UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





FORM 10-Q





(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, 2011


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)





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  ̈Not applicable þ





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
o

Accelerated filer
oNon-accelerated filer
o

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 13, 2011 there were 17,858,837 shares of the issuer’s common stock, par value $0.001 issued and outstanding.










IMAGE METRICS, INC.


MARCH 31, 2011 QUARTERLY REPORT ON FORM 10-Q


TABLE OF CONTENTS




PAGEPART I - FINANCIAL INFORMATIONItem 1.
Financial Statements

1Consolidated Balance Sheets as of March 31, 2011 (Unaudited) and September 30, 2010

1Consolidated Statements of Operations for the three months ended March 31, 2011 and 2010 (Unaudited)

2Consolidated Statements of Cash Flows for the three months ended March 31, 2011 and 2010 (Unaudited)

3Notes to Consolidated Financial Statements (Unaudited)

4Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations

20Item 3.
Quantitative and Qualitative Disclosures About Market Risk

28Item 4.
Controls and Procedures

28PART II - OTHER INFORMATIONItem 1.
Legal Proceedings

29Item 1A.
Risk Factors

29Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds

36Item 3.
Defaults Upon Senior Securities

36Item 4.
Submission of Matters to a Vote of Security Holders

36Item 5.
Other Information

36Item 6.
Exhibits

36










PART 1 – FINANCIAL INFORMATION





ITEM 1. FINANCIAL STATEMENTS




Image Metrics, Inc.


Consolidated Balance Sheets


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





March 31,

2011


September 30,

2010(Unaudited)AssetsCurrent assetsCash and cash equivalents

$
891


$
375Restricted cash


-



60Accounts receivable


235



259Prepaid and other current assets


169



175Total current assets


1,295



869Property and equipment (net)


81



139Other intangibles (net)


3,287



-Total other assets


3,368



139Total assets

$
4,663


$
1,008Liabilities and shareholders’ deficitCurrent liabilitiesAccounts payable

$
1,093


$
1,392Accrued expenses and other current liabilities


834



656Deferred revenue


5,883



5,699Notes payable, current portion, net of discount


2,057



2,231Notes payable to related party, net of discount


650



599Warrant liability


342



2,646Total current liabilities


10,859



13,223Notes payable, non-current portion, net of discount


4,459



-Total liabilities


15,318



13,223Shareholders’ deficitCommon Stock, $0.001 par value. Authorized 75,000,000 shares; issued and outstanding 17,858,837 and 15,869,277 shares at March 31, 2011 and September 30, 2010, respectively


18



16Series A Convertible Preferred stock, $0.001 par value.  authorized 15,000,000 shares; issued and outstanding 10,680,536 and 10,330,536 shares at March 31, 2011 and September 30, 2010, respectively


7,554



7,400Additional paid-in-capital


20,774



17,933Accumulated deficit


(38,810
)


(37,318
)Accumulated other comprehensive loss


(191
)


(246
)Total shareholders’ deficit


(10,655
)


(12,215
)Total liabilities and shareholders’ deficit

$
4,663


$
1,008




See notes to the consolidated financial statements.





1




Image Metrics, Inc.


Consolidated Statements of Operations


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


(unaudited)




Three Months ended

March 31,


Six Months ended March

31,2011


2010


2011


2010Revenue

$
435


$
1,575


$
985


$
3,962Cost of revenues (exclusive of depreciation and amortization shown separately below)


(383
)


(825
)


(792
)


(1,639
)Gross profit


52



750



193



2,323Operating expensesSelling and marketing


258



490



480



843Research and development


433



227



729



610Depreciation and amortization


29



49



65



93General and administrative


1,106



1,780



2,292



3,835Total operating expenses


1,826



2,546



3,566



5,381Operating loss


(1,774
)


(1,796
)


(3,373
)


(3,058
)Interest income (expense), net


2,411



(3,345
)


1,942



(3,425
)Foreign exchange gain(loss)


52



(144
)


4



(128
)Total other income (expense), net


2,463



(3,489
)


1,946



(3,553
)Loss before income taxes


689



(5,285
)


(1,427
)


(6,611
)Provision for income taxes


-



-



-



-Net income (loss)

$
689


$
(5,285
)

$
(1,427
)

$
(6,611
)Deemed dividend


-



(1,110
)


(65
)


(1,110
)Net income (loss) attributable to common stock

$
689


$
(6,395
)

$
(1,492
)

$
(7,721
)Net income (loss) attributable per share of common stockBasic

$
0.04


$
(0.50
)

$
(0.09
)

$
(0.63
)Diluted


0.02



(0.50
)


(0.09
)


(0.63
)Weighted average shares used in computing net income (loss) attributable per share of common stockBasic


17,284,075



12,784,970



16,576,676



12,318,304Diluted


28,791,284



12,784,970



16,576,676



12,318,304





See notes to the consolidated financial statements.





2




Image Metrics, Inc.


Consolidated Statements of Cash Flows


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


(unaudited)




Six Months ended March 31,2011


2010Operating activities:Net loss

$
(1,427
)

$
(6,611
)Adjustments to reconcile net loss to net cash provided by operating activities:Depreciation and amortization


65



93Stock based compensation


173



195Non-cash interest expense (income)


(2,223
)


3,290Foreign currency transaction loss (gain)


(4
)


162Changes in assets and liabilities:Restricted cash


60



-Accounts receivable


24



245Prepaid expenses, other current and non-current assets


5



52Deferred revenue


184



(2,233
)Accounts payable


(299
)


764Accrued expenses and other liabilities


178



(301
)Total adjustments


(1,837
)


2,267Net cash used in operating activities


(3,264
)


(4,344
)Investing activities:Purchase of fixed assets


(6
)


(116
)Net cash used in investing activities


(6
)


(116
)Financing activities:Proceeds from exercise of stock options


-



2Payments on nonconvertible notes to nonrelated parties


(150
)


(253
)Payments on convertible notes to nonrelated parties


(25
)


(400
)Proceeds from issuance of convertible notes and detachable warrants to nonrelated parties


3,800



3,175Proceeds from sale of stock and warrants


215



2,921Change in restricted cash for equity obligations


-



(400
)Payment of debt issuance costs


-



(80
)Net cash provided by financing activities


3,840



4,965Effects of exchange rates on cash and cash equivalents


(54
)


(33
)Net increase in cash and cash equivalents


516



472Cash and cash equivalents, beginning of period


375



803Cash and cash equivalents, end of period

$
891


$
1,275Supplemental disclosure of cash flow information:Cash paid during the period:Interest

$
15


$
102Income taxes


1



-Non-cash financing activities:Conversion of notes payable to Series A Preferred Shares

$
-


$
5,410Gain on retirement of debt

$
(5
)

$
-Issuance of warrants in connection with convertible notes payable

$
-


$
129Beneficial conversion feature in connection with convertible notes payable

$
-


$
630Beneficial conversion feature in connection with Series A convertible preferred stock

$
65


$
640Beneficial conversion feature in connection with Series B convertible preferred stock

$
-


$
470Purchase of Big Stage EnterpriseNet assets acquired

$
3,287


$
-Assumption of debt

$
575


$
-Issuance of common stock

$
2,596


$
-





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 subsidiary.





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 $38.8 million deficit as of March 31, 2011. 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 its 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 Sheet as of March 31, 2011 the Consolidated Statements of Operations for the three and six months ended March 31, 2011 and 2010, and the Consolidated Statements of Cash Flows for the six months ended March 31, 2011 and 2010 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, 2011, our results of operations for the three and six months ended March 31, 2011 and 2010, and our cash flows for the six months ended March 31, 2011 and 2010. The results of operations for the three and six months ended March 31, 2011 are not necessarily indicative of the results to be expected for the year ending September 30, 2011.





