** **

**U. S. SECURITIES ANDEXCHANGE COMMISSION**

**Washington, D.C. 20549**

**FORM 10-Q**

** **

**x**QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**For the quarterly period ended September 30, 2007, or**

**o**TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGEACT OF 1934

**For the transition period from                to                 .**

**Commission File Number 1-11860**

**Focus Enhancements, Inc.**

(Name of Issuer in its Charter)

| **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 Principal ExecutiveOffices)

**(408) 866-8300**

(Issuer’s Telephone Number,Including Area Code)

 

Check whether the Issuer (1) has filed all reports required to be filedby Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such other shorter period that the Registrant wasrequired to file such reports), and (2) has been subject to such filing requirementsfor the past 90 days.  Yes: x  No: o

 

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

Large accelerated filer: o Accelerated filer: o Non-accelerated filer: x

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b02 of the Exchange Act). Yes o  No: x

 

As of November 9, 2007,there were 84,644,297 shares of common stock outstanding.

 

 

----

**FOCUS ENHANCEMENTS, INC.**

**INDEX**

** **
| **PART  I - FINANCIAL INFORMATION** | **Page  Number**                                                                             |
|-------------------------------------|----------------------------------------------------------------------------------------------|
| ** **                          | ** **                                                                                   | ** ** | ** ** | ** ** |
| **Item  1.**                        | Financial  Statements (unaudited):                                                           | 3 |
|                                | Condensed Consolidated Balance Sheets                                                        | 3 |
|                                | Condensed Consolidated Statements of Operations                                              |   | 4 |
|                                | Condensed Consolidated Statements of Cash Flows                                              |   | 5 |
|                                | Notes to Condensed Consolidated Financial Statements                                         |   | 6 |
|                                |                                                                                         |   |   |   |
| **Item 2.**                         | Management’s Discussion and Analysis of Financial  Condition

and Results of Operations |   | 19 |
|                                |                                                                                         |   |   |   |
| **Item 3.**                         | Quantitative and Qualitative Disclosures about Market  Risk                                  |   | 27 |
|                                |                                                                                         |   |   |   |
| **Item 4T.**                        | 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                                                                                     | ** ** | 29 |
| ** **                          |                                                                                         |   | ** ** |   |
| **SIGNATURES**                      | 30                                                                                           |
|                                | ** **                                                                                   |   |
| **CERTIFICATIONS**                  |                                                                                         |

 

2

----

**PART I - FINANCIAL INFORMATION**

** **

**Item 1.    Financial Statements**

 

**Focus Enhancements, Inc.**

**Condensed Consolidated Balance Sheets**

(In thousands, except share and per share amounts)

(Unaudited)

 
| ** **                                                                                                                                                                                               | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|------------------|------------|
| ** **                                                                                                                                                                                               | ** ** | **2007**          | ** ** | **2006**         | ** ** |
| **Assets**                                                                                                                                                                                               | ** ** | ** **        | ** ** | ** **       | ** ** |
| Current assets:                                                                                                                                                                                          |       |              |       |             |       |
| Cash and cash equivalents                                                                                                                                                                                |       | $                 | 5,560      |             | $          | 5,969 |   |
| Accounts receivable, net of allowances of $266 and $304, respectively                                                                                                                                    |       | 4,583             |       | 4,188            |       |
| Inventories                                                                                                                                                                                              |       | 4,131             |       | 4,072            |       |
| Prepaid expenses and other current assets                                                                                                                                                                |       | 1,698             |       | 1,207            |       |
| Total current assets                                                                                                                                                                                     |       | 15,972            |       | 15,436           |       |
|                                                                                                                                                                                                     |       |              |       |             |       |
| Property and equipment, net                                                                                                                                                                              |       | 1,254             |       | 980              |       |
| Other assets                                                                                                                                                                                             |       | 173               |       | 187              |       |
| Intangible assets, net                                                                                                                                                                                   |       | —            |       | 186              |       |
| Goodwill                                                                                                                                                                                                 |       | 13,191            |       | 13,191           |       |
|                                                                                                                                                                                                     |       | $                 | 30,590     |             | $          | 29,980 |   |
| **Liabilities and Stockholders’  Equity**                                                                                                                                                           | ** ** | ** **        | ** ** | ** **       | ** ** |
| Current liabilities:                                                                                                                                                                                     |       |              |       |             |       |
| Accounts payable                                                                                                                                                                                         |       | $                 | 3,050      |             | $          | 3,424 |   |
| Accrued liabilities                                                                                                                                                                                      |       | 4,124             |       | 3,702            |       |
| Current portion of capital lease obligations                                                                                                                                                             |       | 119               |       | 10               |       |
| Borrowings under line of credit                                                                                                                                                                          |       | 4,000             |       | 3,390            |       |
| Term loan                                                                                                                                                                                                |       | 1,700             |       | 2,500            |       |
| Total current liabilities                                                                                                                                                                                |       | 12,993            |       | 13,026           |       |
|                                                                                                                                                                                                     |       |              |       |             |       |
| Convertible notes                                                                                                                                                                                        |       | 11,493            |       | 10,946           |       |
| Capital lease obligations, net of current portion                                                                                                                                                        |       | 32                |       | —           |       |
| Total liabilities                                                                                                                                                                                        |       | 24,518            |       | 23,972           |       |
|                                                                                                                                                                                                     |       |              |       |             |       |
| Commitments and contingencies (note 9)                                                                                                                                                                   |       |              |       |             |       |
|                                                                                                                                                                                                     |       |              |       |             |       |
| Stockholders’ equity:                                                                                                                                                                               |       |              |       |             |       |
| Preferred stock, $0.01 par value; authorized 3,000,000 shares; 3,161  shares issued and outstanding at September 30, 2007 and December 31, 2006,  respectively (aggregate liquidation preference $3,917) |       | —            |       | —           |       |
| Common stock, $0.01 par value; 150,000,000 shares authorized,  85,149,708 and 73,210,870 shares issued at September 30, 2007 and December  31, 2006, respectively                                        |       | 841               |       | 722              |       |
| Treasury stock at cost, 516,667 and 497,055 shares at September 30,  2007 and December 31, 2006, respectively                                                                                            |       | (775              | )          | (750             | )          |
| Additional paid-in capital                                                                                                                                                                               |       | 123,126           |       | 111,203          |       |
| Accumulated other comprehensive income                                                                                                                                                                   |       | 190               |       | 130              |       |
| Accumulated deficit                                                                                                                                                                                      |       | (117,310          | )          | (105,297         | )          |
| Total stockholders’ equity                                                                                                                                                                          |       | 6,072             |       | 6,008            |       |
|                                                                                                                                                                                                     |       | $                 | 30,590     |             | $          | 29,980 |   |
|                                                                                                                                                                                                          |            |                   |            |                  |            |  |  |  |  |  |

 

The accompanying notes are an integral part of the condensedconsolidated financial statements.

 

 

3

----

 

**Focus Enhancements, Inc.**

**Condensed Consolidated Statements of Operations**

(In thousands, except per share amounts)

(Unaudited)

 
| ** **                                                        | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|-------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                        | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** |
|                                                              |       |                   |       |                   |       |   |   |   |   |
| Net revenue                                                       |       | $                      | 7,770      |                   | $          | 11,605 |   | $ | 23,211 |   | $ | 27,195 |   |
| Cost of revenue                                                   |       | 4,282                  |       | 5,819                  |       | 12,647 |   | 14,957 |   |
| Gross margin                                                      |       | 3,488                  |       | 5,786                  |       | 10,564 |   | 12,238 |   |
|                                                              |       |                   |       |                   |       |   |   |   |   |
| Operating expenses:                                               |       |                   |       |                   |       |   |   |   |   |
| Sales, marketing and support                                      |       | 2,153                  |       | 2,131                  |       | 6,757 |   | 6,753 |   |
| General and administrative                                        |       | 1,077                  |       | 1,025                  |       | 3,222 |   | 3,005 |   |
| Research and development                                          |       | 3,497                  |       | 3,114                  |       | 11,414 |   | 8,961 |   |
| Amortization of intangible assets                                 |       | —                 |       | 127                    |       | 156 |   | 381 |   |
|                                                              |       | 6,727                  |       | 6,397                  |       | 21,549 |   | 19,100 |   |
| Loss from operations                                              |       | (3,239                 | )          | (611                   | )          | (10,985 | ) | (6,862 | ) |
| Interest expense, net                                             |       | (396                   | )          | (337                   | )          | (985 | ) | (828 | ) |
| Value of derivative liability                                     |       | —                 |       | —                 |       | — |   | (4,000 | ) |
| Change in value of derivative liability                           |       | —                 |       | —                 |       | — |   | (1,361 | ) |
| Other income (expense), net                                       |       | (3                     | )          | 82                     |       | (2 | ) | 150 |   |
| Loss before income tax expense                                    |       | (3,638                 | )          | (866                   | )          | (11,972 | ) | (12,901 | ) |
| Income tax expense                                                |       | 18                     |       | —                 |       | 41 |   | 9 |   |
| Net loss                                                          |       | $                      | (3,656     | )                      | $          | (866 | ) | $ | (12,013 | ) | $ | (12,910 | ) |
|                                                              |       |                   |       |                   |       |   |   |   |   |
| Net loss per share                                                |       |                   |       |                   |       |   |   |   |   |
| Basic and diluted                                                 |       | $                      | (0.05      | )                      | $          | (0.01 | ) | $ | (0.16 | ) | $ | (0.19 | ) |
|                                                              |       |                   |       |                   |       |   |   |   |   |
| Weighted average number of shares used in per share calculations: |       |                   |       |                   |       |   |   |   |   |
| Basic and diluted                                                 |       | 78,053                 |       | 69,233                 |       | 76,510 |   | 68,611 |   |
|                                                              |       |                   |       |                   |       |   |   |   |   |
|                                                                   |            |                        |            |                        |            |  |  |  |  |  |  |  |  |  |

 

Theaccompanying notes are an integral part of the condensed consolidated financialstatements.

