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

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

| **ý**                                                     | **QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934**        |
|----------------------------------------------------------------|---------------------------------------------------------------------------------------------------------|
|                                                           |                                                                                                    |
| **For the quarterly period ended September 30, 2005, or** |
| ** **                                                     | ** **                                                                                              |
| **o**                                                          | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**For the transition period from              to                .**

 

**Commission File Number 1-11860**

 

**Focus Enhancements, Inc.**

(Name of Issuer in its Charter)

 
| **Delaware**                                           | ** ** | **04-3144936**      |
|--------------------------------------------------------|------------|---------------------|
| (State or Other Jurisdiction of                        |       | (I.R.S. Employer    |
| Incorporation or Organization)                         |       | Identification No.) |
|                                                   |       |                |
| **1370 Dell Ave  Campbell, CA 95008**                  |
| (Address of Principal Executive Offices)               |
|                                                   |
| **(408) 866-8300**                                     |
| (Issuer’s Telephone Number, Including Area  Code) |

 

Check whetherthe 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 12months (or for such other shorter period that the Registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days.  ýYes  No o

 

Indicate bycheck mark whether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act).

 

o Yes  No ý

 

Indicate bycheck mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).

 

o Yes  No ý

 

As of theclose of business on November 10, 2005, there were 67.7 million shares ofFocus Enhancement’s common stock issued and outstanding.

 

 

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**FOCUSENHANCEMENTS, INC.**

 

**INDEX**

 
| ** **                              | ** **                                                                                  | **Page  Number** |
|-----------------------------------------|---------------------------------------------------------------------------------------------|------------------|
| **PART I - FINANCIAL INFORMATION** |                                                                                        |
|                                    |                                                                                        |             |
| **Item 1.**                             | Financial Statements (unaudited):                                                           |             |
|                                    | Condensed  Consolidated Statements of Operations                                            | 2                |
|                                    | Condensed  Consolidated Balance Sheets                                                      | 3                |
|                                    | Condensed  Consolidated Statements of Cash Flows                                            | 4                |
|                                    | Notes to  Condensed Consolidated Financial Statements                                       | 5                |
|                                    |                                                                                        |             |
| **Item 2.**                             | Management’s Discussion and Analysis of  Financial Condition and Results of Operations | 18               |
|                                    |                                                                                        |             |
| **Item  3.**                            | Quantitative  and Qualitative Disclosures about Market Risk                                 | 35               |
|                                    |                                                                                        |             |
| **Item 4.**                             | Controls and Procedures                                                                     | 35               |
|                                    |                                                                                        |             |
|                                    |                                                                                        |             |
| **PART II - OTHER INFORMATION**    |                                                                                        |
|                                    |                                                                                        |             |
| **Item 1.**                             | Legal Proceedings                                                                           | 36               |
|                                    |                                                                                        |             |
| **Item 2.**                             | Unregistered Sales of Equity Securities and  Use of Proceeds                                | 36               |
|                                    |                                                                                        |             |
| **Item 3.**                             | Defaults Upon Senior Securities                                                             | 36               |
|                                    |                                                                                        |             |
| **Item 4.**                             | Submission of Matters to a Vote of Security  Holders                                        | 36               |
|                                    |                                                                                        |             |
| **Item 5.**                             | Other Information                                                                           | 36               |
|                                    |                                                                                        |             |
| **Item 6.**                             | Exhibits                                                                                    | 36               |
|                                    |                                                                                        |             |
| **SIGNATURES**                          | 37                                                                                          |
|                                    |                                                                                        |             |
| **CERTIFICATIONS**                      |                                                                                        |

 

1

----

 

**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**      | ** ** | **Nine Months Ended**       | ** ** |
|--------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                                         | ** ** | **September 30, 2005** | ** ** | **September 30, 2004** | ** ** | **September 30, 2005** | ** ** | **September 30, 2004** | ** ** |
|                                                               |       |                        |       |                        |       |   |   |   |   |
| Net revenue                                                        |       | $                           | 6,880      |                        | $          | 5,774 |   | $ | 18,468 |   | $ | 14,892 |   |
| Cost of revenue                                                    |       | 4,360                       |       | 3,553                       |       | 11,804 |   | 9,596 |   |
| Gross margin                                                       |       | 2,520                       |       | 2,221                       |       | 6,664 |   | 5,296 |   |
|                                                               |       |                        |       |                        |       |   |   |   |   |
| Operating expenses:                                                |       |                        |       |                        |       |   |   |   |   |
| Sales,  marketing and support                                      |       | 1,783                       |       | 1,256                       |       | 4,958 |   | 3,583 |   |
| General and  administrative                                        |       | 925                         |       | 729                         |       | 2,920 |   | 2,194 |   |
| Research and  development                                          |       | 2,977                       |       | 2,489                       |       | 10,260 |   | 5,261 |   |
| Amortization  of intangible assets                                 |       | 127                         |       | 255                         |       | 403 |   | 604 |   |
| In-process  research and development                               |       | —                      |       | —                      |       | — |   | 300 |   |
|                                                               |       | 5,812                       |       | 4,729                       |       | 18,541 |   | 11,942 |   |
| Loss from  operations                                              |       | (3,292                      | )          | (2,508                      | )          | (11,877 | ) | (6,646 | ) |
| Interest  expense, net                                             |       | (93                         | )          | (8                          | )          | (174 | ) | (68 | ) |
| Other income  (expense), net                                       |       | (10                         | )          | (10                         | )          | (50 | ) | 10 |   |
| Loss before  income tax expense (benefit)                          |       | (3,395                      | )          | (2,526                      | )          | (12,101 | ) | (6,704 | ) |
| Income tax  expense (benefit)                                      |       | (1                          | )          | —                      |       | 10 |   | 1 |   |
| Net loss                                                           |       | $                           | (3,394     | )                           | $          | (2,526 | ) | $ | (12,111 | ) | $ | (6,705 | ) |
|                                                               |       |                        |       |                        |       |   |   |   |   |
| Net loss per share                                                 |       |                        |       |                        |       |   |   |   |   |
| Basic and  diluted                                                 |       | $                           | (0.05      | )                           | $          | (0.05 | ) | $ | (0.20 | ) | $ | (0.14 | ) |
|                                                               |       |                        |       |                        |       |   |   |   |   |
| Weighted  average number of shares used in per share calculations: |       |                        |       |                        |       |   |   |   |   |
| Basic and  diluted                                                 |       | 62,268                      |       | 52,803                      |       | 60,414 |   | 48,578 |   |

 

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

 

2

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**Focus Enhancements, Inc.**

**Condensed Consolidated Balance Sheets**

(In thousands, except share and per shareamounts)

(Unaudited)

 
| ** **                                                                                                                                                                                             | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                                                                             |       |                         |       |                        |       |
|                                                                                                                                                                                                   |       |                         |       |                        |       |
| Current assets:                                                                                                                                                                                        |       |                         |       |                        |       |
| Cash and  cash equivalents                                                                                                                                                                             |       | $                            | 758        |                        | $          | 3,380 |   |
| Accounts  receivable, net of allowances of $430 and $443                                                                                                                                               |       | 3,495                        |       | 3,273                       |       |
| Inventories                                                                                                                                                                                            |       | 3,748                        |       | 3,941                       |       |
| Prepaid  expenses and other current assets                                                                                                                                                             |       | 761                          |       | 473                         |       |
| Restricted  cash                                                                                                                                                                                       |       | —                       |       | 312                         |       |
| Total  current assets                                                                                                                                                                                  |       | 8,762                        |       | 11,379                      |       |
|                                                                                                                                                                                                   |       |                         |       |                        |       |
| Long-term assets:                                                                                                                                                                                      |       |                         |       |                        |       |
| Property and  equipment, net                                                                                                                                                                           |       | 1,312                        |       | 1,116                       |       |
| Other assets                                                                                                                                                                                           |       | 54                           |       | 62                          |       |
| Intangible  assets, net                                                                                                                                                                                |       | 1,039                        |       | 1,577                       |       |
| Goodwill                                                                                                                                                                                               |       | 13,191                       |       | 13,191                      |       |
|                                                                                                                                                                                                   |       | $                            | 24,358     |                        | $          | 27,325 |   |
|                                                                                                                                                                                                   |       |                         |       |                        |       |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                                         |       |                         |       |                        |       |
|                                                                                                                                                                                                   |       |                         |       |                        |       |
| Current liabilities:                                                                                                                                                                                   |       |                         |       |                        |       |
| Accounts  payable                                                                                                                                                                                      |       | $                            | 3,616      |                        | $          | 2,555 |   |
| Borrowings  under lines of credit                                                                                                                                                                      |       | 2,728                        |       | 567                         |       |
| Current  portion of long-term debt                                                                                                                                                                     |       | 171                          |       | 55                          |       |
| Current  portion of capital lease obligations                                                                                                                                                          |       | 124                          |       | 22                          |       |
| Accrued  liabilities                                                                                                                                                                                   |       | 3,426                        |       | 2,634                       |       |
| Total  current liabilities                                                                                                                                                                             |       | 10,065                       |       | 5,833                       |       |
|                                                                                                                                                                                                   |       |                         |       |                        |       |
| Long-term liabilities:                                                                                                                                                                                 |       |                         |       |                        |       |
| Long-term  debt                                                                                                                                                                                        |       | 2,500                        |       | 174                         |       |
| Capital  lease obligations, net of current portion                                                                                                                                                     |       | 25                           |       | —                      |       |
| Other  liabilities                                                                                                                                                                                     |       | 74                           |       | —                      |       |
| Total  liabilities                                                                                                                                                                                     |       | 12,664                       |       | 6,007                       |       |
|                                                                                                                                                                                                   |       |                         |       |                        |       |
| Commitments and contingencies (Note 10)                                                                                                                                                                |       |                         |       |                        |       |
|                                                                                                                                                                                                   |       |                         |       |                        |       |
| Stockholders’ equity:                                                                                                                                                                             |       |                         |       |                        |       |
| Preferred  stock, $0.01 par value; authorized 3,000,000 shares; 3,161 shares issued at September 30,  2005 and December 31, 2004, respectively (aggregate liquidation  preference of $3,917) |       | —                       |       | —                      |       |
| Common  stock, $0.01 par value; 100,000,000 shares authorized, 63,197,795 and  60,412,591 shares issued at September 30, 2005 and December 31,  2004, respectively                           |       | 622                          |       | 597                         |       |
| Treasury  stock at cost, 497,055 shares at September 30, 2005 and December 31,  2004, respectively                                                                                           |       | (750                         | )          | (750                        | )          |
| Additional  paid-in capital                                                                                                                                                                            |       | 98,146                       |       | 95,463                      |       |
| Deferred  stock-based compensation                                                                                                                                                                     |       | (231                         | )          | —                      |       |
| Accumulated  other comprehensive income                                                                                                                                                                |       | 24                           |       | 14                          |       |
| Accumulated  deficit                                                                                                                                                                                   |       | (86,117                      | )          | (74,006                     | )          |
| Total  stockholders’ equity                                                                                                                                                                       |       | 11,694                       |       | 21,318                      |       |
|                                                                                                                                                                                                   |       | $                            | 24,358     |                        | $          | 27,325 |   |

 

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

 

3

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**Focus Enhancements, Inc.**

**Condensed Consolidated Statements of Cash Flows**

(In thousands)

(Unaudited)

 
| ** **                                                                                       | ** ** | **Nine Months Ended**       | ** ** |
|--------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                                       | ** ** | **September 30, 2005** | ** ** | **September 30, 2004** | ** ** |
| Cash flows from operating activities:                                                            |       |                        |       |   |   |
| Net loss                                                                                         |       | $                           | (12,111    | ) | $ | (6,705 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities:                     |       |                        |       |   |   |
| Depreciation  and amortization                                                                   |       | 1,015                       |       | 816 |   |
| Stock-based  compensation and non-cash warrant expense                                           |       | 105                         |       | 32 |   |
| Amortization  of debt issuance costs                                                             |       | 40                          |       | — |   |
| Changes in  assets and liabilities:                                                              |       |                        |       |   |   |
| Decrease  (increase) in accounts receivable                                                      |       | (304                        | )          | 171 |   |
| Decrease in  inventories                                                                         |       | 124                         |       | 63 |   |
| Increase in  prepaid expenses and other assets                                                   |       | (277                        | )          | (139 | ) |
| Increase in  accounts payable                                                                    |       | 1,116                       |       | 290 |   |
| Increase in  accrued liabilities                                                                 |       | 935                         |       | 808 |   |
| Net cash  used in operating activities                                                           |       | (9,357                      | )          | (4,664 | ) |
|                                                                                             |       |                        |       |   |   |
| Cash flows from investing activities:                                                            |       |                        |       |   |   |
| Acquisition  of COMO Computer and Motion GmbH net of cash acquired                               |       | —                      |       | (7 | ) |
| Acquisition  of Visual Circuits Corporation                                                      |       | —                      |       | (440 | ) |
| Decrease in  restricted cash                                                                     |       | 289                         |       | — |   |
| Purchases of  property and equipment                                                             |       | (496                        | )          | (720 | ) |
| Net cash used in investing activities                                                            |       | (207                        | )          | (1,167 | ) |
|                                                                                             |       |                        |       |   |   |
| Cash flows from financing activities:                                                            |       |                        |       |   |   |
| Borrowings  from term loan                                                                       |       | 4,000                       |       | — |   |
| Repayments  of term loan                                                                         |       | (1,500                      | )          | — |   |
| Borrowings  under lines of credit                                                                |       | 2,585                       |       | — |   |
| Capital  lease payments                                                                          |       | (62                         | )          | (2 | ) |
| Repayments  under lines of credit                                                                |       | (375                        | )          | — |   |
| Net proceeds  from private offerings of common stock                                             |       | 1,564                       |       | 5,217 |   |
| Proceeds  from issuance of escrow stock related to acquisition of COMO Computer and  Motion GmbH |       | 488                         |       | — |   |
| Reimbursement  of transaction costs related to acquisition of Visual Circuits Corporation        |       | 225                         |       | — |   |
| Payments of  short-term debt                                                                     |       | (33                         | )          | (434 | ) |
| Proceeds  from exercise of common stock options and warrants                                     |       | 57                          |       | 116 |   |
| Net cash provided by financing activities                                                        |       | 6,949                       |       | 4,897 |   |
|                                                                                             |       |                        |       |   |   |
| Effect of exchange rate changes on cash                                                          |       | (7                          | )          | (9 | ) |
|                                                                                             |       |                        |       |   |   |
| Decrease in cash and cash equivalents                                                            |       | (2,622                      | )          | (943 | ) |
| Cash and cash equivalents at beginning of  period                                                |       | 3,380                       |       | 3,731 |   |
| Cash and cash equivalents at end of period                                                       |       | $                           | 758        |   | $ | 2,788 |   |

 

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

 

4

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**FocusEnhancements, Inc.**

**Notes to Condensed Consolidated Financial Statements**

 

**1.****                                      Basisof Presentation – Unaudited Interim Financial Information**

 

The condensed consolidated financial statements of Focus Enhancements, Inc.(“Focus” or “the Company”) as of September 30, 2005 and for the three andnine months ended September 30, 2005 and 2004 are unaudited and should beread in conjunction with the audited consolidated financial statements for theyear ended December 31, 2004, included in Focus’ Annual Report on Form 10-K/Afor the year ended December 31, 2004.

