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

**Washington,D.C. 20549**

** **

**FORM 10-Q**

** **

**ý** QUARTERLY REPORT UNDER SECTION 13 OR15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

** **

**For thequarterly period ending March 31, 2006, or**

** **

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

** **

**For thetransition period from              to             .**

 

**CommissionFile Number 1-11860**

** **

**FOCUSEnhancements, 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 Executive Offices)

 

**(408) 866-8300**

(Issuer’s Telephone Number, Including Area Code)

 

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

 

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

Largeaccelerated filer: o Accelerated filer: o Non-accelerated filer: ý

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b02 of the Exchange Act). 

Yes:o  No: ý

 

As of May 10, 2006, therewere 69.6 million shares of common stock outstanding.

 

Documents Incorporated byReference: None

 

 

----

 

**FOCUS ENHANCEMENTS, INC.**

**INDEX**

** **
| ** **                         | ** **                                                                                  | **Page**   |
|------------------------------------|---------------------------------------------------------------------------------------------|------------|
| ** **                         | ** **                                                                                  | **Number** |
| **PART I - FINANCIAL INFORMATION** | ** **                                                                                  |
| ** **                         | ** **                                                                                  | ** ** |
| **Item 1.**                        | Financial Statements (unaudited):                                                           |       |
|                               | Condensed Consolidated Statements of Operations                                             | 2          |
|                               | Condensed Consolidated Balance Sheets                                                       | 3          |
|                               | Condensed Consolidated Statements of Cash Flows                                             | 4          |
|                               | Notes to Condensed Consolidated Financial Statements                                        | 6          |
|                               |                                                                                        |       |
| **Item 2.**                        | Management’s Discussion and Analysis of Financial Condition and  Results of Operations | 17         |
|                               |                                                                                        |       |
| **Item 3.**                        | Quantitative and Qualitative Disclosures about Market Risk                                  | 24         |
|                               |                                                                                        |       |
| **Item 4.**                        | Controls and Procedures                                                                     | 24         |
|                               |                                                                                        |       |
| **PART  II - OTHER INFORMATION**   | ** **                                                                                  |
| ** **                         | ** **                                                                                  | ** ** |
| **Item 1.**                        | Legal  Proceedings                                                                          | 25         |
|                               |                                                                                        |       |
| **Item 1A.**                       | Risk  Factors                                                                               | 25         |
|                               |                                                                                        |       |
| **Item 2.**                        | Unregistered Sales of Equity Securities and Use of Proceeds                                 | 25         |
|                               |                                                                                        |       |
| **Item 3.**                        | Defaults Upon Senior Securities                                                             | 26         |
|                               |                                                                                        |       |
| **Item 4.**                        | Submission of Matters to a Vote of Security Holders                                         | 26         |
|                               |                                                                                        |       |
| **Item 5.**                        | Other  Information                                                                          | 26         |
|                               |                                                                                        |       |
| **Item 6.**                        | Exhibits                                                                                    | 26         |
| ** **                         | ** **                                                                                  | ** ** |
| **SIGNATURES**                     | 27                                                                                          |
|                               |                                                                                        |       |
| **CERTIFICATIONS**                 |                                                                                        |

 

1

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**PART I -FINANCIAL INFORMATION**

**Item 1.    Financial Statements**

**Focus Enhancements, Inc.**

**Condensed Consolidated Statements ofOperations**

(In thousands, except per share amounts)

(Unaudited)

 
| ** **                                                                | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                | ** ** | **March 31, 2006**     | ** ** | **March 31, 2005** | ** ** |
|                                                                      |       |                             |       |   |   |
| Net revenue                                                               |       | $                                | 7,133      |   | $ | 5,455 |   |
| Cost of revenue                                                           |       | 4,468                            |       | 3,700 |   |
| Gross margin                                                              |       | 2,665                            |       | 1,755 |   |
|                                                                      |       |                             |       |   |   |
| Operating expenses:                                                       |       |                             |       |   |   |
| Sales, marketing and support                                              |       | 2,074                            |       | 1,424 |   |
| General and administrative                                                |       | 915                              |       | 1,001 |   |
| Research and development                                                  |       | 2,981                            |       | 3,942 |   |
| Amortization of intangible assets                                         |       | 127                              |       | 149 |   |
|                                                                      |       | 6,097                            |       | 6,516 |   |
| Loss from operations                                                      |       | (3,432                           | )          | (4,761 | ) |
| Interest expense, net                                                     |       | (199                             | )          | (13 | ) |
| Value of  derivative security                                             |       | (4,000                           | )          | — |   |
| Change in  value of derivative security                                   |       | 400                              |       | — |   |
| Other income                                                              |       | 70                               |       | — |   |
| Loss before income taxes                                                  |       | (7,161                           | )          | (4,774 | ) |
| Income tax expense                                                        |       | 9                                |       | 4 |   |
| Net loss                                                                  |       | $                                | (7,170     | ) | $ | (4,778 | ) |
|                                                                      |       |                             |       |   |   |
| Net loss per share - basic and diluted                                    |       | $                                | (0.11      | ) | $ | (0.08 | ) |
|                                                                      |       |                             |       |   |   |
| Weighted average common and common  equivalent shares - basic and diluted |       | 68,155                           |       | 59,081 |   |

 

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

 

2

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**FocusEnhancements, Inc.**

**Condensed Consolidated Balance Sheets**

(In thousands, except share and per share amounts)

(Unaudited)

 
| ** **                                                                                                                                                                                           | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                           | ** ** | **2006**           | ** ** | **2005**              | ** ** |
| **Assets**                                                                                                                                                                                           |       |               |       |                  |       |
|                                                                                                                                                                                                 |       |               |       |                  |       |
| Current assets:                                                                                                                                                                                      |       |               |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                            |       | $                  | 1,107      |                  | $          | 637 |   |
| Accounts receivable, net of allowances of  $376 and $418, respectively                                                                                                                               |       | 4,445              |       | 3,197                 |       |
| Inventories                                                                                                                                                                                          |       | 4,598              |       | 3,743                 |       |
| Prepaid expenses and other current assets                                                                                                                                                            |       | 799                |       | 759                   |       |
| Total current assets                                                                                                                                                                                 |       | 10,949             |       | 8,336                 |       |
|                                                                                                                                                                                                 |       |               |       |                  |       |
| Long-term assets:                                                                                                                                                                                    |       |               |       |                  |       |
| Property and equipment, net                                                                                                                                                                          |       | 1,116              |       | 1,212                 |       |
| Other assets                                                                                                                                                                                         |       | 54                 |       | 54                    |       |
| Intangible assets, net                                                                                                                                                                               |       | 694                |       | 866                   |       |
| Goodwill                                                                                                                                                                                             |       | 13,191             |       | 13,191                |       |
|                                                                                                                                                                                                 |       | $                  | 26,004     |                  | $          | 23,659 |   |
|                                                                                                                                                                                                 |       |               |       |                  |       |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                                       |       |               |       |                  |       |
|                                                                                                                                                                                                 |       |               |       |                  |       |
| Current liabilities:                                                                                                                                                                                 |       |               |       |                  |       |
| Accounts payable                                                                                                                                                                                     |       | $                  | 4,377      |                  | $          | 3,001 |   |
| Accrued liabilities                                                                                                                                                                                  |       | 2,883              |       | 3,292                 |       |
| Current portion of capital lease  obligations                                                                                                                                                        |       | 81                 |       | 107                   |       |
| Borrowings under line of credit                                                                                                                                                                      |       | —             |       | 2,966                 |       |
| Current portion of notes payable to bank                                                                                                                                                             |       | —             |       | 3                     |       |
| Term loan                                                                                                                                                                                            |       | —             |       | 2,500                 |       |
| Total current liabilities                                                                                                                                                                            |       | 7,341              |       | 11,869                |       |
|                                                                                                                                                                                                 |       |               |       |                  |       |
| Long-term liabilities:                                                                                                                                                                               |       |               |       |                  |       |
| Convertible notes                                                                                                                                                                                    |       | 10,000             |       | —                |       |
| Derivative liability                                                                                                                                                                                 |       | 3,600              |       | —                |       |
| Other liabilities                                                                                                                                                                                    |       | 26                 |       | 100                   |       |
| Capital lease obligations, net of current  portion                                                                                                                                                   |       | —             |       | 10                    |       |
| Total liabilities                                                                                                                                                                                    |       | 20,967             |       | 11,979                |       |
|                                                                                                                                                                                                 |       |               |       |                  |       |
| Stockholders’ equity:                                                                                                                                                                           |       |               |       |                  |       |
| Preferred stock, $0.01 par value; authorized  3,000,000 shares; 3,161 shares issued and outstanding at March 31, 2006 and  December 31, 2005, respectively (aggregate liquidation preference $3,917) |       | —             |       | —                |       |
| Common stock, $0.01 par value; 100,000,000  shares authorized, 69,593,433 and 68,382,113 shares issued and outstanding at  March 31, 2006 and December 31, 2005, respectively                        |       | 686                |       | 674                   |       |
| Treasury stock at cost, 497,055 shares at  March 31, 2006  and December 31, 2005, respectively                                                                                                       |       | (750               | )          | (750                  | )          |
| Additional paid-in capital                                                                                                                                                                           |       | 101,639            |       | 101,297               |       |
| Deferred stock-based compensation                                                                                                                                                                    |       | —             |       | (214                  | )          |
| Accumulated other comprehensive income                                                                                                                                                               |       | 6                  |       | 47                    |       |
| Accumulated deficit                                                                                                                                                                                  |       | (96,544            | )          | (89,374               | )          |
|                                                                                                                                                                                                 |       |               |       |                  |       |
| Total stockholders’ equity                                                                                                                                                                      |       | 5,037              |       | 11,680                |       |
|                                                                                                                                                                                                 |       |               |       |                  |       |
|                                                                                                                                                                                                 |       | $                  | 26,004     |                  | $          | 23,659 |   |

 

The accompanying notes are an integral partof the condensed consolidated financial statements.

