**U.S. SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

**FORM 10-Q**

**x** QUARTERLY REPORT UNDER SECTION 13OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934

**Forthe quarterly period ending June 30, 2006, or**

**o** TRANSITION REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934

**Forthe transition period from                         to                   .**

**CommissionFile Number 1-11860**

**FOCUS Enhancements, Inc.**

(Name of Issuer in itsCharter)
| **Delaware**                     |   | **04-3144936**       |
|----------------------------------|--------|----------------------|
| (State or Other  Jurisdiction of |   | (I.R.S. Employer     |
| Incorporation or  Organization)  |   | Identification  No.) |

 

**1370 Dell Ave**

**Campbell, CA 95008**

(Address of PrincipalExecutive Offices)

**(408) 866-8300**

(Issuer’s TelephoneNumber, Including Area Code)

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

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and large acceleratedfiler” in Rule 12b-2 of the Exchange Act.

Large acceleratedfiler: o Acceleratedfiler: o Non-accelerated filer: x

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b02 of theExchange Act).

Yes: o  No: x

As of August 8,2006, there were 69,909,744 shares of common stock outstanding.

Documents Incorporated by Reference: None

 

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**FOCUSENHANCEMENTS, INC.**

**INDEX**
|                                    | ** ** | Page                                                                                        |
|------------------------------------|------------|---------------------------------------------------------------------------------------------|
| ** **                         | ** ** | **Number**                                                                                  |
| **PART I - FINANCIAL INFORMATION** |       |                                                                                        |
| ** **                         |       |                                                                                        |
| **Item 1.**                        |       | Financial Statements (unaudited):                                                           |   |   |
|                               |       | Condensed Consolidated Statements of Operations                                             |   | 2 |
|                               |       | Condensed Consolidated Balance Sheets                                                       |   | 3 |
|                               |       | Condensed Consolidated Statements of Cash Flows                                             |   | 4 |
|                               |       | Notes to Condensed Consolidated Financial Statements                                        |   | 5 |
|                               |       |                                                                                        |   |   |
| **Item 2.**                        |       | Management’s Discussion and Analysis  of Financial Condition and Results of Operations |   | 18 |
| ** **                         |       |                                                                                        |   |   |
| **Item 3.**                        |       | Quantitative and Qualitative  Disclosures about Market Risk                                 |   | 27 |
| ** **                         |       |                                                                                        |   |   |
| **Item 4.**                        |       | Controls and Procedures                                                                     |   | 27 |
| ** **                         |       |                                                                                        |   |   |
| **PART II - OTHER INFORMATION**    |       |                                                                                        |
| ** **                         |       |                                                                                        |
| **Item 1.**                        |       | Legal Proceedings                                                                           |   | 28 |
| ** **                         |       |                                                                                        |   |   |
| **Item 1A.**                       |       | Risk Factors                                                                                |   | 28 |
| ** **                         |       |                                                                                        |   |   |
| **Item 2.**                        |       | Unregistered Sales of Equity  Securities and Use of Proceeds                                |   | 29 |
| ** **                         |       |                                                                                        |   |   |
| **Item 3.**                        |       | Defaults Upon Senior Securities                                                             |   | 29 |
| ** **                         |       |                                                                                        |   |   |
| **Item 4.**                        |       | Submission of Matters to a Vote of  Security Holders                                        |   | 29 |
| ** **                         |       |                                                                                        |   |   |
| **Item 5.**                        |       | Other Information                                                                           |   | 29 |
| ** **                         |       |                                                                                        |   |   |
| **Item 6.**                        |       | Exhibits                                                                                    |   |   |
| ** **                         |       |                                                                                        |   |   |
| **SIGNATURES**                     |       |                                                                                        |
|                               |       |                                                                                        |
| **CERTIFICATIONS**                 |       |                                                                                        |

 

1

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**PART I -FINANCIAL INFORMATION**

**Item 1.    FinancialStatements**

**Focus Enhancements, Inc.**

**CondensedConsolidated Statements of Operations**

(In thousands, except pershare amounts)

(Unaudited)

 
| ** **                                                         | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                         | ** ** | **June 30, 2006**      | ** ** | **June 30, 2005**    | ** ** | **June 30, 2006** | ** ** | **June 30, 2005** | ** ** |
|                                                               |       |                             |       |                           |       |   |   |   |   |
| Net revenue                                                        |       | $                                | 8,457      |                           | $          | 6,133 |   | $ | 15,590 |   | $ | 11,588 |   |
| Cost of revenue                                                    |       | 4,670                            |       | 3,744                          |       | 9,138 |   | 7,444 |   |
| Gross margin                                                       |       | 3,787                            |       | 2,389                          |       | 6,452 |   | 4,144 |   |
|                                                               |       |                             |       |                           |       |   |   |   |   |
| Operating expenses:                                                |       |                             |       |                           |       |   |   |   |   |
| Sales, marketing  and support                                      |       | 2,548                            |       | 1,751                          |       | 4,622 |   | 3,175 |   |
| General and  administrative                                        |       | 1,065                            |       | 994                            |       | 1,980 |   | 1,995 |   |
| Research and  development                                          |       | 2,866                            |       | 3,341                          |       | 5,847 |   | 7,283 |   |
| Amortization of  intangible assets                                 |       | 127                              |       | 127                            |       | 254 |   | 276 |   |
|                                                               |       | 6,606                            |       | 6,213                          |       | 12,703 |   | 12,729 |   |
| Loss from operations                                               |       | (2,819                           | )          | (3,824                         | )          | (6,251 | ) | (8,585 | ) |
| Interest  expense, net                                             |       | (292                             | )          | (68                            | )          | (491 | ) | (81 | ) |
| Value of  derivative security                                      |       | —                           |       | —                         |       | (4,000 | ) | — |   |
| Change in value  of derivative security                            |       | (1,761                           | )          | —                         |       | (1,361 | ) | — |   |
| Other income  (expense), net                                       |       | (2                               | )          | (40                            | )          | 68 |   | (40 | ) |
| Loss before  income tax expense                                    |       | (4,874                           | )          | (3,932                         | )          | (12,035 | ) | (8,706 | ) |
| Income tax  expense                                                |       | —                           |       | 7                              |       | 9 |   | 11 |   |
| Net loss                                                           |       | $                                | (4,874     | )                              | $          | (3,939 | ) | $ | (12,044 | ) | $ | (8,717 | ) |
|                                                               |       |                             |       |                           |       |   |   |   |   |
| Net loss per share                                                 |       |                             |       |                           |       |   |   |   |   |
| Basic and  diluted                                                 |       | $                                | (0.07      | )                              | $          | (0.07 | ) | $ | (0.18 | ) | $ | (0.15 | ) |
|                                                               |       |                             |       |                           |       |   |   |   |   |
| Weighted average number  of shares used in per share calculations: |       |                             |       |                           |       |   |   |   |   |
| Basic and diluted                                                  |       | 68,755                           |       | 59,893                         |       | 68,455 |   | 59,487 |   |

 

The accompanyingnotes are an integral part of the condensed consolidated financial statements.

2

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**Focus Enhancements, Inc.**

**CondensedConsolidated Balance Sheets**

(In thousands, exceptshare and per share amounts)

(Unaudited)
| ** **                                                                                                                                                                                          | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                          | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| **Assets**                                                                                                                                                                                          | ** ** | ** **        | ** ** | ** **            | ** ** |
|                                                                                                                                                                                                |       |              |       |                  |       |
| Current assets:                                                                                                                                                                                     |       |              |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                           |       | $                 | 866        |                  | $          | 637 |   |
| Accounts receivable, net of allowances of $376 and  $418, respectively                                                                                                                              |       | 4,805             |       | 3,197                 |       |
| Inventories                                                                                                                                                                                         |       | 4,716             |       | 3,743                 |       |
| Prepaid expenses and other current assets                                                                                                                                                           |       | 874               |       | 759                   |       |
| Total current assets                                                                                                                                                                                |       | 11,261            |       | 8,336                 |       |
|                                                                                                                                                                                                |       |              |       |                  |       |
| Long-term  assets:                                                                                                                                                                                  |       |              |       |                  |       |
| Property and equipment, net                                                                                                                                                                         |       | 1,110             |       | 1,212                 |       |
| Other assets                                                                                                                                                                                        |       | 152               |       | 54                    |       |
| Intangible assets, net                                                                                                                                                                              |       | 521               |       | 866                   |       |
| Goodwill                                                                                                                                                                                            |       | 13,191            |       | 13,191                |       |
|                                                                                                                                                                                                |       | $                 | 26,235     |                  | $          | 23,659 |   |
|                                                                                                                                                                                                |       |              |       |                  |       |
| **Liabilities and Stockholders’ Equity**                                                                                                                                                       | ** ** | ** **        | ** ** | ** **            | ** ** |
|                                                                                                                                                                                                |       |              |       |                  |       |
| Current  liabilities:                                                                                                                                                                               |       |              |       |                  |       |
| Accounts payable                                                                                                                                                                                    |       | $                 | 3,383      |                  | $          | 3,001 |   |
| Accrued liabilities                                                                                                                                                                                 |       | 3,161             |       | 3,292                 |       |
| Current portion of capital lease obligations                                                                                                                                                        |       | 45                |       | 107                   |       |
| Borrowings under line of credit                                                                                                                                                                     |       | 3,000             |       | 2,966                 |       |
| Current portion of notes payable to bank                                                                                                                                                            |       | —            |       | 3                     |       |
| Term loan                                                                                                                                                                                           |       | —            |       | 2,500                 |       |
| Total current liabilities                                                                                                                                                                           |       | 9,589             |       | 11,869                |       |
|                                                                                                                                                                                                |       |              |       |                  |       |
| Long-term  liabilities:                                                                                                                                                                             |       |              |       |                  |       |
| Convertible notes                                                                                                                                                                                   |       | 10,425            |       | —                |       |
| Other liabilities                                                                                                                                                                                   |       | —            |       | 100                   |       |
| Capital lease obligations, net of current portion                                                                                                                                                   |       | —            |       | 10                    |       |
| Total liabilities                                                                                                                                                                                   |       | 20,014            |       | 11,979                |       |
|                                                                                                                                                                                                |       |              |       |                  |       |
| Commitments and  contingencies (Note 10)                                                                                                                                                            |       |              |       |                  |       |
|                                                                                                                                                                                                |       |              |       |                  |       |
| Stockholders’  equity:                                                                                                                                                                         |       |              |       |                  |       |
| Preferred stock, $0.01 par value; authorized  3,000,000 shares; 3,161 shares issued and outstanding at June 30, 2006 and  December 31, 2005, respectively (aggregate liquidation preference $3,917) |       | —            |       | —                |       |
| Common stock, $0.01 par value; 100,000,000 shares  authorized, 70,290,685 and 68,382,113 shares issued and outstanding at June  30, 2006 and December 31, 2005, respectively                        |       | 693               |       | 674                   |       |
| Treasury stock at cost, 497,055 shares at June 30, 2006 and December 31, 2005                                                                                                                       |       | (750              | )          | (750                  | )          |
| Additional paid-in capital                                                                                                                                                                          |       | 107,756           |       | 101,297               |       |
| Deferred stock-based compensation                                                                                                                                                                   |       | —            |       | (214                  | )          |
| Accumulated other comprehensive income (loss)                                                                                                                                                       |       | (60               | )          | 47                    |       |
| Accumulated deficit                                                                                                                                                                                 |       | (101,418          | )          | (89,374               | )          |
|                                                                                                                                                                                                |       |              |       |                  |       |
| Total stockholders’ equity                                                                                                                                                                     |       | 6,221             |       | 11,680                |       |
|                                                                                                                                                                                                |       |              |       |                  |       |
|                                                                                                                                                                                                |       | $                 | 26,235     |                  | $          | 23,659 |   |

 

The accompanyingnotes are an integral part of the condensed consolidated financial statements.