 

In the opinionof management, the condensed consolidated financial statements include alladjustments (consisting only of normal recurring adjustments) necessary for afair presentation of Focus’ financial position, operating results and cashflows for the periods presented. The results of operations and cash flows forthe three and nine months ended September 30, 2005 are not necessarilyindicative of the results that may be expected for any future period. Certainitems previously reported in specific financial statement captions have beenreclassified. Such reclassifications have not impacted previously reported totalassets, stockholders’ equity or net loss amounts.

 

Beginning in2005, Focus converted from a 13-week quarter that ended on the last Sunday ofthe period to a calendar quarter. For convenience, the comparative results inthe accompanying condensed consolidated statements of operations and condensedconsolidated statements of cash flows are shown as ending on September 30,2004, although the third quarter of fiscal year 2004 ended on October 3,2004. The change in the quarter end did not have a material impact on thereported operating results or financial position of Focus.

 

**2.****                                     ****Pro Forma Stock Compensation Expense**

 

Statement of FinancialAccounting Standards (“SFAS”) No. 123, *Accounting for Stock-BasedCompensation,* encourages all entities to adopt a fair value basedmethod of accounting for employee stock compensation plans, wherebycompensation cost is measured at the grant date based on the fair value of theaward and is recognized over the service period, which is usually the vestingperiod. However, it also allows an entity to continue to measure compensationcost for those plans using the intrinsic value based method of accountingprescribed by Accounting Principles Board (“APB”) Opinion No. 25, *Accounting for Stock Issued to Employees*, wherebycompensation cost is the excess, if any, of the quoted market price of thestock at the grant date over the amount an employee must pay to acquire thestock. Stock options issued under Focus’ stock option plans have no intrinsicvalue at grant date. Accordingly, under APB Opinion No. 25, nocompensation cost is recognized.

 

Focus has elected to continuewith the accounting prescribed in APB Opinion No. 25 and, as a result,must make pro forma disclosures of net income (loss) and net income (loss) pershare and other disclosures as if the fair value based method of accounting hadbeen applied. The estimated fair value of the options is amortized to expenseover the vesting period of the option. The following table presents the effecton reported net loss and net loss per share of accounting for employee stockoptions under the fair value method:

 
| ** **                                                                   | ** ** | **Three Months Ended**      | ** ** | **Nine Months Ended**       | ** ** |
|------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| **(In thousands, except per share data)**                                    | ** ** | **September 30, 2005** | ** ** | **September 30, 2004** | ** ** | **September 30, 2005** | ** ** | **September 30, 2004** | ** ** |
|                                                                         |       |                        |       |                        |       |   |   |   |   |
| Reported net loss                                                            |       | $                           | (3,394     | )                           | $          | (2,526 | ) | $ | (12,111 | ) | $ | (6,705 | ) |
| Deduct:  Stock-based compensation expense determined under fair value method |       | (209                        | )          | (336                        | )          | (896 | ) | (915 | ) |
|                                                                         |       |                        |       |                        |       |   |   |   |   |
| Pro forma net loss                                                           |       | $                           | (3,603     | )                           | $          | (2,862 | ) | $ | (13,007 | ) | $ | (7,620 | ) |
|                                                                         |       |                        |       |                        |       |   |   |   |   |
| Basic and diluted reported net loss per  share                               |       | $                           | (0.05      | )                           | $          | (0.05 | ) | $ | (0.20 | ) | $ | (0.14 | ) |
|                                                                         |       |                        |       |                        |       |   |   |   |   |
| Basic and diluted pro forma net loss per  share                              |       | $                           | (0.06      | )                           | $          | (0.05 | ) | $ | (0.22 | ) | $ | (0.16 | ) |

 

5

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Common stock equivalents have been excluded from all calculations ofnet loss per share and pro forma net loss per share for the periods presentedbecause the effect of including them would be anti-dilutive.

 

**3.**                                      **Net Loss per Share**

 

Basicnet loss per share was computed by dividing the net loss by the weightedaverage number of shares of common stock outstanding during the period. Dilutednet loss per share is computed by dividing the net loss by the weighted averagenumber of shares of common stock and potential common stock equivalentsoutstanding during the period, if dilutive. Options to purchase 7,488,758 and6,289,473 shares of common stock, unvested shares of restricted stock of245,000 and zero, warrants to purchase 4,160,621 and 1,369,914 shares of commonstock and 3,161 shares of preferred stock convertible into 3,161,000 shares ofcommon stock were outstanding at September 30, 2005 and 2004,respectively, but were not included in the computation of diluted net loss pershare as the effect would have been anti-dilutive.

 

**4.**                                      Significant Customers

 

No customer accounted for more than 10% ofFocus’ revenue in the three and nine months ended September 30, 2005. Onecustomer accounted for 15% of Focus’ revenue in the three months ended September 30,2004. In the nine months ended September 30, 2004, one customer accountedfor 13% of total revenue.

 

One customer had an accounts receivablebalance of 13% of Focus’ accounts receivable at September 30, 2005 and 14%at December 31, 2004.

 

**5.**                                      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 thenine months ended September 30, 2005 and the year ended December 31,2004, Focus incurred net losses of $12.1 million and $11.0 million,respectively, and used net cash in operating activities of $9.4 million and$9.4 million, respectively. These results indicate that Focus may potentiallybe unable to continue as a going concern.

 

The condensed consolidated financial statements do not include anyadjustments relating to the recoverability and classification ofrecorded asset amounts or the amounts and classification of liabilities thatmight be necessary should Focus be unable to continue as a going concern. Focus’continuation as a going concern is dependent upon its ability to generatesufficient cash flows to meet its obligations on a timely basis, to obtainadditional financing as may be required, and ultimately to return toprofitability and significant positive cash flows.

 

Focus has historically met cash needs fromthe proceeds of debt, the sale of common stock in private placements and theexercise of employee stock options and warrants. Management continues to assessits product lines in light of technology trends and economic conditions, toidentify how to enhance existing product lines, create new products, or createnew distribution channels. There can be no assurance that management’s newproducts plans will result in substantial increases in Focus’ revenue.

 

On November 7, 2005, Focus received $3.0 million in net proceeds through a privateequity placement. Management believes that Focus will needto obtain additional financing and/or find a partner to fund operations by theend of the first quarter of 2006 in order to meet all currently plannedexpenditures and cash requirements through the first customer sampling of itsUltra Wideband (“UWB”) chips. Such financing terms could include debt and/orequity instruments. Depending upon the results and timing of this samplingprogram, customers’ adoption and acceptance of the UWB products, theprofitability of its Systems business, and Focus’ efforts to partner withanother entity to market the chips on a widespread commercial basis, Focus mayneed to raise further capital in 2006 for the widespread commercial deploymentof UWB.

 

There is no assurance that management’s planswill be successful or if successful, that they will result in Focus continuingas a going concern.

 

6

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**6.****                                     ****Business Combinations**

 

COMO Computer & Motion GmbH

 

On February 27, 2004, Focus completedthe acquisition of COMO Computer & Motion GmbH (“COMO”), located inKiel, Germany, pursuant to which COMO became a wholly-owned subsidiary ofFocus. The acquisition was accounted for as a purchase business combination ata total cost of approximately $1.0 million. Under the terms of the agreement,Focus acquired COMO through the issuance of 185,066 shares of its common stockand approximately $359,000 in cash to COMO’s shareholders. Focus was alsorequired to issue up to an additional 46,266 shares of its common stock to COMO’sshareholders, in the event certain conditions were met at the end of 2004 and2005. These relevant conditions were met at the end of 2004, and accordingly,23,234 shares were issued to COMO’s former shareholders in March 2005.Additionally, Focus issued 610,096 common shares, held in escrow, to COMO’s twoformer shareholders who became employees of Focus – see Note 11, “Stockholders’Equity”. In connection with this transaction, Focus paid vFinance Investments, Inc.,a success fee of $100,000 and 30,000 shares of Focus’ common stock.

 

Founded in 1990, COMO develops, manufacturesand distributes digital video solutions. COMO’s results of operations areincluded in Focus’ financial statements from the date of acquisition, and theassets and liabilities were recorded based on their fair values as of the dateof acquisition. There were no employee stock options or warrants assumed as aresult of the acquisition.

 

The purchase price of approximately $1.0million, consisting of 185,066 shares of Focus common stock issued to the COMOshareholders, the fair value of the 46,266 earn-out shares, 30,000 shares ofFocus common stock issued to vFinance Investments, Inc., cash paid to theCOMO shareholders of $359,000, and acquisition costs of approximately $220,000,has been allocated based on the estimated fair value of net tangible andintangible assets acquired, and liabilities assumed. The earn-out shares areincluded in the purchase price because Focus management believes it is probablethat the conditions under which such shares would become payable will be met.The value of the 610,096 common shares issued to COMO’s two shareholders andheld in escrow are not included in the purchase price - see Note 11, “Stockholders’Equity”. A summary of the allocation of the purchase price to the assetsacquired and liabilities assumed is as follows:

 
| **(In thousands)**                    | ** ** | **Purchase Price  Allocation** | ** ** |
|---------------------------------------|------------|--------------------------------|------------|
|                                  |       |                           |       |
| Assets acquired                       |       | $                              | 782        |   |
| Intangible asset: Existing technology |       | 890                            |       |
| Goodwill                              |       | 1,104                          |       |
| Liabilities assumed                   |       | (1,766                         | )          |
|                                  |       |                           |       |
|                                  |       | $                              | 1,010      |   |

 

Existing technology is being amortized on astraight-line basis over an estimated useful life of three years.

 

Visual Circuits Corporation

 

On May 28, 2004, Focus acquiredsubstantially all the assets and assumed certain liabilities of Visual CircuitsCorporation (“Visual Circuits”) pursuant to an Agreement and Plan ofReorganization (“Reorganization Agreement”). The transaction was accounted foras a purchase business combination at a total cost of approximately $8.9million. Founded in 1991, Visual Circuits is a manufacturer and developer ofintegrated hardware, software and network products that manage, schedule,distribute, store and present digital video in a wide range of commercial mediaapplications.

 

7

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Under the terms of the ReorganizationAgreement, Visual Circuits, located in Minneapolis, Minnesota, received3,805,453 shares of voting common stock of Focus, including approximately380,000 shares placed in escrow for the recovery by Focus of any lossesresulting from the breach of covenants by Visual Circuits. In connection withthis transaction, Focus paid vFinance Investments, Inc. a success fee of$168,000 and 80,000 shares of Focus’ common stock.

 

Visual Circuits’ results of operations areincluded in Focus’ financial statements from the date of acquisition, and theassets and liabilities were recorded based on their fair values as of the dateof acquisition. There were no employee stock options or warrants assumed as aresult of the acquisition.

 

The purchase price of approximately $8.9million consisted of the fair value of the shares of Focus common stock issuedto Visual Circuits, excluding a portion of the escrow shares associated withamounts owed by Visual Circuits to Focus (see Note 11, “Stockholders’ Equity”),80,000 shares distributed to vFinance Investments, Inc., and acquisitioncosts of approximately $440,000. The acquisition costs consisted of financialadvisory, legal and accounting fees and other direct transaction costs.