 

4

----

 

**FocusEnhancements, Inc.**

**CondensedConsolidated Statements of Cash Flows**

(In thousands)

(Unaudited)

 

| ** **                                                                       | ** ** | **Nine Months Ended**  | ** ** |
|----------------------------------------------------------------------------------|------------|------------------------|------------|
|                                                                             |       | **September 30, 2007** |       | **September 30, 2006** |   |
| Cash flows from operating activities:                                            |       | ** **             |       |   |   |
| Net loss                                                                         |       | $                      | (12,013    | ) | $ | (12,910 | ) |
| Adjustments to reconcile net loss to net cash used in operating                  |       |                   |       |   |   |
| activities:                                                                      |       |                   |       |   |   |
| Depreciation and amortization                                                    |       | 759                    |       | 1,124 |   |
| Stock-based compensation                                                         |       | 713                    |       | 494 |   |
| Value of derivative liability                                                    |       | —                 |       | 4,000 |   |
| Change in value of derivative liability                                          |       | —                 |       | 1,361 |   |
| Accrued interest on convertible notes                                            |       | 838                    |       | 689 |   |
| Amortization of debt issuance costs                                              |       | 15                     |       | — |   |
| Changes in assets and liabilities:                                               |       |                   |       |   |   |
| Accounts receivable                                                              |       | (328                   | )          | (467 | ) |
| Inventories                                                                      |       | 44                     |       | (749 | ) |
| Prepaid expenses and other assets                                                |       | (504                   | )          | (638 | ) |
| Other assets                                                                     |       | 13                     |       | (123 | ) |
| Accounts payable                                                                 |       | (394                   | )          | 714 |   |
| Accrued liabilities                                                              |       | 38                     |       | 418 |   |
| Net cash used in operating activities                                            |       | (10,819                | )          | (6,087 | ) |
|                                                                             |       |                   |       |   |   |
| Cash flows from investing activities:                                            |       |                   |       |   |   |
| Purchases of property and equipment                                              |       | (607                   | )          | (412 | ) |
| Net cash used in investing activities                                            |       | (607                   | )          | (412 | ) |
|                                                                             |       |                   |       |   |   |
| Cash flows from financing activities:                                            |       |                   |       |   |   |
| Proceeds from issuance of convertible notes                                      |       | —                 |       | 10,000 |   |
| Net proceeds from private offerings of common stock                              |       | 11,098                 |       | — |   |
| Repayment of lines of credit                                                     |       | (5,590                 | )          | (2,966 | ) |
| Repayment of term loan                                                           |       | (5,000                 | )          | (2,500 | ) |
| Repayment of short-term debt                                                     |       | —                 |       | (3 | ) |
| Proceeds from exercise of common stock options and warrants, net  issuance costs |       | 207                    |       | 1,344 |   |
| Payments under capital lease obligations                                         |       | (92                    | )          | (93 | ) |
| Repurchase of common stock                                                       |       | (25                    | )          | — |   |
| Borrowings under term loan                                                       |       | 4,200                  |       | 700 |   |
| Borrowings under lines of credit                                                 |       | 6,200                  |       | 500 |   |
| Net cash provided by financing activities                                        |       | 10,998                 |       | 6,982 |   |
|                                                                             |       |                   |       |   |   |
| Effect of exchange rate changes on cash and cash equivalents                     |       | 19                     |       | 13 |   |
|                                                                             |       |                   |       |   |   |
| Increase (decrease) in cash and cash equivalents                                 |       | (409                   | )     | 496 |   |
| Cash and cash equivalents at beginning of period                                 |       | 5,969                  |       | 637 |   |
| Cash and cash equivalents at end of period                                       |       | $                      | 5,560      |   | $ | 1,133 |   |
|                                                                                  |            |                        |            |  |  |  |  |  |

 

Theaccompanying notes are an integral part of the condensed consolidated financialstatements.

 

5

----

 

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

** **

** **

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

 

Incorporated in 1992, FocusEnhancements, Inc. and its subsidiaries (the “Company” or “Focus”) develop andmarket proprietary video technology in two areas: semiconductor and systems.Semiconductor products include several series of Application SpecificIntegrated Circuits (“ASICs”), which address the wireless video and data marketusing Ultra Wideband (“UWB”) technology and the video convergence market. TheUWB ASICs are targeted for the wireless USB (Universal Serial Bus) market whilethe video convergence chips are deployed in portable media players, GPSnavigation devices, video conferencing systems, media center and interactive TVapplications. Focus systems products are designed to provide solutions for theprofessional video production market particularly for the video acquisition,media asset management and digital signage markets. Focus markets its systemsproducts primarily through the professional channel. Focus production productsinclude video scan converters, video mixers, standard and high definitiondigital video disk recorders, MPEG (Moving Picture Experts Group) recorders andfile format conversion tools. Focus media asset management systems productsinclude network-based video servers, long-duration program monitors andcapture/playout components. Focus digital signage and retail media solutionsproducts include standard and high definition MPEG players and servers. Focusmarkets its products globally to original equipment manufacturers (“OEMs”), anddealers and distributors in the consumer and professional channels.

 

 

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

 

The accompanying unaudited condensed consolidatedfinancial statements of Focus have been prepared in conformity with accountingprinciples generally accepted in the United States of America and with theinstructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, theydo not contain all of the information and footnotes required by accountingprinciples generally accepted in the United States of America for completefinancial statements. The year-end condensed consolidated balance sheet datawas derived from audited consolidated financial statements, but does not includeall disclosures required by accounting principles generally accepted in theUnited States of America.

 

In the opinion of management, the condensedconsolidated financial statements include all adjustments (consisting only ofnormal recurring adjustments) necessary for a fair presentation of Focus’financial position, operating results and cash flows for the periods presented.The results of operations and cash flows for the nine months ended September30, 2007 are not necessarily indicative of the results that may be expected forany future period.

 

The condensed consolidated financialstatements of Focus as of September 30, 2007 and for the three and nine-monthperiods ended September 30, 2007 and 2006 are unaudited and should be read inconjunction with the audited consolidated financial statements for the yearended December 31, 2006 included in Focus’ Annual Report on Form 10-K for theyear ended December 31, 2006.

 

 

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

 

Focus accounts forequity-based compensation in accordance with Statement of Financial AccountingStandards No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123R”),which the Company adopted as of January 1, 2006 using the modified prospectivemethod.

 

 

6

----

 

Theshare-based compensation recognized for the three and nine months endedSeptember, 2007 and 2006, respectively, was:

 

| ** **                                         | ** ** | **Three Months Ended**  | ** ** | **Nine Months Ended**   | ** ** |
|----------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| **(In thousands, except per share data)**          | ** ** | **September 30,  2007** | ** ** | **September 30,  2006** | ** ** | **September 30,   2007** | ** ** | **September 30,   2006** | ** ** |
| Stock-based compensation expense by type of award: |       |                    |       |                    |       |   |   |   |   |
| Employee stock options                             |       | $                       | 160        |                    | $          | 134 |   | $ | 454 |   | $ | 408 |   |
| Restricted stock awards                            |       | 83                      |       | 37                      |       | 233 |   | 86 |   |
| Total stock-based compensation                     |       | 243                     |       | 171                     |       | 687 |   | 494 |   |
|                                               |       |                    |       |                    |       |   |   |   |   |
| Tax effect on stock-based compensation             |       | —                  |       | —                  |       | — |   | — |   |
|                                               |       |                    |       |                    |       |   |   |   |   |
| Effect on net loss                                 |       | $                       | 243        |                    | $          | 171 |   | $ | 687 |   | $ | 494 |   |
|                                               |       |                    |       |                    |       |   |   |   |   |
| Effect on net loss per share - basic and diluted   |       | $                       | 0.00       |                    | $          | 0.00 |   | $ | 0.01 |   | $ | 0.01 |   |

 

 

StockOptions

 

The exercise price of each stock option equals the market price ofFocus’ common stock on the date of grant. Option grants generally vest overfour years and expire 10 years from the grant date. The fair value of eachoption grant is estimated on the date of grant using the Black-Scholes optionpricing model. The weighted average assumptions used in the model are outlinedin the following table:

 

| ** **                       | ** ** | **Three Months Ended**  | ** ** | **Nine Months Ended**   | ** ** |
|----------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                       | ** ** | **September 30,  2007** | ** ** | **September 30,  2006** | ** ** | **September 30,  2007** | ** ** | **September 30,   2006** | ** ** |
| Average expected term of options |       | 4  years                |       | 4  years                |       | 4  years |   | 4  years |   |
| Risk-free rate of interest       |       | 4.61                    | %          | 4.92                    | %          | 4.59 | % | 4.72 | % |
| Volatility of common stock       |       | 76                      | %          | 81                      | %          | 80 | % | 81 | % |
| Dividend yield                   |       | 0                       | %          | 0                       | %          | 0 | % | 0 | % |

 

 

The zero dividend yield is based on the fact that theCompany has never paid cash dividends and has no present intention to pay cashdividends. Expected volatility is based on the combination of historicalvolatility of the Company’s common stock and the expected moderation in futurevolatility over the period commensurate with the expected life of the optionsand other factors. The risk-free interest rates are taken from the DailyFederal Yield Curve Rates as of the grant dates as published by the FederalReserve and represent the yields on actively traded Treasury securities forterms equal to the expected term of the options. The expected term calculationis based on the Company’s observed historical option exercise behavior andpost-vesting forfeitures of options by employees.

 

 

7

----

 

A summary of activity related to Focus’ stockoption incentive plans for the nine months ended September 30, 2007 ispresented below:

 
| ** **                                                                | ** ** | **Shares** | ** ** | **Weighted Average Exercise Price** | ** ** | **Weighted Average Remaining Contractual Life** | ** ** | **Aggregate Intrinsic Value (000s)** | ** ** |
|---------------------------------------------------------------------------|------------|------------|------------|-------------------------------------|------------|-------------------------------------------------|------------|--------------------------------------|------------|
| Options outstanding at January 1, 2007                                    |       | 5,479,537  |       | $                                   | 1.15       |                                            |       |                                 |       |   |
| Options granted                                                           |       | 1,161,274  |       | $                                   | 1.28       |                                            |       |                                 |       |   |
| Options exercised                                                         |       | (70,706    | )          | $                                   | 1.13       |                                            |       |                                 |       |   |
| Options canceled                                                          |       | (926,000   | )          | $                                   | 1.18       |                                            |       |                                 |       |   |
|                                                                      |       |       |       |                                |       |                                            |       |                                 |       |
| Options outstanding at September 30, 2007                                 |       | 5,644,105  |       | $                                   | 1.17       |                                            | 6.2        |                                 | $          | 242 |   |
|                                                                      |       |       |       |                                |       |                                            |       |                                 |       |
| Options exercisable and expected to be exercisable at September 30,  2007 |       | 5,376,578  |       | $                                   | 1.17       |                                            | 6.1        |                                 | $          | 231 |   |
|                                                                      |       |       |       |                                |       |                                            |       |                                 |       |
| Options exercisable at September 30, 2007                                 |       | 3,410,077  |       | $                                   | 1.22       |                                            | 5.6        |                                 | $          | 153 |   |

 

 

The weightedaverage grant date fair value of options granted during the three and ninemonths ended September 30, 2007 was $0.55 and $0.79 per share, respectively.The intrinsic value of options exercised during the nine months ended September30, 2007 was $17,000. No options were exercised in the three month period endedSeptember 30, 2007. At September 30, 2007, Focus had $1,060,000 of unrecognizedcompensation expense, net of estimated forfeitures, related to unvested stockoptions, which will be recognized over the weighted average period of 2.0years. Cash received from stock option exercises was $80,000 for the ninemonths ended September 30, 2007.

 

The weightedaverage grant date fair value of options granted in the three and nine monthsended September 30, 2006 was $0.72 and $0.51 per share, respectively. Theintrinsic value of options exercised during the three and nine months endedSeptember 30, 2006 was $145,000 and $194,000, respectively. Cash received fromstock option exercises was $399,000 and $856,000 for the three and nine monthsended September 30, 2006, respectively.