3

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**Focus Enhancements, Inc.**

**CondensedConsolidated Statements of Cash Flows**

(In thousands)

(Unaudited)

 
| ** **                                                                                      | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                                      | ** ** | **June 30, 2006**    | ** ** | **June 30, 2005** | ** ** |
| Cash flows from operating activities:                                                           |       |                           |       |   |   |
| Net loss                                                                                        |       | $                              | (12,044    | ) | $ | (8,717 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities:                    |       |                           |       |   |   |
| Depreciation and  amortization                                                                  |       | 749                            |       | 672 |   |
| Stock-based  compensation                                                                       |       | 323                            |       | 88 |   |
| Amortization of debt  issuance costs                                                            |       | —                         |       | 40 |   |
| Value of derivative  security                                                                   |       | 4,000                          |       | — |   |
| Change in value of  derivative security                                                         |       | 1,361                          |       | — |   |
| Changes in assets and  liabilities:                                                             |       |                           |       |   |   |
| Accounts receivable                                                                             |       | (1,567                         | )          | (28 | ) |
| Inventories                                                                                     |       | (925                           | )          | (298 | ) |
| Prepaid expenses and  other assets                                                              |       | (277                           | )          | (47 | ) |
| Other assets                                                                                    |       | (98                            | )          | — |   |
| Accounts payable                                                                                |       | 368                            |       | 1,311 |   |
| Accrued liabilities                                                                             |       | 225                            |       | 887 |   |
| Net cash used in operating activities                                                           |       | (7,885                         | )          | (6,092 | ) |
|                                                                                            |       |                           |       |   |   |
| Cash flows from investing activities:                                                           |       |                           |       |   |   |
| Decrease in restricted  cash                                                                    |       | —                         |       | 294 |   |
| Purchases of property  and equipment                                                            |       | (296                           | )          | (503 | ) |
| Net cash used in investing activities                                                           |       | (296                           | )          | (209 | ) |
|                                                                                            |       |                           |       |   |   |
| Cash flows from financing activities:                                                           |       |                           |       |   |   |
| Proceeds from issuance  of convertible debt                                                     |       | 10,000                         |       | — |   |
| Net proceeds from  private offerings of common stock                                            |       | —                         |       | 1,607 |   |
| Repayment of lines of  credit                                                                   |       | (2,966                         | )          | (360 | ) |
| Repayment of term loan                                                                          |       | (2,500                         | )          | — |   |
| Repayment of short-term  debt                                                                   |       | (3                             | )          | (19 | ) |
| Repayment of  transaction costs related to acquisition of Visual Circuits Corporation           |       | —                         |       | 225 |   |
| Proceeds from exercise  of warrants                                                             |       | 499                            |       | 10 |   |
| Proceeds from exercise  of common stock options                                                 |       | 446                            |       | — |   |
| Payments under capital  lease obligations                                                       |       | (72                            | )          | — |   |
| Proceeds from issuance  of escrow stock related to acquisition of COMO Computer and Motion GmbH |       | —                         |       | 310 |   |
| Borrowings under term  loan                                                                     |       | —                         |       | 2,500 |   |
| Borrowings under lines  of credit                                                               |       | 3,000                          |       | 2,600 |   |
| Net cash provided by financing activities                                                       |       | 8,404                          |       | 6,873 |   |
|                                                                                            |       |                           |       |   |   |
| Effect of exchange rate changes on cash and cash  equivalents                                   |       | 6                              |       | (11 | ) |
|                                                                                            |       |                           |       |   |   |
| Increase in cash and cash equivalents                                                           |       | 229                            |       | 561 |   |
| Cash and cash equivalents at beginning of period                                                |       | 637                            |       | 3,380 |   |
| Cash and cash  equivalents at end of period                                                     |       | $                              | 866        |   | $ | 3,941 |   |

 

4

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**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

**1.**                                      **Description of Business**

FocusEnhancements, Inc. (“Focus” or “the Company”), headquartered in Campbell,California, is a leading designer of solutions in advanced, proprietary videoand wireless video technologies. Focus’ Semiconductor group develops integratedcircuits (ICs) for high-performance applications in the video convergencemarket, including IPTV set-top boxes and portable media players. Focus iscurrently developing a wireless IC chip set based on the WiMedia Ultra Wideband(“UWB”) standard and designed to be compatible with Wireless USB and used inpersonal computer (PC), consumer electronics and mobile electronicsapplications. Focus’ System group develops video products for the digital mediamarkets, with customers in the broadcast, video production, digital signage anddigital asset management markets.

**2.****                                      Basisof Presentation – Interim Financial Information**

Theaccompanying unaudited condensed consolidated financial statements of Focushave been prepared in conformity with accounting principles generally acceptedin the United States of America and with the instructions to Form 10-Q andArticle 10 of Regulation S-X. Accordingly, they do not contain all of theinformation and footnotes required by accounting principles generally acceptedin the United States of America for complete financial statements. The year-endcondensed consolidated balance sheet data was derived from audited consolidatedfinancial statements, but does not include all disclosures required byaccounting principles generally accepted in the United States of America.

In the opinion ofmanagement, the condensed consolidated financial statements include alladjustments (consisting only of normal recurring adjustments) necessary for afair presentation of Focus’ financial position, operating results and cashflows for the periods presented. The results of operations for the three andsix months ended June 30, 2006 and cash flows for the six months ended June 30,2006 are not necessarily indicative of the results that may be expected for anyfuture period.

The condensedconsolidated financial statements of Focus as of June 30, 2006 and for thethree and six month periods ended June 30, 2006 and 2005 are unaudited andshould be read in conjunction with the audited consolidated financialstatements for the year ended December 31, 2005, included in Focus’ AnnualReport on Form 10-K for the year ended December 31, 2005.

**3.****                                     ****Equity-Based Compensation**

Prior to January1, 2006, Focus accounted for employee stock-based compensation using theintrinsic value method supplemented by pro forma disclosures in accordance withAccounting Principles Board (“APB”) Opinion No. 25 and Statement of FinancialAccounting Standards (“SFAS”) No. 123, “*Accounting for Stock-BasedCompensation*” (“SFAS 123”), as amended by SFAS No.148 “*Accounting for Stock-Based Compensation—Transition and Disclosures*”.Employee stock options granted by Focus with an exercise price equal to thegrant date fair value of the Company’s stock had no intrinsic value andtherefore no expense was recorded for these options under APB Opinion No. 25.Grants of restricted stock awards were measured at fair value on the date ofgrant based on the number of shares granted and the quoted price of the Company’scommon stock with such value recognized as an expense over the correspondingvesting period of the award.

On January 1,2006, Focus adopted SFAS No. 123 (revised 2004), “*Share-BasedPayment” (*“SFAS 123R”). SFAS 123R eliminates the alternative ofapplying the intrinsic value measurement provisions of APB Opinion No. 25 tostock compensation awards issued to employees. SFAS 123R requires companies to measure the cost of employee servicesreceived in exchange for an award of equity instruments based on the grant-datefair value of the award. That cost will be recognized over the period duringwhich an employee is required to provide services in exchange for the award.Focus adopted SFAS 123R using the modified prospective transition approach andtherefore prior periods have not been restated to reflect the impact of SFAS123R. Under SFAS 123R, stock-based awards granted prior to its adoption will beexpensed over the remaining portion of their requisite service period. These awardswill be expensed under the accelerated amortization method using the same fairvalue measurements that were used in calculating pro forma stock-basedcompensation expense under SFAS 123. For stock-based awards granted on or afterJanuary 1, 2006, Focus will amortize stock-based compensation expense on astraight-line basis over the requisite service period, which is generally afour year vesting period. SFAS 123R requires that the deferred stock-basedcompensation on the condensed

5

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consolidatedbalance sheets on the date of adoption be netted against additional paid-incapital. As of December 31, 2005, there was a balance of $214,000 of deferredstock-based compensation, which was netted against additional paid-in capitalon January 1, 2006.

The effect of recordingstock-based compensation for the three and six months ended June 30, 2006 wasas follows:

 
| (In thousands, except per share data) | ** ** | **Three Months  Ended June 30,  2006** | ** ** | **Six Months  Ended June 30,  2006** | ** ** |
|----------------------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
|                                                           |       |                                                  |       |                                                |       |
| Stock-based compensation  expense by type of award:            |       |                                                  |       |                                                |       |
| Employee stock options                                         |       | $                                                     | 123        |                                                | $          | 274 |   |
| Restricted stock awards                                        |       | 27                                                    |       | 49                                                  |       |
|                                                           |       |                                                  |       |                                                |       |
| Total stock-based compensation                                 |       | 150                                                   |       | 323                                                 |       |
|                                                           |       |                                                  |       |                                                |       |
| Tax effect on  stock-based compensation                        |       | —                                                |       | —                                              |       |
|                                                           |       |                                                  |       |                                                |       |
| Effect on net  loss                                            |       | $                                                     | 150        |                                                | $          | 323 |   |
|                                                           |       |                                                  |       |                                                |       |
| Effect on net loss per  share basic and diluted                |       | $                                                     | 0.00       |                                                | $          | 0.00 |   |

 

The implementation ofSFAS 123R did not affect basic and diluted net loss per share nor cash flowsfrom operations for the three and six months ended June 30, 2006. For the threeand six months ended June 30, 2005, Focus recognized $17,000 and $24,000,respectively, of employee stock-based compensation expense under the intrinsicvalue method.

Stock Options

The exercise price ofeach stock option equals the market price of Focus’ common stock on the date ofgrant. Option grants generally vest over four years and expire 5 to 10 yearsfrom the grant date. The fair value of each option grant is estimated on thedate of grant using the Black-Scholes option pricing model. The weightedaverage assumptions used in the model are outlined in the following table:

 
|                                   | ** ** | **Three Months  Ended June 30,  2006** | ** ** | **Six Months  Ended June 30,  2006** | ** ** |
|-----------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
|                              |       |                                                  |       |                                                |       |
| Average computed  life of options |       | 4  years                                              |       | 4-5  years                                          |       |
| Risk-free rate of  interest       |       | 5.03%                                                 |       | 4.56%  - 5.03%                                      |       |
| Volatility of  common stock       |       | 81%                                                   |       | 81%                                                 |       |
| Dividend yield                    |       | 0%                                                    |       | 0%                                                  |       |

 

6

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A summary of activityrelated to Focus’ stock option incentive plans for the six months ended June30, 2006 is presented below:

 
|                                                                      | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** | **Aggregate  Intrinsic  Value (000s)** | ** ** |
|----------------------------------------------------------------------|------------|------------|------------|----------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------|------------|
|                                                                 |       |       |       |                                   |       |                                                |       |                                        |       |
| Options  outstanding at beginning of year                            |       | 7,253,787  |       | $                                      | 1.10       |                                                |       |                                        |       |   |
| Options granted                                                      |       | 728,574    |       | $                                      | 0.75       |                                                |       |                                        |       |   |
| Options  exercised                                                   |       | (756,160   | )          | $                                      | 0.60       |                                                |       |                                        |       |   |
| Options canceled                                                     |       | (226,134   | )          | $                                      | 0.98       |                                                |       |                                        |       |   |
|                                                                 |       |       |       |                                   |       |                                                |       |                                        |       |
| Options  outstanding at June 30, 2006                                |       | 7,000,067  |       | $                                      | 1.12       |                                                | 5.6        |                                        | $          | 436 |   |
|                                                                 |       |       |       |                                   |       |                                                |       |                                        |       |
| Options  exercisable and expected to be exercisable at June 30, 2006 |       | 6,542,485  |       | $                                      | 1.13       |                                                | 5.4        |                                        | $          | 380 |   |
|                                                                 |       |       |       |                                   |       |                                                |       |                                        |       |
| Options exercisable at  June 30, 2006                                |       | 4,772,850  |       | $                                      | 1.19       |                                                | 5.9        |                                        | $          | 226 |   |

 

The weighted average grant date fair value of optionsgranted in the three and six months ended June 30, 2006 was $0.61 and $0.47 pershare, respectively. The intrinsic value of options exercised during the threeand six months ended June 30, 2006 was $1,000 and $49,000, respectively. AtJune 30, 2006, Focus had $706,000 of unrecognized stock compensation expense,net of estimated forfeitures, related to stock option plans, which will berecognized over the weighted average remaining service period of 2.1 years.Cash received from stock option exercises was $89,000 and $456,000 for thethree and six months ended June 30, 2006, respectively.