 

The purchase price allocation is as follows:

 
| **(In thousands)**                    | ** ** | **Purchase Price  Allocation** | ** ** |
|---------------------------------------|------------|--------------------------------|------------|
|                                  |       |                           |       |
| Assets acquired                       |       | $                              | 1,180      |   |
| Intangible asset: Existing technology |       | 1,060                          |       |
| Goodwill                              |       | 6,896                          |       |
| Liabilities assumed                   |       | (508                           | )          |
| In-process research and development   |       | 300                            |       |
|                                  |       |                           |       |
|                                  |       | $                              | 8,928      |   |

 

The tangiblenet assets acquired represent the historical net assets of Visual Circuits’business as of May 28, 2004. As required under purchase accounting, theassets and liabilities of Visual Circuits have been adjusted to fair value.

 

Focusperformed an allocation of the total purchase price of Visual Circuits to itsindividual assets acquired and liabilities assumed. Developed technology andin-process research and development (“IPRD”) were identified and valued throughinterviews, analysis of data provided by the Visual Circuits businessconcerning development projects, their stage of development, the time andresources needed to complete them, if applicable, their expected incomegenerating ability and associated risks. The income approach, which includes ananalysis of the cash flows, and risks associated with achieving such cashflows, was the primary technique utilized in valuing the developed technologyand IPRD.

 

Wheredevelopment projects had reached technological feasibility, they wereclassified as existing technology and the value assigned to existing technologywas capitalized. The existing technology is being amortized on a straight-linebasis over its estimated useful life of three years.

 

Where thedevelopment projects had not reached technological feasibility and had nofuture alternative uses, they were classified as IPRD. Of the total purchaseprice, $300,000 was allocated to IPRD, which was expensed upon the consummationof the Reorganization Agreement in the second quarter of 2004. The value wasdetermined by estimating the expected cash flows from the projects oncecommercially viable, discounting the net cash flows back to their present valueand then applying a percentage of completion to the calculated value. If theprojects are not successfully developed, the sales and profitability of Focus maybe adversely affected in future periods. Goodwill represents the excess of thepurchase price over the fair value of the underlying net identifiable assets.

 

8

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

 

Goodwill as of September 30,2005 and December 31, 2004 included the following:

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

 

The followingtables provide a summary of the carrying amounts of intangible assets:

 
| ** **          | ** ** | **September 30, 2005** | ** ** |
|---------------------|------------|-----------------------------|------------|
| **(In thousands)**  | ** ** | **Gross Amount**            | ** ** | **Accumulated  Amortization** | ** ** | **Net  Amount** | ** ** |
|                |       |                        |       |   |   |   |   |
| Existing technology |       | $                           | 3,945      |   | $ | (2,906 | ) | $ | 1,039 |   |
| Tradename           |       | 176                         |       | (176 | ) | — |   |
|                |       |                        |       |   |   |   |   |
|                |       | $                           | 4,121      |   | $ | (3,082 | ) | $ | 1,039 |   |
|                |       |                        |       |   |   |   |   |
| ** **          | ** ** | **December 31, 2004**  | ** ** |
| ** **          | ** ** | **Gross Amount**            | ** ** | **Accumulated  Amortization** | ** ** | **Net  Amount** | ** ** |
|                |       |                        |       |   |   |   |   |
| Existing technology |       | $                           | 3,945      |   | $ | (2,370 | ) | $ | 1,575 |   |
| Tradename           |       | 176                         |       | (174 | ) | 2 |   |
|                |       |                        |       |   |   |   |   |
|                |       | $                           | 4,121      |   | $ | (2,544 | ) | $ | 1,577 |   |

 

For the three and nine months ended September 30, 2005,amortization expense was $172,000 and $538,000, respectively, of which $45,000and $135,000 were recorded in cost of revenue. For the three and nine monthsended September 30, 2004, amortization expense was $300,000 and $707,000,respectively, of which $45,000 and $103,000 were recorded in cost of revenue.

 

The total expected future amortizationrelated to intangible assets is provided in the table below:

 

9

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| **(In thousands)**                         | ** ** | **Amortization** | ** ** |
|--------------------------------------------|------------|------------------|------------|
|                                       |       |             |       |
| Three months ending December 31, 2005 |       | $                | 172        |   |
| Fiscal year 2006                           |       | 681              |       |
| Fiscal year 2007                           |       | 186              |       |
|                                       |       |             |       |
|                                       |       | $                | 1,039      |   |

 

**8.****                                      Inventories**

 

Inventoriesare stated at lower of cost (first-in, first-out) or market:

 
| **(In thousands)** | ** ** | **September 30, 2005** | ** ** | **December 31, 2004** | ** ** |
|--------------------|------------|-----------------------------|------------|----------------------------|------------|
|               |       |                        |       |                       |       |
| Raw materials      |       | $                           | 2,544      |                       | $          | 2,308 |   |
| Work in process    |       | 29                          |       | 51                         |       |
| Finished goods     |       | 1,175                       |       | 1,582                      |       |
|               |       |                        |       |                       |       |
|               |       | $                           | 3,748      |                       | $          | 3,941 |   |

 

**9.****                                      Borrowings**

 
| **(In thousands)**                        | ** ** | **September 30, 2005** | ** ** | **December 31, 2004** | ** ** |
|-------------------------------------------|------------|-----------------------------|------------|----------------------------|------------|
|                                      |       |                        |       |                       |       |
| Short-term debt:                          |       |                        |       |                       |       |
| Notes  payable to bank                    |       | $                           | 171        |                       | $          | 55 |   |
| COMO line of  credit                      |       | 143                         |       | 567                        |       |
| Accounts  receivable-based line of credit |       | 2,585                       |       | —                     |       |
|                                      |       | 2,899                       |       | 622                        |       |
| Long-term debt:                           |       |                        |       |                       |       |
| Term loan                                 |       | 2,500                       |       | —                     |       |
| Notes  payable to bank                    |       | —                      |       | 174                        |       |
|                                      |       |                        |       |                       |       |
|                                      |       | $                           | 5,399      |                       | $          | 796 |   |

 

Notes payableto a bank and the COMO line of credit were assumed by Focus as a result of theacquisition of COMO in February 2004 – see Note 6, “Business Combinations”.The notes payable and line of credit are with a local German bank.

 

The notespayable to a bank, consisting of two notes of $161,000 and $10,000 aredenominated in Euros and were originally scheduled to be repaid through December 2011and December 2005, respectively, at an average interest rate of 6% perannum. However, the bank has exercised its right to call these notes due at itsdiscretion and the bank has notified Focus that these notes must be repaid by January 31,2006.

 

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In connectionwith the COMO line of credit, COMO maintains a cash balance with the lendinginstitution. Interest is payable on this line of credit at a rate of 10% perannum. There are no financial covenants applicable to this credit facility, noris there an applicable maturity date. However, the bank has notified Focus thatit must repay all amounts due under this line of credit by January 31,2006.

 

The notespayable and COMO line of credit are collateralized by personal guarantees ofapproximately $500,000 and life insurance pledges from the two shareholdersfrom whom Focus purchased the shares of COMO common stock, as well as COMO’sinventory, accounts receivable and fixed assets. In the event the bank were toproceed with claiming against the personal guarantees and/or life insurancepledges, Focus would be responsible for reimbursing the two shareholders fromwhom Focus purchased the shares of COMO common stock.

 

Accounts Receivable-Based Line of Credit

 

In November 2004,Focus obtained a $4.0 million line of credit from Greater Bay Bank under which it can borrow upto 90% of its eligible outstanding accounts receivable. The credit line expireson November 15, 2005 and is collateralized by a personal guarantee fromCarl Berg, a Company director and shareholder. In connection with this creditline, the bank has obtained a first priority security interest in Focus’accounts receivable through an agreement with Mr. Berg, which enables Mr. Bergto retain his existing security interest in all of Focus’ assets whilesubordinating his interest in Focus’ accounts receivable.

 

The creditline is subject to certain ongoing covenants based on operating results.Borrowings under the credit line bear interest at a rate of prime plus 1%,which was 7.5% at September 30, 2005. In connection with this line ofcredit, Focus issued warrants to the bank to purchase 77,186 shares of Focus’common stock at an exercise price of $1.17 per share. The warrants were valuedat $76,000 using the Black-Scholes option-pricing model and are being amortizedto interest expense over the term of the credit line. During the three and ninemonths ended September 30, 2005, $18,000 and $58,000 were amortized togeneral and administrative expenses. At September 30, 2005, there was anoutstanding balance on this credit line of the maximum available amount of $2.6million.

 

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 7.5% at September 30, 2005. Inconnection with Mr. Berg’s personal guarantee, Focus issued Mr. Berga warrant to purchase 100,000 shares of common stock at an exerciseprice of $0.81 per share, which expires on June 28, 2009. Focus recorded acharge of $42,000 to general and administrative expenses at the time ofissuance based on the fair value of this warrant, determined using theBlack-Scholes option-pricing model. AtSeptember 30, 2005, there was an outstanding balance of $2.5 million underthis term loan.

 

**10.**                               Commitments and Contingencies

 

Research and Development Agreements

 

In June 2004, Focus entered into a development and licenseagreement under which Focus agreed to pay $664,000 to a third party forengineering services and the rights to certain intellectual property that willbe used in the research and development of UWB technology. Such amount wasexpensed to research and development ratably over the development period from June 2004to January 2005 based on the level of effort incurred by the third party.A total of $16,000 was expensed in the three months ended March 31, 2005.Payments were made upon the achievement of specific development milestones bythe third party, which were completed in January 2005.

 

In October 2004, Focus entered into a design services contractunder which Focus agreed to pay $2.9 million to a third party for the designand development of high performance UWB integrated circuits. Payments are madeupon the completion of specific milestones by the third party, which areexpected to be completed by December 2005. For the three and nine monthsended September 30, 2005, $218,000 and $1.7 million, respectively, wascharged to research and 

 

11

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development expense based on the level of effort incurred by the thirdparty and $802,000 was included within other accrued liabilities at September 30,2005.

 

InJuly 2005, Focus entered into a development agreement with a customerunder which the customer agreed to pay $600,000 to Focus for the jointdevelopment by Focus and the customer of a custom product. The customer willpay Focus $600,000 in four installments of $150,000 at the completion ofspecific milestones. For the three months ended September 30, 2005,$97,000 was recognized as revenue based on the level of effort incurred byFocus and $89,000 of research and development expense was reclassified to costof revenue. An amount of $53,000 was recorded in other accrued liabilities at September 30,2005, representing the difference between the first installment received fromthe customer of $150,000 and the revenue recognized. In the event of delays inproduction, in certain circumstances, Focus may be subject to penalties not toexceed $150,000.

 

Leases

 

Focus leases officefacilities under operating leases. Under the lease agreements, Focus isobligated to pay for utilities, taxes, insurance and maintenance.

 

Minimum leasecommitments at September 30, 2005 were as follows:

 
| **(In thousands)**                         | ** ** | **Lease Commitments** | ** ** |
|--------------------------------------------|------------|-----------------------|------------|
|                                       |       |                  |       |
| Three months ending December 31, 2005 |       | $                     | 122        |   |
| 2006                                       |       | 555                   |       |
| 2007                                       |       | 522                   |       |
| 2008                                       |       | 181                   |       |
| 2009                                       |       | 190                   |       |
| 2010                                       |       | 114                   |       |
|                                       |       |                  |       |
|                                       |       | $                     | 1,684      |   |

 

Employment Agreements

 

Focus has employmentagreements with certain corporate officers. The agreements are generally one totwo years in length and provide for minimum salary levels. These agreementsinclude severance payments of approximately half to one times each officer’sannual compensation.

 

Indemnification Agreements

 

Focus enters intostandard indemnification agreements with its customers and certain otherbusiness partners in the ordinary course of business. These agreementsinclude provisions for indemnifying the customer against any claim brought by athird party to the extent any such claim alleges that Focus’ products infringea patent, copyright or trademark, or misappropriate a trade secret, of thatthird party. The agreements generally limit the scope of the availableremedies in a variety of industry-standard methods, including but not limitedto product usage and geography-based limitations, a right to control thedefense or settlement of any claim, and a right to replace or modify theinfringing products to make them noninfringing. Such indemnification provisionsare accounted for in accordance with SFAS No. 5, *Accounting for Contingencies*, and aregenerally limited to the amount paid by the customer. Focus has not incurredsignificant expenses related to these indemnification agreements and nomaterial claims for such indemnifications are outstanding as of September 30,2005. As a result, no liability has been recorded with respect to suchindemnifications as of September 30, 2005.

 

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Inventory PurchaseCommitments

 

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

 

At September 30,2005, Focus had issued non-cancelable purchase orders for approximately $2.7million to purchase finished goods from its contract manufacturers, and had notincurred any significant liability for finished goods in excess of current customerdemand or for the costs of excess or obsolete 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**

 

The acquisition of COMO on February 27, 2004 resulted in theissuance of 215,066 shares of Focus’ common stock, consisting of 185,066 sharesissued to COMO’s shareholders, and 30,000 shares issued to vFinanceInvestments, Inc., for investment banking services related to theacquisition. Additionally, Focus issued 610,096 common shares, held in escrow,(“the Escrow shares”) to COMO’s two former shareholders (“the Sellers”) whobecame employees of Focus. The Escrow shares were issued in exchange for theSellers non-interest bearing, non-recourse, demand notes payable to Focus andCOMO in the aggregate amount of $1.1 million. For accounting purposes, theEscrow shares are reported in the accompanying financial statements asoutstanding, subscribed shares. The two former shareholders of COMO can sellthe Escrow shares at no less than the then current fair market value, with allproceeds to be remitted to Focus and COMO in exchange for cancellation of theoutstanding note obligations, regardless of whether such proceeds are greaterthan or less than the balance of the notes. In the nine months ended September 30,2005, a total of 579,428 of the escrow shares were sold for net proceeds of$488,000. The proceeds from the sale of such shares were remitted to Focus bythe Sellers and recorded as an increase in additional paid-in capital. The notereceivable from the Sellers is not recorded in the accompanying condensedconsolidated financial statements, as it will be cancelled upon receipt of theproceeds from the sale of the remaining Escrow shares.  

