UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-Q


(Mark
One)




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





For
the quarterly period ended December 31, 2008





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    0-17304





Cistera Networks,
Inc.


(Exact
name of registrant as specified in its charter)





Nevada
                (State
      or other jurisdiction of incorporation or organization)
              91-1944887
                (I.R.S.
      Employer Identification No.)





6509 Windcrest Drive, Suite
160, Plano,
Texas       75024


(Address
of principal executive
offices)               (Zip
Code)





972-381-4699


(Registrant's
telephone number, including area code)





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




Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
definition of “large accelerated filer,” “accelerated filer” “non-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 ý





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




As of
February 12, 2009, 17,423,410 shares of the registrant’s stock, $0.001 par value
per share, were outstanding.





CISTERA
NETWORKS, INC & SUBSIDIARY




TABLE
OF CONTENTS









PART
      I: FINANCIAL INFORMATIONItem
      1.
                                    Financial
      Statements:Consolidated
      Balance Sheets – December 31, 2008 (unaudited) and March 31, 2008
      (audited)
                                    2Consolidated
      Statements of Operations – For the three months ended December 31, 2008
      and2007
      (unaudited)
                                    3Consolidated
      Statements of Operations – For the nine months ended December 31, 2008
      and2007
      (unaudited)
                                    4Consolidated
      Statements of Stockholders’ Deficit – December 31, 2008 (unaudited)
      andMarch
      31, 2008 (audited)
                                    5Consolidated
      Statements of Cash Flows – For the nine months ended December 31, 2008
      and2007
      (unaudited)
                                    6Notes
      to Consolidated Financial Statements (unaudited)
                                    8Item
      2.
                                    Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                                    16Item
      3.
                                    Quantitative
      and Qualitative Disclosures About Market Risk
                                    23Item
      4T.
                                    Controls
      and Procedures
                                    23PART
      II: OTHER INFORMATIONItem
      1.
                                    Legal
      Proceedings
                                    24Item
      1A.
                                    Risk
      Factors
                                    24Item
      2.
                                    Unregistered
      Sales of Equity Securities and Use of Proceeds
                                    25Item
      3.
                                    Defaults
      Upon Senior Securities
                                    25Item
      4.
                                    Submission
      of Matters to a Vote of Security Holders
                                    25Item
      5.
                                    Other
      Information
                                    25Item
      6.
                                    Exhibits
                                    26SIGNATURE
                                    27


1


Part
I. FINANCIAL INFORMATION




Item
1. Financial Statements





CISTERA
NETWORKS, INC. & SUBSIDIARY


CONSOLIDATED
BALANCE SHEETS


(Unaudited)




December
      31, 2008
                    
                    
                    March
      31, 2008Current
      assetsCash
      and cash equivalents
                    
                    $
                    110,684
                    
                    
                    $
                    125,007Restricted
      cash
                    
                    
                    -
                    
                    
                    
                    50,000Accounts
      receivable, net of allowance for doubtful accounts of $-0-
                    
                    
                    82,248
                    
                    
                    
                    264,023Inventory
                    
                    
                    74,142
                    
                    
                    
                    187,960Prepaid
      expenses
                    
                    
                    34,740
                    
                    
                    
                    46,030Total
      current assets
                    
                    
                    301,814
                    
                    
                    
                    673,020Property
      and equipment, net
                    
                    
                    365,286
                    
                    
                    
                    355,411Intangible
      assets, net
                    
                    
                    1,819,386
                    
                    
                    
                    2,023,218Total
      long-term assets
                    
                    
                    2,184,672
                    
                    
                    
                    2,378,629TOTAL
      ASSETS
                    
                    $
                    2,486,486
                    
                    
                    $
                    3,051,649Current
      liabilitiesAccounts
      payable
                    
                    
                    516,145
                    
                    
                    
                    420,603Related
      party payables
                    
                    
                    -
                    
                    
                    
                    129,702Accrued
      liquidated damages - outside investors
                    
                    
                    177,024
                    
                    
                    
                    629,957Accrued
      liquidated damages - related parties
                    
                    
                    -
                    
                    
                    
                    41,485Accrued
      liabilities
                    
                    
                    1,174,035
                    
                    
                    
                    1,076,360Deferred
      revenue
                    
                    
                    809,715
                    
                    
                    
                    971,474Convertible
      promissory notes and other notes payable, net of discount
                    
                    
                    906,535
                    
                    
                    
                    408,204Line
      of credit
                    
                    
                    -
                    
                    
                    
                    17,503Total
      current liabilities
                    
                    
                    3,583,454
                    
                    
                    
                    3,695,288Convertible
      promissory notes - outside investors, net of discount
                    
                    
                    -
                    
                    
                    
                    1,606,300Convertible
      promissory notes - related parties, net of discount
                    
                    
                    -
                    
                    
                    
                    59,719Deferred
      revenue
                    
                    
                    180,359
                    
                    
                    
                    225,917Other
      long-term liabilities
                    
                    
                    67,266
                    
                    
                    
                    285,470Total
      long-term liabilities
                    
                    
                    247,625
                    
                    
                    
                    2,177,406Total
      liabilities
                    
                    
                    3,831,079
                    
                    
                    
                    5,872,694Commitments
      and contingencies (Note 4)Stockholders'
      deficit:Preferred
      stock, $0.01 par value; 1,000,000 shares authorized;
                      -0-
      shares issued and outstanding
                    
                    
                    -
                    
                    
                    
                    -Common
      stock, $0.001 par value; 50,000,000 shares authorized;
                      17,423,410
      and 8,820,192 shares issued and outstanding,
                      respectively
                    
                    
                    17,423
                    
                    
                    
                    8,820Additional
      paid-in capital
                    
                    
                    19,291,219
                    
                    
                    
                    13,764,517Accumulated
      deficit
                    
                    
                    (20,653,235
                    )
                    
                    
                    (16,594,382
                    )Total
      stockholders' deficit
                    
                    
                    (1,344,593
                    )
                    
                    
                    (2,821,045
                    )TOTAL
      LIABILITIES AND STOCKHOLDERS' DEFICIT
                    
                    $
                    2,486,486
                    
                    
                    $
                    3,051,649





The
accompanying notes are an integral part of these consolidated financial
statements.


2


CISTERA
NETWORKS, INC. & SUBSIDIARY


CONSOLIDATED
STATEMENTS OF OPERATIONS


(Unaudited)





Three
      months ended December 31,2008
                        
                        
                        2007RevenuesConvergence
      solutions
                        
                        $
                        712,340
                        
                        
                        $
                        377,112Professional
      services
                        
                        
                        98,514
                        
                        
                        
                        87,972Support
      and maintenance
                        
                        
                        261,633
                        
                        
                        
                        153,677Total
      revenues
                        
                        
                        1,072,487
                        
                        
                        
                        618,761Cost
      of revenuesConvergence
      solutions
                        
                        
                        254,675
                        
                        
                        
                        98,501Professional
      services
                        
                        
                        55,680
                        
                        
                        
                        43,314Support
      and maintenance
                        
                        
                        24,250
                        
                        
                        
                        23,475Total
      cost of revenues
                        
                        
                        334,605
                        
                        
                        
                        165,290Gross
      Profit
                        
                        
                        737,882
                        
                        
                        
                        453,471Operating
      expensesSales
      and marketing
                        
                        
                        319,758
                        
                        
                        
                        509,627Software
      development
                        
                        
                        188,956
                        
                        
                        
                        193,432Engineering
      and support
                        
                        
                        172,923
                        
                        
                        
                        200,409General
      and administrative
                        
                        
                        338,210
                        
                        
                        
                        404,999Depreciation
      and amortization
                        
                        
                        103,538
                        
                        
                        
                        88,442Total
      operating expenses
                        
                        
                        1,123,385
                        
                        
                        
                        1,396,909Loss
      from operations
                        
                        
                        (385,503
                        )
                        
                        
                        (943,438
                        )Other
      income (expense)Interest
      income
                        
                        
                        158
                        
                        
                        
                        3,760Interest
      expense
                        
                        
                        (43,124
                        )
                        
                        
                        (82,131
                        )Amortization
      of discount on convertible notes – outside investors
                        
                        
                        (108,918
                        )
                        
                        
                        (371,775
                        )Amortization
      of discount on convertible notes – related parties
                        
                        
                        -
                        
                        
                        
                        (10,237
                        )Total
      other income (expense)
                        
                        
                        (151,884
                        )
                        
                        
                        (460,383
                        )Net
      loss
                        
                        $
                        (537,387
                        )
                        
                        $
                        (1,403,821
                        )Basic
      & diluted net loss per share
                        
                        $
                        (0.03
                        )
                        
                        $
                        (0.16
                        )Weighted
      average shares outstanding – basic and diluted
                        
                        
                        17,423,410
                        
                        
                        
                        8,594,469
















The
accompanying notes are an integral part of these consolidated financial
statements.