4


These unaudited interim Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and related notes on our Annual Report on Form 10-K filed on February 14, 2011 as amended on February 22, 2011.
 
 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, the Company 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 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.
 
 Prior to the exchange transaction, the Company was named International Cellular Accessories (“ICLA”). ICLA did not have any operations and had nominal assets.  Subsequent to the exchange transaction, the former Image Metrics LTD shareholders held a majority of the voting interest in the Company.  Therefore, the exchange transaction was determined to be the merger of a private operating company, Image Metrics, LTD, into a public non-operating shell, ICLA.  Accordingly, the Company accounted for the exchange as a capital transaction in which Image Metrics LTD issued stock for the net monetary assets of the Company accompanied by a recapitalization.  The pre-acquisition financial statements of the accounting acquirer, Image Metrics LTD, became the historical financial statements of the combined companies.  These historical 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 subsidiary.  Additionally, the Company’s pre-exchange transaction equity has been restated to reflect the equivalent number of common shares of the Company received by Image Metrics LTD shareholders in the exchange transaction, with differences between the par value of the Company’s and Image Metrics LTD’s stock recorded as an adjustment to additional paid in capital. Upon the exchange transaction, the Company adjusted its capitalization to reflect the legally issued and outstanding shares existing pursuant to the exchange.
 
 Purchase of Big Stage Enterprise Intellectual Property
 
 On January 31, 2011, Image Metrics Inc. entered into an agreement to purchase certain intellectual property, inventories and receivables of Big Stage Entertainment, Inc., a Delaware corporation (“Big Stage”), for 2,000,000 shares of Image Metrics common stock, the assumption of $0.58 million of Big Stage bank debt and the payment of $0.09 million of deal-related expenses on behalf of Big Stage.  Image Metrics did not acquire all of the assets or business previously conducted by Big Stage or any of its employees. This purchase was accounted for as a purchase of assets. The shares of common stock of Image Metrics were valued at approximately $2.60 million using the closing price of the common stock on January 31, 2011 which was $1.30.
 
 5
 
 Concentration of Credit Risk
 
 The Company’s largest single customer accounted for 17% and 62% of our revenue for the three months ended March 31, 2011 and 2010, respectively, and 44% and 81% of our revenue for the six months ended March 31, 2011 and March 31, 2010, 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, 2011 and September 30, 2010, the Company did not have any outstanding accounts receivable from this customer.
 
 Cash and Cash Equivalents
 
 The Company considers cash in bank and short term investments purchased with stated maturities of three months or less from the date of purchase are classified as cash equivalents.  The carrying amounts reflected in the consolidated balance sheets for cash and cash equivalents approximate the fair values due to the highly liquid nature of these investments.
 
 6
 
 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”) 2010-13, “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. 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 Company would transact if the unit of accounting were sold by the Company regularly on a standalone basis. During fiscal year 2010 and the six months ended March 31, 2011, the majority of our revenue is related to contracts that involve the delivery of multiple elements. Since the Company did not have VSOE or TPE, all the revenue associated with these contracts was recognized based on estimated selling price.
 
 Subsequent Events
 
 In May 2010, 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 this quarterly report on 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.
 
 7
 
 Non-Marketable Equity Securities
 
 The Company periodically reviews its marketable securities, as well as its non-marketable equity securities, for impairment. If the Company concludes that any of these investments are impaired, the Company determines whether such impairment is “other-than-temporary.” Factors the Company considers to make such determination include the duration and severity of the impairment, the reason for the decline in value and the potential recovery period, and its intent to sell, or whether it is more likely than not that the Company will be required to sell, the investment before recovery. If any impairment is considered “other-than-temporary,” the Company will write down the asset to its fair value and take a corresponding charge to its Consolidated Statements of Operations.  As of March 31, 2011and September 30, 2010, the Company did not have any marketable securities.
 
 Accounting for Notes Payable with Equity Instruments
 
 In connection with the sale of debt or equity instruments, the Company 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.
 
 For options, warrants and bifurcated embedded derivative features that are accounted for as derivative instrument liabilities, the Company estimates fair value using either the Monte Carlo Simulation models or the Black-Scholes-Merton model. 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, the Company estimates the future volatility of our common stock price based the experience of other entities considered comparable to our company.
 
 Certain of our warrants outstanding contain price protection provisions whereby the exercise price could be adjusted upon certain financing transaction at a lower price per share and therefore are no longer viewed as indexed to our common stock. As a result, the Company accounts for these warrants as a derivative under ASC 815 and recorded them as liabilities under the caption of “Warrant Liability” at fair value. The Company determines the fair value of these instruments through the use of the Monte Carlo Simulation model. In accordance with ASC 480 and 815, any changes to the fair value of these instruments are recorded in interest expense in the consolidated statement of operations.
 
 Impact of Recently Issued Accounting Standards





There were no accounting pronouncements adopted by the Company or issued during the three months ended March 31, 2011 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.





2.      Other Intangibles





Other intangibles consist of software to be sold or leased, which waspurchased as part of the purchase of Big Stage Entertainment’s intellectual property (refer to note 1 for further information) and will be amortized over the expected period of benefit upon the Company starting to market and sell the products and service offerings supported by this intellectual property. Information regarding our intangible assets that are to be amortized is as follows (in thousands):


Gross

Carrying

Amount


Accumulated

Amortization


Net

Carrying

ValueSoftware to be sold or leased

$
3,287


$
-


$
3,287





8





As of March 31, 2011, the Company has not recorded any amortization expense for its software to be sold or leasedand will not record any amortization expense until the Company starts to market and sell the products and service offerings supported by this intellectual property.  The Company anticipates selling products and offerings supported by this technology within the next twelve months.




The Company will start to amortize the intellectual property and any additional capitalized costs when the product is available for general release to customers.  The annual amortization shall be the greater of the amount computed using (a) the ratio that current gross revenues for a product bear to the total of current and anticipated future gross revenues for that product or (b) the straight-line method over the remaining estimated economic life of the product including the period being reported on.




3.
Fair Value Measurements





The Company follows guidance that requires certain fair value disclosures regarding the Company’s financial and non-financial assets and liabilities.  Fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or a liability.  The Company does not have any financial assets required to be recorded at fair value on a recurring basis, nor financial assets and liabilities required to be recorded at fair value on a non-recurring basis.  The Company does record a liability for its outstanding warrants at fair value, see note 5 for further discussion.





Fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or a liability. A three-tier value hierarchy is established as a basis for considering such assumptions and for inputs used in the valuation methodologies in measuring fair value:





Level 1 - Observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets.





Level 2 - Include other inputs that are directly or indirectly observable in the marketplace.





Level 3 - Unobservable inputs which are supported by little or no market activity.





The fair value hierarchy also requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.





The Company’s warrant liability is classified within Level 3 because it is valued using significant inputs unobservable in the market.  (See note 1 for methodology used to determine fair value.)





Assets and liabilities measured at fair value on a recurring basis as of March 31, 2011 were as follows (in thousands):


Description

March31,

2011


Quoted Prices inActive

Markets forIdentical Assets

(Level 1)


Significant Other

ObservableInputs

(Level 2)


Significant

UnobservableInputs

(Level 3)Cash

$
891


$
891



—



—Warrant liability

$
342



—



—


$
342





9





The warrant liability which is included within current liabilities represents the fair value of the warrants outstanding.  The warrants contain anti-dilution provisions that cause a downward adjustment in the exercise price if the Company issues shares of its common stock at a price below the trigger price then in effect.  As of March 31, 2011, the trigger price was $1.00.