 

3

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**Focus Enhancements, Inc.**

**Condensed Consolidated Statements of CashFlows**

(In thousands)

(Unaudited)

 
| ** **                                                                                      | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                      | ** ** | **March 31, 2006**     | ** ** | **March 31, 2005** | ** ** |
| Cash flows from operating activities:                                                           |       |                             |       |   |   |
| Net loss                                                                                        |       | $                                | (7,170     | ) | $ | (4,778 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities:                    |       |                             |       |   |   |
| Depreciation and amortization                                                                   |       | 370                              |       | 329 |   |
| Stock-based compensation                                                                        |       | 173                              |       | 30 |   |
| Convertible debt financing costs                                                                |       | 4,000                            |       | — |   |
| Change in value of derivative security                                                          |       | (400                             | )          | — |   |
| Changes in assets and liabilities:                                                              |       |                             |       |   |   |
| Accounts receivable                                                                             |       | (1,236                           | )          | 262 |   |
| Inventories                                                                                     |       | (840                             | )          | (184 | ) |
| Prepaid expenses and other assets                                                               |       | (96                              | )          | (49 | ) |
| Accounts payable                                                                                |       | 1,371                            |       | 1,567 |   |
| Accrued liabilities                                                                             |       | (454                             | )          | 531 |   |
| Net cash used in operating activities                                                           |       | (4,282                           | )          | (2,292 | ) |
|                                                                                            |       |                             |       |   |   |
| Cash flows from investing activities:                                                           |       |                             |       |   |   |
| Decrease in restricted cash                                                                     |       | —                           |       | 279 |   |
| Purchases of property and equipment                                                             |       | (101                             | )          | (420 | ) |
| Net cash used in investing activities                                                           |       | (101                             | )          | (141 | ) |
|                                                                                            |       |                             |       |   |   |
| Cash flows from financing activities:                                                           |       |                             |       |   |   |
| Proceeds from issuance of convertible debt                                                      |       | 10,000                           |       | — |   |
| Repayment of lines of credit                                                                    |       | (2,966                           | )          | (311 | ) |
| Repayment of short-term debt                                                                    |       | (2,503                           | )          | (11 | ) |
| Repayment of transaction costs related to  acquisition of Visual Circuits Corporation           |       | —                           |       | 225 |   |
| Proceeds from exercise of common stock  options, net of issuance costs                          |       | 357                              |       | (14 | ) |
| Payments under capital lease obligations                                                        |       | (36                              | )          | — |   |
| Proceeds from issuance of escrow stock  related to acquisition of COMO Computer and Motion GmbH |       | —                           |       | 191 |   |
| Borrowings under lines of credit                                                                |       | —                           |       | 2,493 |   |
| Net cash provided by financing activities                                                       |       | 4,852                            |       | 2,573 |   |
|                                                                                            |       |                             |       |   |   |
| Effect of exchange rate changes on cash and  cash equivalents                                   |       | 1                                |       | 12 |   |
|                                                                                            |       |                             |       |   |   |
| Increase in cash and cash equivalents                                                           |       | 470                              |       | 152 |   |
| Cash and cash equivalents at beginning of  period                                               |       | 637                              |       | 3,363 |   |
| Cash and cash equivalents at end of period                                                      |       | $                                | 1,107      |   | $ | 3,515 |   |

 

4

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**Focus Enhancements, Inc.**

**Condensed Consolidated Statements of CashFlows (Continued)**

(In thousands)

(Unaudited)

 
| ** **                                                                | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------------------------------------|------------|----------------------------------|------------|
| **Supplemental Cash Flow Information**                     | ** ** | **March 31, 2006**     | ** ** | **March 31, 2005** | ** ** |
|                                                                      |       |                             |       |   |   |
| Acquisition of property and equipment  through capital leases             |       | $                                | —     |   | $ | 190 |   |
| Issuance of common stock in connection with  earn out agreement with COMO |       | $                                | 38         |   | $ | 38 |   |

 

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

 

5

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** **

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

** **

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

 

FocusEnhancements Inc. (“Focus” or “the Company”), headquartered in Campbell, California, is aleading designer of solutions in advanced, proprietary video and wireless videotechnologies. Focus’ Semiconductor group develops integrated circuits (ICs) forhigh-performance applications in the video convergence market, including IPTVset-top boxes and portable media players. Focus is currently developing awireless IC chip set based on the WiMedia Ultra Wideband (“UWB”) standard anddesigned to be compatible with Wireless USB and used in personal computer (PC),consumer electronics and mobile electronics applications. Focus’ System groupdevelops video products for the digital media markets, with customers in thebroadcast, video production, digital signage and digital asset managementmarkets.

** **

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

 

Theaccompanying unaudited condensed consolidated financial statements of Focushave been prepared in conformitywith accounting principles generally accepted in the United States of Americaand with the instructions to Form 10-Q and Article 10 of Regulation S-X.Accordingly, they do not contain all of the information and footnotes requiredby accounting principles generally accepted in the United States of America forcomplete financial statements. The year-end condensed consolidated balancesheet data was derived from audited consolidated financial statements, but doesnot include all disclosures required by accounting principles generallyaccepted in the United 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 three months ended March 31,2006 are not necessarily indicative of the results that may be expected for anyfuture period. 

 

The condensed consolidated financialstatements of Focus as of March 31, 2006 and for the three-month periods endedMarch 31, 2006 and 2005 are unaudited and should be read in conjunction withthe audited consolidated financial statements for the year ended December 31,2005, included in Focus’ Annual Report on Form 10-K for the year ended December31, 2005.

 

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

 

Prior to January 1, 2006, Focus accounted for employee stock-basedcompensation using the intrinsic value method supplemented by pro formadisclosures in accordance with Accounting Principles Board (“APB”) Opinion No. 25and Statement of Financial Accounting Standards (“SFAS”) No. 123, “*Accounting for Stock-Based Compensation*” (“SFAS 123”), asamended by SFAS No.148 “*Accounting for Stock-BasedCompensation—Transition and Disclosures*”. Employee stock optionsgranted by Focus with an exercise price equal to the grant date fair value ofthe Company’s stock had no intrinsic value and therefore no expense wasrecorded for these options under APB Opinion No. 25. Grants of restricted stockawards were measured at fair value on the date of grant based on the number ofshares granted and the quoted price of the Company’s common stock with suchvalue recognized as an expense over the corresponding vesting period of theaward.

 

OnJanuary 1, 2006, Focus adopted SFAS No. 123 (revised 2004), *Share-Based Payment* (“SFAS 123R”). SFAS 123R eliminates thealternative of applying the intrinsic value measurement provisions of APB OpinionNo. 25 to stock compensation awards issued to employees. SFAS 123R requires companiesto measure the cost of employee services received in exchange for an award ofequity instruments based on the grant-date fair value of the award. That costwill be recognized over the period during which an employee is required toprovide services in exchange for the award. Focus adopted SFAS 123R using themodified prospective approach and therefore prior periods have not beenrestated to reflect the impact of SFAS 123R. Under SFAS 123R, stock-basedawards granted prior to its adoption will be expensed over the remainingportion of their requisite service period. These awards will be expensed underthe accelerated amortization method using the same fair value measurements thatwere used in calculating pro forma stock-based compensation expense under SFAS123. For stock-based awards granted on or after January 1, 2006, Focus willamortize stock-based compensation expense on a straight-line basis over the requisiteservice period, which is generally a four year vesting period. SFAS 123Rrequires that the deferred stock-based compensation on the condensedconsolidated balance sheets on the date of adoption be netted againstadditional paid-in capital. As of December 31,

 

6

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2005,there was a balance of $214,000 of deferred stock-based compensation, which wasnetted against additional paid-in capital on January 1, 2006.

