UNITED
STATES
 SECURITIES
AND EXCHANGE COMMISSION
 Washington,
D.C. 20549
  ———————
 FORM
10-Q/A
 ———————
 (Mark
One)
 þQUARTERLY REPORT PURSUANT TO SECTION
13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
  For the
quarterly period ended March
31, 2010
  or
   ̈TRANSITION REPORT PURSUANT TO SECTION
13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
  For the
transition period from ____________ to ________________
   Commission file number 333-123092
 ———————
 IMAGE
METRICS, INC.
 (Exact
name of registrant as specified in its charter)
 ———————
  Nevada
                
                20-1719023(State
      or other jurisdiction
                  of
      incorporation or organization)
                
                (I
      R S Employer
                  Identification
      No.)
 
 1918
Main Street, Santa Monica, California  90405
 (Address
of principal executive offices)     (Zip
Code)
  (310)
656-6551
 (Registrant’s
telephone number, including area code)
  10 Warren Avenue, Spring Lake,
NJ  07762
 (Former
address if changed since last report)
  ———————
  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  ̈  No þ
  Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405
of this chapter) during the preceding 12 months (or for such shorter period that
the registrant was required to submit and post such
files).   Yes  ̈  No  ̈
  Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company.
(Check one):
 Large
      accelerated filer
               ̈
              
              Accelerated
      filer
               ̈Non-accelerated
      filer
               ̈
              
              Smaller reporting company
              þ
 
 Indicate
by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act).   Yes  ̈No þ
 
 As of May
24, 2010, there were 15,869,277 shares of the issuer’s common stock, par value
$0.001 issued and outstanding.
 
 
 Explanatory Note
  We are
filing this Amendment No. 1 to our quarterly report on Form 10-Q for the three
months ending on March 31, 2010, filed with SEC on May 24, 2010, for the
purposes of adding additional language in the fair value instruments footnote,
adjusting the weighted average outstanding common shares used in calculating the
net loss per share of common stock and the correction of typographical
errors.  This Form 10-Q/A replaces the previous filing in its
entirety.
  IMAGE
METRICS, INC.
 MARCH
31, 2010QUARTERLY REPORT ON FORM 10-Q
 TABLE
OF CONTENTS
  
  PAGEPART
      I - FINANCIAL INFORMATIONItem
      1.
                                    Financial
      Statements
                                    1Balance
      Sheets as at March 31, 2010 (Unaudited) andSeptember
      30, 2009 (Unaudited)
                                    1Statements
      of Operations for the three and six monthsended
      March 31, 2010 and 2009 (Unaudited)
                                    2Statements
      of Cash Flows for the six monthsended
      March 31, 2010 and 2009 (Unaudited)
                                    3Notes
      to Condensed Consolidated Financial Statements (Unaudited)
                                    4Item
      2.
                                    Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                                    14Item
      3.
                                    Quantitative
      and Qualitative Disclosures About Market Risk
                                    19Item
      4.
                                    Controls
      and Procedures
                                    20PART
      II - OTHER INFORMATIONItem
      1.
                                    Legal
      Proceedings
                                    20Item
      1A.
                                    Risk
      Factors
                                    20Item
      2.
                                    Unregistered
      Sales of Equity Securities and Use of Proceeds
                                    28Item
      3.
                                    Defaults
      Upon Senior Securities
                                    28Item
      4.
                                    Submission
      of Matters to a Vote of Security Holders
                                    28Item
      5.
                                    Other
      Information
                                    28Item
      6.
                                    Exhibits
                                    28









PART
1 – FINANCIAL INFORMATION


ITEM 1.
FINANCIAL STATEMENTS




Image
Metrics, Inc.


Condensed
Consolidated Balance Sheets


(Amounts
in thousands of US Dollars, except share data)




March 31,
                                      2010
                                    
                                    
                                    September 30,
                                      2009AssetsCurrent
      assetsCash
      and cash equivalents
                                    
                                    $
                                    1,275
                                    
                                    
                                    $
                                    803Restricted
      cash
                                    
                                    
                                    500
                                    
                                    
                                    
                                    100Accounts
      receivable
                                    
                                    
                                    177
                                    
                                    
                                    
                                    422Prepaid
      and other current assets
                                    
                                    
                                    204
                                    
                                    
                                    
                                    256Total
      current assets
                                    
                                    
                                    2,156
                                    
                                    
                                    
                                    1,581Property
      and equipment (net)
                                    
                                    
                                    205
                                    
                                    
                                    
                                    177Investment
      in Optasia
                                    
                                    
                                    729
                                    
                                    
                                    
                                    729Total
      assets
                                    
                                    $
                                    3,090
                                    
                                    
                                    $
                                    2,487Liabilities
      and shareholders’ deficitCurrent
      liabilitiesAccounts
      payable
                                    
                                    $
                                    1,303
                                    
                                    
                                    $
                                    539Accrued
      expenses and other current liabilities
                                    
                                    
                                    918
                                    
                                    
                                    
                                    1,219Deferred
      revenue
                                    
                                    
                                    6,289
                                    
                                    
                                    
                                    8,522Notes
      payable
                                    
                                    
                                    493
                                    
                                    
                                    
                                    830Warrants
      Liability
                                    
                                    
                                    593
                                    
                                    
                                    
                                    -Total
      current liabilities
                                    
                                    
                                    9,596
                                    
                                    
                                    
                                    11,110Notes
      payable (noncurrent portion)
                                    
                                    
                                    -
                                    
                                    
                                    
                                    80Notes
      payable to related party (noncurrent portion)
                                    
                                    
                                    -
                                    
                                    
                                    
                                    2,078Total
      liabilities
                                    
                                    
                                    9,596
                                    
                                    
                                    
                                    13,268Shareholders’
      deficitCommon
      Stock, $0.001 par value. Authorized 75,000,000 shares; issued and
      outstanding 15,869,277 and 0 shares at March 31, 2010 and September 30,
      2009, respectively
                                    
                                    
                                    16
                                    
                                    
                                    
                                    12Preferred
      stock, $0.001 par value.  Authorized 5,000,000 shares; no shares
      issued and outstanding at March 31, 2010 and September 30,
      2009
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Series
      A Convertible Preferred stock, $0.001 par value.  Authorized
      15,000,000 shares; issued and outstanding 9,319,098 and 0 shares at March
      31, 2010 and September 30, 2009, respectively
                                    
                                    
                                    7,808
                                    
                                    
                                    
                                    -Ordinary
      shares, £0.05 par value. Authorized 10,220,711 shares; issued and
      outstanding 0 and 2,125,197 shares at March 31, 2010 and September
      30,2009, respectively
                                    
                                    
                                    -
                                    
                                    
                                    
                                    161A
      Ordinary shares, £0.05 par value. Authorized 333,863 shares; issued and
      outstanding 0 and 300,607 shares at March 31, 2010 and September 30,2009,
      respectively
                                    
                                    
                                    -
                                    
                                    
                                    
                                    23Preferred
      Ordinary Shares, £0.05 par value. Authorized 1,756,254 shares; issued and
      outstanding 0 and 1,756,254 shares at March 31, 2010 and September
      30,2009, respectively
                                    
                                    
                                    -
                                    
                                    
                                    
                                    5,113Series
      B Preferred Ordinary Shares, £0.05 par value. Authorized 3,084,113 shares;
      issued and outstanding 0 and 2,358,783 shares at March 31, 2010 and
      September 30,2009, respectively
                                    
                                    
                                    -
                                    
                                    
                                    
                                    6,412Additional
      paid-in-capital
                                    
                                    
                                    16,300
                                    
                                    
                                    
                                    3,748Accumulated
      deficit
                                    
                                    
                                    (30,370
                                    )
                                    
                                    
                                    (25,983
                                    )Accumulated
      other comprehensive loss
                                    
                                    
                                    (260
                                    )
                                    
                                    
                                    (255
                                    )Total
      shareholders’ deficit
                                    
                                    
                                    (6,506
                                    )
                                    
                                    
                                    (10,781
                                    )Total
      liabilities and shareholders’ deficit
                                    
                                    $
                                    3,090
                                    
                                    
                                    $
                                    2,487




See notes
to the condensed consolidated financial statements.


1


Image
Metrics, Inc.


Condensed
Consolidated Statements of Operations


(Amounts
in thousands of US Dollars, except share data)


(unaudited)




Three Months ended
                                        March 31,
                                      
                                      
                                      Six Months ended March
                                        31,2010
                                      
                                      
                                      2009
                                      
                                      
                                      2010
                                      
                                      
                                      2009Revenue
                                      
                                      $
                                      1,575
                                      
                                      
                                      $
                                      167
                                      
                                      
                                      $
                                      3,962
                                      
                                      
                                      $
                                      1,561Cost
      of revenues (exclusive of depreciation shown separately
      below)
                                      
                                      
                                      (825
                                      )
                                      
                                      
                                      (197
                                      )
                                      
                                      
                                      (1,639
                                      )
                                      
                                      
                                      (632
                                      )Gross
      profit
                                      
                                      
                                      750
                                      
                                      
                                      
                                      (30
                                      )
                                      
                                      
                                      2,323
                                      
                                      
                                      
                                      929Operating
      expensesSelling
      and marketing
                                      
                                      
                                      490
                                      
                                      
                                      
                                      948
                                      
                                      
                                      
                                      843
                                      
                                      
                                      
                                      1,532Research
      and development
                                      
                                      
                                      227
                                      
                                      
                                      
                                      348
                                      
                                      
                                      
                                      610
                                      
                                      
                                      
                                      736Depreciation
      and amortization
                                      
                                      
                                      49
                                      
                                      
                                      
                                      69
                                      
                                      
                                      
                                      93
                                      
                                      
                                      
                                      135General
      and administrative
                                      
                                      
                                      1,780
                                      
                                      
                                      
                                      831
                                      
                                      
                                      
                                      3,835
                                      
                                      
                                      
                                      1,815Total
      operating expenses
                                      
                                      
                                      2,546
                                      
                                      
                                      
                                      2,196
                                      
                                      
                                      
                                      5,381
                                      
                                      
                                      
                                      4,218Operating
      loss
                                      
                                      
                                      (1,796
                                      )
                                      
                                      
                                      (2,226
                                      )
                                      
                                      
                                      (3,058
                                      )
                                      
                                      
                                      (3,289
                                      )Interest
      expense
                                      
                                      
                                      (817
                                      )
                                      
                                      
                                      (129
                                      )
                                      
                                      
                                      (897
                                      )
                                      
                                      
                                      (249
                                      )Foreign
      exchange gain(loss)
                                      
                                      
                                      (144
                                      )
                                      
                                      
                                      (166
                                      )
                                      
                                      
                                      (128
                                      )
                                      
                                      
                                      282Total
      other income
                                      
                                      
                                      (961
                                      )
                                      
                                      
                                      (295
                                      )
                                      
                                      
                                      (1,025
                                      )
                                      
                                      
                                      33Loss
      before income taxes
                                      
                                      
                                      (2,757
                                      )
                                      
                                      
                                      (2,521
                                      )
                                      
                                      
                                      (4,083
                                      )
                                      
                                      
                                      (3,256
                                      )Provision
      for income taxes
                                      
                                      
                                      -
                                      
                                      
                                      
                                      -
                                      
                                      
                                      
                                      -
                                      
                                      
                                      
                                      -Net
      loss
                                      
                                      $
                                      (2,757
                                      )
                                      
                                      $
                                      (2,521
                                      )
                                      
                                      $
                                      (4,083
                                      )
                                      
                                      $
                                      (3,256
                                      )Basic
      and diluted net loss per share of common stock
                                      
                                      $
                                      (0.37
                                      )
                                      
                                      $
                                      (0.67
                                      )
                                      
                                      $
                                      (0.73
                                      )
                                      
                                      $
                                      (0.88
                                      )Weighted
      average shares used in computing net loss per share of common
      stock
                                      
                                      
                                      7,367,156
                                      
                                      
                                      
                                      3,748,848
                                      
                                      
                                      
                                      5,587,988
                                      
                                      
                                      
                                      3,748,848




See notes
to the condensed consolidated financial statements.


2




Image
Metrics, Inc.