 

The optionsoutstanding and exercisable at September 30, 2007 were in the followingexercise price ranges:

 
| ** **                        | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**                   | ** ** |
|-----------------------------------|------------|-------------------------|------------|-------------------------------------------|------------|
| **Range of Exercise Prices**      | ** ** | **Outstanding**         | ** ** | **Weighted Average Remaining Life (Yrs)** | ** ** | **Weighted Average Exercise Price** | ** ** | **Exercisable** | ** ** | **Weighted Average Exercise Price** | ** ** |
| $0.43-$0.97                       |       | 1,218,488               |       | 6.0                                       |       | $ | 0.72 |   | 707,058 |   | $ | 0.70 |   |
| $0.97-$1.43                       |       | 3,550,901               |       | 6.8                                       |       | $ | 1.20 |   | 1,872,090 |   | $ | 1.21 |   |
| $1.43-$1.97                       |       | 792,380                 |       | 4.0                                       |       | $ | 1.62 |   | 748,593 |   | $ | 1.63 |   |
| $1.97-$5.75                       |       | 82,336                  |       | 5.1                                       |       | $ | 2.21 |   | 82,336 |   | $ | 2.21 |   |
|                              |       |                    |       |                                      |       |   |   |   |   |   |   |
| Outstanding at September 30, 2007 |       | 5,644,105               |       | 6.2                                       |       | $ | 1.17 |   | 3,410,077 |   | $ | 1.22 |   |

 

 

At September 30, 2007,Focus had 1,928,567 shares of common stock available for grant under itscurrent stock option and incentive plans, which include restricted stock.

 

 

8

----

 

RestrictedStock Awards

 

A summary of activity related to Focus’restricted stock awards for the nine months ended September 30, 2007 ispresented below:

 

| ** **                                                           | ** ** | **Shares** | ** ** | **Weighted Average  Grant Date  Fair Value** | ** ** |
|----------------------------------------------------------------------|------------|------------|------------|----------------------------------------------|------------|
| Non-vested restricted stock shares outstanding at beginning of year  |       | 730,707    |       | $                                            | 0.79       |   |
| Restricted stock shares granted                                      |       | 593,718    |       | $                                            | 1.37       |   |
| Restricted stock shares vested                                       |       | (197,266   | )          | $                                            | 0.82       |   |
| Restricted stock shares forfeited                                    |       | (21,692    | )          | $                                            | 0.99       |   |
|                                                                 |       |       |       |                                         |       |
| Non-vested restricted stock shares outstanding at September 30, 2007 |       | 1,105,467  |       | $                                            | 1.09       |   |

 

 

At September 30, 2007, Focus had $830,000 of unrecognized compensationexpense, net of forfeitures, related to restricted stock awards, which will berecognized over the weighted average period of 2.8 years. During the ninemonths ended September 30, 2007, 197,266 shares of restricted stock with a fairmarket value of $258,000 vested. No restricted stock vested during the threemonths ended September 30, 2007. During the nine months ended September 30,2006, 61,250 shares of restricted stock with a fair market value of $41,000vested. No restricted stock vested during the three months ended September 30,2006.

 

 

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

** **

Basic net loss per share wascomputed by dividing the net loss by the weighted average number of shares ofcommon stock outstanding during the period. Diluted net loss per share iscomputed by dividing the net loss by the weighted average number of shares ofcommon stock and potential common stock equivalents outstanding during the period,if dilutive. Options to purchase 5,644,105 and 6,507,857 shares of commonstock, unvested shares of restricted stock of 1,105,467 and 730,307, warrantsto purchase 5,752,447 and 5,195,261 shares of common stock and 3,161 shares ofpreferred stock convertible into 3,161,000 shares of common stock wereoutstanding at September 30, 2007 and 2006, respectively, but were not includedin the computation of diluted net loss per share as the effect would have beenanti-dilutive. In addition, promissory notes that are convertible into11,493,000 and 10,425,000 shares of common stock were outstanding at September30, 2007 and 2006, respectively, 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 one customer accounted for 14% ofFocus’ revenue in the three months ended September 30, 2007.  Sales to one customer accounted for 13% ofFocus’ revenue in the nine months ended September 30, 2007. Sales to onecustomer accounted for 48% of Focus’ revenue in the three months endedSeptember 30, 2006.  Sales to onecustomer accounted for 26% of Focus’ revenue in the nine months ended September30, 2006.

 

Two customers hadaccounts receivable balances in excess of 10% of Focus’ total accountsreceivable at September 30, 2007. These customers accounted for 27% of Focus’total accounts receivable at that date. One customer had an accounts receivable balance in excess of 10% of Focus’total accounts receivable at September 30, 2006. This customer accounted for24% of Focus’ total accounts receivable at that date.

 

 

9

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**6.****                                     ****Goodwill and Intangible Assets**

** **

Goodwill as of September 30, 2007 and December 31, 2006included the 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 thecarrying amounts of intangible assets:

 

| ** **          | ** ** | **September 30, 2007** | ** ** |
|---------------------|------------|------------------------|------------|
| ** **          | ** ** | ** **             | ** ** | **Accumulated** | ** ** | **Net** | ** ** |
| **(In thousands)**  | ** ** | **Gross Amount**       | ** ** | **Amortization** | ** ** | **Amount** | ** ** |
| Existing technology |       | $                      | 3,945      |   | $ | (3,945 | ) | $ | — |   |
| Tradename           |       | 176                    |       | (176 | ) | — |   |
|                |       |                   |       |   |   |   |   |
|                |       | $                      | 4,121      |   | $ | (4,121 | ) | $ | — |   |
|                |       |                   |       |   |   |   |   |
|                |       |                   |       |   |   |   |   |
| ** **          | ** ** | **December  31, 2006** | ** ** |
|                |       | ** **             | ** ** | **Accumulated** | ** ** | **Net** |   |
| **(In  thousands)** |       | **Gross  Amount**      | ** ** | **Amortization** | ** ** | **Amount** |   |
| Existing technology |       | $                      | 3,945      |   | $ | (3,759 | ) | $ | 186 |   |
| Tradename           |       | 176                    |       | (176 | ) | — |   |
|                |       |                   |       |   |   |   |   |
|                |       | $                      | 4,121      |   | $ | (3,935 | ) | $ | 186 |   |
|                     |            |                        |            |  |  |  |  |  |  |  |  |

 

 

**7.****                                     ****Inventories**

 

Inventories are stated at lowerof cost (first-in, first-out) or market:

 

| **(In thousands)** | ** ** | **September 30, 2007** | ** ** | **December 31, 2006** | ** ** |
|--------------------|------------|------------------------|------------|-----------------------|------------|
| Raw materials      |       | $                      | 570        |                  | $          | 1,286 |   |
| Work in process    |       | 1,290                  |       | 1,055                 |       |
| Finished goods     |       | 2,271                  |       | 1,731                 |       |
|               |       |                   |       |                  |       |
|               |       | $                      | 4,131      |                  | $          | 4,072 |   |

 

 

10

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**8.**                                      Borrowings

 
| **(In thousands)**                       | ** ** | **September 30, 2007** | ** ** | **December 31, 2006** | ** ** |
|------------------------------------------|------------|------------------------|------------|-----------------------|------------|
|                                     |       |                   |       |                  |       |
| Short-term debt:                         |       |                   |       |                  |       |
| Accounts receivable-based line of credit |       | $                      | 4,000      |                  | $          | 3,390 |   |
| Term loan                                |       | 1,700                  |       | 2,500                 |       |
|                                     |       | 5,700                  |       | 5,890                 |       |
| Long-term debt:                          |       |                   |       |                  |       |
| Convertible notes                        |       | 11,493                 |       | 10,946                |       |
|                                     |       |                   |       |                  |       |
|                                     |       | $                      | 17,193     |                  | $          | 16,836 |   |

 

 

Accounts Receivable-Based Line of Credit

 

In November 2004, Focus obtained a $4.0million line of credit from Greater Bay Bank (“the Bank”) under which itcan borrow up to 90% of its eligible outstanding accounts receivable. Thecredit line expires on February 23, 2008 as a result of an extension granted inFebruary 2007 and is collateralized by a personal guarantee from Carl Berg, aCompany director and shareholder. In connection with this credit line, the Bankhas obtained a first priority security interest in Focus’ accounts receivablethrough an agreement with Mr. Berg, which enables Mr. Berg to retain hisexisting security interest in all of Focus’ assets while subordinating hispre-existing security interest in Focus’ accounts receivable. In connectionwith the February 2007 extension, Focus agreed to pay loan commitment fees of$22,500 and agreed to issue a warrant to the Bank to purchase 48,148 shares ofcommon stock at an exercise price of $1.35 per share. In addition, Mr. Berg agreed to continue to personally guaranteeboth the $4.0 million accounts receivable-based line of credit and the$2.5 million term loan to the Bank. In connection with Mr. Berg’s continuedextension of his personal guarantee, Focus agreed to issue to Mr. Berg awarrant to purchase 48,148 shares of common stock at an exercise priceof $1.35 per share. The warrants issued in this extension transaction werevalued at $26,000 using the Black-Scholes option pricing model. The warrantissued to the Bank will be amortized to interest expense over the term of theline of credit and the warrant issued to Mr. Berg was charged to general andadministrative expense at the time of issuance.

 

The credit line is subject to ongoing covenants including a covenantbased on operating results. Borrowings under the credit line bear interest at arate of prime plus 1%, which was 8.75% at September 30, 2007. At September 30,2007, there was an outstanding balance on this credit line of $4.0 million.Based on Focus' September 30, 2007 eligible account receivable, the maximumamount available to borrow was $3.6 million. Therefore, on October 16, 2007 Focusrepaid $400,000 under the line of credit. The credit line expires on February28, 2008.

 

Term Loan

 

On June 28, 2005, Focus signed a term loanagreement with the Bank under which Focus can borrow up to $2.5 million. The termloan expires on February 23, 2008 as a result of extensions granted in Februaryand March 2007. Mr. Berg haspersonally guaranteed the loan, which is interest only until maturity and is inaddition to Focus’ existing $4.0 million accounts receivable-based secured lineof credit that Focus has with the Bank. Interest is payable under this termloan at prime plus 1%, which was 8.75% at September 30, 2007. At September 30, 2007, there was anoutstanding balance under this term loan of $1.7 million, which gave Focus theability to borrow an additional $800,000 to the maximum amount of $2.5 million.

 

ConvertibleNotes 

 

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:

•                  Interest accrues on the principal amountof the notes at a rate of 10% per annum, payable semi-annually on June 30 andDecember 30 of each year.

•                  Interest due on the first threesemi-annual payments may, at the issuers option, be paid in the form of a notewith the same terms and conditions of the original notes, including conversionrights.

•                  The notes are convertible, at the optionof the holder, into shares of Focus common stock at a conversion price of $1.00per share. The conversion price is subject to adjustment for stock splits,reverse stock splits, recapitalizations and similar corporate actions.

 

11

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•                  The notes are collateralized by all ofthe assets of Focus in accordance with the terms and subject to the conditionscontained in a security agreement entered into concurrently with the issuanceof the notes.

•                  The notes are redeemable, at the optionof Focus, at any time at a redemption price equal to 102% times the face rateof the notes, plus any accrued interest.

•                  Upon a fundamental change, which includesa change in control of Focus or failure of Focus’ common stock to be listed forquotation on the Nasdaq Stock Market or another established automatedover-the-counter trading marking in the United States, each holder of the notesmay require Focus to repurchase all of its debt at a purchase price equal to101% of the principal amount of the notes plus accrued and unpaid interest.