Currently, there is not an observable market for this type of derivative and, as such, we determined the value of the derivative using a Monte Carlo Simulation, 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, the risk-free interest rate, and assumptions about events triggering down round repricing of the warrants.  The underlying security of the warrants are unregistered common stock, as such, the Company has determined the value of an unregistered share of common stock has a lower value than a registered share of common stock for lack of a market for these shares.  The discount for lack of marketability was determined based on the put value of an option on the common  shares underlying the warrants using a Black-Scholes-Merton model with a three month estimated life.  The three month estimated life was determined to be the expected time before the underlying security would be registered.





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 and liabilities measured and recorded at fair value on a recurring basis, using significant unobservable inputs (Level 3) for the quarter ended March 31, 2011 (in thousands):


Level 3Balance at September 30, 2010

$
2,646Issuance of warrants with derivatives


62Total gains or losses (realized/unrealized):


-Included in earnings (or changes in net assets)


(2,366
)Included in other comprehensive income


-Transfers in to Level 3


-Balance at March 31, 2011

$
342





For assets and liabilities recorded at other than fair value, the carrying value of cash and cash equivalents, accounts receivable, accounts payable, accrued expenses and other current liabilities and short-term debt approximate their fair value because of the short-term maturity of these instruments.   The fair value and carrying value, before applying discounts, of the Company’s notes payable are summarized as follows (in thousands), see note 3 for further details on the Company’s debt:





March 31, 2011


September 30, 2010Carrying

value


Fair

value


Carrying

value


Fair

valueLiabilitiesCurrent portion of notes payable

$
2,057


$
2,057


$
2,305


$
2,305Current portion of notes payable to related party


650



650



650



650Noncurrent portion of notes payable


4,459



4,459



-



-Noncurrent portion of notes payable to related party


-



-



-



-$
7,166


$
7,166


$
2,955


$
2,955Discount on notes payable


-



-



(123
)


-7,166



7,166



2,832



2,955





10





4.
Notes Payable





Q4 2010 Secured Convertible Loan





On September 9, 2010, the Company established a secured convertible loan facility.  The facility   was initially established for a maximum of $2.60 million.  On March 28, 2011, the Company entered into an amendment to this loan agreement which increased the size of the credit facility to $7.1 million and extended the maturity date to January 31, 2013.  Under the amendment, the Company is required to make payments starting on July 1, 2011 and on the first business day of each month thereafter until paid in full or on the maturity date of the facility.  The scheduled payment amount each month equals the total interest accrued on the outstanding principal balance plus $150,000.





Borrowings under the agreement (i) are secured by a first priority lien on all of the Company’s assets, including the assets of the Company’s principal operating subsidiary, and a cross-guarantee by that subsidiary, (ii) bear interest at 13.5% per annum, and (iii) may be converted at any time and from time to time, at the option of the holder, into shares of the Company’s common stock at an exercise price of $1.00 per share.





Holders of the notes associated with this loan are entitled to receive 7.5% of revenue obtained from the future commercialization of the Company’s Facemail offering.  The holders are entitled to this revenue share for five years after the initial commercial release of the Facemail offering.





In the event the Company fails to repay the promissory notes in full on or before the maturity date, the promissory notes’ interest rate will be increased to 18% per annum.   The Company may, at its option, prepay all or any part of the principal of the promissory notes without payment of any premium or penalty.





The Company had recognized interest expense during the three months ended March 31, 2011 of $0.14 million related to this loan.  As of March 31, 2011, the Company had $0.23 million of accrued interest for this loan.  As of March 31, 2011, the amount of principal outstanding for this loan was $5.43 million.





Until the Q4 2010 Secured Convertible Loan is paid in full, the Company is required to obtain written consent of the lender to perform any of the following: issue any secured debt, make any loans or advances, purchase equity of an individual, firm or corporation, merge or consolidate with another corporation, sell assets outside of the normal course of business or for a price below fair market value, enter into a new line of business, or change state of incorporation.





Q3 2010 Bridge Loan





During the third quarter of 2010, the Company established a $1.50 million credit facility (“Q3 2010 Bridge Loan”). Between May and July 2010, the Company issued $1.50 million in promissory notes under this facility. The payment of the promissory notes and the Company’s obligations thereunder are not secured by any collateral. The promissory notes bear interest at 10% per annum and mature at the earlier of February 24, 2011 or such date the Company completes a private placement of units consisting of one share of the Company’s series A convertible preferred stock and a detachable warrant to purchase one-half share of its common stock (an “Offering”); provided that, at any closing of an Offering, not more than 50% of the closing net proceeds will be repaid to any lender before a minimum of $2.50 million in aggregate net proceeds have been raised by the Company. Upon the Company completing an Offering, the holders of these notes have the option to convert the principal and accrued interest into the Offering at the price of $1.00. In the event the Company fails to repay the promissory notes in full on or before the maturity date, the promissory notes’ interest rate will be increased to 18% per annum and the promissory notes will be convertible into common stock of the Company at a conversion price of $0.50 per share. The Company may, at its option, prepay all or any part of the principal of the promissory notes without payment of any premium or penalty. The holders of the notes also received warrants to purchase 450,000 shares of the Company’s common stock at $1.50 per share and have expiration dates between May and July 2014.





11





The warrants contain anti-dilution provisions that cause a downward adjustment in the exercise price if the Company issues shares of its common stock at a price below the trigger price then in effect.  As of March 31, 2011, the trigger price was $1.00. These warrants are treated as derivatives and recorded as warrant liability on the balance sheet.  Currently, there is not an observable market for this type of derivative and, as such, the Company determined the value of the derivative using a Monte Carlo Simulation, 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, the risk-free interest rate, and assumptions about events triggering down round repricing of the warrants.  The underlying security of the warrants are unregistered common stock, as such, the Company has determined the value of an unregistered share of common stock has a lower value than a registered share of common stock for lack of a registered marketability for these shares.  The discount for lack of marketability was determined based on the put value of an option on the common shares underlying the warrants using a Black-Scholes-Merton model with a three month estimated life.  The three month estimated life was determined to be the expected time before the underlying security would be registered.





The Company, though the use of a Monte Carlo Simulation valuation method, assigned a fair value of $204,000 to these warrants and recorded a discount against the Q3 2010 Bridge Loan for an equal amount that was amortized through the contractual maturity date of February 25, 2011.  The discount was completely amortized as of March 31, 2011.





During the 4th quarter of fiscal year 2010, $0.45 million of the promissory notes were converted into equity as part of the Q3 2010 Private Offering, see note 5 for further discussion.





On February 25, 2011, the holder of $0.35 million of the promissory notes amended the terms of the notes, extending the maturity date to December 25, 2011, increasing the interest rate to 12% per annum, and requiring principal payments of $25,000 per month starting March 25th and each month thereafter until December 25, 2011.  Additionally, the holder of these promissory notes will receive warrants to purchase 10,000 shares of common stock each month any amount remains outstanding of the notes.  Each warrant shall have terms identical to the warrants issued in connection with the original promissory note, except that they shall expire four years from the date of their respective issuance and shall have an exercise price of $1.00.





As of March 31, 2011, the Company had $0.65 million in promissory notes outstanding under this credit facility, all of which was held by Saffron Hill Ventures Guernsey LTD.  The promissory notes outstanding are accruing interest at 10% per annum until paid in full.





As of March 31, 2011, the Company had accrued interest related to these notes in the amount of $0.05 million and had recognized interest expense during the three months ended March 31, 2011 of $0.02 million.





ICLA Notes





Between May 10, 2006 and February 22, 2010, the Company issued an aggregate of $0.20 million of convertible notes. The convertible notes accrue interest at 5% per annum, compounded annually.  We are currently in default of these convertible notes.  Upon completion of the share exchange transaction on March 10, 2010, these convertible notes entered a default status as a result of the Company having a change of ownership. As of March 31, 2011, the principal and accrued interest owed on these loans was $0.22 million.





Saffron Hill Ventures II 2010 Loan





On April 27, 2010, Image Metrics LTD signed a loan agreement with its largest shareholder, Saffron Hill Ventures (“SHV”) in the amount of $1.2 million. 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.)





