UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


WASHINGTON, D.C. 20549





FORM 10-Q


(Mark One)





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





For the quarter ended June 30, 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: 000-53668





NET TALK.COM, INC.


(Exact name of Registrant as specified in its charter)





Florida
20-4830633(State or other jurisdiction of incorporation or organization)
(I.R.S. employer identification no.)





1100 NW 163 Drive, Miami, FL
33169(Address of principal executive offices)
(Zip code)





Registrant's telephone number, including area code:  (305) 621-1200





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 þ  No  ̈





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 x No  ̈





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





Large accelerated filer   ̈

Accelerated Filer   ̈

Non-accelerated filer   ̈

Smaller reporting company  þ





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


The Registrant had 37,064,892 shares of Common Stock, par value $0.001 per share, outstanding as of August 15, 2011.











Net Talk.com, Inc





INDEX





Page No.Part I

Financial InformationItem 1

Financial StatementsBalance Sheets at June 30, 2011 (Unaudited) and September 30, 2010

3Statements of Operations for the Three and Nine Months Ended June 30, 2011and 2010 (Unaudited)

4Statements of Cash Flows for the Nine Months Ended June 30, 2011 and 2010 (Unaudited)

5Notes to Financial Statements

6 - 21Item 2

Management’s Discussion and Analysis of Financial Conditions and Results of Operations

22 - 32Item 3

Quantitative and Qualitative Disclosures About Market Risks

33Item 4

Controls and Procedures

33Part II

Other InformationItem 1

Legal Proceedings

34Item 1A

Risk Factors

34Item 2

Unregistered Sales of Equity Securities and Use of Proceeds

34Item 3

Defaults Upon Senior Securities

34Item 4

Submission of Matters to a Vote of Security Holders

34Item 5

Other information

34Item 6

Exhibits

35Signatures



36-40





2




Part I
 
 Item 1.   Financial statements
 
 Net Talk.com, Inc.
 Balance Sheets
 
 June 30,


September 30,2011


2010(unaudited)AssetsCurrent assets:Cash and cash equivalents

$
2,477,444


$
1,021,684Restricted cash


110,361



2,017,655Accounts receivables, net of allowance for bad debts of $0 and $22,749


197,102



39Inventory


2,057,110



568,560Prepaid expenses


2,069



238,651Total current assets


4,844,086



3,846,589Telecommunication equipment and other property, net


529,860



578,618Intangible assets, net


193,207



366,361Deferred financing costs and other assets


127,000



23,000Total assets

$
5,694,153


$
4,814,568Liabilities, redeemable preferred stock and stockholders' deficitCurrent liabilities:Accounts payable

$
1,198,775


$
534,725Accrued dividends


150,000



93,000Accrued expenses


94,712



58,515Deferred revenue


490,139



92,906Loan from related party


-Current portion of senior secured convertible debentures


-



4,998,773Current portion of derivative liabilities


-



5,905,622Total current liabilities


1,933,626



11,683,541Senior debenture


2,313,778



-Total liabilites


4,247,404



11,683,541Redeemable preferred stock $.001 par value, 10,000,000 shares authorized, 300 issued and outstanding


13,246,619



224,968Stockholders' deficit:Common stock, $.001 par value, 300,000,000 shares authorized, 37,064,892 issued and outstanding, as of June 30, 2011.


37,065



13,430Preferred stock to be issued at future dates


-



2,000,000Additional paid in capital


23,940,901



3,314,488Accumulated deficit


(35,777,836
)


(12,421,859
)Total stockholders' deficit


(11,799,870
)


(7,093,941
)Total liabilities, redeemable preferred stock and stockholders' deficit

$
5,694,153


$
4,814,568
 
 The accompanying notes are an integral part of the financial statements
 
 3
  Net Talk.com, Inc.
 Statements of Operations
 
 Three months ended


Nine months endedJune 30,


June 30,2011


2010


2011


2010Revenues

$
589,257


$
167,820


$
1,671,410


$
597,649Cost of sales


631,007



224,613



1,730,545



651,972Gross margin


(41,750
)


(56,793
)


(59,135
)


(54,323
)Advertising and marketing


612,046



59,151



1,127,767



223,189Compensation and benefits


325,796



193,685



868,790



494,685Professional fees


83,469



45,435



229,205



187,039Depreciation and amortization


91,792



90,948



272,739



272,156Research and development


220,133



92,053



554,810



216,517General and administrative expenses


514,689



165,360



1,231,713



543,363Total operating expenses


1,847,925



646,632



4,285,024



1,936,949Loss from operations


(1,889,675
)


(703,425
)


(4,344,159
)


(1,991,272
)-







-Other income (expenses):Interest expense


(266,130
)


-



(542,094
)


(1,184,363
)Derivative income (expense)


5,086,209



7,239,856



(17,280,018
)


1,892,559Debt extinguished


(824,922
)


-



(1,192,422
)


(3,617,983
)Interest income


1,299



5,584



3,468



11,565Total other income (expense)


3,996,456



7,245,440



(19,011,066
)


(2,898,222
)-Net income (loss)


2,106,781



6,542,015



(23,355,225
)


(4,889,494
)-Reconciliation of net income (loss) applicable to common stockholders:Accretion of preferred stock


(2,442,686
)


(91,000
)


(4,287,698
)


(126,000
)Preferred stock dividends


(150,000
)


(54,862
)


(436,667
)


(94,868
)Income (loss) applicable to common stockholders

$
(485,905
)

$
6,396,153


$
(28,079,590
)

$
(5,110,362
)Income (loss) per common shares:Basic earnings per common share

$
(0.01
)

$
0.66


$
(0.76
)

$
(0.53
)Diluted earnings per common share

$
(0.01
)

$
0.22


$
(0.76
)

$
(0.53
)Weighted average shares:Basic


37,064,892



9,719,800



37,064,892



9,719,800Diluted


37,064,892



29,714,892



37,064,892



9,719,800
 
 The accompanying notes are an integral part of the financial statements
 
 4
 
 Net Talk.com, Inc.
 Statements of Cash Flows
 
 Nine months ended June 30,2011


2010Cash flow from operating activities:Net loss

$
(23,355,225
)

$
(4,889,494
)Adjustments to reconcile net loss to net cash (used) in operations:Depreciation


99,584



92,657Amortization


173,154



179,499Amortization of finance costs


-



72,341Amortization of debt discount


-



479,404Bad debt expense


-



12,860Warrant liabilities


-



3,570Derivative fair value adjustments


17,280,018



(1,892,559
)Debt extinguished and inducement expense


1,192,422



3,617,983Stock compensation


29,176



-Cancellation of shares for services


(271,286
)


-Changes in assets and liabilities:Accounts receivables


(197,063
)


3,494Prepaid expenses and other assets


236,582



3,927Inventories


(1,488,550
)


(188,707
)Deferred revenues


397,233



-Accounts payables


664,051



25,193Accrued expenses


33,196



592,679Net cash (used) in operating activities


(5,206,708
)


(1,887,153
)Cash flow used in investing activities:Restricted cash


(1,907,294
)


(2,026,423
)Acquisition of fixed assets


(50,826
)


(12,755
)Decrease in deposits


(104,000
)


5,497Net cash (used) in investing activities


(1,752,468
)


(2,033,681
)Cash flow used in financing activities:Senior debenture


5,000,000



-Issuance of preferred stock and warrants


-



5,000,000Cash paid for dividends on preferred stock


(90,000
)


-Loans from officers


-



(56,300
)Net cash provided by financing activities


4,910,000



4,943,700Net (decrease) increase ein cash


1,455,760



1,022,866Cash and equivalents, beginning


1,021,684



1,010,698Cash and equivalents, ending

$
2,477,444


$
2,033,564Supplemtal disclosures:Cash paid for interest

$
149,953


$
-Cash paid for income taxes

$
-


$
-Cash paid for dividends

$
90,000


$
-
 
 The accompanying notes are an integral part of the financial statements


5




NET TALK.COM, INC.


Notes to Unaudited Financial Statements





Note 1 – Nature of Operations and Basis of Presentation





Basis of presentation:





The accompanying unaudited condensed financial statements as of and for the three and nine  months ended June  30, 2011 have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission for Form 10-Q. Accordingly, they do not include all the information and footnotes required for complete financial statements. However, the unaudited condensed financial information includes all adjustments which are, in the opinion of management, necessary to fairly present the financial position and the results of operations for the interim periods presented. The operations for the three and nine months ended June 30, 2011 and 2010 are not necessarily indicative of the results for the year ending September 30, 2011.





The unaudited condensed financial statements included in this report should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended September 30, 2010, filed with the Securities and Exchange Commission.





Nature of operations:





Net Talk.com, Inc. (“NetTalk” or the “Company”) was incorporated on May 1, 2006 under the laws of the State of Florida. We are a telephone company, who provides, sells and supplies commercial and residential telecommunication services, including services utilizing voice over internet protocol (“VoIP”) technology, session initiation protocol (“SIP”) technology, wireless fidelity technology, wireless maximum technology, marine satellite services technology and other similar type technologies. Our main products are the TK 6000 and the DUO, analog telephone adapters that provide connectivity for analog telephones and faxes to home, home office or corporate local area networks (“LAN”). Our TK 6000 and DUO and their related services are a cost effective solution for individuals, small businesses and telecommuters connecting to any analog telephone, fax or private branch exchange (“PBX”).  Our TK 6000 and DUO provides one USB port, one Ethernet port and one analog telephone port. A full suite of internet protocol features is available to maximize universal connectivity. In addition, analog telephones attached to our TK 6000 and DUO are able to use advanced calling features such as call forwarding, caller ID, 3-way calling, call holding, call retrieval and call transfer.





Note 2 - Summary of Significant Accounting Policies





Use of Estimates





The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires our management to make estimates and assumptions that affect the amounts reported in the financial statements and footnotes. Significant estimates inherent in the preparation of our financial statements include developing fair value measurements upon which to base our accounting for acquisitions of intangible assets and issuances of financial instruments, including our common stock. Our estimates also include developing useful lives for our tangible and intangible assets and cash flow projections upon which we determine the existence of, or the measurements for, impairments. In all instances, estimates are made by competent employees under the supervision of management, based upon the current circumstances and the best information available.





Risk and Uncertainties





Our future results of operations and financial condition will be impacted by the following factors, among others: dependence on the worldwide telecommunication markets characterized by intense competition and rapidly changing technology, on third-party manufacturers and subcontractors, on third-party distributors in certain markets and on the successful development and marketing of new products in new and existing markets. Generally, we are unable to predict the future status of these areas of risk and uncertainty.




Revenue Recognition




Operating revenue consists of customer equipment sales of our main product, the NetTalk DUO, telecommunication service revenues and shipping and handling revenues.





6




Our operating revenues are generated from the sale of customer equipment of our main products, our DUO and TK6000. We also derive service revenues from per minute fees for international calls. Revenue from the sale of our TK6000 is fully recognized at the time of our customer equipment sale.  Our TK6000 provides for life time service (over the life of the device/equipment). Our TK6000 is able to operate within our network/platform or over any other network/platform.  There is no need for income allocation between our TK6000 and life time service provided.  The full intrinsic value of the sale is allocated to the device.  Therefore, we recognized 100% of revenue at time of customer equipment sale and do no allocate any income to life time service provided. Shipping and handling is also recognized at time of sale.




On July 14, 2010 werevealed our newest product the net TALK DUO (“DUO”).  Our DUO offers our customers free nationwide calls to any landline or mobile phone in the U.S. and Canada from anywhere in the world, as well as low-cost international rates. It’s also a versatile digital phone service with no monthly fees, no contracts and no computer required. The DUO is flexible enough to connect directly to your internet connection through the router/modem; there is also a convenient option with our DUO to connect to your computer. The sleek design is small enough to fit in the palm of your hand, making it a portable device.





The DUO reduces the wear and tear on your home or office computer and reduces energy costs, resulting in money savings. The fax-friendly DUO, offers fax (incoming and outgoing), a unique feature not offered, to our knowledge, by similar digital phone services. The portability of this small device is also great for international travelers who want to place free nationwide calls to the U.S. and Canada, or who are looking for a low-cost solution for international rates. Calls to other NetTalk customers are always free.




Our DUO provides for revenue recognition from the sale of the device and from the sale of telephone service. The initial year of telephone service is included on the sale price at time of sale and billed subsequently thereafter. Therefore, revenue recognition on our DUO is fully recognized at the time of our customer equipment sale and the one year telephone service is amortized over a 12 month cycle.  Subsequent renewals of the annual telephone service are amortized over the corresponding 12 months cycle.




International calls are billed as earned from our customers.  International calls are prepaid and the customers account is debited as minutes are used and earned.




Cash and Cash Equivalents





We consider all highly liquid cash balances and debt instruments with an original maturity of three months or less to be cash equivalents. We maintain cash balances only in domestic bank accounts, which currently exceed federally insured limits.





Inventory





Inventories are recorded at cost or market, whichever is lower.