 

Forthe three months ended March 31, 2006, Focus recorded stock-based compensationexpense related to stock options and restricted stock awards of $173,000, ofwhich $22,000 related to restricted stock awards that would have been includedin Focus’ condensed consolidated statements of operations under the provisionsof APB 25. As a result of adopting SFAS 123R, Focus’ net loss was increased by$151,000. The implementation of SFAS 123R did not affect basic and diluted netloss per share nor cash flows from operations for the three months ended March31, 2006. For the three months ended March 31, 2005, Focus recognized $7,000 ofstock-based compensation expense under the intrinsic value method.

 

StockOptions

 

Theexercise price of each stock option equals the market price of Focus’ commonstock on the date of grant. Option grants generally vest over four years andexpire 10 years from the grant date. The fair value of each option grant isestimated on the date of grant using the Black-Scholes option pricing model.The weighted average assumptions used in the model are outlined in thefollowing table:

 
| ** **                       | ** ** | **Three Months  Ended March 31,  2006** | ** ** |
|----------------------------------|------------|--------------------------------------------------------|------------|
|                             |       |                                                   |       |
| Average computed life of options |       | 3-4 years                                              |       |
| Risk-free rate of interest       |       | 4.56% - 4.58                                           | %          |
| Volatility of common stock       |       | 81                                                     | %          |
| Dividend yield                   |       | 0                                                      | %          |

 

A summary of activity related to Focus’ stockoption incentive plans for the three months ended March 31, 2006 is presentedbelow:

 
| ** **                                                            | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** | **Aggregate  Intrinsic  Value (000s)** | ** ** |
|-----------------------------------------------------------------------|------------|------------|------------|----------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------|------------|
|                                                                  |       |       |       |                                   |       |                                                |       |                                        |       |
| Options outstanding at beginning of year                              |       | 7,253,787  |       | $                                      | 1.10       |                                                |       |                                        |       |   |
| Options granted                                                       |       | 548,574    |       | $                                      | 0.68       |                                                |       |                                        |       |   |
| Options exercised                                                     |       | (653,012   | )          | $                                      | 0.56       |                                                |       |                                        |       |   |
| Options canceled                                                      |       | (153,357   | )          | $                                      | 0.89       |                                                |       |                                        |       |   |
|                                                                  |       |       |       |                                   |       |                                                |       |                                        |       |
| Options outstanding at March 31, 2006                                 |       | 6,995,992  |       | $                                      | 1.12       |                                                | 5.5        |                                        | $          | 32 |   |
|                                                                  |       |       |       |                                   |       |                                                |       |                                        |       |
| Options exercisable and expected to be  exercisable at March 31, 2006 |       | 6,642,767  |       | $                                      | 1.12       |                                                | 5.3        |                                        | $          | 31 |   |
|                                                                  |       |       |       |                                   |       |                                                |       |                                        |       |
| Options exercisable at March 31, 2006                                 |       | 4,692,722  |       | $                                      | 1.18       |                                                | 4.1        |                                        | $          | 31 |   |

 

The weightedaverage grant date fair value of options granted in the three months endedMarch 31, 2006 was $0.44 per share. The intrinsic value of options exercisedduring the three months ended March 31, 2006 was $49,000. The total fair valueof options that vested during the quarter ended March 31, 2006 was $189,000. AtMarch 31, 2006, Focus had $817,000 of unrecognized compensation expense, net ofestimated forfeitures, related to stock option plans, which will be recognizedover the weighted average period of 2.9 years. Cash received from stock optionexercises was $367,000 for the three months ended March 31, 2006.

 

7

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RestrictedStock Awards

 

A summary of activity related to Focus’ restrictedstock awards for the three months ended March 31, 2006 is presented below:

 
| ** **                                                             | ** ** | **Shares** | ** ** | **Weighted  Average  Grant Date  Fair Value** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** | **Aggregate  Intrinsic  Value (000s)** | ** ** |
|------------------------------------------------------------------------|------------|------------|------------|---------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------|------------|
|                                                                   |       |       |       |                                                    |       |                                                |       |                                        |       |
| Non-vested restricted stock shares  outstanding at beginning of year   |       | 245,000    |       | $                                                       | 1.11       |                                                |       |                                        |       |   |
| Restricted stock shares granted                                        |       | 535,176    |       | $                                                       | 0.68       |                                                |       |                                        |       |   |
| Restricted stock shares vested                                         |       | (61,250    | )          | $                                                       | 1.11       |                                                |       |                                        |       |   |
|                                                                   |       |       |       |                                                    |       |                                                |       |                                        |       |
| Non-vested restricted stock shares  outstanding at March 31, 2006      |       | 718,926    |       | $                                                       | 0.79       |                                                | 3.6        |                                        | $          | 474 |   |
|                                                                   |       |       |       |                                                    |       |                                                |       |                                        |       |
| Non-vested restricted stock shares expected  to vest at March 31, 2006 |       | 545,004    |       | $                                                       | 0.84       |                                                | 3.2        |                                        | $          | 360 |   |

 

At March 31,2006, Focus had $388,000 of unrecognized compensation expense, net offorfeitures, related to restricted stock awards, which will be recognized overthe weighted average period of 3.6 years.

 

Pro FormaInformation under SFAS 123 for the Three Months Ended March 31, 2005

 

Prior to 2006, Focusfollowed the disclosure-only provisions of SFAS 123. The following tableillustrates the effect on net loss and net loss per share for the three monthsended March 31, 2005 had the fair value recognition provisions of SFAS 123 beenapplied to options granted under Focus’ equity-based employee compensationplans. For purposes of this pro forma disclosure, the estimated value of theoptions is recognized over the options’ vesting periods. If Focus hadrecognized the expense of equity programs in the consolidated statement ofoperations, additional paid-in capital would have increased by a correspondingamount.

 
| **(In thousands, except per share data)**                                      | ** ** | **Three Months  Ended March 31,  2005** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|
|                                                                                                    |       |                                                   |       |
| Reported net loss                                                                                       |       | $                                                      | (4,778     | ) |
| Stock-based compensation determined under  fair value method for all awards, net of related tax effects |       | (369                                                   | )          |
|                                                                                                    |       |                                                   |       |
| Pro forma net loss                                                                                      |       | $                                                      | (5,147     | ) |
|                                                                                                    |       |                                                   |       |
| Reported net loss per share                                                                             |       | $                                                      | (0.08      | ) |
| Stock-based compensation determined under  fair value method for all awards, net of related tax effects |       | (0.01                                                  | )          |
|                                                                                                    |       |                                                   |       |
| Basic and diluted pro forma net loss per  share                                                         |       | $                                                      | (0.09      | ) |

 

For purposes of the weightedaverage estimated fair value calculations, the fair value of each stock optiongrant is estimated on the date of grant using the Black-Scholes option pricingmodel and the following assumptions:

 

8

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| ** **                       | ** ** | **Three Months  Ended March 31,  2005** | ** ** |
|----------------------------------|------------|--------------------------------------------------------|------------|
|                             |       |                                                   |       |
| Average computed life of options |       | 1-6 years                                              |       |
| Risk-free rate of interest       |       | 3.0%-3.8                                               | %          |
| Volatility of common stock       |       | 88                                                     | %          |
| Dividend yield                   |       | 0                                                      | %          |

 

Based on the Black-Scholesoption pricing model, the weighted average estimated fair value of employeestock option grants was $0.60 per share for the three months ended March 31,2005.

 

**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 theperiod, if dilutive. Options to purchase 6,995,992 and 7,707,010 shares ofcommon stock, unvested shares of restricted stock of 718,926 and 245,000,warrants to purchase 6,056,865 and 3,311,768 shares of common stock and 3,161shares of preferred stock convertible into 3,161,000 shares of common stockwere outstanding at March 31, 2006 and 2005, respectively, but were notincluded in the computation of diluted net loss per share as the effect wouldhave been anti-dilutive. In addition, convertible notes that are convertibleinto 10,000,000 shares of common stock were outstanding at March 31, 2006, butwere not included in the computation of diluted net loss per share as theeffect would have been anti-dilutive.

 

**5.**                                      Significant Customers

 

No customer accounted for more than 10% ofFocus’ revenue in the three months ended March 31, 2006. Sales to one customeraccounted for 15% of Focus’ revenue in the three months ended March 31, 2005. 

 

Three customers had accountsreceivable balances in excess of 10% of Focus’ total accounts receivable atMarch 31, 2006. These customers accounted for 38% of Focus’ total accountsreceivable at that date. As of December 31, 2005, twodistributors each represented approximately 12% of Focus’ accounts receivable.

 

**6.**                                      Management’s Plans

 

The accompanying condensed consolidated financial statements have beenprepared on a going concern basis, which contemplates the realization of assetsand the satisfaction of liabilities in the normal course of business. For thethree months ended March 31, 2006 and the year ended December 31, 2005, Focusincurred net losses of $7.2 million and $15.4 million, respectively, and usednet cash in operating activities of $4.3 million and $12.5 million,respectively. These results indicate that Focus may potentially be unable tocontinue as a going concern.