 

Pursuant to a Registration Rights Agreement with the Purchasers datedJanuary 24, 2006 (the “Registration Rights Agreement”), Focus agreed to file aresale registration statement covering the resale of the shares issuable to theinvestors upon the conversion of the notes. The due date may accelerate in theevent Focus commences any case relating to bankruptcy or insolvency, or relatedevents of default.

 

On June 30, 2007, December 30, 2006 and June 30, 2006, Focus issuedadditional notes in the amounts of $547,167, $521,250 and $425,000, in lieu ofthe cash interest payments due on June 30, 2007, December 30, 2006 and June 30,2006, respectively. These notes retain the same terms and conditions as the$10.0 million convertible notes issued on January 27, 2006.

 

 

**9.**                                      Commitments and Contingencies

 

Research and DevelopmentAgreements 

 

In October 2004, Focusentered into a design services contract under which Focus agreed to pay $2.9million to a third party for the design and development of high performance UWBintegrated circuits. The contract amount was subsequently increased to $3.2million. Payments were made upon the completion of specific milestones by thethird party. The contract was completed in April 2007.

 

For the three months endedSeptember 30, 2007, there were no expenses related to this project, which wascompleted in April 2007. For the three months ended September 30, 2006, $58,000was charged to research anddevelopment based on the level of effort incurred by the third party. For thenine months ended September 30, 2007, research and development expenses werereduced by $117,000 upon a final reconciliation of time and materials relatedto the contract. For the nine months ended September 30, 2006, $467,000was charged to research and developmentbased on the level of effort incurred by the third party. No amountsrelated to this contract were included within the condensed consolidatedbalance sheet at September 30, 2007. At December 31, 2006, $141,000 wasincluded within other accrued liabilities on the condensed consolidated balancesheet.

 

In September 2007, Focusentered into a design services contract under which Focus agreed to payapproximately $1.3 million to a third party for the design and development ofnew UWB integrated circuits. Payments will be made upon the completion ofspecific milestones by the third party. Work had not begun as of September 30,2007.

 

12

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Leases

 

Focusleases office facilities and certain equipment under operating and capitalleases. Under the lease agreements, Focus is obligated to pay for utilities,taxes, insurance and maintenance.

 

Minimumlease commitments at September 30, 2007 were as follows:

 
| **(In thousands)**                 | ** ** | **Operating Lease Commitments** | ** ** | **Capital Lease Commitments** | ** ** |
|------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
|                               |       |                            |       |                          |       |
| 2007                               |       | $                               | 193        |                          | $          | 32 |   |
| 2008                               |       | 662                             |       | 129                           |       |
| 2009                               |       | 602                             |       | —                        |       |
| 2010                               |       | 444                             |       | —                        |       |
|                               |       |                            |       |                          |       |
|                               |       | $                               | 1,901      |                          | 161        |   |
| Less: amount representing interest |       |                            |       | (10                           | )          |
|                               |       |                            |       | 151                           |       |
| Less: Long-term portion            |       |                            |       | (32                           | )          |
|                               |       |                            |       |                          |       |
| Current portion                    |       |                            |       | $                             | 119        |   |
|                               |       |                            |       |                          |       |

 

InventoryPurchase Commitments

 

Under contract manufacturing arrangements, contract manufacturersprocure inventory to manufacture products based upon a forecast of customerdemand provided by Focus. Focus is responsible for the financial impact on thecontract manufacturer of any reduction or product mix shift in the forecastrelative to materials that the contract manufacturer had already purchased, andis unable to return, under a prior forecast. Such a variance in forecasteddemand could require a cash payment for finished goods in excess of currentcustomer demand or for costs of excess or obsolete inventory.

 

At September 30, 2007,Focus had issued non-cancelable purchase orders for approximately $1.3 millionfor finished 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.

 

ProductWarranty Costs. 

 

Focus’ warranty period for its products is generally 90 days to twoyears. Focus accrues for warranty costs, based on estimated warranty returnrates and costs to repair, at the time revenue is recognized. At September 30,2007 and December 31, 2006, Focus’ reserves for warranty costs were $159,000and $191,000, respectively.

 

Changes in Focus’ product warranty liability during the nine monthsended September 30, 2007 and 2006 were as follows:

 
| ** **            | ** ** | **Nine Months Ended**  | ** ** |
|-----------------------|------------|------------------------|------------|
| **(In thousands)**    | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** |
|                  |       |                   |       |   |   |
| Balance at January 1  |       | $                      | 191        |   | $ | 220 |   |
| Charged to operations |       | 111                    |       | 118 |   |
| Reductions            |       | (143                   | )          | (113 | ) |
|                  |       |                   |       |   |   |
| Ending balance        |       | $                      | 159        |   | $ | 225 |   |
|                  |       |                   |       |   |   |

 

 

General

 

From time-to-time, Focus isparty to certain claims and legal proceedings that arise in the ordinary courseof business which, in the opinion of management, will not have a materialadverse effect on Focus’ financial position or results of operation.

 

 

13

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**10.****                              ****Stockholders’Equity**

 

As of September 30, 2007, Focus was obligatedunder certain circumstances, to issue the following additional shares of commonstock pursuant to derivative securities, instruments or agreements:

 
| **(In thousands)**                            | ** ** | **Shares of   Common Stock** | ** ** |
|-----------------------------------------------|------------|------------------------------|------------|
|                                          |       |                         |       |
| Options to purchase common stock              |       | 5,644                        |       |
| Warrants to purchase common stock             |       | 5,752                        |       |
| Preferred stock convertible into common stock |       | 3,161                        |       |
| Convertible notes                             |       | 11,493                       |       |
|                                          |       |                         |       |
|                                          |       | 26,050                       |       |

 

** **

In September 2007, Focus entered into two separate transactions withcertain investors, relating to the issuance and sale of (i) 2,272,728 shares ofFocus common stock at a purchase price of $0.88 per share and warrants topurchase 568,182 shares of common stock at an exercise price of $1.05 per shareand (ii) 3,863,635 shares of common stock at a purchase price of $0.88 pershare and warrants to purchase 965,910 shares of Focus common stock at anexercise price of $1.05 per share. In aggregate, Focus sold 6,136,363 shares ofcommon stock and issued warrants to purchase an additional 1,534,092 shares ofcommon stock. In connection with this transaction Focus received net proceedsof approximately $4.9 million.

 

In February 2007, Focus entered into two separate transactions withcertain investors, relating to the issuance and sale of (i) 4,500,000 shares ofFocus common stock at a purchase price of $1.26 per share and warrants topurchase 450,000 shares of common stock at an exercise price of $2.00 per shareand (ii) 500,000 shares of common stock at a purchase price of $1.26 per shareand warrants to purchase 50,000 shares of Focus common stock at an exerciseprice of $2.00 per share. In aggregate, Focus sold 5,000,000 shares of commonstock and issued warrants to purchase an additional 500,000 shares of commonstock. In connection with this transaction Focus received net proceeds ofapproximately $6.2 million.

 

During the nine months endedSeptember 30, 2007, Focus repurchased 19,612 shares of common stock for $25,000and included the repurchased shares in treasury stock at September 30, 2007.Such shares had originally been issued in connection with the Company’s stockcompensation plans as restricted stock.

 

** **

**11.****                              ****RelatedParty Transactions**

** **

Carl Berg

 

In December 2002, Mr. Berg provided SamsungSemiconductor Inc., one of Focus’ contracted ASIC manufacturers, with apersonal guarantee to secure Focus’ working capital requirements for ASICpurchase order fulfillment. Mr. Berg provided the personal guarantee without additionalcost or collateral, as Mr. Berg maintains a secured priority interest insubstantially all of Focus’ assets. At September 30, 2007, Focus owed Samsung$239,000 under net 30 terms.

 

In November 2004, Focus secured a line ofcredit of up to $4.0 million under which Focus could borrow up to 90% of itseligible outstanding accounts receivable. This line of credit is secured by apersonal guarantee from Mr. Berg. In connection with this line of credit, theBank obtained a priority security interest in Focus’ accounts receivable. Mr.Berg will maintain his security interest in all Focus’ assets, subject to theBank’s lien on accounts receivable.

 

On March 19, 2007, as described above in Note8, Mr. Berg received a warrant to purchase 48,148 shares of common stock inconnection with Mr. Berg maintaining his personal guarantee of the term loanand accounts receivable-based line of credit, which were both extended toFebruary 23, 2008. The warrant was issued at $1.35 per share and expires onMarch 19, 2012. The warrant was valued at $26,000 using the Black-Scholesoption pricing model and was charged to general and administrative expense atthe time of issuance.

 

In connection with the $10.0 million convertible note financingcompleted in January 2006, Focus entered into an amendment to the IntercreditorAgreement by and among the Bank, Mr. Berg and Focus, pursuant to which the  Bank, Mr. Berg and the holders of the notesdefined their relative rights and priorities with respect to the sharedcollateral, with the Bank having a first priority security interest in certainspecified collateral of Focus and an Intercreditor Agreement specifying theshared interests of the note holders and Mr. Berg in the collateral securingboth the notes (all of Focus’ assets) and Mr. Berg’s guaranty of Focus’obligations to the  Bank, all subject tothe priority security interest of the Bank in such respective collateral.

 

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DolbyLaboratories Inc.

 

N. William Jasper Jr., theChairman of Focus’ Board of Directors, is also the President and ChiefExecutive Officer of Dolby Laboratories, Inc. (“Dolby”), a signal processingtechnology company located in San Francisco, California. Focus is required tosubmit quarterly royalty payments to Dolby based on Dolby technologyincorporated into certain products. For the three months ended September 30,2007 and 2006, Focus paid Dolby $9,000 and $8,000, respectively, in royalties,which were recorded in cost of revenue. For the nine months ended September 30,2007 and 2006, Focus paid Dolby $30,000 and $17,000, respectively in royalties,which were recorded in cost of revenue. Focus’ arrangements with Dolby are onstandard commercial terms.

 

NormanSchlomka

 

NormanSchlomka, General Manager of COMO and an executive officer of Focus sinceFebruary 2006, owns one third of the building, located in Raisdorf, Germany,that COMO occupies. For the three month periods ended September 30, 2007 and2006, Focus paid rent related to this building of approximately $24,000 and$15,000, respectively. For the nine months ended September 30, 2007 and 2006,Focus paid rent related to this building of approximately $72,000 and $45,000,respectively. The rent is on commercial terms deemed to be fair market valueand comparable to other rents in the area.

 

15

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**12.          BusinessSegment Information**

 

Focus’reportable segments are Systems and Semiconductor. These reportable segmentshave distinct products — Systems consists of products designed to providesolutions in video acquisition, media asset management and digital signage andSemiconductor consists of ASICs. Focus’ chief operating decision maker is theCEO.

 

Focus evaluates segment performance based on operating income (loss)and does not allocate net interest, other income or taxes to operatingsegments. Additionally, Focus does not allocate assets by operating segment.