June 30, 2011


September 30, 2010Productive material, work in process and supplies

$
1,705,533


$
454,231Finished products


351,577



114,329Total

$
2,057,110


$
568,560





During the nine months ended June 30, 2011, in accordance with our lower of cost or market analyses we did not record lower of cost or market adjustments to our finished goods inventories.





Telecommunications Equipment and Other Property




Property, equipment and telecommunication equipment includes acquired assets which consist of network equipment, computer hardware, furniture and software. All of our equipment is stated at cost with depreciation calculated using the straight line method over the estimated useful lives of related assets, which ranges from three to five years.  The cost associated with  major improvements are capitalized while the cost of maintenance and repairs is charged to operating expenses.




Intangible Assets





Our intangible assets were recorded at our acquisition cost, which encompassed estimates of their respective and their relative fair values, as well as estimates of the fair value of consideration that we issued. We amortize our intangible assets using the straight-line method over lives that are predicated on contractual terms or over periods we believe the assets will have utility.





7





Impairments and Disposals





We evaluate our tangible and definite-lived intangible assets for impairment annually or more frequently in the presence ofcircumstances or trends that may be indicators of impairment. Our evaluation is a two step process. The first step is to compare our undiscounted cash flows, as projected over the remaining useful lives of the assets, to their respective carrying values. In the event that the carrying values are not recovered by future undiscounted cash flows, as a second step, we compare the carrying values to the related fair values and, if lower, record an impairment adjustment. For purposes of fair value, we generally use replacement costs for tangible fixed assets and discounted cash flows, using risk-adjusted discount rates for intangible assets.





Research and Development and Software Costs





We expense research and development costs, as these costs are incurred. We account for our offering-related software development costs as costs incurred internally in creating a computer software product and are charged to expense when incurred as research and development until technological feasibility has been established for the product. Technological feasibility is established upon completion of a detail program design or, in its absence, completion of a working model. Thereafter, all software production costs shall be capitalized and subsequently reported at the lower of unamortized cost or net realizable value. Capitalized costs are amortized based on current and future revenue for each product with an annual minimum equal to the straight-line amortization over the remaining estimated economic life of the product.   At this time our main products, the DUO and TK6000 are being sold in the market place. Therefore, research and development cost reported in our financial statements relates to  pre – marketing costs and are expensed accordingly.





Three months ended


Nine months endedJune 30,


June 30,Components of research and development:

2011


2010


2011


2010Product development and engineering

$
90,648


$
52,126


$
222,779


$
77,621Payroll and benefits


129,485



39,927



332.031



138,896Total

$
220,133


$
92,053


$
554,810


$
216,517





Reclassification





Certain reclassifications have been made to prior years financial statements in order to conform to the current year’s presentation.   The reclassification had no impact on net earnings previously reported.





Share-Based Payment Arrangements




In June 2008, the FASB issued authoritative guidance on the treatment of participating securities in the calculation of earnings per shares (“EPS”).  This guidance addresses whether instruments granted in share – based payment transactions are participating securities prior to vesting and, therefore, need to be included in the earnings allocation in computing EPS under the two - class method.  This guidance was effective for fiscal years beginning on or after December 15, 2008.  Adoption of this guidance did not have a material impact on our results of operations and financial position, or on basic or diluted EPS.





We apply the grant date fair value method to our share – based payment arrangements with employees and consultants. Share – based compensation cost to employees is measured at the grant date fair value based on the value of the award and is recognized over the service period.  Share – based payments to non – employees are recorded at fair value on the measurement date and reflected in expense over the service period.





2010 Stock Option Plan





On November 15, 2009, NetTalk adopted the 2010 Stock Option Plan (the "Plan") which is intended  to advance the interests of the Company’s shareholders by enhancing the Company’s ability to attract, retain and motivate persons who make (or are expected to make) important contributions to the Company by providing such persons with equity ownership opportunities and performance-based incentives and thereby better aligning the interests of such persons with those of the Company’s shareholders. All of the Company’s employees, officers, and directors, and those Company’s consultants and advisors (i) that are natural persons and (ii) who provides bona fide services to the Company not connected to a capital raising transaction or the promotion or creation of a market for the Company’s securities, are eligible to be granted options or restricted stock awards under the Plan. The maximum aggregate number of shares of the Company’s common stock that may be issued under the Plan is 10,000,000 shares of the Company’s common stock.





8





On July 26, 2010, we issued 3,709,500 shares of common stock to our employees as part of our 2010 Stock Option Plan. The shares are compensatory in nature and are fully vested.  We have valued the shares at $0.03 per share consistent with fair value at the time of issuance including and adjusted for ownership restrictions.





On May 23 2011, we issued 3,890,000 shares of common stock to our employees as part of our 2010 Stock Option Plan. The shares are compensatory in nature and are fully vested.  We have valued the shares at $0.01 per share consistent with fair value at the time of issuance including and adjusted for ownership restrictions.





2011 Stock Option Plan





On June 15, 2011, NetTalk adopted the 2011 Stock Option Plan (the "Plan") which is intended  to advance the interests of the Company’s shareholders by enhancing the Company’s ability to attract, retain and motivate persons who make (or are expected to make) important contributions to the Company by providing such persons with equity ownership opportunities and performance-based incentives and thereby better aligning the interests of such persons with those of the Company’s shareholders. All of the Company’s employees, officers, and directors, and those Company’s consultants and advisors (i) that are natural persons and (ii) who provides bona fide services to the Company not connected to a capital raising transaction or the promotion or creation of a market for the Company’s securities, are eligible to be granted options or restricted stock awards under the Plan. The maximum aggregate number of shares of the Company’s common stock that may be issued under the Plan is 20,000,000 shares of the Company’s common stock.





Financial Instruments





Financial instruments, as defined in the Accounting Standards Codification (“ASC”) 825 Financial Instruments, consist of cash, evidence of ownership in an entity, and contracts that both (i) impose on one entity a contractual obligation to deliver cash or another financial instrument to a second entity, or to exchange other financial instruments on potentially unfavorable terms with the second entity, and (ii) conveys to that second entity a contractual right (a) to receive cash or another financial instrument from the first entity, or (b) to exchange other financial instruments on potentially favorable terms with the first entity. Accordingly, our financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable, accrued liabilities, secured convertible debentures, and derivative financial instruments.





We carry cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities at historical costs since their respective estimated fair values approximate carrying values due to their current nature. We also carry convertible debentures and redeemable preferred stock at historical cost.





Derivative financial instruments, as defined in ASC 815-10-15-83 Derivatives and Hedging, consist of financial instruments or other contracts that contain a notional amount and one or more underlying (e.g. interest rate, security price or other variable), require no initial net investment and permit net settlement. Derivative financial instruments may be free-standing or embedded in other financial instruments. Further, derivative financial instruments are initially, and subsequently, measured at fair value and recorded as liabilities or, in rare instances, assets.





Redeemable Preferred Stock





Redeemable preferred stock (and other redeemable financial instrument we may enter into) is initially evaluated for possible classification as liabilities under ASC 480 Distinguishing Liabilities from Equity. Redeemable preferred stock classified as liabilities is recorded and carried at fair value. Redeemable preferred stock that does not, in its entirety, require liability classification is evaluated for embedded features that may require bifurcation and separate classification as derivative liabilities under ASC 815. In all instances, the classification of the redeemable preferred stock host contract that does not require liability classification is evaluated for equity classification or mezzanine classification based upon the nature of the redemption features. Generally, any feature that could require cash redemption for matters not within our control, irrespective of probability of the event occurring, requires classification outside of stockholders’ equity. See Note 6 for further disclosures about our redeemable preferred stock.





Income (loss per common share)





Basic income (loss) per common share represents our income (loss) applicable to common shareholders divided by the weighted average number of common shares outstanding during the period. Diluted income (loss) per common share gives effect to all potentially dilutive securities. We compute the effects on diluted income (loss) per common share arising from warrants and options using the treasury stock method. We compute the effects on diluted income (loss) per common share arising from convertible securities using the if-converted method. The effects, if anti-dilutive are excluded.





9





Recent Accounting Pronouncements





Accounting Changes





Effective on October 1, 2009, we adopted Emerging Issues Task Force Consensus No. 07-05 Determining Whether an Instrument (or Embedded Feature) is Indexed to an Entity’s Own Stock (“EITF 07-05”). EITF 07-05 amended previous guidance related to the determination of whether equity-linked contracts, such as our convertible debentures, meet the exclusion to bifurcation and derivative classification of the respective embedded conversion feature. Under EITF 07-05, the embedded conversion option was no longer exempt from bifurcation and derivative classification because the conversion option was subject to adjustments that are not allowable under the new standard. We have accounted for the change as a change in accounting principle where the cumulative effect, which amounted to $872,320, as a charge to our opening additional paid in capital on October 1, 2009.





Effective January 1, 2010, the Company adopted the provisions in ASU 2009-17, “Consolidation (ASC Topic 810): Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities”, which changes how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The adoption of the provisions in ASU 2009-17 did not have an impact on the Company’s financial statements.





Effective January 1, 2010, the Company adopted ASU 2010-01, “Equity (ASC Topic 505): Accounting for Distributions to Shareholders with Components of Stock and Cash”, which clarifies that the stock portion of a distribution to shareholders that allow them to elect to receive cash or stock with a potential limitation on the total amount of cash that all shareholders can elect to receive in the aggregate is considered a share issuance that is reflected prospectively in earnings per share and is not considered a stock dividend for purposes of ASC Topic 505 and ASC Topic 260. The adoption of the provisions in ASU 2010-01 did not have an impact on the Company’s consolidated financial statements.





Effective January 1, 2010, the Company adopted the provisions in ASU 2010-06, “Fair Value Measurements and Disclosures (ASC Topic 820): Improving Disclosures about Fair Value Measurements, which requires new disclosures related to transfers in and out of levels 1 and 2 and activity in level 3 fair value measurements, as well as amends existing disclosure requirements on level of disaggregation and inputs and valuation techniques. The adoption of the provisions in ASU 2010-06 did not have an impact on the Company’s financial statements.





Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies that do not require adoption until a future date are not expected to have a material impact on the Company’s Financial Statements upon adoption.





Income Taxes





We record our income taxes using the asset and liability method. Under this method, the future tax consequences attributed to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis are reflected as tax assets and liabilities using enacted tax rates expected to apply to taxable income in the years in which those temporary differences reverse. Changes in these deferred tax assets and liabilities are reflected in the provision for income taxes. However, we are required to evaluate the recoverability of net deferred tax assets. If it is more likely than not that some portion of a net deferred tax asset will not be realized, a valuation allowance is recognized with a charge to the provision for income taxes.




Our net loss reflects permanent tax differences which are not deductible for tax purposes.  Therefore, our tax net operating loss would be reduced accordingly.  Our major permanent differences for the three and nine  months ended June  30, 2011, are as follows:





Permanent differences:

Three months


Nine months2011


2010


2011


2010Derivative income (expense)

$
5,086,209


$
7,239,856


$
(17,280,018
)

$
1,892,559Debt extinguished


(824,922
)


-



( 1,192,422
)


(3,617,983
)Total income (expense)

$
4,261,287


$
7,239,856


$
(18,472,440
)

$
(1,725,424
)





10





Note 3 - Telecommunications Equipment and Other Property





Telecommunications equipment and other property consist of the following:





Life


June 30, 2011


September 30, 2010Telecommunication equipment


7


$
706,900


$
674,362Computer equipment


5



116,121



107,092Office equipment and furnishing


7



29,914



23,760Purchased software


3



23,759



20,655Sub – total






876,694



825,869Less: accumulated depreciation






(346,834
)


(247,251
)Total





$
529,860


$
578,618





Our telecommunications equipment is deployed in our Network Operations Center (“NOC”) as is most of the computer equipment. Other computer and office equipment and furnishings are deployed at our corporate offices, which we lease under an operating lease.





Depreciation of the above assets was as follows:


Three Months Ended


Nine Months EndedJune 30,


June 30,2011


2010


2011


2010Depreciation expense

$
34,074


$
31,115


$
99,584


$
92,657





Note 4 - Intangible Assets:





Intangible assets consist of following:


Life


June 30, 2011


September 30, 2010Trademarks National and International

5


$
332,708


$
332,708Employment agreements

3



225,084



225,084Knowhow and specialty skills

3



212,254



212,254Workforce

3



54,000



54,000Telephony licenses

2



9,195



9,195Patents

20



11,024



11,024Domain names

2



7,723



7,723851,988



851,988Less accumulated amortization





(658,781
)


(485,627
)$
193,207


$
366,361





Amortization of the above assets was as follows:

Three months ended


Nine Month EndedJune 31,


June 31,2011


2010


2011


2010Amortization expense

$
57,718


$
59,833


$
173,155


$
179,499




The weighted average amortization period for the amortizable intangible assets is 2.4 years.




