      of accounting for stock-based employee and director compensation arrangements,
      and record compensation expense for the fair value of options granted to
      non-employees.





If
      we had
      elected the fair value method of accounting for employee and director stock
      options, compensation cost would be accrued at the estimated fair value of
      stock
      option grants over the service period, regardless of later changes in stock
      prices and price volatility. The fair values at date of grant for options
      granted have been estimated based on a Black-Scholes pricing model with the
      following weighted average assumptions:




2005
              
              2004
              
              2003Dividend
                  yield
              
              —
              
              —
              
              —Expected
                  volatility
              
              
              87
              %
              
              89
              %
              
              82
              %Risk-free
                  interest rates
              
              
              4.1
              %
              
              2.5
              %
              
              2
              %Expected
                  lives
              
              
              4.0
                  years
              
              
              3.2
                  years
              
              
              4.8
                  yearsThe
                  table below shows net loss per share as if the Company had elected
                  the
                  fair value methodof
                  accounting for stock options.2005
              
              
              2004
              
              
              2003Net
                  loss as reported
              
              $
              (14,024,639
              )
              $
              (9,367,001
              )
              $
              (9,516,377
              )Add:
                  stock-based employee compensation includedin
                  reported net loss, net of any related tax effects
              
              
              22,000
              
              
              67,674
              
              
              195,387Deduct:
                    total stock-based employee compensationdetermined
                    under fair value method for all awards,net
                    of any applicable related tax effects
              
              
              (3,701,420
              )
              
              (2,723,586
              )
              
              (1,267,299
              )Proforma
                  net loss, as adjusted
              
              $
              (17,704,059
              )
              $
              (12,022,913
              )
              $
              (10,588,289
              )Loss
                  per share:Basic
                  and diluted, as reported
              
              $
              (0.39
              )
              $
              (0.27
              )
              $
              (0.34
              )Basic,
                  as adjusted
              
              $
              (0.49
              )
              $
              (0.35
              )
              $
              (0.38
              )




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




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





42




**SPATIALIGHT,
        INC.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2005, 2004 AND 2003**




*Impairment
      of Long-lived Assets and Long-lived Assets to be Disposed of* - We
      evaluate our long-lived assets for impairment whenever events or changes in
      circumstances indicate that the carrying amount of such assets or intangibles
      may not be recoverable. Recoverability of assets to be held and used is measured
      by a comparison of the carrying amount of an asset to future undiscounted net
      cash flows expected to be generated by the asset. If such assets are considered
      to be impaired, the impairment to be recognized is measured by the amount by
      which the carrying amount of the assets exceeds the fair value of the assets.
      Assets to be disposed of are reported at the lower of the carrying amount or
      fair value less cost to sell.





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





*Segment
      and Geographical Information* - Our
      chief operating decision-maker is our Chief Executive Officer. The chief
      operating decision-maker reviews only financial information prepared on a basis
      substantially consistent with the accompanying consolidated financial statements
      of operations. Therefore, we have determined that we operate in a single
      business segment. All of our assets are located at our facilities in the United
      States at December 31, 2005, except for the following:




Korea
              
              Hong
                  Kong
              
              Japan
              
              TotalCash
              
              $
              41,452
              
              $
              —
              
              $
              —
              
              $
              41,452Accounts
                  receivable
              
              
              106,776
              
              
              
              
              
              
              
              
              106,776Prepaid
                  expenses
              
              
              94,888
              
              
              
              
              
              
              
              
              94,888Other
                  assets
              
              
              10,432
              
              
              
              
              
              
              
              
              10,432Building,
                  net
              
              
              4,267,529
              
              
              —
              
              
              —
              
              
              4,267,529Machinery
                  and manufacturing equipment, net
              
              
              622,534
              
              
              —
              
              
              —
              
              
              622,534Office
                  furniture and fixtures, net
              
              
              110,850
              
              
              —
              
              
              —
              
              
              110,850Other
                  equipment and instruments, net
              
              
              855,955
              
              
              —
              
              
              —
              
              
              855,955Inventory
              
              
              60,567
              
              
              201,319
              
              
              214,581
              
              
              476,467$
              6,170,983
              
              $
              201,319
              
              $
              214,581
              
              $
              6,586,883






The
      following table summarizes our product revenues percentages for the years ended
      December 31, 2005, 2004 and 2003.





2005
            
            2004
            
            2003LCoS
                (T-3) sets
            
            
            77
            %
            
            5
            %
            
            -
            %LCoS
                (T-1) sets
            
            
            4
            %
            
            42
            %
            
            27
            %Light
                engine display units
            
            
            1
            %
            
            51
            %
            
            73
            %Other
                (primarily supporting electronics)
            
            
            18
            %
            
            2
            %
            
            -
            %Total
            
            
            100
            %
            
            100
            %
            
            100
            %





For
      the
      year ended December 31, 2005, 73% and 12% of our revenue was derived from LG
      Electronics, located in South Korea and ThinTek Optronics Corp, located in
      Taiwan, respectively. These two customers made up 84% of our outstanding
      accounts receivable balance at December 31, 2005. The remaining 15% of revenue
      in 2005 was derived from the sales of our LCoS Sets and related components
      to
      customers located in Hong Kong, China and the United States. For the year ended
      December 31, 2004, 47% and 43% of our revenue was derived from Skyworth TV
      Holding, LTD (Skyworth), and Shanghai China Display Co., LTD (China Display),
      both located in China. These two customers made up 90% of our outstanding
      accounts receivable balance at December 31, 2004. The remaining 10% of revenue
      in 2004 was derived from the sales of our LCoS Sets and related components
      to
      customers located in Hong Kong, Taiwan and South Korea. For the year ended
      December 31, 2003, 51% and 31% of our revenue was derived from Skyworth and
      China Display, both located in China. The remaining 18% of revenue in 2003
      was
      derived from the sales of our LCoS Sets and related components to customers
      located in China and Hong Kong.





*Reclassification
      -* Certain
      prior year amounts have been reclassified in order to conform to current year
      presentation.




43




**SPATIALIGHT,
          INC.**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2005, 2004 AND 2003**




*Recently
      Issued Accounting Standards -* In
      February 2006, the Financial Accounting Standards Board (FASB) issued
      SFAS No. 155, *“Accounting
      for Certain Hybrid Financial Instruments — an amendment of FASB Statements
      No. 133 and 140* ”
      (SFAS 155). SFAS 155 amends SFAS No. 133, *“Accounting
      for Derivative Instruments and Hedging Activities”* (SFAS 133),
      and SFAS No. 140, *“Accounting
      for Transfers and Servicing of Financial Assets and Extinguishments of
      Liabilities”* (SFAS 140).
      This statement also resolves issues addressed in Statement No. 133
      Implementation Issue No. D1, *“Application
      of Statement 133 to Beneficial Interests in Securitized Financial Assets.”* SFAS 155
      permits fair value remeasurement for any hybrid financial instrument that
      contains an embedded derivative that otherwise would require bifurcation and
      clarifies which interest-only strips and principal-only strips are not subject
      to the requirements of SFAS 133. SFAS 140 is amended to eliminate the
      prohibition on a qualifying special-purpose entity from holding a derivative
      financial instrument that pertains to a beneficial interest other than another
      derivative financial instrument. SFAS 155 is effective for all financial
      instruments acquired or issued during fiscal years beginning after
      September 15, 2006 (January 1, 2007 for the
      Company). We do not
      expect this statement to have a material impact on our consolidated financial
      statements.





** In
      June
      2005, the Financial Accounting Standards Board (FASB) issued Statement No.
      154,
“Accounting Changes and Error Corrections” (FAS 154), a replacement of APB No.
      20, “Accounting Changes” and FASB Statement No. 3, “Reporting Accounting Changes
      in Interim Financial Statements.” FAS 154 applies to all voluntary changes in
      accounting principle and changes the requirements for accounting for and
      reporting of a change in accounting principle. This statement establishes that,
      unless impracticable, retrospective application is the required method for
      reporting a change in accounting principle in the absence of explicit transition
      requirements specific to the newly adopted accounting principle. It also
      requires the reporting of an error correction which involves adjustments to
      previously issued financial statements similar to those generally applicable
      to
      reporting an accounting change retrospectively. FAS 154 is effective for
      accounting changes and corrections of errors made in fiscal years beginning
      after December 15, 2005. We do not expect the adoption of FAS 154 will have
      a
      material impact on our results of operations or financial condition.





In
      March 2005, the FASB issued Interpretation No. 47, “Accounting for
      Conditional Asset Retirement Obligations.” Interpretation No. 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.
      Interpretation No. 47 also clarifies when an entity would have sufficient
      information to reasonably estimate the fair value of an asset retirement
      obligation. Interpretation No. 47 is effective no later than the end of the
      fiscal year ending after December 15, 2005. The adoption of Interpretation
      No. 47 did not have a material impact on our results of operations or
      financial condition.





In
      December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment” to revise
      SFAS No. 123, “Accounting for Stock-Based Compensation” and supersede APB
      Opinion No. 25, “Accounting for Stock Issued to Employees” and its related
      implementation guidance. It requires companies to recognize their compensation
      costs related to share-based payment transactions in financial statements.
      These
      costs are to be measured based on the fair value of the equity or liability
      instruments issued issued and are recognized over the period during which an
      employee is required to provide services in exchange for the award - the
      requisite service period (usually the vesting period). We will apply
      SFAS No. 123R in the first quarter of 2006. We expect the adoption of
      this statement to result in a pretax expense of approximately $555,000 in
      2006. This does not include the expense impact of future grants of options.





In
      December 2004, the FASB issued SFAS No. 153, “Exchanges of
      Non-monetary Assets — an Amendment of APB Opinion No. 29,” which
      eliminates the exception for non-monetary exchanges of similar productive assets
      and replaces it with a general exception for exchanges of non-monetary assets
      that do not have commercial substance. A non-monetary exchange has commercial
      substance if the future cash flows of the entity are expected to change
      significantly as a result of the exchange. SFAS No. 153 will be
      effective for non-monetary asset exchanges occurring in fiscal periods beginning
      after June 15, 2005. We do not expect that the adoption of SFAS No. 153
      will have a material impact on our results of operations or financial condition.





In
      November 2004, the FASB issued SFAS No. 151, “Inventory Costs —
an Amendment of ARB No. 43, Chapter 4,” which clarifies that abnormal
      amounts of idle facility expense, freight, handling costs and wasted material
      (spoilage) be recognized as current period charges. In addition,
      SFAS No. 151 requires that allocation of fixed production overheads to
      the costs of conversion be based on the normal capacity of the production
      facilities. SFAS No. 151 will be effective for inventory costs
      incurred in fiscal years beginning after June 15, 2005. We do not expect
      that the adoption of SFAS No. 151 will have a material impact on our results
      of
      operations or financial condition.





In
      March
      2004, the Financial Accounting Standards Board (FASB) approved the consensus
      reached by the Emerging Issues Task Force (EITF) Issue No. 03-1, “The Meaning of
      Other-Than-Temporary Impairment and Its application to Certain Investments”
(“EITF 03-1”). The objective of EITF 03-1 was to provide guidance for
      identifying impaired investments. EITF 03-1 also provided new disclosure
      requirements for investments that are deemed to be temporarily impaired. The
      accounting provisions of EITF 03-1 were
      effective for all reporting periods beginning after June 15, 2004, while the
      disclosure requirements were effective only for annual periods ending after
      June
      15, 2004. In September 2004, the FASB deferred the requirement to record
      impairment losses caused by the effect of increases in “risk-free” interest
      rates and “sector spreads” on debt securities subject to paragraph 16 of EITF
      03-1 and excludes minor impairments from the requirement until new guidance
      becomes effective. We have evaluated the impact of the adoption of EITF 03-1
      and
      do not believe the impact is significant to the Company’s overall results of
      operations or financial position.




44




**SPATIALIGHT,
          INC.**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2005, 2004 AND 2003**




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





Issuance
      of Shares in 2005





In
      October 2005, we closed a $2.0 million private placement of our common shares
      and warrants to purchase our common shares with certain institutional and other
      investors. This transaction included the sale of 571,431 common shares at a
      purchase price of $3.50 per share and warrants to purchase 228,576 common shares
      with an exercise price of $5.00 per share exercisable within five years from
      the
      date of issuance. We received $2.0 million in gross proceeds from this
      transaction, which was used for working capital and other general corporate
      purposes. We did not use a placement agent in this transaction. Three of the
      institutional purchasers in this transaction were investors in our November
      2004
      private placement of our Senior Secured Convertible Notes. We were required
      to
      file a registration statement for resale of the shares and shares issuable
      upon
      exercise of the warrants 30 days after October 12, 2005 and have the
      registration statement declared effective no later than 90 days after October
      12, 2005.





The
      registration statement registering these shares was filed on February 27, 2006.
      Because this statement was not filed by November 12, 2005, we are required
      to
      pay $30,000 as liquidated damages to the investors as of November 12, 2005
      and
      every thirty days thereafter until the registration statement is filed. We
      have
      included $79,000 as liquidated damages in non-cash interest through December
      31,
      2005. Additionally, if the registration statement is not declared effective
      by
      the SEC prior to January 12, 2006, we may be required to pay $30,000 as
      liquidated damages to the investors on January 12, 2006 and for every thirty
      days thereafter until the registration statement is declared
      effective.


The
        Emerging Issues Task Force (“EITF”) is currently reviewing the accounting for
        securities with liquidated damages clauses as stated in EITF 05-04, “The Effect
        of a Liquidated Damages Clause on a Freestanding Financial Instrument Subject
        to
        EITF 00-19”. There are currently several views as to how to account for this
        type of transaction and the EITF has not yet reached a consensus. In accordance
        with EITF 00-19, “Accounting for Derivative Financial Instruments Indexed To,
        and Potentially Settled in, a Company’s Own Stock,” and EITF Topic D-98,
“Classification and Measurement of Redeemable Securities,” because the maximum
        potential liquidated damages as described above may be greater than the
        difference in fair values between registered and unregistered shares, the
        value
        of the common stock subject to registration is to be classified as temporary
        equity until the registration statement becomes effective. Accordingly, we
        have
        classified the $1,026,374 carrying value of common stock subject to registration
        as temporary equity as of December 31, 2005.