 

 

| ** **                        | ** ** | **Three Months Ended September, 2007** | ** ** |
|-----------------------------------|------------|----------------------------------------|------------|
| ** **                        | ** ** | **Systems**                            | ** ** | **Semiconductor** | ** ** | **Total** | ** ** |
|                              |       |                                   |       |   |   |   |   |
| Net revenue                       |       | $                                      | 6,505      |   | $ | 1,265 |   | $ | 7,770 |   |
| Cost of revenue                   |       | 3,735                                  |       | 547 |   | 4,282 |   |
| Gross margin                      |       | 2,770                                  |       | 718 |   | 3,488 |   |
|                              |       |                                   |       |   |   |   |   |
| Operating expenses:               |       |                                   |       |   |   |   |   |
| Sales, marketing and support      |       | 1,444                                  |       | 709 |   | 2,153 |   |
| General and administrative        |       | 683                                    |       | 394 |   | 1,077 |   |
| Research and development          |       | 1,111                                  |       | 2,386 |   | 3,497 |   |
| Amortization of intangible assets |       | —                                 |       | — |   | — |   |
|                              |       | 3,238                                  |       | 3,489 |   | 6,727 |   |
| Loss from operations              |       | $                                      | (468       | ) | $ | (2,771 | ) | $ | (3,239 | ) |
|                                   |            |                                        |            |  |  |  |  |  |  |  |  |

 

| ** **                        | ** ** | **Nine Months Ended September 30, 2007** | ** ** |
|-----------------------------------|------------|------------------------------------------|------------|
| ** **                        | ** ** | **Systems**                              | ** ** | **Semiconductor** | ** ** | **Total** | ** ** |
|                              |       |                                     |       |   |   |   |   |
| Net revenue                       |       | $                                        | 19,378     |   | $ | 3,833 |   | $ | 23,211 |   |
| Cost of revenue                   |       | 10,987                                   |       | 1,660 |   | 12,647 |   |
| Gross margin                      |       | 8,391                                    |       | 2,173 |   | 10,564 |   |
|                              |       |                                     |       |   |   |   |   |
| Operating expenses:               |       |                                     |       |   |   |   |   |
| Sales, marketing and support      |       | 4,489                                    |       | 2,268 |   | 6,757 |   |
| General and administrative        |       | 2,052                                    |       | 1,170 |   | 3,222 |   |
| Research and development          |       | 3,248                                    |       | 8,166 |   | 11,414 |   |
| Amortization of intangible assets |       | 94                                       |       | 62 |   | 156 |   |
|                              |       | 9,883                                    |       | 11,666 |   | 21,549 |   |
| Loss from operations              |       | $                                        | (1,492     | ) | $ | (9,493 | ) | $ | (10,985 | ) |
|                                   |            |                                          |            |  |  |  |  |  |  |  |  |

 

16

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| ** **                        | ** ** | **Three Months Ended September, 2006** | ** ** |
|-----------------------------------|------------|----------------------------------------|------------|
| ** **                        | ** ** | **Systems**                            | ** ** | **Semiconductor** | ** ** | **Total** | ** ** |
|                              |       |                                   |       |   |   |   |   |
| Net revenue                       |       | $                                      | 5,441      |   | $ | 6,164 |   | $ | 11,605 |   |
| Cost of revenue                   |       | 3,332                                  |       | 2,487 |   | 5,819 |   |
| Gross margin                      |       | 2,109                                  |       | 3,677 |   | 5,786 |   |
|                              |       |                                   |       |   |   |   |   |
| Operating expenses:               |       |                                   |       |   |   |   |   |
| Sales, marketing and support      |       | 1,488                                  |       | 643 |   | 2,131 |   |
| General and administrative        |       | 618                                    |       | 407 |   | 1,025 |   |
| Research and development          |       | 902                                    |       | 2,212 |   | 3,114 |   |
| Amortization of intangible assets |       | 78                                     |       | 49 |   | 127 |   |
|                              |       | 3,086                                  |       | 3,311 |   | 6,397 |   |
| Income (loss) from operations     |       | $                                      | (977       | ) | $ | 366 |   | $ | (611 | ) |

 

| ** **                        | ** ** | **Nine Months Ended September, 2006** | ** ** |
|-----------------------------------|------------|---------------------------------------|------------|
| ** **                        | ** ** | **Systems**                           | ** ** | **Semiconductor** | ** ** | **Total** | ** ** |
|                              |       |                                  |       |   |   |   |   |
| Net revenue                       |       | $                                     | 17,856     |   | $ | 9,339 |   | $ | 27,195 |   |
| Cost of revenue                   |       | 10,735                                |       | 4,222 |   | 14,957 |   |
| Gross margin                      |       | 7,121                                 |       | 5,117 |   | 12,238 |   |
|                              |       |                                  |       |   |   |   |   |
| Operating expenses:               |       |                                  |       |   |   |   |   |
| Sales, marketing and support      |       | 5,147                                 |       | 1,606 |   | 6,753 |   |
| General and administrative        |       | 1,768                                 |       | 1,237 |   | 3,005 |   |
| Research and development          |       | 2,236                                 |       | 6,725 |   | 8,961 |   |
| Amortization of intangible assets |       | 235                                   |       | 146 |   | 381 |   |
|                              |       | 9,386                                 |       | 9,714 |   | 19,100 |   |
| Loss from operations              |       | $                                     | (2,265     | ) | $ | (4,597 | ) | $ | (6,862 | ) |

 

** **

** **

**13.          ComprehensiveLoss**

** **

Comprehensiveloss includes net loss and foreign currency translation adjustments. Thecomponents of comprehensive loss are as follows:

| ** **                               | ** ** | **Three Months Ended**   | ** ** | **Nine Months Ended**   | ** ** |
|------------------------------------------|------------|--------------------------|------------|-------------------------|------------|
| **(In  thousands)**                      | ** ** | **September   30, 2007** | ** ** | **September  30, 2006** | ** ** | **September  30, 2007** | ** ** | **September  30, 2006** | ** ** |
|                                     |       |                     |       |                    |       |   |   |   |   |
| Net loss                                 |       | $                        | (3,656     | )                       | $          | (866 | ) | $ | (12,013 | ) | $ | (12,910 | ) |
| Other comprehensive income (loss)        |       |                     |       |                    |       |   |   |   |   |
| Foreign currency translation adjustments |       | 99                       |       | (22                     | )          | 60 |   | (129 | ) |
|                                     |       |                     |       |                    |       |   |   |   |   |
| Comprehensive loss                       |       | $                        | (3,577     | )                       | $          | (888 | ) | $ | (11,953 | ) | $ | (13,039 | ) |
|                                          |            |                          |            |                         |            |  |  |  |  |  |  |  |  |  |  |

** **

**17**

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** **

** **

**14.          IncomeTaxes**

 

On January 1, 2007, the Company adopted the provisions of FinancialAccounting Standards Board (“FASB”) Interpretation No. 48, “Accounting forUncertain Income Taxes — An Interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized inan entity’s financial statements in accordance with FASB Statement No. 109, “Accountingfor Income Taxes” (“FAS 109”) and prescribes a recognition threshold andmeasurement attributes for financial statement disclosure of tax positionstaken or expected to be taken on a tax return.  Under FIN 48, the impactof an uncertain income tax position on the income tax return must be recognizedat the largest amount that is more-likely-than-not to be sustained upon auditby the relevant taxing authority.  An uncertain income tax position willnot be recognized if it has less than a 50% likelihood of beingsustained.  Additionally, FIN 48 provides guidance on de-recognition,classification, interest and penalties, accounting in interim periods,disclosure and transition.

 

As a result of the adoption of FIN 48, there was no impact to theCompany’s consolidated financial position, results of operations or cash flowsfor the nine month period ended September 30, 2007. In accordance with FIN 48,the Company recognizes interest and penalties related to unrecognized taxbenefits as a component of income taxes. At September 30, 2007 no interestor penalties related to unrecognized tax benefits had been recorded. There was no change to the Company’s unrecognized tax benefits for the ninemonth period ended September 30, 2007.

 

TheCompany and certain of its subsidiaries are subject to taxation in the U.S. andvarious states and foreign jurisdictions.  All the Company’s tax yearswill be open to examination by the U.S. federal and certain state taxauthorities due to the Company’s net operating loss and overall credit carryforward position.  With few exceptions, the Company is not subject toexamination by foreign tax authorities for years before 2004.

 

18

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

 

The following information should be read inconjunction with the condensed consolidated financial statements and notesthereto in Part I, Item 1 of this Quarterly Report and with Management’sDiscussion and Analysis of Financial Condition and Results of Operationscontained in Focus’ Annual Report on Form 10-K for the year ended December 31,2006 and Item 1A—”Risk Factors”—contained therein.

 

**Certain Factors That May AffectFuture Results**

 

Discussions of certain matters in thisQuarterly Report on Form 10-Q may constitute forward-looking statements withinthe meaning of Section 27A of the Securities Act of 1933, as amended, andSection 21E of the Securities and Exchange Act of 1934, as amended (the “ExchangeAct”), and as such, may involve risks and uncertainties.  Forward-looking statements, which are basedon certain assumptions and describe future plans, strategies, and expectations,are generally identifiable by the use of words or phrases such as “believe”, “plan”,“expect”, “intend”, “anticipate”, “estimate”, “project”, “forecast”, “mayincrease”, “may fluctuate”, “may improve” and similar expressions or future orconditional verbs such as “will”, “should”, “would”, and “could”.

 

In particular,statements contained in this document that are not historical facts (including,but not limited to, statements concerning anticipated revenues, anticipatedoperating expense levels, capital resources and needs and liquidity outlook,potential new products and orders, and such expense levels relative to ourtotal revenues) constitute forward-looking statements and are made under thesafe harbor provisions of the Private Securities Litigation Reform Act of 1995.Our actual results of operations and financial condition have varied and may inthe future vary significantly and materially from those stated in anyforward-looking statements. Factors that may cause such differences include,without limitation, the availability of capital to fund our future cash needs,reliance on major customers, history of operating losses, market acceptance ofour products, technological obsolescence, competition, successful integrationof 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.

 

19

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**RESULTS OF OPERATIONS**

** **

#### **Net revenue**

 

| ** **                 | ** ** | **Three Months Ended** | ** ** | ** **             | ** ** | ** **              | ** ** |
|----------------------------|------------|------------------------|------------|------------------------|------------|-------------------------|------------|
| **(Dollars in thousands)** | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** | **Increase (decrease)** | ** ** | **% increase (decrease)** | ** ** |
|                       |       |                   |       |                   |       |                    |       |   |   |
| Systems products           |       | $                      | 6,505      |                   | $          | 5,441                   |       | $ | 1,064 |   | 19.6 | % |
| Semiconductor products     |       | 1,265                  |       | 6,164                  |       | (4,899                  | )          | (79.5 | )% |
|                       |       |                   |       |                   |       |                    |       |   |   |
|                       |       | $                      | 7,770      |                   | $          | 11,605                  |       | $ | (3,835 | ) | (33.0 | )% |
|                            |            |                        |            |                        |            |                         |            |  |  |  |  |  |  |  |

 

| ** **                 | ** ** | **Nine Months Ended**  | ** ** | ** **             | ** ** | ** **              | ** ** |
|----------------------------|------------|------------------------|------------|------------------------|------------|-------------------------|------------|
| **(Dollars in thousands)** | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** | **Increase (decrease)** | ** ** | **% increase (decrease)** | ** ** |
|                       |       |                   |       |                   |       |                    |       |   |   |
| Systems products           |       | $                      | 19,378     |                   | $          | 17,856                  |       | $ | 1,522 |   | 8.5 | % |
| Semiconductor products     |       | 3,833                  |       | 9,339                  |       | (5,506                  | )          | (59.0 | )% |
|                       |       |                   |       |                   |       |                    |       |   |   |
|                       |       | $                      | 23,211     |                   | $          | 27,195                  |       | $ | (3,984 | ) | (14.6 | )% |
|                            |            |                        |            |                        |            |                         |            |  |  |  |  |  |  |  |

 

 

Revenue for the three monthsended September 30, 2007 was $7.8 million, a decrease of $3.8 million, or 33%,compared with the three months ended September 30, 2006.  Revenue for the nine months ended September30, 2007 was $23.2 million, a decrease of $4.0, or 14.6%, compared with thenine months ended September 30, 2006.