3


CISTERA
NETWORKS, INC. & SUBSIDIARY


CONSOLIDATED
STATEMENTS OF OPERATIONS


(Unaudited)





Nine
      months ended December 31,2008
                      
                      
                      2007RevenuesConvergence
      solutions
                      
                      $
                      2,247,809
                      
                      
                      $
                      1,496,256Professional
      services
                      
                      
                      204,347
                      
                      
                      
                      282,565Support
      and maintenance
                      
                      
                      709,394
                      
                      
                      
                      413,509Total
      revenues
                      
                      
                      3,161,550
                      
                      
                      
                      2,192,330Cost
      of revenuesConvergence
      solutions
                      
                      
                      664,417
                      
                      
                      
                      430,428Professional
      services
                      
                      
                      148,680
                      
                      
                      
                      126,490Support
      and maintenance
                      
                      
                      71,684
                      
                      
                      
                      64,875Total
      cost of revenues
                      
                      
                      884,781
                      
                      
                      
                      621,793Gross
      Profit
                      
                      
                      2,276,769
                      
                      
                      
                      1,570,537Operating
      expensesSales
      and marketing
                      
                      
                      900,230
                      
                      
                      
                      1,023,925Software
      development
                      
                      
                      612,289
                      
                      
                      
                      543,950Engineering
      and support
                      
                      
                      579,323
                      
                      
                      
                      426,126General
      and administrative
                      
                      
                      1,098,827
                      
                      
                      
                      949,004Depreciation
      and amortization
                      
                      
                      302,368
                      
                      
                      
                      253,315Total
      operating expenses
                      
                      
                      3,493,037
                      
                      
                      
                      3,196,320Loss
      from operations
                      
                      
                      (1,216,268
                      )
                      
                      
                      (1,625,783
                      )Other
      income (expense)Interest
      income
                      
                      
                      326
                      
                      
                      
                      21,883Interest
      expense
                      
                      
                      (190,933
                      )
                      
                      
                      (230,491
                      )Amortization
      of discount on convertible notes – outside investors
                      
                      
                      (1,297,773
                      )
                      
                      
                      (1,104,584
                      )Amortization
      of discount on convertible notes – related parties
                      
                      
                      (41,060
                      )
                      
                      
                      (30,155
                      )Charge
      for inducements related to stock issued to convertible note
      holders
                      
                      
                      (1,324,444
                      )
                      
                      
                      (135,825
                      )Credit
      (charge) for estimated liquidated damages
                      
                      
                      11,299
                      
                      
                      
                      (251,176
                      )Total
      other income (expense)
                      
                      
                      (2,842,585
                      )
                      
                      
                      (1,730,348
                      )Net
      loss
                      
                      $
                      (4,058,853
                      )
                      
                      $
                      (3,356,131
                      )Basic
      & diluted net loss per share
                      
                      $
                      (0.28
                      )
                      
                      $
                      (0.39
                      )Weighted
      average shares outstanding – basic and diluted
                      
                      
                      14,725,627
                      
                      
                      
                      8,594,469






















The
accompanying notes are an integral part of these consolidated financial
statements.


.


4


CISTERA
NETWORKS, INC. & SUBSIDIARY


CONSOLIDATED
STATEMENTS OF STOCKHOLDERS' DEFICIT


(Unaudited)


Preferred
      Stock
                          
                          
                          Common
      Stock
                          
                          
                          Additional
      Paid-in Capital
                          
                          
                          Accumulated
      Deficit
                          
                          
                          Total
      Stockholders’ DeficitShares
                          
                          
                          Amount
                          
                          
                          Shares
                          
                          
                          AmountBalances
      at March 31, 2008
                          
                          
                          -
                          
                          
                          $
                          -
                          
                          
                          
                          8,820,192
                          
                          
                          $
                          8,820
                          
                          
                          $
                          13,764,517
                          
                          
                          $
                          (16,594,382
                          )
                          
                          $
                          (2,821,045
                          )Stock
      issued from the conversion of
                            convertible notes
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          6,175,857
                          
                          
                          
                          6,176
                          
                          
                          
                          3,280,940
                          
                          
                          
                          
                          
                          
                          
                          3,287,116Stock
      issued from the exercise of warrants
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          2,368,584
                          
                          
                          
                          2,368
                          
                          
                          
                          894,547
                          
                          
                          
                          
                          
                          
                          
                          896,915Stock
      issued for waiver of registration
                            rights payments
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          58,777
                          
                          
                          
                          59
                          
                          
                          
                          21,983
                          
                          
                          
                          
                          
                          
                          
                          22,042Inducement
      charges related to conversion of
                            convertiblenotes
      and exercise of warrants
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          1,302,403
                          
                          
                          
                          
                          
                          
                          
                          1,302,403Charge
      for issuance of warrants
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          26,829
                          
                          
                          
                          
                          
                          
                          
                          26,829Net
      loss
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          (4,058,853
                          )
                          
                          
                          (4,058,853
                          )Balances
      at December 31, 2008
                          
                          
                          -
                          
                          
                          $
                          -
                          
                          
                          
                          17,423,410
                          
                          
                          $
                          17,423
                          
                          
                          $
                          19,291,219
                          
                          
                          $
                          (20,653,235
                          )
                          
                          $
                          (1,344,593
                          )





















































The
accompanying notes are an integral part of these consolidated financial
statements.


5


CISTERA
NETWORKS, INC. & SUBSIDIARY


CONSOLIDATED
STATEMENTS OF CASH FLOWS


(Unaudited)





Nine
      months ended December 31,2008
                    
                    
                    2007CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      loss
                    
                    $
                    (4,058,853
                    )
                    
                    $
                    (3,356,131
                    )Adjustments
      used to reconcile net loss to net cash used in operating
      activities:Charge
      for inducement to convert debt to convertible promissory
    notes
                    
                    
                    1,324,444
                    
                    
                    
                    135,825Charge
      (credit) for liquidated damages
                    
                    
                    (11,299
                    )
                    
                    
                    251,176Amortization
      of discount on convertible promissory notes – outside
    parties
                    
                    
                    1,297,773
                    
                    
                    
                    1,104,583Amortization
      of discount on convertible promissory notes – related
    parties
                    
                    
                    41,060
                    
                    
                    
                    30,155Share-based
      compensation
                    
                    
                    26,829
                    
                    
                    
                    -Stock
      issued for investors fees
                    
                    
                    -
                    
                    
                    
                    10,000Depreciation
      and amortization
                    
                    
                    302,368
                    
                    
                    
                    253,315Changes
      in operating assets and liabilities:Accounts
      receivable
                    
                    
                    181,775
                    
                    
                    
                    (103,299
                    )Inventory
                    
                    
                    66,829
                    
                    
                    
                    (74,624
                    )Prepaid
      expenses
                    
                    
                    11,290
                    
                    
                    
                    (17,410
                    )Accounts
      payable
                    
                    
                    (34,160
                    )
                    
                    
                    (33,204
                    )Accrued
      liabilities
                    
                    
                    172,716
                    
                    
                    
                    297,029Deferred
      revenue
                    
                    
                    (207,317
                    )
                    
                    
                    496,854Other
      long-tem liabilities
                    
                    
                    51,066
                    
                    
                    
                    -Net
      cash used in operating activities
                    
                    
                    (835,479
                    )
                    
                    
                    (1,005,731
                    )CASH
      FLOWS FROM INVESTING ACTIVITIES:Purchase
      of property and equipment, net
                    
                    
                    (61,422
                    )
                    
                    
                    (163,666
                    )Net
      cash used in investing activities
                    
                    
                    (61,422
                    )
                    
                    
                    (163,666
                    )CASH
      FLOWS FROM FINANCING ACTIVITIES:Decrease
      in restricted cash
                    
                    
                    50,000
                    
                    
                    
                    -Net
      proceeds from short-term advances
                    
                    
                    25,630
                    
                    
                    
                    -Net
      borrowings (payments) on line of credit
                    
                    
                    (17,503
                    )
                    
                    
                    (44,560
                    )Net
      proceeds from issuance of convertible promissory notes
                    
                    
                    -
                    
                    
                    
                    1,225,000Net
      proceeds from exercise of warrants
                    
                    
                    843,604
                    
                    
                    
                    -Payments
      on convertible promissory notes and other loans
                    
                    
                    (19,153
                    )
                    
                    
                    (95,898
                    )Payments
      on other notes payable and capital lease
                    
                    
                    -
                    
                    
                    
                    (2,415
                    )Net
      cash provided by financing activities
                    
                    
                    882,578
                    
                    
                    
                    1,082,127Net
      decrease in cash and cash equivalents
                    
                    
                    (14,323
                    )
                    
                    
                    (87,270
                    )Cash
      and cash equivalents at beginning of period
                    
                    
                    125,007
                    
                    
                    
                    534,871Cash
      and cash equivalents at end of period
                    
                    $
                    110,684
                    
                    
                    $
                    447,601










The
accompanying notes are an integral part of these consolidated financial
statements.




6




CISTERA
NETWORKS, INC. & SUBSIDIARY


CONSOLIDATED
STATEMENTS OF CASH FLOWS (continued)


(Unaudited)





Nine
      months ended December 312008
                      
                      
                      2007SUPPLEMENTAL
      DISCLOSURE OF CASH FLOW INFORMATION:Cash
      paid during the year for:Interest
                      
                      $
                      53,740
                      
                      
                      $
                      14,878Income
      taxes
                      
                      
                      -
                      
                      
                      
                      -SUPPLEMENTAL
      DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES:Conversion
      of convertible promissory notes and related accrued interest
      and
                        accrued
      liquidated damages to common stock
                      
                      $
                      3,287,116
                      
                      
                      $
                      -Conversion
      of accounts payable and other accrued liabilities to
      convertible
                        promissory
      notes
                      
                      
                      
                      
                      
                      
                      363,171Conversion
      of accrued liabilities to common stock
                      
                      
                      53,312
                      
                      
                      
                      -Transfer
      of inventory to equipment
                      
                      
                      46,989
                      
                      
                      
                      -Allocation
      of discount on convertible promissory notes to warrants
                      
                      
                      -
                      
                      
                      
                      488,054Discount
      related to beneficial conversion feature on convertible
      promissory
                        notes
                      
                      
                      -
                      
                      
                      
                      815,599OTHER
      NON-CASH TRANSACTIONS:Cumulative effect of change in accounting
      principle:Reclassification
      of Warrants from derivative financial instruments to equity
                        securities
      (as valued at inception)
                      
                      $
                      -
                      
                      
                      $
                      2,730,824Accrued
      liquidated damages at April 1, 2007
                      
                      
                      -
                      
                      
                      
                      289,518Reclassification
      of Warrants from derivative financial instruments to equity
                        securities
      (as valued at April 1, 2007)
                      
                      
                      -
                      
                      
                      
                      (2,265,227
                      )Cumulative
      effect of change in accounting principle
                      
                      $
                      -
                      
                      
                      $
                      755,115


































The
accompanying notes are an integral part of these consolidated financial
statements.