 

The condensed consolidated financialstatements do not include any adjustments relating to the recoverability andclassification of recorded asset amounts or the amounts and classification ofliabilities that might be necessary should Focus be unable to continue as agoing concern. Focus’ continuation as a going concern is dependent upon itsability to generate sufficient cash flows to meet its obligations on a timelybasis, to obtain additional financing as may be required, and ultimately toreturn to profitability and significant positive cash flows.

 

Focushas historically met cash needs from the proceeds of debt, the sale of commonstock in private placements and the exercise of employee stock options andwarrants. Management continues to assess its product lines in light oftechnology trends and economic conditions, to identify how to enhance existingproduct lines or create new distribution channels. 

 

Focusreceived gross proceeds of $10.0 million from the issuance of securedconvertible notes to a group of private investors in January 2006. Whilemanagement believes that these funds, along with the cash flow generated byFocus’ 

 

9

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expandingSystems business, should be adequate to enable Focus to complete its Ultra Wideband(“UWB”) engineering development and launch commercialization of its UWBproducts, depending upon the results and timing of its UWB initiative and theprofitability of its Systems business, Focus may need to raise further capitalin 2006. There can be no assurance that sufficient funds will be raised.Moreover, any equity financing or convertible debt financing would result indilution to Focus’ existing stockholders and could have a negative effect onthe market price of its common stock. Furthermore, any additional debtfinancing will result in higher interest expense.

 

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

 

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

 

Goodwill as of March 31, 2006 and December 31, 2005included 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:

 
| ** **              | ** ** | **March 31, 2006** | ** ** |
|-------------------------|------------|------------------------------|------------|
| ** **              | ** ** | ** **                   | ** ** | **Accumulated** | ** ** | **Net** | ** ** |
| **(In thousands)** | ** ** | **Gross Amount**        | ** ** | **Amortization** | ** ** | **Amount** | ** ** |
|                    |       |                         |       |   |   |   |   |
| Existing technology     |       | $                            | 3,945      |   | $ | (3,251 | ) | $ | 694 |   |
| Tradename               |       | 176                          |       | (176 | ) | — |   |
|                    |       |                         |       |   |   |   |   |
|                    |       | $                            | 4,121      |   | $ | (3,427 | ) | $ | 694 |   |

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

 

Thetotal expected future amortization related to intangible assets is provided inthe table below:

 

10

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| **(In thousands)**              | ** ** | **Amortization** | ** ** |
|--------------------------------------|------------|------------------|------------|
|                                 |       |             |       |
| Nine months ending December 31, 2006 |       | $                | 637        |   |
| Fiscal year 2007                     |       | 57               |       |
|                                 |       |             |       |
|                                 |       | $                | 694        |   |

 

**8.****                                      Inventories**

** **

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

 
| **(In thousands)** | ** ** | **March 31, 2006** | ** ** | **December 31, 2005** | ** ** |
|-------------------------|------------|------------------------------|------------|---------------------------------|------------|
|                    |       |                         |       |                            |       |
| Raw materials           |       | $                            | 2,561      |                            | $          | 2,427 |   |
| Work in process         |       | 96                           |       | 146                             |       |
| Finished goods          |       | 1,941                        |       | 1,170                           |       |
|                    |       |                         |       |                            |       |
|                    |       | $                            | 4,598      |                            | $          | 3,743 |   |

 

**9.**                                      Borrowings

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

 

AccountsReceivable-Based Line of Credit

 

In November2004, Focus obtained a $4.0 million line of credit from Greater Bay Bank under which it can borrow upto 90% of its eligible outstanding accounts receivable. The credit line expireson December 24, 2006 as a result of an extension granted in November 2005 andis collateralized by a personal guarantee from Carl Berg, a Company directorand shareholder. In connection with this credit line, the bank has obtained afirst priority security interest in Focus’ accounts receivable through anagreement with Mr. Berg, which enables Mr. Berg to retain his existing securityinterest in all of Focus’ assets while subordinating his interest in Focus’accounts receivable.

 

Thecredit line is subject to ongoing covenants including a covenant based onoperating results. Borrowings under the credit line bear interest at a rate ofprime plus 1%, which was 8.75% at March 31, 2006. At March31, 2006, there was no outstanding balance on this credit line and Focushad the ability to borrow the maximum available amount of $4.0 million.

 

11

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Term Loan

 

On June 28,2005, Focus signed a term loan agreement with Greater Bay Bank under which Focus can borrow up to$2.5 million. The term loan has a maturity date of December 24, 2006. Mr. Berghas personally guaranteed the loan, which is interest only until maturity andis in addition to Focus’ existing $4.0 million accounts receivable basedsecured line of credit that Focus has with this bank. Interest is payable underthis term loan at prime plus 1%, which was 8.75% at March 31, 2006. At March 31, 2006, there was nooutstanding balance under this term loan.

 

ConvertibleNotes and Derivative Liability

 

OnJanuary 27, 2006, Focus issued $10.0 million in aggregate principal amount of10% secured convertible notes due January 1, 2011 to certain purchasers. Thefollowing are the key features of the notes: 

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

•                  Interest due on the first three semi-annualpayments may, at the issuers option, be paid in the form of a note with thesame terms and conditions of the original notes, including conversion rights. 

•                  The notes are convertible, at the option ofthe 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.

•                  The notes are secured by all of the assets ofFocus in accordance with the terms and subject to the conditions contained in asecurity agreement entered into concurrent with the issuance of the notes.

•                  The notes are redeemable, at the option ofFocus, at any time at a redemption price equal to 102% times the face rate ofthe notes, plus any accrued interest.

•                  Upon a fundamental change, which includes achange in control of Focus, each holder of the notes may require Focus torepurchase all of its debt at a purchase price equal to 101% of the principalamount of the notes plus accrued and unpaid interest

 

Pursuantto the Registration Rights Agreement with the Purchasers dated January 24, 2006(the “Registration Rights Agreement”), Focus agreed to file a resaleregistration statement covering the resale of the shares issuable to theinvestors upon the conversion of the notes.The due date may accelerate in the event Focuscommences any case relating to bankruptcy or insolvency, or related events ofdefault. 

 

Pursuantto the Registration Rights Agreement, Focus agreed to file a resaleregistration statement on Form S-3 covering the resale of the shares issuableto the investors upon the conversion of the notes. On May 10, 2006, theregistration statement filed by Focus to register the shares underlying thenotes was declared effective by the Securities and Exchange Commission asrequired by the Registration Rights Agreements. Focus must maintain aneffective registration statement until the earlier to occur of (i) the dateafter which all the shares registered there under have been sold or (ii) thedate all shares underlying the notes may be sold without volume restrictionspursuant to Rule 144(k). Subject to certain conditions, the holders of the convertiblenotes may, at their election, exchange the notes for interests in an entity orentities to which Focus’ semiconductor business is spun off, if such an eventoccurs prior to July 24, 2007, at a conversion rate equal to 1% of votinginterests in such other entity for every $400,000 of note principal, up to acollective maximum of 25% of the voting power of such other entity. As of March31, 2006, no date has been set for the potential spin-off nor have the exactassets and liabilities to be included in such a spin-off been determined.

 

Pursuantto Emerging Issues Task Force (“EITF”) 00-19, “*Accountingfor Derivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock*” (“EITF 00-19”), Focus evaluated theregistration rights agreement and concluded that it triggers the “settlement incash” assumption that underlies the separate evaluation of the derivativeelements of the contract. There is no alternative settlement option in theregistration rights agreement, even though the agreement is quiet as topenalties. The agreement represents a contingent liability that must beconsidered if registration is not successfully maintained. In accordance with SFASNo. 133, “*Accounting for Derivative Instruments and Hedging Activities*”,(“SFAS 133”), Focus determined that the conversion feature of the notes met thecriteria of an embedded derivative and therefore the conversion feature of thedebt needed to be bifurcated and accounted for as a derivative. 

 

The conversion feature failsto qualify for equity classification under EITF 00-19, and must be accountedfor as a derivative liability. Focus accounts for derivative financialinstruments in accordance with SFAS 133. Derivative financial instruments arerecorded as liabilities in the condensed consolidated balance sheets andmeasured at fair value. When available, quoted market prices are used indetermining fair value. However, if quoted market prices are not available, Focusestimates fair value using either quoted market prices of financial instrumentswith similar characteristics or other valuation techniques. These derivativeliabilities will be revalued each quarter with the change in

 

12

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fair value recorded in thestatement of operations. 

 

Using a binomial options valuation model, the fair value of the conversionoption within the convertible notes was initially computed at $4.0 million.The model used several assumptions including: historical stock price volatility(utilizing a five-year period), risk-free interest rate (4.50%), remaining timeto maturity and the closing price of Focus’ common stock, to determine theestimated fair value of the derivative liability. The value of thisembedded derivative instrument was bifurcated from the debt host contract andrecorded as a derivative liability, which resulted in a discount to the initialcarrying amount of the convertible notes. The $4.0 million discount was immediately expensed in the condensedconsolidated statements of operations as value of derivative security as thenotes may be converted to common stock at any time after issuance.