12





Private Individual Loan





On March 13, 2010, Image Metrics LTD signed a loan agreement with a private individual. The loan facility was for a maximum of $0.50 million and bore interest at 5.0% plus the London Interbank Offered Rate (LIBOR), the effective interest rate as of March 10, 2010 was 5.23%. All principal and accrued interest was converted into equity as part of the Company’s private offering that closed on March 10, 2010, see note 5 for further discussion.





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 $1.00 million with the proceeds to be used for general working capital.  The loan is to be paid in equal installments commencing July 2008 and continuing through March 31, 2011 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 £0.14 million of Image Metrics LTD’s shares at an exercise price equal to the lower of £1.65 or the price offered to investors in the next equity offering made by Image Metrics LTD and are treated as derivatives and recorded as warrant liability on the balance sheet.  Currently, there is not an observable market for this type of derivative and, as such, the Company determined the value of the derivative using a Monte Carlo Simulation, 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, the risk-free interest rate, and assumptions about events triggering down round repricing of the warrants.  Prior to March 15, 2010, the Company’s common stock was not traded on any stock exchange, as such, the Company, through the use of a third party valuation firm, determined the fair value of its common stock as of October 1, 2009 and December 31, 2009.   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 Company, through the use of a Monte Carlo Simulation method, assigned a fair value of $0.10 million to these warrants and recorded a discount against the ETV Capital 2008 Loan for an equal amount that was amortized as interest expense through December 31, 2010. The discount was completely amortized as of December 30, 2010.  The Company did not recognized any interest expense from the amortization of the discount during the three months ended March 31, 2011 and recognized $0.03 million of interest expense for the three months ended March 31, 2010 from the amortization of this discount. The Company did not recognize any interest expense for the contractual interest obligation of the note during the three months ended March 31, 2011 and recognized less than $0.02 million of interest expense for the three months ended March 31, 2010 for the contractual interest obligation on the note.





ETV, also, received options to purchase up to $0.20 million of shares of equity of Image Metrics LTD in the Company’s first offering after the loan was established. These options expired unexercised in December 2008. The Company determined the value of these options through the use of the Black-Scholes- Merton option pricing model. The value assigned to these options was $0.21 million and a corresponding notes payable discount in an equal amount was recorded at the time of issuance. The discount was completely amortized as of December 31, 2010.  The amortization of the discount was combined with fair value accounting for the warrants discussed above and was recorded as interest expense on the accompanying consolidated statement of operations.





13





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.





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 per share, for $8.0 million gross proceeds.  The $8.0 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.  The value assigned to the warrants and the Series A Convertible Preferred Stock was determined using a Monte Carlo simulation as described under “Warrant Liability” in this footnote.





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 in the amount of $2.0 million in 10% Unsecured Convertible Notes.





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 per share.





The warrants contain anti-dilution provisions which cause a downward adjustment in the exercise price if the Company issues shares of its common stock at a price below the trigger price then in effect.  As of March 31, 2011, the trigger price was equal to $1.  The warrants were recorded as a warrant liability on the balance sheet.





14





Currently, there is not an observable market for this type of derivative and, as such, we determined the value of the derivative using a Monte Carlo Simulation, 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, the risk-free interest rate, and the assumption about events triggering down round pricing of the warrants.  The underlying security of the warrants are unregistered common stock, as such, the Company has determined the value of an unregistered share of common stock has a lower value than a registered share of common stock for lack of a registered market for these shares.  The discount for lack of market was determined based on the put value of an option on the common stock underlying the warrants using a Black-Scholes-Merton model with a three month estimated life.  The three month estimated life was determined to be the expected time before the underlying security would be registered.  The warrant liability fair value was determined at time of each issuance and is revalued at the end of each reporting period to fair value using a Monte Carlo Simulation with any changes being recorded to the interest expense in the period the change occurs.  $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 in 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.  The value assigned to the warrants and the Series A Convertible Preferred Stock was determined using a Monte Carlo Simulation.  The fair value of the common stock into which the convertible preferred stock was convertible into on the date of issuance exceeded the proceeds allocated to the redeemable convertible preferred stock by $0.60 million, resulting in a beneficial conversion feature that was recognized as an increase to additional paid-in capital and as a deemed dividend to the convertible preferred stockholders.





Q4 2010 Private Equity Offering





On July 26, August 31 and September 20, 2010, the Company closed three rounds of a private equity offering.  The Company sold 959,438 units, each consisting of one share of the Company’s Series A Convertible Preferred Stock and a detachable, transferable warrant to purchase 1⁄2  a share of the Company’s common stock at an exercise price of $1.50 per share, for $0.95 million in gross proceeds.  The $0.95 million in gross proceeds included the conversion of $0.45 million promissory notes from the Q3 2010 Bridge Loan.  The proceeds from this offering were reduced by $0.14 million for transaction costs, which primarily consisted of legal fees and broker commissions, yielding net proceeds of $0.36 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.   The value assigned to the warrants and the Series A Convertible Preferred Stock was determined using a Monte Carlo Simulation.  The fair value of the common stock into which the convertible preferred stock was convertible into on the date of issuance exceeded the proceeds allocated to the redeemable convertible preferred stock by $0.28 million, resulting in a beneficial conversion feature that was recognized as an increase to additional paid-in capital and as a deemed dividend to the convertible preferred stock.





Q1 2011 Private Equity Offering





During the first quarter of fiscal year 2011, the Company sold an aggregate of 350,000 shares of its Series A Convertible Preferred Stock, each with a detachable, transferable warrant to purchase 1⁄2 a share of the Company’s common stock at an exercise price of $1.50 per share, for $0.35 million in gross proceeds.   The proceeds from this offering were reduced by $0.13 million for broker commissions, yielding net proceeds of $0.22 million.





15





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 and have expiration dates between November and December 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 determined using a Monte Carlo Simulation.  The fair value of the common stock into which the convertible preferred stock was convertible into on the date of issuance exceeded the proceeds allocated to the redeemable convertible preferred stock by $0.06 million, resulting in a beneficial conversion feature that was recognized as an increase to additional paid-in capital and as a deemed dividend to the convertible preferred stock.





Warrant Liability





Between March 2010 and March 2011, in connection with the issuance of the Company’s bridge loans and private placements, the Company issued warrants to purchase 8,476,717 shares of common stock at an exercise price of $1.50 per share, 245,000 shares of common stock at an exercise price of $1.00 and 500,700 shares of common stock at an exercise price of $1.20 per share. The warrants are exercisable at the option of the holders at any time through their expiration dates, which occur between March 2014 and 2015.  The warrants were recorded as a warrant liability on the balance sheet. The warrant liability fair value was determined at time of each issuance.  The fair value was determined using a Monte Carlo Simulation. The warrant liability is revalued at the end of each reporting period to fair value using a Monte Carlo Simulation model with any changes being recorded to the interest expense in the period the change occurs.





The warrants associated with the bridge loans and private placements contain anti-dilution provisions that cause a downward adjustment in the exercise price if the Company issues shares of its common stock at a price below the trigger price then in effect.  As of March 31, 2011, the trigger price was equal to $1.  The warrants were recorded as a warrant liability on the balance sheet.





Currently, there is not an observable market for this type of derivative and, as such, we determined the value of the derivative using a Monte Carlo Simulation, 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, the risk-free interest rate, and the assumptions about events triggering down round repricing of the warrants.  The underlying security of the warrants are unregistered common stock, as such, the Company has determined the value of an unregistered share of common stock has a lower value than a registered share of common stock for lack of a market for these shares.  The discount for lack of market was determined based on the put value of an option on the common stock underlying the warrants using a Black-Scholes-Merton model with a three month estimated life.  The three month estimated life was determined to be the expected time before the underlying security would be registered.  The warrant liability fair value was determined at time of each issuance and is revalued at the end of each reporting period to fair value using the Monte Carlo simulation with any changes being recorded to the interest expense in the period the change occurs.