Estimated future amortization of intangible assets is as follows:





June 30,2011

$
60,9632012


70,2382013


62,006Total

$
193,207





11





Note 5 – Long-term debt





The carrying values our long-term debt consisted of the following as of June 30, 2011 and September 30, 2010:





June 30

2011


September 30

2010$5,266,130 face value 12% debenture, due July 1, 2013

$
2,313,778


$
—$3,146,000 face value 12% convertible debenture, due June 30, 2011


—



3,146,000$587,166 face value 12% convertible debenture, due July 20, 2011


—



587,166$1,265,607 face value 12% convertible debenture, due September 25, 2011


—



1,265,607Total

$
2,313,778


$
4,998,773





Issuance of Non-Convertible Debentures:





On June 30, 2011, we issued face value $5,266,130, 12% debentures, due July 1, 2013 and warrants to purchase 21,064,520 shares of our common stock for $0.50 per share, which expire five years from the issuance date, for $2,500,000 cash, settlement of $2,500,000 in bridge financing and settlement of $266,130 in accrued interest on the former convertible debentures. See discussion on the conversion of the convertible debentures, below. The cash and advance settlement were accounted for as financing transactions. The settlement of the accrued interest was accounted for as an extinguishment of debt.





The debentures were allocated $5,000,000 face value and $266,130 to the financing and extinguishment, respectively. Applying that same relationship, we allocated 20,000,000 and 1,064,520 warrants to the financing and extinguishment, respectively.





We allocated the gross proceeds from the financing transaction to the debentures and the warrants based upon their relative fair values, as reflected in the following table:





Fair Values


Relative

Fair Values$5,000,000 face value of debentures

$
5,340,195


$
2,029,536Warrants to purchase 20,000,000 shares of common stock


7,816,000



2,970,464$
13,156,195


$
5,000,000





The fair value of the debentures was computed based upon the present value of all future cash flows, using a credit risk adjusted discount rate of $7.75%. This discount rate was developed based upon bond curves of companies with similar high risk credit ratings plus a 0.50% risk free rate based upon yields for zero coupon government securities with maturities consistent with those of the debentures. The fair value of the warrants was determined using the Noreen Wolfson dilution adjustment model for the Black Scholes Merton valuation technique. The volatility and risk free rate used in the calculation were 113.8% and 1.70%, respectively.





For purposes of the extinguished instrument, we recorded the allocated face value of the debentures and the allocated number of warrants at their fair values. The difference between these amounts and the carrying value of the settled obligation was recorded as an extinguishment loss in our income, as follows:





Extinguishment

Calculation$266,130 face value of debentures

$
284,237Warrants to purchase 1,064,520 shares of common stock


416,014700,251Carrying value of settled obligation


(266,130
)Extinguishment loss

$
434,121





The fair value of the debentures and the warrants were determined in the same manner as those allocated to the financing and as described above.





12





The total carrying value of the debentures arising from the financing and the extinguishment transactions amounted to $2,313,774. This discounted balance is subject to amortization through charges to interest expense over the term to maturity using the effective interest method. Amortization will commence on July 1, 2011.





Conversion of Convertible Debentures:





On June 30, 2011, the holders of our secured convertible debentures converted the debentures for an aggregate of 19,995,092 shares of common stock, which was in accordance with the contractual conversion price. On the date of the conversion, the compound embedded derivatives associated with the secured convertible debentures were adjusted to fair value resulting in a credit to derivative income in the amount of $2,514,209. Following the derivative adjustment, the adjusted carrying value of the compound embedded derivative ($8,797,840) and carrying value of the secured convertible notes ($4,998,773) were combined in the amount of $13,796,613 and reclassified to stockholders equity to give effect to the issuance of the common shares.





Further, on the June 30, 2011 conversion date we issued the holders of the secured convertible debentures warrants to purchase 1,000,000 shares of our common stock as conversion inducement consideration. These warrants have a five year term and a strike price of $0.50 per common share. The warrants meet all conditions for equity classification. The fair value of the warrants, determined using the Noreen Wolfson dilution adjustment model for the Black Scholes Merton valuation technique, amounted to $390,800 which has been recorded in expense. The volatility and risk free rate used in the Black Scholes Merton calculation were 113.8% and 1.70%, respectively.





Issuance of Convertible Debentures:





By way of background, our convertible debentures were issued on February 24, 2010 in connection with an exchange agreement with our creditors that provided for, among other things, the consolidation of our previous secured convertible debt instruments, with maturities listed in the table above, and included the capitalization of $798,773 of accrued interest. The newly issued convertible debentures bear interest at 12%, which is payable at the earlier of the maturity date or the date that the debentures are converted, if ever. Such interest is payable at the Company’s option in cash or common stock at $0.25 per common share. The principal amount of the debentures is convertible into common stock at $0.25. Accordingly, the convertible debentures are indexed to 19,995,092 shares of our common stock. Each of the principal and debt conversion rates are subject to adjustment for recapitalization events or sales of equity or equity-linked contracts with a price or conversion price less than the contractual conversion price. The convertible debentures are secured by substantially all of our assets and are either callable or subject to a default interest rate, at the creditor’s option, if we default on the debentures. The significant events that could trigger a default include our failure to service the debentures, bankruptcy and the filing of significant judgments against us. The debentures also preclude merger and similar transactions, incurring additional debt, our payment of dividends on our equity securities and limit the compensation that we may pay to our officers.





Our accounting for the aforementioned exchange transaction required us to consider whether the exchange resulted in a substantial modification to the original convertible debentures based upon either cash flows or the fair value of the embedded conversion feature, wherein substantial is generally defined as a change greater than 10%. In all instances, our calculations indicated that the exchange of convertible debentures resulted in changes that were substantial to either cash flows, the embedded conversion option, or both. As a result, we were required to extinguish the prior debt instruments and reestablish the new convertible debentures at fair value, with the difference reflected in our expenses.





The following table reflects the components of our extinguishment calculations on February 24, 2010:





Convertible Debenture dueJune 30,

2011


July 20,

2011


September 30

2011


TotalFair value of new debenture

$
7,767,450


$
1,490,256


$
3,196,102


$
12,453,808Carrying value of old debentures:Debentures


1,713,124



152,755



267,000



2,132,879Accrued Interest


546,000



87,166



165,607



798,773Compound embedded derivative


3,723,200



750,000



1,632,400



6,105,600Deferred finance costs


(85,372
)


(23,933
)


(92,122
)


(201,427
)5,896,952



965,988



1,972,885



8,835,825Extinguishment loss

$
1,870,498


$
524,268


$
1,223,217


$
3,617,983





13





The fair values of the Secured Convertible Debentures were determined based upon their respective discounted cash flow, using observable market rates, plus the fair value of the embedded conversion options. Observable market rates on the exchange date ranged from 7.91% for one-year and 8.47% for two years and were derived from publicly available surveys of corporate bond curves for issuers with similar risk characteristics as ours. The fair value of our compound embedded derivatives were determined using the Monte Carlo Simulations model. See Note 8. The compound embedded derivatives were adjusted to fair value on the exchange date, immediately before the exchange transaction, which amount is included in our derivative income (expense).





The fair value of the new convertible debentures was allocated to the debt balance, the compound embedded derivative and paid-in capital. Paid-in capital arises in this transaction, because the allocation resulted in premiums which, under accounting principles, are considered equity components. The following table summarizes the allocation on the exchange date:





Convertible Debenture dueJune 30,

2011


July 20,

2011


September 30

2011


TotalConvertible debentures

$
3,146,000


$
587,166


$
1,265,607


$
4,998,773Compound embedded derivative


4,505,072



880,749



1,878,161



7,263,982Paid-in capital


116,378



22,341



52,334



191,053$
7,767,450


$
1,490,256


$
3,196,102


$
12,453,808





Our accounting for the original debenture financings is as follows:





2008 Convertible Debenture Financing





On September 10, 2008, we issued a $1,000,000 face value, 12% secured convertible debenture (T-1), due September 10, 2010 and Series B warrants indexed to 4,000,000 shares of our common stock in exchange for the Interlink Asset Group. Also on September 30, 2008, we issued a $500,000 face value 12% secured convertible debenture (T-2), due September 10, 2010 and Series B warrants indexed to 2,000,000 shares of our common stock for net cash proceeds of $472,800. The warrants have a term of five years. These financial instruments were issued to the same creditor under contracts that are substantially similar, unless otherwise mentioned in the following discussion.





The principal amount of the debentures was initially payable on September 10, 2010 and the interest is payable quarterly, on a calendar quarter basis. While the debenture is outstanding, the investor has the option to convert the principal balance, and not the interest, into shares of our common stock at a conversion price of $0.25 per common share. The terms of the conversion option provide for anti-dilution protections for traditional restructurings of our equity, such as stock-splits and reorganizations, if any, and for sales of our common stock, or issuances of common-indexed financial instruments, at amounts below the otherwise fixed conversion price. Further, the terms of the convertible debenture provide for certain redemption features. If, in the event of certain defaults on the terms of the debentures, some of which are indexed to equity risks, we are required at the investors option to pay the higher of (i) 110% of the principal balance, plus accrued interest or (ii) the if-converted value of the underlying common stock, using the 110% default amount, plus accrued interest. If this default redemption is not exercised by the investor, we would incur a default interest rate of 18% and the investor would have rights to our assets under the related Security Agreement. We may redeem the convertible debentures at anytime at 110% of the principal amount, plus accrued interest.





Because the two hybrid debt contracts were issued as compensation for the Interlink Asset Group, we concluded that they should be combined for accounting purposes, the accounting resulted in no beneficial conversion feature.





2009 Convertible Debenture Financings





We entered into several Securities Purchase Agreements with Debt Opportunity Fund, LLP (“DOF”) during the year ended September 30, 2009.





-
On January 30, 2009 we issued (a) 12% Senior Secured Convertible Debentures in the aggregate principal amount of $600,000 with a maturity date of January 30, 2011, convertible into shares of common stock at a conversion price of $0.25; and (b) Series C Warrants to purchase 2,400,000 shares of our common stock at an exercise price of $0.50 for net cash proceeds of $507,900. The warrants have a term of five years.





14





-
On February 6, 2009 we issued (a) 12% Senior Secured Convertible Debentures in the aggregate principal amount of $500,000 with a maturity date of January 30, 2011, convertible into shares of common stock at a conversion price of $0.25; and (b) Series C Warrants to purchase 2,000,000 shares of our common stock at an exercise price of $0.50 for net cash proceeds of $443,250. The warrants have a term of five years.





-
On July 20, 2009, we issued (a) 12% Senior Secured Convertible Debentures in the aggregate principal amount of $500,000 with a maturity date of July 20, 2011, convertible into shares of common stock at a conversion price of $0.25; and (b) Series C Warrants to purchase 2,000,000 shares of our common stock at an exercise price of $0.50 for net cash proceeds of $446,250.  The warrants have a term of five years.





-
On September 25, 2009, we issued (a) 12% Senior Secured Convertible Debentures in the aggregate principal amount of $1,100,000 with a maturity date of July 20, 2011, convertible into shares of common stock at a conversion price of $0.25; and (b) Series C Warrants to purchase 4,400,000 shares of our common stock at an exercise price of $0.25 for net cash proceeds of $1,000,000.  The warrants have a term of five years.





Each debenture bears interest at a rate of 12% per annum from the date of issuance until paid in full. Interest is calculated on the basis of a 360-day year and paid for the actual number of days elapsed, and accrues and is payable quarterly or upon conversion (as to the principal amount then being converted). The debentures convert into shares of our common stock at the option of the holder at $0.25 per share (which conversion price is subject to adjustment under certain circumstances). The debentures are secured by a lien in all of the assets of the Company. Further, the terms of the convertible debentures provide for default redemption features similar to those described above.





Midtown Partners & Co., LLC (“Midtown Partners”), an NASD registered broker dealer, acted as the placement agent for the Company in connection with the January 30, July 20, and September 25, 2009 Convertible Debt Offerings (“2009 Convertible Debt Offerings”). We paid Midtown Partners cash commissions equal to $198,000 and we issued Series BD Common Stock Purchase Warrants to Midtown Partners entitling Midtown Partners to purchase 1,720,000 shares of the Company’s common stock at an initial exercise price of $0.50 per share and 440,000 shares of the Company’s common stock at an initial exercise price $0.25 per share. Since the Series BD warrants offered full ratchet anti-dilution protection, any previously issued and outstanding warrants with a conversion price greater than $0.25 automatically had their conversion price ratchet down to $0.25 as subsequent issuances were made with a conversion price of $0.25.





On September 22, 2009 we voided and reissued warrants in connection with our financing transactions. The cancellation and reissuance of warrants was treated as a modification under ASC 470-50 Modifications and Extinguishments although the change in cash flow was <10% so extinguishment accounting was not applicable.