Additionally,
      in accordance with EITF 00-19, and the terms of the above warrants, the fair
      value of the warrants at inception was accounted for as a liability, with an
      offsetting reduction to the carrying value of the common stock. The warrant
      liability will be reclassified to equity upon the effective date of the
      registration statement. The fair value of the warrants at inception, of
      $958,625, was calculated using the Black-Scholes option pricing model, using
      the
      following assumptions: stock price $4.26, exercise price $5.00, volatility
      217%,
      risk free interest rate 3.00%, remaining contractual life 5 years and dividend
      yield of zero. On December 31, 2005, the fair value of the warrants was revalued
      and calculated at $778,270, using the Black-Scholes option pricing model, using
      the following assumptions: stock price $3.47, exercise price $5.00, volatility
      217%, risk free interest rate 3.00%, remaining contractual life 4.87 years
      and
      dividend yield of zero. The decrease of $180,355 was reflected as a gain from
      revaluation of warrants in the consolidated statement of operations during
      the
      year ended December 31, 2005.





On
      August
      5, 2005, we sold 500,000 of our common shares at a purchase price of $5.40
      per
      share to certain institutional investors. Those shares were included in our
      Form
      S-3 “shelf” registration statement (File No. 333-122932), which was declared
      effective by the SEC in July 2005. We received gross proceeds of approximately
      $2.7 million from the transaction, which we used for working capital and other
      general corporate purposes. The purchasers in the August 2005 Equity Financing
      had a 30-day right, which expired on September 4, 2005, to purchase an
      additional aggregate of 225,000 of our common shares included in the “shelf”
registration statement at a purchase price of $5.50 per share. On August 23,
      2005, we filed a post-effective amendment to our “shelf” registration statement
      withdrawing exhibit 23.1, the consent of the independent registered accounting
      firm BDO Seidman, LLP. We stated in the post-effective amendment that we would
      not make any future sales from the “shelf” registration statement until we
      resolved the matter involving the consent.   On August 23, 2005, we
      reclassified the fair value of the Investment Right of $94,500 from equity
      to a
      liability pursuant to EITF 00-19. The fair value of the Investment Right
      was calculated using the Black-Scholes option pricing model, using
      the
      following assumptions: stock price $5.24, exercise price $5.50, volatility
      138.18%, risk free interest rate of 3.33%, remaining contractual term of 12
      days
      and dividend yield of zero.  The Investment Right expired, unexercised, on
      September 4, 2005, and the Investment Right liability was recorded in other
      income. As of the date of this filing, 1,500,000 of our common shares included
      in our “shelf” registration statement have not been sold. In February 2006, the
      SEC declared our Post-Effective Amendment No. 6 to the Shelf Registration
      Statement effective, and we believe that we may sell the balance of the
      securities remaining on the Shelf Registration Statement in compliance with
      the
      federal securities law, through use of the Shelf Registration
      Statement.




45




**SPATIALIGHT,
          INC.**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2005, 2004 AND 2003**




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





Exercise
      of Stock Options and Warrants in 2005





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





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





Issuance
      of Warrant and Option for services in 2005





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





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





Issuance
      of Shares in 2004





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





On
      January 7, 2004, we issued 142,360 common shares with a value of $800,063 as
      a
      prepayment of interest on the Argyle notes for the interest due for 2004.
      Prepaid interest was computed using the closing price of the shares on January
      6, 2004 of $5.62. This amount is fully amortized at December 31, 2004. On March
      4, 2004, we issued an additional 71,676 common shares with a value of $338,311
      as a prepayment of interest on the Argyle notes for the period January 1, 2005
      to June 30, 2005 (see Note 3). Prepaid interest was computed using the closing
      price of the shares of $4.72 on March 3, 2004. On December 22, 2004, we issued
      an additional 50,000 shares, and 448,768 shares became issuable (and were issued
      in January 2005) as a prepayment of interest on the Argyle notes for the period
      from July 1, 2005 through December 31, 2008. These shares had a value of
      $4,049,964 based on the closing price of the shares of $8.12 on December 21,
      2004. The total prepaid interest on the Argyle notes for the period January
      1,
      2005 through December 31, 2008 was $4,388,275 at December 31, 2004, with
      $913,889 classified as a current asset and $3,474,386 classified as a noncurrent
      asset. At December 31, 2005, total prepaid interest is $3,471,398 with
      $1,157,133 classified as a current asset and $2,314,265 classified as a
      noncurrent asset.




46




**SPATIALIGHT,
          INC.**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2005, 2004 AND 2003**




Exercise
      of Stock Options and Warrants in 2004





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





Issuance
      of Warrant and Option for services in 2004





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




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





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





Issuance
      of Shares Under Installment Note





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





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





Short-Swing
      Profits





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





Issuance
      of Shares in 2003





On
      December 31, 2003, we issued 93,633 common shares upon the conversion of a
      short-term convertible note with an outstanding balance of $250,000. The
      conversion price was $2.67 per share. During 2003, we issued 1,344,827 common
      shares upon conversion to notes payable of $2,775,000 and accrued interest
      of
      $565,770 (See Note 3).





In
      August
      2003, in a private equity financing transaction, we issued 1,212,061 common
      shares at $2.28 per share and 303,015 fully vested warrants, with a strike
      price
      of $3.29, and a term of five years in exchange for net proceeds of $2,538,852,
      with six purchasers, none of whom is our affiliate. In addition, warrants to
      purchase 48,482 shares were granted to the placement agent for the financing.
      There was no earnings impact for these warrants, as they were part of the net
      issuance costs.




47




**SPATIALIGHT,
          INC.**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2005, 2004 AND 2003**




In
      May
      2003, in a private equity financing transaction, we issued 2,796,325 common
      shares at $1.84 per share and 699,080 fully vested warrants with a strike price
      of $2.65 in exchange for net proceeds of $4,974,935. Of this amount, 1,357,441
      shares and 339,360 warrants were purchased by Robert A. Olins, Chief Executive
      Officer, Secretary, Treasurer and a Director of our Company. Consequently,
      we recognized non-cash expense of $958,913 related to the deemed beneficial
      pricing Mr. Olins received; the expense consists of two components. First,
      an
      expense of $538,106, representing the fair value of the warrant issued to Mr.
      Olins was recognized in stock-based general and administrative expense using
      a
      Black-Scholes option pricing model and the following assumptions: stock price
      $2.15, historical volatility 105%, risk free rate of 2.27%, dividend rate of
      0,
      and a contractual term of five years. Second, since the market price on the
      day
      of closing of $2.15 was higher than the issuance price of $1.84, a charge of
      $420,807 was recognized in stock-based general and administrative expenses
      for
      the 1,357,441 shares purchased by Mr. Olins.





In
      order
      to complete this equity financing, the outside investors required significant
      participation from Robert A. Olins. To achieve this, Mr. Olins borrowed funds
      to
      purchase his share of the financing. Our board of directors unanimously (except
      for Mr. Olins, who did not vote on this matter) approved reimbursements of
      $250,000 for certain expenses incurred in connection with the personal loan
      to
      Mr. Olins made by a bank, and $300,000, payable through the issuance of 130,435
      common shares, for a finder’s fee that Mr. Olins was obligated to pay to an
      unaffiliated third party. Another shareholder of SpatiaLight, to whom we
      subsequently issued the 130,435 common shares, undertook Mr. Olins’ obligations
      to the finder. The $376,957 fair value of the 130,435 shares was included in
      stock-based general and administrative expense.





Additionally,
      warrants in the aggregate of 77,126 shares were issued to the placement agent
      effecting the financing. There was no earnings impact for these warrants, as
      they were a part of the net issuance costs.





We
      became
      aware that the then current interpretations of the NASDAQ rules by the NASDAQ
      staff require shareholder approval of the sale by us to Mr. Olins of 1,357,441
      shares at the same discount received by the other investors in that transaction.
      Upon review, we determined that we were required to seek shareholder
      ratification of the sale to Mr. Olins at our 2004 annual meeting of
      shareholders. Mr. Olins informed us that in the interim he would not dispose
      of,
      nor vote, these shares until such ratification was obtained. Such ratification
      was obtained on July 7, 2004.





Issuance
      of Stock and Warrants for Interest in 2003





On
      January 3, 2003, we issued 142,360 common shares with a fair value of $354,476
      as a prepayment of interest. Prepaid interest was computed using the closing
      price of the common shares on December 31, 2002 of $2.49, and was amortized
      through December 31, 2003.





In
      May
      2003, we issued a fully vested warrant to purchase 10,000 common shares in
      lieu
      of interest on a short-term note. A value of $6,647 was assigned to this warrant
      using a Black-Scholes option pricing model and the following assumptions: stock
      price $2.15, historical volatility 79%, risk free rate of 1.01%, dividend yield
      of 0, and a contractual term of 1 year. The value of this warrant was recorded
      in non-cash interest expense.





Exercise
      of Stock Options and Warrants in 2003





During
      2003, we issued 215,874 and 149,750 common shares upon the exercise of warrants
      and employee and director stock options, respectively. Total cash received
      was
      $376,542 and $168,239, respectively. Included in the warrant exercise are 69,547
      shares issued upon the cashless exercise of 250,000 warrants. Additionally,
      proceeds of $305,685 were received prior to December 31, 2003, for the exercise
      of warrants. At December 31, 2003, these proceeds were included in common stock
      issuable and 120,082 common shares were issued in January 2004 for these
      warrants.





Issuance
      of Stock, Stock Options and Warrants for services in 2003





In
      October 2002, we issued a fully vested warrant for consulting services rendered
      in 2002 and 2003. An expense of $91,000 was recognized for the portion of the
      services rendered in 2003. The warrant to purchase 250,000 common shares had
      an
      exercise price of $3.50. The following assumptions were used in determining
      the
      value: stock price $1.84, historical volatility 100%, risk free rate 5%, a
      dividend yield of 0, and a contractual term of two years, and is reflected
      in
      the statement of operations as stock-based general and administrative expense.




48




**SPATIALIGHT,
          INC.**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2005, 2004 AND 2003**




In
      March
      2003, we issued a fully vested warrant to purchase 200,000 common shares in
      exchange for consulting services. A value of $85,400 was assigned to the warrant
      using the Black-Scholes option pricing model and the following assumptions:
      stock price


$2.43,
      historical volatility 100%, risk free rate 5%, a dividend yield of 0, and a
      contractual term of five months. The value of the warrant is included in
      stock-based general and administrative expense.





In
      March
      2003, we issued 47,000 common shares in exchange for consulting services
      provided in 2002 totaling $116,250. The expense associated with these services
      was recorded in stock-based general and administrative expense in
      2002.





In
      May
      2003, we issued a fully vested option to purchase 25,000 common shares in
      exchange for services rendered. A value of $49,734 was assigned to this option
      using a Black-Scholes option pricing model and the following assumptions: stock
      price $2.14, historical volatility 112%, risk free rate of 3.33%, a dividend
      yield of 0, and a contractual term of 10 years. The value of this option was
      recorded in stock-based general and administrative expense.





In
      May
      2003, we issued a fully vested warrant to purchase 125,000 common shares in
      exchange for consulting services. A value of $56,994 was assigned to the warrant
      using a Black-Scholes option pricing model and the following assumptions: stock
      price $2.05, historical volatility 79%, risk free rate of 1.01%, dividend yield
      of 0, and a contractual term of 18 months. The value of this warrant was
      recorded in stock-based general and administrative expense.





In
      May
      2003, we issued 32,000 common shares to an outside consultant. The shares were
      issued in consideration of services rendered by the consultant in 2003. These
      shares were valued at $68,800, the market value of the shares on the date of
      grant. The value of these shares was recorded in stock-based general and
      administrative expense.





In
      July
      2003, we issued an option to one of our officers to purchase 800,000 common
      shares. The stock option was granted pursuant to the Amended and Restated Time
      Accelerated Restricted Stock Award Plan (“TARSAP”). The TARSAP was granted to
      the officer in the following manner: (i) 125,000 options which vested as of
      July
      7, 2003 and which options expire on July 7, 2006 (35,000 options have an
      exercise price of $2.55 and 90,000 options have an exercise price of $12.50),
      and (ii) 675,000 options which vest upon the earlier of the achievement of
      certain performance tests within two years after the date of the grant or the
      second anniversary of the grant date. The options expire three years after
      they
      vest and become exercisable (175,000 of such options have an exercise price
      of
      $5.00, which vested on January 27, 2004, 225,000 of such options have an
      exercise price of $7.50 and 275,000 of such options have an exercise price
      of
      $12.50). Of the vested options, 25,000 were exercised at a price of $2.55 on
      December 30, 2004. The total expense recognized in 2003 under this agreement
      was
      $86,750 included in stock based general and administrative expense. The TARSAP
      was amended in July 2005 increasing the exercise price of 175,000 vested options
      from $5.00 per share to $7.50 per share and extending the vesting from the
      second anniversary to the fourth anniversary noted in (ii) above.





In
      October 2003, we issued a fully vested option to purchase 5,000 common shares
      in
      exchange for services rendered in 2003. A value of $22,003 was assigned to
      this
      option using a Black-Scholes option pricing model and the following assumptions:
      stock price $4.69, historical volatility 112%, risk free rate of 4.27%, dividend
      yield of 0 and contractual life of 10 years. In October 2003, we issued a fully
      vested warrant to purchase 50,000 common shares to a consultant in exchange
      for
      services rendered in 2003. A value of $80,546 was assigned to the warrant using
      a Black-Scholes option pricing model and the following assumptions: stock price
      $4.68, exercise price $3.50, historical volatility 63%, risk free rate of 1%,
      a
      dividend yield of 0 and contractual life of nine months.





Other
      expenses in 2003 related to the valuation of options granted to directors for
      additional services and employee options issued with an exercise price lower
      than market price totaled $108,637 and are included in stock-based general
      and
      administrative expense.