7
 CISTERA
NETWORKS, INC. & SUBSIDIARY
 Notes
to Consolidated Financial Statements
 (Unaudited)


NOTE
1 – BASIS OF PRESENTATION





The
accompanying unaudited consolidated financial statements of Cistera Networks,
Inc. (“Cistera” the “Company” or “we”) and its wholly-owned subsidiary have been
prepared pursuant to the rules and regulations of the Securities and Exchange
Commission (“SEC”). All significant intercompany transactions and balances have
been eliminated in consolidation. Certain information and footnote disclosures
normally included in financial statements prepared in accordance with accounting
principles generally accepted in the United States of America (“US GAAP”) have
been condensed or omitted pursuant to such rules and regulations. In the opinion
of management, the unaudited consolidated financial statements have been
prepared on the same basis as the annual audited consolidated financial
statements, and reflect all adjustments, consisting only of normal, recurring
adjustments necessary for a fair presentation in accordance with US GAAP. The
results of operations for interim periods presented are not necessarily
indicative of the operating results for the full year. These unaudited
consolidated financial statements should be read in conjunction with the
consolidated financial statements and notes thereto included in the Company’s
Annual Report on Form 10-KSB for the fiscal year ended March 31, 2008 (the “2008
10-KSB”).





Significant
Accounting Policies





The
Company prepares its financial statements in accordance with US GAAP. The
accounting policies most fundamental to understanding our financial statements
are those relating to recognition of revenue, our use of estimates and the
accounting for convertible debt and warrants. For a detailed discussion on the
application of these accounting policies, see Note 2 to our audited consolidated
financial statements contained in our 2008 10-KSB.





Recently
Issued Accounting Pronouncements




In
February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for
Financial Assets and Financial Liabilities—Including an Amendment of FASB
Statement No. 115"(“SFAS 159”).  SFAS 159 permits companies
to measure many financial instruments and certain other items at fair value at
specified election dates. Unrealized gains and losses on these items will be
reported in earnings at each subsequent reporting date. The fair value option
may be applied instrument by instrument (with a few exceptions), is irrevocable
and is applied only to entire instruments and not to portions of instruments.
SFAS 159 is effective for fiscal years beginning after November 15,
2007. We intend to adopt the standard beginning in the first quarter of fiscal
year 2010 and do not believe it will have a material impact.




In December 2007, the FASB issued SFAS No. 160,
“Non-Controlling Interests in Consolidated Financial Statements” (“SFAS 160”),
which requires all entities to report non-controlling (minority interests) in
subsidiaries with equity in the consolidated financial statements, but separate
from the parent stockholders' equity. We intend to adopt the standard beginning
in the first quarter of fiscal year 2010 and do not believe it will have a
material impact.




In
December 2007, the FASB issued SFAS No. 141 (revised 2007), "Business
Combinations" ("SFAS 141R"), which replaces FASB Statement No. 141.
SFAS 141R establishes principles and requirements for how an acquirer
recognizes and measures in its financial statements the identifiable assets
acquired, the liabilities assumed, any non-controlling interest in the acquiree
and the goodwill acquired. The Statement also establishes disclosure
requirements that will enable users to evaluate the nature and financial effects
of the business combination. We intend to adopt the standard beginning in the
first quarter of fiscal year 2010 and do not believe it will have a material
impact.




8
 CISTERA
NETWORKS, INC. & SUBSIDIARY
 Notes
to Consolidated Financial Statements
 (Unaudited)


Balance
Sheet Accounts





Accounts
receivable are comprised of the following:


December 31,
                        2008
                      
                      
                      March
      31,
                        2008Unfactored
      accounts receivable
                      
                      $
                      9,524
                      
                      
                      $
                      222,277Receivables
      assigned to factor
                      
                      
                      200,198
                      
                      
                      
                      183,945Advances
      from factor
                      
                      
                      (142,543
                      )
                      
                      
                      (157,972
                      )Reserve
      balance held by factor
                      
                      
                      13,569
                      
                      
                      
                      (64
                      )Amounts
      due from factor
                      
                      
                      71,224
                      
                      
                      
                      25,909Related
      party
                      
                      
                      1,500
                      
                      
                      
                      15,837Total
      accounts receivable
                      
                      $
                      82,248
                      
                      
                      $
                      264,023




Accrued
liabilities are comprised of the following:


December 31,
                          2008
                        
                        
                        March
      31,
                          2008Accrued
      interest
                        
                        $
                        194,976
                        
                        
                        $
                        88,375Reserve
      for litigation contingency
                        
                        
                        650,000
                        
                        
                        
                        650,000Accrued
      compensation and payroll taxes
                        
                        
                        192,299
                        
                        
                        
                        234,029Other
                        
                        
                        136,760
                        
                        
                        
                        103,956$
                        1,174,035
                        
                        
                        $
                        1,076,360





Other
long-term liabilities are comprised of the following:


December 31,
                        2008
                      
                      
                      March
      31,
                        2008Accrued
      interest
                      
                      $
                      -
                      
                      
                      $
                      269,270Other
                      
                      
                      67,266
                      
                      
                      
                      16,200$
                      67,266
                      
                      
                      $
                      285,470





Loss
per Share





Basic
earnings (loss) per share is based on the weighted average number of common
shares outstanding.





Diluted
earnings (loss) per share is computed using the weighted average number of
common shares outstanding plus the number of common shares that would be issued
assuming exercise or conversion of all potentially dilutive common stock
equivalents.  The Company had approximately 6.6 million and 10.4
million potentially dilutive common stock equivalents (in the form of stock
options and stock purchase warrants) outstanding as of December 31, 2008 and
2007, respectively. These potentially dilutive common stock equivalents have
been excluded from the diluted share calculations for the three months and nine
months ended December 31, 2008 and 2007, respectively, as they were antidilutive
as a result of the net losses incurred for those periods. Accordingly, basic
shares equal diluted shares for all periods presented.


9
 CISTERA
NETWORKS, INC. & SUBSIDIARY
 Notes
to Consolidated Financial Statements
 (Unaudited)


Significant
Customers and Concentration of Credit Risk





The
following table shows significant customers as a percentage of accounts
receivable at December 31 and March 31, 2008.  A customer is included
in the table if they comprise greater than 10% of accounts receivable as of
either period.





December 31,
                                  
                                  
                                  March 31,2008
                                  
                                  
                                  2008Customer
      A
                                  
                                  
                                  31.6%
                                  
                                  
                                  
                                  27.9%Customer
      B
                                  
                                  
                                  8.3%
                                  
                                  
                                  
                                  13.2%Customer
      C
                                  
                                  
                                  3.6%
                                  
                                  
                                  
                                  19.9%Customer
      D
                                  
                                  
                                  11.3%
                                  
                                  
                                  
                                  2.4%





The
following table shows significant customers as a percentage of revenue for the
three and nine months ended December 31, 2008 and 2007.  A customer is
included in the table if they comprise 10% for any of the periods in 2008 or
2007.





Three
      months ended
                              December 31,
                            
                            
                            Nine
      months ended
                              December 31,2008
                            
                            
                            2007
                            
                            
                            2008
                            
                            
                            2007Customer
      A
                            
                            
                            2.7%
                            
                            
                            
                            14.6%
                            
                            
                            
                            7.4%
                            
                            
                            
                            13.2%Customer
      C
                            
                            
                            11.2%
                            
                            
                            
                            0.2%
                            
                            
                            
                            4.1%
                            
                            
                            
                            0.1%Customer
      E
                            
                            
                            2.1%
                            
                            
                            
                            0.6%
                            
                            
                            
                            17.5%
                            
                            
                            
                            0.2%Customer
      F
                            
                            
                            15.4%
                            
                            
                            
                            13.8%
                            
                            
                            
                            5.3%
                            
                            
                            
                            4.0%Customer
      G
                            
                            
                            0.9%
                            
                            
                            
                            13.1%
                            
                            
                            
                            0.3%
                            
                            
                            
                            3.8%





Reclassifications





Certain
reclassifications have been made in the fiscal year 2008 financial statements to
conform to the fiscal year 2009 presentation.





NOTE
2 - FINANCIAL CONDITION





The
accompanying consolidated financial statements have been prepared in conformity
with US GAAP (except with regard to omission of certain disclosures within
interim financial statements, as permitted by the SEC), which contemplate our
continuation as a going concern and do not include any adjustments relating to
the recoverability and classification of recorded asset amounts or amounts and
classification of liabilities that might be necessary if we were unable to
continue as a going concern. However, the report of our independent registered
public accounting firm on our consolidated financial statements, as of and for
the year ended March 31, 2008, contains an explanatory paragraph expressing
substantial doubt as to our ability to continue as a going concern. The “going
concern” explanatory paragraph resulted from, among other things, the
substantial losses from operations we have incurred since inception, our
liquidity position and the net loss of $5.3 million for the year ended March 31,
2008, which included non-cash charges of $1.9 million related to amortization of
discounts associated with our sale and issuance of Senior Unsecured Convertible
Promissory Notes in the fiscal years 2007 and 2008 (the “PP2 Notes”) and
negative working capital (current liabilities in excess of current assets) of
$3.0 million as of March 31, 2008.  In addition, we had a net loss of
$4.1 million for the nine months ended December 31, 2008, which included
non-cash charges in the amount of $2.7 million related to the amortization of
discounts associated with the PP2 Notes and inducements related to the
conversion of PP2 Notes and exercise of warrants issued with the PP1 Notes (“PP1
Warrants”) and the exercise of warrants issued with the PP2 Notes (“PP2
Warrants”).  Also, as of December 31, 2008, we have negative working
capital (current liabilities in excess of current assets) of $3.3
million.


10
 CISTERA
NETWORKS, INC. & SUBSIDIARY
 Notes
to Consolidated Financial Statements
 (Unaudited)


Accordingly,
as of December 31, 2008, the recoverability of a major portion of the recorded
asset amounts is dependent on our continuing operations, which in turn is
dependent on our ability to maintain our current financing arrangements and our
ability to become profitable in our future operations through generating higher
revenues or lowering operating costs, or a combination of the two. These factors
raise substantial doubt about our ability to continue as a going concern. These
consolidated financial statements do not reflect adjustments that would be
necessary if we were unable to continue as a going concern.