The options outstandingand exercisable at June 30, 2006 were in the following exercise priceranges:

 
| ** **                                                        | ** ** | ** **                          | ** ** | ** **              | ** ** | ** **                | ** ** | **Options Vested and Exercisable** | ** ** |
|-------------------------------------------------------------------|------------|-------------------------------------|------------|-------------------------|------------|---------------------------|------------|---------------------------------------------------|------------|
| **Options Outstanding at June 30, 2006** | ** ** | **at June 30, 2006** | ** ** |
| ** **                                                        | ** ** | ** **                          | ** ** | ** **              | ** ** | **Weighted-Average**      | ** ** | ** **                                        | ** ** | ** ** | ** ** |
| ** **                                                        | ** ** | ** **                          | ** ** | **Weighted-Average**    | ** ** | **Remaining**             | ** ** | ** **                                        | ** ** | **Weighted-Average** | ** ** |
| **Range of Exercise Price**                        | ** ** | **Shares**                          | ** ** | **Exercise Price** | ** ** | **Contractual Life** | ** ** | **Shares**                                        | ** ** | **Exercise Price** | ** ** |
| $0.43 — $0.97                                                |       | 1,770,164                           |       | $                       | 0.73       |                      | 5.9        |                                              | 922,390    |   | $ | 0.74 |   |
| $1.01 — $1.43                                                |       | 4,312,567                           |       | $                       | 1.14       |                      | 5.5        |                                              | 2,983,378  |   | $ | 1.16 |   |
| $1.53 — $1.97                                                |       | 824,557                             |       | $                       | 1.62       |                      | 5.0        |                                              | 783,053    |   | $ | 1.62 |   |
| $2.05 — $10.21                                               |       | 92,779                              |       | $                       | 2.80       |                      | 5.8        |                                              | 84,029     |   | $ | 2.87 |   |
|                                                              |       |                                |       |                    |       |                      |       |                                              |       |   |   |
|                                                              |       | 7,000,067                           |       | $                       | 1.12       |                      | 5.6        |                                              | 4,772,850  |   | $ | 1.19 |   |

 

7

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Restricted Stock Awards

A summary of activityrelated to Focus’ restricted stock awards for the six months ended June 30,2006 is presented below:

 
|                                                                       | ** ** | **Shares** | ** ** | **Weighted  Average  Grant Date  Fair Value** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** | **Aggregate  Intrinsic  Value (000s)** | ** ** |
|-----------------------------------------------------------------------|------------|------------|------------|---------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------|------------|
|                                                                  |       |       |       |                                                    |       |                                                |       |                                        |       |
| Non-vested  restricted stock shares outstanding at beginning of year  |       | 245,000    |       | $                                                       | 1.11       |                                                |       |                                        |       |   |
| Restricted stock  shares granted                                      |       | 570,176    |       | $                                                       | 0.67       |                                                |       |                                        |       |   |
| Restricted stock  shares vested                                       |       | (61,250    | )          | $                                                       | 1.11       |                                                |       |                                        |       |   |
| Restricted stock  shares cancelled                                    |       | (23,619    | )          | $                                                       | 0.82       |                                                |       |                                        |       |   |
|                                                                  |       |       |       |                                                    |       |                                                |       |                                        |       |
| Non-vested  restricted stock shares outstanding at June 30, 2006      |       | 730,307    |       | $                                                       | 0.79       |                                                | 3.4        |                                        | $          | 716 |   |
|                                                                  |       |       |       |                                                    |       |                                                |       |                                        |       |
| Non-vested restricted  stock shares expected to vest at June 30, 2006 |       | 520,077    |       | $                                                       | 0.81       |                                                | 3.3        |                                        | $          | 509 |   |

 

At June 30, 2006, Focushad $366,000 of unrecognized compensation expense, net of forfeitures, relatedto restricted stock awards, which will be recognized over the weighted averageperiod of 3.3 years.  During the sixmonths ended June 30, 2006, 61,250 shares of restricted stock vested with afair market value of $41,000. No restricted stock vested during the three monthsended June 30, 2006.

Pro Forma Information under SFAS 123 for the Three andSix Months Ended June 30, 2005

Prior to 2006, Focus followed the disclosure-onlyprovisions of SFAS 123. The following table illustrates the effect on net lossand net loss per share for the three and six months ended June 30, 2005, hadthe fair value recognition provisions of SFAS 123 been applied to optionsgranted under Focus’ equity-based employee compensation plans. For purposes ofthis pro forma disclosure, the estimated value of the options is recognizedover the options’ vesting periods. If Focus had recognized the expense ofequity programs in the condensed consolidated statements of operations,additional paid-in capital would have increased by a corresponding amount.

 
| (In thousands, except per share data)                                                   | ** ** | **Three Months  Ended June 30,  2005** | ** ** | **Six Months  Ended June 30,  2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
|                                                                                                             |       |                                                  |       |                                                |       |
| Reported net  loss                                                                                               |       | $                                                     | (3,939     | )                                                   | $          | (8,717 | ) |
| Add: Stock-based  compensation expense included in net loss                                                      |       | 17                                                    |       | 24                                                  |       |
| Deduct:  Stock-based compensation determined under fair value method for all awards,  net of related tax effects |       | (335                                                  | )          | (711                                                | )          |
|                                                                                                             |       |                                                  |       |                                                |       |
| Pro forma net  loss                                                                                              |       | $                                                     | (4,257     | )                                                   | $          | (9,404 | ) |
|                                                                                                             |       |                                                  |       |                                                |       |
| Reported net  loss per share                                                                                     |       | $                                                     | (0.07      | )                                                   | $          | (0.15 | ) |
|                                                                                                             |       |                                                  |       |                                                |       |
| Basic and diluted pro forma  net loss per share                                                                  |       | $                                                     | (0.07      | )                                                   | $          | (0.16 | ) |

 

8

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For purposes of the weighted average estimated fairvalue calculations, the fair value of each stock option grant is estimated onthe date of grant using the Black-Scholes option pricing model and the followingassumptions:

 
|                                   | ** ** | **Three Months  Ended June 30,  2005** | ** ** | **Six Months  Ended June 30,  2005** | ** ** |
|-----------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
|                              |       |                                                  |       |                                                |       |
| Average computed  life of options |       | 3.5  - 5.0 years                                      |       | 3.5  - 5.0 years                                    |       |
| Risk-free rate  of interest       |       | 3.3%  - 3.8%                                          |       | 3.0%  - 3.8%                                        |       |
| Volatility of  common stock       |       | 87%                                                   |       | 87%  - 88%                                          |       |
| Dividend yield                    |       | 0%                                                    |       | 0%                                                  |       |

 

Based on the Black-Scholes option pricing model, theweighted average estimated fair value of employee stock option grants was $0.45and $0.55 per share for the three and six months ended June 30, 2005.

**4.**                                      **Net Loss per Share**

Basic net loss per share was computed by dividing thenet loss by the weighted average number of shares of common stock outstandingduring the period. Diluted net loss per share is computed by dividing the netloss by the weighted average number of shares of common stock and potentialcommon stock equivalents outstanding during the period, if dilutive. Options topurchase 7,000,067 and 7,831,179 shares of common stock, unvested shares ofrestricted stock of 730,307 and 245,000, warrants to purchase 5,442,761 and4,160,621 shares of common stock and 3,161 shares of preferred stockconvertible into 3,161,000 shares of common stock were outstanding at June 30,2006 and 2005, respectively, but were not included in the computation of dilutednet loss per share as the effect would have been anti-dilutive. In addition,convertible notes that are convertible into 10,425,000 shares of common stockwere outstanding at June 30, 2006, but were not included in the computation ofdiluted net loss per share as the effect would have been anti-dilutive.

**5.**                                      Significant Customers

Sales to twocustomers accounted for 36% of Focus’s revenue in the three months ended June30, 2006.  Sales to two customersaccounted for 25% of Focus’s revenue in the six months ended June 30,2006.  Sales to one customer accountedfor 10% of Focus’s revenue in the three months ended June 30, 2005.  No customer accounted for more than 10% ofFocus’s revenue in the six months ended June 30, 2005.

Three customershad accounts receivable balances in excess of 10% of Focus’ total accountsreceivable at June 30, 2006. These customers accounted for 43% of Focus’ totalaccounts receivable at that date. As of December 31, 2005, two distributorseach represented approximately 12% of Focus’ accounts receivable.

**6.**                                   Management’s Plans

The accompanying condensed consolidated financial statements have beenprepared on a going concern basis, which contemplates the realization of assetsand the satisfaction of liabilities in the normal course of business. For thesix months ended June 30, 2006 and the year ended December 31, 2005, Focusincurred net losses of $12.0 million and $15.4 million, respectively, and usednet cash in operating activities of $7.9 million and $12.5 million, respectively.These results indicate that Focus may potentially be unable to continue as agoing concern.

The condensedconsolidated financial statements do not include any adjustments relating tothe recoverability and classification of recorded asset amounts or the amountsand classification of liabilities that might be necessary should Focus beunable to continue as a going concern. Focus’ continuation as a going concernis dependent upon its ability to generate sufficient cash flows to meet itsobligations on a timely basis, to obtain additional financing as may berequired, and ultimately to return to profitability and significant positivecash flows.

Focushas historically met cash needs from the proceeds of debt, the sale of commonstock in private placements and the exercise of employee stock options andwarrants. Management continues to assess its product lines in light of

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technologytrends and economic conditions, to identify how to enhance existing productlines or create new distribution channels.

Focusreceived gross proceeds of $10.0 million from the issuance of securedconvertible notes to a group of private investors in January 2006. Whilemanagement believes that these funds, along with the cash flow generated byFocus’ expanding Systems business, should be adequate to enable Focus tocomplete its Ultra Wideband (“UWB”) engineering development and launchcommercialization of its UWB products, depending upon the results and timing ofits UWB initiative and the profitability of its Systems business, Focus mayneed to raise further capital in 2006. There can be no assurance thatsufficient funds will be raised. Moreover, any equity financing or convertibledebt financing would result in dilution to Focus’ existing stockholders andcould have a negative effect on the market price of its common stock.Furthermore, any additional debt financing will result in higher interestexpense.

Thereis no assurance that management’s plans will be successful, or if successful,that they will result in Focus continuing as a going concern.