The fair value of the warrants was estimated to be $0.3 million as of March 31, 2011 and $2.6 million as of September 30, 2010.  The following assumptions were used to estimate the fair value of the warrants as of March 31, 2011 and September 30, 2010:


March

31, 2011


September

30, 2010Common stock fair value

$
0.50
(1)

$
1.07
(1)Volatility


51
%


53
%Contractual term (years)


2.95



3.44Risk-free rate


1.29
%


0.64
%Expected dividend yield


0.0
%


0.0
%





(1)
The common stock underlying the warrant is not registered with U.S. Securities and Exchange Commission; therefore, the underlying security is not tradeable on the OTC Bulletin Board.  The Company applied a discount for lack of market to the market value of its common stock to determine the fair value of the Company’s common stock. The discount for lack of market was determined based on an analysis completed by management based upon the value of a put option on the common stock using the Black-Scholes-Merton model.





16





During the three and six months ended March 31, 2011, the Company recorded $2.66 million and $2.36 million of interest income for these warrants, respectively.  The Company recorded $2.53 million of interest expense during the three and six months ended March 31, 2010 for these warrants.





SEC Registration rights





Pursuant to a subscription agreement with the selling stockholders relating to our March and July - September 2010 private placements and the Q4 2010 Secured Convertible Loan, the Company committed to meeting certain SEC registration requirements, including the requirement to file a Form S-1.  If the Company fails to meet any of these filing 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 default is cured to the investors who subscribed to the March private placement.  These damages can be waived if the Company's Board of Directors determines the Company's management has exerted its best efforts to meet the requirements.





In May 2010, the Company’s Board of Directors granted the Company an indefinite waiver of its obligations to meet its requirement to file a Form S-1.  In addition, in August 2010, the Board of Directors granted the Company a waiver of its obligation to meets its requirement to file Form 8-Ks and  a Form 10-Q for the period ended June 30, 2010.  On February 13, 2011, the Company’s Board of Directors granted the Company a waiver of its obligation to meet its requirement to file a Form 10-K for the fiscal year 2010.  As a result of these waivers, the Company is not subject to pay its investors any damages; therefore, the Company has not recorded any liabilities for such damages.





On November 1, 2010, the Company filed a Form S-1.  The Form S-1 was a registration for the sale of up to 21,397,955 shares of our common stock by the selling stockholders listed in the Form S-1.  These shares consist of 10,330,538 shares of common stock issuable upon conversion of our series A convertible preferred stock, 8,767,417 shares of common stock issuable upon exercise of our warrants and 2,300,000 shares of common stock issuable upon conversion of all of the principal and accrued interest of our convertible promissory notes. The distribution of the shares by the selling stockholders is not subject to any underwriting agreement.  The Company will receive none of the proceeds from the sale of the shares by the selling stockholders, except upon exercise of the warrants.  The Company will bear all expenses of registration incurred in connection with this offering, but all selling and other expenses incurred by the selling stockholders will be borne by them.  As of May 13, 2011, the Company was in process of submitting an amendment to the Form S-1 to update all the financial information and disclosures and replying to the SEC’s comments to its original Form S-1 filing.





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 224,522 preferred shares of the Company at an exercise price of $1.50.  As of March 31, 2011, all the warrants were outstanding. The Company compared the fair value of the ETV options and warrants prior to exchange and subsequent to the exchange and concluded the value did not increase; therefore, the Company did not record any additional interest expense for this exchange.  The discount associated with these warrants was fully amortized as of March 31, 2011. (See note 3 for additional discussion.)





17





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 31,2011


2010


2011


2010Net income (loss)

$
689


$
(5,285
)

$
(1,427
)

$
(6,611
)Foreign currency translation adjustments


52



(4
)


55



(5
)Comprehensive income (loss)

$
741


$
(5,289
)

$
(1,372
)

$
(6,616
)





7.
Net Income (Loss) per Common Stock and Dilutive Securities





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.  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, 2011, shares of potential common stock of 12.0 million and 23.0 million, respectively, were not included in the diluted calculation because the effect would be anti-dilutive. For the three and six months ended March 31, 2010, shares of potential common stock of 7.4 million and 4.5 million, respectively, 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 $0.04 million and $0.17 million for the three months ended March 31, 2011 and 2010, respectively.  The Company is committed under operating leases with terminations through 2012 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 ending2011 (April through September)

$
402012


80Thereafter


-Total future minimum lease payments

$
120





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

March 31 ,


Six Months Ended

March 31,2011


2010


2011


2010Europe

$
252



1,211


$
625


$
3,457North America


183



364



360



505Total revenue

$
435


$
1,575


$
985


$
3,962





18





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





Three Months Ended

March 31,


Six Months Ended

March 31,2011


2010


2011


2010Europe

$
(410
)

$
(115
)

$
(640
)

$
(1,545
)North America


1,099



(5,170
)


(787
)


(5,066
)Total net income (loss)

$
689


$
(5,285
)

$
(1,427
)

$
(6,611
)





The following table summarizes interest expense and depreciation by region (in thousands):





Three Months Ended March 31,


Six Months Ended

March 31,2011


2010


2011


2010EuropeInterest expense

$
-


$
(35
)

$
(32
)

$
(126
)Depreciation and amortization


(6
)


(9
)


(14
)


(20
)North AmericaInterest income (expense)


2,411



(3,310
)


1,974



(3,330
)Depreciation and amortization

$
(23
)

$
(40
)

$
(51
)

$
(73
)





10.
Related Party Transactions





During the three months ended March 31, 2011, as part of the Q4 2010 Secured Convertible Loan, the Company received $0.15 million from Peter Norris, one of its Board Directors.  As of March 31, 2011, the Company had outstanding notes payable to Mr. Norris of $0.15 million.  The Company incurred interest expense of less than $0.01 million and had accrued interest on the notes payable of less than $0.01 million as of March 31, 2011.





During the three months ended March 31, 2011 and 2010, the Company incurred interest expense of $0.02 million and $0.04 million, respectively, related to notes payable to SHV, its largest shareholder.  The Company had accrued interest payable to SHV of $0.05 million and $0.03 million as of March 31, 2011 and September 30, 2010, respectively.





The Company did not make any loan payments to SHV during the three months ended March 31, 2011 and 2010.  As of March 31, 2011 and September 30, 2010, the Company had outstanding notes payable to SHV of $0.65 million.





In connection with the March 10, 2010 private equity offering, SHV converted all of its outstanding notes payable into Series A Convertible Preferred Stock and purchased an additional $0.50 million of Series A Convertible Preferred Stock and warrants.  (See note 5 for further discussion.)





11.
Subsequent events





Subsequent to March 31, 2011, the Company had received $0.50 million of additional funds as part of the Q4 2010 Secured Convertible Loan.





19





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 statements that 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 Part II, Item 1A and other factors discussed from time to time in our news releases, public statements and/or filings with 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 are forward-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. The Company undertakes no obligation to update any forward-looking statements or other information contained herein. Although the Company believes 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. The Company discloses 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 Statements for the years ended on September 30, 2010 and 2010 included in our Annual Report on Form 10-K filed with the SEC on February 14, 2011, as amended on February 22, 2011, and the Consolidated Financial Statements and notes thereto included in Part I, Item 1 of this quarterly report on Form 10-Q.





20





Description of Our Company and Predecessor





The Company was 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, the Company 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 the Company was inactive through March 10, 2010, though we continued to timely file our periodic reports with the SEC.