 

At March 31, 2006, Focus revalued the derivativeliability based on the closing price of Focus’ common stock of $0.66, theremaining term coinciding with the contract and utilizing a volatility of 87%.For the three months ended March 31, 2006, due in part to a decrease in themarket value of Focus’ common stock, Focus recorded a $400,000 gain for thechange in the fair value of the derivative liability.

 

Therecorded value of the derivative liability can fluctuate significantly based onfluctuations in the fair value of Focus’ common stock, as well as in thevolatility of the stock price during the term used for observation and theterm. Accordingly, these fluctuations can create significant income and expenseitems in Focus’ consolidated financial statements.

 

**10.**                               Commitments and Contingencies

 

Research and Development Agreements

 

In October2004, Focus entered into a design services contract under which Focus agreed topay $2.9 million to a third party for the design and development of highperformance UWB integrated circuits. The contract amount was subsequently increasedto $3.3 million. Payments are made upon the completion of specific milestones bythe third party, which are expected to be completed by June 2006. For the threemonths ended March 31, 2006 and 2005, $292,000 and $850,000, respectively, wascharged to research and development expense based on the level of effortincurred by the third party. At March 31, 2006, $5,000 was included withinprepaid expenses and other current assets.

 

In July 2005,Focus entered into a development agreement with a customer under which thecustomer agreed to pay Focus for the joint development by Focus and thecustomer of a custom product. The customer agreed to pay Focus $600,000 in fourinstallments of $150,000 at the completion of specific milestones. For thethree months ended March 31, 2006, $217,000 was recognized as revenue based onthe level of effort incurred by Focus and $274,000 of development expense wasrecorded in cost of revenue. An amount of $104,000 was recorded in accountsreceivable at March 31, 2006, representing the difference between the amountreceived from the customer of $450,000 and the total revenue recognized fromthe inception of the project. 

 

Leases

 

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

 

Minimum leasecommitments at March 31, 2006 were as follows: 

 

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| ** **                                             | ** ** | **Operating Lease** | ** ** | **Capital Lease** | ** ** |
|--------------------------------------------------------|------------|--------------------------|------------|------------------------|------------|
| **(In thousands)**                                | ** ** | **Commitments**          | ** ** | **Commitments**        | ** ** |
|                                                   |       |                     |       |                   |       |
| 2006                                                   |       | $                        | 417        |                   | $          | 76 |   |
| 2007                                                   |       | 522                      |       | 10                     |       |
| 2008                                                   |       | 182                      |       | —                 |       |
| 2009                                                   |       | 190                      |       | —                 |       |
| 2010                                                   |       | 114                      |       | —                 |       |
|                                                   |       |                     |       |                   |       |
|                                                   |       | $                        | 1,425      |                   | 86         |   |
|                                                   |       |                     |       |                   |       |
| Less: amount representing interest                     |       |                     |       | (5                     | )     |
|                                                   |       |                     |       |                   |       |
| Present value of future minimum future  lease payments |       |                     |       | $                      | 81         |   |

 

Inventory PurchaseCommitments

 

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

 

AtMarch 31, 2006, Focus had issued non-cancelable purchase orders forapproximately $2.3 million to purchase finished goods from its contractmanufacturers, and had not incurred any significant liability for finishedgoods in excess of current customer demand or for the costs of excess orobsolete inventory.

 

General

 

Fromtime-to-time, Focus is party to certain other claims and legal proceedings thatarise in the ordinary course of business which, in the opinion of management,will not have a material adverse effect on Focus’ financial position or resultsof operation.

 

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

 

Aspart of the acquisition of COMO Computer & Motion GmbH (“COMO”) on February27, 2004, Focus agreed toissue an additional 46,266 shares of its common stock to COMO’s shareholders,in the event certain conditions were met at the end of 2004 and 2005. Theserelevant conditions were met, and accordingly, 23,134 shares were issued toCOMO’s former shareholders in March 2005 and 23,132 shares were issued inFebruary 2006.

 

As of March 31, 2006, Focus was obligated under certain circumstances,to issue the following additional shares of common stock pursuant to derivativesecurities, instruments or agreements:

 
| ** **                                     | ** ** | **Shares of**    | ** ** |
|------------------------------------------------|------------|-----------------------|------------|
| **(In thousands)**                        | ** ** | **Common Stock** | ** ** |
|                                           |       |                  |       |
| Options to purchase common stock               |       | 6,996                 |       |
| Warrants to purchase common stock              |       | 6,057                 |       |
| Preferred stock convertible into common  stock |       | 3,161                 |       |
| Convertible notes                              |       | 10,000                |       |
|                                           |       |                  |       |
|                                           |       | 26,214                |       |

 

14

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

 

Carl Berg

 

In December2002, Mr. Berg provided Samsung Semiconductor Inc., Focus’ contracted ApplicationSpecific Integrated Circuit (“ASIC”) manufacturer, with a personal guarantee tosecure Focus’ working capital requirements for ASIC purchase order fulfillment.Mr. Berg agreed to provide the personal guarantee on Focus’ behalf withoutadditional cost or collateral, as Mr. Berg maintains a secured priorityinterest in substantially all of Focus’ assets. At March 31, 2006, Focus owedSamsung $442,000, under net 30 terms. 

 

In November2004, Focus secured a line of credit of up to $4.0 million under which Focuscan borrow up to 90% of its eligible outstanding accounts receivable. This lineof credit is secured by a personal guarantee from Mr. Berg. In connection withthis line of credit, the bank will obtain a priority security interest in Focus’accounts receivable. Mr. Berg will maintain his security interest in all Focus’assets, subject to the bank’s lien on accounts receivable. 

 

On June 28,2005, Focus signed a term loan agreement with Greater Bay Bank under which Focus can borrow up to$2.5 million - see Note 9, “Borrowings”. Mr. Berg has personally guaranteed theterm loan. In connection with Mr. Berg’s extension of his personal guarantee,Focus agreed to continue Mr. Berg’s priority interest in the Company’s assets,except for Focus’ accounts receivable, which Mr. Berg has subordinated to thebank, and to issue to Mr. Berg a warrant to purchase 100,000 shares of commonstock at an exercise price of $0.81 per share and which expires on June28, 2009. The warrant was valued at $42,000 using the Black-Scholesoption-pricing model and was charged to general and administrative expense at thetime of issuance.

 

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

 

Dolby Laboratories Inc.

 

N. William Jasper Jr., who is the Chairman of Focus’ Board ofDirectors, is also the President and Chief Executive Officer of DolbyLaboratories, Inc. (“Dolby”), a signal processing technology company located inSan Francisco, California. Focus is required to submit quarterly royaltypayments to Dolby based on Dolby technology incorporated into certain products.For the three months ended March 31, 2006 and 2005, Focus paid Dolby nil and $3,000in royalties, respectively, which were recorded in cost of revenue.

 

Norman Schlomka

 

Norman Schlomka, GeneralManager of COMO and an executive officer of Focus since February 2006, owns onethird of the building that COMO partially occupies. For both the three-monthperiods ended March 31, 2006 and 2005, Focus paid rent of approximately $15,000related to this building.

 

***13.          BusinessSegment Information***

 

Focus’ reportablesegments are Systems and Semiconductor. These reportable segments have distinctproducts – Systems consists of products designed to provide solutions inPC-to-TV scan conversion, video presentation, digital-video conversion, videoproduction and home theater markets and Semiconductor consists of ASICs. Focus’chief operating decision maker is the CEO. 

 

Focus evaluates segmentperformance based on operating income (loss) and does not allocate netinterest, other income or taxes to operating segments. Additionally, Focus doesnot allocate assets by operating segment.