Condensed
Consolidated Statements of Cash Flows


(Amounts
in thousands of US Dollars, except share data)






2010
                                                                              
                                                                              
                                                                              2009Operating
      activities:Net
      loss
                                                                              
                                                                              $
                                                                              (4,083
                                                                              )
                                                                              
                                                                              $
                                                                              (3,256
                                                                              )Adjustments
      to reconcile net loss to net cash provided by operating
      activities:
                                                                              
                                                                              
                                                                              1,212
                                                                              
                                                                              
                                                                              
                                                                              62Changes
      in assets and liabilities:
                                                                              
                                                                              
                                                                              (1,473
                                                                              )
                                                                              
                                                                              
                                                                              1,582Net
      cash used in operating activities
                                                                              
                                                                              
                                                                              (4,344
                                                                              )
                                                                              
                                                                              
                                                                              (1,612
                                                                              )Net
      cash used for investing activities
                                                                              
                                                                              
                                                                              (116
                                                                              )
                                                                              
                                                                              
                                                                              (87
                                                                              )Net
      cash provided by financing activities
                                                                              
                                                                              
                                                                              4,965
                                                                              
                                                                              
                                                                              
                                                                              2,090Effects
      of exchange rates on cash and cash equivalents
                                                                              
                                                                              
                                                                              (33
                                                                              )
                                                                              
                                                                              
                                                                              (38
                                                                              )Net
      increase in cash and cash equivalents
                                                                              
                                                                              
                                                                              472
                                                                              
                                                                              
                                                                              
                                                                              353Cash
      and cash equivalents, beginning of period
                                                                              
                                                                              
                                                                              803
                                                                              
                                                                              
                                                                              
                                                                              108Cash
      and cash equivalents, end of period
                                                                              
                                                                              $
                                                                              1,275
                                                                              
                                                                              
                                                                              $
                                                                              461Supplemental
      disclosure of chas flow information:Cash
      paid during the period:Interest
                                                                              
                                                                              $
                                                                              102
                                                                              
                                                                              
                                                                              $
                                                                              57Income
      taxes
                                                                              
                                                                              
                                                                              -
                                                                              
                                                                              
                                                                              
                                                                              -Non-cash
      financing activities:Conversion
      of notes payable to Series H
    Preferred Shares
                                                                              
                                                                              $
                                                                              5,410
                                                                              
                                                                              
                                                                              $
                                                                              4,859Issuance
      of warrants in connection with convertible notes
      payable
                                                                              
                                                                              $
                                                                              50
                                                                              
                                                                              
                                                                              $
                                                                              -Beneficial
      conversion feature in connection with convertible notes
      payable
                                                                              
                                                                              $
                                                                              550
                                                                              
                                                                              
                                                                              $
                                                                              -




See notes
to condensed consolidated financial statements.




3


Image
Metrics, Inc.


Notes
to Condensed Consolidated Financial Statements


(unaudited)








1.
              Description
      of Business and Summary of Significant Accounting
  Policies
 
 Nature
of Business
 Image
Metrics Inc. is a leading global provider of technology-based facial animation
services to the interactive entertainment and film industries.  Any
references to the “Company” or “Image Metrics” are to Image Metrics Inc. and its
consolidated subsidiaries.
 
 Basis
of Presentation
 The
Company’s consolidated financial statements have been prepared in accordance
with accounting principles generally accepted in the United States of America on
a going concern basis, which presumes that the Company will be able to realize
its assets and discharge its liabilities in the normal course of business for
the foreseeable future.
 
 The
Company has incurred significant operating losses and has accumulated a
$30,370,000 deficit as of March 31, 2010. The Company's ability to continue as a
going concern is dependent upon it being able to successfully raise further
capital through equity or debt financing and
continued improvement of our results of operations.
  These
conditions indicate a material uncertainty that casts significant doubt about
the Company’s ability to continue as a going concern.   The
Company believes it will secure the necessary debt or equity financing to
continue operations and meet its obligations.  Thus, we have continued
to adopt the going concern basis of accounting in preparing the financial
statements.
 
 These
consolidated financial statements do not include any adjustments to the amounts
and classifications of assets and liabilities that might be necessary should the
Company be unable to continue as a going concern.
   Unaudited
Interim Financial Information
 The
accompanying Consolidated Balance Sheets as of March 31, 2010 and 2009, the
Consolidated Statements of Operations for the three and six months ended March
31, 2010 and 2009, and the Condensed Consolidated Statements of Cash Flows for
the six months ended March 31, 2010 and 2009 are unaudited. These unaudited
interim Consolidated Financial Statements have been prepared in accordance with
accounting principles generally accepted in the United States of America (GAAP).
In our opinion, the unaudited interim Consolidated Financial Statements include
all adjustments of a normal recurring nature necessary for the fair presentation
of our financial position as of March 31, 2010, our results of operations for
the three and six months ended March 31, 2010 and 2009, and our cash flows for
the six months ended March 31, 2010 and 2009. The results of operations for the
three and six months ended March 31, 2010 are not necessarily indicative of the
results to be expected for the year ending September 30, 2010.
  These
unaudited interim Consolidated Financial Statements should be read in
conjunction with the Consolidated Financial Statements and related notes filed
as an Exhibit to our Form 8-K/A filed on April 14, 2010.


4


Image
Metrics, Inc.


Notes
to Condensed Consolidated Financial Statements


(unaudited)





Principles
of Consolidation


The
consolidated financial statements include the accounts of the Company and its
wholly-owned subsidiary.  Intercompany accounts and transactions have
been eliminated in consolidation.




Reverse
Merger
 On March
10, 2010, we acquired through an exchange offer all of the outstanding ordinary
shares and preferred shares of Image Metrics Limited, a private company
incorporated in England and Wales (“Image Metrics LTD”), in exchange for
11,851,637 shares of our common stock, par value $.001 per share. In the merger,
we exchanged 11,851,637 shares of our common stock, par value $.001 per share in
exchange for all of the outstanding share capital of Image Metrics LTD comprised
of  2,125,197 shares of ordinary stock, 300,607 A ordinary stock,
1,567,178 preferred ordinary stock and 2,725,633 series B preferred ordinary
stock.  As a result, Image Metrics LTD is now our wholly-owned
subsidiary. The transaction is referred to in this quarterly report on Form 10-Q
as the exchange transaction.
 As a
result of the exchange transaction, former Image Metrics LTD shareholders hold a
majority of the voting interest in the Company. In accordance with FASB ASC
805-40 “Reverse Acquisitions,” the exchange transaction was accounted for as a
reverse acquisition; therefore, Image Metrics LTD was the accounting acquirer.
The pre-acquisition financial statements of the accounting acquirer, Image
Metrics LTD, will become the historical financial statements of the combined
companies. The consolidated financial statements of the Company do not include
the operations of International Cellular Accessories (“ICLA”) prior to March 10,
2010 but only reflect the operations of Image Metrics LTD and its subsidiaries.
Pre-exchange transaction equity of Image Metrics LTD is restated for the
equivalent number of shares of the Company received by Image Metrics LTD
shareholders in the exchange transaction, with differences between the par value
of the Company and Image Metrics LTD’s stock recorded as additional paid in
capital. Upon the exchange transaction, the Company adjusted the capitalization
to reflect the legally issued and outstanding shares of the combined
companies.


Concentration
of Credit Risk
 The
Company’s largest single customer accounted for 62% and 0% of total consolidated
revenues for the three months ended March 31, 2010 and 2009,
respectively.  The Company’s relationship with the customer is
governed by a contract between the two parties which identifies games and game
characters upon which the company will work, prices for the services to be
rendered, and specified payments to be made by the customer to the Company. As
of March 31, 2010 and September 30, 2009, the Company did not have any
outstanding accounts receivable from this customer.
 
 Revenue
Recognition
 The
Company derives its revenues from the sale of consulting services, model
building, character rigging and animation services. The majority of services are
sold in multiple-element arrangements.  The Company recognizes revenue
pursuant to the requirements of the Financial Accounting Standards Board
Accounting Standards Codification (“ASC”) 605, as amended by Accounting
Standards Update (“ASU”) 2009-13, “Revenue Recognition - Multiple-Deliverable
Revenue Arrangements”, when persuasive evidence of an arrangement exists,
delivery has occurred, the fee is fixed or determinable, and collectability is
probable. A majority of the Company’s animation revenue is recognized in this
manner. Revenue is presented net of sales, use and value-added taxes collected
on behalf of the Company’s customers.
  For sales
that involve the delivery of multiple elements, the Company allocates revenue to
each undelivered element based on the element’s fair value as determined by
vendor-specific objective evidence (“VSOE”), which is the price charged when
that element is sold separately, or third party evidence
(“TPE”).  When VSOE and TPE are unavailable, fair value is based on
management’s best estimate of selling price.  When management’s
estimate is used to determine fair value, management makes its estimates using
reasonable and objective evidence to determine the price.  For
elements not yet sold separately, the fair value is equal to the price
established by the Company’s management if it is probable that the price will
not change before the element is sold separately. The Company reviews its VSOE
and third party evidence at least annually. As the Company has concluded it is
unable to establish fair values for one or more undelivered elements within a
multiple-element arrangement using VSOE, the Company uses TPE or, the Company’s
best estimate of the selling price for that unit of accounting, being the price
at which the vendor would transact if the unit of accounting were sold by the
vendor regularly on a standalone basis.
  Subsequent
Events
 In
May 2009, the FASB issued ASC 855, “Subsequent Events”, which establishes
the general standards of accounting for and disclosures required for events
occurring after the balance sheet date but before financial statements are
issued or are available to be issued.  Under ASC 855 the effects of all
subsequent events that provide additional evidence about conditions that existed
at the date of the balance sheet, including the estimates inherent in the
process of preparing financial statements, are required to be recognized in the
financial statements.  Subsequent events that provide evidence about
conditions that did not exist at the date of the balance sheet but arose after
the balance sheet date but before financial statements are issued or are
available to be issued should not be recognized in the financial statements but
may need to be disclosed to prevent the financial statements from being
misleading.  In accordance with this standard, we evaluated subsequent
events through the filing date of the form 10-Q.


Use
of Estimates


The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the amounts reported and disclosed in the financial
statements and accompanying notes. Actual results could differ from those
estimates.  On an ongoing basis, the Company evaluates its estimates,
including those related to revenue recognition, valuation of deferred tax assets
and tax contingency reserves and fair value of the Company’s options and
warrants to purchase common stock. Changes in estimates resulting from
continuing changes in the economic environment will be reflected in the
financial statements in future periods.




Impact
of Recently Issued Accounting Standards


There
were no accounting pronouncements adopted by the Company or issued during the
three months ended March 31, 2010 that had a material effect on the
unaudited condensed consolidated financial statements or that are reasonably
certain to have a material impact on the unaudited condensed consolidated
financial statements in future periods.


5


Image
Metrics, Inc.


Notes
to Condensed Consolidated Financial Statements


(unaudited)





2.
            Cost
      Method Investments




As of
March 31, 2010, the Company maintained a $729,000 long-term investment in its
previously wholly-owned subsidiary, Optasia Medical, Ltd.
(“Optasia”).  In October 2006, the Company sold the subsidiary to a
group of investors which was led by the Company’s largest investor, Saffron Hill
Ventures.  Upon the sale of Optasia, the Company retained 34%
ownership in Optasia.  The Company does not have the ability to exert
“significant influence” as defined by ASC 323 “Investments- Equity methods and
Joint Ventures” and accounts for the investment on the cost
method.   The investment is reviewed periodically for indicators
of impairment and, if indentified as having such indicator(s), would be subject
to further analysis to determine if the investment is other-than-temporarily
impaired. No impairment was made to the carrying value of this investment during
the three months ended March 31, 2010.




3.
            Fair
      Value Measurements




ASC
820 defines fair value as the exchange price that would be received for an asset
or paid to transfer a liability (an exit price) in the principal or most
advantageous market for the asset or liability in an orderly transaction between
market participants on the measurement date.  ASC 820 also establishes
a fair value hierarchy, which requires an entity to maximize the use of
observable inputs and minimize the use of unobservable inputs when measuring
fair value. ASC 820 describes three levels of inputs that may be used to measure
fair value:
 
 Level 1Quoted prices are
available in active markets for identical assets or liabilities as of the
reporting date. Active markets are those in which transactions for the asset or
liability occur in sufficient frequency and volume to provide pricing
information on an ongoing basis. Level 1 primarily consists of financial
instruments such as exchange-traded derivatives, listed equities and U.S.
government treasury securities.
 
 Level 2Pricing inputs are
other than quoted prices in active markets included in Level 1, which are either
directly or indirectly observable as of the reporting date. Level 2 includes
those financial instruments that are valued using models or other valuation
methodologies.  These models are primarily industry-standard models
that consider various assumptions, including quoted forward prices for
commodities, time value, volatility factors and current market and contractual
prices for the underlying instruments, as well as other relevant economic
measures.  Substantially all of these assumptions are observable in
the marketplace throughout the full term of the instrument, can be derived from
observable data or are supported by observable levels at which transactions are
executed in the
 marketplace.
Instruments in this category include non-exchange-traded derivatives such as
over-the-counter forwards, options and repurchase agreements.
 
 Level 3Pricing inputs include
significant inputs that are generally less observable from objective sources.
These inputs may be used with internally developed methodologies that result in
management's best estimate of fair value from the perspective of a market
participant. Level 3 instruments include those that may be more structured or
otherwise tailored to customers' needs. At each balance sheet date, the Company
performs an analysis of all instruments subject to ASC 820 and includes in Level
3 all of those whose fair value is based on significant unobservable
input.
 
 Financial
instrument's level within the fair value hierarchy is based on the lowest level
of any input that is significant to the fair value measurement.
 