Cancelled and re-issued warrants were as follows:





Original Warrants

Indexed

Shares


Strike

Price

Reissued

Warrants

Indexed

Shares


Strike

PriceC-1 warrants


2,400,000


$
0.50

C-3 warrants


2,400,000


$
0.50C-2 warrants


2,000,000


$
0.50

C-4 warrants


2,000,000


$
0.50BD-1 warrants


480,000


$
0.50

BD-4 warrants


240,000


$
0.25BD-5 warrants


240,000


$
0.50BD-2 warrants


400,000


$
0.50

BD-6 warrants


200,000


$
0.25BD-7 warrants


200,000


$
0.50BD-3 warrants


200,000


$
0.50

BD-8 warrants


200,000


$
0.25BD-4 warrants


200,000


$
0.50

BD-9 warrants


200,000


$
0.50





Accounting for the Financing Arrangements:





We have evaluated the terms and conditions of the secured convertible debentures under the guidance of ASC 815, Derivatives and Hedging. We have determined that, while the anti-dilution protections preclude treatment of the embedded conversion option as conventional, the conversion option is exempt from classification as a derivative because it otherwise achieves the conditions for equity classification (if freestanding) provided in ASC 815. We have further determined that the default redemption features described above are not exempt for treatment as derivative financial instruments, because they are not clearly and closely related in terms of risk to the host debt agreement. On the inception date of the arrangements through June 30, 2010, we determined that the fair value of these compound derivatives is de minus. However, we are required to re-evaluate this value at each reporting date and record changes in its fair value, if any, in income. For purposes of determining the fair value of the compound derivative, we have evaluated multiple, probability-weighted cash flow scenarios. These cash flow scenarios include, and will continue to include fair value information about our common stock. Accordingly, fluctuations in our common stock value will significantly influence the future outcomes from applying this technique.





15





Since, as discussed above, the embedded conversion options did not require treatment as derivative financial instruments; however, we were required to evaluate the feature as embodying a beneficial conversion feature under ASC 470-20, Debt with Conversion and Other Options. A beneficial conversion feature (“BCF”) is present when the fair value of the underlying common share exceeds the effective conversion price of the conversion option. The effective conversion price is calculated as the basis in the financing arrangement allocated to the hybrid convertible debt agreement, divided by the number of shares into which the instrument is indexed.  Because the two hybrid debt contracts dated September 10, 2008 were issued as compensation for the Interlink Asset Group and as further discussed in Note 3 we concluded that they should be combined for accounting purposes and the accounting resulted in no beneficial conversion feature. The financings issued in 2009 were found to have a BCF which gives effect to the (i) the trading market price on the contract dates and (ii) the effective conversion price of each issuance after allocation of proceeds to all financial instruments sold based upon their relative fair values. Notwithstanding, the BCF was limited to the value ascribed to the remaining hybrid contract (using the relative fair value approach). Accordingly, the BCF allocated to paid-in capital from the 2009 financings amounted to $872,320 for the year ended September 30, 2009.





We evaluated the terms and conditions of the Series B, Series C and Series BD warrants under the guidance of ASC 480, Distinguishing Liabilities from Equity (“ASC 480”). The warrants embody a fundamental change-in-control redemption privilege wherein the holder may redeem the warrants in the event of a change in control for a share of assets or consideration received in such a contingent event. This redemption feature places the warrants within the scope of ASC 480-10, as put warrants and, accordingly, they are classified in liabilities and measured at inception and on an ongoing basis at fair value. Fair value of the warrants was measured using the Black-Scholes-Merton valuation technique and in applying this technique we were required to develop certain subjective assumptions which are listed in more detail below.





Premiums on the secured convertible debentures arose from initial recognition at fair value, which is higher than face value. Discounts arose from initial recognition at fair value, which is lower than face value. Premiums and discounts are amortized through credits and debits to interest expense over the term of the debt agreement.





Direct financing costs were allocated to the financial instruments issued (hybrid debt and warrants) based upon their relative fair values. Amounts related to the hybrid debt are recorded as deferred finance costs and amortized through charges to interest expense over the term of the arrangement using the effective interest method. Amounts related to the warrants were charged directly to income because the warrants were classified in liabilities, rather than equity, as described above. Direct financing costs are amortized through charges to interest expense over the term of the debt agreement.





On September 24, 2009, we obtained an extension of the interest payments due June 30, 2009 and September 30, 2009 to June 30, 2010 and September 30, 2010, respectively. The change in cash flow from this modification was analyzed to determine if it was greater than 10% which would give rise to extinguishment accounting. In each case, the change in cash flows was less than 10% so extinguishment accounting was not applicable.





On February 24, 2010, we exchanged the convertible debentures for newly issued convertible debentures as discussed in the beginning of this footnote.





Note 6 – Redeemable Preferred Stock





Redeemable preferred stock consists of the following as of June 30, 2011 and September 30, 2010:





June 30,

2011


September 30,

2010Series A Convertible Preferred Stock, par value $0.001 per share, stated value $10,000 per share; 500 shares issued and outstanding at June 30, 2011; redemption value $5,000,000, and 300 shares issued and outstanding at September 30, 2010; redemption value $3,000,000.Initial carrying value

$
13,246,619


$
—Accumulated accretion


—



224,968Carrying values

$
13,246,619


$
224,968





16





Our Series A Convertible Preferred Stock became mandatorily redeemable for cash of $5,000,000 on June 30, 2011. On that date, after negotiations with our preferred investors, we modified the underlying Certificate of Designation solely to extend the mandatory redemption date to July 1, 2013. In considering all facts and circumstances, including the changes in future cash flows and the fair value of the embedded conversion feature, we concluded that the modification to the Series A Convertible Preferred Stock was substantial, thus warranting accounting analogous to extinguishment accounting for debt wherein the fair value of the amended contracts replace the carrying value of the original contracts. The difference between those two amounts in the case of preferred stock is recorded in stockholders equity.





We first accreted the Series A Convertible to the June 30, 2011 redemption date with a charge to paid-in capital (in the absence of accumulated earning) in the amount of $2,442,686. The accretion adjustment resulted in a carrying value of our redeemable preferred stock in the amount of $5,000,000. We then adjusted the compound embedded derivative that had been carried in liabilities at fair value on the modification date, which resulted in a reduction credit of $2,500,000 and was recorded in income. The derivative fair value adjustment resulted in a carrying value of $8,800,000. Therefore, the combined carrying value of the Series A Convertible Preferred immediately preceding the modification amounted to $13,800,000. We computed the fair value using a combination of the forward cash flow, at risk adjusted discount rates, plus the fair value of the embedded conversion feature using Monte Carlo Simulation (“MCS”) techniques. The value of the preferred stock on this basis amounted to $13,246,609. As a result, our calculation of the extinguishment resulted in a credit to paid-in capital in the amount of $553,391.





The discount rate that we used to present value future cash flows from the modified preferred stock amounted to 7.75%. This rate was developed using bond curves for companies with similar high-risk credit ratings, plus a risk free rate of 0.50% representing the yield on zero coupon government securities with two year remaining terms. Material inputs into the MCS included volatilities ranging from 89.9% to 105.3%, a market interest rate equal to the contractual coupon of 12%, and credit adjusted yields ranging from 7.19% to 7.75%.





By way of background, on February 24, 2010, we designated 500 shares of our authorized preferred stock as Series A Convertible Preferred Stock; par value $0.001 per share, stated value $10,000 per share (“Preferred Stock”). The Preferred Stock is redeemable for cash on June 30, 2011 at the stated value, plus accrued and unpaid dividends. Dividends accrue, whether or not declared, at a rate of 12% of the stated value. The Preferred Stock is convertible into common stock at the holder’s option at $0.25 based upon the stated value (20,000,000 linked common shares). Such conversion rate is subject to adjustment for traditional reorganizations and recapitalization and in the event that we sell common stock or other equity-linked instruments below the conversion price. Holders of the Preferred Stock are entitled to a preference equal to the stated value, plus accrued and unpaid dividends. While the Preferred Stock is outstanding, holders vote the number of indexed common shares.





We sold 300 shares of Series A Preferred on February 24, 2010, with warrants to purchase 12,000,000 shares of our common stock for proceeds of $3,000,000. We sold 200 shares of Series A Preferred on October 25, 2010, with warrants to purchase 8,000,000 shares of our common stock for proceeds of $2,000,000.





Our accounting for the Preferred Stock and warrant financing transaction required us to evaluate the classification of the embedded conversion feature and the warrants. As a prerequisite to establishing the classification of the embedded conversion option, we were required to determine the nature of the hybrid Preferred Stock contract based upon its risks as either a debt-type or equity-type contract. The presence of the mandatory cash redemption and the requirement to accrue dividends were persuasive evidence that the Preferred Stock was more akin to a debt than an equity contract, with insufficient evidence to the contrary (e.g. voting privilege). Given that the embedded conversion feature, when evaluated as embodied in a debt-type contract, did not meet the definition for an instrument indexed to a company’s own stock, the embedded conversion feature required bifurcation and classification in liabilities, at fair value. Similarly, the warrants did not meet the definition for an instrument indexed to a company’s own stock, resulting in their classification in liabilities, at fair value.





The following table reflects the allocation of the purchase price on the financing date:





Allocation:

October 25,

2010


February 24,

2010Redeemable preferred Stock

$
624,000


$
—Warrants


936,000



5,062,800Compound embedded derivative


440,000



4,260,000Derivative loss, included in derivative income (expense)


—



(6,322,800
)$
2,000,000


$
3,000,000





17





Warrants issued with the February 24, 2010 financing were valued on the financing date using the Black-Scholes-Merton valuation technique. Significant assumptions were as follows: Market value of underlying, using the trading market of $0.58; expected term, using the contractual term of 5.0 years; market volatility, using a peer group of 90.20%; and, risk free rate, using the yield on zero coupon government instruments of 2.40%. Warrants issued with the October 25, 2010 financing were valued on the financing date and subsequently using Binomial Lattice. Significant assumptions were as follows: Market value of the underlying, using the trading market of $0.26; market volatility, using a peer group ranged from 76.06% to 99.78% with an equivalent volatility of 89.40%; and risk free rate using the yield on zero coupon government instruments ranging from 0.12% to 2.01% with an equivalent rate of 0.66%. The implied expected life of the warrant is 4.7 years.





The compound embedded derivative was valued using the Monte Carlo Simulations (“MCS”) technique. The MSC technique is a generally accepted valuation technique for valuing embedded conversion features in hybrid convertible notes, because it is an open-ended valuation model that embodies all significant assumption types, and ranges of assumption inputs that management of the Company believe would likely be considered in connection with the arms-length negotiation related to the transference of the instrument by market participants. However, there may be other circumstances or considerations, other than those addressed herein, that relate to both internal and external factors that would be considered by market participants as it relates specifically to the Company and the subject financial instruments.





Given its redeemable nature, we are required to classify our Series A Preferred Stock outside of stockholders’ equity. Further, the inception date carrying value is subject to accretion to its ultimate redemption value over the term to redemption, using the effective method. During the period from its issuance to September 30, 2010, we accreted $224,968, which was reflected as a charge to paid-in capital in the absence of accumulated earnings.





Note 7 – Derivative Financial Instruments





On June 30, 2011, our investors agreed to modifications of our Series A Preferred Stock and our Series D Warrants that provided for reclassification of the derivatives to stockholders equity or, in the case of the preferred stock, redeemable preferred stock. The components of our derivative liabilities consisted of the following at June 29, 2011 (the last closing prices available prior to the modifications) and September 30, 2010:





June 29, 2011Derivative Financial Instrument

Indexed

Shares


Fair

Value


September 30

2010Compound Derivative Financial Instruments:February 24, 2010 Secured Convertible Debentures


19,995,092


$
8,797,840


$
2,276,794February 24, 2010 Series A Convertible Preferred Stock


12,000,000



5,280,000



1,404,000October 24, 2010 Series A Convertible Preferred Stock


8,000,000



3,520,000



—Warrants (dates correspond to financing):February 24, 2010 Series D warrants, issued with the preferred financing (Note 7)


12,000,000



2,064,000



858,000February 24, 2010 Series D warrants, issued with the exchange (Note 8)


16,800,000



2,889,600



1,201,200October 25, 2010 Series D warrants, issued with the financing (Note 7)


8,000,000



1,736,000



—Financing warrants issued to brokers


2,160,000



—



165,628Total


78,955,092


$
24,287,440


$
5,905,622





On January 11, 2011, certain warrants previously issued to brokers and that were linked to 2,160,000 shares of our common stock were modified to remove provisions that could result in adjustments to the exercise prices if we sold common shares or common share linked contracts at a per share price that was less than the exercise price of these warrants. As a result of this modification, these warrants no longer require liability classification and measurement at fair value. On the modification date we adjusted these warrants to their fair values with a charge to income and reclassified the balance, amounting to $274,200 to paid-in capital. On June 30, 2011, warrants linked to 36,800,000 shares of our common stock were modified to remove provisions that could result in adjustments to the exercise prices if we sold common shares or common share linked contracts at a per share price that was less than the exercise price of these warrants. As a result of this modification, these warrants no longer require liability classification and measurement at fair value.