**7.****                                      Goodwilland Intangible Assets**

Goodwill as of June 30, 2006 and December 31, 2005 includedthe following:

 
| **(In thousands)** | ** ** | **Goodwill** | ** ** |
|--------------------|------------|--------------|------------|
|               |       |         |       |
| Videonics          |       | $            | 5,070      |   |
| Tview              |       | 121          |       |
| COMO               |       | 1,104        |       |
| Visual Circuits    |       | 6,896        |       |
|               |       |         |       |
|               |       | $            | 13,191     |   |

 

The following tables provide a summary of the carryingamounts of intangible assets:

 
|                      | ** ** | **June 30, 2006** | ** ** |
|----------------------|------------|-----------------------------|------------|
| ** **           | ** ** | ** **                  | ** ** | **Accumulated** | ** ** | **Net** | ** ** |
| **(In thousands)**   | ** ** | **Gross Amount**       | ** ** | **Amortization** | ** ** | **Amount** | ** ** |
|                 |       |                        |       |   |   |   |   |
| Existing  technology |       | $                           | 3,945      |   | $ | (3,424 | ) | $ | 521 |   |
| Tradename            |       | 176                         |       | (176 | ) | — |   |
|                 |       |                        |       |   |   |   |   |
|                 |       | $                           | 4,121      |   | $ | (3,600 | ) | $ | 521 |   |

 
|                      | ** ** | **December 31, 2005** | ** ** |
|----------------------|------------|---------------------------------|------------|
| ** **           | ** ** | ** **                      | ** ** | **Accumulated** | ** ** | **Net** | ** ** |
| **(In thousands)**   | ** ** | **Gross Amount**           | ** ** | **Amortization** | ** ** | **Amount** | ** ** |
|                 |       |                            |       |   |   |   |   |
| Existing  technology |       | $                               | 3,945      |   | $ | (3,079 | ) | $ | 866 |   |
| Tradename            |       | 176                             |       | (176 | ) | — |   |
|                 |       |                            |       |   |   |   |   |
|                 |       | $                               | 4,121      |   | $ | (3,255 | ) | $ | 866 |   |

 

10

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The total expected future amortization related to intangibleassets is provided in the table below:

 
| (In thousands)                  | ** ** | **Amortization** | ** ** |
|--------------------------------------|------------|------------------|------------|
|                                 |       |             |       |
| Six months ending  December 31, 2006 |       | $                | 464        |   |
| Fiscal year 2007                     |       | 57               |       |
|                                 |       |             |       |
|                                 |       | $                | 521        |   |

 

**8.****                                      Inventories**

 

Inventories arestated at lower of cost (first-in, first-out) or market:

 
| (In thousands) | ** ** | **June 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|---------------------|------------|-----------------------------|------------|---------------------------------|------------|
|                |       |                        |       |                            |       |
| Raw materials       |       | $                           | 2,668      |                            | $          | 2,427 |   |
| Work in process     |       | 31                          |       | 146                             |       |
| Finished goods      |       | 2,017                       |       | 1,170                           |       |
|                | ** ** | ** **                  |       |                            |       |
|                |       | $                           | 4,716      |                            | $          | 3,743 |   |

 

**9.**                                      Borrowings

 
| (In thousands)                      | ** ** | **June 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
|                                     |       |                        |       |                            |       |
| Short-term debt:                         |       |                        |       |                            |       |
| Current portion of notes payable to bank |       | $                           | —     |                            | $          | 3 |   |
| Term loan                                |       | —                      |       | 2,500                           |       |
| Accounts receivable-based line of credit |       | 3,000                       |       | 2,966                           |       |
|                                     |       | 3,000                       |       | 5,469                           |       |
| Long-term debt:                          |       |                        |       |                            |       |
| Convertible notes                        |       | 10,425                      |       | —                          |       |
|                                     | ** ** | ** **                  |       | ** **                      | ** ** |
|                                     |       | $                           | 13,425     |                            | $          | 5,469 |   |

 

AccountsReceivable-Based Line of Credit

InNovember 2004, Focus obtained a $4.0 million line of credit from Greater Bay Bank under which it can borrow upto 90% of its eligible outstanding accounts receivable. The credit line expireson December 24, 2006 as a result of an extension granted in November 2005 andis collateralized by a personal guarantee from Carl Berg, a Company directorand shareholder. In connection with this credit line, the bank has obtained afirst priority security interest in Focus’ accounts receivable through anagreement with Mr. Berg, which enables Mr. Berg to retain his existing securityinterest in all of Focus’ assets while subordinating his interest in Focus’accounts receivable.

The credit line is subject to ongoing covenantsincluding a covenant based on operating results. Borrowings under the creditline bear interest at a rate of prime plus 1%, which was 9.25% at June 30,2006. At June 30, 2006, there was

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$3.0 million outstanding on this credit line andFocus had the ability to borrow up to the maximum available amount of $4.0million. At June 30, 2006, Focus was not incompliance with the maximum netloss covenant as a result of the $1.8 million expense related to thechange in value of the derivative security. If a waiver is not obtained, allamounts outstanding under the credit line would be immediately due and payable.Focus is currently working with Greater Bay Bank and expects to obtain awaiver.

TermLoan

On June28, 2005, Focus signed a term loan agreement with Greater Bay Bank under which Focus can borrow up to$2.5 million. The term loan has a maturity date of December 24, 2006. Mr. Berghas personally guaranteed the loan, which is interest only until maturity andis in addition to Focus’ existing $4.0 million accounts receivable basedsecured line of credit that Focus has with this bank. Interest is payable underthis term loan at prime plus 1%, which was 9.25% at June 30, 2006. At June 30, 2006, there was nooutstanding balance under this term loan.

Convertible Notes and Derivative Liability

On January 27,2006, Focus issued $10.0 million in aggregate principal amount of 10% securedconvertible notes due January 1, 2011 to certain purchasers. The following arethe key features of the notes:

·                  Interestaccrues on the principal amount of the notes at a rate of 10% per annum,payable semi-annually on June 30 and December 30 of each year.

·                  Interestdue on the first three semi-annual payments may, at the issuers option, be paidin the form of a note with the same terms and conditions of the original notes,including conversion rights.

·                  Thenotes are convertible, at the option of the holder, into shares of Focus commonstock at a conversion price of $1.00 per share. The conversion price is subjectto adjustment for stock splits, reverse stock splits, recapitalizations and similarcorporate actions.

·                  Thenotes are secured by all of the assets of Focus in accordance with the termsand subject to the conditions contained in a security agreement entered intoconcurrent with the issuance of the notes.

·                  Thenotes are redeemable, at the option of Focus, at any time at a redemption priceequal to 102% times the face rate of the notes, plus any accrued interest.

·                  Upona fundamental change, which includes a change in control of Focus, each holderof the notes may require Focus to repurchase all of its debt at a purchaseprice equal to 101% of the principal amount of the notes plus accrued andunpaid interest

Pursuant to theRegistration Rights Agreement with the Purchasers dated January 24, 2006 (the “RegistrationRights Agreement”), Focus agreed to file a resale registration statementcovering the resale of the shares issuable to the investors upon the conversionof the notes. The due date may accelerate in the event Focus commences any caserelating to bankruptcy or insolvency, or related events of default.

On May 10, 2006,the registration statement filed by Focus to register the shares underlying thenotes was declared effective by the Securities and Exchange Commission asrequired by the Registration Rights Agreements. Focus must maintain aneffective registration statement until the earlier to occur of (i) the dateafter which all the shares registered there under have been sold or (ii) thedate all shares underlying the notes may be sold without volume restrictionspursuant to Rule 144(k). Subject to certain conditions, the holders of theconvertible notes may, at their election, exchange the notes for interests inan entity or entities to which Focus’ semiconductor business is spun off, ifsuch an event occurs prior to July 24, 2007, at a conversion rate equal to 1%of voting interests in such other entity for every $400,000 of note principal,up to a collective maximum of 25% of the voting power of such other entity. Asof June 30, 2006, no date has been set for the potential spin-off nor have theexact assets and liabilities to be included in such a spin-off been determined.

Pursuant toEmerging Issues Task Force (“EITF”) 00-19, “*Accounting for DerivativeFinancial Instruments Indexed to, and Potentially Settled in, a Company’s OwnStock*” (“EITF 00-19”), Focus evaluated the registration rightsagreement and concluded that it triggers the “settlement in cash” assumptionthat underlies the separate evaluation of the derivative elements of thecontract. There is no alternative settlement option in the registration rightsagreement, even though the agreement is quiet as to penalties. The agreementrepresents a contingent liability that must be considered if registration isnot successfully maintained. In accordance with SFAS No. 133, “*Accounting for Derivative Instruments and Hedging Activities*”,(“SFAS 133”), Focus determined that the conversion feature of the notes met thecriteria of an embedded derivative and therefore the conversion feature of thedebt needed to be bifurcated and accounted for as a derivative.

The conversion featurefails to qualify for equity classification under EITF 00-19, and must beaccounted for as a derivative liability. Focus accounts for derivativefinancial instruments in accordance with SFAS 133. Derivative

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financial instruments arerecorded as liabilities in the condensed consolidated balance sheets andmeasured at fair value. When available, quoted market prices are used indetermining fair value. However, if quoted market prices are not available,Focus estimates fair value using either quoted market prices of financialinstruments with similar characteristics or other valuation techniques. Thesederivative liabilities will be revalued each quarter with the change in fairvalue recorded in the statement of operations.

Using a binomialoptions valuation model, the fair value of the conversion option within theconvertible notes was initially computed at $4.0 million. The model usedseveral assumptions to determine the estimated fair value of the derivativeliability including: historical stock price volatility (utilizing a five-yearperiod), risk-free interest rate (4.50%), remaining time to maturity and theclosing price of Focus’ common stock. The value of this embedded derivative instrument was bifurcated from thedebt host contract and recorded as a derivative liability, which resulted in adiscount to the initial carrying amount of the convertible notes. The $4.0million discount was immediately expensed in the condensed consolidatedstatements of operations as value of derivative security as the notes may beconverted to common stock at any time after issuance.

At March 31, 2006, Focusrevalued the derivative liability based on the closing price of Focus’ commonstock of $0.66, the remaining term coinciding with the contract and utilizing avolatility of 87%. For the three months ended March 31, 2006, due in part to adecrease in the market value of Focus’ common stock, Focus recorded a $400,000gain for the change in the fair value of the derivative liability.

Effective June 28, 2006,Focus amended certain agreements associated with the convertible notes,eliminating the requirements that Focus: (i) register the common stockunderlying the convertible notes issuable pursuant to the Note Purchase Agreementand (ii) once such underlying stock is registered, keep such registrationcontinuously effective. Such amendments effectively removed the derivativeliability component of the convertible notes. However, in accordance with SFAS133, Focus was required to revalue the derivative liability based on theclosing price of Focus’ common stock on June 28, 2006 ($0.85), utilizing theremaining original contract term and a volatility of 83%. In accordance withsuch revaluation, Focus recorded a $1.8 million expense for the change in thefair value of the derivative liability between March 31, 2006 and June 18,2006. With the elimination of the derivative component, Focus reclassified thetotal derivative liability of approximately $5.4 million to additional paid-incapital.

**10.**                               Commitments and Contingencies

Research and DevelopmentAgreements

In October 2004, Focus entered into a design servicescontract under which Focus agreed to pay $2.9 million to a third party for thedesign and development of high performance UWB integrated circuits. Thecontract amount was subsequently increased to $3.3 million. Payments are madeupon the completion of specific milestones by the third party, which areexpected to be completed by December 2006. For the three months ended June 30,2006 and 2005, $117,000 and $672,000, respectively, was charged to research anddevelopment expense based on the level of effort incurred by the third party.For the six months ended June 30, 2006 and 2005, $409,000 and $1.5 million wascharged to research and development based on the level of effort incurred bythe third party.  At June 30, 2006, Focushad $112,000 recorded as payable, of which $29,000 was included within accountspayable and $83,000 was included in other accrued liabilities.

In July 2005, Focus entered into a development agreement with acustomer under which the customer agreed to pay Focus for the joint developmentby Focus and the customer of a custom product. The customer agreed to pay Focus$600,000 in four installments of $150,000 at the completion of specificmilestones. For the three months ended June 30, 2006, $46,000 was recognized asrevenue based on the level of effort incurred by Focus and $45,000 ofdevelopment expense was recorded in cost of revenue. For the six months endedJune 30, 2006, $263,000 was recognized as revenue based on the level of effortincurred by Focus and $319,000 of development expense was recorded in cost ofrevenue.  The project was completed inApril 2006 and all amounts due under the development agreement were billed andcollected by June 30, 2006.

Leases

Focus leases officefacilities and certain equipment under operating and capital leases. Under thelease agreements, Focus is obligated to pay for utilities, taxes, insurance andmaintenance.

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Minimumlease commitments at June 30, 2006 were as follows:

 
| (In thousands)                                    | ** ** | **Operating Lease  Commitments** | ** ** | **Capital Lease  Commitments** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
|                                                   |       |                                  |       |                                |       |
| 2006                                                   |       | $                                     | 306        |                                | $          | 32 |   |
| 2007                                                   |       | 612                                   |       | 15                                  |       |
| 2008                                                   |       | 235                                   |       | —                              |       |
| 2009                                                   |       | 192                                   |       | —                              |       |
| 2010                                                   |       | 114                                   |       | —                              |       |
|                                                   |       |                                  |       |                                |       |
|                                                   |       | $                                     | 1,459      |                                | 47         |   |
|                                                   |       |                                  |       |                                |       |
| Less: amount  representing interest                    |       |                                  |       | (2                                  | )          |
|                                                   |       |                                  |       |                                |       |
| Present value of future  minimum future lease payments |       |                                  |       | $                                   | 45         |   |

 

Inventory PurchaseCommitments

Under contractmanufacturing arrangements, contract manufacturers procure inventory tomanufacture products based upon a forecast of customer demand provided byFocus. Focus is responsible for the financial impact on the contractmanufacturer of any reduction or product mix shift in the forecast relative tomaterials that the contract manufacturer had already purchased, and is unableto return, under a prior forecast. Such a variance in forecasted demand couldrequire a cash payment for finished goods in excess of current customer demandor for costs of excess or obsolete inventory.