 Assets and liabilities
measured at fair value on a recurring basis include the following at March 31,
2010 and September 30, 2009 (in thousands):
  Fair value Measurements
      UsingLevel 1
                      
                      
                      Level 2
                      
                      
                      Level 3
                      
                      
                      TotalMarch
      31, 2010Derivative
      liability - warrants
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      593
                      
                      
                      $
                      593September
      30, 2009Derivative
      liability - warrants
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      -
 
 The
derivative liability - warrants, which is included within other current
liabilities, represents the fair value of the warrants
outstanding.  The warrants contain anti-dilution provisions that in
certain circumstances cause a downward adjustment in the exercise price if the
Company issues shares of its common stock at a price below the conversion price
then in effect.
 
 There
is no current observable market for this type of derivative and, as such, we
determined the value of the embedded derivative using the Black-Scholes model,
which takes into consideration the fair market value of the Company’s stock, the
warrant strike price, the life of the warrant, the volatility of our common
stock, and the risk-free interest rate.
  6
  Image
Metrics, Inc.
 Notes
to Condensed Consolidated Financial Statements
 (unaudited)
  The
valuation methodologies used by the Company as described above may produce a
fair value calculation that may not be indicative of net realizable value or
reflective of future fair values. Furthermore, although management believes its
valuation methods are appropriate and consistent with other market participants,
the use of different methodologies or assumptions to determine the fair value of
certain financial instruments could result in a different fair value measurement
at the reporting date.
 
 The
following table presents a reconciliation for our assets measured and recorded
at fair value on a recurring basis, using significant unobservable inputs (Level
3) for the three months and six months ended March 31, 2009 (in
millions):
  Level
      3Balance
      at September 30, 2008
                      
                      $
                      -Issuance
      of warrants with embedded derivativesTotal
      gains or losses (realized/unrealized):
                      
                      
                      -Included
      in earnings (or changes in net assets)
                      
                      
                      -Included
      in other comprehensive income
                      
                      
                      -Transfers
      in to Level 3
                      
                      
                      -Balance
      at March 31, 2009
                      
                      $
                      -
 
 
 The
following table presents a reconciliation for our assets measured and recorded
at fair value on a recurring basis, using significant unobservable inputs (Level
3) for the three months and six months ended March 31, 2010 (in
millions):
 
 Level
      3Balance
      at September 30, 2009
                      
                      $
                      -Issuance
      of warrants with embedded derivatives
                      
                      
                      593Total
      gains or losses (realized/unrealized):
                      
                      
                      -Included
      in earnings (or changes in net assets)
                      
                      
                      -Included
      in other comprehensive income
                      
                      
                      -Transfers
      in to Level 3
                      
                      
                      -Balance
      at March 31, 2010
                      
                      $
                      593
 For
assets and liabilities recorded at other than fair value, the carrying value of
cash and cash equivalents, accounts receivable, accounts payable, other current
liabilities and short-term debt approximate their fair value because of the
short-term maturity of these instruments.  The fair-value of long-term
debt is estimated using a discounted cash flow method based on the Company’s
current borrowing rates for similar types of financing without a quoted market
price.  No fair value has been included for cost method investments,
as the Company is unable to determine a reliable and practicable valuation to
adequately value the development stage investee because it has uncertainties
about its ultimate growth potential and viability.  There are no
identified events or changes in circumstances during the period that had an
adverse effect on the fair value of the investment. No impairment analysis was
performed during the quarter.  The fair value and carrying value,
before applying discounts, of the Company’s notes payable are summarized as
follows (in thousands), see note 4 for further details on the Company’s
debt:




March31,2010
                  
                  
                  September30,2009Carrying
                    value
                  
                  
                  Fair
                    Value
                  
                  
                  Carrying
                    value
                  
                  
                  Fair
                    valueLiabilitiesCurrent
      portion of notes payable
                  
                  $
                  578
                  
                  
                  $
                  567
                  
                  
                  $
                  956
                  
                  
                  $
                  948Noncurrent
      portion of notes payable
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  2,191
                  
                  
                  
                  1,846$
                  578
                  
                  
                  $
                  567
                  
                  
                  $
                  3,147
                  
                  
                  $
                  2,794




7


Image
Metrics, Inc.


Notes
to Condensed Consolidated Financial Statements


(unaudited)




4.
            Notes
      Payable




ICLA
Notes
 Between
May 10, 2006 and February 22, 2010, the Company issued an aggregate of $196,000
of convertible notes. The convertible notes accrue interest at 5% per annum,
compounded annually.  As a result of the share exchange offer that
completed on March 10, 2010 between ICLA and Image Metrics LTD, ICLA’s ownership
changed by more than 50% causing the notes to go in default.
  Saffron
Hill Ventures II 2009 Loan
 On April
27, 2009, Image Metrics LTD signed a loan agreement with its largest investor,
Saffron Hill Ventures (“SHV”) in the amount of $1,200,000. The loan bore
interest at 6.0% plus the Bank of England base rate, the effective interest rate
as of March 10, 2010 was 6.5%.  The loan’s principal and all accrued
interest were converted into equity as part of the Company’s private offering
that closed on March 10, 2010.  (See note 5 for further
discussion.)
  Private
Individual Loan
 On March
13, 2009, Image Metrics LTD signed a loan agreement with a private individual.
The loan facility is for a maximum of $500,000 and bore interest at 5.0% plus
LIBOR (London Interbank Offered Rate), the effective interest rate as of March
10, 2010 was 5.23%. All principal and accrued interest were converted into
equity as part of the Company’s private offering that closed on March 10,
2010.  (See note 5 for further discussion.)
  Saffron
Hill Ventures Loans
 Between
July 2005 and April 2008, Image Metrics LTD signed three loan agreements with
Saffron Hill Ventures Limited Partnership (“SHVLP”). The loan facilities
available amounts were £450,000, £1,000,000 and £1,500,000 with the proceeds to
be used for general working capital.  The £450,000 loan bore interest
at LIBOR plus 2%, and the other loans bore interest at LIBOR plus
8%.  As of September 30, 2008, the total amount outstanding including
accrued interest was $4,324,000.
 
 The loan
for £450,000 had beneficial contingent conversion rights, whereby the loan could
be converted into equity of Image Metrics LTD.  The contingency was
based upon the Company completing a successful equity offering which raises at
least £100,000.  The conversion price would have been equal to 80% of
the share price in the offering.  Upon receiving proceeds from the
loan, the Company recorded a discount on the note equal to the intrinsic value
of the beneficial conversion rights in the amount of $222,000. In accordance
with ASC 470-20 “Debt with Conversion and Other Options”, the Company did not
recognize this discount into earnings as the contingency had not been
removed.
  On
October 27, 2008, Image Metrics LTD converted the loans from SHVLP into series B
preferred ordinary shares of Image Metrics LTD’s stock, which were converted to
ordinary shares and then exchanged for common stock as part of the exchange
transaction.  (See notes 1 and 5 for further discussion.)
 8


Image
Metrics, Inc.


Notes
to Condensed Consolidated Financial Statements


(unaudited)




ETV
Capital 2008 Loan




On March
3, 2008, Image Metrics LTD signed a loan agreement with ETV Capital, Inc.
(“ETV”). The loan facility was for a maximum of $1,000,000 with the proceeds to
be used for general working capital.  The loan is to be paid in equal
instalments commencing July 2008 and continuing through December 31, 2010 at a
fixed interest rate of 11.43%.  The loans are secured by a first
priority security interest in all assets of Image Metrics LTD.
  As
part of the loan agreement, ETV received warrants to purchase shares of stock of
Image Metrics LTD.  The warrants would have allowed ETV to purchase up
to $140,000 of Image Metrics LTD’s shares at an exercise price equal to the
lower of £1.19 or the price offered to investors in the next equity offering
made by Image Metrics LTD. These warrants were exchanged on March 10, 2010 for
new warrants to purchase shares of common stock in the Company.  (See
note 5 for further discussion.)
  Upon
receipt of the loan proceeds, the Company allocated the proceeds based on the
fair values of the warrants and the debt.  The fair value assigned to
the warrants was equal to $102,000 and was recorded as a discount to the
loan.  The discount is being amortized over the term of the
loan.  As of March 31, 2010, the unamortized balance of the discount
was $5,000 and $18,000 as of September 30, 2009.  The Company
recognized $5,000 and $13,000 of interest expense for the three months ended
March 31, 2010 and 2009, respectively, from the amortization of this discount.
The Company recognized $6,000 and $13,000 of interest expense for three months
ended March 31, 2010 and 2009, respectively, for the contractual interest
obligation on the note.  The Company recognized $13,000 and $28,000 of
interest expense for the six months ended March 31, 2010 and 2009, respectively,
from the amortization of this discount. The Company recognized $14,000 and
$29,000 of interest expense for six months ended March 31, 2010 and 2009,
respectively, for the contractual interest obligation on the
note.
  ETV,
also, received options to purchase up to $200,000 of shares of equity of Image
Metrics LTD.  These options had an initial exercise price of $1.72 but
were subject to be reduced based on future equity offerings.  As of
March 31, 2010, the unamortized balance of the discount was
$85,000.  The Company recognized an expense of $27,000 and $54,000 in
the three and six months ended March 31, 2010 associated with these
options.  These options were exchanged on March 10, 2010 for new
warrants to purchase shares of Common Stock in the Company.  (See note
5 for further discussion.)
  Royal
Bank of Scotland Loan
  In
January 2002, Image Metrics LTD obtained a bank loan for £250,000. The loan bore
interest at 2.5% per annum.  The loan was guaranteed under the Small
Firms Loans Guarantee Scheme in the United Kingdom. The loan was paid off in
February 2010.
  5.
              Shareholders’
      Equity
   Classes
of Shares
 The
Company’s Board of Directors has authorized two classes of shares, common stock
and preferred stock.  The rights of the holders of the two classes of
shares are identical, except preferred stock receives priority if the Company
was to have a liquidation or reduction of capital, and preferred stock
shareholders are not entitled to receive dividends. The only currently
designated preferred stock is the Series A Convertible Preferred
Stock.   Series A Convertible Preferred Stock may be converted at
any time at the option of the stockholder and automatically convert upon sale or
transfer of common stock at a ratio of 1:1.


9


Image
Metrics, Inc.


Notes
to Condensed Consolidated Financial Statements


(unaudited)





Saffron
Hill Venture Loans Conversion


On
October 27, 2008, Image Metrics LTD converted the Saffron Hill Venture Loans
into Series B Preferred Ordinary shares of its stock, which were converted to
ordinary shares and then exchanged for common stock as part of the exchange
transaction, see note 1 for further discussion. The outstanding principal and
accrued interest on this date was £2,902,000 and was converted into 1,759,390
Series B Preferred stock at a conversion price of £1.65 per
share.  The exchange did not result in a gain or loss.  (See
note 4 for further discussion.)


December
2008 Private Equity Offering
 In
December 2008, Image Metrics LTD completed a private equity fund raising round
by selling 599,393 shares of its Series B Preferred Ordinary shares at £1.65 per
share for a total raise of £989,000.  The round was fully subscribed
by two of Image Metrics LTD’s existing investors, one of which was a member of
Image Metrics LTD’s Board of Directors.  The Series B Preferred
Ordinary shares were converted to ordinary shares and then exchanged for common
stock as part of the exchange transaction. (See note 1 for further
discussion.)
 
 March
2010 Private Equity Offering
  On March
10, 2010, the Company closed the first round of a private equity
offering.  The Company sold 8,394,098 units, each consisting of one
share of the Company’s Series A Convertible Preferred Stock and a detachable,
transferable warrant to purchase common stock at an exercise price of $1.50, for
$8.00 million gross proceeds.  The $8.00 million included the
conversion of $5.41 million of its notes payable. The proceeds from the first
close were reduced by $0.46 million for transaction costs, which primarily
consist of legal fees and broker commissions and $0.47 million for debt
repayments, yielding net proceeds of $1.66 million.  Each share of
Series A Convertible Preferred Stock is initially convertible into one share of
common stock at any time.  Each warrant entitles the holder to purchase
one-half share of common stock at an exercise price of $1.50 per share through
March 26, 2014, subject to redemption provisions based on the trading price and
trading volume of our common stock.  Each warrants issued to SHV
entitle the holder to purchase one share of common stock at an exercise price of
$1.50 per share through March 26, 2014, subject to redemption provisions based
on the trading price and trading volume of our common stock.  The
value assigned to the warrants and the Series A Convertible Preferred Stock was
based on an enterprise valuation performed by the Company.
  Simultaneously
with the close of the private equity offering, Image Metrics LTD exchanged all
of its outstanding equity for 11,851,637 shares of the Company.  As a
result, Image Metrics LTD became a wholly-owned subsidiary of the
Company.
  In
connection with the exchange transaction, Saffron Hill Ventures and other
potential investors provided Image Metrics LTD with bridge
financing.  The bridge financing provided working capital while Image
Metrics LTD worked to complete the private equity offering.  On
January 10, 2010, Image Metrics LTD established a credit instrument up to
$2,000,000 10% Unsecured Convertible Notes.


10


Image
Metrics, Inc.