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




49




**SPATIALIGHT,
          INC.**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2005, 2004 AND 2003**




Years
                  ended December 31,2005
              
              2004
              
              2003Financing
                  costs related to reduction of stockholder note
              
              $
              —
              
              $
              600,000
              
              $
              —Stock
                  and options granted to employees and directors
              
              
              22,000
              
              
              67,674
              
              
              195,387Common
                  stock and warrants expensed for services
              
              
              164,187
              
              
              263,850
              
              
              385,663Stock
                  issued in connection with May stock purchase
              
              
              —
              
              
              —
              
              
              376,957Beneficial
                  pricing on sale of stock and warrants to officers
              
              
              —
              
              
              —
              
              
              958,913Other
              
              
              —
              
              
              —
              
              
              68,800$
              186,187
              
              $
              931,524
              
              $
              1,985,720




**3.** **S** **hort
      Term Loans and Notes Payable**





Short
      Term Loan from a Related Party





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





Short
      Term Loans





In
      the
      third and fourth quarter of 2005, our wholly-owned subsidiary SpatiaLight Korea,
      Inc. entered into unsecured revolving credit facilities with three separate
      South Korean banks. Two of these credit facilities bear fixed interest rates
      of
      8.79% and 10.88% per annum, respectively, and the other credit facility bears
      a
      variable interest rate at December 31, 2005 of 6.82% per annum, which is
      benchmarked against the yield of a 365-day Korean bank debenture. Interest
      under
      each of the credit facilities is payable monthly. As of December 31, 2005,
      there
      was 569,179,151 Korean Won (approximately $572,000) drawn down against these
      credit facilities with 130,820,849 Korean Won (approximately $131,475) remaining
      available on the credit facilities. We are required to repay funds on the credit
      facilities by the final termination dates of each of the respective credit
      facilities, which are currently as follows: 177,784,033 Korean Won
      (approximately $178,673) by April 10, 2006, 195,257,863 Korean Won
      (approximately $196,234) by September 22, 2006 and 196,137,255 Korean Won
      (approximately $197,118) by October 27, 2006.




Convertible
      Notes




Convertible
      notes at December 31, 2005 consist of the following:





Argyle
      Notes





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





50




**SPATIALIGHT,
          INC.**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2005, 2004 AND 2003**




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





We
      paid
      interest payable on the Argyle notes by issuing 142,360 common shares with
      a market value of $354,476 in 2003, and 142,360 common shares with a market
      value of $800,063 in 2004. The market value of the shares was based on the
      closing price of the shares on the day before issuance, and was recorded as
      interest expense.




On
      March
      4, 2004, we issued 71,676 common shares with a market value of $338,311 as
      a
      prepayment of interest payable on the Argyle notes of $35,640 for the period
      January 1, 2005 to June 30, 2005. Prepaid interest was computed using the
      closing price of the shares of $4.72 on March 3, 2004. In December 2004, we
      issued 50,000 common shares, and in January 2005, we issued 448,768 common
      shares, as a prepayment of interest payable on the Argyle notes of $249,480
      for
      the period July 1, 2005 through December 31, 2008. These shares had a market
      value of $4,049,964, based on the closing price of the shares of $8.12 on
      December 21, 2004. As of December 31, 2005, total prepaid interest on the Argyle
      notes for the period January 1, 2006 to December 31, 2008 is $3,471,398 with
      $1,157,133 classified as a current asset, and $2,314,265 classified as a
      non-current asset.




Interest
      expense includes non-cash interest expense
      of $283,196 in 2003, $728,780 in 2004 and $845,957 in 2005. The non-cash
      interest expense results from the beneficial conversion price of interest
      payable, which is convertible into common shares at $0.50 per share, and was
      computed as the excess of the market price of the shares issued for the interest
      over accrued interest payable.




At
      December 31, 2005, the carrying value of the Argyle notes totaled $1,188,000
      representing the unpaid principal balance *.*





Senior
      Secured Convertible Debt Financing




On
      November 30, 2004, we completed a non-brokered private placement of $10 million
      of senior secured notes (the Senior Secured Convertible Notes). The Senior
      Secured Convertible Notes accrue interest at 10% per annum, payable quarterly,
      and the interest is payable in cash or common shares, at our option if certain
      conditions, such as the availability of an effective registration statement
      pursuant to which resales may be made or the availability of Rule 144(k) for
      resale of the common shares underlying our Senior Secured Convertible Notes
      are
      met. The value of the shares for the purposes of calculating interest payments
      shall be equal to the 20-day trailing average of the volume weighted average
      prices of our common shares at the end of each quarterly interest period. The
      Secured Convertible Notes are due November 30, 2007.





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





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




51




**SPATIALIGHT,
          INC.**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2005, 2004 AND 2003**




In
      a
      letter that we received on December 12, 2005, one of the holders of our 2004
      notes, Portside, notified us of two alleged events of default under their note
      set forth below. In a letter that we received on December 13, 2005, another
      holder of our 2004 Notes, Smithfield Fiduciary LLC, an affiliate of Highbridge
      Capital Management, LLC, notified us only with respect to the second alleged
      event of default. In a letter that we received on February 9, 2006, Portside
      notified us of a third alleged event of default under their note, as set forth
      below. Each of these notices call for us to redeem the entire $4.5 million
      principal amount of the Portside and Smithfield 2004 Notes, or $9.0 million
      in
      the aggregate, plus a redemption premium of $675,000 to each of these holders
      of
      the 2004 notes pursuant to Section 12(a) of their Notes. Furthermore, the Notes
      provide for the 10% per annum interest rate to increase to 12% in the event
      of a
      default under the Notes.





The
      following are the alleged events of default: (i) Registration Statement Failure
      pursuant to Section 4(a)(i) of their Note - Based upon the filing of our first
      Post-Effective Amendment to the Registration Statement described above; (ii)
      Failure to Make Interest Payment pursuant to Section 4(a)(v) of their Note
      -
      Based upon a claim that we did not make a November 2005 interest payment timely;
      and (iii) Entering into debt financing transactions prohibited pursuant to
      Section 4(a) (xi) of their Note - Based upon a claim that certain debt financing
      transactions that we have entered into are not permitted under the Note.





We
      believe, after review with outside legal counsel, that these allegations lack
      merit and would not entitle the Noteholders to call the notes and other remedies
      that they are seeking. With respect to the first alleged event of default
      concerning the alleged registration maintenance failure, we contend that the
      filing of our post-effective amendments to the registration statements
      registering the underlying common shares did not and does not constitute an
      event of default under Section 4(a)(i) of the Portside Note. We contend that
      the
      second allegation of default is incorrect because on November 30, 2005 (the
      interest due date), we tendered payment by forwarding checks payable to
      Portside, Smithfield and the other holders of the 2004 notes by overnight
      courier to an attorney representing the holders for the full amounts of the
      relevant quarterly interest payments. That attorney did not distribute the
      checks to the four holders (although located in the same city), but instead
      returned the checks to us in California. We have since tendered payment of
      the
      full interest amount owing to all of the holders via federal funds wire into
      designated accounts for each of these parties. We contend that the third
      allegation of default lacks merit because we believe that the debt
      financing transactions that we have entered into are permitted under their
      Note
      and, even if deemed not permitted, do not constitute a breach or
      failure in any material respect under the Note.





We
      believe that Portside has undertaken to make allegations of events of default
      that lack merit in an attempt to achieve its objective of amending the terms
      of
      its Note to its advantage, including a reduction in the conversion price of
      the
      Notes or an acceleration in repayment of principal on its Note, although that
      principal is not due and payable until the Note's maturity date, which is
      November 30, 2007. We have rejected its offers in this regard, and plan to
      vigorously defend our position.





If
      the
      Noteholders prevail in calling the Notes, the entire $10 million debt obligation
      would become due and payable immediately, including the redemption premiums
      of
      $1.5 million and liquidated damages of $605,000. We have not accrued the above
      described redemption premiums or liquidated damages as of December 31,
      2005.





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





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





Under
      the
      terms of the November 2004 Financing, the purchasers received the right
      (additional investment rights or AIR) to purchase up to an additional $5 million
      of senior secured convertible notes subject to the same terms and conditions,
      including the same conversion price as the notes issued in the November 2004
      Financing. The AIR originally expired on November 30, 2005, but was amended
      on
      December 21, 2004 to expire on August 31, 2005. The fair value of the AIR was
      calculated on the November 30, 2004 issuance date at $1,072,248 using the
      Black-Scholes option pricing model (see table below.) This AIR is being treated
      as a derivative and has been recorded as a note purchase option liability and
      as
      a discount on the 2004 Senior Secured Convertible Notes.




52




**SPATIALIGHT,
          INC.**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2005, 2004 AND 2003**




The
      AIR
      is not a hedging derivative. The fair value of the derivative has been
      recalculated on a quarterly basis until exercise or expiration to reflect the
      changing market price of the stock, the remaining contractual term, and the
      changing volatility. The objective in entering into the agreement for the AIR
      was that it was required by the lenders in order to complete the financing
      agreement. Below is a table reflecting the fair value of the AIR at each period
      end date and the Black-Scholes assumptions used to calculate the fair value.
      The
      assumptions changed from the November 2004 valuation date in that the market
      price of our common shares had changed, the contractual life had changed due
      to
      the December 21, 2004 amendment, and the volatility changed as a result of
      the
      changes in market price and contractual life. Any reduction in the note purchase
      option liability due to the revaluation of the AIR is recorded as a gain from
      the revaluation of the note purchase option liability and is included in other
      income. The remaining value of the note purchase option liability was written
      off upon expiration on August 31, 2005.




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


*
                  Exercise price for all dates is $9.72 per share and dividend yield
                  for all
                  dates is zero.




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





Other
      Notes Paid or Converted in 2003





In
      each
      of the months of December 1999 and November 2000, we received cash and issued
      convertible notes of $1,437,500, for a total of $2,875,000. The notes and
      accrued interest were convertible at $2.75 per share. The notes were extended
      on
      June 15, 2001, and again on September 30, 2002. During 2003, we repaid $100,000
      and the remaining principal balance of $2,775,000 plus accrued interest of
      $565,770 was converted into 1,344,827 common shares.




53




**SPATIALIGHT,
          INC.**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2005, 2004 AND 2003**




Activity
      in convertible notes payable for 2005 and 2004 is as follows:





**Debt
                  Principal:**
              
              **Balance
                  at December 31, 2004**
              
              **Addition
                  or New Discount**
              
              **(Payment)
                  or Discount Amortization**
              
              **Conversion
                  to Equity**
              
              **Balance
                  at December 31, 2005**Argyle
              
              $
              1,188,000
              
              $
              —
              
              $
              —
              
              $
              —
              
              $
              1,188,000Argyle
                  discount
              
              
              (11,000
              )
              
              —
              
              
              11,000
              
              
              —
              
              
              —November
                  financing
              
              
              10,000,000
              
              
              —
              
              
              —
              
              
              —
              
              
              10,000,000November
                  financing discounts for:Beneficial
                  conversion feature
              
              
              (152,260
              )
              
              —
              
              
              52,200
              
              
              —
              
              
              (100,060
              )Reimbursement
                  of investor's legal fees
              
              
              (97,222
              )
              
              —
              
              
              33,333
              
              
              —
              
              
              (63,889
              )AIR
                  or note purchase option
              
              
              (1,042,378
              )
              
              —
              
              
              358,440
              
              
              —
              
              
              (683,938
              )**Total
                  Convertible Notes**
              
              $
              9,885,140
              
              $
              —
              
              $
              454,973
              
              $
              —
              
              $
              10,340,113**Accrued
                  Interest:**Accrued
                  Argyle 6%
              
              $
              —
              
              $
              71,280
              
              $
              —
              
              $
              (71,280
              )
              $
              —Beneficial
                  interest
              
              
              —
              
              
              845,597
              
              
              —
              
              
              (845,597
              )
              
              —November
                  financing
              
              
              84,932
              
              
              1,002,740
              
              
              (1,002,740
              )
              
              —
              
              
              84,932**Total
                  Accrued Interest**
              
              $
              84,932
              
              $
              1,919,617
              
              $
              (1,002,740
              )
              $
              (916,877
              )
              $
              84,932**Debt
                  Principal:**
              
              
              **Balance
                  at December 31, 2003**
              
              
              **Addition
                  or New Discount**
              
              
              **(Payment)
                  or Discount Amortization**
              
              
              **Conversion
                  to Equity**
              
              
              **Balance
                  at December 31, 2004**Argyle
              
              $
              1,188,000
              
              $
              —
              
              $
              —
              
              $
              —
              
              $
              1,188,000Argyle
                  discount
              
              
              (33,000
              )
              
              —
              
              
              22,000
              
              
              —
              
              
              (11,000
              )November
                  financing
              
              
              —
              
              
              10,000,000
              
              
              —
              
              
              —
              
              
              10,000,000November
                  financing discounts for:Beneficial
                  conversion feature
              
              
              —
              
              
              (156,610
              )
              
              4,350
              
              
              —
              
              
              (152,260
              )Reimbursement
                  of investor's legal fees
              
              
              —
              
              
              (100,000
              )
              
              2,778
              
              
              —
              
              
              (97,222
              )AIR
                  or note purchase option
              
              
              —
              
              
              (1,072,248
              )
              
              29,870
              
              
              —
              
              
              (1,042,378
              )**Total
                  Convertible Notes**
              
              $
              1,155,000
              
              $
              8,671,142
              
              $
              58,998
              
              $
              —
              
              $
              9,885,140**Accrued
                  Interest:**Accrued
                  Argyle 6%
              
              $
              —
              
              $
              71,280
              
              $
              —
              
              $
              (71,280
              )
              $
              —Beneficial
                  interest
              
              
              —
              
              
              728,780
              
              
              —
              
              
              (728,780
              )
              
              —November
                  financing
              
              
              —
              
              
              84,932
              
              
              —
              
              
              —
              
              
              84,932**Total
                  Accrued Interest**
              
              $
              —
              
              $
              884,992
              
              $
              —
              
              $
              (800,060
              )
              $
              84,932






Non-cash
      interest expense is as follows:




2005
              
              2004
              
              2003Amortization
                  of Alabama Group discount
              
              $
              —
              
              $
              —
              
              $
              161,829Amortization
                  of Argyle discount
              
              
              11,000
              
              
              22,000
              
              
              132,000Amortization
                  of 2004 notes discounts
              
              
              443,973
              
              
              36,998
              
              
              —Potential
                  registration rights payment
              
              
              —
              
              
              —
              
              
              —Liquidated
                  damages
              
              
              79,000
              
              
              —
              
              
              —Beneficial
                  conversion privileges of interest on Argyle convertible
                  debt
              
              
              845,597
              
              
              728,780
              
              
              283,196Amortization
                  of prepaid financing costs
              
              
              50,936
              
              
              3,258
              
              
              —Other
                  (See Note 2)
              
              
              —
              
              
              —
              
              
              6,647Total
                  non-cash interest expense
              
              $
              1,430,506
              
              $
              791,036
              
              $
              583,672




54




**SPATIALIGHT,
          INC.**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2005, 2004 AND 2003**




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




Inventory
      as of December 31 consists of the following:




2005
              
              2004Raw
                  materials
              
              $
              796,770
              
              $
              691,168Work-in-progress
              
              
              17,043
              
              
              31,684Finished
                  goods
              
              
              294,287
              
              
              450,4621,108,100
              
              
              1,173,314Inventory
                  reserve
              
              
              (351,377
              )
              
              —Total
                  Inventory, net
              
              $
              756,723
              
              $
              1,173,314




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




2005
              
              2004Building
              
              $
              4,360,663
              
              $
              —Other
                  equipment and instruments
              
              
              2,659,653
              
              
              1,901,333Machinery
                  and manufacturing equipment
              
              
              1,141,726
              
              
              —Office
                  furniture and fixtures
              
              
              590,696
              
              
              545,201Tooling
              
              
              371,700
              
              
              344,890Leasehold
                  improvements
              
              
              175,654
              
              
              175,654Computer
                  software
              
              
              141,106
              
              
              —Computer
                  hardware
              
              
              74,003
              
              
              —Total
                  property, plant and equipment
              
              
              9,515,201
              
              
              2,967,078Accumulated
                  depreciation
              
              
              (2,701,681
              )
              
              (2,108,866
              )Property,
                  plant and equipment, net
              
              $
              6,813,520
              
              $
              858,212






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




2005
              
              2004Deferred
                  rent
              
              $
              269,843
              
              $
              314,611Accrued
                  compensation
              
              
              184,283
              
              
              246,967Construction
                  in progress liabilities
              
              
              —
              
              
              1,800,603Accrued
                  interest on senior secured convertible notes
              
              
              84,932
              
              
              84,932Liquidated
                  damages
              
              
              79,000
              
              
              —Accrued
                  legal and accounting related services
              
              
              741,855
              
              
              72,752Other
              
              
              29,514
              
              
              13,681Total
                  accrued expenses and other current liabilities
              
              $
              1,389,427
              
              $
              2,533,546


We
      incurred depreciation and amortization expense of $728,383, $575,391 and
      $393,302 **** for
      the
      years ended December 31, 2005, 2004 and 2003, respectively.





Rent
      expense related to operating leases for 2005, 2004 and 2003 was $675,339,
      $585,897 and $523,995, respectively.





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




55




**SPATIALIGHT,
          INC.**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2005, 2004 AND 2003**




Future
      lease obligations under non-cancelable operating leases as of December 31,
      2005
      are as follows:




**Year**
              
              **Amount**2006
              
              $
              501,0832007
              
              
              476,6742008
              
              
              471,7682009
              
              
              320,6512010
              
              
              —Total
              
              $
              1,770,176




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





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





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




2005
              
              2004
              
              2003Computed
                  tax benefit at federal statutory rate
              
              $
              (4,768,000
              )
              $
              (3,185,000
              )
              $
              (3,236,000
              )Federal
                  research and development credit
              
              
              (81,000
              )
              
              (91,000
              )
              
              (103,000
              )Permanent
                  differences, primarily nondeductibleinterest
                  and loss in
                foreign
                  subsidiary
              
              
              1,050,000
              
              
              401,000
              
              
              207,000Changes
                  in valuation allowances
              
              
              4,967,000
              
              
              3,869,000
              
              
              3,339,000State
                  tax benefit, net of effect on federal income taxes
              
              
              (670,000
              )
              
              (252,000
              )
              
              (586,000
              )Other,
                  net
              
              
              (495,700
              )
              
              (740,525
              )
              
              379,000Total
                  tax expense
              
              $
              2,300
              
              $
              1,475
              
              $
              —


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





2005
              
              2004Deferred
                  tax assets:Federal
                  net operating loss carryforwards
              
              $
              24,168,000
              
              $
              20,140,000State
                  income tax effects and credits
              
              
              5,186,000
              
              
              4,128,000Accrued
                  expenses
              
              
              28,000
              
              
              26,000Federal
                  research and development credits
              
              
              1,031,000
              
              
              978,000Options
                  and warrants
              
              
              883,000
              
              
              1,139,000Other
              
              
              361,000
              
              
              279,000Gross
                  deferred tax assets
              
              
              31,657,000
              
              
              26,690,000Valuation
                  allowance
              
              
              (31,657,000
              )
              
              (26,690,000
              )Net
                  deferred tax assets
              
              $
              —
              
              $
              —




56




**SPATIALIGHT,
          INC.**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2005, 2004 AND 2003**




The
      net
      change in the total valuation allowance was $4,967,000 $3,869,000 and $3,339,900
      in 2005, 2004 and 2003, respectively. As of December 31, 2005, we had net
      operating loss carryforwards of approximately $71.1 million for federal and
      $64.8 million for state tax purposes, respectively, which expire in varying
      amounts from 2006 through 2025 for federal purposes and through 2015 for state
      purposes. In addition, as of December 31, 2005, we had research and development
      carryforwards of approximately $1,031,000 for federal tax purposes, which will
      begin to expire in 2008 and $1,180,000 for state tax purposes, which do not
      expire.




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





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





Deferred
      tax assets resulting from net operating losses attributable to certain stock
      option exercises and warrant issuances could result in a cumulative $3,800,000
      credit to additional paid-in capital instead of reducing income tax expense
      if
      realized.





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





*Stock
      Option Plans* - In
      1999 the Stockholders approved the 1999 Stock Option Plan (the Plan), which
      replaced our 1993 Non-Statutory Employee Stock Option Plan, the 1993
      Non-Statutory Director Stock Option Plan, and the 1991 Stock Option Plan. The
      Plan authorizes the issuance of options to purchase up to 4,000,000 shares
      of
      our common shares. The Plan provides for options which may be issued as
      nonqualified or qualified incentive stock options under Section 422A of the
      Internal Revenue Code of 1986, as amended.





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





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





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





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





The
      following is a status of the options under the Plan and outside of the Plan
      and
      a summary of the changes in options outstanding during 2005, 2004 and 2003:




57




**SPATIALIGHT,
          INC.**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2005, 2004 AND 2003**




**Number
                  of**
                **Shares**
              
              **Weighted
                  Average**
                **Exercise
                  Price**Outstanding
                  January 1, 2003
              
              
              5,560,833
              
              $
              3.17Options
                  granted under the plan
              
              
              738,750
              
              $
              2.36Options
                  granted outside the plan
              
              
              800,000
              
              $
              7.89Options
                  exercised
              
              
              (149,750
              )
              $
              1.12Options
                  cancelled
              
              
              (1,987,500
              )
              $
              4.79Outstanding
                  December 31, 2003
              
              
              4,962,333
              
              $
              3.26Options
                  granted under the plan
              
              
              1,122,500
              
              $
              5.39Options
                  exercised
              
              
              (465,083
              )
              $
              2.49Options
                  cancelled
              
              
              (161,250
              )
              $
              4.43Outstanding
                  December 31, 2004
              
              
              5,458,500
              
              $
              3.89Options
                  granted under the plan
              
              
              735,000
              
              $
              5.03Options
                  exercised
              
              
              (213,606
              )
              $
              2.08Options
                  cancelled
              
              
              (97,500
              )
              $
              5.90Outstanding
                  December 31, 2005
              
              
              5,882,394
              
              $
              4.06




At
      December 31, 2005, 1,635,000 of the options outstanding were granted outside
      of
      the Plan. Options exercisable as of December 31, 2005 and 2004 totaled 5,302,394
      and 4,128,917 options, respectively, at a weighted average exercise price of
      $3.55 and $2.84 per share, respectively. Of the options exercisable as of
      December 31, 2005, 1,135,000 options were issued outside of the Plan at a
      weighted average exercise price of $2.91.





The
      weighted average fair value of options granted during 2005, 2004 and 2003 are
      as
      follows:




2005
              
              2004
              
              2003Exercise
                  price equals market price
              
              $
              5.03
              
              $
              2.18
              
              $
              2.49Exercise
                  price is less than market price
              
              
              —
              
              
              —
              
              
              4.07Exercise
                  price is more than market price
              
              
              —
              
              
              —
              
              
              2.24




Additional
      information regarding options outstanding as of December 31, 2005 is as follows:




**Options
                  Outstanding**
              
              **Options
                  Exercisable**Range
                  of Exercise Prices
              
              Outstanding
                at
                  December
                31,
                  2005
              
              Weighted
                  Average Remaining Contractual Life (Yrs.)
              
              Weighted
                  Average Exercise
                Price
              
              Number
                  Exercisable
              
              Weighted
                  Average Exercise
                Price$9.01
                  - 12.50
              
              
              365,000
              
              
              3.5
              
              $
              12.50
              
              
              90,000
              
              $
              12.50$8.01
                  - 9.00
              
              
              10,000
              
              
              8.9
              
              $
              8.35
              
              
              10,000
              
              $
              8.35$7.01
                  - 8.00
              
              
              400,000
              
              
              3.0
              
              $
              7.50
              
              
              175,000
              
              $
              7.50$6.01
                  - 7.00
              
              
              10,000
              
              
              7.7
              
              $
              6.73
              
              
              10,000
              
              $
              6.73$5.01
                  - 6.00
              
              
              982,500
              
              
              8.0
              
              $
              5.42
              
              
              982,500
              
              $
              5.42$4.01
                  - 5.00
              
              
              877,500
              
              
              8.7
              
              $
              4.93
              
              
              797,500
              
              $
              4.92$3.01
                  - 4.00
              
              
              489,444
              
              
              6.1
              
              $
              3.60
              
              
              489,444
              
              $
              3.60$2.01
                  - 3.00
              
              
              1,513,750
              
              
              6.6
              
              $
              2.38
              
              
              1,513,750
              
              $
              2.38$1.01
                  - 2.00
              
              
              962,000
              
              
              5.5
              
              $
              1.51
              
              
              962,000
              
              $
              1.51$0.25
                  - 1.00
              
              
              272,200
              
              
              2.3
              
              $
              0.65
              
              
              272,200
              
              $
              0.655,882,394
              
              
              
              
              
              
              
              
              5,302,394




58




**SPATIALIGHT,
          INC.**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2005, 2004 AND 2003**


At
      December 31, 2005, 806,666 options were available for future grants under the
      Plan.





*Warrants
      outstanding and exercisable*





Additional
      information regarding warrants outstanding as of December 31, 2005 is as
      follows:




**Warrants
                  Outstanding and Exercisable**Exercise
                Price
              
              Outstanding
                  at December 31,
                2005
              
              Remaining
                  Contractual Life (Yrs.)$ 2.65
              
              
              323,296
              
              
              2.4$ 3.29
              
              
              123,465
              
              
              2.6$ 5.00
              
              
              228,576
              
              
              4.8$ 7.50
              
              
              75,000
              
              
              4.5750,337




*Diluted
      net loss per share*




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




2005
              
              2004
              
              2003Shares
                  issuableunder
                  stock options
              
              
              5,882,394
              
              
              5,458,500
              
              
              4,962,333Shares
                  issuable pursuant to warrants to purchase common shares
              
              
              750,337
              
              
              746,761
              
              
              1,297,626Shares
                  of convertible notes on an "as if converted" basis
              
              
              3,404,807
              
              
              3,404,807
              
              
              2,376,000




The
      weighted average exercise price of stock options outstanding was $4.06, $3.89,
      and $3.26 as of December 31, 2005, 2004, and 2003 respectively. The weighted
      average exercise price of warrants was $3.96, $3.12, and $2.92 per share as
      of
      December 31, 2005, 2004 and 2003, respectively.





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





Summarized
      unaudited condensed combined results of operations for each quarter of the
      years
      ended December 31, 2005 and December 31, 2004 are as follows:




Fiscal
                  Year Ended
              
              First
                  Quarter
              
              Second
                  Quarter
              
              Third
                  Quarter
              
              Fourth
                  QuarterDecember
                  31, 2005Revenue
              
              $
              97,759
              
              $
              41,149
              
              $
              58,457
              
              $
              40,359Gross
                  margin
              
              $
              27,915
              
              $
              (47,895
              )
              $
              965
              
              $
              (1,500,350
              )Net
                  loss
              
              $
              2,148,535
              
              $
              3,524,447
              
              $
              3,620,751
              
              $
              4,730,906Basic
                  and diluted loss per share
              
              $
              (0.06
              )
              $
              (0.10
              )
              $
              (0.10
              )
              $
              (0.13
              )Fiscal
                  Year Ended
              
              
              First
                  Quarter
              
              
              Second
                  Quarter
              
              
              Third
                  Quarter
              
              
              Fourth
                  QuarterDecember
                  31, 2004Revenue
              
              $
              319,100
              
              $
              540,775
              
              $
              268,200
              
              $
              32,903Gross
                  margin
              
              $
              (27,582
              )
              $
              115,126
              
              $
              143,010
              
              $
              (51,858
              )Net
                  loss
              
              $
              1,945,893
              
              $
              2,333,977
              
              $
              2,148,351
              
              $
              2,938,780Basic
                  and diluted loss per share
              
              $
              (0.06
              )
              $
              (0.07
              )
              $
              (0.06
              )
              $
              (0.08
              )


59





**SPATIALIGHT,
          INC.**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2005, 2004 AND 2003**





**8.
      Inventory** **Valuation
      Accounts**





Balance
                  at Beginning of Period
              
              Additions
                  - Charged to Expense
              
              Deductions
                  - and Writeoffs Charged to Reserves
              
              Balance
                  at End of PeriodYear
                  ended December 31, 2005Inventory
                  allowance
              
              $
              —
              
              $
              351,377
              
              $
              —
              
              $
              351,377Year
                  ended December 31, 2004Inventory
                  allowance
              
              $
              210,000
              
              $
              —
              
              $
              210,000
              
              $
              —Year
                  ended December 31, 2003Inventory
                  allowance
              
              $
              286,000
              
              $
              311,000
              
              $
              387,000
              
              $
              210,000




**9.**  **Commitments
      and Contingencies**





*Lease
      Commitments*





Our
      lease
      commitments are described in Note 4.