 

For the three months endedSeptember 30, 2007, net sales of systems products to distributors, retailersand value added resellers, were approximately $6.5 million compared to $5.4million for the same period in 2006, an increase of $1.1 million. For the ninemonths ended September 30, 2007, net sales of our systems products wereapproximately $19.4 million compared to $17.9 million for the same period in2006, an increase of $1.5 million. This increase in sales of systems productsmainly reflects sales of our Direct to Edit acquisition products and ProxSysproducts, partially offset by a decrease in sales of digital signage systems.

 

Sales of semiconductor productsto distributors and OEM customers were approximately $1.3 million in the threemonths ended September 30, 2007, compared to $6.2 million for the same periodin 2006, a decrease of $4.9 million. For the nine months ended September 30,2007, sales of our semiconductor products were approximately $3.8 million comparedto $9.3 million for the same period in 2006, a decrease of $5.5 million. Thisdecrease reflects reduced demand by a customer that had incorporated our videoconvergence chips in its portable media player (PMP) in 2006. We did notreceive subsequent orders from that customer in 2007.

 

As of September 30, 2007, we had a salesorder backlog of approximately $1.2 million, a decrease of $600,000 compared toJune 30, 2007.

 

Sales to one customer accounted for 14% ofour revenue in the three months ended September 30, 2007. Sales to one customeraccounted for 48% of our revenue in the three months ended September 30, 2006. Sales to one customer accounted for 13% ofour revenue for the nine month ended in September 30, 2007. Sales to onecustomer accounted for 26% of our revenue in the nine months ended September30, 2006.

 

20

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**Gross margin**

 

| ** **                 | ** ** | **Three Months Ended** | ** ** | ** **             | ** ** |
|----------------------------|------------|------------------------|------------|------------------------|------------|
| **(Dollars in thousands)** | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** | **Decrease** | ** ** |
|                       |       |                   |       |                   |       |   |   |
| Gross margin               |       | $                      | 3,488      |                   | $          | 5,786 |   | $ | (2,298 | ) |
|                       |       |                   |       |                   |       |   |   |
| Gross margin rate          |       | 44.9                   | %          | 49.9                   | %          | (5.0) | percentage points |   |
|                            |            |                        |            |                        |            |  |  |  |  |  |  |

 

| ** **                 | ** ** | **Nine Months Ended**  | ** ** | ** **             | ** ** |
|----------------------------|------------|------------------------|------------|------------------------|------------|
| **(Dollars in thousands)** | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** | **Increase/ (Decrease)** | ** ** |
|                       |       |                   |       |                   |       |   |   |
| Gross margin               |       | $                      | 10,564     |                   | $          | 12,238 |   | $ | (1,674 | ) |
|                       |       |                   |       |                   |       |   |   |
| Gross margin rate          |       | 45.5                   | %          | 45.0                   | %          | 0.5  percentage points |   |
|                            |            |                        |            |                        |            |  |  |  |  |  |

 

 

Our grossmargin rate for the three months ended September 30, 2007 decreased to 44.9%from 49.9% compared to the three months ended September 30, 2006, a decrease of5.0 percentage points. The decrease is due to a decrease in semiconductorproduct sales of $4.9 million, which were at a higher than average gross marginrate. Our gross margin rate in the nine months ended September 30, 2007increased to 45.5% from 45.0% in the nine months ended September 30, 2006, anincrease of 0.5 percentage points. This increase in the gross margin rate ismainly related to product mix.

 

21

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**Operatingexpenses**

 
| ** **                        | ** ** | **Three Months Ended** | ** ** | ** **             | ** ** | ** **                | ** ** |
|-----------------------------------|------------|------------------------|------------|------------------------|------------|---------------------------|------------|
| **(Dollars in thousands)**        | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** | **Increase / (Decrease)** | ** ** |
| ** **                        | ** ** | ** **             | ** ** | **% of**               | ** ** | ** **                | ** ** | **% of** | ** ** | ** ** | ** ** | **% of** | ** ** |
| ** **                        | ** ** | ** **             | ** ** | **revenue**            | ** ** | ** **                | ** ** | **revenue** | ** ** | ** ** | ** ** | **revenue** | ** ** |
|                              |       |                   |       |                   |       |                      |       |   |   |   |   |   |   |
| Sales, marketing and support      |       | $                      | 2,153      |                   | 27.7       | %                         | $          | 2,131 |   | 18.4 | % | $ | 22 |   | 9.3 | % |
| General and administrative        |       | 1,077                  |       | 13.9                   | %          | 1,025                     |       | 8.8 | % | 52 |   | 5.1 | % |
| Research and development          |       | 3,497                  |       | 45.0                   | %          | 3,114                     |       | 26.8 | % | 383 |   | 18.2 | % |
| Amortization of intangible assets |       | —                 |       | 0.0                    | %          | 127                       |       | 1.1 | % | (127 | ) | (1.1% | ) |
|                              |       |                   |       |                   |       |                      |       |   |   |   |   |   |   |
|                              |       | $                      | 6,727      |                   | 86.6       | %                         | $          | 6,397 |   | 55.1 | % | $ | 330 |   | 31.5 | % |
|                                   |            |                        |            |                        |            |                           |            |  |  |  |  |  |  |  |  |  |  |

 
| ** **                        | ** ** | **Nine Months Ended**  | ** ** | ** **             | ** ** | ** **                | ** ** |
|-----------------------------------|------------|------------------------|------------|------------------------|------------|---------------------------|------------|
| **(Dollars in thousands)**        | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** | **Increase / (Decrease)** | ** ** |
| ** **                        | ** ** | ** **             | ** ** | **% of**               | ** ** | ** **                | ** ** | **% of** | ** ** | ** ** | ** ** | **% of** | ** ** |
| ** **                        | ** ** | ** **             | ** ** | **revenue**            | ** ** | ** **                | ** ** | **revenue** | ** ** | ** ** | ** ** | **revenue** | ** ** |
|                              |       |                   |       |                   |       |                      |       | ** ** |   |   |   | ** ** |   |
| Sales, marketing and support      |       | $                      | 6,757      |                   | 29.1       | %                         | $          | 6,753 |   | 24.8 | % | $ | 4 |   | 4.3 | % |
| General and administrative        |       | 3,222                  |       | 13.9                   | %          | 3,005                     |       | 11.0 | % | 217 |   | 2.9 | % |
| Research and development          |       | 11,414                 |       | 49.2                   | %          | 8,961                     |       | 33.0 | % | 2,453 |   | 16.2 | % |
| Amortization of intangible assets |       | 156                    |       | 0.7                    | %          | 381                       |       | 1.4 | % | (225 | ) | (0.7% | ) |
|                              |       |                   |       |                   |       |                      |       |   |   |   |   |   |   |
|                              |       | $                      | 21,549     |                   | 92.9       | %                         | $          | 19,100 |   | 70.2 | % | $ | 2,449 |   | 22.7 | % |
|                                   |            |                        |            |                        |            |                           |            |  |  |  |  |  |  |  |  |  |  |  |

 

 

Sales, marketing and support 

 

Sales, marketing and supportexpenses for the three and nine months ended September 30, 2007 wereapproximately $2.2 million and $6.8 million, respectively, and were consistentwith amounts for the three and nine months ended September 30, 2006. Theincrease in sales, marketing and support expenses are due to an increase inhead count, partially offset by lower commission and bonus expenses as a resultof decreased sales between the comparison periods.

 

General and administrative 

 

General and administrativeexpenses for the three months ended September 30, 2007 were approximately $1.1million, and were consistent with amounts for the three months ended September30, 2006. General and administrative expenses for the nine months endedSeptember 30, 2007 were $3.2 million, an increase of $217,000 from $3.0 millionfor the nine months ended September 30, 2006.

 

The increase in general andadministrative expenses reflects an increase in consulting fees of $64,000mainly related to implementation of the requirements of Section 404 of theSarbanes-Oxley Act, an increase in legal fees of $25,000, an increase in bankcharges of $39,000 which are warrant issuance fees for the Q1 PIPE, an increasein travel expense of $37,000 and an increase in payroll and payroll relatedexpenses of $29,000.

 

 

Research and development 

 

Research and developmentexpenses for the three months ended September 30, 2007 were $3.5 million, anincrease of $383,000 from $3.1 million for the three months ended September 30,2006. The increase in research and development expenses mainly reflects anincrease in payroll and payroll-related expenses of $400,000 and an increase inmaterial and prototyping charges of $272,000 related to our UWB initiative.These increases were partially offset by a decrease in consulting expense dueto the completion of a third party design service. The increase in payroll andpayroll-related expenses is due to a higher average headcount during the threemonths ended September 30, 2007 compared to the three months ended September30, 2006.

 

22

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Research and developmentexpenses for the nine months ended September 30, 2007 were $11.4 million,compared to $9.0 million for the nine months ended September 30, 2006, an increaseof $2.5 million. The increase in research and development expenses mainlyreflects an increase in payroll and payroll-related expenses of $1.8 millionand an increase in material and prototyping charges expenses of $900,000,partly offset by a decrease in consulting expense due to the completion of athird party design service. The increase in payroll and payroll-relatedexpenses mainly due to a higher average headcount during the nine months endedSeptember 30, 2007 compared to the nine months ended September 30, 2006.