 

On May 28,2004, Focus acquired substantially all the assets and assumed certainliabilities of Visual Circuits pursuant to an Agreement and Plan ofReorganization. The agreement required VCC Liquidating Corporation (“VCC”),formerly Visual Circuits Corporation, to reimburse Focus for all transactioncosts paid by Visual Circuits prior to the acquisition. Such transaction costs,originally estimated to be $400,000 and later reduced to approximately $337,000upon final determination of the transaction costs, were to have been reimbursedto Focus on or before October 8, 2004. Focus was entitled to recover theamount owed, in the event such amount was not reimbursed to Focus, by thereturn to Focus of Focus common stock held in escrow, with such number ofshares to be determined by dividing the amount owed by an agreed-upon exchangerate of $2.33 per share. VCC subsequently sought to reduce this obligation,citing certain potential offsetting claims against Focus. Consequently, on November 2,2004, the parties entered into a settlement agreement, whereby the obligationto Focus was initially reduced to approximately $225,000, to be repaid on orbefore February 15, 2005. The receivable from VCC was not recorded in theaccompanying consolidated balance sheet at December 31, 2004, as therecourse available to Focus in the event of default was limited to the sharesheld in escrow. On February 15, 2005, Focus collected the amount owed of$225,000 and recorded the proceeds as an increase in additional paid-in capitalat that date.

 

On June 21,2005, Focus completed the sale of 2,414,282 shares of its common stock in aprivate placement to 11 independent third party investors, receiving proceedsof approximately $1.6 million, net of offering costs of approximately $47,000.The shares were issued at $0.70 per share, an approximate 5% discount to theclosing price of Focus’ common stock on June 20, 2005. Additionally, Focusissued warrants to the investors and placement agents to purchase an aggregateof 795,713 shares of common stock at an exercise price of $0.70 per share. Thewarrants are exercisable immediately and expire on June 21, 2009.

 

13

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As of September 30, 2005, Focus was obligated under certaincircumstances, to issue the following additional shares of common stockpursuant to derivative securities, instruments or agreements:

 
| **(In thousands)**                             | ** ** | **Shares of  Common Stock** | ** ** |
|------------------------------------------------|------------|-----------------------------|------------|
|                                           |       |                        |       |
| Warrants to purchase common stock              |       | 4,161                       |       |
| Options to purchase common stock               |       | 7,489                       |       |
| Preferred Stock convertible into common  stock |       | 3,161                       |       |
|                                           |       |                        |       |
|                                           |       | 14,811                      |       |

 

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

 

Carl Berg

 

In December 2002,Mr. Berg, a Company director and shareholder, provided SamsungSemiconductor Inc., Focus’ contracted manufacturer of Application SpecificIntegrated Circuits (“ASIC”), with a personal guarantee to secure Focus’working capital requirements for ASIC purchase order fulfillment. Mr. Bergagreed to provide the personal guarantee on Focus’ behalf without additionalcost or collateral, as Mr. Berg maintains a secured priority interest insubstantially all of Focus’ assets. At September 30, 2005, Focus owedSamsung $190,000 under net 30 terms.

 

In November 2004,Focus secured a line of credit of up to $4.0 million under which Focus canborrow up to 90% of its eligible outstanding accounts receivable. This line ofcredit is collateralized by a personal guarantee from Mr. Berg. Inconnection with this line of credit, the bank obtained a priority securityinterest in Focus’ accounts receivable. Mr. Berg will maintain hissecurity interest in all Focus’ assets, subject to the bank’s lien on accountsreceivable.

 

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 personallyguaranteed the term loan. In connection with Mr. Berg’s extension of hispersonal guarantee, Focus agreed to continue Mr. Berg’s priority interestin the Company’s assets, except for Focus’ accounts receivable, which Mr. Berghas subordinated to the bank, and to issue to Mr. Berg a warrant topurchase 100,000 shares of common stock at an exercise price of $0.81per share and which expires on June 28, 2009. The warrant was valued at$42,000 using the Black-Scholes option-pricing model and was charged to generaland administrative expense at the time of issuance.

 

Dolby Laboratories Inc.

 

N. William Jasper Jr., who is the Chairman ofFocus’ Board of Directors, is also the President and Chief Executive Officer ofDolby Laboratories, Inc. (“Dolby”), a signal processing technology companylocated in San Francisco, California. Focus is required to submit quarterlyroyalty payments to Dolby based on Dolby technology incorporated into certainproducts assumed in the acquisition of Visual Circuits in May 2004. Forthe nine months ended September 30, 2005 and September 30, 2004,Focus paid Dolby total royalties of $8,000 and $18,000, respectively, whichwere recorded in cost of revenue.

 

**13.**                               Business Segment 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.

 

14

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

 
| ** **                         | ** ** | **Three Months Ended September 30,  2005** | ** ** |
|------------------------------------|------------|-------------------------------------------------|------------|
| **(In thousands)**                 | ** ** | **Systems**                                     | ** ** | **Semiconductor** | ** ** | **Total** | ** ** |
|                               |       |                                            |       |   |   |   |   |
| Net revenue                        |       | $                                               | 5,934      |   | $ | 946 |   | $ | 6,880 |   |
| Cost of revenue                    |       | 3,733                                           |       | 627 |   | 4,360 |   |
| Gross margin                       |       | 2,201                                           |       | 319 |   | 2,520 |   |
|                               |       |                                            |       |   |   |   |   |
| Operating expenses:                |       |                                            |       |   |   |   |   |
| Sales,  marketing and support      |       | 1,351                                           |       | 432 |   | 1,783 |   |
| General and  administrative        |       | 548                                             |       | 377 |   | 925 |   |
| Research and  development          |       | 786                                             |       | 2,191 |   | 2,977 |   |
| Amortization  of intangible assets |       | 79                                              |       | 48 |   | 127 |   |
|                               |       | 2,764                                           |       | 3,048 |   | 5,812 |   |
| Loss from  operations              |       | $                                               | (563       | ) | $ | (2,729 | ) | $ | (3,292 | ) |
|                               |       |                                            |       |   |   |   |   |
| ** **                         | ** ** | **Three Months Ended September 30,  2004** | ** ** |
| **(In thousands)**                 | ** ** | **Systems**                                     | ** ** | **Semiconductor** | ** ** | **Total** | ** ** |
|                               |       |                                            |       |   |   |   |   |
| Net revenue                        |       | $                                               | 5,119      |   | $ | 655 |   | $ | 5,774 |   |
| Cost of revenue                    |       | 3,178                                           |       | 375 |   | 3,553 |   |
| Gross margin                       |       | 1,941                                           |       | 280 |   | 2,221 |   |
|                               |       |                                            |       |   |   |   |   |
| Operating expenses:                |       |                                            |       |   |   |   |   |
| Sales,  marketing and support      |       | 1,005                                           |       | 251 |   | 1,256 |   |
| General and  administrative        |       | 544                                             |       | 185 |   | 729 |   |
| Research and  development          |       | 1,166                                           |       | 1,323 |   | 2,489 |   |
| Amortization  of intangible assets |       | 174                                             |       | 81 |   | 255 |   |
|                               |       | 2,889                                           |       | 1,840 |   | 4,729 |   |
| Loss from  operations              |       | $                                               | (948       | ) | $ | (1,560 | ) | $ | (2,508 | ) |

 

15

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| ** **                                   | ** ** | **Nine Months Ended September 30,  2005** | ** ** |
|----------------------------------------------|------------|------------------------------------------------|------------|
| **(In thousands)**                           | ** ** | **Systems**                                    | ** ** | **Semiconductor** | ** ** | **Total** | ** ** |
|                                         |       |                                           |       |   |   |   |   |
| Net revenue                                  |       | $                                              | 16,176     |   | $ | 2,292 |   | $ | 18,468 |   |
| Cost of revenue                              |       | 10,401                                         |       | 1,403 |   | 11,804 |   |
| Gross margin                                 |       | 5,775                                          |       | 889 |   | 6,664 |   |
|                                         |       |                                           |       |   |   |   |   |
| Operating expenses:                          |       |                                           |       |   |   |   |   |
| Sales,  marketing and support                |       | 3,860                                          |       | 1,098 |   | 4,958 |   |
| General and  administrative                  |       | 1,841                                          |       | 1,079 |   | 2,920 |   |
| Research and  development                    |       | 2,834                                          |       | 7,426 |   | 10,260 |   |
| Amortization  of intangible assets           |       | 257                                            |       | 146 |   | 403 |   |
|                                         |       | 8,792                                          |       | 9,749 |   | 18,541 |   |
| Loss from  operations                        |       | $                                              | (3,017     | ) | $ | (8,860 | ) | $ | (11,877 | ) |
|                                         |       |                                           |       |   |   |   |   |
| ** **                                   | ** ** | **Nine Months Ended September 30,  2004** | ** ** |
| **(In thousands)**                           | ** ** | **Systems**                                    | ** ** | **Semiconductor** | ** ** | **Total** | ** ** |
|                                         |       |                                           |       |   |   |   |   |
| Net revenue                                  |       | $                                              | 12,238     |   | $ | 2,654 |   | $ | 14,892 |   |
| Cost of revenue                              |       | 7,862                                          |       | 1,734 |   | 9,596 |   |
| Gross margin                                 |       | 4,376                                          |       | 920 |   | 5,296 |   |
|                                         |       |                                           |       |   |   |   |   |
| Operating expenses:                          |       |                                           |       |   |   |   |   |
| Sales,  marketing and support                |       | 2,845                                          |       | 738 |   | 3,583 |   |
| General and  administrative                  |       | 1,601                                          |       | 593 |   | 2,194 |   |
| Research and  development                    |       | 2,633                                          |       | 2,628 |   | 5,261 |   |
| Amortization  of intangible assets           |       | 370                                            |       | 234 |   | 604 |   |
| In-process  research and development expense |       | 300                                            |       | — |   | 300 |   |
|                                         |       | 7,749                                          |       | 4,193 |   | 11,942 |   |
| Loss from  operations                        |       | $                                              | (3,373     | ) | $ | (3,273 | ) | $ | (6,646 | ) |

 

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

 

Focus accounts for stock-based compensation awards issued to employeesusing the intrinsic value measurement provisions of APB No. 25.Accordingly, no compensation expense has been recorded for stock optionsgranted with exercise prices greater than or equal to the fair value of theunderlying common stock at the option grant date. On December 16, 2004,the Financial Accounting Standards Board issued SFAS No. 123 (revised2004), *Share-Based Payment* (“SFAS 123R”). SFAS123R eliminates the alternative of applying the intrinsic value measurementprovisions of APB No. 25 to stock compensation awards issued to employees.Rather, the new standard requires enterprises to measure the cost of employeeservices received in exchange for an award of equity instruments based on thegrant-date fair value of the award. That cost will be recognized over theperiod during which an employee is required to provide services in exchange forthe award, known as the requisite service period (usually the vesting period).

 

Focus has not yet quantified the effects of the adoption of SFAS 123R,but it is expected that the new standard may result in significant stock-basedcompensation expense. The pro forma effects on net loss and net loss per shareif Focus had applied the fair value recognition provisions of original SFAS No. 123on stock compensation awards (rather than applying the intrinsic valuemeasurement provisions of APB No. 25) are disclosed in Note 2, “Pro FormaStock Compensation Expense”. Although such pro forma effects of applying theoriginal SFAS 123 may be indicative of the 

 

16

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effects of adopting SFAS 123R, the provisions of these two statementsdiffer in some important respects. The actual effects of adopting SFAS 123Rwill be dependent on numerous factors including, but not limited to, thevaluation model chosen by Focus to value stock-based awards; the assumed awardforfeiture rate; the accounting policies adopted concerning the method ofrecognizing the fair value of awards over the requisite service period; and thetransition method (as described below) chosen for adopting SFAS 123R.

 

SFAS 123R will be effective for Focus’ fiscalquarter beginning January 1, 2006, and requires the use of the ModifiedProspective Application Method. Under this method, SFAS 123R is applied to newawards and to awards modified, repurchased, or cancelled after the effectivedate. Additionally, compensation cost for the portion of awards for which therequisite service has not been rendered (such as unvested options) and that areoutstanding as of the date of adoption shall be recognized as the remainingrequisite services are rendered. The compensation cost relating to unvestedawards at the date of adoption shall be based on the grant-date fair value ofthose awards as calculated for pro forma disclosures under the original SFAS No. 123.In addition, companies may use the Modified Retrospective Application Method.This method may be applied to all prior years for which the original SFAS No. 123was effective or only to prior interim periods in the year of initial adoption.If the Modified Retrospective Application Method is applied, financial statementsfor prior periods shall be adjusted to give effect to the fair-value-basedmethod of accounting for awards on a consistent basis with the pro formadisclosures required for those periods under the original SFAS No. 123.

 

**15.****                               SubsequentEvents**

 

OnNovember 7, 2005, Focus received $3.0 million in net proceeds through aprivate equity placement. Focus issued 5,018,248 shares of its common stock at$0.66 per share to certain institutional investors, along with warrants topurchase an additional 1,254,562 shares of its common stock at an exerciseprice of $0.85 per share. Such warrants are exercisable for five years from thedate of grant.