The
Company maintains a factoring facility with Allied Capital Partners, L.P.
(“Allied”) for up to $1,500,000 of the Company’s customer accounts
receivable.  The facility allows for an advance rate up to 85.88% and
initial factoring charges are 1.75% of the total accounts receivable
balance.  Advances made by Allied are collateralized by the Company’s
accounts receivable, chattel paper, general intangibles, supporting obligations,
inventory and proceeds thereof.  The term of the current agreement is
for a period of two years with an automatic one year renewal
thereafter.  Advances under the factoring facility at December 31,
2008 were $142,543 and are netted against total accounts receivable on the
Consolidated Balance Sheet.





As of
December 30, 2008, we were in default on approximately $148,000 of principal and
accrued interest on certain PP2 Notes (the “December PP2 Notes”).  As
of that date, we began to accrue interest on the December PP2 Notes at a default
rate of 18% per annum, which is the maximum allowable rate as stipulated under
the PP2 Note purchase agreement.  We will need to renegotiate the
payment or conversion of the principal and interest due on all of the PP2 Notes,
of which approximately $1.1 million is due in April 2009, or raise additional
capital, or a combination of the two. If we need to raise additional capital it
could be in the form of equity or debt, or a combination of the two. The capital
markets are extremely challenging at this time and there can be no assurance
that we will be successful in raising additional funds and, if so, on favorable
terms or that the cost savings or required new capital will be
sufficient.  We are also actively exploring other strategic
alternatives.




NOTE
3 – DEBT





As of
December 31, 2008, the Company had $976,426 of gross principal, accrued interest
of $194,976 and accrued liquidated damages of $177,024 outstanding on its PP1
Notes and PP2 Notes.  The PP1 Notes and the PP2 Notes due in April
2009 (the “April PP2 Notes”) bear interest at an annual rate of 8%, compounded
quarterly.  The December PP2 Notes bear interest at an annual rate of
18%, compounded quarterly.





PP1 Notes and
Warrants





The
outstanding principal and accrued interest are convertible into shares of common
stock at a conversion rate equal to the lesser of (a) $1.30 per share, or (b) a
25% discount to the average closing bid price of the Company’s common stock for
the five days including and immediately preceding the interest compounding date,
provided that in no event shall the conversion price per share be less than
$1.00 per share.  The PP1 Notes may be converted, in whole or in part,
at the option of the PP1 Note holder on any interest compounding
date.  The PP1 Notes converted in December 2005 were converted at
$1.00 per share.





The PP1
Warrants have a term of five years and are exercisable at an exercise price of
$1.30 per share.  Subject to an effective registration statement
covering the resale of the shares of common stock issuable upon exercise of the
PP1 Warrants, the Company may, upon thirty days prior written notice, redeem the
PP1 Warrants for $0.10 per share, in whole or in part, if our common stock
closes with a bid price of at least $3.50 for any ten (10) out of fifteen (15)
consecutive trading days.





PP2 Notes and
Warrants





The
outstanding principal and accrued interest are convertible into shares of common
stock at a fixed rate of $0.75 per share.  The PP2 Notes may be
converted, in whole or in part, at the option of the PP2 Note holder on any
interest compounding date.


11
 CISTERA
NETWORKS, INC. & SUBSIDIARY
 Notes
to Consolidated Financial Statements
 (Unaudited)


The
Company may prepay the PP2 Notes in whole or in part, upon thirty days prior
written notice to note holders; provided that partial prepayments may be made
only in increments of $10,000 and, provided further, that the PP2 Note holders
may convert the amount of the proposed prepayment into shares of our common
stock at any time.





The PP2
Warrants have a term of five years and are exercisable at an exercise price of
$1.00 per share.  Subject to an effective registration statement
covering the resale of the shares of common stock issuable upon exercise of the
PP2 Warrants, the Company may, upon thirty days prior written notice, redeem the
PP2 Warrants for $0.10 per share, in whole or in part, if our common stock
closes with a bid price of at least $3.50 for any ten (10) out of fifteen (15)
consecutive trading days.





For the
three months ended December 31, 2008 and 2007, the Company recorded $108,918 and
$382,012 respectively, of amortization of debt discounts associated with the PP2
Notes.  For the nine months ended December 31, 2008 and 2007, the
Company recorded $1,338,833 and $1,134,739 respectively, of amortization of debt
discounts associated with the PP2 Notes.  For the nine months ended
December 31, 2008 the total amortization charge included $747,357 for the
write-off of unamortized debt discounts related to the conversion of $2,470,156
in principal of PP2 Notes under the Company’s Short Term Investment Incentive
Plan (the “STIIP”).





STIIP





Under the
STIIP, which commenced on June 9, 2008, the Company temporarily modified the
terms of its outstanding PP1 Notes, PP2 Notes, PP1 Warrants and PP2 Warrants.
During the period beginning June 9, 2008 through June 24, 2008 (the “Conversion
Period”), the conversion prices of the PP1 Notes and PP2 Notes, which were $1.00
and $0.75 per share, respectively, were reduced to $0.53 per
share.  In addition, the exercise prices for the PP1 Warrants and the
PP2 Warrants, which were $1.30 and $1.00 per share, respectively, were reduced
to $0.40 per share.  Under the STIIP, certain PP2 Note holders
converted $3,240,290, comprised of $2,470,156 in principal and $770,134 in
accrued interest and liquidated damages into approximately 6.2 million shares of
the Company’s common stock at the reduced conversion price.




Also under
the STIIP, certain PP1 and PP2 Warrant holders exercised approximately 2.3
million PP1 and PP2 Warrants at an exercise price of $0.40 per
share.  All PP1 and PP2 Warrant holders who exercised their warrants
also received three additional warrants (the “Bonus Warrants”) for every ten
warrants exercised.  The Bonus Warrants were exercisable during the
Conversion Period at an exercise price of $0.30 per share, and if not exercised
on or before such date, the exercise price for such Bonus Warrants was increased
to $0.60 per share.  A total of 507,675 Bonus Warrants were exercised at
$0.30 per share.  The bonus warrants were valued using the Black-Scholes
option pricing model (“Black-Scholes model”) and a charge and a corresponding
credit to additional paid-in capital were recorded for the June 30, 2008 and
September 30, 2008 quarters in the amounts of $36,125 and $131,631,
respectively.  The bonus warrants expire on April 6,
2012.  The total cash proceeds received from the exercises of the PP1,
PP2 and Bonus Warrants was approximately $844,000.




The
Company accounted for the reduction in the conversion prices of the PP2 Notes
under the STIIP in accordance with FASB Statement No. 84, “Induced Conversions
of Convertible Debt an amendment of APB Opinion No. 26” (“SFAS
84”).  Accordingly, the Company calculated and recorded an inducement
charge and a corresponding credit to additional paid-in capital in the June 30,
2008 quarter in the amount of $931,893 for the fair value of common stock issued
based on the reduced price in excess of the fair value of the common stock
issuable pursuant to the original conversion price.





The
Company accounted for the reduction in the exercise price of the PP1 and PP2
Warrants exercised under the STIIP in accordance with the guidance in SFAS
123(R), “Share-based payment” (“SFAS 123R”) and FASB Staff Position No. FSP FAS
123(R)-6, “Technical Corrections of FASB Statement No. 123(R)” for a
modification due to a short-term inducement.  Accordingly, the Company
recorded a charge and a corresponding credit to additional paid-in capital in
the June 30, 2008 quarter in the amount of $202,743 for the difference between
the fair value of the PP1 and PP2 Warrants immediately before and after the
modification multiplied by the number of PP1 and PP2 Warrants that were
exercised during the Conversion Period of the STIIP.  The fair value
of the PP1 and PP2 Warrants
were calculated using the Black-Scholes model. The total non-cash charge
recorded for the inducement on the PP2 Notes and the reduction in exercise price
on the PP1 and PP2 Warrants was $1,134,216.


12
 CISTERA
NETWORKS, INC. & SUBSIDIARY
 Notes
to Consolidated Financial Statements
 (Unaudited)





Line of
Credit





On May 18,
2007, the Company secured a line of credit with JPMorgan Chase Bank in the
amount of $50,000.  The line of credit carried an interest rate of
prime plus one-half point.  The line of credit was secured with a
deposit guaranty of $50,000.  On September 8, 2008, the Company repaid
the outstanding obligation from the balance of its deposit guaranty and
cancelled this line of credit facility.





The
Company’s total debt as of December 31, 2008, all of which is current, is as
follows:


PP1
      and PP2 Notes:Principal
                        
                        $
                        976,426Accrued
      interest
                        
                        
                        194,976Accrued
      estimated liquidated damages
                        
                        
                        177,0241,348,426Less:
      unamortized discount
                        
                        
                        (95,521
                        )1,252,905Other
      notes payable
                        
                        
                        25,630Total
                        
                        $
                        1,278,535





Registration Payment
Arrangements





Effective
April 1, 2007, the Company adopted FASB Staff Position No. EITF 00-19-2
“Accounting for Registration Payment Arrangements” (“FSP EITF 00-19-2”), which
was applicable to the accounting for the liquidated damages on the PP2
Notes.  Upon adoption, the Company recorded a cumulative effect of an
accounting change entry (i.e., a charge to the beginning balance of the
accumulated deficit) as of April 1, 2007 for the combination of:  1)
the reclassification of the Warrants from derivative liabilities to equity
securities (based on the criteria as outlined under EITF 00-19 “Accounting for
Derivative Financial Instruments Indexed to, and Potentially Settled in, a
Company’s Own Stock” (“EITF 00-19”)), and 2) a contingent liability for probable
future payment of liquidated damages (based on the Company’s best estimate as of
the date of adoption, which was through March 31, 2008).  The amount
of the contingent liability recorded was approximately $289,000.  The
difference between the Warrants as measured on the date of adoption of FSP EITF
00-19 and their original recorded value was approximately $466,000, and, as
stated above, was included in the charge to the beginning balance of the
accumulated deficit.  The total cumulative effect of this accounting
change was $755,000.





On April
5, 2007, the Company closed the balance of its PP2 offering and, in accordance
with FSP EITF 00-19-2, recorded a contingent liability and related charge to the
consolidated Statement of Operations for estimated liquidated damages related to
this funding through March 31, 2008.  The amount recorded was
$251,176.