On March 10, 2010, the Company 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 engaged in the business of providing technology-based facial animation solutions to the interactive entertainment industry.  Effective March 10, 2010, the Company 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, the Company believes that it is able to accomplish what other providers simply cannot.  Examples of our notable and innovative facial animation projects include the 2010 “Red Dead Redemption” video game, which sold more than 5 million copies in its first two weeks, 2010 “Grand Theft Auto IV” video game, which generated for Rockstar Games over $500 million in sales in its first week, the 2010 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 2010 Black Eyed Peas’ Boom Boom Pow music video, which in 2010 won the Grammy Award for best short form music video.





Image Metrics was founded in 2000 and has more than 60 man-years - and $14.0 million - invested in our computer vision based software.  The Company derives its 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.





Total revenue during the three months ended March 31, 2011 had decreased by $1.15 million to $0.43 million from $1.58 million during the three months ended March 31, 2010.  The decrease in revenue is the result of fewer customer projects and more of our customers choosing to use purchase our Headstart animation service offering in lieu of our Pro level of animation services.  Our Headstart animation service is primarily completed through the use of our proprietary software and can generate seconds of animation considerably faster than traditional hand animation and is sold by us at a lower price than our Pro level animation.





Gross margin was 12% for the second quarter of fiscal 2011, compared to 48% for the same prior year quarter.  The decrease in gross margin is a direct result of the Company having minimal amount of paying projects to service during the three months ended March 31, 2011 and as a result experienced significant under utilization of our labor that comprises our cost of revenue.





21





Cash flows used for operations were $3.26 million for the first six months of fiscal 2011, compared to $4.34 million in the same period of fiscal 2010. The use of cash flow for operations was positively impacted from a lower net loss and an increase in deferred revenue of $0.18 million during the six months ended March 31, 2011 compared to deferred revenue decreasing by $2.23 million during the six months ended March 31, 2010. Cash flows from financing activities were $3.84 million for the first six months of fiscal 2011, compared to $4.97 million for the same period in 2010.  Decreased cash flows were the result of a lower amount of equity offerings compared to the six months ended March 31, 2010.





Impact of Recently Issued Accounting Standards – need to update


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.





The Company considers 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





The Company derives its 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”) 2010-13, “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, 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 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 the Company concludes it is unable to establish fair values for one or more undelivered elements within a multiple-element arrangement using VSOE, it uses TPE, being the price at which the Company would transact if the unit of accounting were sold by the Company regularly on a stand-alone basis or our best estimate of the selling price for that unit of accounting.  During fiscal year 2010 and the three months ended March 31, 2011, substantially all of our revenue is related to contracts that involve the delivery of multiple elements.  Since the Company did not have VSOE or TPE, all the revenue associated with these contracts was recognized based on estimated selling price.




22





Notes Payable





In connection with the sale of debt or equity instruments, the Company 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 embedded contain 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.





For options, warrants and bifurcated embedded derivative features that are accounted for as derivative instrument liabilities, the Company estimates fair value using either Monte Carlo Simulation, or the Black-Scholes Merton option pricing model. 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, the Company estimates 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. The Company assesses 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 and six months ended March 31, 2011 and 2010, both in dollars and as a percentage of our net sales.





3 months ended March 31,


6 months ended March 31,2011


2010


2011


2010Amount


% of

Revenue


Amount


% of

Revenue


Amount


% of

Revenue


Amount


% of

RevenueRevenue

$
435



100
%

$
1,575



100
%

$
985



100
%

$
3,962



100
%Cost of goods sold (exclusive of depreciation and amortization shown separately below)


(383
)


-88
%


(825
)


-52
%


(792
)


-80
%


(1,639
)


-41
%Gross Profit


52







750







193







2,323Operating ExpensesSelling & Marketing


(258
)


-59
%


(490
)


-31
%


(480
)


-49
%


(610
)


-15
%Research & Development


(433
)


-100
%


(227
)


-14
%


(729
)


-74
%


(843
)


-21
%Depreciation and amortization


(29
)


-7
%


(49
)


-3
%


(65
)


-7
%


(93
)


-2
%General & Administrative


(1,106
)


-254
%


(1,780
)


-113
%


(2,292
)


-233
%


(3,835
)


-97
%Total Op Expenses


(1,826
)


-417
%


(2,546
)


-162
%


(3,566
)


-362
%


(5,381
)


-136
%Operating loss


(1,774
)


-468
%


(1,796
)


-114
%


(3,373
)


-342
%


(3,058
)


-77
%Interest income (expense)


2,411



554
%


(3,345
)


-212
%


1,942



197
%


(3,425
)


-86
%Foreign exchange gain (loss)


52



12
%


(144
)


-9
%


4



0
%


(128
)


-3
%Total other income/(expense)


2,463



566
%


(3,489
)


-222
%


1,946



198
%


(3,553
)


-90
%Income (loss) before taxes


689



158
%


(5,285
)


-336
%


(1,427
)


-145
%


(6,611
)


-167
%Income Taxes


-



0
%


-



0
%


-



0
%


-



0
%Net income (loss)

$
689



158
%

$
(5,285
)


-336
%

$
(1,427
)


-145
%

$
(6,611
)


-167
%




23





Three months ended March 31, 2011 compared to the three months ended March 31, 2010





Total revenue for the three months ended March 31, 2011 decreased by 72% to $0.44 million, compared to $1.58 million in the three months ended March 31, 2010.  The decrease was primarily the result of our largest customer changing the timing of their next major game release further into fiscal year 2011.





Cost 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, decreased by 54%, or $0.44 million, to $0.38 million for the three months ended March 31, 2011, from $0.82 million for the three months ended March 31, 2010.  This decrease was the result of fewer projects being serviced during the three months ended March 31, 2011.





Our profit margin decreased significantly for the three months ended March 31, 2011 to 12% from 48% for the three months ended March 31, 2010.  This deterioration is directly attributable to fewer projects being serviced during the three months ended March 31, 2011.  The lower amount of projects during the three months ended March 31, 2011 resulted in decreased labor utilization rates and excess capacity variances.





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 47%, or $0.23 million, to $0.26 million for the three months ended March 31, 2011 from $0.49 million for the three months ended March 31, 2010.   The lower expenses were directly attributable to fewer sales personnel.





As a percentage of revenue, sales and marketing expenses for the three months ended March 31, 2011 increased by 28% compared to the three months ended March 31, 2010.  The increase compared to revenue is attributable to revenue in the first fiscal quarter of 2011 being significantly lower than the first fiscal quarter of 2010.





Research and Development





Research and development expenses consist primarily of employee-related costs for product research and development.  Research and development expenses increased to $0.43 million for the three months ended March 31, 2011 compared to $0.23 million for the three months ended March 31, 2010.  The increase was attributable to higher personnel as the company continues to expand its R&D efforts on new products. As a percentage of revenue, research and development expenses increased by 86% for the three months ended March 31, 2011 from March 31, 2010.  This increase compared to revenue is attributable to revenue in the first fiscal quarter of 2011 being significantly lower than the first fiscal quarter of 2010.


24





Depreciation and amortization





As a percentage of revenue, depreciation expense increased to 7% for the three months ended March 31, 2011 from 3% for the three months ended March 31, 2010.  This increase compared to revenue is attributable to revenue in the first fiscal quarter of 2011 being significantly lower than the first fiscal quarter of 2010.





General and Administrative





General and administrative expenses consist principally of employee-related costs, professional fees and occupancy costs.  General and administrative expenses decreased 38% or $0.67 million to $1.11 million for the three months ended March 31, 2011 from $1.78 million for the three months ended March 31, 2010.  The majority of the decreased expenses were from decreased legal, accounting and other professional consulting fees of $0.26 million, decreased number of personnel resulting in lower payroll by $0.13 million, decreased rent and other occupancy costs of $0.08 million, and lower travel related expenses of $0.08 million.