 

In addition, Focus hasagreed to pay placement agents a cash fee of up to $264,000 and to issueadditional warrants to purchase up to 501,822 shares of our common stock at anexercise price of $0.85 per share. These warrants are exercisable for fiveyears from the date of grant.

 

17

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####  

#### **Item 2.Management’s Discussion and Analysis of Financial Condition and Results ofOperations**

####  

The followinginformation should be read in conjunction with the condensed consolidatedfinancial statements and notes thereto in Part I, Item 1 of this QuarterlyReport and with Management’s Discussion and Analysis of Financial Condition andResults of Operations contained in Focus’ Annual Report on Form 10-K/A forthe year ended December 31, 2004.

 

**CertainFactors That May Affect Future Results**

 

Discussions of certain matters in this Quarterly Report on Form 10-Qmay constitute forward-looking statements within the meaning of the Section 27Aof the Securities Act of 1933, as amended, and Section 21E of theSecurities and Exchange Act of 1934, as amended (the “Exchange Act”), and assuch, may involve risks and uncertainties. Forward-looking statements, which are based on certain assumptions anddescribe future plans, strategies, and expectations, are generally identifiableby the use of words or phrases such as “believe”, “plan”, “expect”, “intend”, “anticipate”,“estimate”, “project”, “forecast”, “may increase”, “may fluctuate”, “mayimprove” and similar 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, potential new products and orders, and such expense levels relative toour total revenues) constitute forward-looking statements and are made underthe safe harbor provisions of the Private Securities Litigation Reform Act of1995. Our actual results of operations and financial condition have varied andmay in the future vary significantly from those stated in any forward-lookingstatements.  Factors that may cause suchdifferences include, without limitation, the availability of capital to fundour future cash needs, reliance on major customers, history of operatinglosses, market acceptance of our products, technological obsolescence,competition, successful integration of acquisitions, component supply problemsand protection of proprietary information, as well as the accuracy of ourinternal estimates of revenue and operating expense levels.  For a discussion of these factors and some ofthe other factors that might cause such a difference see also “ - Risk Factors.”These factors should be considered in evaluating the forward-lookingstatements, and undue reliance should not be placed on such statements. We donot undertake, and specifically disclaim any obligation, to update anyforward-looking statements to reflect occurrences or unanticipated events orcircumstances after the date of such statements.

 

**RESULTS OF OPERATIONS**

 

#### **Net revenue**

 
| ** **                 | ** ** | **Three Months Ended**       | ** ** | ** **                   | ** ** | ** **   | ** ** |
|----------------------------|------------|------------------------------|------------|------------------------------|------------|--------------|------------|
| **(Dollars in thousands)** | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** | **Increase** | ** ** |
|                       |       |                         |       |                         |       |         |       |   |   |
| System products            |       | $                            | 5,934      |                         | $          | 5,119        |       | $ | 815 |   | 15.9 | % |
| Semiconductor products     |       | 946                          |       | 655                          |       | 291          |       | 44.4 | % |
|                       |       |                         |       |                         |       |         |       |   |   |
|                       |       | $                            | 6,880      |                         | $          | 5,774        |       | $ | 1,106 |   | 19.2 | % |

 

18

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| ** **                 |   | **Nine Months Ended**        |   |                         |   |                     |   |
|----------------------------|--------|------------------------------|--------|------------------------------|--------|--------------------------|--------|
| **(Dollars in thousands)** |   | **September 30,  2005** |   | **September 30,  2004** |   | **Increase/ (decrease)** |   |
|                       |   |                         |   |                         |   |                     |   |   |   |
| System products            |   | $                            | 16,176 |                         | $      | 12,238                   |   | $ | 3,938 |   | 32.2 | % |
| Semiconductor products     |   | 2,292                        |   | 2,654                        |   | (362                     | )      | -13.6 | % |
|                       |   |                         |   |                         |   |                     |   |   |   |
|                       |   | $                            | 18,468 |                         | $      | 14,892                   |   | $ | 3,576 |   | 24.0 | % |

 

Revenue forthe three months ended September 30, 2005 was $6.9 million, an increase of$1.1 million compared with the three months ended September 30, 2004.Revenue for the nine months ended September 30, 2005 was $18.5 million, anincrease of $3.6 million compared with the nine months ended September 30,2004.

 

For the threemonths ended September 30, 2005, sales of system products to distributors,retailers and Value Added Resellers were approximately $5.9 million compared to$5.1 million for the same period in 2004, an increase of $815,000. For the ninemonths ended September 30, 2005, sales of our system products wereapproximately $16.2 million compared to $12.2 million for the same period in2004, an increase of $3.9 million. This increase in sales of our systemsproducts in both the three- and nine-month periods mainly reflects theintroduction of a new variation of FireStore – the FS-4, partially offset by adecrease in sales of our consumer scan conversion and home theater products.Our consumer scan conversion product sales have decreased as an increasingnumber of personal computers and televisions now incorporate scan conversion technology.The increase in revenue of systems products in the nine-month period alsoreflects sales of products acquired through the acquisitions of COMO Computer &Motion GmbH (“COMO”) in February 2004 and Visual Circuits Corporation (“VisualCircuits”) in May 2004.

 

Sales ofsemiconductor products to distributors and OEM customers were $946,000 in thethree months ended September 30, 2005, an increase of $291,000 compared to$655,000 in the comparative period in 2004. This increase reflectsproduction ramps for internet protocol television (IPTV) set-top boxes and DVDplayers by our customers incorporating our chips. The $362,000 decreasein sales of semiconductor products in the nine-month period primarily reflects$1.0 million in sales of our FS454 chip in the first quarter of 2004, whichwere primarily to Microsoft for use in its Xbox, partially offset by newproduction starts by our customers in the nine months ended September 30, 2005.In January 2004, Microsoft ceased placing significant orders for our FS454product.

 

As of September 30,2005, we had a sales order backlog of $893,000, a decrease of $1.5 million whencompared to the second quarter of 2005 as a result of us fulfilling back ordersprimarily of our FS-4 and semiconductor products.

 

No customer accounted for more than 10% ofour revenue in the three and nine months ended September 30, 2005. Onecustomer accounted for 15% of our revenue in the three months ended September 30,2004. In the nine months ended September 30, 2004, one customer accountedfor 13% of total revenue.

 

19

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#### **Gross margin**

 
| ** **                 | ** ** | **Three Months Ended**      | ** ** | ** **                  | ** ** | ** **                | ** ** |
|----------------------------|------------|-----------------------------|------------|-----------------------------|------------|---------------------------|------------|
| **(Dollars in thousands)** | ** ** | **September 30, 2005** | ** ** | **September 30, 2004** | ** ** | **Increase / (decrease)** | ** ** |
|                       |       |                        |       |                        |       |                      |       |   |   |
| Gross margin               |       | $                           | 2,520      |                        | $          | 2,221                     |       | $ | 299 |   |
|                       |       |                        |       |                        |       |                      |       |   |   |
| Gross margin rate          |       | 36.6                        | %          | 38.5                        | %          | -1.9  percentage points   |       |
|                       |       |                        |       |                        |       |                      |       |   |   |
| ** **                 | ** ** | **Nine Months Ended**       | ** ** | ** **                  | ** ** | ** **                | ** ** |
| **(Dollars in thousands)** | ** ** | **September 30, 2005** | ** ** | **September 30, 2004** | ** ** | **Increase**              | ** ** |
|                       |       |                        |       |                        |       |                      |       |   |   |
| Gross margin               |       | $                           | 6,664      |                        | $          | 5,296                     |       | $ | 1,368 |   |
|                       |       |                        |       |                        |       |                      |       |   |   |
| Gross margin rate          |       | 36.1                        | %          | 35.6                        | %          | 0.5  percentage points    |       |
|                            |            |                             |            |                             |            |                           |            |  |  |  |  |  |

 

Our grossmargin rate in the three months ended September 30, 2005 decreased by 1.9percentage points to 36.6% from 38.5% in the three months ended September 30,2004. Our gross margin rate in the nine months ended September 30, 2005increased to 36.1% from 35.6% in the nine months ended September 30, 2004,an increase of 0.5 percentage points.

 

The decrease in the gross margin rate in thethree-month comparison reflects an increase in sales discounts and an increasein low-margin chip sales to one customer. The increase in gross margin rate inthe nine-month comparison mainly reflects increased sales volumes, the belowaverage gross margin business that we conducted with Microsoft in the threemonths ended March 31, 2004, which did not occur in nine months ended September 30,2005, a charge of $140,000 in the three months ended June 30, 2004associated with a fair value adjustment to Visual Circuits’ inventory uponacquisition and an accrual in the three months ended June 30, 2004 of$100,000 for a royalty payment based on the achievement of certain salesvolumes. These factors were partially offset by the increase in sales discountsand low-margin chip sales to one customer in the three months ended September 30,2005.

 

**Operating expenses**

 
| ** **                        | ** ** | **Three Months Ended**      | ** ** | ** **                  | ** ** | ** **                 | ** ** |
|-----------------------------------|------------|-----------------------------|------------|-----------------------------|------------|----------------------------|------------|
| **(Dollars in thousands)**        | ** ** | **September 30, 2005** | ** ** | **September 30, 2004** | ** ** | **Increase / (decrease )** | ** ** |
| ** **                        | ** ** | ** **                  | ** ** | **% of  revenue**           | ** ** | ** **                 | ** ** | **% of  revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
|                              |       |                        |       |                        |       |                       |       |   |   |   |   |   |   |
| Sales, marketing and support      |       | $                           | 1,783      |                        | 25.9       | %                          | $          | 1,256 |   | 21.8 | % | $ | 527 |   | 42.0 | % |
| General and administrative        |       | 925                         |       | 13.4                        | %          | 729                        |       | 12.6 | % | 196 |   | 26.9 | % |
| Research and development          |       | 2,977                       |       | 43.3                        | %          | 2,489                      |       | 43.1 | % | 488 |   | 19.6 | % |
| Amortization of intangible assets |       | 127                         |       | 1.8                         | %          | 255                        |       | 4.4 | % | (128 | ) | -50.2 | % |
|                              |       |                        |       |                        |       |                       |       |   |   |   |   |   |   |
|                              |       | $                           | 5,812      |                        | 84.5       | %                          | $          | 4,729 |   | 81.9 | % | $ | 1,083 |   | 22.9 | % |

 

20

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| ** **                          | ** ** | **Nine Months Ended**       | ** ** | ** **                  | ** ** | ** **                 | ** ** |
|-------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|----------------------------|------------|
| **(Dollars in thousands)**          | ** ** | **September 30, 2005** | ** ** | **September 30, 2004** | ** ** | **Increase / (decrease )** | ** ** |
| ** **                          | ** ** | ** **                  | ** ** | **% of  revenue**           | ** ** | ** **                 | ** ** | **% of  revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                |       |                        |       |                        |       |                       |       |   |   |   |   |   |   |
| Sales, marketing and support        |       | $                           | 4,958      |                        | 26.8       | %                          | $          | 3,583 |   | 24.1 | % | $ | 1,375 |   | 38.4 | % |
| General and administrative          |       | 2,920                       |       | 15.8                        | %          | 2,194                      |       | 14.7 | % | 726 |   | 33.1 | % |
| Research and development            |       | 10,260                      |       | 55.6                        | %          | 5,261                      |       | 35.3 | % | 4,999 |   | 95.0 | % |
| Amortization of intangible assets   |       | 403                         |       | 2.2                         | %          | 604                        |       | 4.1 | % | (201 | ) | -33.3 | % |
| In-process research and development |       | —                      |       | 0.0                         | %          | 300                        |       | 2.0 | % | (300 | ) | -100.0 | % |
|                                |       |                        |       |                        |       |                       |       |   |   |   |   |   |   |
|                                |       | $                           | 18,541     |                        | 100.4      | %                          | $          | 11,942 |   | 80.2 | % | $ | 6,599 |   | 55.3 | % |

 

Sales,marketing and support 

 

Sales,marketing and support expenses for the three months ended September 30,2005 were $1.8 million compared to $1.3 million in the three months ended September 30,2004, an increase of $527,000. Sales, marketing and support expenses for thenine months ended September 30, 2005 were $5.0 million, compared to $3.6million for the nine months ended September 30, 2004, an increase of $1.4million.

 

The increasein sales, marketing and support expenses in the three- and nine-month periodsmainly reflects additional headcount in our business development group,advertising expense associated with recent introductions of our new FS-4, andincreased commission expense as a result of increased revenues during theseperiods. The increase in sales, marketing and support expenses in thenine-month period also reflects, to a lesser extent, the inclusion of VisualCircuits and COMO’s sales and marketing expenses for the entire period. VisualCircuits’ and COMO’s expenses were only partially included in the prior year’snine-month period as the acquisitions occurred on May 28, 2004 and February 27,2004, respectively.

 

General andadministrative 

 

General andadministrative expenses for the three months ended September 30, 2005 were$925,000, compared to $729,000 in the three months ended September 30,2004, an increase of $196,000. General and administrative expenses for the ninemonths ended September 30, 2005 were $2.9 million, compared to $2.2million for the nine months ended September 30, 2004, an increase of$726,000.

 

The increasein general and administrative expenses in the three- and nine-month periods ismainly due to higher salary expense, stock compensation expense associated withthe issuance of restricted stock grants, and an increase in accounting andlegal fees, partially offset by a decrease in public relation fees. Theincrease in salary expense mainly reflects one additional hire in ourSemiconductor group, and in the nine-month comparison, reflects COMO’s andVisual Circuits expenses being only partially included in the prior year’snine-month period.