 

Amortization

 

Amortization expense was recorded as follows:

 

| ** **         | ** ** | **Three Months Ended** | ** ** | ** **             | ** ** |
|--------------------|------------|------------------------|------------|------------------------|------------|
| **(In thousands)** | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** | **Decrease** | ** ** |
|               |       |                   |       |                   |       |   |   |
| Cost of revenue    |       | $                      | —     |                   | $          | 45 |   | $ | (45 | ) |
| Operating expenses |       | —                 |       | 127                    |       | (127 | ) |
|               |       |                   |       |                   |       |   |   |
|               |       | $                      | —     |                   | $          | 172 |   | $ | (172 | ) |

 

| ** **         | ** ** | **Nine Months Ended**  | ** ** | ** **             | ** ** |
|--------------------|------------|------------------------|------------|------------------------|------------|
| **(In thousands)** | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** | **Decrease** | ** ** |
|               |       |                   |       |                   |       |   |   |
| Cost of revenue    |       | $                      | 30         |                   | $          | 136 |   | $ | (106 | ) |
| Operating expenses |       | 156                    |       | 381                    |       | (225 | ) |
|               |       |                   |       |                   |       |   |   |
|               |       | $                      | 186        |                   | $          | 517 |   | $ | (331 | ) |

 

 

There was no amortizationexpense for the three months ended September 30, 2007. Amortization expense forthe three months ended September 30, 2006 was $172,000. Amortization expensefor the nine months ended September 30, 2007 was $186,000, which decreased$331,000 from the nine months ended September 30, 2006. The decrease inamortization expense reflects no further amortization for certain intangiblesassociated with our acquisition of COMO Computer & Motion GmbH in February2004 and Visual Circuits Corporation in May 2004.

 

23

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**Interest expense, net, Value of derivativeliability, Change in value of derivative liability and Other income, net**

| ** **                  | ** ** | **Three Months Ended** | ** ** | **Increase /**         | ** ** |
|-----------------------------|------------|------------------------|------------|------------------------|------------|
| **(Dollars in thousands)**  | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** | **(Decrease)** | ** ** |
|                        |       |                   |       |                   |       |   |   |
| Interest expense, net       |       | $                      | (396       | )                      | $          | (337 | ) | $ | 59 |   |
|                        |       |                   |       |                   |       |   |   |
| Other income/(expense), net |       | $                      | (3         | )                      | $          | 82 |   | $ | (85 | ) |

 

| ** **                                       | ** ** | **Nine Months Ended**  | ** ** | **Increase /**         | ** ** |
|--------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| **(Dollars in thousands)**                       | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** | **(Decrease)** | ** ** |
|                                             |       |                   |       |                   |       |   |   |
| Interest expense, net                            |       | $                      | (985       | )                      | $          | (828 | ) | $ | 157 |   |
|                                             |       |                   |       |                   |       |   |   |
| Value of derivative liability                    |       | $                      | —     |                   | $          | (4,000 | ) | $ | (4,000 | ) |
|                                             |       |                   |       |                   |       |   |   |
| Change in value of derivative security liability |       | $                      | —     |                   | $          | (1,361 | ) | $ | (1,361 | ) |
|                                             |       |                   |       |                   |       |   |   |
| Other income/(expense), net                      |       | $                      | (2         | )                      | $          | 150 |   | $ | (152 | ) |

 

 

Net interest expense for thethree months ended September 30, 2007 was $396,000, compared to $337,000 in thethree months ended September 30, 2006. Net interest expense for the nine monthsended September 30, 2007 was $985,000 compared to $828,000 in the nine monthsended September 30, 2006. The increase in net interest expense reflectsinterest expense on approximately $17.2 million of debt at September 30, 2007compared to debt of approximately $11.6 million at September 30, 2006.

 

The $4.0 million derivative liabilityrepresents the fair value of the conversion option calculated in connectionwith the $10.0 million convertible notes issued in January 2006. The value ofthe conversion option was bifurcated from the debt host contract and recordedas a derivative liability, which resulted in a discount to the initial carryingamount of the convertible notes. The $4.0 million discount was immediatelyexpensed in the condensed consolidated statements of operations as value ofderivative security as the notes may be converted to common stock at any timeafter issuance.

 

Effective June 28, 2006, weamended certain agreements associated with our $10 million in 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 expense forthe change in the fair value of the derivative liability in the three monthperiod ended June 30, 2006. With the elimination of the derivative component,we reclassified the total derivative liability of approximately $5.4million to additional paid-in capital.

 

The nine monthchange in value of the derivative liability 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 28, 2006, the daythe derivative component of the convertible notes was eliminated. Therevaluation of the derivative liability on March 31, 2006 and June 28, 2006, resultedin a $1.4 million expense in the nine months ended September 30, 2006.

 

Other income (expense) for thethree and nine months ended September 30, 2007 consists mainly of fluctuationsassociated with exchange rate differences related to transactions denominatedin Euros.

 

24

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**LIQUIDITY ANDCAPITAL RESOURCES**

 

The accompanying condensedconsolidated financial statements have been prepared on a going concern basis,which contemplates the realization of assets and the satisfaction ofliabilities in the normal course of business. For the nine months endedSeptember 30, 2007 and the year ended December 31, 2006, we incurred net lossesof $12.0 million and $15.9 million, respectively, and used cash in operatingactivities of $10.8 million, and $8.3 million, respectively. Absent continuedaccess to capital from the sale of securities or other sources, we maypotentially be unable to continue as a going concern.

 

The condensed consolidatedfinancial statements do not include any adjustments relating to therecoverability and classification of recorded asset amounts or the amounts andclassification of liabilities that might be necessary should we be unable tocontinue as a going concern. Continuing as a going concern depends upon ourability to generate sufficient positive cash flows to meet our obligations on atimely basis, to obtain additional financing as may be required, and ultimatelyto return to profitability.

 

Since inception, we havefinanced our operations primarily through the public and private sale of commonstock and other convertible debt securities, lines of credit and debtborrowings from financial institutions, proceeds from the exercise of optionsand warrants, short-term borrowings or guarantees from private lenders(including individuals) and credit arrangements with vendors and suppliers.

 

| **(Dollars in thousands)**   | ** ** | **September 30, 2007** | ** ** | **December 31, 2006** | ** ** |
|------------------------------|------------|------------------------|------------|-----------------------|------------|
|                         |       |                   |       |                  |       |
| Cash and cash equivalents    |       | $                      | 5,560      |                  | $          | 5,969 |   |
| Working capital              |       | $                      | 2,979      |                  | $          | 2,410 |   |
| Days sales outstanding (DSO) |       | 55.0                   |       | 36.0                  |       |
| Inventory turns - annualized |       | 4.1                    |       | 5.2                   |       |

 

| ** **                                | ** ** | **Nine  Months Ended**  | ** ** |
|-------------------------------------------|------------|-------------------------|------------|
| ** **                                | ** ** | **September  30, 2007** | ** ** | **September  30, 2006** | ** ** |
|                                      |       |                    |       |   |   |
| Net cash used in operating activities     |       | $                       | (10,819    | ) | $ | (6,087 | ) |
| Net cash used in investing activities     |       | $                       | (607       | ) | $ | (412 | ) |
| Net cash provided by financing activities |       | $                       | 10,998     |   | $ | 6,982 |   |

 

 

Net cash used in operatingactivities

 

| ** **                            | ** ** | **Nine Months Ended,**  | ** ** | ** **              | ** ** |
|---------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| **(In thousands)**                    | ** ** | **September  30, 2007** | ** ** | **September  30, 2006** | ** ** | **Change  in** | ** ** |
| ** **                            | ** ** | **cash  (used)**        | ** ** | **cash  (used)**        | ** ** | **cash  (used)** | ** ** |
| ** **                            | ** ** | **provided**            | ** ** | **provided**            | ** ** | **provided** | ** ** |
|                                  |       |                    |       |                    |       |   |   |
| Net loss                              |       | $                       | (12,013    | )                       | $          | (12,910 | ) | $ | 897 |   |
| Non-cash income statement items       |       | 2,325                   |       | 7,668                   |       | (5,343 | ) |
| Adjusted net loss                     |       | (9,688                  | )          | (5,242                  | )          | (4,446 | ) |
|                                  |       |                    |       |                    |       |   |   |
| Changes in working capital            |       | (1,131                  | )          | (845                    | )          | (286 | ) |
|                                  |       |                    |       |                    |       |   |   |
| Net cash used in operating activities |       | $                       | (10,819    | )                       | $          | (6,087 | ) | $ | (4,732 | ) |
|                                       |            |                         |            |                         |            |  |  |  |  |  |  |

 

 

Net cash used in operatingactivities for the nine months ended September 30, 2007 and 2006 was $10.8million and $6.1 million, respectively. The increase in net cash used inoperating activities mainly reflects an increase in the net loss adjusted fornon-cash items, a decrease in cash provided by accounts payable and accruedliabilities, partially offset by a decrease in cash used by accountsreceivable, inventories and prepaid expenses and other current assets. Thedecrease in cash used by accounts receivable and inventories reflects our lowersales run rate compared to prior year. The decrease in cash provided byaccounts payable and accrued liabilities mainly reflects the timing of paymentsrelated to our UWB investment.

 

25

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Two customers had accounts receivablebalances in excess of 10% of our total accounts receivable at September 30,2007. These customers accounted for 27% of our total accounts receivable atthat date.

 

We expect that our operatingcash flows may fluctuate in future periods as a result of fluctuations in ouroperating results, shipment timetable and accounts receivable collections,inventory management, and the timing of payments among other factors.

 

Net cash used in investingactivities

 

Net cash used in investingactivities was $607,000 for the nine months ended September 30, 2007, comparedto $412,000 used in the nine months ended September 30, 2006. The increase incash used in investing activities mainly reflects the timing of purchases ofequipment and design tools related to our investment in UWB technology.

 

Net cash provided by financingactivities

 

Net cash provided by financingactivities was $11.0 million for the nine months ended September 30, 2007,compared to $7.0 million for the nine months ended September 30, 2006. The netcash provided by financing activities in the nine months ended September 30,2007 mainly consists of net proceeds of $11.1 million from the issuance ofstock in two private placements, $207,000 from the exercise of stock optionsand warrants, partly offset by the net repayment of $190,000 associated withour term loan and line of credit. The net cash provided by financing activitiesin the nine months ended September 30, 2006 mainly consists of proceeds of$10.0 million from the issuance of convertible notes, $500,000 of borrowingunder the line of credit, $700,000 of borrowing under the term loan andproceeds of $1.3 million from the exercise of stock options and warrants,partially offset by the repayment of $5.5 million associated with our term loanand line of credit.

** **

**CapitalResources and Liquidity Outlook**

** **

We have incurred losses andused net cash in operating activities for the nine months ended September 30,2007 and each of the two years in the period ended December 31, 2006, and assuch, have been dependent upon raising money for short- and long-term cashneeds through the issuance of debt, proceeds from the exercise of options andwarrants, and the sale of our common stock in private placements.

 

In November 2004, we obtained arevolving $4.0 million bank credit line under which we can borrow up to 90% ofour eligible outstanding accounts receivable. Carl Berg, a Company director andshareholder, provided a personal guarantee to secure this credit line. Inconnection with this credit line, Greater Bay Bank (“the Bank”) obtained afirst priority security interest on our accounts receivable through anagreement with Mr. Berg, which enabled Mr. Berg to retain his existing securityinterest in all of our assets while subordinating to the Bank his securityinterest in our accounts receivable. The Bank credit line is subject to ongoingcovenants, including a covenant related to operating results. Interest is payable under this loan atprime plus 1%. At September 30, 2007, there was an outstanding balanceon this credit line of $4.0 million. Based on our September 30, 2007 eligibleaccounts receivable, the maximum amount available to borrow was $3.6 million.Therefore, on October 16, 2007 we repaid $400,000 under the line of credit. Thecredit line expires on February 23, 2008.