As of
March 31, 2008, the Company estimated and accrued $671,342 related to liquidated
damages related to the PP2 Notes and concluded that this amount was the maximum
pay-out required.  Under the STIIP, certain PP2 Note holders,
comprising approximately 70% of the original principal of PP2 Notes, converted
their outstanding PP2 Notes at a reduced price of $0.53.  On June 30,
2008, the Company executed an agreement with the institutional investor in the
PP2 offering that had the contractual right to liquidated damages.  In
exchange for the waiver from the investor, the Company issued to the investor
58,777 shares of its common stock. The agreement terminated any assessment of
liquidated damages beyond June 24, 2008. For the three months ended June 30,
2008, the Company recorded a charge and credit to additional paid-in capital for
the fair value of these shares issued in the amount of $22,041.


13
 CISTERA
NETWORKS, INC. & SUBSIDIARY
 Notes
to Consolidated Financial Statements
 (Unaudited)


The table
below summarizes the cumulative effect entry recorded as of April 1, 2007 for
the adoption of FSP EITF 00-19-2:





Accumulated
      deficit, April 1, 2007
                  
                  $
                  (10,586,847
                  )Adjustments
      for the cumulative effect of the change in accounting
      principle:Contingent
      liability recorded for estimated liquidated damages
                  
                  
                  (289,518
                  )Reclassification
      of Warrants from derivative liabilities to equity
    securities
                  
                  
                  (465,597
                  )Total
      adjustments
                  
                  
                  (755,115
                  )Accumulated
      deficit, April 1, 2007, as adjusted
                  
                  $
                  (11,341,962
                  )








NOTE
4 – COMMITMENTS AND CONTINGENCIES





The
Company and certain of its current and former officers and directors are
defendants in litigation pending in Dallas, Texas, styled KINGDON R. HUGHES VS.
GREGORY T. ROYAL, CYNTHIA A. GARR, JAMES T. MILLER, JR., CHARLES STIDHAM, CNH
HOLDINGS COMPANY D/B/A CISTERA NETWORKS AND XBRIDGE SOFTWARE, INC.; Cause No.
DV05-0600-G; G-134th District Court, Dallas County, Texas.  The
plaintiff has alleged a number of complaints against the defendants, including
breach of fiduciary duty, misappropriation of corporate opportunities, fraud,
fraudulent inducement, breach of contract, tortuous interference with contract,
fraudulent transfer, and shareholder oppression arising in connection with the
license agreement between the Company and XBridge in May 2003 and the
acquisition of XBridge by the Company in May 2005.  The parties held a
mediation conference in April 2006 and have come to an understanding with
respect to the principal elements of a potential settlement. The Company is
currently in the process of negotiating definitive settlement agreements. In
accordance with SFAS No. 5, “Accounting for Contingencies” (“SFAS 5”), we
recorded a contingent liability in the amount of $650,000 as of March 31, 2008
related to the outstanding litigation.  As of December 31, 2008, the
Company believes that this amount represents the best estimate of a potential
settlement.




The
Company is a defendant in a breach-of-contract claim filed on behalf of Richard
McDowell, the Company’s former Chief Financial Officer, who was terminated from
the Company on July 14, 2008.  Mr. McDowell is demanding severance
under his employment agreement with the Company.  On August 22, 2008,
the Company through its legal counsel notified Mr. McDowell’s attorney that it
categorically denied Mr. McDowell's claim for severance under the employment
agreement.  On September 23, 2008, the Company received notice that Mr.
McDowell had filed claims against it with the American Arbitration Association
in accordance with the employment agreement.  On October 17, 2008, the
Company through its legal counsel filed an answer with the American Arbitration
Association that categorically denied Mr. McDowell's claims.  The Company
also asserted counterclaims against Mr. McDowell.  An arbitrator has been
assigned and the hearing is to occur during the period May 11 through May 13,
2009.  The Company plans to vigorously defend itself and pursue its
counterclaims in the arbitration.


14
 CISTERA
NETWORKS, INC. & SUBSIDIARY
 Notes
to Consolidated Financial Statements
 (Unaudited)


NOTE
5 - RELATED PARTY TRANSACTIONS





On April
5, 2007, the Company issued PP2 Notes to the Company’s President, CEO and
director, Derek Downs, and the Company’s Chief Technology Officer and director,
Greg Royal for accrued, but unpaid base salary due to each as of this
date.  On June 24, 2008, both individuals converted their PP2 notes
plus accrued interest as part of the STIIP.  Mr. Downs and Mr. Royal
converted $38,940 and $91,871, respectively into 73,471 and 173,341 shares of
our common stock at a conversion price of $0.53.  After this
conversion, the Company no longer had any indebtedness with either Mr. Downs or
Mr. Royal.





On
November 1, 2008, the Company issued to an employee 100,000 common stock
purchase warrants that were immediately exercisable at $0.40 per share and have
a five-year life.  The Company calculated the fair value of the
warrants using the Black-Scholes model and recorded a charge in the amount
$22,728 for the December 2008 quarter.





On
December 4, 2008, an employee advanced the Company $25,000.  In
consideration for this advance, the Company issued to the employee 25,000 common
stock purchase warrants that were immediately exercisable at $0.40 per share and
have a five-year life.  The Company calculated the fair value of the
warrants using the Black-Scholes model and recorded a charge in the amount
$4,100 for the December 2008 quarter.  As of December 31, 2008, the
entire obligation remained outstanding and began to accrue interest at 8% per
annum.  The obligation is due upon demand.











15


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





FORWARD-LOOKING
STATEMENTS





This
report contains “forward-looking statements” within the meaning of the Private
Securities Litigation Reform Act of 1995. In many but not all cases you can
identify forward-looking statements by words such as “anticipate,”
“believe,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “potential,”
“should,” “will” and “would” or the negative of these terms or other similar
expressions.  These forward-looking statements include statements regarding
our expectations, beliefs, or intentions about the future, and are based on
information available to us at this time. We assume no obligation to update any
of these statements and specifically decline any obligation to update or correct
any forward-looking statements to reflect events or circumstances after the date
of such statements or to reflect the occurrence of anticipated or unanticipated
events. Actual events and results could differ materially from our expectations
as a result of many factors, including those identified in this report. We urge
you to review and consider those factors, and those identified from time to time
in our reports and filings with the SEC, for information about risks and
uncertainties that may affect our future results. All forward-looking statements
we make after the date of this filing are also qualified by this cautionary
statement and identified risks. Additional risk factors are discussed in our
Annual Report on Form 10-KSB for the fiscal year ended March 31, 2008 and our
other reports filed with the SEC, to which reference should be
made.





EXECUTIVE SUMMARY AND RECENT
BUSINESS DEVELOPMENTS





For the
third quarter ending December 31, 2008, we continued executing against our
business plan, and achieved a 73% increase in revenues as compared to the same
quarter in the prior year.  We experienced a drop in revenue on a
sequential quarter basis as a result of the deteriorating global economic
situation. High margin recurring revenue from support and maintenance
continues to become a more significant piece of our revenues as our installed
base grows. Despite the economic slowdown, our pipeline of opportunities is
increasing in both number of opportunities and project size.





Our
business model relies upon the leverage of a network of strong reseller partners
to sell our products.  During the quarter, we continued to invest in
building out our internal technical, sales and business development
organizations to properly support our channel reseller program - CollaborNETTM,
which was launched in August 2008.  This program allows us to
effectively apply our resources to focus on the partners that are significant
generators of revenue. In conjunction with CollaborNET, we have conducted joint
business planning sessions, executed joint marketing campaigns and continued to
certify partner installation engineers.





Even in a
period of economic constraints, we recognize the importance of continuing and
extending our R&D efforts to ensure that our products offer features and
functionality specific to industry requirements and that add measurable value
for our customers.  We believe that the enhanced safety benefits,
productivity gains and increased efficiencies delivered by our products will
help in attracting customers pressured to accomplish more with fewer people and
shrinking budgets.





We
continued to make good penetration into the public sector markets where our
solutions are increasingly well received as the answer to critical communication
challenges.  This quarter, we have extended our efforts to enter the
Federal market. We are seeing continued support from the Cisco Industry
Solutions Partner Network (ISPN) program and Cisco’s State and Local
Government teams, which enhance our visibility and credibility with partners and
customers alike.





In light
of the significant downturn in the U.S. economy, we are carefully
monitoring our sales pipeline and have refocused our solutions selling
efforts onto our top reseller relationships.  Further, beginning
January 1, 2009, we instituted additional operating expense reductions,
including salary reductions for the management team, employee terminations and
marketing program elimination. We expect that market segments, such as
government, and education will be more resilient to the current economic
conditions, primarily due to continued demand for event alerting and
notification solutions for public safety and campus safety requirements. With
the demographics of an aging population, healthcare is also an industry that is
continuing to grow.  Because there are fewer employees to operate
facilities, the efficiencies and increased productivity our products provide
can measurably enhance business operations.


16


We remain
focused on driving the Company to profitability, and believe our emphasis on
leveraging our reseller partner relationships will lead to the continued
pipeline growth, completed installations and increased average deal size that
will be necessary to achieve that goal.  Our program of certifying
partner installation engineers is a key piece of this effort, as it will allow
us to significantly extend our reach while providing partners with enhanced
customer interaction.  We believe that this focus will continue the
trending of our product mix toward the higher margin convergence solutions and
maintenance and support product categories, with proportionally less
contribution generated by lower margin professional services.





RESULTS
OF OPERATIONS





Selected
Consolidated Statements of Operations Data





The
following tables present consolidated statements of operations data for the
three and nine months ended December 31, 2008 and 2007 based on the percentage
of revenue for each line item, as well as the dollar and percentage change of
each of the items.