18





On the modification date we adjusted these warrants to their fair values with a charge to income and reclassified the balance, amounting to $6,689,600 to paid-in capital.





The following table reflects the activity in our derivative liability balances from October 1, 2010 to June 30, 2011:





Compound


Warrants


TotalBalances at October 1, 2010

$
3,680,794


$
2,224,828


$
5,905,622Issuances


936,000



440,000



1,376,000Conversion and redemption


—



—



—Unrealized derivative (gains) losses


618,764



(512,988
)


105,776Balances at December 31, 2010


5,235,558



2,151,840



7,387,398Issuances


—



—



—Conversion and redemption


—



—



—Reclassifications


—



(274,200
)


(274,200
)Unrealized derivative (gains) losses


17,376,491



4,883,960



22,260,451Balances at March 31, 2011


22,612,049



6,761,600



29,373,649Conversion and redemption


(8,797,840
)


—



(8,797,840
)Reclassifications


(8,800,000
)


(6,689,600
)


(15,489,600
)Unrealized derivative (gains) losses


(5,014,209
)


(72,000
)


(5,086,209
)Balances at June 30, 2011

$
—


$
—


$
—





Effective on January 1, 2011, we changed our method for valuing our derivative warrants from a Black-Scholes Merton Model, adjusted to give effect to the anti-dilution features (the Noreen Wolfson Model) to Binomial Lattice. Binomial Lattice was considered by our management to be more appropriate because it both provides for early exercise scenarios and incorporates the down-round anti-dilution protection possibilities that could arise in early exercise scenarios.





The following table reflects the activity in our derivative liability balances from October 1, 2009 to June 30, 2010:





Compound


Warrants


TotalBalances at October 1, 2009

$
—


$
1,327,272


$
1,327,272Accounting change


1,865,600



—



1,865,600Effect of exchange transaction


1,158,382



—



1,158,382Issuances


4,260,000



5,062,800



9,322,800Conversion and redemption


—



—



—Unrealized derivative (gains) losses


(5,053,467
)


(3,161,892
)


(8,215,359
)Balances at June 30, 2010

$
2,230,515


$
3,228,180


$
5,458,695





Effective on October 1, 2009, we adopted Emerging Issues Task Force Consensus No. 07-05 Determining Whether an Instrument (or Embedded Feature) is Indexed to an Entity’s Own Stock (“EITF 07-05”). EITF 07-05 amended previous guidance related to the determination of whether equity-linked contracts, such as our convertible debentures, meet the exclusion to bifurcation and derivative classification of the respective embedded conversion feature. Under EITF 07-05, the embedded conversion option was no longer exempt from bifurcation and derivative classification because the conversion option was subject to adjustments that are not allowable under the new standard. We have accounted for the change as a change in accounting principle where the derivative liability in the amount of $1,865,600 was established and the cumulative effect, which amounted to $872,319, was charged to our opening accumulated deficit on October 1, 2009.





As more fully discussed in Note 6, on February 24, 2010, we exchanged our convertible debentures for newly issued convertible debentures. This amount represents the change in the fair value of the compound embedded derivatives between the old and new debentures, which in part arose from the capitalization of accrued interest and in part arose from other changes to the debentures. As further noted in Note 6, the exchange transaction gave rise to the extinguishment of the old debentures, and therefore the compound derivative, due to the substantive nature of these changes. Since an extinguishment is recorded by replacing the carrying value of the old debentures with the fair value of the new debentures, with a charge to expense for the difference, this amount is included in the extinguishment loss that we recorded in connection with the exchange.





19





Fair Value Considerations





We adopted the provisions of ASC 820 Fair Value Measurements and Disclosures(“ASC 820”) with respect to our financial instruments. As required by of ASC 820, assets and liabilities measured at fair value are classified in their entirety based on the lowest level of input that is significant to their fair value measurement. Our derivative financial instruments which are required to be measured at fair value on a recurring basis under of ASC 815 are all measured at fair value using Level 3 inputs. Level 3 inputs are unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.





We selected the Monte Carlo Simulations valuation technique to fair value the compound embedded derivative because we believe that this technique is reflective of all significant assumption types, and ranges of assumption inputs, that market participants would likely consider in transactions involving such types of derivatives while the financial instruments were outstanding. Such assumptions include, among other inputs, interest risk assumptions, credit risk assumptions and redemption behaviors in addition to traditional inputs for option models such as market trading volatility and risk free rates. On June 29, 2011, we valued the compound embedded derivatives at intrinsic value since there was no or no material remaining time value associated with mature or near mature financial instruments.


June 29,


September 30,


June 30,2011


2010


2010Quoted market price of our common stock

$
0.69


$
0.25


$
0.18Contractual conversion rate

$
0.25


$
0.25


$
0.25Implied expected term (years)

NA



0.59—0.92



0.96—1.18Market volatility:Range of volatilities

NA



134%-160
%


113%-127
%Equivalent volatility

NA



145%—152
%


118%-125
%Market-risk adjusted interest rate:Range of rates

NA



12.0
%


12.0
%Equivalent market-risk adjusted interest rate

NA



12.0
%


12.0
%Credit-risk adjusted yield rate:Range of rates

NA



7.5%-8.0
%


8.0%-8.8
%Equivalent credit-risk adjusted yield rate

NA



7.7
%


8.4
%Risk-free rates using yields on zero coupon US Treasury    Security rates:Range of rates

NA



0.27%-0.64
%


0.32%-1.00
%





The warrants are valued using the Binomial Lattice Valuation technique on June 30, 2011 and Black-Scholes-Merton (“BSM”) valuation methodology on September 30, 2010, adjusted to give effect to the anti-dilution features, because that model embodies all of the relevant assumptions that address the features underlying these instruments. Significant assumptions were as follows as of June 30, 2011 and September 30, 2010:





June 29, 2011 (Assumptions for

Series D


BD


BDBD Warrants are January 11, 2011)

Warrants


Warrants


WarrantsContractual strike price

$
0.50



—



—Adjusted strike price (for anti-dilution)

$
0.69



—



—Term to expiration


3.6-4.3



—



—Implied expected life


3.6-4.3



—



—Volatility range


94%-114
%


—



—Effective volatility


107%-107
%


—



—Risk-free rate ranges


0.02%-1.47
%


—



—Effective risk free rates


0.42%-0.51
%


—



—





September 30, 2010

Series D

Warrants


BD

Warrants


BD

WarrantsContractual strike price

$
0.50


$
0.25


$
0.50Adjusted strike price

$
0.43


$
0.23


$
0.43Volatility


107.9
%


111.5%-116.7
%


111.5%-116.7
%Term to expiration


4.40



3.33—4.00



3.33—4.00Risk-free rate


1.27



0.64-1.27



0.64-1.27Dividends


—



—



—





20





Note 8 - Commitment and Contingencies





Leases




Our principal executive offices are located at 1100 NW 163rd Drive, Miami, Florida 33169.  Our present lease is for a one year term.





Three months ended


Nine months endedJune 30,


June 30,2011


2010


2011


2010Occupancy expense

$
74,950


$
43,384


$
195,945


$
129,774





On May 16, 2011 we executed an Amended Employment Agreement with Mr. Anastasios Kyriakides, our Chief Executive Officer and President.





Changes include, without limitation:


1.
Salary set $199,000 per year and $250,000 starting January 1, 2012


2.
Three year term with automatic renewal of two years


3.
Change of control cash payment set at $1,500,000




Note 9 – Related Party Transactions





During June of 2011, a related party loaned the Company $154,000, due on demand.  The loan was repaid during July of 2011.





Note 10 - Subsequent Events





On July 19, 2011, we issued 2,400,500 shares of common stock to our employees as part of our 2010 Stock Option Plan. The shares are compensatory in nature and are fully vested.  We have valued the shares at $0.01 per share consistent with fair value at the time of issuance including and adjusted for ownership restrictions.





We have issued all approved common shares under our 2010 Stock Option Plan.





New premises





On August 8, 2011, we purchased a freestanding building to which we will relocate our corporate offices, operational center, call center and technical support functions.  The building is 22, 716 square feet and will be available for occupancy during the quarter of March 31, 2012.





New Financing





On August 9, 2011, we issued face value $2,000,000, 12% debentures, due July 1, 2013 and warrants to purchase 8,000,000 shares of our common stock for $0.50 per share, which expire five years from the issuance date for $2,000,000 cash.





21




Item 2 – Management Discussion and Analysis of Financial Conditions and Results of Operations




Our Management’s Discussion and Analysis should be read in conjunction with our financial statements included in this report.




Forward Looking Statements




Certain statements contained in this quarterly report on Form 10-Q and other written material and oral statements made from time to time by us do not relate to historical or current facts.  As such, they are referred to as “forward-looking statements,” which are intended to convey our expectations or predictions regarding the occurrence of possible future events or the existence of trends and factors that may impact our future plans and operating results. These forward-looking statements are derived, in part, from various assumptions and analyses we have made in the context of our current business plan and information currently available to us and in light of our experience and perceptions of historical trends, current conditions and expected future developments and other factors we believe to be appropriate in the circumstances. You can generally identify forward-looking statements through words and phrases such as “ seek, ” “ anticipate, ” “ believe, ” “ estimate, ” “ expect, ” “ intend, ” “ plan, ” “ budget, ” “ project, ” “ may be, ” “ may continue, ” “ may likely result, ” and similar expressions. When reading any forward looking statement, you should remain mindful that actual results or developments may vary substantially from those expected as expressed in or implied by that statement for a number of reasons or factors, such as those relating to:




·
whether or not a market for our products and services develop and, if a market develops, the pace at which it develops;


·
our ability to successfully sell our products and services if a market develops;


·
our ability to attract the qualified personnel to implement our growth strategies;


·
our ability to develop sales and marketing capabilities;


·
the accuracy of our estimates and projections;


·
our ability to fund our short-term and long-term financing needs;


·
changes in our business plan and corporate strategies; and other risks and uncertainties discussed in greater detail in the sections of this quarterly report, including the section captioned “Plan of Operation”.




Each forward-looking statement should be read in context with, and with an understanding of, the various other disclosures concerning our Company and our business made elsewhere in this prospectus, as well as other public reports filed with the SEC. You should not place undue reliance on any forward-looking statement as a prediction of actual results or developments. We are not obligated to update or revise any forward-looking statement contained in this report to reflect new events or circumstances unless and to the extent required by applicable law.




Background




Company and Business




We are a telephone company, who provides, sells and supplies commercial and residential telecommunication services, including services utilizing voice over internet protocol (“VoIP”) technology, session initiation protocol (“SIP”) technology, wireless fidelity technology, wireless maximum technology, marine satellite services technology and other similar type technologies. Our main product is the DUO, an analog telephone adapter that provides connectivity for analog telephones and faxes to home, home office or corporate local area networks (“LAN”).




Our newest product, the DUO was launched on July 14, 2010. The DUO offers our customers free nationwide calls to any landline or mobile phone in the U.S. and Canada from anywhere in the world, as well as low-cost international rates.  It’s also a versatile digital phone service with no monthly fees, no contracts and no computer required.  The DUO offers a full suite of  advanced calling features including call forwarding, caller ID, 3-way calling, call holding, call retrieval and call transfer.




Our first product, the TK 6000 and its related services is a cost effective solution for individuals, small businesses and telecommuters connecting to any analog telephone, fax or private branch exchange (“PBX”).  The TK 6000 provides one USB port, one Ethernet port and one analog telephone port. A full suite of internet protocol features is available to maximize universal connectivity. In addition, analog telephones attached to the TK 6000 are able to use advanced calling features such as call forwarding, caller ID, 3-way calling, call holding,call retrieval and call transfer.





On July 14, 2010 werevealed our newest product the netTALK DUO (“DUO”).





We are presently working on other new products and anticipate future deployment over the next year.





22







History and Overview




We are a Florida corporation, incorporated on May 1, 2006 under the name Discover Screens, Inc. (“Discover Screens”).




Prior to September 10, 2008, we were known as Discover Screens, a development-stage company, dedicated to providing advertising through interactive, audiovisual, information and advertising portals located in high-traffic indoor venues. Our name and business operations changed in a series of transactions beginning in December of 2007. Pursuant to an asset purchase agreement dated December 30, 2007, we sold all of the assets associated with the advertising business as a going concern to Robert H. Blank, who was then our President and Chief Operating Officer. Following that transaction, we ceased all existing operations, and from December 30, 2007 to September 9, 2008, we owned nominal assets and generated no revenue. In February of 2008,       Mr. Blank resigned as officer and director.




On September 9, 2008, Robin C. Hoover, our sole remaining officer and director, appointed four new members to the Board of Directors, Anastasios Kyriakides, Kenneth Hosfeld, Guillermo Rodriguez and Leo Manzewitsch. Mr. Hoover then resigned as an officer and director. Mr. Richard Diamond was appointed by the Board of Directors to fill the vacancy left by Mr. Hoover’s resignation.  Mr. Diamond resigned as a director of the Company, effective November 23, 2009.