Notes
to Condensed Consolidated Financial Statements


(unaudited)




The
interest paid on the 10% Unsecured Convertible Notes was 4% of the total
principal of $2.0 million.  The note holders also received warrants to
purchase 663,000 shares of common stock of the Company.  210,600
warrants of the total issued warrants were issued to Saffron Hill
Ventures.  Each warrant provides the holder the right to purchase one
share of the Company’s common stock at $1.50.   The Company
assigned a value of $0.08 to the warrants, based on an enterprise valuation
performed by the Company, and recorded an interest expense of $0.05 million
during the three and six months ended March 31, 2010 associated with these
warrants.
  $1.6
million of the 10% Unsecured Convertible Notes were converted into equity as
part of the Company’s private equity offering that closed on March 10,
2010.  The remaining $0.4 million of the notes were repaid with the
proceeds from the private offering.
  On March
26, 2010, the Company closed the second round of its private equity
offering.  The Company sold 925,000 units, each consisting of one
share of the Company’s Series A Convertible Preferred Stock and a detachable,
transferable warrant to purchase common stock, for $0.93 million gross
proceeds.  The proceeds from the second close were reduced by $0.07
million for broker commission and expenses yielding net proceeds of $0.86
million.  Each share of Series A Convertible Preferred Stock is
initially convertible into one share of common stock at any time.  Each
warrant entitles the holder to purchase one-half share of common stock at an
exercise price of $1.50 per share through March 26, 2014, subject to redemption
provisions based on the trading price and trading volume of our common
stock.
  As part
of the March 2010 private equity offering, the Company is committed to meeting
certain SEC registration requirements, among them is to file a S-1 by June 9,
2010.  If the Company fails to meet any of these obligations, the Company
could be required to pay damages of $178,000 (2% of the aggregate offering
price) per month up to 12% until the breach is corrected.  These damages
can be waived if the Company's Board of Directors determine the Company's
management has exerted it best efforts to meet the requirements.
 ETV
Equity Rights
 As part
of the loan agreements with ETV, the Company granted ETV rights to purchase
shares of equity of Image Metrics LTD.  On March 10, 2010, ETV
exchanged these warrants and options to purchase equity shares of Image Metrics
LTD for warrants to purchase up to 224,583 preferred shares of the Company at an
exercise price of $1.50.  As of March 31, 2010, all the warrants were
outstanding. The Company compared the value of the ETV options and warrants
prior to exchange and subsequent to the change and concluded the value did not
increase; therefore, the Company did not record any additional interest expense
for this exchange.  The remaining discount associated with these
warrants will continue to amortize over the remaining period of the loan. (See
note 4 for additional discussion.)




6.
            Comprehensive
      Loss


The below
table reconciles the Company’s net loss with its comprehensive loss, (in
thousands):




Three Months Ended
                                March 31,
                              
                              
                              Six Months Ended
                                March 31,2010
                              
                              
                              2009
                              
                              
                              2010
                              
                              
                              2009Net
      loss
                              
                              $
                              (2,757
                              )
                              
                              $
                              (2,521
                              )
                              
                              $
                              (4,083
                              )
                              
                              $
                              (3,256
                              )Foreign
      currency translation adjustments
                              
                              
                              (4
                              )
                              
                              
                              32
                              
                              
                              
                              (5
                              )
                              
                              
                              (2
                              )Comprehensive
      loss
                              
                              $
                              (2,761
                              )
                              
                              $
                              (2,489
                              )
                              
                              $
                              (4,088
                              )
                              
                              $
                              (3,258
                              )






11


Image
Metrics, Inc.


Notes
to Condensed Consolidated Financial Statements


(unaudited)




7.
            Net
      Loss per Common Stock


Basic net
loss per common stock excludes dilution for potentially dilutive securities and
is computed by dividing loss applicable to common stock shareholders by the
weighted average number of common shares outstanding during the period. Diluted
net loss per common stock reflects the potential dilution that could occur if
securities or other contracts to issue common stock were exercised or converted
into common stock. Potentially dilutive securities are excluded from the
computation of diluted net loss per share for all of the periods presented in
the accompanying statements of operations because the reported net loss in each
of these periods results in their inclusion being antidilutive. Common stock
equivalent shares consist of the shares issuable upon conversion of Series A
Convertible Preferred Stock and the exercise of stock options and warrants using
the treasury stock method. For the three and six months ended March 31,
2010, shares of potential common stock of approximately 22,052,150
million  were not included in the diluted calculation because the
effect would be anti-dilutive. For the three and six months ended March 31,
2009, shares of potential common stock of approximately 8,331,593 million
were not included in the diluted calculation because the effect would be
anti-dilutive.


8.
            Commitments
      and Contingencies




Operating
Leases


The
Company has entered into non-cancellable operating leases for office
space.  Rent expense for operating leases was $147,000 and $315,000
for the three and six months ended March 31, 2010, respectively, and $124,000
and $272,000 for the three and six months ended March 31, 2009, respectively.
The Company is committed under operating leases with terminations through 2013
and has the option to renew for five years. The Company received one year of
free rent under its UK office’s operating lease, upon inception of the
lease.  This rent free period is spread over the minimum lease period. All
leases under the company are expensed on a straight-line basis. The total future
minimum lease rentals are scheduled to be paid as follows (in
thousands):





Fiscal
      year ending2010
      (Apr to Sep 2010)
                      
                      $
                      3382011
                      
                      
                      6872012
                      
                      
                      7122013
                      
                      
                      324Thereafter
                      
                      
                      -Total
      future minimum lease payments
                      
                      $
                      2,061




Letter
of Credit




In
connection with one of its office space leases, the Company has fulfilled its
security deposit requirement with an irrevocable standby letter of
credit.  At March 31, 2010 and 2009 the value of the letter of credit
was $100,000.  Under the terms of the lease, the security deposit
requirement is reduced by $20,000 on the anniversary date of each lease year
through the lease end date.  There is an annual fee of 0.25% payable
on the available balance of the letter of credit.  The letter of
credit expires on March 31, 2011. The letter of credit was undrawn at March 31,
2010 and 2009.




12


Image
Metrics, Inc.


Notes
to Condensed Consolidated Financial Statements


(unaudited)




Under the
terms of this arrangement, the Company is required to maintain on deposit with
the bank a compensating balance in the form of a certificate of deposit equal to
the amount of the standby letter of credit.  At March 31, 2010 and
September 30, 2009 the certificate of deposit is included in restricted
cash.




9.
              Business
      Segment Information


The
Company primarily operates in two geographic business segments: the North
American region, which includes the United States and Canada, and Europe.
Revenue is assigned based on the region where the services are performed.
Expenses incurred are assigned to each respective region based on which region
incurred the expense. The following table summarizes revenue recognized by
region (in thousands):




Three Months Ended
                    March31,
                  
                  
                  Six Months Ended
                    March31,2010
                  
                  
                  2009
                  
                  
                  2010
                  
                  
                  2009Europe
                  
                  $
                  1,211
                  
                  
                  $
                  134
                  
                  
                  $
                  3,457
                  
                  
                  $
                  1,476North
      America
                  
                  
                  364
                  
                  
                  
                  33
                  
                  
                  
                  505
                  
                  
                  
                  85Total
      revenue
                  
                  $
                  1,575
                  
                  
                  $
                  167
                  
                  
                  $
                  3,962
                  
                  
                  $
                  1,561




The
following table summarizes net loss by region (in thousands):




Three Months Ended
                              March 31,
                            
                            
                            Six Months Ended
                              March 31,2010
                            
                            
                            2009
                            
                            
                            2010
                            
                            
                            2009Europe
                            
                            $
                            (146
                            )
                            
                            $
                            (682
                            )
                            
                            $
                            455
                            
                            
                            $
                            86North
      America
                            
                            
                            (2,611
                            )
                            
                            
                            (1,839
                            )
                            
                            
                            (4,538
                            )
                            
                            
                            (3,342
                            )Total
      net loss
                            
                            $
                            (2,757
                            )
                            
                            $
                            (2,521
                            )
                            
                            $
                            (4,083
                            )
                            
                            $
                            (3,256
                            )




10.
              Related
      Party Transactions
 During
the three and six months ended March 31, 2010 and 2009, the Company entered into
transactions, in the ordinary course of business, with Optasia Medical Ltd. The
value of services provided by Optasia was $6,000 and $13,000 during the three
and six months ended March 31, 2010, respectively, and $6,000 and $13,000 during
the three and six months ended March 31, 2009, respectively.  The
amount due to Optasia as of March 31, 2010 was $8,000.


During
the three and six months ended March 31, 2010, the Company incurred interest
expense of $50,000 and $107,000, respectively, related to notes payable to SHV,
its principal investor.  During the three and six months ended March
31, 2009, the Company did not incur any interest expense, related to notes
payable to SHV, its principal investor.  The Company did not have any
accrued interest payable to SHV as of March 31, 2010 and had accrued interest of
$27,000 payable to SHV as of September 30, 2009.


13


Image
Metrics, Inc.


Notes
to Condensed Consolidated Financial Statements


(unaudited)




In
October 2008, Image Metrics LTD converted its Saffron Hill Ventures Loans into
Series B Preferred Ordinary shares, which were converted to ordinary shares and
then exchanged for common stock as part of the exchange transaction. (See notes
1, 4 and 5 for further discussion.)
  In
December 2008, Image Metrics LTD sold an aggregate of 599,393 shares of its
Series B Preferred Ordinary shares at £1.65 per share for a total of £989,000 to
two of the its  existing investors, one of which an affiliate of one
is also a member of the Company’s Board of Directors.  These shares
were converted to ordinary shares and then exchanged for common stock as part of
the exchange transaction.  (See note 1 for further
discussion.)
  During
the three months ended March 31, 2010, the Company received loan proceeds in the
amount of $350,000 from its principal investor, SHV.
  In
connection with the March 10, 2010 private equity offering, SHV converted all of
its outstanding notes payables into Series A Convertible Preferred Stock and
purchased an additional $500,000 of Series A Convertible Preferred Stock and
warrants.  (See notes 4 and 5 for further discussion.)
 11.
Subsequent Events
 In
April 2010, SHV provided Image Metrics with a $400,000 cash
advance.  The terms of the $400,000 have not yet been
defined.




14




ITEM
2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS


Forward Looking Statements
 
 In addition to historical information, this
Quarterly Report on Form 10-Q contains forward-looking statementsthat involve risks and
uncertainties, many of which are beyond our control. Our actual results could
differ materially and adversely from those anticipated in such
forward-looking statements as
a result of certain factors, including those set forth in this report. Important
factors that may cause actual results to differ from these forward-looking
statements include, but are not limited to,for
example:
 
 ·
              our inability to raise sufficient additional
      capital to operate our business;
 
 ·
              adverse economic conditions;
 
 ·
              unexpected costs, lower than expected sales and
      revenues, and operating deficits,
 
 ·
              the ability of our products and services to
      achieve market acceptance;
 
 ·
              our reliance on four customers for a significant
      percentage of our revenue;
 
 ·
              the volatility of our operating results and
      financial condition;
 
 ·
              our ability to develop and maintain relationships
      with entertainment
companies;
 
 ·
              our ability to protect our intellectual
      property;
 
 ·
              our ability to attract or retain qualified senior
      management personnel, including software and computer graphics engineers,
      and
 
 ·
              the factors set forth under the caption “Risk
      Factors” in Item 1A and other factors discussed from time to time in our
      news releases, public statements and/or filingswith the Securities and Exchange Commission
      (the
  “SEC”).
 
 All
statements, other than statements of historical facts, included in this report
regarding our strategy, future operations, financial position, estimated revenue
or losses, projected costs, prospects and plans and objectives of management
areforward-looking
statements.When
used in this report, the words “will,” “may,”“believe,”
“anticipate,”
“intend,” “estimate,” “expect,” “project,” “plan” and similar expressions are
intended to identify forward-looking statements, although not all
forward-looking statements contain such identifying words. All forward-looking
statements speak only as of the date of this report. We undertake no obligation
to update any forward-looking statements or other information contained herein.
Although we believe that our plans, intentions and expectations reflected in or
suggested by the forward-looking statements in this report are reasonable, we
cannot assure stockholders and potential investors that these plans, intentions
or expectations will be achieved. We disclose important factors that could cause
our actual results to differ materially from expectations under Part
II,
Item 1A entitled “Risk Factors”.
These cautionary statements qualify all forward-looking statements attributable
to us or persons acting on our behalf.




Introduction
 
 The
following discussion should be read in conjunction with the information included
within our Audited Financial Statments for the years ended on September 30, 2009
and 2008 included as an exhibit in our Form 8-K/A filed with SEC on April 14,
2010, and the Condensed Consolidated Financial Statements and notes thereto
included in Part I Item ! of this Quarterly Report on Form 10-Q.
 
 Description of Our Company and
Predecessor
 
 We were incorporated in the State of Nevada on October
6, 2004.  We were formed to import and distribute a range of cellular
accessories to wholesalers and retailers throughout Canada and the United
States.  In March 2005, we filed a registration statement with the
SEC, which became effective in May 2005, and we became a publicly-reporting and
trading company.  Our cellular accessories business was discontinued
in 2006 and we have been inactive since such time, though we continued to timely
file our periodic reports with the SEC.
 