*Alleged
      Events of Default on Senior Secured Convertible Notes*





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





*Other*





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





*U.S.
      Securities and Exchange Commission Investigation*





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





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




60




**SPATIALIGHT,
          INC.**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2005, 2004 AND 2003**


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





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





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





*Other
      matters*





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





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





At
      present, we are unable to ascertain the exact amount of damages, if any, to
      which we could potentially be subject under a Section 11 claim instituted by
      any
      persons who directly purchased shares pursuant to those registration statements.
      Furthermore, at this date, we cannot ascertain the amount of damages, if any,
      for which we could be liable for claims instituted by any subsequent purchasers
      who could trace the shares purchased by them to those registration statements.
      In August 2005, we sold 500,000 common shares to three institutional purchasers
      for $5.40 per share pursuant to the “shelf” registration statement referenced
      herein. Each of those investors has since represented to us in writing, in
      connection with a separate transaction, that they have disposed of all of those
      shares. One of those institutional investors has represented to us that it
      sold
      those shares at a sale price at or higher than its purchase price from us.
      We
      believe, based upon discussions with the other two investors, that they sold
      their shares at a sale price of not lower than $4.25 per share. Therefore,
      we
      believe that our maximum damages pursuant to Section 11 claims from direct
      purchasers, which we would fully contest, would be $385,250, or the difference
      between the two investor’s purchase price and lowest believed resale price,
      multiplied by the 335,000 shares that they purchased and then
      resold.





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




61




**SPATIALIGHT,
          INC.**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2005, 2004 AND 2003**




**10.**  **Subsequent
      Events**





In
      mid-January 2006, we issued and sold 1,300,000 of our common shares in a private
      placement to three institutional investors. The purchase price of the common
      shares was $2.62 per share. We received approximately $3.4 million in gross
      proceeds, before issuance costs, from the sale of these shares, which were
      used
      for working capital and other general corporate purposes, including the
      repayment of certain short-term debt obligations. We are required under a
      registration rights agreement, to file a registration statement for the resale
      of the shares within 30 calendar days after January 12, 2006 and have the
      registration statement declared effective no later than 90 calendar days after
      January 12, 2006. The latter may be extended to no later than 120 calendar
      days if
      the
      registration statement is subject to review, comments or other actions by the
      SEC. As the registration statement was not filed by February 11, 2006 or may
      not
      be declared effective prior to April 12, 2006, we may be required to pay an
      amount equal to 5% of the aggregate purchase price or $170,300 as partial
      liquidated damages when each of these dates occur and an additional $170,300
      for
      every 30 days thereafter up to six months. After six months, the percentage
      increases to 10% or $340,600 for each additional 30 days.




62




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





We
      mutually agreed that BDO Seidman, LLP would resign as our independent public
      accountant and on December 6, 2004; we received a letter from BDO Seidman,
      confirming such resignation.





During
      each of the fiscal year ended December 31, 2003 and the fiscal year ended
      December 31, 2002, and the subsequent interim period from January 1, 2004
      through December 6, 2004, we had no disagreements with BDO Seidman on any matter
      of accounting principles or practices, financial statement disclosure or
      auditing scope or procedure, which disagreements, if not resolved to the
      satisfaction of BDO Seidman, LLP, would have caused BDO Seidman to make
      reference to the subject matter of the disagreement(s) in connection with its
      report on the consolidated financial statements for such periods.





With
      respect to the fiscal year ended December 31, 2003 and the fiscal year ended
      December 31, 2002, BDO Seidman report on the financial statements of the Company
      did not contain an adverse opinion or a disclaimer opinion and was not qualified
      or modified as to uncertainty, audit scope, or accounting principles, except
      that BDO Seidman report, dated March 3, 2003, included in Item 7 of our Form
      10-KSB filed with the SEC on April 15, 2003, with respect to our financial
      statements for the fiscal year ended December 31, 2002, included an explanatory
      paragraph regarding substantial doubt about our ability to continue as a going
      concern.





During
      each of the fiscal year ended December 31, 2003 and the fiscal year ended
      December 31, 2002, and the subsequent interim period from January 1, 2004
      through December 6, 2004, there were no “reportable events” as that term is
      defined in Item 304(a)(1)(v) of Regulation S-K.





We
      provided a copy of the foregoing disclosures to BDO Seidman prior to our filing
      of the Current Report on Form 8-K/A on December 22, 2004 (the “Form 8-K/A”) and
      requested that BDO Seidman furnish us with a letter addressed to the SEC stating
      whether or not it agrees with the statements in Item 4.01 of the Form 8-K/A.
      A
      copy of the letter furnished in response to that request (as required by Item
      304 (a)(3) of Regulation S-K) dated December 10, 2004, is filed as Exhibit
      16.1
      to the Form 8-K/A.





On
      December 10, 2004, our Audit Committee engaged Odenberg, Ullakko, Muranishi
      & Co. LLP (OUM) as our independent public accountant. We did not, nor did
      anyone on our behalf, consult OUM during our two (2) most recent fiscal years
      and during the subsequent interim period prior to our engagement of OUM
      regarding the application of accounting principles to a specified transaction
      (completed or proposed) or the type of audit opinion that might be rendered
      on
      our financial statements. The Audit Committee’s decision was based upon a review
      of competitive bids submitted from various accounting firms.





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





*Disclosure
      Controls and Internal Controls.* **** As
      of
      December 31, 2005, management of our Company, under the supervision of our
      principal executive and financial officer (CEO), evaluated (the Controls
      Evaluation) the effectiveness of the design and operation of our "disclosure
      controls and procedures", as such term is defined under Rule 13a-15(e)
      promulgated under the Securities Exchange Act of 1934, as amended (Disclosure
      Controls), and our "internal controls and procedures for financial reporting"
      (Internal Controls).




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




63




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




As
      of
      December 31, 2005, the end of the period covered by this Annual Report, our
      CEO
      conducted evaluations of our disclosure controls and procedures. As defined
      under Sections 13a-15(e) and 15d-15(e) of the Exchange Act, the term “disclosure
      controls and procedures” means controls and other procedures of an issuer that
      are designed to ensure that information required to be disclosed by the issuer
      in the reports that it files or submits under the Exchange Act is recorded,
      processed, summarized and reported, within the time periods specified in the
      SEC’s rules and forms. Disclosure controls and procedures include, without
      limitation, controls and procedures designed to ensure that information required
      to be disclosed by an issuer in the reports that it files or submits under
      the
      Exchange Act is accumulated and communicated to the issuer’s management,
      including the issuer’s CEO, to allow timely decisions regarding required
      disclosure. Based on his evaluation, for the reasons set forth below, the CEO
      has concluded that our disclosure controls and procedures were not effective
      to
      ensure that material information is recorded, processed, summarized and reported
      by management on a timely basis in order to comply with our disclosure
      obligations under the Exchange Act, and the rules and regulations promulgated
      thereunder.




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




Our
      management, under the supervision of the CEO, is responsible for establishing
      and maintaining adequate internal control over financial reporting as defined
      in
      Rule 13a-15(f) under the Exchange Act. An internal control system is designed
      to
      provide reasonable assurance regarding the preparation and fair presentation
      of
      published financial statements. Management has assessed the effectiveness of
      our
      internal control over financial reporting as of December 31, 2005. In making
      its
      assessment of internal control over financial reporting, management used the
      criteria set forth by the Committee of Sponsoring Organizations (“COSO”) of the
      Treadway Commission in its report entitled “Internal Control—Integrated
      Framework.”





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




(1)
            pertain
                to the maintenance of records that, in reasonable detail, accurately
                and
                fairly reflect our transactions and dispositions of the
                assets;




(2)
            provide
                reasonable assurance that transactions are recorded as necessary
                to permit
                preparation of financial statements in accordance with GAAP, and
                that our
                receipts and expenditures are being made only in accordance with
                authorizations of our management and Board of Directors;
                and




(3)
            provide
                reasonable assurance regarding prevention or timely detection of
                unauthorized acquisition, use, or disposition of our assets that
                could
                have a material effect on the financial
                statements.




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





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





As
      a
      result of our assessment, performed on the basis of the COSO criteria,
      management has identified the material weaknesses in annual financial reporting
      set forth below, and has concluded that, based on the specified criteria, we
      did
      not maintain effective internal control
      over financial reporting as of December 31, 2005.





The
      material weaknesses identified were:





·
            Our
                corporate governance is deficient
                because:





o
            We
                do not have a corporate governance or
                disclosure committee.





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




64





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





·
            We
                do not currently have a chief financial officer to work with the
                chief
                executive officer and chief operating officer in overseeing and monitoring
                complex and significant transactions in order to provide reasonable
                assurance that such transactions are reflected accurately and fairly
                in
                the consolidated financial statements except as set forth under
                remediation plans.





·
            We have inadequate controls and procedures (1) to
              monitor
              the tracking and movement of inventory, and (2) to prevent and detect
              the
              unauthorized use of inventory due to an inadequate segregation of duties.
              The employee who performs the periodic physical inventory counts also
              has
              access to the inventory and inventory
              records.





·
            The
                  Company has not implemented effective internal controls over the
                  financial
                  reporting at its wholly owned foreign subsidiary operating in South
                  Korea.
                  The Company’s review and supervision of the subsidiary’s accounting
                  functions are inadequate, as are the policies and procedures for
                  such
                  review and supervision. These deficiencies could result in a material
                  misstatement to the annual and interim consolidated financial statements
                  that may not be prevented or detected.





·
            The
                  Company did not have formal procedures to prevent the filing of
                  a
                  registration statement with the U.S. Securities and Exchange Commission
                  without obtaining the required accountant’s consents.





·
            The
                Company does not maintain formal accounting policies and procedures
                for
                the proper analysis, review and approval of the accounting for
                transactions under GAAP, nor does the Company have formal accounting
                policies and procedures to ensure proper recording of journal entries,
                review of reconciliations and account analysis, and effective segregation
                of duties. Affected areas of accounting include critical accounting
                processes such as revenue recognition, inventory accounting, allowance
                for
                doubtful accounts, intercompany reconciliations, and financial statement
                consolidation.





In
      making
      its assessment of internal control over financial reporting, management used
      the
      criteria issued by the Committee of Sponsoring Organizations of the Treadway
      Commission (COSO) in Internal Control-Integrated Framework. Because of the
      material weaknesses described in the preceding paragraph, management believes
      that, as of December 31, 2005, the company's internal control over financial
      reporting was not effective based on those criteria.




**Remediation
      Plans**





Management
      has reported to the Audit Committee the identification of the material
      weaknesses identified in its assessment. We intend to pursue the following
      corrective actions during fiscal year 2006 to address the material weaknesses
      we
      have identified. Our remediation plans include:




*Corporate
      governance* - We
      have not taken any steps, as of the date of this filing, to address the material
      weaknesses relating to the facts that we do not have a corporate governance
      or
      formal disclosure committee, and that the audit committee does not have a
      financial expert, as defined by SEC rules. We do not presently have specific
      plans with respect to adding a director who would constitute a financial expert
      or with respect to establishing a corporate governance or formal disclosure
      committee.





*Information
      Technology controls* -
      Navision, from the accounting perspective, was substantially implemented in
      our
      California office in July 2005. Navision’s warehousing application, which covers
      inventory and manufacturing, was substantially implemented in our California
      office in November 2005. We anticipate that Navision will become active in
      our
      offices in South Korea by the end of the second quarter of 2006.





In
      connection with the implementation of Navision, we are implementing systematic
      controls designed to prevent unauthorized access to our accounting and financial
      systems, which we believe that Navision will facilitate. We have hired a
      full-time Network Administrator and we are in the process of improving our
      physical and electronic back-up and storage procedures to help ensure that
      our
      accounting and financial records will be recoverable in the event of a disaster.
      We believe that security will be fully implemented in our Navision software
      in
      the United States by the end of the first quarter, 2006 and in Korea by the
      end
      of the second quarter, consistent with the overall implementation of Navision
      in
      Korea.




65




*Chief
      Financial Officer (CFO) and Corporate Controller* - During
      the second quarter of 2005, we hired a Corporate Controller, Assistant Vice
      President of Accounting and Finance, at which time we discontinued our search
      for a CFO based upon management’s belief that because we had hired a highly
      qualified full-time corporate controller, such person obviated the need for
      us
      to hire a CFO.  Subsequently, on August 23, 2005, our Corporate Controller
      resigned.  We presently have a senior consultant working on a part-time
      basis with our accounting department carrying out certain core functions of
      a
      Corporate Controller. However, we are not currently seeking to hire a full
      time
      CFO and/or a Corporate Controller.





*Controls
      and procedures with respect to certain aspects of public filings with the
      SEC* - The
      Audit Committee of our Board of Directors has conducted an independent review
      of
      the circumstances pertaining to the issue of the filing with the SEC of consents
      of our former independent registered public accounting firm, BDO Seidman LLP,
      without their requisite authorization, as described in the post-effective
      amendments on Form S-3 that we filed with the SEC on August 23, 2005
      (Registration No.'s 333-122391 and 333-122392). As part of this review, the
      Audit Committee investigated how and why unauthorized consents of BDO Seidman
      were filed in the final and penultimate amendments to these Form S-3
      registration statements.