 

Research anddevelopment 

 

Research anddevelopment expenses for the three months ended September 30, 2005 were$3.0 million, compared to $2.5 million in the three months ended September 30,2004, an increase of $488,000. Research and development expenses for the ninemonths ended September 30, 2005 were $10.3 million, compared to $5.3million for the nine months ended September 30, 2004, an increase of $5.0million.

 

The increasein research and development expenses in the three- and nine-month periodsmainly reflects our investment in Ultra Wideband (“UWB”) technology, whichresulted in an increase in research and development expenses of $868,000 and $4.8million in the three and nine months ended September 30, 2005,respectively. This increase in our investment in UWB consisted mainly ofsemiconductor design service fees of $330,000 and $2.7 million in the three andnine months ended September 30, 2005, respectively, and increasedpersonnel costs reflecting additional headcount. The increase in research anddevelopment expenses in the three months ended September 30, 2005, waspartially offset by expense reductions in our system business’ research and developmentactivities. The acquisition of Visual Circuits contributed to a $466,000increase in research and development expenses 

 

21

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in thenine-month period as these expenses were not comparatively included.

 

Amortization of Intangible Assets

 

Amortization expense was recorded as follows:

 
| ** **         | ** ** | **Three Months Ended**       | ** ** | ** **                   | ** ** |
|--------------------|------------|------------------------------|------------|------------------------------|------------|
| **(In thousands)** | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** | **Decrease** | ** ** |
|               |       |                         |       |                         |       |   |   |
| Cost of revenue    |       | $                            | 45         |                         | $          | 45 |   | $ | — |   |
| Operating expenses |       | 127                          |       | 255                          |       | (128 | ) |
|               |       |                         |       |                         |       |   |   |
|               |       | $                            | 172        |                         | $          | 300 |   | $ | (128 | ) |
|               |       |                         |       |                         |       |   |   |
| ** **         | ** ** | **Nine Months Ended**        | ** ** | **Increase/  (Decrease)**    | ** ** |
| **(In thousands)** | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** | ** ** |
|               |       |                         |       |                         |       |   |   |
| Cost of revenue    |       | $                            | 135        |                         | $          | 103 |   | $ | 32 |   |
| Operating expenses |       | 403                          |       | 604                          |       | (201 | ) |
|               |       |                         |       |                         |       |   |   |
|               |       | $                            | 538        |                         | $          | 707 |   | $ | (169 | ) |

 

Amortizationexpense for the three months ended September 30, 2005 was $172,000, adecrease of $128,000 from $300,000 for the three months ended September 30,2004. Amortization expense for the nine months ended September 30, 2005was $538,000, a decrease of $169,000 from $707,000 for the nine months ended September 30,2004.

 

The decreasein amortization expense reflects the completion of amortization on certainintangible assets, partially offset in the nine-month comparison by an increasein amortization expense associated with the intangible assets that resultedfrom the acquisitions of COMO in February 2004 and Visual Circuits in May 2004.

 

In-Processresearch and development

 

The results of operations for the nine months ended September 30,2004 include a charge of $300,000 for in-process research and developmentexpense associated with the acquisition of Visual Circuits in May 2004.

 

22

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**Interestexpense, net and Other income (expense), net**

 
| ** **                  | ** ** | **Three Months Ended**       | ** ** | ** **                   | ** ** |
|-----------------------------|------------|------------------------------|------------|------------------------------|------------|
| **(Dollars in thousands)**  | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** | **Increase** | ** ** |
|                        |       |                         |       |                         |       |   |   |
| Interest expense, net       |       | $                            | (93        | )                            | $          | (8 | ) | $ | 85 |   |
|                        |       |                         |       |                         |       |   |   |
| Other income (expense), net |       | $                            | (10        | )                            | $          | (10 | ) | $ | — |   |
|                        |       |                         |       |                         |       |   |   |
| ** **                  | ** ** | **Nine Months Ended**        | ** ** | **Increase/  (Decrease)**    | ** ** |
| **(Dollars in thousands)**  | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** | ** ** |
|                        |       |                         |       |                         |       |   |   |
| Interest expense, net       |       | $                            | (174       | )                            | $          | (68 | ) | $ | 106 |   |
|                        |       |                         |       |                         |       |   |   |
| Other income (expense), net |       | $                            | (50        | )                            | $          | 10 |   | $ | (60 | ) |

 

Net interestexpense for the three months ended September 30, 2005 was $93,000,compared to $8,000 in the three months ended September 30, 2004. Netinterest expense for the nine months ended September 30, 2005 was$174,000, compared to $68,000 in the nine months ended September 30, 2004.The increase in net interest expense in both the three- and nine-month periodsreflects interest expense associated with our accounts receivable-based line ofcredit and term loan, both of which were not outstanding in the three and ninemonths ended September 30, 2004. The increase in net interest expense inthe nine-month period was partially offset by interest expense in the threemonths ended March 31, 2004 on convertible promissory notes, which wereoutstanding until their conversion in March 2004 into common and preferredstock.

 

Other income(expense) for the nine months ended September 30, 2005 consists mainly ofexpense associated with exchange rate differences related to transactionsdenominated in Euros. Other income (expense) for the three and nine monthsended September 30, 2004 primarily consists of income related to thesettlement of vendor obligations for less than original amounts.

 

23

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**LIQUIDITYAND CAPITAL RESOURCES**

 

The accompanyingcondensed consolidated financial statements have been prepared on a goingconcern basis, which contemplates the realization of assets and thesatisfaction of liabilities in the normal course of business. For the ninemonths ended September 30, 2005 and the year ended December 31, 2004,we incurred net losses of $12.1 million and $11.0 million, respectively, andused cash in operating activities of $9.4 million, and $9.4 million,respectively. These factors indicate that we may potentially be unable to continueas a going concern.

 

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

 

Sinceinception, we have financed our operations primarily through the public andprivate sale of common stock, proceeds from the exercise of options andwarrants, short-term borrowings from private lenders, and favorable creditarrangements with vendors and suppliers.

 
| **(Dollars in thousands)**                | ** ** | **September 30,  2005** | ** ** | **December 31,  2004**  | ** ** |
|-------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
|                                      |       |                         |       |                         |       |
| Cash and cash equivalents                 |       | $                            | 758        |                         | $          | 3,380 |   |
|                                      |       |                         |       |                         |       |
| Working capital                           |       | $                            | (1,303     | )                            | $          | 5,546 |   |
|                                      |       |                         |       |                         |       |
|                                      |       | **Nine Months Ended**        |       |
| ** **                                | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** |
|                                      |       |                         |       |                         |       |
| Days sales outstanding (DSO)              |       | 45.7                         |       | 48.8                         |       |
|                                      |       |                         |       |                         |       |
| Inventory turns - annualized              |       | 4.7                          |       | 3.6                          |       |
|                                      |       |                         |       |                         |       |
| Net cash used in operating activities     |       | $                            | (9,357     | )                            | $          | (4,664 | ) |
| Net cash used in investing activities     |       | $                            | (207       | )                            | $          | (1,167 | ) |
| Net cash provided by financing activities |       | $                            | 6,949      |                         | $          | 4,897 |   |

 

24

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Net cash usedin operating activities

 
| ** **                                     | ** ** | **Nine Months Ended**       | ** ** | ** **                  | ** ** |
|------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                     | ** ** | **September 30, 2005** | ** ** | **September 30, 2004** | ** ** | **Change in  cash (used)/  provided** | ** ** |
| ** **                                     | ** ** | **cash (used)/  provided**  | ** ** | **cash (used)/  provided**  | ** ** | ** ** |
| **(In thousands)**                             | ** ** | ** **                  | ** ** | ** **                  |
|                                           |       |                        |       |                        |       |   |   |
| Net loss                                       |       | $                           | (12,111    | )                           | $          | (6,705 | ) | $ | (5,406 | ) |
| Non-cash income statement items                |       | 1,160                       |       | 848                         |       | 312 |   |
| Decrease (increase) in accounts receivable     |       | (304                        | )          | 171                         |       | (475 | ) |
| Decrease in inventories                        |       | 124                         |       | 63                          |       | 61 |   |
| Increase in prepaid expenses and other  assets |       | (277                        | )          | (139                        | )          | (138 | ) |
| Increase in accounts payable                   |       | 1,116                       |       | 290                         |       | 826 |   |
| Increase in accrued liabilities                |       | 935                         |       | 808                         |       | 127 |   |
|                                           |       |                        |       |                        |       |   |   |
|                                           |       | $                           | (9,357     | )                           | $          | (4,664 | ) | $ | (4,693 | ) |

 

Net cash usedin operating activities for the nine months ended September 30, 2005 and2004 was $9.4 million and $4.7 million, respectively. The increase in net cashused in operating activities mainly reflects an increase in our net loss,partially offset by an increase in cash provided from accounts payable andaccrued liabilities. The increase in cash provided by accounts payable andaccrued liabilities reflects timing of payments and research and development expenseaccruals related to our investment in UWB technology.

 

One customerhad an accounts receivable balance that accounted for 13% of our total accountsreceivable on September 30, 2005.

 

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

 

Net cash usedin investing activities

 

Net cash usedin investing activities was $207,000 for the nine months ended September 30,2005, compared to $1.2 million for the nine months ended September 30,2004. The decrease in cash used in investing activities mainly reflectstransaction costs incurred during the nine months ended September 30, 2004with respect to the acquisitions of Visual Circuits and COMO and a decrease inour restricted cash balance at COMO in the nine months ended September 30,2005.

 

Net cashprovided by financing activities

 

Net cashprovided by financing activities was $6.9 million for the nine months ended September 30,2005, compared to $4.9 million for the nine months ended September 30,2004. Net cash from financing activities in the nine months ended September 30,2005 consisted mainly of borrowings of $2.6 million under our accountsreceivable-based line of credit, a term loan of $2.5 million, net proceeds of$1.6 million received in June 2005 from a private equity placementtransaction, proceeds of $488,000 from the sale of escrow shares and the reimbursementof acquisition fees by Visual Circuits Corporation Liquidating Trust related tothe acquisition of Visual Circuits, partially offset by repayments of $375,000related to our German subsidiary’s line of credit balance. Net cash fromfinancing activities in the nine months ended September 30, 2004 primarilyreflected net proceeds of $5.2 million received in April 2004 from aprivate equity placement transaction, partially offset by payments ofshort-term debt.

 

**CapitalResources and Liquidity Outlook**

 

We haveincurred losses and used net cash in operating activities for the nine monthsended September 30, 2005 and each of the two years in the period ended December 31,2004, and as such, have been dependent upon raising money for 

 

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short- andlong-term cash needs through debt, proceeds from the exercise of options andwarrants, and the sale of our common stock in private placements. For the yearended December 31, 2004, we received approximately $10.7 million inproceeds from the sale of approximately 10.5 million shares of our common stockin private placement transactions. For the nine months ended September 30,2005, we received approximately $1.6 million in net proceeds from the sale ofapproximately 2.4 million shares of our common stock in a private placementtransaction. On November 7, 2005, we received $3.0 million innet proceeds through a private equity placement of approximately 5.0 millionshares.

 

In November 2004,we obtained a $4.0 million 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, thebank obtained a first priority security interest in our accounts receivablethrough an agreement with Mr. Berg, which enables Mr. Berg to retainhis existing security interest in all of our assets while subordinating hisinterest in our accounts receivable. The bank credit line is subject to ongoingcovenants, including maintenance of certain liquidity ratios and operatingresults. At September 30, 2005, there was an outstanding balance on thiscredit line of the maximum available amount of $2.6 million. The credit lineexpires on November 15, 2005. As of November 14, 2005, we were indiscussions with the bank and expect to renew this facility under similarterms. If we are unable to successfully renew this facility then the fullamount will be immediately due.

 

On June 28,2005, we signed a term loan agreement with Greater Bay Bank under which we can borrow up to $2.5million. The term loan has a maturity date of December 24, 2006, isinterest only until maturity and is in addition to our existing $4.0 millionaccounts receivable based secured line of credit that we have with this samebank. Interest is payable under this loan at prime plus 1% (7.5% as of September 30,2005). At September 30, 2005, there was an outstanding balance under thisterm loan of the maximum available amount of $2.5 million.

 

At September 30,2005, our German subsidiary – COMO – had outstanding debt obligations thatconsisted of notes payable of $171,000 and borrowings under a line of credit of$143,000, both of which are denominated in Euros and were assumed by Focus inconnection with the 2004 acquisition of COMO. The bank has notified COMO thatit must repay the notes and all amounts due under this line of credit by January 31,2006.

 

In addition to regularly reviewing our coststructure, management continues to assess its product lines in light oftechnology trends and economic conditions, to identify how to enhance existingproduct lines, create new products or create new distribution channels. There canbe no assurance that management’s new product plans will result in substantialincreases in our revenue.

 

On November 7, 2005, we received $3.0 million in net proceeds through a privateequity placement. We believe that we will requireadditional financing and/or need to find a partner to fund operations by theend of the first quarter of 2006  inorder to meet all currently planned expenditures and cash requirements throughthe first customer sampling of our UWB chips. Such financing terms couldinclude debt and/or equity instruments. Depending upon the results and timing ofthis sampling program, customers’ adoption and acceptance of the UWB products,the profitability of our Systems business, and our efforts to partner withanother entity to market the chips on a widespread commercial basis, we mayneed to raise further capital in 2006 for the commercial deployment of UWB.