 On March 10, 2010, we acquired through an exchange offer
all of the outstanding ordinary shares and preferred shares of Image Metrics
Limited, a private company incorporated in England and Wales (Image Metrics
LTD).  As a result of the exchange offer, the Company is now engaged
in the business of providing technology-based facial animation solutions to the
interactive entertainment industry.  Effective March 10, 2010, we
changed our corporate name to Image Metrics, Inc.  The term “Image
Metrics” refers to Image Metrics LTD prior to March 10, 2010, and Image Metrics,
Inc. as of and after such date.




Executive
Overview
 
 Image
Metrics Inc., a Nevada corporation, is a leading global provider of
technology-based facial animation services to the interactive entertainment and
film industries.  Using proprietary software and mathematical
algorithms that “read” human facial expressions, our technology converts video
footage of real-life actors into 3D computer generated animated
characters.   We believe we are the leader in the field of facial
animation in terms of quality, cost and completion time.  In many
contexts, we believe that we are able to accomplish what other providers simply
cannot.  Examples of our notable and innovative facial animation
projects include the 2009 “Grand Theft Auto IV” video game, which generated over
$500 million in sales in its first week, the 2009 computer generated aging of
Brad Pitt in the feature film “The Curious Case of Benjamin Button,” which won
three Oscars including one for achievement in visual effects, and the 2009 Black
Eyed Peas’ Boom Boom Pow music video, which earlier this year won the Grammy
Award for best short form music video.
 
 Image
Metrics was founded in 2000, utilizes a staff of 43 full-time employees, and has
more than 60 man-years -  and $14.0 million -  invested in
our computer vision based software.  We
derive our revenues from the sale of consulting services, model building,
character rigging and animation services.Our key intellectual property
consists of one patent registered in the United States, four additional patents
in process, the identification of 16 potential new patents, and significant
well-documented trade secrets.  We are continually updating our
software and are prosecuting a roadmap of technology
innovations.  Prior to 2009, our corporate emphasis was on developing
technology rather than sales.  In 2009, our current management assumed
their positions and, in 2009, a growth plan was implemented that included our
recently installed sales force and becoming a public company.
  The facial
animation market is not specifically followed by independent market research
firms, but independent research is available around animation in general and on
the video game and film businesses.  Using independent market research
from companies such as Acacia Research Group, SCRI International, Inc. and NPD
Group, we have developed estimates for the facial animation
market.  These estimates indicate that the facial animation market
generated $807 million of revenue in 2006, $1.4 billion in 2009, and is forecast
to grow to $1.9 billion by 2011. Presently, we have a small market
share.  Our management anticipates being able to grow our presence
with our competitive advantages, our recently-formed management team and the
additional capital from our March 2010 private placement.




15




Total
revenue during the second quarter of fiscal 2010 was $1.58 million up from
$0.17 million in the same period of fiscal 2009. Total revenue during the
first six months of fiscal 2010 was $3.96 million up from
$1.56 million in the same period of fiscal 2009. The increases in revenue
are the result of increased demand for our services and expansion of our
customer base.
 
 Gross
margin was 48% for the second quarter of fiscal 2010, compared to -18% for the
same prior year quarter.  The marked improvement is a result of
increased number of projects completed in the second quarter of 2010. The gross
margin was consistent for the first six months of fiscal 2010 and 2009 at
59%.
 
 Cash
flows used for operations were $4.35 million for the first six months of
fiscal 2010, compared to $1.61 million in the same period of fiscal 2009.
The decrease in cash flows from operations was primarily the result of a
decrease in deferred revenue, partially offset by increased accounts payable.
Cash flows from financing activities was $4.96 million for the first six months
of fiscal 2010, compared to $2.09 million for the same period in
2009.  Increased cash flows were from additional debt and equity
financings.
  Impact
of Recently Issued Accounting Standards
 
 There
were no accounting pronouncements adopted by the Company or issued during the
three months ended March 31, 2010 that had a material effect on the
unaudited condensed consolidated financial statements or that are reasonably
certain to have a material impact on the unaudited condensed consolidated
financial statements in future periods.
 
 Critical Accounting
Policies
  A summary
of our significant accounting policies are disclosed in Note 1 of our Condensed
Consolidated Financial Statements included in Part I Item 1 of this Quarterly
Report on Form 10-Q.  The following discussion addresses our most
critical accounting policies, which are those that are both important to the
portrayal of our financial condition and results of operations and that require
significant judgment or use of complex estimates.
 
 We
consider certain accounting policies related to revenue recognition, notes
payable, and deferred tax assets and liabilities to be critical policies due to
the significance of these items to our operating results and the estimation
processes and management judgment involved in each.
 
 Revenue
Recognition
  We derive
our revenue from the sale of consulting services, model building, character
rigging and animation services. The majority of services are sold in
multiple-element arrangements.  We  recognize revenue
pursuant to the requirements of the Financial Accounting Standards Board
Accounting Standards Codification (“ASC”) 605, as amended by Accounting
Standards Update (“ASU”) 2009-13, “Revenue Recognition - Multiple-Deliverable
Revenue Arrangements”, when persuasive evidence of an arrangement exists,
delivery has occurred, the fee is fixed or determinable, and collectability is
probable. A majority of our animation revenue is recognized in this manner.
Revenue is presented net of sales, use and value-added taxes collected on behalf
of our customers.
  For sales
that involve the delivery of multiple elements, we  allocate revenue
to each undelivered element based on the element’s fair value as determined by
vendor-specific objective evidence (“VSOE”), which is the price charged when
that element is sold separately, or third party evidence
(“TPE”).  When VSOE and TPE are unavailable, fair value is based on
management’s best estimate of selling price.  When management’s
estimate is used to determine fair value, management makes its estimates using
reasonable and objective evidence to determine the price.  For
elements not yet sold separately, the fair value is equal to the price
established by our management if it is probable that the price will not change
before the element is sold separately. We review our VSOE and third party
evidence at least annually. If we conclude we are unable to establish fair
values for one or more undelivered elements within a multiple-element
arrangement using VSOE, we use TPE, being the price at which the vendor would
transact if the unit of accounting were sold by the vendor regularly on a
standalone basis or, our best estimate of the selling price for that unit of
accounting.
  Notes
Payable
 In
connection with the sale of debt or equity instruments, we may sell options or
warrants to purchase our common stock. In certain circumstances, these options
or warrants may be classified as derivative liabilities, rather than as equity.
Additionally, the debt or equity instruments may contain embedded derivative
instruments, such as embedded derivative features which in certain circumstances
may be required to be bifurcated from the associated host instrument and
accounted for separately as a derivative instrument liability.
 16




For
options, warrants and bifurcated embedded derivative features that are accounted
for as derivative instrument liabilities, we estimate fair value using either
Black-Scholes Merton option pricing model, quoted market prices of financial
instruments with similar characteristics or other valuation techniques. The
valuation techniques require assumptions related to the remaining term of the
instruments and risk-free rates of return, our current common stock price and
expected dividend yield, and the expected volatility of our common stock price
over the life of the option. Because of the limited trading history for our
common stock, we estimate the future volatility of our common stock price
based the experience of other entities considered comparable to our
company.
  Deferred
Tax Assets and Liabilities
 
 Significant
judgment is required in determining our provision for income taxes. We assess
the likelihood that our deferred tax asset will be recovered from future taxable
income, and to the extent we believe that recovery is not likely, we establish a
valuation allowance. We consider future taxable income projections, historical
results and ongoing tax planning strategies in assessing the recoverability of
deferred tax assets. However, adjustments could be required in the future if we
determine that the amount to be realized is less or greater than the amount that
we recorded. Such adjustments, if any, could have a material impact on our
results of our operations.
  We record
a valuation allowance to reduce our deferred income tax assets to the amount
that is more likely than not to be realized. In evaluating our ability to
recover our deferred income tax assets, we consider all available positive and
negative evidence, including our operating results, ongoing tax planning and
forecasts of future taxable income on a jurisdiction by jurisdiction basis. Our
cumulative pre-tax loss in recent years represents sufficient negative evidence
for us to determine that the establishment of a full valuation allowance against
the deferred tax asset is appropriate. This valuation allowance offsets net
deferred tax assets associated with future tax deductions as well as
carryforward items. In the event we were to determine that we would be able to
realize our deferred income tax assets in the future in excess of their net
recorded amount, we would make an adjustment to the valuation allowance which
would reduce the provision for income taxes.
  Results of Operations




The
following table sets forth key components of our results of operations during
the three months ended March 31, 2010 and 2009, both in dollars and as a
percentage of our net sales.




3
      months ended March 31,
                                                                                                          
                                                                                                          
                                                                                                          6
      months ended March 31,2010
                                                                                                          
                                                                                                          
                                                                                                          2009
                                                                                                          
                                                                                                          
                                                                                                          2010
                                                                                                          
                                                                                                          
                                                                                                          2009Amount
                                                                                                          
                                                                                                          
                                                                                                          %
      of
                                                                                                            Revenue
                                                                                                          
                                                                                                          
                                                                                                          Amount
                                                                                                          
                                                                                                          
                                                                                                          %
      of
                                                                                                            Revenue
                                                                                                          
                                                                                                          
                                                                                                          Amount
                                                                                                          
                                                                                                          
                                                                                                          %
      of
                                                                                                            Revenue
                                                                                                          
                                                                                                          
                                                                                                          Amount
                                                                                                          
                                                                                                          
                                                                                                          %
      of
                                                                                                            RevenueRevenue
                                                                                                          
                                                                                                          $
                                                                                                          1,575
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          100
                                                                                                          %
                                                                                                          
                                                                                                          $
                                                                                                          167
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          100
                                                                                                          %
                                                                                                          
                                                                                                          $
                                                                                                          3,962
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          100
                                                                                                          %
                                                                                                          
                                                                                                          $
                                                                                                          1,561
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          100
                                                                                                          %Cost
      of goods sold (exclusive of depreciation shown separately
      below)
                                                                                                          
                                                                                                          
                                                                                                          (825
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -52
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          (197
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -118
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          (1,639
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -41
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          (632
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -40
                                                                                                          %Gross
      Profit
                                                                                                          
                                                                                                          
                                                                                                          750
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          (30
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          2,323
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          929Operating
      ExpensesSelling
      & Marketing
                                                                                                          
                                                                                                          
                                                                                                          (490
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -31
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          (948
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -568
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          (843
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -21
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          (1,532
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -98
                                                                                                          %Research
      & Development
                                                                                                          
                                                                                                          
                                                                                                          (227
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -14
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          (348
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -208
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          (610
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -15
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          (736
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -47
                                                                                                          %Depreciation
                                                                                                          
                                                                                                          
                                                                                                          (49
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -3
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          (69
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -41
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          (93
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -2
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          (135
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -9
                                                                                                          %General
      & Administrative
                                                                                                          
                                                                                                          
                                                                                                          (1,780
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -113
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          (831
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -498
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          (3,835
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -97
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          (1,815
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -116
                                                                                                          %Total
      Op Expenses
                                                                                                          
                                                                                                          
                                                                                                          (2,546
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -162
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          (2,196
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -1315
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          (5,381
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -136
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          (4,218
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -270
                                                                                                          %Operating
      loss
                                                                                                          
                                                                                                          
                                                                                                          (1,796
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -114
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          (2,226
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -1333
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          (3,058
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -77
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          (3,289
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -211
                                                                                                          %Interest
      expense
                                                                                                          
                                                                                                          
                                                                                                          (817
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -52
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          (129
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -77
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          (897
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -23
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          (249
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -16
                                                                                                          %Foreign
      exchange gain (loss)
                                                                                                          
                                                                                                          
                                                                                                          (144
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -9
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          (166
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -99
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          (128
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -3
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          282
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          18
                                                                                                          %Total
      other income/(expense)
                                                                                                          
                                                                                                          
                                                                                                          (961
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -61
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          (295
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -177
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          (1,025
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -26
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          33
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          2
                                                                                                          %Income
      before taxes
                                                                                                          
                                                                                                          
                                                                                                          (2,757
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -175
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          (2,521
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -1510
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          (4,083
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -103
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          (3,256
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -209
                                                                                                          %Income
      Taxes
                                                                                                          
                                                                                                          
                                                                                                          -
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          0
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          -
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          0
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          -
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          0
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          -
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          0
                                                                                                          %Net
      Loss
                                                                                                          
                                                                                                          $
                                                                                                          (2,757
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -175
                                                                                                          %
                                                                                                          
                                                                                                          $
                                                                                                          (2,521
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -1510
                                                                                                          %
                                                                                                          
                                                                                                          $
                                                                                                          (4,083
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -103
                                                                                                          %
                                                                                                          
                                                                                                          $
                                                                                                          (3,256
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          -209
                                                                                                          %




17




Total
revenue for the three months ended March 31, 2010 increased by 843% at
$1.58 million, compared to $0.17 million in the three months ended March
31, 2009. Total revenue for the six months ended March 31, 2010 increased by
154% at $3.96 million, compared to $1.56 million in the six months ended
March 31, 2010.The increase was primarily the result of the Company’s expansion
of its customer base and increased customer demand.
  Costs
of Revenue, Excluding Depreciation and Amortization
  Costs of
revenue primarily consist of direct personnel costs incurred to deliver
animation services.  Costs of revenue, excluding depreciation and
amortization, increased by 319%, or $0.63 million, to $0.83 million for the
three months ended March 31, 2010, from $0.20 million for the three months ended
March 31, 2009.  This increase was the direct result of increased
projects during the three months ended March 31, 2010 compared to the number and
size of projects in the three months ended March 31, 2009.
 