 

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| ** **                        | ** ** | **Three Months Ended March 31, 2006** | ** ** |
|-----------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                        | ** ** | **Systems**                                                    | ** ** | **Semiconductor** | ** ** | **Total** | ** ** |
|                              |       |                                                           |       |   |   |   |   |
| Net revenue                       |       | $                                                              | 5,752      |   | $ | 1,381 |   | $ | 7,133 |   |
| Cost of revenue                   |       | 3,673                                                          |       | 795 |   | 4,468 |   |
| Gross margin                      |       | 2,079                                                          |       | 586 |   | 2,665 |   |
|                              |       |                                                           |       |   |   |   |   |
| Operating expenses:               |       |                                                           |       |   |   |   |   |
| Sales, marketing and support      |       | 1,583                                                          |       | 491 |   | 2,074 |   |
| General and administrative        |       | 605                                                            |       | 310 |   | 915 |   |
| Research and development          |       | 656                                                            |       | 2,325 |   | 2,981 |   |
| Amortization of intangible assets |       | 82                                                             |       | 45 |   | 127 |   |
|                              |       | 2,926                                                          |       | 3,171 |   | 6,097 |   |
| Loss from operations              |       | $                                                              | (847       | ) | $ | (2,585 | ) | $ | (3,432 | ) |

 
| ** **                        | ** ** | **Three Months Ended March 31, 2005** | ** ** |
|-----------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                        | ** ** | **Systems**                                                    | ** ** | **Semiconductor** | ** ** | **Total** | ** ** |
|                              |       |                                                           |       |   |   |   |   |
| Net revenue                       |       | $                                                              | 4,964      |   | $ | 491 |   | $ | 5,455 |   |
| Cost of revenue                   |       | 3,441                                                          |       | 259 |   | 3,700 |   |
| Gross margin                      |       | 1,523                                                          |       | 232 |   | 1,755 |   |
|                              |       |                                                           |       |   |   |   |   |
| Operating expenses:               |       |                                                           |       |   |   |   |   |
| Sales, marketing and support      |       | 1,093                                                          |       | 331 |   | 1,424 |   |
| General and administrative        |       | 662                                                            |       | 339 |   | 1,001 |   |
| Research and development          |       | 1,082                                                          |       | 2,860 |   | 3,942 |   |
| Amortization of intangible assets |       | 86                                                             |       | 63 |   | 149 |   |
|                              |       | 2,923                                                          |       | 3,593 |   | 6,516 |   |
| Loss from operations              |       | $                                                              | (1,400     | ) | $ | (3,361 | ) | $ | (4,761 | ) |

 

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

 

InFebruary 2006, the Financial Accounting Standards Board issued Statement ofFinancial Accounting Standards No. 155 (“SFAS 155”), “*Accountingfor Certain Hybrid Instruments – an amendment of FASB Statements No. 133 and140*”. SFAS 155 amends SFAS 133, “*Accounting for DerivativeInstruments and Hedging Activities”*and SFAS No. 140*“Accounting for Transfers and Servicing of Financial Assets andExtinguishments of Liabilities”.*SFAS 155 gives entities the optionof applying fair value accounting to certain hybrid financial instruments**in their entirety if they contain certain embeddedderivatives that would otherwise require bifurcation under SFAS 133. SFAS 155will be effective as of January 1, 2007. Focus is currently assessing theimpact that SFAS 155 may have on its consolidated financial statements.

 

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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 31,2005 and Item 1A—“Risk Factors”—containedtherein.

 

**CertainFactors That May Affect Future Results**

** **

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

 

In particular, statements contained in thisdocument that are not historical facts (including, but not limited to,statements concerning anticipated revenues, anticipated operating expenselevels, capital resources and liquidity outlook, potential new products andorders, and such expense levels relative to our total revenues) constituteforward-looking statements and are made under the safe harbor provisions of thePrivate Securities Litigation Reform Act of 1995. Our actual results ofoperations and financial condition have varied and may in the future varysignificantly and materially from those stated in any forward-lookingstatements. Factors that may cause such differences include, withoutlimitation, the availability of capital to fund our future cash needs, relianceon major customers, history of operating losses, market acceptance of ourproducts, technological obsolescence, competition, successful integration ofacquisitions, 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 these factors and some of the factors that mightcause such a difference see also Item 1A of our Form 10-K under the heading “RiskFactors” and those described from time to time in our other reports filed withthe Securities and Exchange Commission. These factors should be considered inevaluating the forward-looking statements, and undue reliance should not beplaced on such statements. We do not undertake, and specifically disclaim anyobligation, to update any forward-looking statements to reflect occurrences orunanticipated events or circumstances after the date of such statements.

 

**RESULTS OF OPERATIONS**

 

#### **Net revenue**

 
| ** **                           | ** ** | **Three Months Ended** | ** ** | ** **                   | ** ** | ** **   | ** ** |
|--------------------------------------|------------|----------------------------------|------------|------------------------------|------------|--------------|------------|
| **(Dollars in thousands)** | ** ** | **March 31, 2006**     | ** ** | **March 31, 2005** | ** ** | **Increase** | ** ** | **% increase** | ** ** |
|                                 |       |                             |       |                         |       |         |       |   |   |
| System products                      |       | $                                | 5,752      |                         | $          | 4,964        |       | $ | 788 |   | 15.9 | % |
| Semiconductor products               |       | 1,381                            |       | 491                          |       | 890          |       | 181.3 | % |
|                                 |       |                             |       |                         |       |         |       |   |   |
|                                 |       | $                                | 7,133      |                         | $          | 5,455        |       | $ | 1,678 |   | 30.8 | % |

 

Revenue for the three monthsended March 31, 2006 was $7.1 million, an increase of $1.7 million, or 31percent, compared with the three months ended March 31, 2005. 

 

For the three months endedMarch 31, 2006, net sales of system products to distributors, retailers andValue Added Resellers, were approximately $5.8 million compared to $5.0 millionfor the same period in 2005, an increase of $788,000. This increase in sales ofsystems products mainly reflects sales of our FS-4, which was introduced in thefirst quarter of 2005, and the release of high definition variations of theFS-4 in the first quarter of 2006. 

 

17

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Sales of semiconductor productsto distributors and OEM customers were approximately $1.4 million in the threemonths ended March 31, 2006, compared to $491,000 for the same period in 2005,an increase of $890,000. This increase reflects continued increasing demand byour customers incorporating our video convergence chips in their internetprotocol television (IPTV) set-top box and portable media player (PMP) designs.

 

As of March 31, 2006, we had asales order backlog of approximately $2.8 million, an increase of $2.3 millionwhen compared to the fourth quarter of 2005. The increase in sales orderbacklog reflects orders for our video convergence chips and orders for our highdefinition Firestore products.

 

No customer accounted for more than 10% ofour revenue in the three months ended March 31, 2006. Sales to one customeraccounted for 15% of our revenue in the three months ended March 31, 2005. 

 

#### **Gross margin**

 
| ** **                           | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **March 31, 2006**     | ** ** | **March 31, 2005** | ** ** |
|                                 |       |                             |       |   |   |
| Gross margin                         |       | $                                | 2,665      |   | $ | 1,755 |   |
|                                 |       |                             |       |   |   |
| Gross margin rate                    |       | 37.4                             | %          | 32.2 | % |
|                                      |            |                                  |            |  |  |  |  |

 

Our gross margin rate for the three months ended March 31, 2006increased to 37.4% from 32.2% for the three months ended March 31, 2005, anincrease of 5.2 percentage points. This increase in the gross margin rate mainlyreflects the increase in sales volume and to a lesser extent reducedoperational costs.

 

**Operating expenses**

 
| ** **                           | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **March 31, 2006**     | ** ** | **March 31, 2005** | ** ** | **Increase / (decrease)** | ** ** |
| ** **                           | ** ** | ** **                       | ** ** | **% of** | ** ** | ** ** | ** ** | **% of** | ** ** | ** ** | ** ** | **% of** | ** ** |
| ** **                           | ** ** | ** **                       | ** ** | **revenue** | ** ** | ** ** | ** ** | **revenue** | ** ** | ** ** | ** ** | **revenue** | ** ** |
|                                 |       |                             |       |   |   |   |   |   |   |   |   |   |   |
| Sales, marketing and support         |       | $                                | 2,074      |   | 29.1 | % | $ | 1,424 |   | 26.1 | % | $ | 650 |   | 3.0 | % |
| General and administrative           |       | 915                              |       | 12.8 | % | 1,001 |   | 18.4 | % | (86 | ) | -5.6 | % |
| Research and development             |       | 2,981                            |       | 41.8 | % | 3,942 |   | 72.3 | % | (961 | ) | -30.5 | % |
| Amortization of intangible assets    |       | 127                              |       | 1.8 | % | 149 |   | 2.7 | % | (22 | ) | -0.9 | % |
|                                 |       |                             |       |   |   |   |   |   |   |   |   |   |   |
|                                 |       | $                                | 6,097      |   | 85.5 | % | $ | 6,516 |   | 119.5 | % | $ | (419 | ) | -34.0 | % |

 

Sales, marketing and support 

 

Sales, marketing and supportexpenses for the three months ended March 31, 2006 were $2.1 million, anincrease of $650,000 from $1.4 million in the three months ended March 31, 2005.

 

The increase in sales,marketing and support expenses mainly reflects an increase in salary expense of$330,000 resulting from an overall increase in headcount of nine employees mainlyin our Systems customer support department and Semiconductor sales department.Also contributing to the increase in sales, marketing and support expenses wasan increase in commission expense, reflecting the increase in sales revenue. 

 

General and administrative 

 

General and administrativeexpenses for the three months ended March 31, 2006 were $915,000, a decrease of$86,000

 

18

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from $1.0 million for the threemonths ended March 31, 2005. 

 

The decrease in general andadministrative expenses was mainly due to a decrease in auditing, legal andother professional fees, partially offset by stock-based compensation expense of$73,000 resulting from the adoption of SFAS No. 123 (revised 2004), *Share-Based Payment*(see Note 3, “Equity-Based Compensation”).

 

Research and development 

 

Research and developmentexpenses for the three months ended March 31, 2006 were $3.0 million, a decreaseof $961,000 from $3.9 million for the three months ended March 31, 2005. 