Interest Income (Expense)





Interest income and expense is from our notes payable, fair value adjustment for warrant liability and warrants associated with our notes payable.  We recorded net interest income for the three months ended March 31, 2011 of $2.41 million compared to interest expense of $3.35 million in the three months ended March 31, 2010.  This change was attributable to reduction in the valuation of our warrant liability.  The warrants had anti-dilution provisions and are accounted for as a liability until exercised or expired and are marked to market at the end of each reporting period.  The warrant liability adjustment to fair market value resulted in interest income of $2.66 million during the three months ended March 31, 2011.  Whereas we incurred interest expense associated with warrant liability during the three months ended March 31, 2010 of $2.53 million.





As a result of the Company defaulting on certain notes payable issued between October 2006 and February 2010, all outstanding amounts related to these notes payable became immediately payable.  As such, we have classified all these notes payable as current on our Balance Sheet.  These notes continue to accrue interest at 5% per year until paid in full.





Gain (Loss) on Foreign Exchange Transactions





Foreign currency translation was a gain of $0.05 million during the three months ended March 31, 2011 compared to a foreign currency translation loss of $0.14 million during the three months ended March 31, 2010.  The variance was the result of fluctuations in the Euro and the British Pound exchange rates for US Dollars.





Six months ended March 31, 2011 compared to the six months ended March 31, 2010





Total revenue for the six months ended March 31, 2011 decreased by 75% to $0.99 million, compared to $3.97 million in the six months ended March 31, 2010.  The decrease was the result of fewer projects and our largest customer changing the timing of their next major game release further into fiscal year 2011.





Cost 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, decreased by 52%, or $0.85 million, to $0.79 million for the six months ended March 31, 2011, from $1.64 million for the six months ended March 31, 2010.  This decrease was the result of fewer projects being serviced during the six months ended March 31, 2011.


25





Our profit margin decreased significantly for the six months ended March 31, 2011 to 20% from 59% for the six months ended March 31, 2010.  This deterioration is directly attributable to fewer projects being serviced during the six months ended March 31, 2011.  The lower amount of projects during the six months ended March 31, 2011 resulted in decreased labor utilization rates and excess capacity variances.





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 21%, or $0.13 million, to $0.48 million for the six months ended March 31, 2011 from $0.61 million for the six months ended March 31, 2010.   The lower expenses were directly attributable to fewer sales personnel.





As a percentage of revenue, sales and marketing expenses for the six months ended March 31, 2011 increased by 34% compared to the six months ended March 31, 2010.  The increase compared to revenue is attributable to revenue in the first six months of 2011 being significantly lower than the first six months of 2010.





Research and Development





Research and development expenses consist primarily of employee-related costs for product research and development.  Research and development expenses increased to $0.73 million for the six months ended March 31, 2011 compared to $0.84 million for the six months ended March 31, 2010.  The increase was attributable to higher personnel as the company continues to expand its R&D efforts on new products.  As a percentage of revenue, research and development expenses increased by 53% for the six months ended March 31, 2011 from March 31, 2010.  The increase compared to revenue is attributable to revenue in the first six months of 2011 being significantly lower than the first six months of 2010.





Depreciation and amortization





As a percentage of revenue, depreciation expense increased to 7% for the six months ended March 31, 2011 from 2% for the six months ended March 31, 2010.  The increase compared to revenue is attributable to revenue in the first six months of 2011 being significantly lower than the first six months of 2010.





General and Administrative





General and administrative expenses consist principally of employee-related costs, professional fees and occupancy costs.  General and administrative expenses decreased 40% or $1.54 million to $2.29 million for the six months ended March 31, 2011 from $3.83 million for the six months ended March 31, 2010.  The majority of the decreased expenses were from decreased legal, accounting and other professional consulting fees of $0.62 million, decreased number of personnel resulting in lower payroll by $0.29 million, decreased rent and other occupancy costs of $0.22 million, and lower travel related expenses of $0.08 million.





Interest Income (Expense)





Interest income and expense is from our notes payable, fair value adjustment for warrant liability and warrants associated with our notes payable.  We recorded net interest income for the six months ended March 31, 2011 of $1.94 million compared to interest expense of $3.43 million in the six months ended March 31, 2010.  This decrease was attributable to reduction in the valuation of our warrant liability.  The warrants had anti-dilution provisions and are accounted for as a liability until exercised or expired and are marked to market at the end of each reporting period.  The warrant liability adjustment to fair market value resulted in net interest income of $2.37 million during the six months ended March 31, 2011.  Whereas we incurred interest expense associated with warrant liability during the six months ended March 31, 2010 of $2.53 million.


26





As a result of the Company defaulting on certain notes payable issued between October 2006 and February 2010, all outstanding amounts related to these notes payable became immediately payable.  As such, we have classified all these notes payable as current on our Balance Sheet.  These notes continue to accrue interest at 5% per year until paid in full.





Gain (Loss) on Foreign Exchange Transactions





Foreign currency translation was a gain of less than $0.01 million during the six months ended March 31, 2011 compared to a foreign currency translation loss of $0.13 million during the six months ended March 31, 2010.  The variance was the result of fluctuations in the Euro and the British Pound exchange rates for US Dollars.





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, 2011, we had $0.89 million in cash.





Net cash used in operating activities for the six months ended March 31, 2011 and 2010 was $3.27 million and $4.34 million, respectively.  Our net loss of $1.50 million in the six months ended March 31, 2011, was partially adjusted for stock compensation expense of $0.24 million, increased deferred revenue of $0.18 million and increased other liabilities of $0.18 million.  Operating cash flows were negatively impacted by net payments for accounts payable of $0.30 million and noncash interest income of $0.18 million.





The Company used less than $0.01 million in cash for investing activities for the six months ended March 31, 2011 and used $0.12 million for the three months ended March 31, 2010.  The primary purchases for March 31, 2011 consisted of computer equipment and software.





Net cash provided by financing activities was $3.84 million and $4.97 million for the six months ended March 31, 2011 and 2010, respectively.  The primary source of cash provided from financing was the issuance of convertible notes for $3.80 million. Additionally the company received net proceeds of $0.21 million from the sale Series A preferred stock.  Cash inflows were partially offset by $0.15 million of payments on nonconvertible notes and $0.03 million of payments on convertible notes.  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 Series A preferred stock and warrants.  The cash receipts from financing during the six months ended March 31, 2010 were partially offset from payments on nonconvertible notes totaling $0.25 million and $0.4 million of payments on convertible notes.





We have certain notes payable that are in default, these notes payable have not had an adverse impact on our ability to secure additional debt or equity financing and we do not anticipate the defaults on these notes payable to restrict our ability to secure additional financing in the future.





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.




27





Cash Requirements





In addition to the $0.89 million in cash on hand and the $0.23 million in accounts receivable, we have approximately $1.50 million remaining available under our credit facility.  We believe that our cash on hand, cash available from our outstanding credit facility 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 needs 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





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.





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 three month ended March 31, 2011, we had foreign currency transaction gains of $0.05 million while we had foreign currency transaction losses of $0.14 million during the three months ended March 31, 2010.  The variance was a result of fluctuations in the exchange rate between the British pound and the U.S. dollar and the Euro and the U.S. 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





Management’s Report on Internal Control Over Financial Reporting





Our management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Exchange Act Rule 13a-15(f)).  Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes of accounting principles generally accepted in the United States.  Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements.  Therefore, even those systems determined to be effective can provide only reasonable assurance of achieving their control objectives.  In evaluating the effectiveness of our internal control over financial reporting, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control – Integrated Framework.




28





Based on management’s evaluation under the framework in Internal Control—Integrated Framework, our management concluded that our internal control over financial reporting was effective as of March 31, 2011.





This quarterly report does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting.  Management’s report was not subject to attestation by our registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit us to provide only management’s report in this annual report.