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





*Controls
      and procedures over inventory -* The
      Navision software implementation has required that additional policies and
      procedures be adopted and our management believes that this will assist in
      addressing the identified inadequate controls and procedures described in the
      Controls Evaluation.  During
      the fourth quarter of 2005, we started using Navision to track inventory
      movement and calculate standard costs. During the fourth quarter of 2005, we
      started using Navision to track inventory movement and calculate standard
      costs.





*Controls
      and procedures over our South Korean subsidiary* -
      Navision, from the accounting perspective, was substantially implemented in
      our
      California office in July 2005. Navision’s warehousing application, which covers
      inventory and manufacturing, was substantially implemented in our California
      office in November 2005. We anticipate that Navision will become active in
      our
      offices in South Korea by the end of the second quarter of 2006.





The
      Navision software implementation has required that additional policies and
      procedures be adopted and our management believes that this will assist in
      addressing the identified inadequate controls and procedures described in the
      Controls Evaluation. We believe that the implementation of Navision in our
      Korean subsidiary will address and remediate the lack of controls and procedures
      noted in our control evaluation.





In
      making
      its assessment of internal control over financial reporting management used
      the
      criteria issued by the Committee of Sponsoring Organizations of the Treadway
      Commission (COSO) in Internal Control-Integrated Framework. Because of the
      material weaknesses described in the preceding paragraph, management believes
      that, as of December 31, 2005, the company's internal control over financial
      reporting was not effective based on those criteria.





Our
      independent auditors have issued an attestation report on management's
      assessment of the company's internal control over financial reporting. Our
      independent registered public accountants, Odenberg, Ullakko, Muranishi &
Co., LLP, audited the consolidated financial statements included in this Annual
      Report on Form 10-K and have issued an attestation report on management’s
      assessment of our internal control over financial reorting as well as on the
      effectiveness of our internal control over financial reorting. The attestation
      report on the audit of internal control over financial reporting and the report
      on the audit of the consolidated financial statements appear elsewhere in this
      Annual report on Form 10-K.




66




**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING**


**FIRM
      ON INTERNAL CONTROL OVER FINANCIAL REPORTING**





To
      the
      Board of Directors and Stockholders of


SpatiaLight,
      Inc.





We
      have
      audited management's assessment, included in the accompanying Management's
      Report on Internal Control Over Financial Reporting, that SpatiaLight, Inc.
      (“Company”) did not maintain effective internal control over financial reporting
      as of December 31, 2005, because of the effect of material weaknesses identified
      in management's assessment, based on criteria established in Internal Control
      -
      Integrated Framework issued by the Committee of Sponsoring Organizations of
      the
      Treadway Commission (the COSO criteria). SpatiaLight, Inc.'s management is
      responsible for maintaining effective internal control over financial reporting
      and for its assessment of the effectiveness of internal control over financial
      reporting. Our responsibility is to express an opinion on management's
      assessment and an opinion on the effectiveness of the Company's internal control
      over financial reporting based on our audit.





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





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





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





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








A.
            TheCompany
                did not maintain an effective control environment based on the criteria
                established in the COSO framework, and the Company’s management was unable
                to remediate certain previously identified significant deficiencies
                and
                material weaknesses. The unremediated material weaknesses reported
                previously are as follows:





The
      Company's corporate governance and disclosure controls and procedures do not
      provide reasonable assurance that material transactions are timely and
      accurately reported in the consolidated financial statements and related
      disclosures. In particular:




·
            The
                Company does not have a corporate governance or disclosure
                committee.





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





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





·
            The Company does not currently have a chief financial
              officer to work with the chief executive officer and chief operating
              officer in overseeing and monitoring complex and significant transactions
              in order to provide reasonable assurance that such transactions are
              reflected accurately and fairly in the consolidated financial
              statements.




67




·
            The
                  Company has inadequate controls and procedures (1) to monitor the
                  tracking
                  and movement of inventory, and (2) to prevent and detect the unauthorized
                  use of inventory due to an inadequate segregation of duties. The
                  employee
                  who performs the periodic physical inventory counts also has access
                  to the
                  inventory and inventory
                  records.





B.
            The
                Company has not implemented effective internal controls over the
                financial
                reporting at its wholly owned foreign subsidiary operating in South
                Korea.
                The Company’s review and supervision ofthe
                subsidiary’saccounting
                functionsareinadequate,
                as are the policies and procedures for such review and supervision.
                These
                deficiencies could result in a material misstatement to the annual
                and
                interim consolidated financial statements that may not be prevented
                or
                detected.


C.
                The
                    Company did not have formal procedures to prevent the filing
                    of a
                    registration statement with the U.S. Securities and Exchange
                    Commission
                    without obtaining the requiredaccountant’s
                    consents.


D.
              The
                  Company does not maintain formal accounting policies and procedures
                  for
                  the proper analysis, review and approval of the accounting for
                  transactions under GAAP, nor does the Company have formal accounting
                  policies and procedures to ensure proper recording of journal entries,
                  review of reconciliations and account analysis, and effective segregation
                  of duties. Affected areas of accounting include critical accounting
                  processes such as revenue recognition, inventory accounting, allowance
                  for
                  doubtful accounts, intercompany reconciliations, and financial
                  statement
                  consolidation.




These
      material weaknesses were considered in determining the nature, timing, and
      extent of audit tests applied in our audit of the 2005 consolidated financial
      statements, and this report does not affect our report dated March 6, 2006
      on
      those consolidated financial statements.





In
      our
      opinion, management's assessment that SpatiaLight, Inc. did not maintain
      effective internal control over financial reporting as of December 31, 2005
      is
      fairly stated, in all material respects, based on the COSO criteria. Also,
      in
      our opinion, because of the effect of the material weakness described above
      on
      the achievement of the objectives of the control criteria, SpatiaLight, Inc.
      has
      not maintained effective internal controls over financial reporting as of
      December 31, 2005 based on the COSO criteria.








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





San
      Francisco, California


March
      6,
      2006







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




None




68




**PART
      III**





**ITEM
      10.**  **Directors
      and Executive Officers**





**DIRECTORS
      AND EXECUTIVE OFFICERS OF THE COMPANY**





**Name**
            
            **Age**
            
            **Position(s)**Robert
                A. Olins
            
            49
            
            Director,
                Chief Executive OfficerDavid
                F. Hakala
            
            54
            
            Chief
                Operating OfficerMichael
                S. Jin
            
            42
            
            Chief
                Technology OfficerDon
                S. Suh
            
            49
            
            Sr.
                Vice President - Sales and MarketingJe
                Won Yuen
            
            55
            
            President,
                SpatiaLight Korea, Inc.Theodore
                H. Banzhaf
            
            40
            
            Executive
                Vice President of Strategic PlanningLawrence
                J. Matteson
            
            66
            
            DirectorClaude
                Piaget
            
            64
            
            DirectorRobert
                C. Munro
            
            78
            
            Director





All
      Directors serve for terms of one year and until their successors are duly
      elected.





**Robert
      A. Olins** ,
      director since February 1998, Chief Executive Officer, Secretary and Treasurer
      since June 2000 and Principal Financial and Accounting Officer since June 2004.
      Mr. Olins has served as President of Argyle Capital Management Corporation
      during the past twenty years. Argyle Capital Management Corporation is a private
      investment advisory company.





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





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





**Don
      S. Suh** ,
      Senior
      Vice President - Marketing and Sales since July 19, 2004, previously served
      as
      Senior Vice President, Display and Multimedia for LG Electronics in San Jose,
      California from 1999 to May 2004. Prior to that, since 1984, Mr. Suh worked
      within the LG Electronics organization, serving as a leader in a variety of
      consumer electronics, information technology and convergence product groups.
      Mr.
      Suh has worked as a senior manager within LG Electronics for groups based in
      Asia, Europe and the United States. Mr. Suh received the LG Electronics’ Best
      Honored Employee of the Year Award in 1998 and received the South Korean
      President’s 1999 Gold Tower-Order Medal given for achievement of outstanding
      export results.





**Je
      Won Yeun** ,
      President of SpatiaLight Korea, Inc. since July 29, 2004, has over 25 years
      of
      experience in managing and directing large manufacturing operations, mostly
      for
      various divisions of Hyundai Group. Mr. Yeun holds a degree in physics from
      Sung
      Kyun Kwan University, and began his career as an engineer at Philips Electronics
      Co., Ltd. He then joined Hyundai Group as a senior engineer, contributing to
      the
      design and construction of heating, ventilating and air conditioning systems
      for
      nuclear and thermal power plants. Mr. Yeun has served the bulk of his career
      within Hyundai Group as a senior level manager and director of several
      manufacturing and construction operations. Most recently, Mr. Yeun served as
      president and chief executive officer of two Korean enterprises: Kyoung Won
      Co.,
      Ltd., a designer and manufacturer of high voltage power transformers and Kang
      Lim Construction Co., Ltd., a major construction firm.




69




**Theodore
      H. Banzhaf** ,
      Executive Vice President of Strategic Planning, and President and CEO of
      SpatiaLight Technologies, Inc., an inactive wholly owned subsidiary of
      SpatiaLight, Inc., since July 2003. Before joining SpatiaLight, Mr. Banzhaf
      worked from 2002 to 2003 in the institutional equities group as a Senior Vice
      President at C. E. Unterberg, Towbin, an investment bank, and as a Senior Vice
      President at Friedman Billings Ramsey, an investment bank, in 2002. Mr. Banzhaf
      served as a Managing Director and Managing Member of Fulcrum Global Partners,
      a
      hedge fund, from 2000 to 2002. Mr. Banzhaf was a Senior Vice President at
      Raymond James & Associates in the capital markets group from 1995-2000. Mr.
      Banzhaf received an MBA from Southern Methodist University in Dallas, Texas,
      and
      a Bachelor of Arts from Miami University in Oxford, Ohio.





**Lawrence
      J. Matteson** ,
      Chairman of the Board since April 2001, has served as director since 1991,
      and
      previously served as the Chairman of the Board from 1995 through 1997. He has
      served as an executive professor of business policy at the William E. Simon
      Graduate School of Business Administration, University of Rochester since 1992.
      Mr. Matteson was Senior Vice President and General Manager, Electronic Imaging
      for Eastman Kodak Company until December 1991. Mr. Matteson began his career
      with Eastman Kodak in 1965 as a research engineer and worked at Eastman Kodak
      in
      various positions continuously from that date until December 1991. He holds
      degrees in engineering and an MBA from the University Of Rochester Graduate
      School Of Business.





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





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





*Audit
      Committee*





The
      Audit
      Committee is comprised of three of our non-employee directors: Messrs. Matteson,
      Munro (Chair), and Piaget. It met 11 times during 2005. The Audit Committee
      is
      responsible for the appointment, retention and termination of a firm of
      independent registered public accountants and monitors the effectiveness of
      the
      audit effort, our financial and accounting organization and our system of
      internal accounting and disclosure controls. Each member of the Audit Committee
      is independent within the meaning of SEC regulations and the NASD listing
      standards. We do not currently have a financial expert serving on the Audit
      Committee of the Board of Directors. We did not take any action in 2005 and
      do
      not presently have specific plans with respect to adding a director who would
      constitute a financial expert, as defined by SEC rules. The Audit Committee
      Charter is available on our website.





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




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





**Code
      of Ethics**





We
      have a
      Code of Business Conduct and Ethics which is applicable to all of our employees
      including the principal executive officer, the principal financial officer
      and
      the principal accounting officer or Controller. The Code of Business Conduct
      and
      Ethics is available on our website www.spatialight.com under Corporate
      Governance. We intend to post amendments to or waivers from our Code of Business
      Conduct and Ethics (to the extent applicable to our chief executive officer,
      principal financial and accounting officer or controller) at this location
      on
      our website.





**ITEM
      11.**  **Executive
      Compensation**





The
      following table sets forth the compensation paid by us for the fiscal years
      ended December 31, 2003 to 2005, to our Chief Executive Officer and all of
      the
      other executive officers as of December 31, 2005.




70




**Name
                  & Principal Position**
              
              **Year**
              
              **Salary($)**
              
              **Bonus($)**
              
              
              
              **Securities
                  Underlying Options/SARS (#)**
              
              
              
              **All
                  other compensation ($)**Robert
                  A. Olins, Chief Executive Officer,
              
              
              2005
              
              $
              -
              
              $
              -
              
              
              
              
              
              500,000
              
              
              
              
              $
              100,205
              
              (7
              )Treasurer,
                  Secretary and PrincipalFinancial
              
              
              2004
              
              $
              -
              
              $
              -
              
              
              
              
              
              500,000
              
              
              
              
              $
              -and
                  Accounting Officer
              
              
              2003
              
              $
              -
              
              $
              -
              
              
              
              
              
              500,000
              
              
              
              
              $
              -David
                  F. Hakala, Chief Operating Officer
              
              
              2005
              
              $
              237,231
              
              $
              -
              
              
              
              
              
              N/A
              
              
              
              
              $
              -2004
              
              $
              240,000
              
              $
              -
              
              
              
              
              
              N/A
              
              
              
              
              $
              -2003
              
              $
              240,000
              
              $
              -
              
              
              
              
              
              N/A
              
              
              
              
              $
              -Michael
                  S. Jin, Chief Technology Officer
              
              
              2005
              
              $
              200,000
              
              $
              21,106
              
              (8
              )
              
              
              100,000
              
              (6
              )
              
              $
              -2004
              
              $
              200,000
              
              $
              -
              
              
              
              
              
              125,000
              
              (6
              )
              
              $
              -2003
              
              $
              150,000
              
              $
              -
              
              
              
              
              
              N/A
              
              
              
              
              $
              -Theodore
                  H. Banzhaf, Executive Vice President
              
              
              2005
              
              $
              360,000
              
              $
              -
              
              
              
              
              
              N/Aof
                  Strategic Planning
              
              
              2004
              
              $
              360,000
              
              $
              -
              
              
              
              
              
              N/A
              
              
              
              
              $
              -2003
              
              $
              103,385
              
              $
              -
              
              
              
              
              
              800,000
              
              (1
              )
              
              $
              -Je
                  Won Yeun, President, SpatiaLight Korea, Inc.
              