At June 30, 2006, Focus had issuednon-cancelable purchase orders for approximately $4.6 million to purchasefinished goods from its contract manufacturers, and had not incurred anysignificant liability for finished goods in excess of current customer demandor for the costs of excess or obsolete inventory.

General

From time-to-time, Focusis party to certain other claims and legal proceedings that arise in theordinary course of business which, in the opinion of management, will not havea material adverse effect on Focus’ financial position or results of operation.

**11.****                            Stockholders’Equity**

As of June 30, 2006,Focus was obligated under certain circumstances, to issue the followingadditional shares of common stock pursuant to derivative securities, instrumentsor agreements:

 
| (In thousands)                            | ** ** | **Shares of  Common Stock** | ** ** |
|------------------------------------------------|------------|---------------------------------------|------------|
|                                           |       |                                  |       |
| Options to  purchase common stock              |       | 7,000                                 |       |
| Warrants to  purchase common stock             |       | 5,443                                 |       |
| Preferred stock  convertible into common stock |       | 3,161                                 |       |
| Convertible  notes                             |       | 10,425                                |       |
|                                           |       |                                  |       |
|                                           |       | 26,029                                |       |

 

During the threemonths ended June 30, 2006, 594,104 shares of common stock were issued upon theexercise of warrants, for gross proceeds of approximately $499,000.

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**12.****                               RelatedParty Transactions**

CarlBerg

In December 2002,Mr. Berg provided Samsung Semiconductor Inc., Focus’ contracted ApplicationSpecific Integrated Circuit (“ASIC”) manufacturer, with a personal guarantee tosecure Focus’ working capital requirements for ASIC purchase order fulfillment.Mr. Berg agreed to provide the personal guarantee on Focus’ behalf withoutadditional cost or collateral, as Mr. Berg maintains a secured priorityinterest in substantially all of Focus’ assets. At June 30, 2006, Focus owedSamsung $277,000 under net 30 terms.

In connection withthe $10.0 million convertible note financing completed in January 2006, Focusentered into an amendment to the Intercreditor Agreement by and among GreaterBay Bank, Mr. Berg and Focus, pursuant to which Greater Bay Bank, Mr. Berg andthe holders of the notes have defined their relative rights and priorities withrespect to the shared collateral, with Greater Bay Bank having a first prioritysecurity interest in certain specified collateral of Focus and an IntercreditorAgreement specifying the shared interests of the note holders and Mr. Berg inthe collateral securing both the notes (all of Focus’ assets) and Mr. Berg’sguaranty of Focus’ obligations to Greater Bay Bank, subject to the prioritysecurity interest of the Greater Bay Bank.

Dolby LaboratoriesInc.

N. William JasperJr., who is the Chairman of Focus’ Board of Directors, is also the Presidentand Chief Executive Officer of Dolby Laboratories, Inc. (“Dolby”), a signalprocessing technology company located in San Francisco, California. Focus isrequired to submit quarterly royalty payments to Dolby based on Dolbytechnology incorporated into certain products. For the three months ended June30, 2006 and 2005, Focus paid Dolby $4,000 in royalties each period, which wererecorded in cost of revenue.  For the sixmonths ended June 30, 2006 and June 30, 2005, Focus paid Dolby $9,000 and$7,000, respectively, which were recorded in cost of revenue.

Norman Schlomka

Norman Schlomka, GeneralManager of COMO Computer & Motion GmbH (“COMO”), Focus’ wholly owned Germansubsidiary, and an executive officer of Focus since February 2006, owns onethird of the building that COMO occupies. For both three month periods endedJune 30, 2006 and 2005, COMO paid rent of approximately $15,000 related to thisbuilding.  For the six month periodsended June 30, 2006 and 2005, COMO paid rent of approximately $30,000 relatedto this building.

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***13.          BusinessSegment Information***

Focus’ reportablesegments are Systems and Semiconductor. These reportable segments have distinctproducts – Systems consists of video products for the digital media markets,with customers in the broadcast, video production, digital signage and digitalasset management markets and Semiconductor develops integrated circuits (ICs)for high-performance applications in the video convergence market. Focus’ chiefoperating decision maker is the CEO.

Focus evaluates segmentperformance based on operating income (loss) and does not allocate netinterest, other income or taxes to operating segments. Additionally, Focus doesnot allocate assets by operating segment.
|                                   | ** ** | **Three Months Ended June 30, 2006** | ** ** |
|-----------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                        | ** ** | **Systems**                                                   | ** ** | **Semiconductor** | ** ** | **Total** | ** ** |
|                              |       |                                                          |       |   |   |   |   |
| Net revenue                       |       | $                                                             | 6,663      |   | $ | 1,794 |   | $ | 8,457 |   |
| Cost of revenue                   |       | 3,730                                                         |       | 940 |   | 4,670 |   |
| Gross margin                      |       | 2,933                                                         |       | 854 |   | 3,787 |   |
|                              |       |                                                          |       |   |   |   |   |
| Operating  expenses:              |       |                                                          |       |   |   |   |   |
| Sales, marketing and support      |       | 2,076                                                         |       | 472 |   | 2,548 |   |
| General and administrative        |       | 545                                                           |       | 520 |   | 1,065 |   |
| Research and development          |       | 678                                                           |       | 2,188 |   | 2,866 |   |
| Amortization of intangible assets |       | 75                                                            |       | 52 |   | 127 |   |
|                              |       | 3,374                                                         |       | 3,232 |   | 6,606 |   |
| Loss from  operations             |       | $                                                             | (441       | ) | $ | (2,378 | ) | $ | (2,819 | ) |

 
|                                   | ** ** | **Six Months Ended June 30, 2006** | ** ** |
|-----------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                        | ** ** | **Systems**                                                 | ** ** | **Semiconductor** | ** ** | **Total** | ** ** |
|                              |       |                                                        |       |   |   |   |   |
| Net revenue                       |       | $                                                           | 12,415     |   | $ | 3,175 |   | $ | 15,590 |   |
| Cost of revenue                   |       | 7,403                                                       |       | 1,735 |   | 9,138 |   |
| Gross margin                      |       | 5,012                                                       |       | 1,440 |   | 6,452 |   |
|                              |       |                                                        |       |   |   |   |   |
| Operating  expenses:              |       |                                                        |       |   |   |   |   |
| Sales, marketing and support      |       | 3,659                                                       |       | 963 |   | 4,622 |   |
| General and administrative        |       | 1,150                                                       |       | 830 |   | 1,980 |   |
| Research and development          |       | 1,334                                                       |       | 4,513 |   | 5,847 |   |
| Amortization of intangible assets |       | 157                                                         |       | 97 |   | 254 |   |
|                              |       | 6,300                                                       |       | 6,403 |   | 12,703 |   |
| Loss from  operations             |       | $                                                           | (1,288     | ) | $ | (4,963 | ) | $ | (6,251 | ) |

 

16

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|                                   | ** ** | **Three Months Ended June 30, 2005** | ** ** |
|-----------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                        | ** ** | **Systems**                                                   | ** ** | **Semiconductor** | ** ** | **Total** | ** ** |
|                              |       |                                                          |       |   |   |   |   |
| Net revenue                       |       | $                                                             | 5,278      |   | $ | 855 |   | $ | 6,133 |   |
| Cost of revenue                   |       | 3,227                                                         |       | 517 |   | 3,744 |   |
| Gross margin                      |       | 2,051                                                         |       | 338 |   | 2,389 |   |
|                              |       |                                                          |       |   |   |   |   |
| Operating  expenses:              |       |                                                          |       |   |   |   |   |
| Sales, marketing and support      |       | 1,417                                                         |       | 334 |   | 1,751 |   |
| General and administrative        |       | 630                                                           |       | 364 |   | 994 |   |
| Research and development          |       | 966                                                           |       | 2,375 |   | 3,341 |   |
| Amortization of intangible assets |       | 82                                                            |       | 45 |   | 127 |   |
|                              |       | 3,095                                                         |       | 3,118 |   | 6,213 |   |
| Loss from  operations             |       | $                                                             | (1,044     | ) | $ | (2,780 | ) | $ | (3,824 | ) |

 
|                                   | ** ** | **Six Months Ended June 30, 2005** | ** ** |
|-----------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                        | ** ** | **Systems**                                                 | ** ** | **Semiconductor** | ** ** | **Total** | ** ** |
|                              |       |                                                        |       |   |   |   |   |
| Net revenue                       |       | $                                                           | 10,242     |   | $ | 1,346 |   | $ | 11,588 |   |
| Cost of revenue                   |       | 6,668                                                       |       | 776 |   | 7,444 |   |
| Gross margin                      |       | 3,574                                                       |       | 570 |   | 4,144 |   |
|                              |       |                                                        |       |   |   |   |   |
| Operating  expenses:              |       |                                                        |       |   |   |   |   |
| Sales, marketing and support      |       | 2,510                                                       |       | 665 |   | 3,175 |   |
| General and administrative        |       | 1,292                                                       |       | 703 |   | 1,995 |   |
| Research and development          |       | 2,048                                                       |       | 5,235 |   | 7,283 |   |
| Amortization of intangible assets |       | 178                                                         |       | 98 |   | 276 |   |
|                              |       | 6,028                                                       |       | 6,701 |   | 12,729 |   |
| Loss from  operations             |       | $                                                           | (2,454     | ) | $ | (6,131 | ) | $ | (8,585 | ) |

 

**14.****                               RecentAccounting Pronouncements**

In February 2006,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards No. 155, “*Accounting for CertainHybrid Instruments – an amendment of FASB Statements No. 133 and 140*”(“SFAS 155”). SFAS 155 amends SFAS 133, “*Accounting for DerivativeInstruments and Hedging Activities”*and SFAS No. 140*“Accounting for Transfers and Servicing of Financial Assets andExtinguishments of Liabilities”.*SFAS 155 gives entities the optionof applying fair value accounting to certain hybrid financial instruments**in their entirety if they contain certain embeddedderivatives that would otherwise require bifurcation under SFAS 133. SFAS 155will be effective as of January 1, 2007. Focus is currently assessing theimpact that SFAS 155 may have on its consolidated financial statements.

In June 2006,the FASB issued FASB Interpretation No. 48 *“AccountingFor Uncertain Tax Positions – An Interpretation of FASB Statement No. 109”*(“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxesrecognized in an enterprise’s financial statements in accordance with FASBStatement No. 109 “Accounting for Income Taxes”*.*It prescribes a recognition threshold and measurementattribute for the financial statement recognition and measurement of a taxposition taken or expected to be taken in a tax return. FIN 48 also providesguidance on derecognition, classification, interest and penalties, accountingin interim periods, disclosure, and transition. FIN 48 is effective for fiscalyears beginning after December 15, 2006. Focus is currently evaluating theimpact of FIN 48 to its financial position and results of operations.

17

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####  

#### **Item 2. Management’s Discussion and Analysis of Financial Condition andResults of Operations**

The following informationshould be read in conjunction with the condensed consolidated financialstatements and notes thereto in Part I, Item 1 of this Quarterly Report andwith Management’s Discussion and Analysis of Financial Condition and Results ofOperations contained in Focus’ Annual Report on Form 10-K for the year endedDecember 31, 2005 and Item 1A—”Risk Factors”—contained therein.

**Certain Factors That May AffectFuture Results**

Discussions of certain matters in this Quarterly Report on Form 10-Q mayconstitute forward-looking statements within the meaning of the Section 27A ofthe Securities Act of 1933, as amended, and Section 21E of the Securities andExchange Act of 1934, as amended (the “Exchange Act”), and as such, may involverisks and uncertainties.  Forward-lookingstatements, which are based on certain assumptions and describe future plans,strategies, and expectations, are generally identifiable by the use of words orphrases such as “believe”, “plan”, “expect”, “intend”, “anticipate”, “estimate”,“project”, “forecast”, “may increase”, “may fluctuate”, “may improve” andsimilar expressions or future or conditional verbs such as “will”, “should”, “would”,and “could”.