 

While we have been successful in the past inraising sufficient capital to fund our operations, there can be no assurancethat we will obtain sufficient financing in the future on acceptable terms tocontinue operations, or if we do obtain such funding, that we can do so withoutdiluting the equity interests of our current stockholders.

 

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Summary ofCertain Contractual Obligations as of September 30, 2005

 
| ** **                                         | ** ** | **Payment due by Period** | ** ** | ** **    | ** ** |
|----------------------------------------------------|------------|---------------------------|------------|---------------|------------|
| **(In thousands)**                                 | ** ** | **< 1 year**           | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **> 5 years** | ** ** | **Total** | ** ** |
|                                               |       |                      |       |          |       |   |   |   |   |   |   |
| Capital and  operating leases (including interest) |       | $                         | 680        |          | $          | 829 |   | $ | 321 |   | $ | 29 |   | $ | 1,859 |   |
| Inventory purchase commitments                     |       | 2,655                     |       | —        |       | — |   | — |   | 2,655 |   |
| Notes payable                                      |       | 171                       |       | —        |       | — |   | — |   | 171 |   |
| Term loan                                          |       | —                    |       | 2,500         |       | — |   | — |   | 2,500 |   |
| Interest expense on term loan                      |       | 188                       |       | 47            |       | — |   | — |   | 235 |   |
| Lines of credit                                    |       | 2,728                     |       | —        |       | — |   | — |   | 2,728 |   |
|                                               |       |                      |       |          |       |   |   |   |   |   |   |
|                                               |       | $                         | 6,422      |          | $          | 3,376 |   | $ | 321 |   | $ | 29 |   | $ | 10,148 |   |

 

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**RISK FACTORS**

 

**Risks Relatedto Our Business**

 

**We have a longhistory of operating losses.**

 

As of September 30,2005, we had an accumulated deficit of $86.1 million. We incurred net losses of$12.1 million, $11.0 million and $1.7 million for the nine months ended September 30,2005 and the years ended December 31, 2004 and 2003, respectively. Therecan be no assurance that we will ever become profitable. Additionally, ourauditors have included an explanatory paragraph in their report on our consolidatedfinancial statements for the year ended December 31, 2004 with respect tosubstantial doubt about our ability to continue as a going concern. The consolidatedfinancial statements do not include any adjustments that might result from theoutcome of that uncertainty.

 

**We will needto raise additional capital through equity securities placements, which willresult in further dilution of existing and future stockholders.**

 

Historically, we have met our short- andlong-term extra cash needs through debt and the sale of common stock in privateplacements, because cash flow from operations has been insufficient to fund ouroperations.

 

Future capital requirements will depend onmany factors, including cash flow from operations, continued progress inresearch and development programs, competing technological and marketdevelopments, and our ability to market our products successfully. There can beno assurance that sufficient funds will be raised. Moreover, any equityfinancing or convertible debt would result in dilution to our existingstockholders and could have a negative effect on the market price of our commonstock. Furthermore, any additional debt financing will result in higherinterest expense.

 

**During much of the firsthalf of 2003 and from March to August of 2005, our common stock didnot 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 stockis traded on the Nasdaq Capital Market. There are various quantitative listingrequirements for a company to remain listed on the Nasdaq Capital Market,including maintaining a minimum bid price of $1.00 per share of common stockand maintaining stockholders’ equity of $2.5 million. On May 4, 2005, theNasdaq Capital 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.However, on September 12, 2005, we received notificationfrom Nasdaq that we had regained compliance and the matter was closed.

 

At September 30,2005, we had total stockholders’ equity of $11.7 million. To the extent weincur net losses and do not raise additional capital, our stockholders’ equitywill be reduced.

 

The closingminimum bid price of our common stock on November 10, 2005 was $0.70 andhad closed below $1.00 for 22 consecutive days. If the minimum bid price of ourcommon stock were to close below $1.00 for 30 consecutive days, we would likelyagain receive 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 toa Nasdaq Listing Qualifications Panel and request a hearing.

 

In the eventwe are delisted from the Nasdaq Capital Market, we would be forced to list ourshares on the OTC Electronic Bulletin Board or some other quotation medium,such as pink sheets, depending on our ability to meet the specific listingrequirements of those quotation systems. As a result, an investor might find itmore difficult to trade, or to obtain accurate price quotations for, suchshares. Delisting might also reduce the visibility, liquidity, and price of ourvoting common stock.

 

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**We are dependent upon asignificant shareholder to meet our financing needs and there can be noassurance that this shareholder will continue to provide financing.**

** **

We have reliedupon the ability of Carl Berg, a director and significant owner of our commonstock, for interim financing needs. Mr. Berg has provided a personalguarantee to Samsung Semiconductor Inc., our contracted ASIC manufacturer, tosecure our working capital requirements for ASIC purchase order fulfillment anda personal guarantee to Greater Bay Bank in connection with our $4.0 millionaccounts receivable-based line of credit facility and $2.5 million term loan.In connection with these guarantees, Mr. Berg maintains a securityinterest in all the company’s assets, subject to the bank’s lien on ouraccounts receivable. There can be no assurances that Mr. Berg willcontinue to provide such interim financing or personal guarantees, should weneed additional funds or increased credit facilities with our vendors.

 

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

** **

At November 10,2005, we had 3,161 shares of preferred shares issued and outstanding, and5,917,005 warrants and 7,459,652 options, which are all exercisable into sharesof common stock. The 3,161 shares of preferred stock are convertible into3,161,000 shares of our voting common stock. Furthermore, at November 10,2005, 977,641 additional shares of common stock were available for grant to ouremployees, officers, directors and consultants under our current stock optionand incentive plans. We also may issue additional shares in acquisitions. Anyadditional grant of options under existing or future plans or issuance ofshares in connection with an acquisition will further dilute existingstockholders.

 

**Any acquisitions ofcompanies or technologies by us, including our acquisitions of COMO and VisualCircuits in 2004, may result in distraction of our management and disruptionsto our business.**

** **

We may acquire or make investments incomplementary businesses, technologies, services or products if appropriateopportunities arise, as was the case in February 2004 when we acquired thestock of COMO and in May 2004 when we acquired substantially all theassets of Visual Circuits. From time-to-time, we may engage in discussions andnegotiations with companies regarding the possibility of acquiring or investingin their businesses, products, services or technologies. We may not be able toidentify suitable acquisition or investment candidates in the future, or if wedo identify suitable candidates, we may not be able to make such acquisitionsor investments on commercially acceptable terms, if at all. If we acquire orinvest in another company, we could have difficulty assimilating that company’spersonnel, operations, technology or products and service offerings. Inaddition, the key personnel of the acquired company may decide not to work forus. These difficulties could disrupt our ongoing business, distract our managementand employees, increase our expenses and adversely affect the results ofoperations. Furthermore, we may incur indebtedness or issue equity securitiesto pay for any future acquisitions and/or pay for the legal, accounting orfinders fees, typically associated with an acquisition. The issuance of equitysecurities could be dilutive to our existing stockholders. In addition, theaccounting treatment for any acquisition transaction may result in significantgoodwill and intangible assets, which, if impaired, will negatively affect ourconsolidated results of operations. The accounting treatment for any potentialacquisition may also result in a charge for in-process research and developmentexpense, as was the case with the acquisition of Visual Circuits, which willnegatively affect our consolidated results of operations.

 

**We rely on certainvendors for a significant portion of our manufacturing. If these vendorsexperience delays in the production and shipping of our products, this wouldhave an adverse effect on our results of operations.**

** **

Approximately 57% of the components for our products are manufacturedon a turnkey basis by four vendors: BTW Inc., Furthertech Company Ltd., SamsungSemiconductor Inc. and Veris Manufacturing. If these vendors experienceproduction or shipping problems for any reason, we in turn could experiencedelays in the production and shipping of our products, which would have anadverse effect on our results of operations.

 

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**We aredependent on our suppliers. If our suppliers experience labor problems, supplyshortages or product discontinuations, this would have an adverse effect on ourresults of operations.**

 

We purchaseall of our parts from outside suppliers and from time-to-time experience delaysin obtaining some components or peripheral devices. Additionally, we aredependent on sole source suppliers for certain components.  There can be no assurance that laborproblems, supply shortages or product discontinuations will not occur in thefuture, which could significantly increase the cost, or delay shipment, of ourproducts, which in turn could adversely affect our results of operations.

 

**If we fail to meet certaincovenants in our credit facility, we may not be able to draw down on suchfacility and our ability to finance our operations could be adversely affected*.***

 

We have a $4.0 million credit line under whichwe can borrow up to 90% of our eligible outstanding accounts receivable and a$2.5 million term loan. The various agreements in connection with such creditline and term loan require us to maintain certain covenants. In the event weare not able to obtain a waiver for any covenant violation, and/or remain outof compliance with a particular covenant, we will not be able to draw down onthe line of credit or term loan, and any amounts outstanding under such line ofcredit or term loan may become immediately due and payable, either of whichcould have a material adverse impact on our financial condition and results ofoperation.

 

Furthermore, the restrictions contained in theline of credit and term loan documents, as well as the terms of otherindebtedness we may incur from time-to-time, could limit our ability to planfor or react to market conditions or meet capital needs or otherwise restrictour activities or business plans. These restrictions could also adverselyaffect our ability to finance our operations or other capital needs, or toengage in other business activities that would be in our interest.

 

**If we are unable to renew or extend our existinglines of credit or term loan when they naturally expire, our ability to financeour operations could be adversely affected.**

 

We have a $2.5 million term loan and a $4.0million credit line facility. Our term loan expires on December 24, 2006, andour credit line expires on November 15, 2005. If we are unable to renew theterm loan or credit line on favorable terms upon their natural expiration, wewould be required to immediately pay all outstanding obligations under such termloan and credit line. Repayment of the principal amounts due under our creditline and term loan could adversely affect our other capital requirements, aswell as our ability to finance our operations on an ongoing basis.

 

**We depend on a few customers for a high percentageof our revenues and the loss or failure to pay of any one of these customerscould result in a substantial decline in our revenues and profits.**

** **

For the ninemonths ended September 30, 2005, our five largest customers in aggregateprovided 28% of our total revenues and as of September 30, 2005 comprised38% of our accounts receivable balance. We do not have long-term contractsrequiring any customer to purchase any minimum amount of products. There can beno assurance that we will continue to receive orders of the same magnitude asin the past from existing customers or will be able to market our current orproposed products to new customers. The loss of any major customer, the failureof any such identified customer to pay us, or to discontinue issuance ofadditional purchase orders, would have a material adverse effect on ourrevenues, results of operation, and business as a whole, absent the timelyreplacement of the associated revenues and profit margins associated with suchbusiness. Furthermore, many of our products are dependent upon the overallsuccess of our customers’ products, over which we often have no control.

 

**Our quarterly financialresults are subject to significant fluctuations and if actual revenues are lessthan projected revenues, we may be unable to reduce expenses proportionately,and our operating results, cash flows and liquidity would likely be adverselyaffected.**

** **

We have beenunable in the past to accurately forecast our operating expenses or revenues.Revenues currently depend heavily on volatile customer purchasing patterns. Ifactual revenues are less than projected revenues, we may be unable to reduceexpenses proportionately, and our operating results, cash flows and liquiditywould likely be adversely affected.

 

**Our markets are subject to rapidtechnological change, and to compete effectively, we must continually introducenew products, requiring significant influx of additional capital.**

 

Many of ourmarkets are characterized by extensive research and development and rapidtechnological change resulting in short product life cycles. Development byothers of new or improved products, processes or technologies may make ourproducts or proposed products obsolete or less competitive. We must devotesubstantial efforts and financial 

 

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resources toenhance our existing products and to develop new products, including oursignificant investment in UWB technology. To fund such ongoing research anddevelopment, we will require a significant influx of additional capital. Therecan be no assurance that we will succeed with these efforts. Failure toeffectively develop such products, notably our UWB technology, could have amaterial adverse effect on our financial condition and results of operations.

 

**We may not beable to protect our proprietary information.**

 

As of September 30,2005 we held six patents and four pending applications, one of which combinedfive previous provisional patent applications, in the United States. Certain ofthese patents have also been filed and issued in countries outside the UnitedStates. We treat our technical data as confidential and rely on internalnon-disclosure safeguards, including confidentiality agreements with employees,and on laws protecting trade secrets, to protect our proprietary information.There can be no assurance that these measures will adequately protect theconfidentiality of our proprietary information or prove valuable in light offuture technological developments.

 

There can beno assurance that third parties will not assert infringement claims against usor that such assertions will not result in costly litigation or require us tolicense intellectual proprietary rights from third parties. In addition, therecan be no assurance that any such licenses would be available on termsacceptable to us, if at all.

 

**Delays inproduct development could adversely affect our market position or customerrelationships.**

 

We haveexperienced delays in product development in the past and may experiencesimilar delays in the future. Given the short product life cycles in themarkets for certain products, any delay or unanticipated difficulty associatedwith new product introductions or product enhancements could cause us to losecustomers and damage our competitive position. Prior delays have resulted from numerous factors, such as:

 

•                                          changingproduct specifications;

•                                          thediscontinuation of certain third party components;

•                                          difficultiesin hiring and retaining necessary personnel;

•                                          difficultiesin reallocating engineering resources and other resource limitations;

•                                          difficultieswith independent contractors;

•                                          changingmarket or competitive product requirements;

•                                          unanticipatedengineering complexity;

•                                          undetectederrors or failures in software and hardware; and

•                                          delaysin the acceptance or shipment of products by customers.