On September 10, 2008, we changed our name from Discover Screens, Inc. to NetTalk.com, Inc. On September 10, 2008, we entered into a Contribution Agreement with Vicis Capital Master Fund (“Vicis”) by which Vicis contributed certain operating assets to the Company in exchange for (a) a 12% Senior Secured Convertible Debenture in the principal amount of $1,000,000; and (b) a Series B Warrant to purchase 4,000,000 shares of common stock of the Company. Also on September 10, 2008, the Company entered into a Securities Purchase Agreement with Debt Opportunity Fund, LLP (“DOF”) by which DOF purchased   (a) a 12% Senior Secured Convertible Debenture in the principal amount of $500,000; and (b) a Series B Warrant to purchase 2,000,000 shares of Common Stock of the Company.




On September 10, 2008, we acquired certain tangible and intangible assets, formerly owned by Interlink Global Corporation (“Interlink”), (the “Interlink Asset Group”) directly from Interlink’s creditor who had seized the assets pursuant to a Security and Collateral Agreement. Our purpose in acquiring these assets, which included employment rights to the executive management team of Interlink who now currently serve as our officers, was to advance the TK 6000 VoIP Technology Program, which Interlink launched in July 2008. Accordingly, these assets substantially comprise our current business assets and the infrastructure for our future operations. Contemporaneously with this purchase, we executed an assignment and intellectual property agreement with Interlink that served to perfect our ownership rights to the assets.




Consideration for the acquisition consisted of a face value $1,000,000 convertible debenture, plus warrants to purchase 4,000,000 shares of our common stock. On the date of the Interlink Asset Group acquisition, we also entered into a financing agreement with DOF (as described above) that provided for the issuance of a face value $500,000 convertible debenture, plus warrants to purchase 2,000,000 shares of our common stock for net cash consideration of $448,300.  In connection with this acquisition, we issued 6,000,000 shares of common stock to our new management team in connection with the Interlink Asset Group acquisition.




We continue to improve and enhance the following factors in building and expanding our customer base:




·
Deployment and distribution of our  products TK 6000 and DUO devices.




·
Attractive and innovative value proposition.  We offer our customers an attractive and innovative value proposition: a portable telephone replacement with multiple and unique features that differentiates our services from the competition.




·
Innovative, high technology and low cost technology platform.  We believe our innovative software and network technology platform provides us with a competitive advantage over our competition and allows us to maintain a low cost infrastructure relative to our competitors.




Plan of Operation




We provide, sell and supply commercial and residential telecommunication services, including services utilizing voice over internet protocol (“VoIP”) technology, session initiation protocol (“SIP”) technology, wireless fidelity technology, wireless maximum technology, marine satellite services technology and other similar type technologies. We are developing our business infrastructure and new products and services.





23




Our Products




At this time, our main products are the DUO and TK 6000. Our DUO and TK 6000 are designed to provide specifications unique to each customer’s existing equipment. It allows the customer full mobile flexibility by being able to take internet interface anywhere the customer has an internet connection. Our DUO and TK 6000 both have the following features:





-A Universal Serial Bus (“USB”) connection allowing the interconnection of our DUO and TK 6000 to any host computer.





-In addition to the USB power source option, our DUO and TK 6000 have  an external power supply allowing the phone to independently power itself when not connected to a host computer;





-Unlike most VoIP telephone systems, our DUO and TK 6000 both have standalone feature allowing them to be plugged directly into a standard internet connection.





-Our DUO and TK 6000 are compact, space-efficient products.




Our DUO and TK 6000 both have interface component so that the customer can purchase multiple units that can communicate with each other allowing simultaneous ringing from multiple locations.




Our products are portable and allow our customers to make and receive phone calls with a telephone anywhere where a broadband internet connection is available without the need of a computer.  We transmit the calls using Voice over Internet Protocol “VOIP” technology, which converts voice signals into digital data transmissions over the internet.




Our Services




Our business is to provide products and services that utilize Voice Over Internet Protocol, which we refer to as “VoIP.” VoIP is a technology that allows the consumer to make telephone calls over a broadband internet connection instead of using a regular (or analog) telephone line. VoIP works by converting the user’s voice into a digital signal that travels over the internet until it reaches its destination. If the user is calling a regular telephone line number, the signal is converted back into a voice signal once it reaches the end user. Our business model is to develop and commercialize software technology solutions for cost effective, real-time communications over the internet and related services.





Services provided or to be provided





Text to phone reminder service: We are currently developing a service that will allow VoIP to synchronize  with the customer’s data base schedule management system (such as Microsoft Office Outlook© ).   Our goal is to develop a service that will call the customer at a pre-designated time to provide an audio  reminder of that day’s agenda to the customer. By offering this service at a low price point of less than five  dollars per month we hope to appeal to a broad customer base. This software is currently under development.





Free conference server. This product is currently available to all our customers.





Future Voice Message Delivery: This service allows the user to record a voice message which will be delivered to a recipient at a later date and time specified by the user.





Speech to text services for the hearing impaired: This is a standalone service that will allow the hearing impaired to receive real time conversion of incoming voice signals into text displayed on an incorporated display panel.




Patents – Domestic and International




Our products are currently under US patent pending as well as International patent pending in over 123 countries.





24




Federal CALEA




On August 5, 2005, the Federal Communications Commission (the “FCC”) released an Order extending the obligations of the Communication Assistance for Law Enforcement Act (“CALEA”) to interconnected VoIP providers. Under CALEA, telecommunication carriers must assist law enforcement in executing electronic surveillance, which includes the capability of providing call content and call-identifying information to a local enforcement agency, or LEA, pursuant to a court order of other lawful authorization.




The FCC required all interconnected VoIP providers to become fully CALEA compliant by May 14, 2007.  To date, we have complied with all lawful CALEA requests.




Marketing




We have developed direct sales channels, as represented by web sites and toll free numbers.  Our direct sales channels are supported by highly integrated advertising campaigns across multiple media such as infomercials, television and other media channels.   Our website is www.nettalk.com, our telephone number is (305) 621-1200 and our fax number is (305) 621-1201.




Our primary source of revenue is the sale and distribution of our DUO and TK 6000 products.  We also generate revenue from the sale of accessories to our product and international long distance monthly charges that are billed to our customers.




Advertising




Our goal is to position ourselves as a premier supplier of choice for VoIP services. Our current business strategy is to focus our advertising dollars on our home market in South Florida.  Our advertising will consist of mass marketing campaigns focusing on television infomercials for the South Florida market and other states including cable television channels.





Customers




Our customers are made up of residential and small businesses. We anticipate that future services will appeal to our existing customers and hope that our additional phone products and services will provide a complete phone package experience to our customers.




Our target audience is individual consumers and small businesses looking to lower their current cost of telecommunications.    We are also reaching a large audience with our websites. We hope that consumers will find our websites by doing an internet search for VoIP service providers. We also use other means of advertising such as direct to consumer sales, eCommerce and wholesale sales to retail stores.




Geographic Markets




Our primary geographic market is our home market of South Florida. Our target audience is individual consumers and small businesses looking to lower their current cost of telecommunications.  We also expect to reach a large audience with our websites.      We hope that consumers will find our websites by doing an internet search for VoIP service providers. We will also use other means of advertising such as direct to consumer sales, ecommerce and  wholesale sales to retail stores.




We have been granted and or are applying for Competitive Local Exchange Carrier (“CLEC”) Licenses in thirty two states, as follows:


Alabama

Idaho

Massachusetts

New York

South Dakota

West VirginiaArkansas

Illinois

Missouri

North Carolina

Texas

WisconsinCalifornia

Indiana

Montana

North Dakota

UtahConnecticut

Iowa

Nebraska

Ohio

VermontFlorida

Kansas

New Jersey

Oregon

Washington D.C.Georgia

Kentucky

New Mexico

Pennsylvania

Washington




It is our intent to focus our expansion on the geographic markets in which we have been granted CLEC Licenses. We also intend to expand our market place to reach customers worldwide.




Results of Operations




Three months ended June 30, 2011 compared to three months ended June 30, 2010




Revenues: Our revenues amounted to $589,257 and $167,820 for the three months ended June 30, 2011, and 2010, respectively. The increase in revenues relates to increase in sales activities due to market penetration, increase in advertising and marketing expenditures and new sales to large retailers.





25




Cost of sales: Our cost of sales amounted to $631,007 and $224,613 for the three months ended June 30, 2011, and 2010, respectively. The increase in cost of sales relates to increase in sales activities due to market penetration, increase advertising and marketing expenditures and new sales to large retailers.  We also reclassified our customer support costs and commissions  from cost of sales to operating expenses, similar to other large VOIP providers.




Gross margin:Our gross margin amounted to $(41,750) and $(56,793) for the three months ended June 30, 2011 and 2010, respectively. The decrease in gross margin is negative due to original costing of the DUO upon release, which initially was much higher because components were purchased in small amounts, resulting in higher per unit costs and manufacturing of the DUO was done in the United States at a much higher cost.  We now have full manufacturing set up in China and are able to buy components in larger quantities resulting in overall lower per unit costs.  We have also had to air ship product in from China to meet demand for the short term.  We expect to have all product shipped by container in the future, which will reduce our overall per unit cost.  We expect our build of material cost to reduce over time consistent with sales as we take advantages of economies of scale,  Further, we are working with call terminating vendors to reduce our price per minute costs, which we expect to be much lower as we expand our subscriber base and take advantage of economies of scale and other opportunities.




Advertising and marketing:Our advertising and marketing expenses amounted to $612,046 and $59,151 for the three months ended June 30, 2011 and 2010, respectively.  The breakdown of our advertising expense is as follows:




June 30,2011


2010Infomercial/production time

$
-


$
-Media and others


529,965



59,151Smartphone application costs (branding)


82,081



-Total

$
578,321


$
59,151




Smartphone Application:  We released our Smartphone application during December of 2010.  The smart phone application continues to be one of the top downloaded apps in Canada.  We had more than 350,000 users of our application at June 30, 2011.




Compensation and Benefits: Our compensation and benefits expense amounted to $325,796 and $193,685 for the three months ended June 30, 2011 and 2010, respectively. This amount represents normal salaries and wages paid to management members and employees including marketing and administrative functions.




Professional Fees: Our professional fees amounted to $83,469 and $45,435 for the three months ended June 30, 2011 and 2010, respectively. This amount includes normal payments and accruals for legal, accounting and other professional services.         Our costs associated with legal and accounting fees will remain higher than historical amounts because, as a reporting company,        we are required to comply with the reporting requirements of the Securities and Exchange Act of 1934, as amended    (the “Exchange Act”). This involves the preparation and filing of the quarterly and annual reports required under the Exchange Act      as well as other reporting requirements under the Exchange Act.




We will also incur additional expenses associated with the services provided by our transfer agent. In addition, to the work we are presently doing, we will need to focus our time and energy to complying with the Exchange Act. This will detract from our ability    and efforts to develop and market our products and services. We anticipate incurring these additional expenses related to being a public company without receiving a substantial increase in revenues associated with this undertaking.




Depreciation and Amortization: Depreciation and amortization amounted to $91,792 and $90,948 for the three months ended June 30, 2011 and 2010, respectively. These amounts represent amortization of our long-lived tangible and intangible assets using straight-line methods and lives commensurate with the assets’ remaining utility. Our long-lived assets, both tangible and intangible, are subject to annual impairment review, or more frequently if circumstances so warrant. During the three months ended      June 30, 2011, we did not calculate or record impairment charges. However, negative trends in our business and our inability to meet our projected future results could give rise to impairment charges in future periods.




Research and Development and Software Costs:We expense research and development expenses, as these costs are incurred. We account for our offering-related software development costs as costs incurred internally in creating a computer software product and are charged to expense when incurred as research and development until technological feasibility has been established for the product. Technological feasibility is established upon completion of a detail program design or, in its absence, completion of a working model.  At this time our main product TK6000 is being sold in the market place.  Therefore, research and development cost reported in our financial statements relates to pre – marketing cost and are expensed accordingly.





26


Three months endedJune 30,2011


2010Components of research and development:Product development and engineering

$
90,648


$
52,126Payroll and benefits


129,485



39,927Total

$
220,133


$
92,053




General and Administrative Expenses: General and administrative expenses amounted to $514,689 and $165,360 for the three months ended June 30, 2011 and 2010, respectively, and consisted of general corporate expenses. General corporate expenses included $74,950 in occupancy costs for the three months ended June 30, 2011 and $43,384 for the comparable period ended June 30, 2010.  Due to our growth, we have expanded office space under our current lease to accommodate our increased number of employees.  All increased space is within the same building under the same lease as discussed in our financial statements for the quarter ended June 30, 2011. Our other increased general and administrative costs are associated with increased administrative support related to our growth and  efforts of being a public company.