In particular, statements contained in this document that are nothistorical facts (including, but not limited to, statements concerninganticipated revenues, anticipated operating expense levels, capital resourcesand liquidity outlook, potential new products and orders, and such expenselevels relative to our total revenues) constitute forward-looking statementsand are made under the safe harbor provisions of the Private SecuritiesLitigation Reform Act of 1995. Our actual results of operations and financialcondition have varied and may in the future vary significantly and materiallyfrom those stated in any forward-looking statements.  Factors that may cause such differencesinclude, without limitation, the availability of capital to fund our futurecash needs, reliance on major customers, history of operating losses, marketacceptance of our products, technological obsolescence, competition, successfulintegration of acquisitions, component supply problems and protection of proprietaryinformation, the unpredictability of costs to develop new technologies, as wellas the accuracy of our internal estimates of revenue and operating expenselevels.  For a discussion of thesefactors and some of the factors that might cause such a difference see alsoItem 1A of our Form 10-K under the heading “Risk Factors” and those describedfrom time to time in our other reports filed with the Securities and ExchangeCommission.  These factors should beconsidered in evaluating the forward-looking statements, and undue relianceshould not be placed on such statements. We do not undertake, and specificallydisclaim any obligation, to update any forward-looking statements to reflectoccurrences or unanticipated events or circumstances after the date of suchstatements except as required by law.

18

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**RESULTS OF OPERATIONS**

#### **Net revenue**

|                                      | ** ** | **Three Months Ended** | ** ** | ** **                  | ** ** | ** **   | ** ** |
|--------------------------------------|------------|----------------------------------|------------|-----------------------------|------------|--------------|------------|
| **(Dollars in thousands)** | ** ** | **June 30, 2006**      | ** ** | **June 30, 2005** | ** ** | **Increase** | ** ** | **% increase** | ** ** |
|                                 |       |                             |       |                        |       |         |       |   |   |
| System products                      |       | $                                | 6,663      |                        | $          | 5,278        |       | $ | 1,385 |   | 26.2 | % |
| Semiconductor  products              |       | 1,794                            |       | 855                         |       | 939          |       | 109.8 | % |
|                                 |       |                             |       |                        |       |         |       |   |   |
|                                 |       | $                                | 8,457      |                        | $          | 6,133        |       | $ | 2,324 |   | 37.9 | % |

 
|                                      | ** ** | **Six Months Ended** | ** ** | ** **                  | ** ** | ** **   | ** ** |
|--------------------------------------|------------|--------------------------------|------------|-----------------------------|------------|--------------|------------|
| **(Dollars in thousands)** | ** ** | **June 30, 2006**    | ** ** | **June 30, 2005** | ** ** | **Increase** | ** ** | **% increase** | ** ** |
|                                 |       |                           |       |                        |       |         |       |   |   |
| System products                      |       | $                              | 12,415     |                        | $          | 10,242       |       | $ | 2,173 |   | 21.2 | % |
| Semiconductor  products              |       | 3,175                          |       | 1,346                       |       | 1,829        |       | 135.9 | % |
|                                 |       |                           |       |                        |       |         |       |   |   |
|                                 |       | $                              | 15,590     |                        | $          | 11,588       |       | $ | 4,002 |   | 34.5 | % |

 

Revenue for the threemonths ended June 30, 2006 was $8.5 million, an increase of $2.3 million, or 38%,compared with the three months ended June 30, 2005.  Revenue for the six months ended June 30,2006 was $15.6 million, an increase of $4.0 million, or 35%, compared with thesix months ended June 30, 2006.

For the three monthsended June 30, 2006, net sales of system products to distributors, retailersand Value Added Resellers, were approximately $6.7 million compared to $5.3million for the same period in 2005, an increase of $1.4 million. For the sixmonths ended June 30, 2006, net sales of our system products were approximately$12.4 million compared to $10.2 million for the same period in 2005, anincrease of $2.2 million. This increase in sales of systems products mainlyreflects sales of our FS-4, which was introduced in the first quarter of 2005,and the release of high definition variations of the FS-4 in the first quarterof 2006. Offsetting this increase were decreased sales of our mature mixer andconsumer scan conversion products.

Sales of semiconductorproducts to distributors and OEM customers were approximately $1.8 million inthe three months ended June 30, 2006, compared to $855,000 for the same periodin 2005, an increase of $939,000. For the six months ended June 30, 2006, salesof our semiconductor products were approximately $3.2 million compared to $1.3million for the same period in 2005, an increase of $1.8 million. This increasereflects continued increasing demand by our customers incorporating our videoconvergence chips in their portable media player (PMP) designs.

As of June 30, 2006, wehad a sales order backlog of approximately $8.8 million, an increase of $6.0million when compared to the first quarter of 2006. The increase in sales orderbacklog primarily reflects orders for our personal media player videoconvergence chips as our customers ramp up for the holiday season.

Sales to twocustomers accounted for 36% of Focus’s revenue in the three month ended June30, 2006.  Sales to two customersaccounted for 25% of Focus’s revenue in the six months ended June 30, 2006. Sales to one customer accounted for 10% ofour revenue in the three months ended June 30, 2005.  No customer accounted for more than 10% ofour revenue in the six months ended June 30, 2005.

19

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#### **Gross margin**

|                                      | ** ** | **Three Months Ended** | ** ** | ** **                  | ** ** |
|--------------------------------------|------------|----------------------------------|------------|-----------------------------|------------|
| **(Dollars in thousands)** | ** ** | **June 30, 2006**      | ** ** | **June 30, 2005** | ** ** | **Increase** | ** ** |
|                                 |       |                             |       |                        |       |   |   |
| Gross margin                         |       | $                                | 3,787      |                        | $          | 2,389 |   | $ | 1,398 |   |
|                                 |       |                             |       |                        |       |   |   |
| Gross margin rate                    |       | 44.8                             | %          | 39.0                        | %          | 5.8 percentage points |   |
|                                      |            |                                  |            |                             |            |  |  |  |  |  |

 
|                                      | ** ** | **Six Months Ended** | ** ** | ** **                  | ** ** |
|--------------------------------------|------------|--------------------------------|------------|-----------------------------|------------|
| **(Dollars in thousands)** | ** ** | **June 30, 2006**    | ** ** | **June 30, 2005** | ** ** | **Increase** | ** ** |
|                                 |       |                           |       |                        |       |   |   |
| Gross margin                         |       | $                              | 6,452      |                        | $          | 4,144 |   | $ | 2,308 |   |
|                                 |       |                           |       |                        |       |   |   |
| Gross margin rate                    |       | 41.4                           | %          | 35.8                        | %          | 5.6 percentage points |   |
|                                      |            |                                |            |                             |            |  |  |  |  |  |

 

Our gross marginrate for the three months ended June 30, 2006 increased to 44.8% from 39.0% forthe three months ended June 30, 2005, an increase of 5.8 percentage points. Ourgross margin rate in the six months ended June 30, 2006 increased to 41.4% from35.8% in the six months ended June 30, 2005, an increase of 5.6 percentagepoints. This increase in the gross margin rate mainly reflects an increase insales of our higher margin Direct to Edit (DTE) HD recorders and semiconductorchips and an increase in overall sales volume. 

**Operatingexpenses**
|                                      | ** ** | **Three Months Ended** | ** ** | ** **                  | ** ** | ** **                          | ** ** |
|--------------------------------------|------------|----------------------------------|------------|-----------------------------|------------|-------------------------------------|------------|
| ** **                           | ** ** | **June 30, 2006**      | ** ** | **June 30, 2005** | ** ** | **Increase / (Decrease)** | ** ** |
| ** **                           | ** ** | ** **                       | ** ** | **% of**               | ** ** | ** **                          | ** ** | **% of** | ** ** | ** ** | ** ** | **% of** | ** ** |
| **(Dollars in thousands)** | ** ** | ** **                       | ** ** | **revenue**                 | ** ** | ** **                          | ** ** | **revenue** | ** ** | ** ** | ** ** | **revenue** | ** ** |
|                                 |       |                             |       |                        |       |                                |       |   |   |   |   |   |   |
| Sales, marketing  and support        |       | $                                | 2,548      |                        | 30.1       | %                                   | $          | 1,751 |   | 28.6 | % | $ | 797 |   | 1.5 | % |
| General and  administrative          |       | 1,065                            |       | 12.6                        | %          | 994                                 |       | 16.2 | % | 71 |   | -3.6 | % |
| Research and  development            |       | 2,866                            |       | 33.9                        | %          | 3,341                               |       | 54.5 | % | (475 | ) | -20.6 | % |
| Amortization of  intangible assets   |       | 127                              |       | 1.5                         | %          | 127                                 |       | 2.1 | % | — |   | -0.6 | % |
|                                 |       |                             |       |                        |       |                                |       |   |   |   |   |   |   |
|                                 |       | $                                | 6,606      |                        | 78.1       | %                                   | $          | 6,213 |   | 101.3 | % | $ | 393 |   | -23.2 | % |

 
|                                      | ** ** | **Six Months Ended** | ** ** | ** **                  | ** ** | ** **                          | ** ** |
|--------------------------------------|------------|--------------------------------|------------|-----------------------------|------------|-------------------------------------|------------|
| ** **                           | ** ** | **June 30, 2006**    | ** ** | **June 30, 2005** | ** ** | **Increase / (Decrease)** | ** ** |
| ** **                           | ** ** | ** **                     | ** ** | **% of**               | ** ** | ** **                          | ** ** | **% of** | ** ** | ** ** | ** ** | **% of** | ** ** |
| **(Dollars in thousands)** | ** ** | ** **                     | ** ** | **revenue**                 | ** ** | ** **                          | ** ** | **revenue** | ** ** | ** ** | ** ** | **revenue** | ** ** |
|                                 |       |                           |       |                        |       |                                |       |   |   |   |   |   |   |
| Sales, marketing  and support        |       | $                              | 4,622      |                        | 29.6       | %                                   | $          | 3,175 |   | 27.4 | % | $ | 1,447 |   | 2.2 | % |
| General and  administrative          |       | 1,980                          |       | 12.7                        | %          | 1,995                               |       | 17.2 | % | (15 | ) | -4.5 | % |
| Research and  development            |       | 5,847                          |       | 37.5                        | %          | 7,283                               |       | 62.8 | % | (1,436 | ) | -25.3 | % |
| Amortization of  intangible assets   |       | 254                            |       | 1.6                         | %          | 276                                 |       | 2.4 | % | (22 | ) | -0.8 | % |
|                                 |       |                           |       |                        |       |                                |       |   |   |   |   |   |   |
|                                 |       | $                              | 12,703     |                        | 81.5       | %                                   | $          | 12,729 |   | 109.8 | % | $ | (26 | ) | -28.3 | % |

 

20

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Sales, marketing andsupport

Sales, marketing andsupport expenses for the three months ended June 30, 2006 were $2.5 million, anincrease of $797,000 million from $1.8 million in the three months ended June30, 2005. The increase in sales, marketing and support expenses mainly reflectsthe increase of trade show expenses of approximately $150,000 due to a largerbooth and floor space to present our expanded product line, an increase inpayroll and payroll-related expenses of $290,000 resulting from an increase inheadcount and an increase in commission and bonus expense primarily reflectingthe increase in sales revenue and an increase of $155,000 of consulting andtemporary help to assist with advertising, lead generation and web marketing.Additionally, advertising and direct marketing activity increased $65,000 overprior period. Stock-based compensation increased $30,000 over the prior period.