 

The development of new,technologically advanced products, including our significant investment in UWB,is a complex and uncertain process requiring high levels of innovation andhighly skilled engineering and development personnel, as well as the accurateanticipation of technological and market trends. In order to compete, we mustbe able to deliver products to customers that are highly reliable, operate withthe customer’s existing equipment, lower the customer’s costs of acquisition,installation and maintenance, and provide an overall cost-effective solution.We may not be able to identify, develop, manufacture, market or support new orenhanced products successfully, if at all, or on a timely basis. Further, ournew products may not gain market acceptance or we may not be able to respondeffectively to product announcements by competitors, technological changes oremerging industry standards. Our failure to respond effectively totechnological changes would significantly harm our business.  Finally, there can be no assurances we willbe successful in these efforts.

 

**If we areunable to respond to rapid technological change in a timely manner, then we maylose customers to our competitors.**

 

To remaincompetitive, we must continue to enhance and improve the responsiveness,functionality and features of our products. Our industry is characterized byrapid technological change, changes in user and customer requirements andpreferences and frequent new product and service introductions. If competitorsintroduce products and services embodying new technologies, or if new industrystandards and practices emerge, then our existing proprietary 

 

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technology andsystems may become obsolete.  Our futuresuccess will depend on our ability to do the following:

 

•                                          bothlicense and internally develop leading technologies useful in our business;

•                                          enhanceour existing technologies;

•                                          developnew services and technology that address the increasingly sophisticated andvaried needs of our prospective customers; and

•                                          respondto technological advances and emerging industry standards and practices on acost-effective and timely basis.

 

To develop ourproprietary technology entails significant technical and business risks. We mayuse new technologies ineffectively, or we may fail to adapt our proprietarytechnology and transaction processing systems to customer requirements oremerging industry standards. If we face material delays in introducing newservices, products and enhancements, then our customers may forego the use ofour services and use those of our competitors.

 

**Wetypically operate without a significant amount of backlog, which could have anadverse impact on our operating results**.

 

We typicallyoperate with a small amount of backlog. Accordingly, we generally do not have amaterial backlog of unfilled orders, and revenues in any quarter aresubstantially dependent on orders booked in that quarter. Any significantweakening in current customer demand would therefore have, and has had in thepast, an almost immediate adverse impact on our operating results.

 

**Ourcommon stock price is volatile.**

 

The market price for ourvoting common stock is volatile and has fluctuated significantly to date. Forexample, between January 1, 2005 and November 10, 2005, the per shareprice has fluctuated between $0.62 and $1.22 per share, closing at $0.71 on November 10,2005. The trading price of our voting common stock is likely to continue to behighly volatile and subject to wide fluctuations in response to factorsincluding the following:

 

•                                          actualor anticipated variations in our quarterly operating results;

•                                          announcementsof technological innovations or failures, new sales formats or new products orservices by us or our competitors;

•                                          cyclicalnature of consumer products using our technology;

•                                          changesin financial estimates by us or securities analysts;

•                                          changesin the economic performance and/or market valuations of other multi-media,video scan companies;

•                                          announcementsby us of significant acquisitions, strategic partnerships, joint ventures orcapital commitments;

•                                          additionsor departures of key personnel;

•                                          additionsor losses of significant customers; and

•                                          salesof common stock or issuance of other dilutive securities.

 

In addition, thesecurities markets have experienced extreme price and volume fluctuations inrecent times, and the market prices of the securities of technology companieshave been especially volatile. These broad market and industry factors mayadversely affect the market price of common stock, regardless of actualoperating performance. In the past, following periods of volatility in themarket price of stock, many companies have been the object of securities classaction litigation, including us. If we are sued in a securities class action,then it could result in additional substantial costs and a diversion ofmanagement’s attention and resources.

 

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**We are subject to various environmental lawsand regulations that could impose substantial costs upon us and may adverselyaffect our business.**

 

The European Parliament has enacted the Restriction on Use of HazardousSubstances Directive, or RoHS Directive, which restricts the use of certainhazardous substances in electrical and electronic equipment. We may need toredesign products containing hazardous substances regulated under the RoHSDirective to reduce or eliminate those regulated hazardous substances in ourproducts. As an example, certain of our products include lead, which isincluded in the list of restricted substances.

 

We are in the process ofevaluating the impact of this directive on our business and have not yetestimated the potential costs of compliance.

 

**Risks Relatedto Our Industry**

 

**Internationalsales are subject to significant risk.**

 

Our revenuesfrom outside the United States are subject to inherent risks related thereto,including currency rate fluctuations, the general economic and politicalconditions in each country. There can be no assurance that an economic orcurrency crisis experienced in certain parts of the world will not reducedemand for our products and therefore have a material adverse effect on ourrevenue or operating results.

 

**Our businessesare very competitive.**

 

The computer peripheralmarkets are extremely competitive and are characterized by significant priceerosion over the life of a product. We currently compete with other developersof video conversion products and with video-graphic integrated circuitdevelopers. Many of our competitors have greater market recognition and greaterfinancial, technical, marketing and human resources. There can be no assurancethat we will be able to compete successfully against existing companies or newentrants to the marketplace.

 

The video productionequipment market is highly competitive and is characterized by rapidtechnological change, new product development and obsolescence, evolving industrystandards and significant price erosion over the life of a product. Competitionis fragmented with several hundred manufacturers supplying a variety ofproducts to this market. We anticipate increased competition in the videopost-production equipment market from both existing manufacturers and newmarket entrants. Increased competition could result in price reductions,reduced margins and loss of market share, any of which could materially andadversely affect our business, financial condition and results of operations.There can be no assurance that we will be able to compete successfully againstcurrent and future competitors in this market.

 

Often ourcompetitors have greater financial, technical, marketing, sales and customersupport resources, greater name recognition and larger installed customer basesthan we possess. In addition, some of our competitors also offer a wide varietyof video equipment, including professional video tape recorders, video camerasand other related equipment. In some cases, these competitors may have acompetitive advantage based upon their ability to bundle their equipment incertain large system sales.

 

**We are exposedto general economic conditions that have resulted in significantly reducedsales levels.  If we experience adverseeconomic conditions our business, financial condition and operating resultscould be adversely impacted.**

 

If weexperience adverse economic conditions in the United States and throughout theworld, we may continue to experience a material adverse impact on our business,operating results, and financial condition. A prolonged continuation orworsening of sales trends may require additional actions and charges to reducecost of sales and operating expenses in subsequent quarters. We may be unable toreduce cost of sales and operating expenses at a rate and to a level consistentwith such a future adverse sales environment. If we must undertake furtherexpense reductions, 

 

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we may incursignificant incremental special charges associated with such expense reductionsthat are disproportionate to sales, thereby adversely affecting our business,financial condition and operating results. Adverse economic conditions coulddecrease demand for our products, increase delinquencies in payments andotherwise have an adverse impact on our business.

 

**Recentcorporate bankruptcies, accounting irregularities, and alleged insider wrongdoings have negatively affected general confidence in the stock markets and theeconomy, causing the United States Congress to enact sweeping legislation,which will increase the costs of compliance.**

 

In an effortto address growing investor concerns, the United States Congress passed, and onJuly 30, 2002, President Bush signed into law, the Sarbanes-Oxley Act of2002. This sweeping legislation primarily impacts investors, the publicaccounting profession, public companies, including corporate duties andresponsibilities, and securities analysts. Some highlights includeestablishment of a new independent oversight board for public accounting firms,enhanced disclosure and internal control requirements for public companies andtheir insiders, required certification by CEO’s and CFO’s of Securities andExchange Commission financial filings, prohibitions on certain loans to officesand directors, efforts to curb potential securities analysts’ conflicts ofinterest, forfeiture of profits by certain insiders in the event financialstatements are restated, enhanced board audit committee requirements,whistleblower protections, and enhanced civil and criminal penalties forviolations of securities laws. Such legislation and subsequent regulations willincrease the costs of securities law compliance for publicly traded companiessuch as us.

 

**We are exposed to potential risks fromlegislation requiring companies to evaluate financial controls under Section 404of the Sarbanes-Oxley Act of 2002.**

 

Section 404of the Sarbanes-Oxley Act of 2002 requires that we evaluate and report on oursystem of internal controls. We will be required to meet the requirements ofthe Sarbanes-Oxley Act by December 31, 2006 if our market capitalization,adjusted for certain items, is greater than $75 million on June 30, 2006,otherwise we must meet the requirements by December 31, 2007. Compliancewith the requirements of Section 404 is expected to be expensive andtime-consuming. If we fail to complete this evaluation in a timely manner, orif our independent registered public accounting firm cannot timely attest toour evaluation, we could be subject to regulatory scrutiny and a loss of publicconfidence in our internal controls. In addition, any failure to implementrequired new or improved controls, or difficulties encountered in theirimplementation, could harm our operating results or cause us to fail to meetour reporting obligations.

 

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

 

**Interest Rate Risk**

 

At September 30, 2005, we did not holdany short-term investments that would be exposed to market risk from adversemovements in interest rates.

 

At September 30, 2005, our outstanding debt obligations consisted of notes payable of $171,000, a term loan of $2.5 million and borrowings under lines of credit of $2.7 million. The average interest rate applicable to these debt obligations is 7.5% per annum. If short-term interest rates were to increase 100 basis points (100 basis points equals 1%), the increased interest expense associated with these debt obligations would increase by approximately $14,000 on a quarterly basis.

 

**Foreign Currency Risk**

 

Gains or losses related to foreign exchange currency transactions werenot material for the periods ended September 30, 2005 and 2004.  A 10% movement in the EUR/USD exchange ratewould not have a material impact on our consolidated financial statements.

 

**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 Focus’ disclosure controls and procedures asof the 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, Focus’ disclosure controls andprocedures are effective to ensure that information required to be disclosed byFocus in the reports filed or submitted by it under the Securities Exchange Actof 1934, as amended, is recorded, processed, summarized and reported within thetime periods specified in the SEC’s rules and forms, and include controlsand procedures designed to ensure that information required to be disclosed byFocus in such reports is accumulated and communicated to Focus’ management,including the President and Chief Executive Officer and the Chief FinancialOfficer of Focus, as appropriate to allow timely decisions regarding requireddisclosure.

 

There was nochange in Focus’ internal control over financial reporting that occurred duringFocus’ third fiscal quarter of 2005 that has materially affected, or isreasonably likely to materially affect, Focus’ internal control over financialreporting.

 

Focus will berequired to evaluate its internal controls over financial reporting in order tocomply with the requirements of the Sarbanes-Oxley Act of 2002 and expects toincur significant costs in meeting these requirements. We estimate the externalcosts involved in meeting these requirements to be approximately $650,000.Focus will be required to meet the requirements of the Sarbanes-Oxley Act by December 31,2006 if market capitalization, adjusted for certain items, is greater than $75million on June 30, 2006, otherwise it must meet the requirements by December 31,2007.

 

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**PART II - OTHER INFORMATION**

 
| **Item 1.** | **Legal proceedings**                                                                                                                                                                                                                                                      |
|-------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |                                                                                                                                                                                                                                                                       |
|        | From time to  time, Focus is party to certain other claims and legal proceedings that arise  in the ordinary course of business of which, in the opinion of management, do  not have a material adverse effect on Focus’ financial position or results of  operation. |
|        |                                                                                                                                                                                                                                                                       |
| **Item 2.** | **Unregistered sales of equity securities and use of proceeds**                                                                                                                                                                                                            |
|        |                                                                                                                                                                                                                                                                       |
|        | None.                                                                                                                                                                                                                                                                      |
|        |                                                                                                                                                                                                                                                                       |
| **Item 3.** | **Defaults upon senior securities**                                                                                                                                                                                                                                        |
|        |                                                                                                                                                                                                                                                                       |
|        | None.                                                                                                                                                                                                                                                                      |
|        |                                                                                                                                                                                                                                                                       |
| **Item 4.** | **Submission of matters to a vote of security holders**                                                                                                                                                                                                                    |
| ** **  | ** **                                                                                                                                                                                                                                                                 |
|        | None.                                                                                                                                                                                                                                                                      |
|        |                                                                                                                                                                                                                                                                       |
| **Item 5.** | **Other information**                                                                                                                                                                                                                                                      |
|        |                                                                                                                                                                                                                                                                       |
|        | None.                                                                                                                                                                                                                                                                      |
|        |                                                                                                                                                                                                                                                                       |
| **Item 6.** | **Exhibits**                                                                                                                                                                                                                                                               |
|        |                                                                                                                                                                                                                                                                       |
|        | Exhibit 31.1 - Rule 13a-14(a) Certification of CEO                                                                                                                                                                                                          |
|        | Exhibit 31.2 - Rule 13a-14(a) Certification of CFO                                                                                                                                                                                                          |
|        | Exhibit 32.1  – CEO 906 Certification                                                                                                                                                                                                                            |
|        | Exhibit 32.2  – CFO 906 Certification                                                                                                                                                                                                                            |

 

36

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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.

 

 
|    November 14, 2005 |                                  | 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                      |
|                                     | Vice President of Finance,            |
|                                     | Chief Financial Officer               |
|                                     | (Principal Accounting Officer)        |
|                                          |                                       |                               |        |  |  |  |  |

 

37

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