 Costs of
revenue, excluding depreciation and amortization, increased by 159%, or $1.01
million, to $1.64 million for the six months ended March 31, 2010, from $0.63
million for the six months ended March 31, 2009.  Cost of revenue
increase was the result of an increase in number of projects and service
deliverables. Our profit margin stayed consistent as the gross margin for the
six months ended March 31, 2010 and 2009 was 59%.
 
 Sales
and Marketing
  Sales and
marketing expenses primarily consist of compensation costs, including incentive
compensation, travel expenses, advertising, and other sales and marketing
related costs.  Sales and marketing expenses decreased 48%, or $0.46
million, to $0.49 million for the three months ended March 31, 2010 from $0.95
million for the three months ended March 31, 2009.   Sales and
marketing expenses decreased 45%, or $0.69 million, to $0.84 million for the six
months ended March 31, 2010 from $1.53 million for the six months ended March
31, 2009.  The decreases are the result of our expenditures during the
periods ending March 31, 2009 for market analysis, market research and market
development.  we  put a high emphasis during the fiscal year
2009 in developing our market presence to expand its customer base. The primary
decreases included a $0.10 million reduction in marketing salaries, $0.20
million from reduced use of consultants and fewer sales promotional projects
representing $0.10 reduced expenses.
 
 As a
percentage of revenue, sales and marketing expenses for the three months ended
March 31, 2010 decreased by 537% compared to the three months ended March 31,
2009 and decreased by 77% for the six months ended March 31, 2010 compared to
the six months ended March 31, 2009.  The decrease compared to revenue
is a direct result of more projects from an expanded customer base being
completed during the three months ended March 31, 2010 compared to the three
months ended March 3, 2009.




18


Research
and Development




Research
and development expenses consist primarily of employee-related costs for product
research and development.  Research and development expenses decreased 35%,
or $0.12 million, to $0.23 million for the three months ended March 31, 2010
from $0.35 million for the three months ended March 31,
2009.  Research and development expenses decreased 17%, or $0.13
million, to $0.61 million for the six months ended March 31, 2010 from $0.74
million for the six months ended March 31, 2009. The decreases were attributable
to fewer employees and a reduction in incentive compensation for the remaining
personnel. As a percentage of revenue, research and development expenses
decreased by 194% for the three months ended March 31, 2010 from March 31,
2009.  This decrease compared to revenue is a direct result of our
continued service revenue growth.
  Depreciation
  Depreciation
expense consists of depreciation of long-lived property and equipment. 
Depreciation expenses decreased 29%, to $0.05 million for the three months ended
March 31, 2010 from $0.07 million for the three months ended March 31, 2009 and
decreased during the six months ended March 31, 2010 by 32% to $0.09 million
compared to $0.14 million during the six months ended March 31, 2009.  This
decrease was a result of certain assets becoming fully depreciated. As a
percentage of revenue, depreciation expense decreased to 3% for the three months
ended March 31, 2010 from 41% for the three months ended March 31, 2010 and
decreased to 2% for the six months ended March 31, 2009 from 9% for the six
months ended March 31, 2009.  The decreases compared to revenue were a
result of the increased number of projects combined with certain assets being
fully depreciated.
 
 General
and Administrative
  General
and administrative expenses consist principally of employee-related costs,
professional fees and occupancy costs.  General and administrative expenses
increased 114%, or $0.95 million, for the three months ended March 31, 2010 from
$0.83 million for the three months ended March 31, 2009.   The
majority of the increased expenses were from increased number of personnel
resulting in higher payroll by $0.14 million, increased stock compensation of
$0.11 million, professional fees that increased by $0.51 million and were
primarily incurred for the exchange transaction and audits. Other increases
include rent, travel and information technology services that, combined,
accounted for $0.18 million.
 
 General
and administrative expenses for the six months ended March 31, 2010 increased
111%, or $2.02 million, from $1.8 million for the six months ended March 31,
2009.  The increased expenses were from increased number of personnel
resulting in higher base payroll and incentive compensation by $0.46 million,
increased stock compensation of $0.18 million, professional fees that increased
by $1.2 million and were primarily incurred for the exchange transaction and
audits. Other increases include rent, travel and information technology services
that, combined, accounted for $0.25 million.  Increased expenses were
partially offset by lower office supply and general expenses.
  Interest
Expense
  Interest
expense is from our notes payable.  Interest expense for the three months
ended March 31, 2010 increased 533% to $0.82 million as compared to $0.13
million for the three months ended March 31, 2010 and increased 260% to $0.90
million during the six months ended March 31, 2010 compared to $0.25 million in
the six months ended March 31, 2009.  This increase was the result of
increased average debt balances, higher interest rates, and issuance of debt
with detachable warrants during the periods ended March 31, 2010.
  Gain
(Loss) on Foreign Exchange Transactions
  Foreign
currency translation expense decreased 13% to $0.14 million during the three
months ended March 31, 2010 compared to $0.17 million during the three months
ended March 31, 2009.  The decrease is primarily attributable to fewer
expenses and sales transactions based in British pounds. We had a foreign
currency translation loss of $0.13 million for the six months ended March 31,
2010 which was an increased expense of $0.41 million compared to the foreign
exchange gain of $0.28 million we had for the six months ended March 31,
2009.  The increase in expense was a result of the U.S. dollar
strengthening less than 10% against the British pound during the six months
ended March 31, 2010 compared to the more than 20% strengthening of the US
dollar against the British pound during the six months ended March 31,
2009.
  Liquidity and Capital Resources
  We have
continued to finance operations through cash flows from operations, as well as
debt and equity transactions.  At March 31, 2010, we had $1.27 million
in cash, which does not include $0.5 million of restricted
cash.




19





Net cash
used in operating activities for the six months ended March 31, 2010 and 2009
was $4.34 million and $1.61 million, respectively.  In addition to our
net loss of $4.08 million in the six months ended March 31, 2010, operating cash
flows were negatively impacted by a $2.23 million decrease in deferred revenue,
which was the result of substantial work completed for our largest customer, and
$0.30 million decrease in accrued expenses primarily related to payment of
incentive compensation.  Operating cash out flows were offset by
increased accounts payable of $0.76 million and reduction in accounts receivable
of $0.25 million.
 
 Net cash
used for investing activities for the six months ended March 31, 2010 and 2009
was $0.12 million, and $0.09 million, respectively.  The primary
purchases for March 31, 2010 and 2009 consisted of computer equipment and
software.
 
 Net cash
provided by financing activities was $4.97 million and $2.09 million for the six
months ended March 31, 2010 and 2009, respectively.  The net cash
provided from financing activities during the six months of 2010, was from the
issuance of convertible notes, in the amount of $3.18 million, and $2.92 million
received from the sale of stock.  These cash receipts were partially
offset from payments on convertible and nonconvertible notes totaling $0.65
million, and restriction of cash and the issuance of debt costs totaling $0.48
million.  The net cash provided from financing activities in March 31,
2009, included proceeds from the sale of stock and issuance of debt totaling
$2.63 million, which was partially offset by payments on nonconvertible notes
for $0.54 million.
  Off Balance Sheet
Arrangements
 We do not
have any off balance sheet arrangements that have or are reasonably likely to
have a current or future effect on our financial condition, changes in financial
condition, revenues or expenses, results of operations, liquidity or capital
expenditures or capital resources that is material to an investor in our
securities.
  Cash Requirements
  We
believe that our cash on hand and cash flow from operations will meet part of
our present cash needs and we will require additional cash resources, including
selling equity and seeking additional loans, to meet our expected capital
expenditure and working capital for the next 12 months. The sale of additional
equity securities could result in dilution to our stockholders. The incurrence
of indebtedness would result in increased debt service obligations and could
require us to agree to operating and financial covenants that would restrict our
operations. Financing may not be available in amounts or on terms acceptable to
us, if at all. Any failure by us to raise additional funds on terms favorable to
us, or at all, could limit our ability to expand or continue our business
operations and could harm our overall business prospects.
  These
conditions indicate a material uncertainty that casts significant doubt about
our ability to continue as a going concern.   We require
additional debt or equity financing to have the necessary funding to continue
operations and meet our obligations, and we believe that we will be able to
obtain financing.  Thus, we have continued to adopt the going concern
basis of accounting in preparing the financial statements.
  ITEM
3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
 Foreign
Exchange
 
 Approximately
18% and 29% of our expenses were denominated in currencies other than the U.S.
dollar for the six months ended July 31, 2009 and 2009,
respectively.   We are maintaining a market presence in the UK
and throughout Europe.  As a result, fluctuations in the values of the
currencies in which we generate revenue and incur expenses could adversely
impact our results.




20




Fluctuations
in currencies relative to the U.S. dollar have affected and will continue to
affect period-to-period comparisons of our reported results of operations. For
the six month ended March 31, 2010, we had foreign currency transaction losses
of $0.13 million while we had foreign currency transaction gains of $0.28
million during the six months ended March 31, 2009.  The variance was
a result of significant fluctuations in the exchange rate between the British
pound and the US dollar.  As a result of the constantly changing
currency exposures and the volatility of currency exchange rates, we may
experience foreign currency losses in the future. We cannot predict the effect
of exchange rate fluctuations upon future operating results. Although we do not
currently undertake hedging transactions, we may choose to hedge a portion of
our currency exposure in the future.
  Interest
Rate Risk
  Fluctuation in interest
rates could impact our ability to obtain additional debt financing.Historically, we have
used external financing to fund operations and fluctuations could have a
significant impact on our operating results.
  ITEM
4T. CONTROLS AND PROCEDURES
  Evaluation
of disclosure controls and procedures
 
 Under the
supervision and with the participation of our management, including our Chief
Executive Officer and Chief Financial Officer, we conducted an evaluation of the
effectiveness 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, as of the end of the period covered by
this report. Based upon that evaluation, our Chief Executive Officer and
Chief Financial Officer have concluded that as of the end of such period our
disclosure controls and procedures are effective.
  Changes
in internal control over financial reporting
 
 There
were no changes in our internal control over financial reporting during our most
recent fiscal quarter that have materially affected, or are reasonably likely to
materially affect, our internal control over financial reporting.
  PART
II – OTHER INFORMATION
 
 ITEM
1. LEGAL PROCEEDINGS
 
 We are
not party to any material legal proceedings.
 
 ITEM
1A. RISK FACTORS
 
 Risks
Related to Our Business and Our Industry
 
 If we are unable to secure additional
debt or equity financing, we may not be able to meet our obligations and
continue operations.
 
 Our cash on hand and cash flow from operations will only
meet part of our present cash needs and we will require additional cash
resources, including selling equity and seeking additional loans, to meet our
expected capital expenditure and working capital for the next 12
months.  Therefore, we require additional debt or equity
financing secure the necessary funding to continue operations and meet our obligations.  Financing may not be
available in amounts or on terms acceptable to us, if at all.  Any
failure by us to raise additional funds on terms favorable to us, or at all,
could limit our ability to expand or continue our business operations and could
harm our overall business prospects.  We believe that if we are
unsuccessful in securing additional financing or improve our operational cash
flows, our auditors will issue a disclaimer about our ability to continue as a
going concern in our upcoming year end financial audit.




21


We
have a limited operating history, which limits the information available to you
to evaluate our business, and have a history of operating losses and uncertain
future profitability.