Sales, marketing andsupport expenses for the six months ended June 30, 2006 were $4.6 million, anincrease of $1.4 million from the six months ended June 30, 2005.  The increase in sales, marketing and supportexpenses mainly reflects an increase in payroll and payroll-related expenses ofover $610,000 resulting from an overall increase in headcount of nine employeesmainly in our Systems customer support department and Semiconductor salesdepartment, an increase in commission and bonus expense primarily reflectingthe increase in sales revenue and an increase of $185,000 in the use ofconsultants to assist with advertising, lead generation and web marketing.Trade show expenses increased $160,000 as a result of a larger booth and floorspace to present our expanded product line. Increased advertising and directmarketing resulted in additional marketing expenses of $190,000 during theperiod. Stock-based compensation increased $71,000 in the six months ended June30, 2006, compared with the six months ended June 30, 2005.

General andadministrative

General andadministrative expenses for the three months ended June 30, 2006 were $1.1million, an increase of $71,000 from $994,000 for the three months ended June30, 2005. The increase in general and administrative expenses was due to anincrease in payroll and payroll-related expenses of $40,000 resulting from anincrease in headcount and an increase in bonus expense and increased investorrelation fees of approximately $26,000.

General andadministrative expenses for the six months ended June 30, 2006 were $2.0million, a decrease of $15,000 from $2.0 million for the six months ended June30, 2005.  The increase in general andadministrative expenses was due to an increase in payroll and payroll-relatedexpenses of $40,000 resulting from an increase in headcount and bonus expense,additional stock-based compensation expense of $80,000 offset by a decrease inlegal and accounting fees of $92,000 and decreased recruiting fees of $36,000.

Research and development

Research and developmentexpenses for the three months ended June 30, 2006 were $2.9 million, a decreaseof $475,000 from $3.3 million for the three months ended June 30, 2005. Thedecrease in research and development expenses mainly reflects a decrease inpayroll and payroll-related expenses of $145,000 and a decrease in consultingexpenses of $760,000, partially offset by increased material and prototypingcharges of $440,000 related to our UWB initiative. The decrease in payroll andpayroll-related expenses is due to the classification of expenses related to acertain engineering project in cost of revenue and a lower average headcountduring the second quarter ended June 30, 2006 compared to the quarter endedJune 30, 2005. The decrease in consulting expense is due to the UWB developmentproject nearing completion. 

Research and developmentexpenses for the six months ended June 30, 2006 were $5.8 million, compared to$7.3 million for the six months ended June 30, 2005, a decrease of $1.4million. The decrease in research and development expenses mainly reflects adecrease in payroll and payroll-related expenses of $624,000 and a decrease inconsulting expenses of $1.8 million, partially offset by increased material andprototyping charges of $840,000 related to our UWB initiative and increasedstock-based compensation of $95,000. The decrease in payroll and payroll-relatedexpenses mainly reflects the classification of expenses related to a certainengineering project in cost of revenue and lower average headcount. Thedecrease in consulting expense is due to the UWB development project nearingcompletion.

21

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Amortization

Amortizationexpense was recorded as follows:
|                         | ** ** | **Three Months Ended** | ** ** | ** **                  | ** ** |
|-------------------------|------------|----------------------------------|------------|-----------------------------|------------|
| **(In thousands)** | ** ** | **June 30, 2006**      | ** ** | **June 30, 2005** | ** ** | **Increase / (Decrease)** | ** ** |
|                    |       |                             |       |                        |       |   |   |
| Cost of revenue         |       | $                                | 46         |                        | $          | 45 |   | $ | 1 |   |
| Operating  expenses     |       | 127                              |       | 127                         |       | — |   |
|                    |       |                             |       |                        |       |   |   |
|                    |       | $                                | 173        |                        | $          | 172 |   | $ | 1 |   |

 
|                         | ** ** | **Six Months Ended** | ** ** | ** **                  | ** ** |
|-------------------------|------------|--------------------------------|------------|-----------------------------|------------|
| **(In thousands)** | ** ** | **June 30, 2006**    | ** ** | **June 30, 2005** | ** ** | **Increase / (Decrease)** | ** ** |
|                    |       |                           |       |                        |       |   |   |
| Cost of revenue         |       | $                              | 91         |                        | $          | 90 |   | $ | 1 |   |
| Operating expenses      |       | 254                            |       | 276                         |       | (22 | ) |
|                    |       |                           |       |                        |       |   |   |
|                    |       | $                              | 345        |                        | $          | 366 |   | $ | (21 | ) |

 

Amortization expense forthe three months ended June 30, 2006 was $173,000, which was consistent withthe three months ended June 30, 2005. Amortization expense for the six months ended June 30, 2006 was$345,000, which decreased $21,000 from the six months ended June 30, 2005. Thedecrease in amortization expense reflects the completion of amortization forcertain intangibles associated with our acquisition of Videonics in January2001.

22

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**Non-OperatingItems**
|                                         | ** ** | **Three Months Ended** | ** ** | ** **                  | ** ** |
|-----------------------------------------|------------|----------------------------------|------------|-----------------------------|------------|
| **(Dollars in thousands)**    | ** ** | **June 30, 2006**      | ** ** | **June 30, 2005** | ** ** | **Increase / (Decrease)** | ** ** |
|                                    |       |                             |       |                        |       |   |   |
| Interest  expense, net                  |       | $                                | (292       | )                           | $          | (68 | ) | $ | 224 |   |
|                                    |       |                             |       |                        |       |   |   |
| Change in value  of derivative security |       | $                                | (1,761     | )                           | $          | — |   | $ | 1,761 |   |
|                                    |       |                             |       |                        |       |   |   |
| Other income (expense),  net            |       | $                                | (2         | )                           | $          | (40 | ) | $ | (38 | ) |

 
|                                         | ** ** | **Six Months Ended** | ** ** | ** **                  | ** ** |
|-----------------------------------------|------------|--------------------------------|------------|-----------------------------|------------|
| **(Dollars in thousands)**    | ** ** | **June 30, 2006**    | ** ** | **June 30, 2005** | ** ** | **Increase / (Decrease)** | ** ** |
|                                    |       |                           |       |                        |       |   |   |
| Interest  expense, net                  |       | $                              | (491       | )                           | $          | (81 | ) | $ | 410 |   |
|                                    |       |                           |       |                        |       |   |   |
| Value of  derivative security           |       | $                              | (4,000     | )                           | $          | — |   | $ | 4,000 |   |
|                                    |       |                           |       |                        |       |   |   |
| Change in value  of derivative security |       | $                              | (1,361     | )                           | $          | — |   | $ | 1,361 |   |
|                                    |       |                           |       |                        |       |   |   |
| Other income (expense),  net            |       | $                              | 68         |                        | $          | (40 | ) | $ | 108 |   |

 

Net interest expense forthe three months ended June 30, 2006 was $292,000, compared to $68,000 in thethree months ended June 30, 2005. Net interest expense for the six months endedJune 30, 2006 were $491,000 compared to $81,000 in the six months ended June30, 2005. The increase in net interest expense reflects interest expense onapproximately $13.4 million of debt at June 30, 2006 compared to debt ofapproximately $5.5 million in the same period a year ago.

The $4.0 millionderivative liability represents the fair value of the conversion optioncalculated in connection with the $10.0 million convertible notes issued inJanuary 2006. The value of the conversion option was bifurcated from the debthost contract and recorded as a derivative liability, which resulted in adiscount to the initial carrying amount of the convertible notes. The $4.0million discount was immediately expensed in the condensed consolidatedstatements of operations as value of derivative security as the notes may beconverted to common stock at any time after issuance.

Effective June 28, 2006,we amended certain agreements associated with the $10 million convertiblenotes, eliminating the derivative component. However, we were required torevalue the derivative liability as of the amendment date based on the closingprice of Focus’ common stock of $0.85, the remaining term coinciding with thecontract and a volatility of 83%. As such, we recorded a $1.8 million expensefor the change in the fair value of the derivative liability. With the eliminationof the derivative component, we reclassified the total derivative liability ofapproximately $5.4 million to additional paid-in capital.

The three monthchange in value of the derivative security represents the difference betweenthe fair value of the derivative liability at March 31, 2006 and the fair valueof the derivative liability at June 28, 2006. The revaluation of the derivativeliability resulted in a $1.7 million expense in the three months ended June 30,2006.

The six monthchange in value of the derivative security represents the difference betweenthe fair value of the derivative liability when the convertible notes wereissued and the fair value of the derivative liability at June 30, 2006. Therevaluation of the derivative liability resulted in a $1.3 million expense inthe six months ended June 30, 2006.

Other income (expense)for the three and six months ended June 30, 2006 consists mainly offluctuations associated with exchange rate differences related to transactionsdenominated in Euros.

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**LIQUIDITYAND CAPITAL RESOURCES**

The accompanyingcondensed consolidated financial statements have been prepared on a goingconcern basis, which contemplates the realization of assets and thesatisfaction of liabilities in the normal course of business. For the sixmonths ended June 30, 2006 and the year ended December 31, 2005, we incurrednet losses of $12.0 million and $15.4 million, respectively, and used cash inoperating activities of $7.9 million, and $12.5 million, respectively. These factorsindicate that we may potentially be unable to continue as a going concern.

The condensedconsolidated financial statements do not include any adjustments relating tothe recoverability and classification of recorded asset amounts or the amountsand classification of liabilities that might be necessary should we be unableto continue as a going concern. Our continuation as a going concern isdependent upon our ability to generate sufficient positive cash flows to meetour obligations on a timely basis, to obtain additional financing as may berequired, and ultimately to return to profitability.

Since inception, we havefinanced our operations primarily through the public and private sale of commonstock, lines of credit and debt borrowings from financial institutions,proceeds from the exercise of options and warrants, short-term borrowings fromprivate lenders and credit arrangements with vendors and suppliers. 
| (Dollars in thousands) | ** ** | **June 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|----------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
|                             |       |                        |       |                            |       |
| Cash and cash  equivalents       |       | $                           | 866        |                            | $          | 637 |   |
| Working capital  (deficit)       |       | $                           | 1,672      |                            | $          | (3,533 | ) |
| Days sales  outstanding (DSO)    |       | 49.2                        |       | 48.1                            |       |
| Inventory turns -  annualized    |       | 4.0                         |       | 4.1                             |       |

 
|                                            | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------|------------|--------------------------------|------------|
| ** **                                 | ** ** | **June 30, 2006**    | ** ** | **June 30, 2005** | ** ** |
|                                       |       |                           |       |   |   |
| Net cash used in  operating activities     |       | $                              | (7,885     | ) | $ | (6,092 | ) |
| Net cash used in  investing activities     |       | $                              | (296       | ) | $ | (209 | ) |
| Net cash provided by financing  activities |       | $                              | 8,404      |   | $ | 6,873 |   |

 

Net cash used inoperating activities
|                                    | ** ** | **Six Months Ended,** | ** ** | ** **                  | ** ** |
|------------------------------------|------------|---------------------------------|------------|-----------------------------|------------|
| ** **                         | ** ** | **June 30, 2006**     | ** ** | **June 30, 2005** | ** ** | **Change in** | ** ** |
| ** **                         | ** ** | **cash (used),**           | ** ** | **cash (used),**       | ** ** | **cash (used),** | ** ** |
| **(In thousands)**            | ** ** | **provided**                    | ** ** | **provided**                | ** ** | **provided** | ** ** |
|                               |       |                            |       |                        |       |   |   |
| Net loss                           |       | $                               | (12,044    | )                           | $          | (8,717 | ) | $ | (3,327 | ) |
| Non-cash income  statement items   |       | 6,433                           |       | 800                         |       | 5,620 |   |
|                               |       | (5,611                          | )          | (7,917                      | )          | 2,293 |   |
|                               |       |                            |       |                        |       |   |   |
| Changes in  assets and liabilities |       | (2,274                          | )          | 1,825                       |       | (4,086 | ) |
|                               |       |                            |       |                        |       |   |   |
|                               |       | $                               | (7,885     | )                           | $          | (6,092 | ) | $ | (1,793 | ) |

 

Net cash used inoperating activities for the six months ended June 30, 2006 and 2005 was $7.9million and $6.1 million, respectively. The increase in net cash used inoperating activities mainly reflects an increase in cash used for

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accounts receivable,inventories and other assets, partially offset by a decrease in the net lossadjusted for non-cash items and an increase in accounts payable and accruedliabilities. The increase in accounts receivable reflects an increase in salesin the six months ended June 30, 2006. The increase in inventories reflects theincreased sales forecast for the remainder of 2006. The increase in accountspayable and accrued liabilities mainly reflects timing of payments related toour UWB investment.