 

On September 28, 2005, wesigned a term loan agreement with the Bank under which we can borrow up to $2.5million. The term loan has a maturity date of February 23, 2008, is interestonly until maturity and is in addition to our existing $4.0 million accountsreceivable based secured line of credit facility described above with the Bank.Interest is payable under this loan at prime plus 1%. At September 30, 2007,the outstanding balance under this term loan was $1.7 million, $800,000 lessthan the maximum amount of $2.5 million that was available to borrow.

 

On January 27, 2006, we raised gross proceeds of $10.0 million from theissuance of secured convertible notes to a group of private investors. Interestaccrues on the principal amount of the notes at a rate of 10% per annum,payable semi-annually. The notes are convertible into shares of Focus commonstock at a conversion price of $1.00 per share. The notes are due January 1,2011 and are secured by all of the assets of Focus. Under certaincircumstances, including a change in control or our failure to continue to belisted on the Nasdaq Stock Market, the due date of the notes may beaccelerated. On June 30, 2006, December 30, 2006 and June 30, 2007, in accordancewith the terms of the secured convertible notes, we issued an additional$425,000, $521,000 and $547,000 of convertible notes in lieu of a cash interestpayment due on June 30, 2006,  December30, 2006 and June 30, 2007, respectively.

 

We received net proceeds of $6.2 million from the issuance of commonstock to a group of private investors in February 2007, and $4.9 millionfrom the issuance of common stock to a group of private investors inSeptember 2007. In addition to these funds, we will have to raiseadditional amounts before March 31, 2008, to continue development and launchcommercialization of our next generation

 

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UWB products. The amount necessary will depend upon the results and timingof ongoing UWB development efforts and the anticipated growth of oursemiconductor and systems businesses. Our future capital requirements will remain dependent upon  these and other  factors, including cash flow from operations,maintaining our gross margins at current or increased  levels, continued progress in research anddevelopment programs, competing technological and market developments, and ourability to market our new products successfully.

 

Summary of Certain Contractual Obligations as ofSeptember 30, 2007
| **(In thousands)**                                | ** ** | **< 1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **Total** | ** ** |
|---------------------------------------------------|------------|-----------------|------------|---------------|------------|---------------|------------|-----------|------------|
|                                              |       |            |       |          |       |          |       |      |       |
| Capital and operating leases (including interest) |       | $               | 808        |          | $          | 1,173         |       | $         | 81         |   | $ | 2,062 |   |
| Inventory purchase commitments                    |       | 1,250           |       | —        |       | —        |       | 1,250     |       |
| Line of credit                                    |       | 4,000           |       | —        |       | —        |       | 4,000     |       |
| Term loan                                         |       | 1,700           |       | —        |       | —        |       | 1,700     |       |
| Convertible notes                                 |       | —          |       | —        |       | 11,493        |       | 11,493    |       |
| Interest on convertible notes                     |       | 1,149           |       | 2,877         |       | —        |       | 4,026     |       |
|                                              |       |            |       |          |       |          |       |      |       |
|                                              |       | $               | 8,907      |          | $          | 4,050         |       | $         | 11,574     |   | $ | 24,531 |   |

 

** **

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

** **

**Interest Rate Risk**

 

At September 30, 2007, we did not hold anyshort-term investments that would be exposed to market risk from adversemovements in interest rates.

 

At September 30, 2007, our outstanding debt obligations consisted of secured convertible notes of $11.5 million — see Note 8, “Borrowings”. A fixed interest rate is applicable to these debt obligations of 10.0% per annum.

 

**Foreign Currency Risk**

 

Gains or losses related toforeign exchange currency transactions were not material for the periods endedSeptember 30, 2007 and 2006.

 

**Item 4T.Controls and Procedures**

 

Management of the Company, withthe participation of the President and Chief Executive Officer and the ChiefFinancial Officer (its principal executive officer and principal financialofficer, respectively), evaluated our disclosure controls and procedures as ofthe end of the period covered by this Report. Based on that evaluation, thePresident and Chief Executive Officer and the Chief Financial Officer haveconcluded that, as of the end of the period covered by this Report, ourdisclosure controls and procedures are effective.

 

There was nochange in our internal control over financial reporting that occurred duringour third quarter of 2007 that has materially affected, or is reasonably likelyto materially 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 beginningwith our fiscal year ended December 31, 2008. We estimate the cost of meetingthese requirements will be approximately $650,000 through March 2009.

 

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**PART II- OTHER INFORMATION**

** **

 

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

From time to time, Focus isparty to certain claims and legal proceedings that arise in the ordinary courseof business of which, in the opinion of management, will not have a materialadverse effect on Focus’ financial position or results of operations.

 

**Item 1A.****                          ****Risk Factors**

**Exceptas described below, there have been no material changes to our risk factorsdisclosed in our Annual Report on Form 10-K for the year ended December 31,2006. You should carefully consider the risks identified therein any of whichcould materially affect our business, financial condition or future results.**

 

**We will need to raise additionalcapital, which, if through equity securities placements, will result in furtherdilution of existing and future stockholders.**

 

Historically, we have met our short- and long-term cash needs throughdebt issuances and the sale of common stock in private placements, because cashflow from operations has been insufficient to fund our operations. We receivednet proceeds of $6.2 million and $4.9 million from the issuance of common stockto a group of private investors in February 2007 and September 2007,respectively.  In addition to thesefunds, we will have to raise additional amounts before March 31, 2008, tocontinue development and launch commercialization of our next generation UWBproducts. The amount necessary will depend upon the results and timing ofongoing UWB development efforts and the anticipated growth of our Semiconductorand Systems businesses.  Our futurecapital requirements will remain dependent upon these and other  factors,including cash flow from operations, maintaining our gross margins at currentor increased  levels, continued progressin research and development programs, competing technological and marketdevelopments, and our ability to market our new products successfully.  There can be no assurance that additionalequity or debt financing, if required, will be available on acceptable terms orat all. Moreover, any equity financing or convertible debt financing wouldresult in dilution to our existing stockholders and could have a negativeeffect on the market price of our common stock.

 

**We have a significant amount of convertiblesecurities that will dilute existing stockholders upon conversion.**

 

At November 9, 2007, we had 3,161 shares of preferred stock issued andoutstanding, 5,732,447 warrants and 5,610,802 options outstanding, and $11.5million of convertible notes, which are all exercisable or convertible intoshares of common stock. The 3,161 shares of preferred stock are convertibleinto 3,161,000 shares of our voting common stock and the promissory notes areconvertible into 11,493,000 shares of common stock. Furthermore, at November 9,2007, 1,950,614 additional shares of common stock were available for grant toour employees, officers, directors and consultants under our current stockoption and incentive plans. We also may issue additional shares inacquisitions. Any additional grant of options under existing or future plans orissuance of shares in connection with an acquisition will further diluteexisting stockholders.

 

**Currently our common stock does not meet theminimum bid price requirement to remain listed on the Nasdaq CapitalMarket.  If we were to be delisted, it could, among other things, decreasethe liquidity of our common stock and limit our ability to raise additionalcapital and accelerate the amounts due under our $11.5 million outstandingprincipal amount of convertible notes at the option of the holders.**

 

Ourvoting common stock is traded on the Nasdaq Capital Market. There are variousquantitative listing requirements for a company to remain listed on the NasdaqCapital Market, including maintaining a minimum bid price of $1.00 per share ofcommon stock and maintaining stockholders’ equity of $2.5 million. On August15, 2007, the Nasdaq Stock Market notified us that for the previous 30consecutive business days, the bid price of our common stock had closed belowthe minimum $1.00 per share price requirement for continued inclusion underNasdaq Marketplace Rules. We were given until February 11, 2008 to regaincompliance with the Nasdaq Capital Market $1.00 minimum bid price rule.

If wedo not regain 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 trading market for our shares.While we would then be entitled to appeal this determination to a NasdaqListing Qualifications Panel and request a hearing. If we fail at such hearingin our efforts to retain our listing, we would be delisted.

 

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If weare delisted from the Nasdaq Capital Market, we would be forced to list ourshares on the OTC Electronic Bulletin Board or some other quotation medium,such as the pink sheets, depending on our ability to meet the specific listingrequirements of those quotation systems. As a result, an investor might find itmore difficult to trade, or to obtain accurate price quotations for, suchshares. Delisting might also reduce our ability to raise capital as wellas the visibility, liquidity, and price of our voting common stock. If ourcommon stock were not listed on the Nasdaq Capital Market or another establishedautomated over-the-counter trading market in the United States, all amountsoutstanding under our $11.5 million senior secured convertible notes wouldbecome due and payable at the option of the holders, and we may not havesufficient resources or access to additional capital to satisfy those noteobligations at the time they become due.
| **Item 2.** | **Unregistered Sales of Equity  Securities and Use of Proceeds**      |
|-------------|-----------------------------------------------------------------------|
| ** **  | ** **                                                            |
|        | (a) to (e)         None. |
|        |                                                                  |
| **Item 3.** | **Defaults Upon Senior Securities**                                   |
| ** **  | ** **                                                            |
|        | None.                                                                 |
|        |                                                                  |
| **Item 4.** | **Submission of Matters to a Vote of Security  Holders**              |
| ** **  | ** **                                                            |
|        | None.                                                                 |
| ** **  | ** **                                                            |
| **Item 5.** | **Other Information**                                                 |
| ** **  | ** **                                                            |
|        | None.                                                                 |
|        |                                                                  |
| **Item 6.** | **Exhibits**                                                          |

** **

** **
| 3.1  | ** ** | Company’s Bylaws as amended                                                                                                                                                                                                            |
|------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 4.1  | ** ** | Form of Warrant (incorporated  by reference Form 8-K filled September 18, 2007)                                                                                                                                                             |
| 4.2  | ** ** | Form of Warrant (incorporated  by reference Form 8-K filled September 27, 2007)                                                                                                                                                             |
| 10.1 | ** ** | Fifth  Addendum to Lease dated July 6, 1994, by and between H-K Associates (Lessor)  and Focus Enhancements, Inc. (Lessee) for premises at 1370 Dell Ave,  Campbell, California (incorporated by reference Form 8-K filled August 7,  2007) |
| 10.2 |       | Form  of Securities Purchase Agreement between the Company and the investor  signatories thereto (incorporated by reference Form 8-K filled September 18,  2007)                                                                            |
| 10.3 |       | Engagement Letter, dated  September 7, 2007, by and between the Company and Crestline Consultancy Ltd.  (incorporated by reference Form 8-K filled September 18, 2007)                                                                      |
| 10.4 |       | Selling  Agent Agreement, dated September 24, 2007, by and between the Company  and First Montauk Securities Corp. (incorporated by reference Form 8-K filled  September 27, 2007)                                                     |
| 10.5 |       | Form  of Securities Purchase Agreement between the Company and the investor  signatories thereto (incorporated by reference Form 8-K filled September 27,  2007)                                                                            |
| 31.1 |       | Rule 13a-14(a) Certification  of CEO                                                                                                                                                                                                        |
| 31.2 |       | Rule  13a-14(a) Certification of CFO                                                                                                                                                                                                        |
| 32.1 |       | CEO  906 Certification                                                                                                                                                                                                                      |
| 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.

 

 

 
| November  14, 2007 |   |   | 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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