Our general and administrative expenses are made up of the following accounts:




June 30,2011


2010Bad debt expense

$
-


$
2,628Commission


148,739



10,818Rent and occupancy


74,950



43,384Insurance


31,205



16,803Software


-



638Taxes and licenses


14,713



18,288Telephone


-



4,739Customer support cost


144,173



33,555Travel


55,319



7,488Other


45,590



27,019Total

$
514,689


$
165,360





Interest Expense: Interest expense amounted to $266,130 and $0 for the three months ended June 30, 2011 and 2010 respectively.  Such amount represented (i) stipulated interest under our aggregate $4,200,000 face value convertible debentures, (ii) the related amortization of premiums and discounts and (iii) the amortization of deferred finance costs.  Aggregate premiums continue to be credited to interest expense over the term of the debentures using the effective interest method.




On June 30, 2011, we issued face value $5,266,130, 12% debentures, due July 1, 2013 and warrants to purchase 21,064,520 shares of our common stock for $0.50 per share, which expire five years from the issuance date, for $2,500,000 cash, settlement of $2,500,000 in bridge financing and settlement of $266,130 in accrued interest on the former convertible debentures.




Derivative income (expense): Derivative expense amounted to $5,086,209 and $7,239,856 for the three months ended June 30, 2011 and 2010, respectively.  Such amount represents the change in fair value of liability-classified warrants. Derivative financial instruments are carried as liabilities, at fair value, in our financial statements with changes reflected in income.  In addition to the liability-classified warrants, we also have certain compound derivative financial instruments related to our $4,200,000 face value convertible debentures that had de minimus values. We are required to adjust our warrant and compound derivatives to fair value at each reporting period. The fair value of our warrant derivative is largely based upon fluctuations in the fair value of our common stock. The fair value of our compound derivative is largely based upon estimates of cash flow arising from the derivative and credit-risk adjusted interest rates. Accordingly, the volatility in these underlying valuation assumptions will have future effects on our earnings.





27





Debt extinguished:Debt extinguished expense amounted to $824,922 and $0 for the three months ended June 30, 2011 and 2010, respectively. The extinguishment expense arose from inducement warrants that were issued as part of the conversion of our convertible debt to equity and to induce the investors to roll up the existing accrued interest at June 30, 2011 to the new debentures issued on June 30, 2011.





ExtinguishmentCalculation$266,130 face value of debentures

$
284,238Warrants to purchase 1,064,520 shares of common stock


416,014700,252Carrying value of settled obligation


(266,130
)Inducement warrants for conversion of debt and accrued interest


390,800Extinguishment loss

$
824,922




Net income (loss): Net income (loss) amounted to $2,106,781 and $6,542,015 for the three months ended June 30, 2011 and 2010, respectively.  Net income includes derivative income associated with the valuation of debentures, embedded conversion features and warrants, extinguishment expense, negative gross margin and increase in rent expense, travel expenses and customer support costs.





Net loss applicable to common stockholders: The net loss applicable to common stockholders amounted to $485,905 and $6,396,153 for the three months ended June 30, 2011 and 2010, respectively.  This includes the components of net income discussed above, accretion of preferred stock of $2,442,686 and $91,000 and preferred stock dividends of $150,000 and $54,862 for the three months ended June 3, 2011 and 2010 respectively.




Income (loss) Per Common Share:Basic income (loss) per common share represents our income (loss) applicable to common shareholders divided by the weighted average number of common shares outstanding during the period. Diluted income (loss) per common share gives effect to all potentially dilutive securities. We compute the effects on diluted loss per common share arising from warrants and options using the treasury stock method or, in the case of liability classified warrants, the reverse treasury stock method. We compute the effects on diluted loss per common share arising from convertible securities using the if-converted method. The effects, if anti-dilutive are excluded.




Results of Operations




Nine months ended June 30, 2011 compared to six months ended June 30, 2010




Revenues: Our revenues amounted to $1,671,410 and $597,649 for the nine months ended June 30, 2011, and 2010, respectively. The increase in revenues relates to increase in sales activities due to market penetration, increase advertising and marketing expenditures and new sales to large retailers.




Cost of sales: Our cost of sales amounted to $1,730,545 and $651,972 for the nine months ended June 30, 2011, and 2010, respectively. The increase in cost of sales relates to increase in sales activities due to market penetration, increase advertising and marketing expenditures and new sales to large retailers.  We also reclassified our customer support costs and commissions from cost of sales to operating expenses, similar to other large VOIP providers.




Gross margin:Our gross margin amounted to $(59,135) and $(54,323) for the nine months ended June 30, 2011 and 2010, respectively. The decrease in gross margin is negative due to original costing of the DUO upon release, which initially was much higher because components were purchased in small amounts, resulting in higher per unit costs and manufacturing of the DUO was done in the United States at a much higher cost.  We now have full manufacturing set up in China and are able to buy components in larger quantities resulting in overall lower per unit costs.  We have also had to air ship product in from China to meet demand for the short term.  We expect to have all product shipped by container in the future, which will reduce our overall per unit cost.  We expect our build of material cost to reduce over time consistent with sales as we take advantages of economies of scale,  Further, we are working with call terminating vendors to reduce our price per minute costs, which we expect to be much lower as we expand our subscriber base and take advantage of economies of scale and other opportunities.





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Advertising and Marketing:Our advertising expenses amounted to $1,127,767 and $223,189 for the nine months ended June 30, 2011 and 2010, respectively.  The breakdown of our advertising expense is as follows:




June 30,2011


2010Infomercial/production time

$
-


$
18,400Media and others


1,013,662



204,789Smartphone application costs (branding)


114,105 -Total

$
1,127,767


$
223,189




Compensation and Benefits: Our compensation and benefits expense amounted to $868,790 and $494,685 for the nine months ended June 30, 2011 and 2010, respectively. This amount represents normal salaries and wages paid to management members and employees including marketing and administrative functions.




Professional Fees: Our professional fees amounted to $229,205 and $187,039 for the nine months ended June 30, 2011 and 2010, respectively. This amount includes normal payments and accruals for legal, accounting and other professional services.         Our costs associated with legal and accounting fees will remain higher than historical amounts because, as a reporting company,        we are required to comply with the reporting requirements of the Securities and Exchange Act of 1934, as amended    (the “Exchange Act”). This involves the preparation and filing of the quarterly and annual reports required under the Exchange Act      as well as other reporting requirements under the Exchange Act.




We will also incur additional expenses associated with the services provided by our transfer agent. In addition, to the work we are presently doing, we will need to focus our time and energy to complying with the Exchange Act. This will detract from our ability    and efforts to develop and market our products and services. We anticipate incurring these additional expenses related to being a public company without receiving a substantial increase in revenues associated with this undertaking.




Depreciation and Amortization: Depreciation and amortization amounted to $272,739 and $272,156 for the nine  months ended   June 30, 2011 and 2010, respectively. These amounts represent amortization of our long-lived tangible and intangible assets using straight-line methods and lives commensurate with the assets’ remaining utility. Our long-lived assets, both tangible and intangible, are subject to annual impairment review, or more frequently if circumstances so warrant. During the six months ended  June 30, 2011, we did not calculate or record impairment charges. However, negative trends in our business and our inability to meet our projected future results could give rise to impairment charges in future periods.




Research and Development and Software Costs:We expense research and development expenses, as these costs are incurred. We account for our offering-related software development costs as costs incurred internally in creating a computer software product and are charged to expense when incurred as research and development until technological feasibility has been established for the product. Technological feasibility is established upon completion of a detail program design or, in its absence, completion of a working model.  At this time our main product TK6000 is being sold in the market place.  Therefore, research and development cost reported in our financial statements relates to pre – marketing cost and are expensed accordingly.





Components of research and development:

June 30,2011


2010Product development and engineering

$
215,882


$
77,621Payroll and benefits


338,928



138,896Total

$
554,810


$
216,517





General and Administrative Expenses: General and administrative expenses amounted to $1,231,713 and $543,363 for the nine months ended June 30, 2011 and 2010, respectively, and consisted of general corporate expenses and certain other start up expenses. General corporate expenses included $195,944 in occupancy costs for the nine months ended June 30, 2011 and $129,774 for comparable period ended June 30, 2010.  Our increased costs are associated with our efforts of being a public company.





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Our general and administrative expenses are made up of the following accounts:




June 30,2011


2010Bad debt expense

$
408


$
12,860Commission


328,570



76,131Rent and occupancy


195,944



129,774Insurance


76,775



52,435Software


24,485



5,587Taxes and licenses


32,195



28,329Telecommunication


276,294



105,349Travel


144,282



62,207Other


152,760



70,691Total

$
1,231,713


$
543,363




Interest Expense: Interest expense amounted to $542,094 and $1,184,363 for the nine months ended June 30, 2011 and 2010 respectively.  Such amount represented (i) stipulated interest under our aggregate $4,200,000 face value convertible debentures, (ii) the related amortization of premiums and discounts and (iii) the amortization of deferred finance costs.  Aggregate premiums continue to be credited to interest expense over the term of the debentures using the effective interest method.




On June 30, 2011, we issued face value $5,266,130, 12% debentures, due July 1, 2013 and warrants to purchase 21,064,520 shares of our common stock for $0.50 per share, which expire five years from the issuance date, for $2,500,000 cash, settlement of $2,500,000 in bridge financing and settlement of $266,130 in accrued interest on the former convertible debentures.




In addition, our convertible debentures as of June 30, 2010 were issued on February 24, 2010 in connection with an exchange agreement with our creditors that provided for, among other things, the consolidation of our previous secured convertible debt instruments, and included the capitalization of $798,773 of accrued interest. The capitalization of accrued interest was to include interest up to December 31, 2010.  Therefore, during quarter ended June 30, 2010 we recorded no interest expense.




Derivative income (expense) : Derivative (expense) income amounted to $(17,280,018) and $1,892,559 for the nine months ended June 30, 2011 and 2010, respectively.  Such amount represents the change in fair value of liability-classified warrants. Derivative financial instruments are carried as liabilities, at fair value, in our financial statements with changes reflected in income.  In addition to the liability-classified warrants, we also have certain compound derivative financial instruments related to our $4,200,000 face value convertible debentures that had de minimus values. We are required to adjust our warrant and compound derivatives to fair value at each reporting period. The fair value of our warrant derivative is largely based upon fluctuations in the fair value of our common stock. The fair value of our compound derivative is largely based upon estimates of cash flow arising from the derivative and credit-risk adjusted interest rates. Accordingly, the volatility in these underlying valuation assumptions will have future effects on our earnings.




Debt extinguished:Debt extinguished expense amounted to $1,192,422 and $3,617,983 for the nine months ended June 30, 2011 and 2010, respectively.  The extinguishment expense arose from inducement warrants that were issued as part of the conversion of our convertible debt to equity and to induce the investors to roll up the existing accrued interest at June 30, 2011 to the new debentures issued on June 30, 2011.  The extinguishment expense for the nine months ended June 30, 2010 resulted from the modification of our convertible debt, which resulted in a cash flow difference of greater than 10%.  Under US GAAP rules, debt modifications that result in a cash flow difference of greater than 10% must be treated as an extinguishment of the debt and issuance of new debt based on the new terms.  The result was an extinguishment expense of $3,617,983.





Net loss: The net loss amounted to $23,355,225 and $4,889,494 for the nine months ended June 30, 2011 and 2010, respectively.  The net loss includes derivative expense associated with valuation of debentures and warrants, negative gross margin and an increase in rent expense, travel expenses and customer support costs.





Net income (loss) excluding derivative valuation:Net loss excluding derivative valuation expenses amounted to $(4,882,785) and $(3,164,070) for the nine months ended June 30, 2011 and 2010.  Derivative valuation expenses are “paper loss” and are not normal recurring operating expenses.





Net loss applicable to common stockholders: The net loss applicable to common stockholders amounted to $28,079,590 and $5,110,362 for the nine months ended June 30, 2011 and 2010, respectively.  This includes the components of net loss discussed above, accretion of preferred stock of $4,287,698 and $126,000 and preferred stock dividends of $436,667 and $94,868 for the nine months ended June 30, 2011 and 2010 respectively.





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Loss Per Common Share:Basic loss per common share represents our loss applicable to common shareholders divided by the weighted average number of common shares outstanding during the period. Diluted loss per common share gives effect to all potentially dilutive securities. We compute the effects on diluted loss per common share arising from warrants and options using the treasury stock method or, in the case of liability classified warrants, the reverse treasury stock method. We compute the effects on diluted loss per common share arising from convertible securities using the if-converted method. The effects, if anti-dilutive are excluded.




Liquidity and Capital Resources




Statement of cash flow data:

June 30 , 2011


June 30,2010Net cash provided (used) in operating activities

$
(5,206,708
)

$
(1,887,153
)Net cash provided (used) in investing activities


(1,752,468
)


(2,033,681
)Net cash provided (used) in financing activities


4,910,000



4,943,700





Net cash used by operating activities of $(5,206,708) was primarily due to operating expenses including a large increase in inventory purchased and on hand at June 30, 2011, a decrease in accounts receivable balances, and increases in telecommunication expenses, research and development expenses for anticipated new products, marketing expenses, travel expenses to set up facilities in China, increases in wages expenses due to new hires and increased general and administrative expenses,





Net cash used in investing activities of $(1,752,468) was due to purchase of equipment a decrease in deposits and our restricted cash at June 30, 2011.