We have
incurred significant operating losses and have an accumulated deficit of $
30,370,000 as of March 31, 2010.  We incurred a loss from operations
of $4,083,000 during the six months ended March 31, 2010, and expect to continue
operating at a loss for some period of time.  Our independent
registered public accounting firm has expressed substantial doubt about our
ability to continue as a going concern.  We face the risks and difficulties
of an early-stage company including the uncertainties of market acceptance,
competition, cost increases and delays in achieving business
objectives.  There can be no assurance that we will succeed in
addressing any or all of these risks, that we will achieve future profitability,
or that we will achieve profitability at any particular time.  The
failure to do so would have a material adverse effect on our business, financial
condition and operating results.
  Because
the games and film industries are always evolving, their future growth and
ultimate size are difficult to predict.  Our business will not grow if
the use of our facial animation services does not continue to grow.
  We are a
provider of technology-based facial animation services to the entertainment
industry.  Our industry is in the early stages of market acceptance of
products and related services and is subject to rapid and significant
technological change.  Because of the new and evolving nature of
facial animation technology, it is difficult to predict the size of this
specialized market, the rate at which the market for our facial animation
services will grow or be accepted, if at all, or whether emerging
computer-generated animation technologies will render our services less
competitive or obsolete.  If the market for our facial animation
services fails to develop or grows slower than anticipated, we would be
significantly and materially adversely affected.
  If
our products and services do not achieve market acceptance, we may not achieve
our revenue and earnings goals in the time projected, or at all.
  If we are
unable to operate our business as contemplated by our business model or if the
assumptions underlying our business model prove to be unfounded, we could fail
to achieve our revenue and earnings goals within the time we have projected, or
at all, which would have a detrimental effect on our business.  As a
result, the value of your investment could be significantly reduced or
completely lost.
  Our
ability to generate revenue is highly dependent on building and maintaining
relationships with film and visual effects (VFX) studios, commercial producers
and game developers.  No assurance can be given that a sufficient
number of such companies will demand our facial animation services or other
computer-generated animation services, thereby expanding the overall market for
digital characters in films, games and other forms of entertainment and enabling
us to increase our revenue to the extent expected.  In addition, the
rate of the market’s acceptance of other computer-generated animation
technologies cannot be predicted.  Failure to attract and maintain a
significant customer base would have a detrimental effect on our business,
operating results and financial condition.
  Our
future growth will be harmed if we are unsuccessful in developing and
maintaining good relationships with entertainment companies.
  Our
business strategy may in the future be dependent on our ability to develop
relationships with entertainment companies to increase our customer
base.  These companies recommend our services to their customers,
provide us with referrals and help us build presence in the
market.  These relationships require a significant amount of time to
develop.  Currently, we have established a limited number of these
relationships.  We must expand current relationships and establish new
relationships to grow our business in accordance with our business
plan.  We may not be able to identify, establish, expand and maintain
good relationships with quality entertainment
companies.  Additionally, it is uncertain that such relationships will
fully support and recommend our facial animation services.  Our
failure to identify, establish, expand and maintain good relationships with
quality entertainment companies would have a material and adverse effect on our
business.
  The
majority of the contracts we have with customers are cancelable for any reason
by giving 30 days advance notice.
  Our
customers have historically engaged us to perform services for them on a
project-by-project basis and are required by us to enter into a written
contractual agreement for the work, labor and services to be
performed.  Generally, our project contracts are terminable by the
customer for any or no reason on 30 days advance notice to us.  If a
number of our customers were to exercise cancellation rights, our business and
operating results would be materially and adversely affected.


22




We
have a large concentration of business from a small number of
accounts.  A decision by a key customer to discontinue or limit its
relationship with us could have a material adverse effect on our
business.




We have
been highly dependent on sales of our facial animation products to a small
number of accounts.  Approximately 87.2% of our revenue for fiscal
2009 resulted from sales to four customers (including Take-Two Interactive
Software, Inc. and Sony Computer Entertainment), and 77.7% of our revenue for
fiscal 2008 resulted from sales to two customers (Take-Two Interactive and
Digital Domain, Inc).  Therefore, at present, a significant portion of
our business depends largely on the success of specific customers in the
commercial marketplace.  Our business could be adversely affected if
any of our key customers’ share of the commercial market declined or if their
customer base, in turn, eroded in that market.  A decision by one or
more of our key customers to discontinue or limit its relationship with us could
result in a significant loss of revenue to us and have a material adverse impact
on our business.
  Our
operating results will be harmed if we are unable to manage and sustain our
growth.
  Our
business is unproven on a large scale and actual revenue and operating margins,
or revenue and margin growth, may be less than expected.  If we are
unable to scale our production capabilities efficiently, we may fail to achieve
expected operating margins, which would have a material and adverse effect on
our operating results.
  Our
facial animation services may become obsolete if we do not effectively respond
to rapid technological change on a timely basis.
  Our
facial animation services are new and our business model is
evolving.  Our services depend on the needs of our customers and their
desire to create believable facial performances in computer-generated
characters.  Since the games and film industries are characterized by
evolving technologies, uncertain technology and limited availability of
standards, we must respond to new research and development and technological
changes affecting our customers and collaborators.  We may not be
successful in developing and marketing, on a timely and cost-effective basis,
new or modified services, which respond to technological changes, evolving
customer needs, and competition.
  If
we fail to recruit and retain qualified senior management and other key
personnel, we will not be able to execute our business plan.
  Our
business plan requires us to hire a number of qualified personnel, as well as
retain our current key management.  The industry is characterized by
heavy reliance on software and computer graphics engineers.  We must,
therefore, attract leading technology talent both as full-time employees and as
collaborators, to be able to execute our business
strategy.  Presently, our key senior management and key personnel are
Michael Starkenburg, President and Chief Executive Officer, Ron Ryder, Chief
Financial Officer, Brian Waddle, Executive Vice President, and Kevin Walker,
Ph.D., Chief Technology Officer.
  The loss
of the services of one or more of our senior managers could impair our ability
to execute our business plan, which could hinder the development of products and
services.  We have entered into employment agreements with members of
our key senior management team, along with agreements with some of these members
regarding confidentiality, non-competition and invention
assignment.  Under California law, the non-competition provisions in
the employment agreements will likely be unenforceable, which could result in
one or more members of our senior management or key personnel leaving us and
then, despite our efforts to prevent them from doing so, competing directly
against us for customers, projects and personnel.




23


If
we fail to protect our intellectual property our current competitive strengths
could be eroded and we could lose customers, market share and
revenue.




Our
viability will depend on our ability to develop and maintain the proprietary
aspects of our technology to distinguish our service from our competitors’
products and services.  To protect our proprietary technology, we rely
primarily on a combination of confidentiality procedures, copyright, trademark
and patent laws.




We hold a
United States patent which expires in December 2025.  We have a number
of additional filings pending, or issued, which cover the technology that is
related to the subject of our United States patent.  In addition, we
are developing a number of new innovations for which we intend to file patent
applications.  No assurance can be given that any of these patents
will afford meaningful protection against a competitor or that any patent
application will be issued.  Patent applications filed in foreign
countries are subject to laws, rules, regulations and procedures that differ
from those of the United States, and thus there can be no assurance that foreign
patent applications related to United States patents will issue.  If
these foreign patent applications issue, some foreign countries provide
significantly less patent protection than the United States.  In
addition, our contractual relationships give rights, including ownership rights,
in proprietary technology to parties other than us.  The status of
patents involves complex legal and factual questions and the breadth of claims
issued is uncertain.  Accordingly, there can be no assurance that our
patents, and any patents that may be issued to us in the future, will afford
protection against competitors with similar technology.  No assurance
can be given that patents issued to us will not be infringed upon or designed
around by others or that others will not obtain patents that we would need to
license or design around.  If other companies’ existing or future
patents containing broad claims are upheld by the courts, the holders of such
patents could require companies, including us, to obtain licenses or else to
design around those patents.  If we are found to be infringing
third-party patents, there can be no assurance that any necessary licenses would
be available on reasonable terms, if at all.




Despite our
efforts to protect our proprietary rights, unauthorized parties may attempt to
copy aspects of our services or obtain and use information that we regard as
proprietary.  Unauthorized use of our proprietary technology could
harm our business.  Litigation to protect our intellectual property
rights can be costly and time-consuming to prosecute, and there can be no
assurance that we will be able to enforce our rights or prevent other parties
from developing similar technology or designing around our intellectual
property.





Although
we believe that our products and services do not and will not infringe upon the
patents or violate the proprietary rights of others, it is possible such
infringement or violation has occurred or may occur which could have a material
adverse effect on our business.




Our business
is heavily reliant upon patented and patentable systems and methods used in
our  facial animation technology and related intellectual
property.  In the event that products and services we sell are deemed
to infringe upon the patents or proprietary rights of others, we could be
required to modify our products and services or obtain a license for the
manufacture and/or sale of such products and services.  In such event,
there can be no assurance that we would be able to do so in a timely manner,
upon acceptable terms and conditions, or at all, and the failure to do any of
the foregoing could have a material adverse effect upon our
business.  Moreover, there can be no assurance that we will have the
financial or other resources necessary to enforce or defend a patent
infringement or proprietary rights violation action.  Any litigation
would also require our management to devote their time and effort to fight it,
which would detract from their ability to implement our business plan, and would
have a negative impact on our operations.  In addition, if our
products and services or proposed products and services are deemed to infringe
or likely to infringe upon the patents or proprietary rights of others, we could
be subject to injunctive relief and, under certain circumstances, become liable
for damages, which could also have a material adverse effect on our
business.




Our
customers are subject to numerous entertainment industry regulations, which
could adversely affect the nature and extent of the services we offer as a
result of changes in the regulatory or political climate.




Many aspects
of the games and film industries are subject to legislation at the federal level
concerning graphic violence and sexually explicit material.  From time
to time, the regulatory entities that have jurisdiction over the industries
adopt new or modified regulations or take other actions as a result of their own
regulatory processes or as directed by other governmental bodies, including
legislative and other authorities.  This changing regulatory and
political environment could adversely affect the nature and extent of the
services we are able to offer.




24


We
may in the future experience competition from film studios and game
developers.





Competition
in the development of facial animation technology is expected to become more
intense.  Competitors range from university-based research and
development graphics labs to development-stage companies and major domestic and
international film studios and game developers.  Many of these
entities have financial, technical, marketing, sales, distribution and other
resources significantly greater than those of ours.  There can be no
assurance that we can continue to develop our facial animation technology or
that present or future competitors will not develop computer-generated animation
technologies that render our facial animation technology obsolete or less
marketable or that we will be able to introduce new products and product
enhancements that are competitive with other products marketed by industry
participants.
  If
we fail to properly identify, negotiate and execute potential business
combinations, any merger and acquisition activity may adversely affect the value
of your investment.
  We may
engage in mergers and acquisitions activity to accelerate our growth and market
presence, and our growth strategy includes such acquisitions.  These
transactions may cause you to experience dilution in your equity ownership
percentage, and there can be no assurance that we will be able to successfully
execute upon these potential acquisitions.  These transactions may
have a significant impact upon our overall business, management focus and
ongoing cash requirements.  If we fail to properly identify
appropriate strategic targets, to negotiate advantageous financial terms, to
retain key personnel from acquired companies, or to properly complete and
integrate these operations, our business may be adversely affected.
  Our
customers are on various payment schedules and liquidity may be negatively
impacted if payment schedules change or customers are slow to pay.
  We have
negotiated a variety of payment schedules with customers, and there is no
standard for payment cycles in our business.  These payment schedules
are likely to change, and we may not be able to negotiate equally favorable
payment schedules in the future. Further, we are vulnerable to delays in
payments by customers for services rendered or the uncollectibility of accounts
receivable.  Either of these factors could have a material adverse
effect on our liquidity and working capital position.  We are subject
to credit risks from time to time, particularly in the event that any of our
receivables represent sales to a limited number of customers.  Failure
to properly assess and manage such risks could require us to make accounting
adjustments to our revenue recognition policies and our allowance for doubtful
accounts.
  The
value of your investment may be significantly reduced if we cannot fully fund
our growth strategy from the net proceeds of the private placement and from
projected revenue.
  We need
to be able to fund the development and growth of our business from existing and
projected revenue, along with the net proceeds from our private placements, to
operate for the next 12 months as a going concern.  To execute our
growth strategy, we expect to need significant further development of both our
technology and our marketing infrastructure in existing and new
markets.  We have not completely identified all of the development and
marketing requirements to successfully execute this strategy.  If funds raised from our private placements and
generated on our own are insufficient to fund our operations and to fully
implement the actual required development, marketing and expansion activities,
we will be required to seek additional capital to fund these activities, and may
not be able to continue as a going concern, if we are unable to secure such
additional capital.  In addition, our plans or assumptions with
respect to our business, operations and cash flow may materially change or prove
to be inaccurate.  In this case, we may be required to use part or all
of the net proceeds of our private placements to fund such expenses and/or seek
additional capital.  This will depend on a number of factors,
including, but not limited to:




·
            the
      growth, condition and size of the games and film
    industries;





·
            the
      rate of growth of customer interest in believable facial animation in
      their games and films;





·
            the
      rate of market acceptance and new customer acquisition of our
      products;





·
            the
      rate of new product introduction and uptake by
  customers;




25





·
            our
      ability to negotiate favorable pricing and participation terms with
      customers;





·
            our
      ability to negotiate favorable payment arrangements with customers;
      and





·
            our
      ability to execute against our growth strategy and manage cash
      effectively.