 

The decrease in research anddevelopment expenses mainly reflects a decrease in payroll expense of $358,000and consulting expenses of $808,000, partially offset by material andprototyping charges of $380,000 related to our UWB initiative. The decrease inpayroll expense mainly reflects a reduction in headcount of 13 employees andthe classification of expenses related to a certain engineering project in costof revenue. The decrease in consulting expense is due to the UWB developmentproject nearing completion. 

 

Amortization

 

Amortizationexpense was recorded as follows:

 
| ** **              | ** ** | **Three Months Ended** | ** ** | ** **                   | ** ** |
|-------------------------|------------|----------------------------------|------------|------------------------------|------------|
| **(In thousands)** | ** ** | **March 31, 2006**     | ** ** | **March 31, 2005** | ** ** | **Decrease** | ** ** |
|                    |       |                             |       |                         |       |   |   |
| Cost of revenue         |       | $                                | 45         |                         | $          | 45 |   | $ | — |   |
| Operating expenses      |       | 127                              |       | 149                          |       | (22 | ) |
|                    |       |                             |       |                         |       |   |   |
|                    |       | $                                | 172        |                         | $          | 194 |   | $ | (22 | ) |

 

Amortization expense for thethree months ended March 31, 2006 was $172,000, a decrease of $22,000 from $194,000for the three months ended March 31, 2005. The decrease in amortization expensereflects the completion of amortization for certain intangible assetsassociated with our acquisition of Videonics in January 2001.

 

**Non-OperatingItems**

 
| ** **                             | ** ** | **Three Months Ended** | ** ** | ** **         | ** ** |
|----------------------------------------|------------|----------------------------------|------------|--------------------|------------|
| ** **                             | ** ** | **March 31,**               | ** ** | **March 31,** | ** ** | **Decrease /** | ** ** |
| **(Dollars in thousands)**   | ** ** | **2006**                         | ** ** | **2005**           | ** ** | **(Increase)** | ** ** |
|                                   |       |                             |       |               |       |   |   |
| Interest expense, net                  |       | $                                | (199       | )                  | $          | (13 | ) | $ | 186 |   |
|                                   |       |                             |       |               |       |   |   |
| Value of derivative security           |       | $                                | (4,000     | )                  | $          | — |   | $ | 4,000 |   |
|                                   |       |                             |       |               |       |   |   |
| Change in value of derivative security |       | $                                | 400        |               | $          | — |   | $ | (400 | ) |
|                                   |       |                             |       |               |       |   |   |
| Other income, net                      |       | $                                | 70         |               | $          | — |   | $ | 70 |   |

 

Net interest expense for thethree months ended March 31, 2006 was $199,000, compared to $13,000 in thethree months ended March 31, 2005. The increase in net interest expensereflects interest expense on our $10.0 million convertible notes from the dateof issuance of January 27, 2006, and interest expense on a previouslyoutstanding term loan balance of $2.5 million and an outstanding accounts-receivablebased line of credit facility balance of $3.0 million. A portion of the fundsreceived from the issuance of the convertible notes were used to pay down thecredit facility and 

 

19

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term loan balances.

 

The $4.0 million derivative liability represents the fair value of theconversion option calculated in connection with the $10.0 million convertiblenotes issued in January 2006. The value of the conversion option was bifurcatedfrom the debt host contract and recorded as a derivative liability, whichresulted in a discount to the initial carrying amount of the convertible notes.The $4.0 million discount was immediately expensed in the condensedconsolidated statements of operations as value of derivative security as thenotes may be converted to common stock at any time after issuance.

 

Thechange in value of the derivative security represents the difference betweenthe fair value of the derivative liability when the convertible notes wereissued and the fair value of the derivative liability at March 31, 2006. Therevaluation of the derivative liability resulted in a $400,000 gain in the threemonths ended March 31, 2006.

 

Other income for the threemonths ended March 31, 2006 consists mainly of income associated with exchangerate differences related to transactions denominated in Euros.

 

20

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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 three months ended March31, 2006 and the year ended December 31, 2005, we incurred net losses of $7.2million and $15.4 million, respectively, and used cash in operating activitiesof $4.3 million, and $12.5 million, respectively. These factors indicate thatwe may potentially 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. Our continuation as a going concern is dependentupon our ability to generate sufficient positive cash flows to meet ourobligations on a timely basis, to obtain additional financing as may berequired, and ultimately to return to profitability.

 

Since inception, we havefinanced our operations primarily through the public and private sale of commonstock, lines of credit and debt borrowings from financial institutions,proceeds from the exercise of options and warrants, short-term borrowings fromprivate lenders and credit arrangements with vendors and suppliers. 

 

**First Quarterof Fiscal Year 2006 compared to the First Quarter of Fiscal Year 2005**

 
| **(Dollars in thousands)** | ** ** | **March 31, 2006** | ** ** | **December 31, 2005** | ** ** |
|--------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
|                                 |       |                         |       |                            |       |
| Cash and cash equivalents            |       | $                            | 1,107      |                            | $          | 637 |   |
| Working capital                      |       | $                            | 3,608      |                            | $          | (3,533 | ) |
| Days sales outstanding (DSO)         |       | 48.2                         |       | 48.1                            |       |
| Inventory turns - annualized         |       | 3.9                          |       | 4.1                             |       |

 
| ** **                                | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|
| ** **                                | ** ** | **March 31, 2006**     | ** ** | **March 31, 2005** | ** ** |
|                                      |       |                             |       |   |   |
| Net cash used in operating activities     |       | $                                | (4,282     | ) | $ | (2,292 | ) |
| Net cash used in investing activities     |       | $                                | (101       | ) | $ | (141 | ) |
| Net cash provided by financing activities |       | $                                | 4,852      |   | $ | 2,573 |   |

 

Net cash used in operatingactivities

 
| ** **                      | ** ** | **Three Months Ended,** | ** ** |
|---------------------------------|------------|-----------------------------------|------------|
| ** **                      | ** ** | **March 31, 2006**      | ** ** | **March 31, 2005** | ** ** | **Change in** | ** ** |
| ** **                      | ** ** | **cash (used),**             | ** ** | **cash (used),** | ** ** | **cash (used),** | ** ** |
| **(In thousands)**         | ** ** | **provided**                      | ** ** | **provided** | ** ** | **provided** | ** ** |
|                            |       |                              |       |   |   |   |   |
| Net loss                        |       | $                                 | (7,170     | ) | $ | (4,778 | ) | $ | (2,392 | ) |
| Non-cash income statement items |       | 4,143                             |       | 359 |   | 3,784 |   |
|                            |       | (3,027                            | )          | (4,419 | ) | 1,392 |   |
|                            |       |                              |       |   |   |   |   |
| Changes in working capital      |       | (1,255                            | )          | 2,127 |   | (3,382 | ) |
|                            |       |                              |       |   |   |   |   |
|                            |       | $                                 | (4,282     | ) | $ | (2,292 | ) | $ | (1,990 | ) |

 

Net cash used in operatingactivities for the three months ended March 31, 2006 and 2005 was $4.3 millionand $2.3 million, respectively. The increase in net cash used in operatingactivities mainly reflects an increase in cash used for

 

21

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accounts receivable,inventories and accrued liabilities, partially offset by a decrease in net lossadjusted for non-cash items and an increase in accounts payable. The increasein accounts receivable reflects an increase in sales in the three months endedMarch 31, 2006. The increase in inventories reflects the timing of new productshipments and our increased sales forecast for the remainder of the 2006 year. Theincrease in cash used for other accrued liabilities mainly reflects timing ofpayments related to our UWB investment.

 

Three customers had accounts receivablebalances in excess of 10% of our total accounts receivable at March 31, 2006.These customers accounted for 38% of our total accounts receivable at that 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 $101,000 for the three months ended March 31, 2006, compared to$141,000 used in the three months ended March 31, 2005. The decrease in cashused in investing activities mainly reflects a decrease in purchases ofequipment and design tools related to our investment in UWB technology.

 

Net cash provided by financingactivities

 

Net cash provided by financingactivities was $4.9 million for the three months ended March 31, 2006, comparedto $2.6 million for the three months ended March 31, 2005. The net cash providedby financing activities in the three months ended March 31, 2006 mainlyconsists of proceeds of $10.0 million from the issuance of convertible notes,partially offset by the repayment of a $3.0 million accounts-receivable basedline of credit and a $2.5 million term loan. The net cash provided by financingactivities in the three months ended March 31, 2005 mainly consist ofborrowings under lines of credit of $2.5 million. 

 

**CapitalResources and Liquidity Outlook**

** **

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

 

For the year ended December 31,2005, we received approximately $4.5 million in proceeds from the sale ofapproximately 7.4 million shares of our common stock in private placementtransactions. 