              
              2005
              
              $
              224,000
              
              $
              -
              
              
              
              
              
              N/A
              
              
              
              
              $
              -2004
              
              $
              91,735
              
              $
              -
              
              
              
              
              
              100,000
              
              (3
              )(6)
              
              $
              -2003
              
              
              N/A
              
              $
              -
              
              
              
              
              
              N/A
              
              
              
              
              $
              -Don
                  S. Suh, Senior Vice President, Marketing & Sales
              
              
              2005
              
              $
              189,615
              
              $
              -
              
              
              
              
              
              N/A
              
              
              
              
              $
              -2004
              
              $
              48,467
              
              $
              -
              
              
              
              
              
              150,000
              
              (5
              )(6)
              
              $
              -2003
              
              
              N/A
              
              
              N/A
              
              
              
              
              
              N/A
              
              
              
              
              $
              -




(1)
            This
                stock option was granted pursuant to the Amended and Restated Time
                Accelerated Restricted Stock Award Plan (TARSAP) dated as of July
                7, 2003,
                between Mr. Banzhaf and the Corporation. The TARSAP granted to Mr.
                Banzhaf
                options to purchase 800,000 common shares, in the aggregate, in the
                following manner: (i) 125,000 options which vested as of July 7,
                2003 and
                which options expire on July 7, 2006 (35,000 options have an exercise
                price of $2.55, of which 25,000 were exercised on December 30, 2004,
                4,669
                were exercised on July 5, 2005 and 5,331 were exercised on July 6,
                2005,
                and 90,000 options have an exercise price of $12.50), and (ii) 675,000
                options which vest upon the earlier of the achievement of certain
                performance tests within two years after the date of the grant or
                the
                second anniversary of the grant date. The options expire three years
                after
                such options vest and become exercisable (175,000 of such options
                have an
                exercise price of $5.00, which vested on January 27, 2004, 225,000
                of such
                options have an exercise price of $7.50 and 275,000 of such options
                have
                an exercise price of $12.50). The TARSAP agreement was amended on
                July 6,
                2005 extending the vesting period of the unvested options to the
                fourth
                anniversary of the grant date and increasing the exercise prices
                of
                175,000 options from $5.00 to $7.50.


(2)
            Employment
                commenced on July 29, 2004.


(3)
            This
                stock option granted July 29, 2004 and originally vested over a three-year
                period.


(4)
            Employment
                commenced on July 19, 2004.


(5)
            This
                stock option granted July 19, 2004 and originally vested over a three-year
                period.


(6)
            These
                options became fully vested on December 15, 2005 as part of our
                acceleration of vesting. See footnote 1 Stock Option Acceleration
                in the
                financial statements for more
                detail.


(7)
            Represents
                (a) $72,552 paid by the Company for housing for Robert Olins and
                (b)
                $27,653paid by the Company for a car for Mr.
                Olins.


(8)
            Represents
                $21,106 as bonus compensation by the
                Company.





**Stock
      Option Grants**





The
      following table sets forth certain information for the year ended December
      31,
      2005, with respect to stock options granted to the individuals named in the
      Summary Compensation Table.




71




**OPTION
      GRANTS IN LAST FISCAL YEAR**




(a)
              (b)
              (c)
              (d)
              (e)
              (f)
              (g)**Name**
              **Number
                  of Shares Underlying Options/SARs Granted (#)**
              **%
                  of Total Options/SARs Granted to Employees in Fiscal
                  Year**
              **Exercise
                  or Base Price ($/Sh)**
              **Expiration**
                **Date**
              **Potential
                  Realizable Value**
                **at
                  Assumed Annual Rates**
                **of
                  Stock Price Appreciation**
                **for
                  Option Term**5%($)
              10%($)Robert
                  A. Olins
              500,000
              68%
              $4.97
              01/18/2015
              $1,562,803
              $3,960,450Michael
                  S. Jin
              100,000
              14%
              $4.97
              01/18/2015
              $
                  312,561
              $
                  792,090




**Option
      Exercises and Fiscal 2005 Year End Values**




The
      following table sets forth information with respect to options to purchase
      common shares granted to our named executive officers including: (i) the number
      of common shares purchased upon exercise of options in the fiscal year ended
      December 31, 2005; (ii) the net value realized upon such exercise; (iii) the
      number of unexercised options outstanding at December 31, 2005; and (iv) the
      value of such unexercised options at December 31, 2005.




**AGGREGATED
      OPTION EXERCISES IN LAST FISCAL YEAR AND**


**DECEMBER
      31, 2005 OPTION VALUES**




**Name**
              **Shares**
                **Acquired
                  on**
                **Exercise
                  (#)**
              **Value**
                **Realized
                  ($)**
              **Number
                  of Unexercised Options at Dec. 31, 2005 (#)****Exercisable /
                  Unexercisable**
              
              **Value
                  of Unexercised In-the-Money Options at Dec. 31, 2005****(#)**
                ******Exercisable
                  / Unexercisable**Robert
                  A. Olins
              45,556
              $0
              3,229,444/
                  0
              
              $3,337,250/
                  $0David
                  F. Hakala
              0
              $0
              335,000/
                  0
              
              $891,100/
                  $0Theodore
                  H. Banzhaf
              10,000
              $31,670
              265,000/500,000
              
              $0/
                  $0Michael
                  S. Jin
              0
              $0
              300,000/
                  0
              
              $35,200/
                  $0Don
                  S. Suh
              0
              $0
              150,000/
                  0
              
              $0/
                  $0Je
                  Won Yeun
              0
              $0
              100,000/
                  0
              
              $0/
                  $0




**Employment
      Arrangements and Agreements**




Robert
      A.
      Olins has served as one of our directors since 1998 and has also served as
      our
      Chief Executive Officer, Secretary and Treasurer of the Corporation since July
      2000. Mr. Olins does not have an employment agreement with the Corporation.
      Mr.
      Olins has received no cash compensation from us for his services to date, but
      has been granted options as reported under “Summary Compensation Table - Option
      Grants In Last Fiscal Year.” We also pay for Mr. Olins housing and car, which
      amounted to $102,205 during 2005.




David
      F.
      Hakala has served as our Chief Operating Officer since September 3, 2002. We
      have extended Dr. Hakala’s employment by one-year extensions on the anniversary
      of his employment. Dr. Hakala receives an annual salary of $240,000 and received
      a grant of Incentive Stock Options, in 2002, to purchase 360,000 common shares
      that vested over a three-year period. Dr. Hakala exercised 25,000 of his vested
      options on December 15, 2004. As of December 31, 2005, Dr. Hakala has 335,000
      fully-vested options.




We
      are
      party to an employment agreement dated July 7, 2003, with Theodore H. Banzhaf,
      for him to serve as our Executive Vice President of Strategic Planning, which
      was in effect through July 7, 2005. The employment agreement was amended on
      July
      6, 2005, extending its effect to July 7, 2006. As currently in effect, the
      agreement provides for an annual salary of $360,000. We agreed to grant Mr.
      Banzhaf equity incentive compensation in the form of stock options to purchase
      an aggregate of 800,000 common shares, $.01 par value, of SpatiaLight pursuant
      to the provisions of an Amended and Restated Time Accelerated Restricted Stock
      Award Agreement (TARSAP). The options under this plan are not granted under
      our
      1999 Stock Option Plan or any other stock option plan. Mr. Banzhaf exercised
      25,000 of his vested options on December 30, 2004 and another 10,000 during
      July
      2005. As of December 31, 2005, Mr. Banzhaf has 265,000 fully-vested
      options.




72




Michael
      S. Jin was promoted to Chief Technology Officer on July 7, 2004. We do not
      have
      an employment agreement with Dr. Jin. As of July 7, 2004, Dr. Jin receives
      an
      annual salary of $200,000 and he received a grant of Incentive Stock Options
      to
      purchase 125,000 common shares vesting over a two-year period. Dr. Jin has
      a
      total of 300,000 options, which were fully vested as of December 15, 2005.
      The
      Company also paid a bonus to Dr. Jin, which amounted to $21,106 during
      2005.




Don
      S.
      Suh has served as our Senior Vice President - Marketing and Sales since July
      19,
      2004. We do not have an employment agreement with Mr. Suh. Mr. Suh received
      an
      initial annual salary of $165,000, which was increased to $175,000 in December
      2004, and he received a grant of Incentive Stock Options to purchase 150,000
      common shares vesting over a three-year period. In March 2005, Mr. Suh received
      an increase in salary to $195,000. As of December 15, 2005 Mr. Suh’s options
      became fully vested. Mr. Suh has the right to earn a sales commission equal
      to
      one-half of one percent (0.5%) of the gross sales of products made by us to
      certain customers only if certain conditions are met.




Je
      Won
      Yeun has served as the President of SpatiaLight Korea, Inc., a wholly-owned
      subsidiary of SpatiaLight, Inc. since July 29, 2004. Prior to July 29, 2004,
      Mr.
      Yeun served as a consultant to us for approximately one month. We do not have
      an
      employment agreement with Mr. Yeun, although the expected term of his employment
      is three years. Mr. Yeun receives an annual salary of KRW 228,571,429.00
      (approximately $224,000) and received a grant of Incentive Stock Options to
      purchase 100,000 common shares vesting over a three-year period. As of December
      15, 2005, Mr. Yeun’s options became fully vested.




There
      was
      one repricing of options to purchase Shares in 2005, pursuant to Amendment
      No. 2
      of the TARSAP with Mr. Banzhaf, the exercise price of 175,000 currently
      exercisable options was increased from $5.00 to $7.50. There was one repricing
      of options to purchase Shares in 2004. The exercise price of 90,000 currently
      exercisable options granted to Mr. Banzhaf under the TARSAP was increased from
      $2.55 to $12.50. Each of these upward repricings were part of agreements with
      Mr. Banzhaf to alter his total employment compensation.




**Name**
              
              **Date**
              
              **Number
                  of Securities Underlying Options/**
                **SARs**
                **Repriced
                  Or Amended**
              
              **Market
                  Price Of Stock At Time Of Repricing Or Amendment**
              
              **Exercise**
                **Price
                  At**
                **Time
                  Of Repricing Or Amendment**
              
              **New**
                **Exercise**
                **Price**
              
              **Length
                  of Original Option Term Remaining At Date Of Repricing Or
                  Amendment**Theodore
                  H. Banzhaf, Executive Vice
                Presidentof
                  Strategic Planning
              
              
              4/1/2004
              
              
              90,000
              
              $
              3.70
              
              $
              2.55
              
              $
              12.50
              
              
              2.25
                  yearsTheodore
                  H. Banzhaf, Executive Vice
                President of
                  Strategic Planning
              
              
              7/6/2005
              
              
              175,000
              
              $
              5.55
              
              $
              5.00
              
              $
              7.50
              
              
              1.50
                  years




**Compensation
      Committee Interlocks and Insider Participation**




The
      Compensation Committee of our Board recommending compensation for executive
      officers during 2005 consisted of Lawrence J. Matteson, Claude Piaget and Robert
      M. Munro.





Mr.
      Olins
      served as our Chief Executive Officer, Secretary, Treasurer and Principal
      Financial and Accounting Officer for fiscal 2005. During 2005, all executive
      compensation was determined by the Compensation Committee of our Board of
      Directors. Three out four of the directors are independent directors.





Argyle
      Capital Management Corporation (Argyle), which is wholly owned by Mr. Olins,
      entered into various transactions with the Corporation in 1998. As of November
      30, 2004, we completed a non-brokered private placement of $10,000,000 original
      principal amount of 10% senior secured convertible notes (the 2004 Senior
      Secured Convertible Notes), due November 30, 2007 (the November 2004 Financing).
      As a condition to our entering into the November 2004 Financing and pursuant
      to
      the November 2004 Financing transaction documents, the investors required Argyle
      to enter into an intercreditor and subordination agreement (the Intercreditor
      Agreement) pursuant to which Argyle agreed to subordinate our obligations to
      Argyle and the senior security interest in substantially all of the assets
      of
      SpatiaLight that were granted under certain notes (the Argyle Notes) to the
      interest represented by the investors in the November 2004 Financing. For more
      information regarding these transactions, refer to “Certain Relationships and
      Related Transactions” herein.





73




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





The
      following table sets forth information regarding beneficial ownership of common
      shares as of March 10, 2006, by each person known by us to own beneficially
      more
      than five percent of our outstanding common shares, by each of our directors,
      and by each of our executive officers named in the Summary Compensation Table
      contained in “Executive Compensation,” and by all of our directors and executive
      officers as a group. Except as otherwise noted, each person named in the table
      has sole voting and investment power with respect to all common shares shown
      as
      beneficially owned by him, her or it.