If we
attempt to raise additional capital, it may not be available on acceptable
terms, or at all.  The failure to obtain required capital would have a
material adverse effect on our business.  If we issue additional
equity securities in the future, you could experience dilution or a reduction in
priority of your stock.
  Our
ability to use net operating loss carryforwards to reduce future years' taxes
could be substantially limited if we experience an ownership change as defined
in the Internal Revenue Code.
  Section 382
of the Internal Revenue Code contains rules that limit the ability of a company
to use its net operating loss carryforwards in years after an ownership change,
which is generally defined as any change in ownership of more than 50% of its
stock over a three-year testing period. These rules generally operate by
focusing on ownership changes among stockholders owning directly or indirectly
5% or more of the stock of a company and/or any change in ownership arising from
a new issuance of stock by the company. If, as a result of future transactions
involving our common stock, including purchases or sales of stock by 5%
stockholders, we undergo cumulative ownership changes which exceed 50% over the
testing period, our ability to use our net operating loss carryforwards would be
subject to additional limitations under Section 382.
  Generally,
if an ownership change occurs, the annual taxable income limitation on the use
of net operating loss carryforwards is equal to the product of the applicable
long-term tax exempt rate and the value of the company's stock immediately
before the ownership change. Depending on the resulting limitation, a portion of
our net operating loss carryforwards could expire before we would be able to use
them.
  As a
result of the exchange transaction on March 10, 2010, we are completing a review
of our net operating losses incurred by Image Metrics LTD and Image Metrics CA,
prior to the exchange transaction.
  Our
inability to fully utilize our net operating losses to offset taxable income
generated in the future could have a material and negative impact on our future
financial position and results of operations.
  Risks
Related to Our Common Stock
  Because we became public through a
share exchange transaction (or reverse acquisition), we may not be able to
attract the attention of major brokerage firms.
  Additional
risks are associated with our becoming public through a reverse acquisition. For
example, security analysts of major brokerage firms may not provide coverage of
us since there is no incentive to brokerage firms to recommend the purchase of
our common stock. We cannot assure you that brokerage firms will want to conduct
any public offerings on our behalf in the future.
  If
we do not timely file and have declared effective the initial registration
statement required pursuant to our private placement, we will be required to pay
liquidated damages.
  As part
of our private placement, we entered into a registration rights agreement. Under
this agreement, we are obligated to file an initial registration statement
providing for the resale of the shares of common stock underlying the Series A
Convertible Preferred Stock and the warrants. Pursuant to the agreement, we
agreed to file and have declared effective the registration statement by a
certain date. If we do not meet this timeline, we must pay liquidated damages in
the amount equal to 2% of the aggregate investment amount per month, subject to
a maximum limit of 12% of the aggregate investment amount.
  If
and when our registration statement becomes effective, a significant number of
shares of common stock will be eligible for sale, which could depress the market
price of our common stock.
  Following
the effective date of the registration statement, a significant number of our
shares of common stock will become eligible for sale in the public market, which
could harm the market price of the stock. Further, shares may be offered from
time to time in the open market pursuant to Rule 144, and these sales may have a
depressive effect as well. In general, a person who has held restricted shares
for a period of six months may, upon filing a notification with the SEC on Form
144, sell our common stock into the market, subject to certain
limitations.
 
 26




There
has been no active public trading market for our common stock.




There is
currently no active public market for our common stock. An active trading market
may not develop or, if developed, may not be sustained. The lack of an active
market may impair your ability to sell your shares of common stock at the time
you wish to sell them or at a price that you consider reasonable. The lack of an
active market may also reduce the market value and increase the volatility of
your shares of common stock. An inactive market may also impair our ability to
raise capital by selling shares of common stock and may impair our ability to
acquire other companies or assets by using shares of our common stock as
consideration.




The
market price of our common stock may be volatile and may decline in
value.




The
market price of our common stock has been and will likely continue to be highly
volatile, as is the stock market in general, and the market for OTC Bulletin
Board quoted stocks, in particular. Some of the factors that may materially
affect the market price of our common stock are beyond our control, such as
changes in financial estimates by industry and securities analysts, conditions
or trends in the industry in which we operate or sales of our common stock.
These factors may materially adversely affect the market price of our common
stock, regardless of our performance. In addition, the public stock markets have
experienced extreme price and trading volume volatility. This volatility has
significantly affected the market prices of securities of many companies for
reasons frequently unrelated to the operating performance of the specific
companies. These broad market fluctuations may adversely affect the market price
of our common stock.




Our
stockholders may experience significant dilution if future equity offerings are
used to fund operations or acquire complementary businesses.




If our
future operations or acquisitions are financed through the issuance of equity
securities, our stockholders could experience significant dilution. In addition,
securities issued in connection with future financing activities or potential
acquisitions may have rights and preferences senior to the rights and
preferences of our common stock. We also established an incentive compensation
plan for our management and employees. We expect to grant options to purchase
shares of our common stock to our directors, employees and consultants and we
will grant additional options in the future. The issuance of shares of our
common stock upon the exercise of these options may result in dilution to our
stockholders.




Our
current management can exert significant influence over us and make decisions
that are not in the best interests of all stockholders.




Our
executive officers and directors beneficially own as a group approximately 50.9%
of our outstanding shares of common stock, inclusive of shares of common stock
issuable upon conversion of our Series A Convertible Preferred Stock. As a
result, these stockholders will be able to assert significant influence over all
matters requiring stockholder approval, including the election and removal of
directors and any change in control. In particular, this concentration of
ownership of our outstanding shares of common stock could have the effect of
delaying or preventing a change in control, or otherwise discouraging or
preventing a potential acquirer from attempting to obtain control. This, in
turn, could have a negative effect on the market price of our common stock. It
could also prevent our stockholders from realizing a premium over the market
prices for their shares of common stock. Moreover, the interests of the owners
of this concentration of ownership may not always coincide with our interests or
the interests of other stockholders and, accordingly, could cause us to enter
into transactions or agreements that we would not otherwise
consider.




27


Our
common stock is considered “penny stock” and may be difficult to
sell.




The SEC
has adopted regulations which generally define “penny stock” to be an equity
security that has a market or exercise price of less than $5.00 per share,
subject to specific exemptions. The market price of our common stock may be
below $5.00 per share and therefore may be designated as a “penny stock”
according to SEC rules. This designation requires any broker or dealer selling
these securities to disclose certain information concerning the transaction,
obtain a written agreement from the purchaser and determine that the purchaser
is reasonably suitable to purchase the securities. These rules may restrict the
ability of brokers or dealers to sell our common stock and may affect the
ability of our stockholders to sell their shares. In addition, since our common
stock is quoted on the OTC Bulletin Board, our stockholders may find it
difficult to obtain accurate quotations of our common stock and may find few
buyers to purchase the stock or a lack of market makers to support the stock
price.
  We
do not anticipate paying dividends in the foreseeable future; you should not buy
our stock if you expect dividends.
  We
currently intend to retain our future earnings to support operations and to
finance expansion and, therefore, we do not anticipate paying any cash dividends
on our common stock in the foreseeable future.
 
 We
intend to apply for trading our common stock on Nasdaq, although we may not
satisfy its eligibility criteria for listing or will ever be listed on
Nasdaq.
 
 We intend
to apply to list our common stock for trading on the Nasdaq Capital
Market.  No assurance can be given that we will satisfy the
eligibility criteria or other initial listing requirements, or that our shares
of common stock will ever be listed on Nasdaq or another national securities
exchange.
  We
could issue “blank check” preferred stock without stockholder approval with the
effect of diluting then current stockholder interests and impairing their voting
rights, and provisions in our charter documents and under Nevada law could
discourage a takeover that stockholders may consider favorable.
  Our
certificate of incorporation provides for the authorization to issue up to
20,000,000 shares of “blank check” preferred stock with designations, rights and
preferences as may be determined from time to time by our board of directors.
Our board of directors is empowered, without stockholder approval, to issue a
series of preferred stock with dividend, liquidation, conversion, voting or
other rights which could dilute the interest of, or impair the voting power of,
our common stockholders. The issuance of a series of preferred stock could be
used as a method of discouraging, delaying or preventing a change in control.
For example, it would be possible for our board of directors to issue preferred
stock with voting or other rights or preferences that could impede the success
of any attempt to change control of our company. In addition, advanced notice is
required prior to stockholder proposals.
 
  If
we raise additional funds through the issuance of equity securities, or
determine in the future to register additional common or preferred stock, your
percentage ownership will be reduced, you will experience dilution which could
substantially diminish the value of your stock and such issuance may convey
rights, preferences or privileges senior to your rights which could
substantially diminish your rights and the value of your stock.
  We may
issue additional shares of common stock for various reasons and may grant stock
options to employees, officers, directors and third parties. If we determine to
register for sale to the public additional shares of common stock or other debt
or equity securities in any future financing or business combination, a material
amount of dilution can be expected to cause the market price of the common stock
to decline. One of the factors which generally effects the market price of
publicly traded equity securities is the number of shares outstanding in
relationship to assets, net worth, earnings or anticipated earnings.
Furthermore, the public perception of future dilution can have the same effect
even if actual dilution does not occur.


28




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


We did not issue any unregistered securities during the
three months ended March 31, 2010 that were not previously reported in a Current
Report on Form 8-K, and we did not repurchase any securities during that period. .
  ITEM
3. DEFAULT UPON SENIOR SECURITIES
  We are
currently in default of the $196,000 notes issued between May 2006 and
February 2010 by the Company when it operated as International Cellular
Accessories.  Upon completion of the share exchange transaction on
March 10, 2010, these notes payables entered a default status as a result of the
Company having a change of ownership.  As of March 31, 2010, the
principal and accrued interest owed on these loans was
$221,000.  There were no other defaults upon senior securities during
the period ended March 31, 2010.
  ITEM
4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
  The
Company’s security holders voted on and approved the exchange transaction with
Image Metrics LTD, which occurred on March 10, 2010.
  ITEM
5. OTHER INFORMATION
  None
  ITEM
6. EXHIBITS




Exhibit Number
                            
                            Desciption2.1
                            
                            Share
      Exchange Agreement, dated as of March 10, 2010, between International
      Cellular Accessories and Image Metrics Limited (Exhibit 2.1 to the
      Company’s Current Report on Form 8-K filed with the Securities and
      Exchange Commission on March 11, 2010 is incorporated herein by
      reference).3.1
                            
                            Charter
      of the Company.3.2
                            
                            Bylaws
      of the Company (Exhibit 3.2 to the Company’s Registration Statement on
      Form SB-2/A filed with the Securities and Exchange Commission on April 8,
      2005 is incorporated herein by reference).10.1
                            
                            Form
      of Private Placement Subscription Agreement to purchase units in Image
      Metrics, Inc. (Exhibit 10.1 to the Company’s Current Report on Form 8-K
      filed with the Securities and Exchange Commission on March 11, 2010 is
      incorporated herein by reference).10.2
                            
                            2009
      Stock Incentive Plan (Exhibit 10.2 to the Company’s Current Report on Form
      8-K filed with the Securities and Exchange Commission on March 16, 2010 is
      incorporated herein by reference).*10.3
                            
                            2010
      Stock Incentive Plan.*10.4
                            
                            Form
      of Nonstatutory Stock Option Agreement Granted Under the 2010 Stock
      Incentive Plan.*31.1
                            
                            Certification
      by the Chief Executive Officer pursuant to Rule 13a-14(a) of the
      Securities Exchange Act of 1934, as adopted pursuant to Section 302
      of the Sarbanes-Oxley Act of 200231.2
                            
                            Certification
      by the Chief Financial Officer pursuant to Rule 13a-14(a) of the
      Securities Exchange Act of 1934, as adopted pursuant to Section 302
      of the Sarbanes-Oxley Act of 200232.1
                            
                            Certification
      by the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as
      adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
      200232.2
                            
                            Certification
      by the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as
      adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
      2002






29




SIGNATURE
 
 Pursuant to the requirements of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned thereunto duly authorized.
    IMAGE METRICS,
      INC.By:
                /s/ Ron
      RyderRon
      RyderChief
      Financial Officer(Principal
      Financial Officer and
                  DulyAuthorized Officer)









EXHIBIT
INDEX


Exhibit
                            Number
                          
                          Description2.1
                          
                          Share
      Exchange Agreement, dated as of March 10, 2010, between International
      Cellular Accessories and Image Metrics Limited (Exhibit 2.1 to the
      Company’s Current Report on Form 8-K filed with the Securities and
      Exchange Commission on March 11, 2010 is incorporated herein by
      reference).3.1
                          
                          Charter
      of the Company.3.2
                          
                          Bylaws
      of the Company (Exhibit 3.2 to the Company’s Registration Statement on
      Form SB-2/A filed with the Securities and Exchange Commission on April 8,
      2005 is incorporated herein by reference).10.1
                          
                          Form
      of Private Placement Subscription Agreement to purchase units in Image
      Metrics, Inc. (Exhibit 10.1 to the Company’s Current Report on Form 8-K
      filed with the Securities and Exchange Commission on March 11, 2010 is
      incorporated herein by reference).10.2
                          
                          2009
      Stock Incentive Plan (Exhibit 10.2 to the Company’s Current Report on Form
      8-K filed with the Securities and Exchange Commission on March 16, 2010 is
      incorporated herein by reference).*10.3
                          
                          2010
      Stock Incentive Plan.*10.4
                          
                          Form
      of Nonstatutory Stock Option Agreement Granted Under the 2010 Stock
      Incentive Plan.*31.1
                          
                          Certification
      by the Chief Executive Officer pursuant to Rule 15d-14(a) of the
      Securities Exchange Act of 1934, as adopted pursuant to Section 302
      of the Sarbanes-Oxley Act of 200231.2
                          
                          Certification
      by the Chief Financial Officer pursuant to Rule 15d-14(a) of the
      Securities Exchange Act of 1934, as adopted pursuant to Section 302
      of the Sarbanes-Oxley Act of 200232.1
                          
                          Certification
      by the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as
      adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
      200232.2
                          
                          Certification
      by the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as
      adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
      2002
 
 *  Management
contract or compensatory plan or arrangement.