Results
of Operations for the Three Months Ended December 31, 2008


Compared
to the Three Months Ended December 31, 2007


For
      the three months ended December 31,2008
                          
                          
                          %
      of
                            revenue
                          
                          
                          2007
                          
                          
                          %
      of
                            revenueRevenues:Convergence
      solutions
                          
                          $
                          712,340
                          
                          
                          
                          67%
                          
                          
                          $
                          377,112
                          
                          
                          
                          61%Professional
      services
                          
                          
                          98,514
                          
                          
                          
                          9%
                          
                          
                          
                          87,972
                          
                          
                          
                          14%Support
      and maintenance
                          
                          
                          261,633
                          
                          
                          
                          24%
                          
                          
                          
                          153,677
                          
                          
                          
                          25%Total
      revenues
                          
                          
                          1,072,487
                          
                          
                          
                          100%
                          
                          
                          
                          618,761
                          
                          
                          
                          100%Cost
      of revenues:Convergence
      solutions
                          
                          
                          254,675
                          
                          
                          
                          24%
                          
                          
                          
                          98,501
                          
                          
                          
                          16%Professional
      services
                          
                          
                          55,680
                          
                          
                          
                          5%
                          
                          
                          
                          43,314
                          
                          
                          
                          7%Support
      and maintenance
                          
                          
                          24,250
                          
                          
                          
                          2%
                          
                          
                          
                          23,475
                          
                          
                          
                          4%Total
      cost of revenues
                          
                          
                          334,605
                          
                          
                          
                          31%
                          
                          
                          
                          165,290
                          
                          
                          
                          27%Gross
      Profit
                          
                          
                          737,882
                          
                          
                          
                          69%
                          
                          
                          
                          453,471
                          
                          
                          
                          73%Operating
      expenses:Sales
      and marketing
                          
                          
                          319,758
                          
                          
                          
                          30%
                          
                          
                          
                          509,627
                          
                          
                          
                          82%Software
      development
                          
                          
                          188,956
                          
                          
                          
                          18%
                          
                          
                          
                          193,432
                          
                          
                          
                          31%Engineering
      and support
                          
                          
                          172,923
                          
                          
                          
                          16%
                          
                          
                          
                          200,409
                          
                          
                          
                          33%General
      and administrative
                          
                          
                          338,210
                          
                          
                          
                          31%
                          
                          
                          
                          404,999
                          
                          
                          
                          66%Depreciation
      and amortization
                          
                          
                          103,538
                          
                          
                          
                          10%
                          
                          
                          
                          88,442
                          
                          
                          
                          14%Total
      operating expenses
                          
                          
                          1,123,385
                          
                          
                          
                          105%
                          
                          
                          
                          1,396,909
                          
                          
                          
                          226%Loss
      from operations
                          
                          
                          (385,503
                          )
                          
                          
                          (36)%
                          
                          
                          
                          (943,438
                          )
                          
                          
                          (153)%Other
      income (expense)Interest
      income
                          
                          
                          158
                          
                          
                          
                          -%
                          
                          
                          
                          3,760
                          
                          
                          
                          1%Interest
      expense
                          
                          
                          (43,124
                          )
                          
                          
                          (4)%
                          
                          
                          
                          (82,131
                          )
                          
                          
                          (13)%Amortization
      of discount on convertible notes
                          
                          
                          (108,918
                          )
                          
                          
                          (10)%
                          
                          
                          
                          (382,012
                          )
                          
                          
                          (62)%Total
      other income (expense)
                          
                          
                          (151,884
                          )
                          
                          
                          (14)%
                          
                          
                          
                          (460,383
                          )
                          
                          
                          (74)%Net
      loss
                          
                          $
                          (537,387
                          )
                          
                          
                          (50)%
                          
                          
                          $
                          (1,403,821
                          )
                          
                          
                          (227)%




17


Revenue





Revenue
for the quarter ended December 31, 2008 increased $453,726 or approximately 73%
from the comparable prior year quarter primarily due to increased revenue from
convergence solutions as a result of larger average project size and higher
support and maintenance revenue generated by our growing installed
based.  Revenue from professional services increased nominally from
the prior year quarter primarily due to the timing of completion of certain
project service engagements and as a result of a change of certifying reseller
partners to handle installations in lieu of performing them
ourselves.  This strategy is part of the CollaborNETTM initiative and
allows our internal technical and support personnel to support our partner
resellers and provide higher-end and better margin services. As we transition to
larger projects, we expect more installations to be completed by certified
partners.





Gross Profit and Gross
Margin





Gross
profit for the quarter ended December 31, 2008 increased $284,411 or
approximately 63% from the comparable prior year quarter primarily due to
increased revenue offset by overall lower gross margin.  Gross margin
decreased in the December 2008 quarter as compared to the December 2007 quarter
to 69% from 73%.  This decrease was primarily due to product mix on
convergence solutions offset by higher margins on support and maintenance as a
result of the higher installed base.





Operating
Expenses





Operating
expenses, excluding depreciation and amortization decreased from $1,308,467 in
the December 2007 quarter to $1,019,847 in the December 2008 quarter, a decrease
of $288,620 or approximately 22%.  The decreasewas primarily attributable
to: 1) a decrease in sales commission expense in the December 2008 quarter as a
result of our adoption of a formal sales commissions policy in the December 2007
quarter, which resulted in the recording of a cumulative adjustment in the
December 2007 quarter for sales commissions due for the first nine months of
fiscal year 2008; 2) a decrease in sales headcount; 3) a decrease in sales and
marketing tradeshow expenses; and 4) a decrease in professional
fees.  Offsetting the overall decrease in operating expenses in the
December 2008 quarter were an increase in rent and facilities related expenses
and an increase in our engineering headcount.





Interest
Expense





Interest
expense for the December 2008 quarter decreased $39,007 from the December 2007
quarter primarily due to the decrease in accrued interest on the PP2 Notes due
to the decrease in the PP2 Notes as a result of the conversions under our “Short
Term Investment Incentive Plan” (the “STIIP”).  Offsetting the overall
interest expense decrease was an increase in interest on our accounts receivable
factoring facility as a result of higher factorings in the December 2008 quarter
as compared to the December 2007 quarter.





Amortization of Debt
Discount





The
amortization of debt discount on our PP2 Notes in the December 2008 quarter
decreased $273,094 from the December 2007 quarter primarily as a result of the
significant amount of PP2 Notes that were converted in June and July of 2008 as
part of the STIIP.  As required under GAAP, all unamortized debt
discount outstanding at the date of the conversion was expensed.  See
further discussion of the STIIP under “Liquidity” under this Item.





18


Results
of Operations for the Nine Months Ended December 31, 2008


Compared
to the Nine Months Ended December 31, 2007


For
      the nine months ended December 31,2008
                            
                            
                            %
      of
                              revenue
                            
                            
                            2007
                            
                            
                            %
      of
                              revenueRevenues:Convergence
      solutions
                            
                            $
                            2,247,809
                            
                            
                            
                            71%
                            
                            
                            $
                            1,496,256
                            
                            
                            
                            68%Professional
      services
                            
                            
                            204,347
                            
                            
                            
                            7%
                            
                            
                            
                            282,565
                            
                            
                            
                            13%Support
      and maintenance
                            
                            
                            709,394
                            
                            
                            
                            22%
                            
                            
                            
                            413,509
                            
                            
                            
                            19%Total
      revenues
                            
                            
                            3,161,550
                            
                            
                            
                            100%
                            
                            
                            
                            2,192,330
                            
                            
                            
                            100%Cost
      of revenues:Convergence
      solutions
                            
                            
                            664,417
                            
                            
                            
                            21%
                            
                            
                            
                            430,428
                            
                            
                            
                            19%Professional
      services
                            
                            
                            148,680
                            
                            
                            
                            5%
                            
                            
                            
                            126,490
                            
                            
                            
                            6%Support
      and maintenance
                            
                            
                            71,684
                            
                            
                            
                            2%
                            
                            
                            
                            64,875
                            
                            
                            
                            3%Total
      cost of revenues
                            
                            
                            884,781
                            
                            
                            
                            28%
                            
                            
                            
                            621,793
                            
                            
                            
                            28%Gross
      Profit
                            
                            
                            2,276,769
                            
                            
                            
                            72%
                            
                            
                            
                            1,570,537
                            
                            
                            
                            72%Operating
      expenses:Sales
      and marketing
                            
                            
                            900,230
                            
                            
                            
                            28%
                            
                            
                            
                            1,023,925
                            
                            
                            
                            47%Software
      development
                            
                            
                            612,289
                            
                            
                            
                            19%
                            
                            
                            
                            543,950
                            
                            
                            
                            25%Engineering
      and support
                            
                            
                            579,323
                            
                            
                            
                            18%
                            
                            
                            
                            426,126
                            
                            
                            
                            19%General
      and administrative
                            
                            
                            1,098,827
                            
                            
                            
                            35%
                            
                            
                            
                            949,004
                            
                            
                            
                            43%Depreciation
      and amortization
                            
                            
                            302,368
                            
                            
                            
                            10%
                            
                            
                            
                            253,315
                            
                            
                            
                            12%Total
      operating expenses
                            
                            
                            3,493,037
                            
                            
                            
                            110%
                            
                            
                            
                            3,196,320
                            
                            
                            
                            146%Loss
      from operations
                            
                            
                            (1,216,268
                            )
                            
                            
                            (38)%
                            
                            
                            
                            (1,625,783
                            )
                            
                            
                            (74)%Other
      income (expense)Interest
      income
                            
                            
                            326
                            
                            
                            
                            -%
                            
                            
                            
                            21,883
                            
                            
                            
                            1%Interest
      expense
                            
                            
                            (190,933
                            )
                            
                            
                            (6)%
                            
                            
                            
                            (230,491
                            )
                            
                            
                            (10)%Amortization
      of discount on convertible notes
                            
                            
                            (1,338,833
                            )
                            
                            
                            (42)%
                            
                            
                            
                            (1,134,739
                            )
                            
                            
                            (52)%Charge
      for inducements related to stock
                              issued
      to convertible note holders
                            
                            
                            (1,324,444
                            )
                            
                            
                            (42)%
                            
                            
                            
                            (135,825
                            )
                            
                            
                            (6)%Credit
      (charge) for estimated liquidated
                              damages
                            
                            
                            11,299
                            
                            
                            
                            -%
                            
                            
                            
                            (251,176
                            )
                            
                            
                            (12)%Total
      other income (expense)
                            
                            
                            (2,842,585
                            )
                            
                            
                            (90)%
                            
                            
                            
                            (1,730,348
                            )
                            
                            
                            (79)%Net
      loss
                            
                            $
                            (4,058,853
                            )
                            
                            
                            (128)%
                            
                            
                            $
                            (3,356,131
                            )
                            
                            
                            (153)%




19


Revenue





Revenue
for the nine months ended December 31, 2008 increased $969,220 or approximately
44% from the nine months ended December 31, 2007 primarily due to increased
revenue from convergence solutions as a result of increased average project size
and increased support and maintenance revenue from our increased installed
base.  Revenue from professional services decreased from the prior
year period primarily due to the timing of completion of certain project service
engagements and as a result of a change of certifying reseller partners to
handle installations in lieu of performing them ourselves.  This
strategy is part of the CollaborNETTM initiative and allows our internal
technical and support personnel to support our partner resellers and provide
higher-end and better margin services. As we transition to larger projects, we
expect more installations to be completed by certified partners.