**Name
                  and Address**
                **Beneficial
                  Owner**
              **Amount
                  and**
                **Nature
                  of**
                **Beneficial**
                **Ownership**
              
              **Percent
                  of**
                **Class**Robert
                  A. Olins
                Argyle
                  Capital Management Corporation
                Five
                  Hamilton Landing, Suite 100
                Novato,
                  CA 94949
              9,435,622
              (1)
              21.0%Wellington
                  Management Company, LLP
                75
                  State Street
                Boston,
                  Massachusetts 02109
              5,158,257
              (2)
              13.3%Adele
                  Becker
                215
                  E 68th Street
                New
                  York, NY 10021
              2,861,033
              (3)
              7.1%Lawrence
                  J. Matteson
                Five
                  Hamilton Landing, Suite 100
                Novato,
                  CA 94949
              279,200
              (4)
              *Claude
                  Piaget
                Five
                  Hamilton Landing, Suite 100
                Novato,
                  CA 94949
              175,000
              (5)
              *Robert
                  C. Munro
                Five
                  Hamilton Landing, Suite 100
                Novato,
                  CA 94949
              75,000
              (6)
              *David
                  F. Hakala
                Five
                  Hamilton Landing, Suite 100
                Novato,
                  CA 94949
              335,000
              (7)
              *Michael
                  S. Jin
                Five
                  Hamilton Landing, Suite 100
                Novato,
                  CA 94949
              322,400
              (8)
              *Theodore
                  H. Banzhaf
                Five
                  Hamilton Landing, Suite 100
                Novato,
                  CA 94949
              765,000
              (9)
              2.0%Don
                  S. Suh
                Five
                  Hamilton Landing, Suite 100
                Novato,
                  CA 94949
              305,000
              (10)
              *Je
                  Won Yeun
                Five
                  Hamilton Landing, Suite 100
                Novato,
                  CA 94949
              100,000
              (11)
              *All
                  directors and officers as a group (9 persons)
              11,792,222
              
              24.9%*Less
                  than 1%




74




(1)
            Includes
                2,376,000 Shares beneficially owned subject to conversion of principal
                and
                interest of convertible notes held by Argyle Capital Management
                Corporation (Argyle), of which Mr. Olins is President and over which
                Mr.
                Olins exercises voting control, and 1,678,597 Shares owned by Argyle.
                Also
                includes 1,476,535 common shares and Warrants to purchase 204,360
                common
                shares held by Mr. Olins. Also includes 3,204,444 Shares subject
                to
                outstanding stock options held by Mr. Olins that are exercisable
                as of
                March 10, 2006 and 500,000 Shares subject to options not exercisable
                within 60 days.


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


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


(4)
            Includes
                241,700 Shares subject to options exercisable as of March 10, 2006
                and
                37,500 Shares subject to options not exercisable within 60
                days.


(5)
            Includes
                137,500 Shares subject to options exercisable as of March 10, 2006
                and
                37,500 Shares subject to options not exercisable within 60
                days.


(6)
            Includes
                37,500 Shares subject to options exercisable as of March 10, 2006
                and
                37,500 Shares subject to options not exercisable within 60
                days.


(7)
            Includes
                335,000 Shares subject to outstanding stock options held by Dr. Hakala
                that are exercisable as of March 10,
                2006.


(8)
            Includes
                300,000 Shares subject to options exercisable as of March 10,
                2006.


(9)
            Includes
                265,000 Shares subject to options exercisable as of March 10, 2006
                and
                500,000 Shares subject to options not exercisable within 60
                days.


(10)
            Includes
                150,000 Shares subject to options exercisable as of March 10, 2006
                and
                150,000 Shares subject to options not exercisable within 60
                days.


(11)
            Includes
                100,000 Shares subject to options exercisable as of March 10,
                2006.





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





*Argyle
      Notes:*





In
      1998,
      the Corporation received $1,188,000 in cash in exchange for notes in that amount
      to Argyle Capital Management Corporation (Argyle), a company owned and
      controlled by Robert A. Olins, our Chief Executive Officer, Secretary,
      Treasurer, and Director. The notes accrue interest at a contractual rate of
      6%
      per annum, and are secured by substantially all of our assets. Both principal
      and interest are convertible into our common shares at $0.50 per Share. On
      May
      23, 2001, the due date of the notes was extended until December 31, 2002. On
      the
      extension date, the beneficial conversion effect representing the excess
      aggregate value of the common shares receivable upon conversion of the notes
      based on the then current market price of $1.90 per Share, over the aggregate
      conversion price for such common shares (limited to the original proceeds of
      $1,188,000), was recorded as additional paid-in capital. The resulting
      $1,188,000 discount to the debt arising from the beneficial conversion feature
      was originally being amortized through December 31, 2002. The notes were
      extended in September 2002 to March 31, 2004, and on December 31, 2003 were
      extended until June 30, 2005. At each extension date, the amortization rate
      of
      the remaining unamortized discount was also extended over the new life of the
      notes. The effective interest rate for financial statement purposes due to
      this
      discount differs from the actual contractual interest received or receivable
      in
      cash or Shares by Argyle. The current amortization rate of the discount, along
      with the contractual 6% interest rate, resulted in a new effective interest
      rate
      of 8% per annum as of the December 31, 2003 extension date when compared to
      the
      outstanding principal balances.




On
      January 7, 2004, we paid interest payable on the Argyle Notes by issuing 142,360
      common shares with a market value of $800,063 for the year ended December 31,
      2004. The market value of the shares was based on the closing price of the
      shares on the day before issuance, and was recorded as interest expense. This
      interest expense includes non-cash interest expense of $728,780. The non-cash
      interest expense results from the beneficial conversion price of interest
      payable, which is convertible into common shares at $0.50 per share and was
      computed as the excess of the market price of the shares issued over accrued
      interest payable. In addition, on March 4, 2004, we issued 71,676 common shares
      with a market value of $338,311 as prepayment of interest payable on the Argyle
      notes of $35,640 for the six months ended June 30, 2005. Prepaid interest was
      computed using the closing price of the common shares on March 3, 2004 of $4.72.
      At December 31, 2004, the carrying value of the Argyle notes total $1,177,000,
      which includes the $1,188,000 principal balance net of unamortized discounts
      of
      $11,000.





As
      a
      condition to our entering into the November 2004 Financing, as defined herein,
      and pursuant to the November 2004 Financing transaction documents, the investors
      required Argyle to enter into an intercreditor and subordination agreement
      (the
      Intercreditor Agreement) pursuant to which Argyle agreed to subordinate our
      obligations to Argyle and the senior security interest in substantially all
      of
      the assets of SpatiaLight that were granted under certain notes (the Argyle
      Notes) to the interest represented by the investors in the November 2004
      Financing.




75




In
      consideration for Argyle entering into the Intercreditor Agreement and because,
      by their terms, the November 2004 Financing transaction documents prohibit
      the
      use of the proceeds of the November 2004 Financing to repay Company debt, our
      Board of Directors (Mr. Olins did not participate in this matter as a member
      of
      the Board) authorized SpatiaLight to enter into an extension and modification
      agreement between SpatiaLight and Argyle with respect to the Argyle Notes (the
      Extension Agreement). The Argyle Notes were originally issued in 1998 in
      exchange for $1,188,000 in cash and, prior to the November Financing, the due
      date of the Argyle Notes was extended from December 31, 2003 to June 30, 2005.
      The Argyle Notes accrue interest at a contractual annual rate of 6%. Both
      principal and interest under the Argyle Notes are convertible into our common
      shares at $0.50 per share. Pursuant to the Extension Agreement, the due date
      of
      the Argyle Notes was extended to December 31, 2008, and we issued 498,768 common
      shares to Argyle as prepayment of interest payable of $249,480 for the period
      July 1, 2005 through December 31, 2008. These shares had a market value of
      $4,049,964 based on the closing price of the shares of $8.12 on December 21,
      2004. In connection with the Intercreditor Agreement, the Board also authorized
      the reimbursement of $50,000 to Argyle for a fee that Argyle was required to
      pay
      to a bank to relinquish the bank’s previously existing security interest in the
      assets of our Company. At December 31, 2005 the carrying value of the Argyle
      notes total $1,188,000.





*November
      2004 Senior Secured Convertible Debt Financing:*




As
      of
      November 30, 2004, we completed a non-brokered private placement of $10,000,000
      original principal amount of 10% senior secured convertible notes (the 2004
      Senior Secured Convertible Notes), due November 30, 2007 (the November 2004
      Financing). Under the terms of the November 2004 Financing, the purchasers
      of
      the 2004 Senior Secured Convertible Notes, who, upon conversion of such notes
      shall become selling shareholders, have a nine-month right, expiring August
      31,
      2005, to purchase up to an additional $5,000,000 principal amount of
      notes **** subject
      to the same terms and conditions, including the $9.72 conversion price,
      as **** the
      2004
      Senior Secured Convertible Notes issued in the November 2004 Financing (the
      Additional Investment Rights). **** The
      2004
      Senior Secured Convertible Notes are convertible, at the option of the holders,
      into SpatiaLight common shares at the conversion price of $9.72 per share.
      At
      the conversion price, each $1,000 principal amount of the 2004 Senior Secured
      Convertible Notes is convertible into 102.88 of our common shares. The
      conversion price of the principal amount of the 2004 Senior Secured Convertible
      Notes is equal to a 25% premium above the ten-day trailing average of the volume
      weighted average price of our common shares ended November 29, 2004, which
      was
      $7.78.




The
      2004
      Senior Secured Convertible Notes bear interest at an annual rate of 10%, payable
      quarterly, and are senior secured obligations of SpatiaLight. The interest
      is
      payable in cash or our common shares at our option, subject to certain
      conditions being met. In the event that we elect to pay interest with our common
      shares, the value of such shares shall be equal to the 20-day trailing average
      of the volume weighted average price of our common shares at the end of each
      quarterly interest period. For each of the quarterly interest periods ended
      February 28, 2005, May 30, 2005, August 31, 2005 and November 30, 2005, we
      paid
      interest to holders of 2004 Senior Secured Convertible Notes in cash. We have
      used the net proceeds from the transaction to fund construction and equipping
      of
      our state of the art manufacturing facility in South Korea and for general
      working capital purposes.




Under
      the
      terms of the November 2004 Financing, Robert A. Olins, the Chief Executive
      Officer and a director of SpatiaLight, and Greenpark Limited, an unaffiliated
      shareholder of SpatiaLight, jointly and severally committed, in the event that
      the Board determines that such financing is necessary, to provide us with up
      to
      $6,000,000 in future financing on terms and conditions to be determined at
      the
      time of any such transaction. That financing commitment shall be reduced by
      any
      funds that SpatiaLight receives from future sales or exercises of its equity,
      debt or derivative securities, including the sale of our common shares under
      the
      Prospectus that we filed with the SEC on January 31, 2005, as part of a “shelf”
registration process. As of the date of this filing we have received an
      aggregate total of greater than $6 million thereby ending the commitment by
      Mr.
      Olins and Greenpark Ltd.




In
      consideration for the financing commitment by Greenpark Limited, we agreed
      to
      reduce by $600,000 the amount owed by Greenpark Limited to us under that certain
      warrant installment agreement, dated as of October 14, 2002 (the Installment
      Agreement). Mr. Olins advised the Board that any consideration that the Board
      determined was owed to Mr. Olins for the financing commitment should instead
      be
      given as consideration to Greenpark Limited for its participation in the
      financing commitment. As a result, Mr. Olins was not, and is not to be,
      compensated for his participation in the financing commitment and the Board
      weighed that fact in their negotiation with Greenpark Limited with respect
      to
      amending the Installment Agreement. Pursuant to the Installment Agreement,
      in
      November 2002, Greenpark Limited exercised its warrant to purchase 746,268
      common shares at the exercise price of $2.00 per share, for an aggregate
      purchase price of $1,492,536. Under the Installment Agreement, the Commitment
      Shareholder is required to make periodic installment payments towards such
      aggregate purchase price. There is a 6% annual interest rate with respect to
      the
      balance of the share purchase price owed to us and all accrued interest is
      due with the final payment. We issued all of the 746,268 shares to
      Greenpark Limited in 2003. We received the remaining outstanding balance, less
      amounts forgiven as described above, plus accrued interest during the first
      three quarters of 2005. We will not give any further financial consideration
      to
      Greenpark Limited for such financing commitment.





*Short-term
      Financing*




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




76




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





The
      following represents the fees billed to us for the last two fiscal years by
      OUM,
      our current independent registered public accountants for the year ended
      December 31, 2005 and December 31, 2004 and BDO, our former independent
      registered public accountants for the first, second and third quarters of 2004
      and the year ended December 31, 2003.




2005
              
              2004
              
              2003Audit
                  Fees
              
              
              (1)
                  (4)
              
              $
              350,467
              
              $
              172,965
              
              $
              166,500Audit-Related
                  Fees
              
              
              (2)
              
              
              —
              
              
              6,330
              
              
              12,000Tax
                  Fees
              
              
              (3)
              
              
              —
              
              
              16,525
              
              
              17,000All
                  Other Fees
              
              
              
              
              
              
              
              
              N/A
              
              
              N/A


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


(2)
            Includes
                accounting consultations


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


(4)
            2005
                audit fees include reaudit of the consolidated financial statements
                of
                2003 and 2002.




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





**PART
      IV**





**ITEM
      15.**  **Exhibits,
      Consolidated Financial Statement Schedules and Reports on Form 8-K.**








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





The
      following documents are filed as part of this Report under Item 8
      herein:




(a)
                Consolidated Financial Statements
            PageReport of Independent Registered Public
              Accounting Firm
            31Consolidated Balance Sheets at December
              31,
              2005 and 2004
            32Consolidated Statements of Operations
              for
              years ended December 31, 2005, 2004 and 2003
            33Consolidated
              Statements of Stockholders’ Equity (Deficit) for years endedDecember
              31, 2005, 2004 and 2003
            34Consolidated Statements of Cash Flows
              for
              years ended December 31, 2005, 2004 and 2003
            37Notes To Consolidated Financial
              Statements
            39




(b) Consolidated
        Financial Statement Schedules





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





77




**2.**  **Exhibits**





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




78





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


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


† Previously filed.





79




Pursuant
      to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
      1934, the Registrant has duly caused this report to be signed on its behalf
      by
      the undersigned, thereunto duly authorized, on the 15th day of March 2006.




SPATIALIGHT,
              INC.By:
            /s/ ROBERT
              A.
              OLINSRobert
              A. OlinsChief
                Executive Officer, Principal
              Financial
                and Accounting Officer,
              Secretary
                and Treasurer




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






Signature
            
            Title
            Date/s/ROBERT
              A. OLINS
            
            Chief
              Executive Officer,
            March
                15, 2006Robert A. Olins
            
            Secretary, Treasurer and
              Director*/s/LAWRENCE
              J. MATTESON
            
            Director
            March
                15, 2006Lawrence J. Matteson*/s/CLAUDE
              PIAGET
            
            Director
            March
                15, 2006Claude Piaget*/s/ROBERT
              C. MUNRO
            
            Director
            March
                15, 2006Robert C. MunroPursuant to Power of Attorney
              filed as Exhibit 24.1*/s/ROBERT
              A. OLINS
            
            
            March
                15, 2006Robert A. Olins(Attorney-in-fact)






80