Changes in Internal Control Over Financial Reporting




There were no changes in our internal control over financial reporting that occurred during the second quarter of 2011 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act). Internal control over financial reporting means a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.





PART II – OTHER INFORMATION





ITEM 1. LEGAL PROCEEDINGS





We are not party to any material legal proceedings.





ITEM 1A. RISK FACTORS





If any of the following risks actually occur, our business, results of operations and financial condition would likely suffer.  In these circumstances, the market price of our common stock could decline.





Risks Relating to Our Business and Industry





We have a history of operating losses and uncertain future profitability, and we received a going concern qualification in our fiscal 2010 audit; there can be no assurance that we will succeed.





We have incurred losses from operating activities since we began operations and have an accumulated deficit of $38.8 million as of March 31, 2011.  We incurred an operating loss of $1.5 million during the six months ended March 31, 2011, and expect to continue operating at a loss for some period of time. We continue to 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.  The report of our independent registered public accounting firm with respect to our fiscal year ended September 30, 2010 included in this annual report on Form 10-K includes a going concern explanatory paragraph indicating that our recurring operating losses and our current liabilities in excess of our current assets raise substantial doubt about our ability to continue as a going concern.  Depending upon the results of our operations for fiscal 2011 and our ability to raise additional capital, we may also receive a report with a going concern explanatory paragraph from our independent registered public accountants in connection with our financial statements to be included in our annual report on  Form 10-K for the fiscal year ending September 30, 2011.


29


Failure to maintain effective internal controls in accordance with Section 404 of the Sarbanes-Oxley Act of 2002 could prevent us from producing reliable financial reports or identifying fraud.  In addition, current and potential stockholders could lose confidence in our financial reporting, which could have an adverse effect on our stock price.





Effective internal controls are necessary for us to provide reliable financial reports and effectively prevent fraud, and a lack of effective controls could preclude us from accomplishing these critical functions.  We are required to document and test our internal control procedures in order to satisfy the requirements of Section 404 of the Sarbanes-Oxley Act of 2002, which requires annual management assessments of the effectiveness of an issuer’s internal controls over financial reporting.  Assigned to accounting issues at present are only Ron Ryder, our Chief Financial Officer, and two financial consultants, which may be deemed to be inadequate.  Although we intend to augment our internal controls procedures and expand our accounting staff, there is no guarantee that this effort will be adequate.





During the course of our testing, we may identify deficiencies which we may not be able to remediate.  In addition, if we fail to maintain the adequacy of our internal accounting controls, as such standards are modified, supplemented or amended from time to time, we may not be able to ensure that we can conclude on an ongoing basis that we have effective internal controls over financial reporting in accordance with Section 404.  Failure to achieve and maintain an effective internal control environment could cause us to face regulatory action and also cause stockholders to lose confidence in our reported financial information, either of which could have an adverse effect on our stock price.





Management concluded that, as of September 30, 2010, our internal controls and disclosure control processes were not effective.  Subsequent to September 30, 2010, we implemented remedial actions to strengthen our internal controls and disclosure control processes and have since remediated these deficiencies, although there can be no assurance that such deficiencies will not reoccur.





Because the video game 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 never have significant revenues or any profits.





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 an investment in our company 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 these 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.


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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 who 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 an 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.  If a number of our customers were to exercise cancellation rights, our business and operating results would be materially and adversely affected.





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 17% and 62% of our revenue for the three months ended March 31, 2011 and 2010, respectively, and 44% and 81% of our revenue for the six months ended March 31, 2011 and March 31, 2010, respectively, resulted from sales to Take-Two Interactive Software, Inc. (Rockstar Games).  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 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 video game 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 Robert Gehorsam, Chief Executive Officer, Ron Ryder, Chief Financial Officer, and Kevin Walker, Ph.D., Chief Technology Officer.


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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 assumed certain employment agreements from our U.K. predecessor 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.





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 services 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 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.  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 software 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.


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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 our company.  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 an investment in our company.





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 in our company, 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, negotiate advantageous financial terms, retain key personnel from acquired companies, or properly complete and integrate these operations, our business may be adversely affected.





Our customers are on various payment schedules and our 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 uncollectability 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 an investment in our company may be significantly reduced if we cannot fully fund our growth strategy from projected revenue and the proceeds from private placements.





We expect that we will be able to fund the development and growth of our business from existing and projected revenue, along with the net proceeds from debt and equity private placements, to operate for the next 12 months.  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 we are unable to generate on our own, the necessary funds for 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.  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 private placements to fund such expenses and/or seek additional capital.  This will depend on a number of factors, including, but not limited to:


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·
the growth, condition and size of the video game 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 services;


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


·
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, stockholders could experience dilution or a reduction in priority of their 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 in March 2010, we are completing a review of the net operating losses incurred by Image Metrics Limited and Image Metrics CA, Inc., a Delaware corporation and wholly-owned subsidiary of Image Metrics Limited, prior to the transaction.  Our inability to fully utilize our net operating losses to offset taxable income generated in the future could have a negative impact on our future financial position and results of operations.





Disruption and fluctuations in financial and currency markets could have a negative effect on our business.





Financial markets in the United States, Europe and Asia have been experiencing extreme disruption in recent years, including, among other things, extreme volatility in security prices, severely diminished liquidity and credit availability, rating downgrades of certain investments and declining valuations of others. Governments have taken unprecedented actions intended to address extreme market conditions that include severely restricted credit and declines in real estate values. While currently these conditions have not impaired our ability to operate our business, there can be no assurance that there will not be a further deterioration in financial markets and confidence in major economies, which can then lead to challenges in the operation of our business. These economic developments affect businesses such as ours in a number of ways. The tightening of credit in financial markets adversely affects the ability of commercial customers to finance purchases and operations and could result in a decrease in orders and spending for our products as well as create supplier disruptions. Economic developments could also reduce future government spending on our products. We are unable to predict the likely duration and severity of the current disruption in financial markets and adverse economic conditions and the effects they will have on our business and financial condition.


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Our wholly owned subsidiary, Image Metrics Limited, operates in the United Kingdom and we have several customers that pay us in foreign currencies.  Consequently, we are subject to fluctuations in foreign currency exchange rates. Fluctuations in foreign currencies that we make and receive payments in could negatively impact our financial results.





Risks Related to Our Common Stock





There is no active public market for our common stock and an active trading market may not develop.





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 the ability of stockholders to sell their shares at the time they wish to sell them or at a price that they consider reasonable.  The lack of an active market may also reduce the market value and increase the volatility of our 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.





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





As of May 13, 2011, our executive officers and directors as a group beneficially owned approximately 45.6% of our outstanding shares of common stock and voting 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.





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 ® (OTCBB), a regulated quotation service that displays real-time quotes, last-sale prices, and volume information in over-the-counter (OTC) equity securities, stockholders may find fewer buyers to purchase the stock or a lack of market makers to support the stock price.


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We do not anticipate paying dividends in the foreseeable future; investors should not buy our stock if they 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 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 corporate law could discourage a takeover that stockholders may consider favorable.





Our articles of incorporation authorize the issuance of 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.





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, 2011 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 $191,000 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, 2011, the principal and accrued interest owed on these loans was $223,000.  There were no other defaults upon senior securities during the period ended March 31, 2011.





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





None





ITEM 5. OTHER INFORMATION





None





ITEM 6. EXHIBITS





Exhibit

Number

Description31.1

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 2002.31.2

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 2002.32.1

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 2002.32.2

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.




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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.





Date: May 13, 2011





IMAGE METRICS, INC.By:
/s/ Ron RyderRon RyderChief Financial Officer(Principal Financial Officer and Duly Authorized Officer)




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EXHIBIT INDEX


Exhibit

Number

Description31.1*

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





* Filed herewith.


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