Gross Profit and Gross
Margin





Gross
profit for the nine months ended December 31, 2008, increased $706,232 or
approximately 45% from the comparable prior year nine-month period primarily due
to increased revenue.  Gross margin remained flat at 72% for the nine
months ended December 31, 2008 as compared to the prior year nine-month period
primarily as a result of higher margins on support and maintenance revenue
offset by lower margins on professional services revenue.




Operating
Expenses





Operating
expenses, excluding depreciation and amortization increased from $2,943,005 in
the nine months ended December 31, 2007 to $3,190,669 in the December 2008
nine-month period, an increase of $247,664 or 8%.  The increase was
primarily attributable to: 1) increased salaries that were applied over the
course of fiscal year 2008 for a significant number of employees, who had been
receiving much below the “average market” salaries for similar positions; 2)
increased headcount in all departments; 3) higher payroll taxes as a result of
the higher salaries and increased personnel; and, 4) increased rent and
facilities related expenses due to our new corporate office location. Offsetting
these increases were decreases in professional fees and sales
commissions.  The decrease in sales commissions was a result of our
adoption of a formal sales commissions policy in the December 2007 quarter,
which resulted in the recording of a cumulative adjustment in the December 2007
quarter for sales commissions due for the first nine months of fiscal year
2008.




Interest
Expense





Interest
expense for the nine months ended December 31, 2008 decreased $39,558 as
compared to the nine months ended December 31, 2007 due primarily to lower
interest expense on our PP2 Notes as a result of the conversions of certain of
these Notes in June and July under our STIIP.  Offsetting this
decrease was an increase in interest on our accounts receivable facility as a
result of higher factorings during the December 2008 nine-month period as
compared to the December 2007 nine-month period.




Amortization of Debt
Discount





The
amortization of debt discount on our PP2 Notes in the nine months ended December
31, 2008 increased approximately $204,094 from the December 2007 nine-month
period primarily as a result of the significant amount of PP2 Notes that were
converted under our STIIP.  As required under US GAAP, all unamortized
debt discount outstanding at the date of the conversion was
expensed.  See further discussion of the STIIP under “Liquidity and
Capital Resources.”




Charge for Inducements
Related to Stock Issued to Convertible Note Holders





As part of
the STIIP, we lowered the conversion price of our PP2 Notes and the exercise
price of both our PP1 and PP2 Warrants.  As required under US GAAP, we
recorded non-cash charges for the June 2008 and September 2008 quarters in the
amounts of $1,192,813 and $131,631, respectively, related to these
inducements.  See further discussion of the STIIP under “Liquidity and
Capital Resources.”





20


During the
September 30, 2007 quarter, we elected to compensate PP1 investors who had opted
to convert their PP1 Notes into shares of common stock, which remained
unregistered with the SEC as of the date the PP1 Notes became due and payable on
December 13, 2006.  The amount offered to, and accepted by, the
shareholders was $135,825, payable in the form of additional shares of common
stock, and a non-cash charge was recorded in the September 2007 quarter and is
included in our operating results for the nine months ended December 31,
2007.




Liquidated
Damages





The
decrease in the charge for liquidated damages from the nine months ended
December 31, 2007 was primarily the result of the settlement of future
liquidated damages as of June 24, 2008.  As of June 30, 2008, we
recorded an adjustment to the amount of accrued liquidated damages for PP2 Note
holders who did not convert their notes in the STIIP.  As part of an
agreement dated June 30, 2008 with the investor in the PP2 offering that had the
contractual right to liquidated damages, we issued to the investor 58,777 shares
of our common stock in exchange for a waiver on future liquidated damages after
June 24, 2008. The agreement terminated any assessment of liquidated damages
beyond June 24, 2008.




Liquidity
and Capital Resources





The
unaudited consolidated financial statements contained in this report have been
prepared in conformity with US GAAP (except with regard to omission of certain
disclosures within interim financial statements, as permitted by the SEC), which
contemplate our continuation as a going concern and do not include any
adjustments relating to the recoverability and classification of recorded asset
amounts or amounts and classification of liabilities that might be necessary if
we were unable to continue as a going concern. However, the report of our
independent registered public accounting firm on our consolidated financial
statements, as of and for the year ended March 31, 2008, contains an explanatory
paragraph expressing substantial doubt as to our ability to continue as a going
concern. The “going concern” explanatory paragraph resulted from, among other
things, the substantial losses from operations we have incurred since inception,
our liquidity position and net loss of $5.3 million for the year ended March 31,
2008, which included non-cash charges of $1.9 million related to amortization of
discounts associated with our PP2 Notes and negative working capital (current
liabilities in excess of current assets) of $3.0 million as of March 31,
2008.  In addition, we had a net loss of $4.1 million for the nine
months ended December 31, 2008, which included non-cash charges of $2.7 million
related to amortization of discounts associated with the PP2 Notes and
inducements related to the conversion of PP2 Notes and the exercise of the PP1
Warrants and the PP2 Warrants.  Also, as of December 31, 2008, we have
negative working capital (current liabilities in excess of current assets) of
$3.3 million.





Accordingly,
as of December 31, 2008, the recoverability of a major portion of the recorded
asset amounts is dependent on our continuing operations, which in turn is
dependent on our ability to maintain our current financing arrangements and our
ability to become profitable in our future operations through generating higher
revenues or lowering operating costs, or a combination of the two. These factors
raise substantial doubt about our ability to continue as a going concern. These
consolidated financial statements do not reflect adjustments that would be
necessary if we were unable to continue as a going concern.





Our
primary source of working capital liquidity is a factoring facility we have with
Allied Capital Partners, L.P. (“Allied”), which allows for cash advances of up
to $1,500,000 on our customer accounts receivable, subject to the approval of
Allied of the customer and the type of product or service that is
invoiced.  The facility allows for an advance rate up to 85.88% and
initial factoring charges are 1.75% of the total accounts receivable
balance.  Advances made by Allied are collateralized by our accounts
receivable, chattel paper, general intangibles, supporting obligations,
inventory and proceeds thereof.  The term of the current agreement is
for a period of two years with an automatic one year renewal
thereafter.  Advances under the factoring facility at December 31,
2008 were $142,543 and are netted against total accounts receivable on our
Consolidated Balance Sheet.





21


As of
December 30, 2008, we were in default on approximately $148,000 of principal and
accrued interest on certain PP2 Notes (the “December PP2 Notes”).  As
of that date, we began to accrue interest on the December PP2 Notes at a default
rate of 18% per annum, which is the maximum allowable rate as stipulated under
the PP2 Note purchase agreement.  We will need to renegotiate the
payment or conversion of the principal and interest due on all of the PP2 Notes,
of which approximately $1.1 million is due in April 2009, or raise additional
capital, or a combination of the two. If we need to raise additional capital it
could be in the form of equity or debt, or a combination of the two. The capital
markets are extremely challenging at this time and there can be no assurance
that we will be successful in raising additional funds and, if so, on favorable
terms or that the cost savings or required new capital will be
sufficient.  We are also actively exploring other strategic
alternatives.





Cash and Cash
Flows





Our cash
and cash equivalents at December 31, 2008 were $110,684. For the nine months
ended December 31, 2008, net cash used in operations was
$835,479.  The primary use of cash was the loss from operations
incurred for the period of $1,216,268 adjusted for non-cash charges of $302,368
for depreciation and amortization.  Net cash used in investing
activities of $61,422 related to purchases of computer and lab equipment and
office furniture.  Net cash from financing activities of $882,578 was
primarily the result of the net proceeds raised from the exercise of certain PP1
and PP2 Warrants as part of the STIIP.





Contractual
Obligations





Our
current material contractual obligations are our current and former corporate
office leases and the principal, accrued interest and accrued liquidated damages
under our PP1 and PP2 Notes.  During the September 2008 quarter, the
sub-lessee on our former corporate office lease ceased its business and has
defaulted on its lease obligation to us.  In December 2008, we
executed a new sub-lease with a new tenant on this office facility at
approximately $4,100 per month for the remaining lease term, which is through
November 2009.  We have pursued formal legal action against the former
sub-lessee and are seeking payment on the unpaid rent for the period from
October 1 through December 14, 2008 as well as the difference between the rent
due on the former sub-lease agreement versus the current sub-lease agreement,
which in the aggregate is approximately $19,000.





The
following notes payable, accrued interest and related accrued estimated
liquidated damages are due on or before April 5, 2009.


PP1
      and PP2 Notes:Principal
                      
                      $
                      954,436Accrued
      interest
                      
                      
                      194,976Accrued
      estimated liquidated damages
                      
                      
                      177,0241,326,436Less:
      unamortized discount
                      
                      
                      (95,521
                      )1,230,915Other
      notes payable
                      
                      
                      25,630Total
                      
                      $
                      1,256,545





Critical Accounting
Policies





We prepare
our financial statements in accordance with US GAAP. The accounting policies
most fundamental to understanding our financial statements are those relating to
recognition of revenue, our use of estimates and the accounting for convertible
debt and warrants. For a detailed discussion on the application of these
accounting policies, see Note 2 to our audited consolidated financial statements
contained in our 2008 10-KSB.