 

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, excluding accounts receivable ofCOMO. Carl Berg, a Company director and shareholder, provided a personalguarantee to secure this credit line. In connection with this credit line, theGreater Bay Bank obtained a first priority security interest on our accountsreceivable through an agreement with Mr. Berg, which enabled Mr. Berg to retainhis existing security interest in all of our assets while subordinating toGreater Bay Bank his security interest in our accounts receivable. The bankcredit line is subject to ongoing covenants, including a covenant related tooperating results. Interest is payable under this loan at prime plus 1%. At March 31,2006, there was no outstanding balance on this credit line and the maximumamount of $4.0 million was available to borrow. The credit line expires onDecember 24, 2006.

 

On June 28, 2005, we signed aterm loan agreement with Greater Bay Bank under which we can borrow up to $2.5million. The term loan has a maturity date of December 24, 2006, is interestonly until maturity and is in addition to our existing $4.0 million accountsreceivable based secured line of credit facility described above with this samebank. Interest is payable under this loan at prime plus 1%. At March 31, 2006,there was no outstanding balance under this term loan and the maximum amount of$2.5 million was available to borrow.

 

OnJanuary 27, 2006, we raised gross proceeds of $10.0 million from the issuanceof secured convertible notes to a group of private investors. While we believethat these funds, along with the cash flow generated by our expanding Systemsbusiness, should be adequate to enable us to complete our UWB engineeringdevelopment and launch commercialization of UWB products, depending upon theresults and timing of our UWB initiative and the profitability of our Systemsbusiness, we may need to raise further capital in 2006. There can be noassurance that sufficient funds

 

22

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willbe raised. 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. Furthermore, any additionaldebt financing will result in higher interest expense.

 

Summary ofCertain Contractual Obligations as of March 31, 2006

 
| ** **                                         | ** ** | ** **                | ** ** | ** **         | ** ** | ** **         | ** ** | ** ** | ** ** |
|----------------------------------------------------|------------|---------------------------|------------|--------------------|------------|--------------------|------------|------------|------------|
| **(In thousands)**                            | ** ** | **< 1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **Total**  | ** ** |
|                                               |       |                      |       |               |       |               |       |       |       |
| Capital and operating leases (including  interest) |       | $                         | 633        |               | $          | 620                |       | $          | 258        |   | $ | 1,511 |   |
| Inventory purchase commitments                     |       | 2,257                     |       | —             |       | —             |       | 2,257      |       |
| Convertible notes                                  |       | —                    |       | —             |       | 10,000             |       | 10,000     |       |
| Interest expense on convertible notes              |       | 1,000                     |       | 2,000              |       | 917                |       | 3,917      |       |
|                                               |       |                      |       |               |       |               |       |       |       |
|                                               |       | $                         | 3,890      |               | $          | 2,620              |       | $          | 11,175     |   | $ | 17,685 |   |

 

23

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

** **

**InterestRate Risk**

 

At March 31, 2006, we did not hold any short-term investments thatwould be exposed to market risk from adverse movements in interest rates.

 

At March 31, 2006, our outstanding debt obligations consisted of secured convertible notes of $10.0 million – see Note 9, “Borrowings”. A fixed interest rate is applicable to these debt obligations of 10.0% per annum. 

 

**ForeignCurrency Risk**

 

Gains or losses related to foreign exchange currency transactions werenot material for the periods ended March 31, 2006 and 2005.

 

**Item 4.Controls and Procedures**

** **

Management of the Company, with theparticipation 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, the President andChief Executive Officer and the Chief Financial Officer have concluded that, asof the end of the period covered by this Report, our disclosure controls andprocedures are effective to ensure that information required to be disclosed byus in the reports filed or submitted by us under the Securities Exchange Act of1934, as amended, is recorded, processed, summarized and reported within thetime periods specified in the SEC’s rules and forms, and include controls andprocedures designed to ensure that information required to be disclosed by usin such reports is accumulated and communicated to our management, including thePresident and Chief Executive Officer and the Chief Financial Officer of Focus,as appropriate to allow timely decisions regarding required disclosure.

 

There was no change in ourinternal control over financial reporting that occurred during our first fiscalquarter of 2006 that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

 

We will be required to evaluateour internal controls over financial reporting and prepare a management assessmenton our internal controls in order to comply with the requirements of theSarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act of 2002 requires that themanagement assessment of our internal controls be audited. We estimate the costof meeting these requirements will be approximately $750,000. We will berequired to meet these requirements by December 31, 2006 if our non-affiliate marketcapitalization, adjusted for certain items, is greater than $75 million on June30, 2006. Otherwise, we will have to meet the requirements by December 31,2007. 

 

24

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**PART II -OTHER INFORMATION**

** **

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

** **

From time to time, Focus is party to certain other claims and legalproceedings that arise in the ordinary course of business of which, in theopinion of management, do not have a material adverse effect on Focus’financial position or results of operation.

 

**Item 1A. Risk Factors**

** **

**Except as described below,there have been no material changes to our risk factors disclosed in our AnnualReport on Form 10-K for the year ended December 31, 2005. You should carefullyconsider the risks identified therein any of which could materially affect ourbusiness, financial condition or future results.**

** **

**FromMarch to August of 2005 and November 2005 to early May 2006, our common stockdid not meet the minimum bid price requirement to remain listed on the NasdaqCapital Market. If we were to be delisted, it could make trading in our stockmore difficult.**

** **

Our voting common stock is traded on the NasdaqCapital Market. There are various quantitative listing requirements for acompany to remain listed on the Nasdaq Capital Market, including maintaining aminimum bid price of $1.00 per share of common stock and maintaining stockholders’equity of $2.5 million. On November 23, 2005, theNasdaq Stock Market notified us that for the previous 30 consecutive businessdays, the bid price of our common stock had closed below the minimum $1.00 pershare price requirement for continued inclusion under Nasdaq Marketplace Rules.We were given until May 22, 2006 to regain compliance with the Nasdaq Capital Market$1.00 minimum bid price rule. On May 10, 2006, we receivednotification from Nasdaq that we had regained compliance and the matter wasclosed. 

 

At March 31, 2006, we had total stockholders’ equityof $5.0 million. To the extent we incur net losses and do not raise additionalcapital, our stockholders’ equity will be reduced. 

 

If the minimum bid price of our common stockwere to close below $1.00 for 30 consecutive days, we would likely againreceive notification from the Nasdaq Capital Marketthat we were not in compliance with the $1.00 minimum bid price rule. If we donot 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 marketfor our shares.We would then be entitled to appeal this determination to a Nasdaq ListingQualifications Panel and request a hearing.

 

Inthe event we are delisted from the Nasdaq Capital Market, we would be forced tolist our shares on the OTC Electronic Bulletin Board or some other quotationmedium, such as the pink sheets, depending on our ability to meet the specificlisting requirements of those quotation systems. As a result, an investor mightfind it more difficult to trade, or to obtain accurate price quotations for, suchshares. Delisting might also reduce the visibility, liquidity, and price of ourvoting common stock.

 

**Wehave a significant amount of convertible securities that will dilute existingstockholders upon conversion.**

** **

At May 10, 2006, we had 3,161 shares ofpreferred shares issued and outstanding, 5,592,644 warrants and 6,977,936options outstanding, and $10.0 million of convertible notes, which are allexercisable into shares of common stock. The 3,161 shares of preferred stockare convertible into 3,161,000 shares of our voting common stock and theconvertible notes are convertible into 10,000,000 shares of common stock.Furthermore, at May 10, 2006, 797,897 additional shares of common stock wereavailable for grant to our employees, officers, directors and consultants underour current stock option and incentive plans. We also may issue additionalshares in acquisitions. Any additional grant of options under existing orfuture plans or issuance of shares in connection with an acquisition willfurther dilute existing stockholders. 

 

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

 

(a)to (e)                           None.

 

25

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**Item 3.    DefaultsUpon Senior Securities**

 

None.

 

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

####  

#### **None.**

####  

**Item 5.    OtherInformation**

 

None.

 

**Item 6.    Exhibits**

** **

Exhibit 31.1 - Rule 13a-14(a) Certificationof CEO

Exhibit 31.2 - Rule 13a-14(a) Certificationof CFO

Exhibit 32.1 – CEO 906 Certification

Exhibit 32.2 – CFO 906 Certification

 

26

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**SIGNATURES**

** **

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

 

 
| May 15, 2006      Focus  Enhancements, Inc. |       |                                  |
|----------------------------------------------------------------------|------------|---------------------------------------|
|        Date                       | Registrant |
|                                                                 |       |
|                                                                 | By:        | /s/                                   | Brett A. Moyer |   |
|                                                                 |       | Brett A. Moyer                        |
|                                                                 |       | Chief Executive Officer and President |
|                                                                 |       | (Principal Executive Officer)         |
|                                                                 |       |
|                                                                 | By:        | /s/                                   | Gary L. Williams |   |
|                                                                 |       | Gary L. Williams                      |
|                                                                 |       | Executive Vice President of Finance,  |
|                                                                 |       | Chief Financial Officer               |
|                                                                 |       | (Principal Accounting Officer)        |
|                                                                      |            |                                       |  |  |  |

 

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