Net cash of $4,910,000 provided by financing activities was due to proceeds from Senior debenture in the amount of $5,000,000 offset by dividends paid on our preferred stock.





On June 30, 2011, we had cash on hand of $2,477,444 and restricted cash on hand of $110,361.




Our largest operating expenditures currently consist of the following items: $30,000 per month on leasing our corporate office space and network operational center (NOC) and includes our base rent and associated utility expenses and $120,000 per month on payroll. We do not anticipate that our leasing cost s will change during the next 12 months.




Our current long term business plan contemplates acquiring the ongoing business of related companies, either through asset acquisitions, consolidations or mergers.




Off-Balance Sheet Arrangements - NONE




Critical Accounting Policies and estimates




Our accounting policies are discussed and summarized in Note 2 to our financial statements.  The following describes our critical accounting policies and estimates.




Critical Accounting Policies




The financial information contained in our comparative results of operations and liquidity disclosures has been derived from our financial statements. The preparation of those financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and notes.        The following significant estimates were made in the preparation of our financial statements and should be considered when reading our Management’s Discussion and Analysis:




·
Impairment of Long-lived Assets: Our telecommunications equipment, other property and intangible assets are material to our financial statements. Further, they are subject to the potential negative effects arising from technological obsolescence. We evaluate our tangible and definite-lived intangible assets for impairment annually or more frequently in the presence of circumstances or trends that may be indicators of impairment. Our evaluation is a two step process. The first step is to compare our undiscounted cash flows, as projected over the remaining useful lives of the assets, to their respective carrying values.  In the event that the carrying values are not recovered by future undiscounted cash flows, as a second step, we compare the carrying values to the related fair values and, if lower, record an impairment adjustment.  For purposes of fair value, we generally use replacement costs for tangible fixed assets and discounted cash flows, using risk-adjusted discount rates, for intangible assets. These estimates are made by competent employees, using the best available information, under the direct supervision of our management.




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·
Intangible assets: Our intangible assets require us to make subjective estimates about our future operations and cash flows so that we can evaluate the recoverability of such assets. These estimates consider available information and market indicators including our operational history, our expected contract performance, and changes in the industries that we serve.


·
Share-based payment arrangements: We currently intend to issue share-indexed payments in future periods to employees and non-employees. There are many valuation techniques, such as Black-Scholes-Merton valuation model that we may use to value share-indexed contracts, such as warrants and options.  All such techniques will require certain assumptions that require us to develop forward-looking information as well as historical trends. For purposes of historical trends, we may need to look to peer groups of companies and the selection of such groups of companies is highly subjective.


·
Common stock valuation: Estimating the fair value of our common stock is necessary in the preparation of computations related to acquisition, share-based payment and financing transactions.  We believe that the most appropriate and reliable basis for common stock value is trading market prices in an active market.


·
Derivative Financial Instruments: We generally do not use derivative financial instruments to hedge exposures to cash-flow, market or foreign-currency risks. However, we have entered into certain other financial instruments and contracts, such as our secured convertible debenture and warrant financing arrangements that are either (i) not afforded equity classification,   (ii) embody risks not clearly and closely related to host contracts, or (iii) may be net-cash settled by the counterparty.   We are required to carried as derivative liabilities, at fair value, in our financial statements.  The fair value of share-indexed derivatives will be significantly influenced by the fair value of our common stock (see Common Stock Valuation, above). Certain other elements of forward-type derivatives are significantly influenced by credit-adjusted interest rates used in         cash-flow analysis. Since we are required to carry derivative financial instruments at fair value and make adjustments through earnings, our future profitability will reflect the influences arising from changes in our stock price, changes in interest rates,  and changes in our credit standing.





Revenue Recognition




Operating revenue consists of customer equipment sales of our main product, the NetTalk DUO, telecommunication service revenues and shipping and handling revenues.





Our operating revenues are generated from the sale of customer equipment of our main products, our DUO and TK6000. We also derive service revenues from per minute fees for international calls. Revenue from the sale of our TK6000 is fully recognized at the time of our customer equipment sale.  Our TK6000 provides for life time service (over the life of the device/equipment). Our TK6000 is able to operate within our network/platform or over any other network/platform.  There is no need for income allocation between our TK6000 and life time service provided.  The full intrinsic value of the sale is allocated to the device.  Therefore, we recognized 100% of revenue at time of customer equipment sale and do no allocate any income to life time service provided. Shipping and handling is also recognized at time of sale.





On July 14, 2010 werevealed our newest product the net TALK DUO (“DUO”).  Our DUO offers our customers free nationwide calls to any landline or mobile phone in the U.S. and Canada from anywhere in the world, as well as low-cost international rates. It’s also a versatile digital phone service with no monthly fees, no contracts and no computer required. The DUO is flexible enough to connect directly to your internet connection through the router/modem; there is also a convenient option with our DUO to connect to your computer. The sleek design is small enough to fit in the palm of your hand, making it a portable device.





The DUO reduces the wear and tear on your home or office computer and reduces energy costs, resulting in money savings. The fax-friendly DUO, offers fax (incoming and outgoing), a unique feature not offered, to our knowledge, by similar digital phone services. The portability of this small device is also great for international travelers who want to place free nationwide calls to the U.S. and Canada, or who are looking for a low-cost solution for international rates. Calls to other Nettalk customers are always free.




Our DUO provides for revenue recognition from the sale of the device and from the sale of telephone service. The initial year of telephone service is included on the sale price at time of sale and billed subsequently thereafter. Therefore, revenue recognition on our DUO is fully recognized at the time of our customer equipment sale and the one year telephone service is amortized over a 12 month cycle.  Subsequent renewals of the annual telephone service are amortized over the corresponding 12 months cycle.




International calls are billed as earned from our customers.  International calls are prepaid and the customer’s account is debited as minutes are used and earned.





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Item 3 Quantitative and Qualitative Disclosures About Market Risk





We are a smaller reporting company as defined by Rule 12b-2 of the Securities Exchange Act of 1934 and, as such, are not required   to provide the information under this item.




Item 4 Controls and Procedures




Disclosure Controls




We maintain “disclosure controls and procedures,” as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), that are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.





As of June 30, 2011, we carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were not effective in ensuring that information required to be disclosed by us in our periodic reports is recorded, processed, summarized and reported, within the time periods specified for each report and that such information is accumulated and communicated to our management, including our principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.





In connection with the assessment described above, management identified the following control deficiencies that represent material weaknesses at June 30, 2011:





·
Due to the Company’s limited resources, the Company has insufficient personnel resources and technical accounting and reporting expertise to properly address all of the accounting matters inherent in the Company’s financial transactions.  The Company does not have a formal audit committee, and the Board does not have a financial expert, thus the Company lacks the board oversight role within the financial reporting process.





·
The Company’s small size and “one-person” office prohibits the segregation of duties and the timely review of accounts payable, expense reporting and inventory management and banking information.





Our Chief Executive Officer and Chief Financial Officer are in the process of determining how best to change our current system         and implement a more effective system to insure that information required to be disclosed in our quarterly and annual reports has     been recorded, processed, summarized and reported accurately.  Our management acknowledges the existence of this problem,   and intends to develop procedures to address them to the extent possible given limitations in financial and manpower resources.





While management is working on a plan, no assurance can be made at this point that the implementation of such controls and procedures will be completed in a timely manner or that they will be adequate once implemented.





33




Changes in Internal Controls.




During the three months ended March  31, 2011 , there were no changes in our internal control over financial reporting identified     in connection with the evaluation required by paragraph (f) of Rule 13a-15 or Rule 15d-15 that has materially affected,    or is reasonably likely to materially affect, our internal control over financial reporting.





PART II                      OTHER INFORMATION





Item 1.
Legal Proceedings – NONE.





Item 1A.  Risk Factors





We are a smaller reporting company as defined by Rule 12b-2 of the Securities Exchange Act of 1934 and, as such, are not required   to provide the information under this item.





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





On June 30, 2011, we issued face value $5,266,130, 12% debentures, due July 1, 2013 and warrants to purchase 21,064,520 shares of our common stock for $0.50 per share, which expire five years from the issuance date, for $2,500,000 cash, settlement of $2,500,000 in bridge financing and settlement of $266,130 in accrued interest on the former convertible debentures.





On August 9, 2011, we issued face value $2,000,000, 12% debentures, due July 1, 2013 and warrants to purchase 8,000,000 shares of our common stock for $0.50 per share, which expire five years from the issuance date for $2,000,000 cash.





Item 3.  Defaults Upon Senior Securities – NONE.





Item 4.        Submission of Matters to a Vote of Security Holders – NONE.





Item 5.        Other Information





On June 30, 2011, we issued face value $5,266,130, 12% debentures, due July 1, 2013 and warrants to purchase 21,064,520 shares of our common stock for $0.50 per share, which expire five years from the issuance date, for $2,500,000 cash, settlement of $2,500,000 in bridge financing and settlement of $266,130 in accrued interest on the former convertible debentures.





On August 9, 2011, we issued face value $2,000,000, 12% debentures, due July 1, 2013 and warrants to purchase 8,000,000 shares of our common stock for $0.50 per share, which expire five years from the issuance date for $2,000,000 cash.





2010 Stock Option Plan





On November 15, 2009, Net Talk.com, Inc. (the “Company”) adopted the 2010 Stock Option Plan (the "Plan") which is intended  to advance the interests of the Company’s shareholders by enhancing the Company’s ability to attract, retain and motivate persons who make (or are expected to make) important contributions to the Company by providing such persons with equity ownership opportunities and performance-based incentives and thereby better aligning the interests of such persons with those of the Company’s shareholders. All of the Company’s employees, officers, and directors, and those Company’s consultants and advisors (i) that are natural persons and (ii) who provides bona fide services to the Company not connected to a capital raising transaction or the promotion or creation of a market for the Company’s securities, are eligible to be granted options or restricted stock awards under the Plan. The maximum aggregate number of shares of the Company’s common stock that may be issued under the Plan is 10,000,000 shares of the Company’s common stock.





On July 26, 2010, we issued 3,709,500 shares of common stock to our employees as part of our 2010 Stock Option Plan. The shares are compensatory in nature and are fully vested.  We have valued the shares at $0.03 per share consistent with fair value at the time of issuance including and adjusted for ownership restrictions.





On May 23 2011, we issued 3,890,000 shares of common stock to our employees as part of our 2010 Stock Option Plan. The shares are compensatory in nature and are fully vested.  We have valued the shares at $0.01 per share consistent with fair value at the time of issuance including and adjusted for ownership restrictions.





On July 19, 2011, we issued 2,400,500 shares of common stock to our employees as part of our 2010 Stock Option Plan. The shares are compensatory in nature and are fully vested.  We have valued the shares at $0.01 per share consistent with fair value at the time of issuance including and adjusted for ownership restrictions.





34





We have issued all approved common shares under our 2010 Stock Option Plan.





2011 Stock Option Plan





On June 15, 2011, Net Talk.com, Inc. (the “Company”) adopted the 2011 Stock Option Plan (the "Plan") which is intended  to advance the interests of the Company’s shareholders by enhancing the Company’s ability to attract, retain and motivate persons who make (or are expected to make) important contributions to the Company by providing such persons with equity ownership opportunities and performance-based incentives and thereby better aligning the interests of such persons with those of the Company’s shareholders. All of the Company’s employees, officers, and directors, and those Company’s consultants and advisors (i) that are natural persons and (ii) who provides bona fide services to the Company not connected to a capital raising transaction or the promotion or creation of a market for the Company’s securities, are eligible to be granted options or restricted stock awards under the Plan. The maximum aggregate number of shares of the Company’s common stock that may be issued under the Plan is 20,000,000 shares of the Company’s common stock.





Item 6.

ExhibitsExhibit No.

Description31.1

Certification of Chief Executive Officer pursuant to Rule 13a-14(a) and 15d-14(a) as adopted pursuant toSection 302 of the Sarbanes-Oxley Act of 2002, dated May 15, 2011.31.2

Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and 15d-14(a) as adopted pursuant toSection 302 of the Sarbanes-Oxley Act of 2002, dated May 15, 2011.32.1

Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant toSection 906 of the Sarbanes-Oxley Act of 2002, dated May 15, 2011.32.1

Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant toSection 906 of the Sarbanes-Oxley Act of 2002, dated May 15, 2011.





35





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.





NET TALK.COM, INC.Date:  August 15, 2011
By
/s/ Anastasios KyriakidesAnastasios KyriakidesChief Executive Officer (Principal Executive Officer)Date:  August 15, 2011
By:
/s/ Guillermo RodriguezGuillermo RodriguezChief Financial Officer (Principal Financial Officer and Principal Accounting Officer)





36