Recently Issued Accounting
Pronouncements





We discuss
the potential impact of recent accounting pronouncements in Note 1 to the
unaudited consolidated financial statements contained in this
report.


22


Item
3. Quantitative and Qualitative Disclosures About Market Risk





As a
smaller reporting company, we are not required to provide this
information.





Item
4(T). Controls and Procedures





Evaluation of Disclosure
Controls and Procedures




Disclosure
controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under
the Exchange Act) are designed to ensure that information required to be
disclosed in reports filed or submitted under the Exchange Act is recorded,
processed, summarized, and reported within the time periods specified in SEC
rules and forms and that such information is accumulated and communicated to
management, including our Chief Executive Officer, who is also currently our
interim Chief Financial Officer (the “Certifying Officer”), to allow timely
decisions regarding required disclosures.





As of
December 31, 2008, we carried out an analysis, under the supervision and with
the participation of our management, including our Certifying Officer, of the
effectiveness of the design and operation of our disclosure controls and
procedures. During the September 2008 quarter, the Certifying Officer determined
that our consolidated financial statements for the fiscal years ended March 31,
2007 and 2006 and the quarterly periods June 30, 2007 and 2006, September 30,
2007 and 2006 and December 31, 2007 and 2006 should not be relied upon and that
the Company would restate its consolidated financial statements for those
respective years and periods.  We completed these restatements during
the period from September to October 2008.  As of December 31, 2008,
our Certifying Officer concluded that our disclosure controls and procedures and
internal controls over financial reporting continued to be not effective and
identified remediation measures to be implemented.





We
estimate that the Certifying Officer, along with the Company’s other management
personnel, will need to complete remediation measures that may include engaging
an independent consulting firm to further evaluate, remediate, implement,
document and test the internal controls in these key areas:





1.
            Financial
      Reporting, including technical accounting surrounding complex accounting
      transactions


2.
            Order
      Entry Accounting & Reporting


3.
            Debt/Equity
      Accounting & Compliance


4.
            Cash
      & Other Working Capital
Management


5.
            Compensation
      Accounting & Administration


6.
            Other
      Assets & Liability Account
Management





We will
also monitor our disclosure controls and procedures on a continuing basis to
ensure that information required to be disclosed in the reports we file or
submit under the Exchange Act is accumulated and communicated to our management,
including its principal executive and principal financial officers, as
appropriate, to allow timely decisions regarding required disclosure. In the
future as such controls change in relation to developments in the our business
and financial reporting requirements, our evaluation and monitoring measures
will also address any additional corrective actions that may be
required.





Inherent Limitations of
Internal Controls





Our
management does not expect that our disclosure control procedures or our
internal controls over financial reporting will prevent all errors and fraud. A
control system, no matter how well conceived and operated, can provide only
reasonable, not absolute, assurance that the objectives of the control system
are met. Because of the inherent limitations in all control systems, no
evaluation of controls can provide absolute assurance that all control issues
and instances of fraud, if any, have been detected.





23


PART
II - OTHER INFORMATION





Item
1.  Legal Proceedings





The
Company and certain of its current and former officers and directors are
defendants in litigation pending in Dallas, Texas, styled KINGDON R. HUGHES VS.
GREGORY T. ROYAL, CYNTHIA A. GARR, JAMES T. MILLER, JR., CHARLES STIDHAM, CNH
HOLDINGS COMPANY D/B/A CISTERA NETWORKS AND XBRIDGE SOFTWARE, INC.; Cause No.
DV05-0600-G; G-134th District Court, Dallas County, Texas.  The
plaintiff has alleged a number of complaints against the defendants, including
breach of fiduciary duty, misappropriation of corporate opportunities, fraud,
fraudulent inducement, breach of contract, tortuous interference with contract,
fraudulent transfer, and shareholder oppression arising in connection with the
license agreement between the Company and XBridge in May 2003 and the
acquisition of XBridge by the Company in May 2005.  The parties held a
mediation conference in April 2006 and have come to an understanding with
respect to the principal elements of a potential settlement. The Company is
currently in the process of negotiating definitive settlement agreements. In
accordance with SFAS No. 5, “Accounting for Contingencies” (“SFAS 5”), we
recorded a contingent liability in the amount of $650,000 as of March 31, 2008
related to the outstanding litigation.  As of December 31, 2008, the
Company believes that this amount represents the best estimate of a potential
settlement.





The Company is a defendant in a breach-of-contract claim filed on
behalf of Richard McDowell, the Company’s former Chief Financial Officer, who
was terminated from the Company on July 14, 2008.  Mr. McDowell is
demanding severance under his employment agreement with the
Company.  On August 22, 2008, the Company through its legal counsel
notified Mr. McDowell’s attorney that it categorically denied Mr. McDowell's
claim for severance under the employment agreement.  On September 23, 2008,
the Company received notice that Mr. McDowell had filed claims against it with
the American Arbitration Association in accordance with the employment
agreement.  On October 17, 2008, the Company through its legal counsel
filed an answer with the American Arbitration Association that categorically
denied Mr. McDowell's claims.  The Company also asserted counterclaims
against Mr. McDowell.  An arbitrator has been assigned and the hearing is
to occur during the period May 11 through May 13, 2009.  The Company
plans to vigorously defend itself and pursue its counterclaims in the
arbitration.





Item
1A.  Risk Factors




The risk factors discussed
below are in addition to those set forth in our Form 10-KSB fot the fiscal year
ended March 31, 2008.




We may
need to raise additional capital to fund our operations.





Our
ability to continue as a going concern is in doubt and we
may not be successful in generating revenue and gross profit at levels
sufficient to cover our operating costs and cash investment
requirements.  Our current and primary source of cash availability is
a $1.5 million credit facility with an accounts receivable “factoring”
institution, Allied Capital.  Funds available to us under the credit
line with Allied Capital are limited by the amount of eligible accounts
receivable we hold at any given time. Additionally, fluctuations in the timing
of customer orders adversely affect our ability to draw on the line when
required. Allied Capital may declare the loan in default if we do not meet
certain financial covenants, and the inability to continue factoring accounts
receivable would result in a significant loss of working capital
liquidity.





Additionally,
we purchase over half of our products from one supplier—Equus Computer Systems.
(“Equus”).  Equus provides us with open trade credit on 30 day terms
based on a pre-established credit limit and, historically, has provided
additional credit to support larger purchase order demands on a “one-off
basis.”  We purchase most of our other products from our other
suppliers on open trade credit terms with set dollar limits.  If Equus
or our other significant suppliers were to cease to sell to us on trade credit
terms, or were to substantially lower the credit limits they have set, we would
need to accelerate our payments to those vendors, creating additional demands on
our cash resources, or we would need to find other sources for those
goods.


24


We
will need to renegotiate or extend the currently outstanding PP2 Notes and
related interest.





As of
December 30, 2008, we were in default on approximately $148,000 of principal and
accrued interest on certain PP2 Notes.  Currently, we are accruing
interest on these PP2 Notes at a default rate of 18% per annum, which is the
maximum allowable rate as stipulated under the PP2 Note purchase
agreement.  Further, the remaining $1.1 million of principal and
interest of PP2 Notes are due in April 2009.  If we need to raise
additional capital it could be in the form of equity or debt, or a combination
of the two. There can be no assurance that we will be successful in raising
additional funds and, if so, on favorable terms or that the cost savings or
required new capital will be sufficient.





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





On
November 1, 2008, the Company issued to an employee 100,000 common stock
purchase warrants that were immediately exercisable at $0.40 per share and have
a five-year life.  The Company calculated the fair value of the
warrants using the Black-Scholes model and recorded a charge in the amount
$22,728 for the December 2008 quarter.





On
December 4, 2008, an employee advanced the Company $25,000.  In
consideration for this advance, the Company issued to the employee 25,000 common
stock purchase warrants that were immediately exercisable at $0.40 per share and
have a five-year life.  The Company calculated the fair value of the
warrants using the Black-Scholes model and recorded a charge in the amount
$4,100 for the December 2008 quarter.  As of December 31, 2008, the
entire obligation remained outstanding and began to accrue interest at 8% per
annum.  The obligation is due upon demand.





The
foregoing issuances of warrants described above were made in private
transactions intending to meet the requirements of one or more exemptions from
registration.  In addition to any noted exemption below, we relied
upon Section 4(2) of the Securities Act of 1933, as amended (the
“Act”).  The investor was not solicited through any form of general
solicitation or advertising, the transactions being non-public offerings, and
the sales were conducted in private transactions.





Item
3.  Defaults Upon Senior Securities





As of
December 30, 2008, we were in default on approximately $148,000 of principal and
accrued interest on certain PP2 Notes (the “December PP2 Notes”).  As
of this date, we began to accrue interest on the December PP2 Notes at a default
rate of 18% per annum, which is the maximum allowable rate as stipulated under
the PP2 Note purchase agreement.  We will likely need to renegotiate
the payment or conversion of the principal and interest due on all of the PP2
Notes, of which approximately $1.1 million is due in April 2009, or raise
additional capital, or a combination of the two. If we need to raise additional
capital it could be in the form of equity or debt, or a combination of the two.
There can be no assurance that we will be successful in raising additional funds
and, if so, on favorable terms or that the cost savings or required new capital
will be sufficient.





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





None.





Item
5.  Other Information





None.





25


Item
6.  Exhibits







3(i)
              Restated Articles of
      Incorporation3(ii)
              Bylaws31.1
              Certification
      Pursuant to Section 302 of the Sarbanes-Oxley Act of
  200232.1
              Certification
      Pursuant to Section 906 of the Sarbanes-Oxley Act of
  2002


26


SIGNATURE





Pursuant to the requirements of the
Exchange Act of 1934, the registrant caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.





CISTERA
      NETWORKS, INC.Date:
      February 17,
      2009
              
              /s/    Derek P.
      DownsDerek
      P. DownsChief
      Executive Officer and interimChief
      Financial Officer(Principal
      Executive, Financial andAccounting
      Officer)