Three customers had accounts receivable balances in excess of 10% of ourtotal accounts receivable at June 30, 2006. These customers accounted for 43%of our total accounts receivable at that date. 

We expect that ouroperating cash flows may fluctuate in future periods as a result offluctuations in our operating results, shipment timetable and accountsreceivable collections, inventory management, and the timing of payments amongother factors.

Net cash used ininvesting activities

Net cash used ininvesting activities was $296,000 for the six months ended June 30, 2006,compared to $209,000 used in the six months ended June 30, 2005. The increasein cash used in investing activities mainly reflects an increase in purchasesof equipment for our semiconductor operations and purchases of design toolsprimarily related to our investment in UWB technology.

Net cash provided byfinancing activities

Net cash provided byfinancing activities was $8.4 million for the six months ended June 30, 2006,compared to $6.9 million for the six months ended June 30, 2005. The net cashprovided by financing activities in the six months ended June 30, 2006 mainlyconsists of proceeds of $10.0 million from the issuance of convertible notes,$3.0 million of borrowing under the line of credit and proceeds of $945,000from the exercise of stock options and warrants, partially offset by therepayment of $5.5 million associated with our term loan and line of credit. Thenet cash provided by financing activities in the six months ended June 30, 2005consisted of borrowings under lines of credit of $2.6 million, borrowings underthe term loan of $2.5 and net proceeds of $1.6 million from private placementof common stock which was partially offset by repayment of $360,000 under thelines of credit.

**CapitalResources and Liquidity Outlook**

We have incurred lossesand used net cash in operating activities for the six months ended June 30,2006 and each of the two years in the period ended December 31, 2005, and as such,have been dependent upon raising money for short- and long-term cash needsthrough debt, proceeds from the exercise of options and warrants, and the saleof our securities in private placements. 

For the year endedDecember 31, 2005, we received approximately $4.5 million in proceeds from thesale of approximately 7.4 million shares of our common stock in privateplacement transactions. 

In November 2004, weobtained a revolving $4.0 million bank credit line under which we can borrow upto 90% of our eligible outstanding accounts receivable, excluding accountsreceivable of COMO. Carl Berg, a Company director and shareholder, provided apersonal guarantee to secure this credit line. In connection with this creditline, the Greater Bay Bank obtained a first priority security interest on ouraccounts receivable through an agreement with Mr. Berg, which enabled Mr. Bergto retain his existing security interest in all of our assets whilesubordinating to Greater Bay Bank his security interest in our accountsreceivable. The bank credit line is subject to ongoing covenants, including acovenant related to operating results. Interest is payable under this loan at prime plus 1%. At June 30,2006, there was $3.0 million outstanding balance on this credit line and $1.0million was available to borrow. The credit line expires on December 24, 2006.

On June 28, 2005, wesigned a term loan agreement with Greater Bay Bank under which we can borrow up to $2.5million. The term loan has a maturity date of December 24, 2006, is interestonly until maturity and is in addition to our existing $4.0 million accountsreceivable based secured line of credit facility described above with this samebank. Interest is payable under this loan at prime plus 1%. At June 30, 2006,there was no outstanding balance under this term loan and the maximum amount of$2.5 million was available to borrow.

OnJanuary 27, 2006, we raised gross proceeds of $10.0 million from the issuanceof secured convertible notes to a group of private investors. On June 30, 2006,in accordance with the terms of the secured convertible notes, we

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issuedan additional $425,000 of convertible notes in lieu of a cash payment due on June30, 2006.  While we believe that thesefunds, along with the cash flow generated by our expanding Systems business,should be adequate to enable us to complete our UWB engineering development andlaunch commercialization of UWB products, depending upon the results and timingof our UWB initiative and the profitability of our Systems business, we mayneed to raise further capital in 2006. There can be no assurance thatsufficient funds will be raised. Moreover, any equity financing or convertibledebt financing would result in dilution to our existing stockholders and couldhave a negative effect on the market price of our common stock. Furthermore,any additional debt financing will result in higher interest expense.

 

Summary of Certain ContractualObligations as of June 30, 2006

 
| (In thousands)                                | ** ** | **< 1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **Total** | ** ** |
|----------------------------------------------------|------------|---------------------------|------------|--------------------|------------|--------------------|------------|-----------|------------|
|                                               |       |                      |       |               |       |               |       |      |       |
| Capital and  operating leases (including interest) |       | $                         | 658        |               | $          | 637                |       | $         | 211        |   | $ | 1,506 |   |
| Line of credit                                     |       | 3,000                     |       | —             |       | —             |       | 3,000     |       |
| Inventory  purchase commitments                    |       | 4,600                     |       | —             |       | —             |       | 4,600     |       |
| Convertible  notes                                 |       | —                    |       | —             |       | 10,425             |       | 10,425    |       |
| Interest expense  on convertible notes             |       | 1,068                     |       | 3,448              |       | 578                |       | 5,094     |       |
|                                               |       |                      |       |               |       |               |       |      |       |
|                                               |       | $                         | 9,326      |               | $          | 4,085              |       | $         | 11,214     |   | $ | 24,625 |   |

 

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**Item 3.Quantitative and Qualitative Disclosures about Market Risk**

**Interest Rate Risk**

AtJune 30, 2006, we did not hold any short-term investments that would be exposedto market risk from adverse movements in interest rates.

At June 30, 2006, our outstanding debt obligations consisted of secured convertible notes of $10.4  million – see Note 9, “Borrowings”. A fixed interest rate is applicable to these debt obligations of 10.0% per annum.

**Foreign Currency Risk**

Gains or losses related to foreign exchange currency transactions werenot material for the periods ended June 30, 2006 and 2005.

**Item 4.Controls and Procedures**

Management of theCompany, with the participation of the President and Chief Executive Officerand the Chief Financial Officer (its principal executive officer and principalfinancial officer, respectively), evaluated our disclosure controls andprocedures as of the end of the period covered by this Report.

Based on thatevaluation, the President and Chief Executive Officer and the Chief FinancialOfficer have concluded that, as of the end of the period covered by thisReport, our disclosure controls and procedures, as defined in Rule 13a-15(e) ofthe Securities and Exchange Act of 1934, as amended, are effective.

There was no change inour internal control over financial reporting that occurred during our secondfiscal quarter of 2006 that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

We will be required toevaluate our internal controls over financial reporting and prepare amanagement assessment on our internal controls in order to comply with therequirements of the Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act of 2002requires that the management assessment of our internal controls be audited. Weestimate the cost of meeting these requirements will be approximately $750,000.We will be required to meet these requirements by December 31, 2007.

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**PART II - OTHER INFORMATION**

**Item 1.****                                LegalProceedings**

From time to time, Focus is party to certain otherclaims and legal proceedings that arise in the ordinary course of business ofwhich, in the opinion of management, do not have a material adverse effect onFocus’ financial position or results of operation.

**Item1A.**        Risk Factors

**Except as described below, there have been no materialchanges to our risk factors disclosed in our Annual Report on Form 10-K for theyear ended December 31, 2005. You should carefully consider the risksidentified therein any of which could materially affect our business, financialcondition or future results as well as the following risk factors.**

**From November 2005 toearly May 2006 and late May 2006 to mid July 2006, our common stock did notmeet the minimum bid price requirement to remain listed on the Nasdaq CapitalMarket. If we were to be delisted, it could make trading in our stock moredifficult.**

Our voting common stock is traded on the Nasdaq Capital Market. Thereare various quantitative listing requirements for a company to remain listed onthe Nasdaq Capital Market, including maintaining a minimum bid price of $1.00per share of common stock and maintaining stockholders’ equity of $2.5 million.On June 27, 2006, theNasdaq Stock Market notified us that for the previous 30 consecutive businessdays, the bid price of our common stock had closed below the minimum $1.00 pershare price requirement for continued inclusion under Nasdaq Marketplace Rules.We were given until December 26, 2006 to regain compliance with the Nasdaq Capital Market $1.00 minimum bid pricerule. On July 28, 2006, we received notification fromNasdaq that we had regained compliance and the matter was closed.

At June 30, 2006, we had total stockholders’ equity of $6.2 million. Tothe extent we incur net losses and do not raise additional capital, ourstockholders’ equity will be reduced.

If the minimum bid price of our common stock were to close below $1.00for 30 consecutive days, we would likely again receive notification from the Nasdaq Capital Market that wewere not in compliance with the $1.00 minimum bid price rule. If we do notregain compliance within the allotted compliance period, including anyextensions that may be granted by the Nasdaq Capital Market, the Nasdaq CapitalMarket would notify us that our common stock would be delisted from the NasdaqCapital Market, eliminating the only established tradingmarket for our shares.We would then be entitled to appeal this determination to a Nasdaq ListingQualifications Panel and request a hearing.

In the event we are delisted from the Nasdaq CapitalMarket, we would be forced to list our shares on the OTC Electronic BulletinBoard or some other quotation medium, such as the pink sheets, depending on ourability to meet the specific listing requirements of those quotation systems.As a result, an investor might find it more difficult to trade, or to obtainaccurate price quotations for, such shares. Delisting might also reduce thevisibility, liquidity, and price of our voting common stock.

**We have a significantamount of convertible securities that will dilute existing stockholders uponconversion.**

At August 8, 2006, we had 3,161 shares of preferred shares issued andoutstanding, 5,195,261 warrants and 6,808,471 options outstanding, and $10.4million of convertible notes outstanding, which are all exercisable into sharesof common stock. The 3,161 shares of preferred stock are convertible into3,161,000 shares of our voting common stock and the convertible notes areconvertible into 10,425,000 shares of common stock. Furthermore, at August 8,2006, 478,057 additional shares of common stock were available for grant to ouremployees, officers, directors and consultants under our current stock optionand incentive plans. We also may issue additional shares in acquisitions andadditional convertible notes as interest payments on our outstandingconvertible notes. Any additional grant of options under existing or futureplans or issuance of shares in connection with an acquisition or issuance ofadditional convertible notes will further dilute existing stockholders.

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**Item 2.****           UnregisteredSales of Equity Securities and Use of Proceeds**

On April 7, 2006, we issued a warrant to Marketing By Design, to purchase30,000 shares of our common stock at a purchase price of $0.79 per share formarketing services. The warrant was issued pursuant to section 4(2) of theSecurities Act based on the nature of the investor and certain representationsmade to us. The warrant was immediately exercisable and expires four years fromthe date of grant.

**Item 3.****           DefaultsUpon Senior Securities**

None.

#### **Item 4.****           Submission of Matters to a Vote of SecurityHolders**

#### None.

**Item 5.****           OtherInformation**

None.

**Item 6.****           Exhibits**

Exhibit 10.1 - Amendment to Senior Secured Convertible Note PurchaseAgreement, effective June 28, 2006 (incorporated by reference from our Form 8-Kfiled on August 2, 2006)

Exhibit 10.2- Amendment to Registration Rights Agreement, effective June28, 2006 (incorporated by reference from our Form 8-K filed on August 2, 2006)

Exhibit 31.1 - Rule 13a-14(a) Certification of CEO

Exhibit 31.2 - Rule 13a-14(a) Certification of CFO

Exhibit 32.1 – CEO906 Certification

Exhibit 32.2 – CFO 906 Certification

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**SIGNATURES**

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

 
| August 14, 2006 |                                  | Focus  Enhancements, Inc.  |   |
|-----------------|---------------------------------------|----------------------------|--------|
| Date            |                                  | Registrant                 |   |
|            |                                  |
|            | By:                                   | /s/ Brett A. Moyer         |   |
|            | Brett A. Moyer                        |
|            | Chief Executive Officer and President |
|            | (Principal Executive Officer)         |
|            |                                  |
|            |                                  |
|            | By:                                   | /s/  Gary L. Williams |   |
|            | Gary L. Williams                      |
|            | Executive Vice President of Finance,  |
|            | Chief Financial Officer               |
|            | (Principal Accounting Officer)        |
|                 |                                       |                            |        |  |  |

 

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