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

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

**ý****QUARTERLY REPORT UNDER SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

# **For the quarterly period ended June 30, 2005, or**

# ** **

**o****TRANSITION REPORT PURSUANT TO SECTION13 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  Incorporation or Organization) |       | (I.R.S. Employer  Identification No.) |

 

**1370 Dell Ave**

**Campbell, CA 95008**

(Address of Principal Executive Offices)

 

**(408) 866-8300**

(Issuer’s Telephone Number, Including AreaCode)

 

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

 

As of theclose of business on August 10, 2005, there were 62.4 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 | 17               |
|                                     |                                                                                        |             |
| **Item  3.**                             | Quantitative  and Qualitative Disclosures about Market Risk                                 | 34               |
|                                     |                                                                                        |             |
| **Item  4.**                             | Controls  and Procedures                                                                    | 34               |
|                                     |                                                                                        |             |
| **PART II - OTHER INFORMATION**     |                                                                                        |
|                                     |                                                                                        |             |
| **Item 1.**                              | Legal Proceedings                                                                           | 35               |
|                                     |                                                                                        |             |
| **Item  2.**                             | Unregistered  Sales of Equity Securities and Use of Proceeds                                | 35               |
|                                     |                                                                                        |             |
| **Item  3.**                             | Defaults  Upon Senior Securities                                                            | 35               |
|                                     |                                                                                        |             |
| **Item  4.**                             | Submission  of Matters to a Vote of Security Holders                                        | 35               |
|                                     |                                                                                        |             |
| **Item  5.**                             | Other  Information                                                                          | 35               |
|                                     |                                                                                        |             |
| **Item  6.**                             | Exhibits                                                                                    | 35               |
|                                     |                                                                                        |
| **SIGNATURES**                           | 36                                                                                          |
|                                     |                                                                                        |
| **CERTIFICATIONS**                       |                                                                                        |

 

1

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**PART I - FINANCIAL INFORMATION**

 

**Item 1.    Financial Statements**

 

**Focus Enhancements, Inc.**

**Condensed Consolidated Statements of Operations**

(In thousands, except per share amounts)

(Unaudited)

 
| ** **                                                         | ** ** | **Three Months Ended** | ** ** | **Six Months Ended**   | ** ** |
|--------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                         | ** ** | **June 30, 2005** | ** ** | **June 30, 2004** | ** ** | **June 30, 2005** | ** ** | **June 30, 2004** | ** ** |
|                                                               |       |                   |       |                   |       |   |   |   |   |
| Net revenue                                                        |       | $                      | 6,133      |                   | $          | 5,024 |   | $ | 11,588 |   | $ | 9,118 |   |
| Cost of revenue                                                    |       | 3,744                  |       | 3,263                  |       | 7,444 |   | 6,043 |   |
| Gross margin                                                       |       | 2,389                  |       | 1,761                  |       | 4,144 |   | 3,075 |   |
|                                                               |       |                   |       |                   |       |   |   |   |   |
| Operating expenses:                                                |       |                   |       |                   |       |   |   |   |   |
| Sales, marketing and support                                       |       | 1,751                  |       | 1,273                  |       | 3,175 |   | 2,327 |   |
| General and administrative                                         |       | 994                    |       | 908                    |       | 1,995 |   | 1,465 |   |
| Research and development                                           |       | 3,341                  |       | 1,666                  |       | 7,283 |   | 2,772 |   |
| Amortization of intangible assets                                  |       | 127                    |       | 203                    |       | 276 |   | 349 |   |
| In-process research and development                                |       | —                 |       | 300                    |       | — |   | 300 |   |
|                                                               |       | 6,213                  |       | 4,350                  |       | 12,729 |   | 7,213 |   |
| Loss from operations                                               |       | (3,824                 | )          | (2,589                 | )          | (8,585 | ) | (4,138 | ) |
| Interest expense, net                                              |       | (68                    | )          | (14                    | )          | (81 | ) | (60 | ) |
| Other income (expense), net                                        |       | (40                    | )          | 14                     |       | (40 | ) | 20 |   |
| Loss before income tax expense                                     |       | (3,932                 | )          | (2,589                 | )          | (8,706 | ) | (4,178 | ) |
| Income tax expense                                                 |       | 7                      |       | 1                      |       | 11 |   | 1 |   |
| Net loss                                                           |       | $                      | (3,939     | )                      | $          | (2,590 | ) | $ | (8,717 | ) | $ | (4,179 | ) |
|                                                               |       |                   |       |                   |       |   |   |   |   |
| Net loss per share                                                 |       |                   |       |                   |       |   |   |   |   |
| Basic and diluted                                                  |       | $                      | (0.07      | )                      | $          | (0.05 | ) | $ | (0.15 | ) | $ | (0.09 | ) |
|                                                               |       |                   |       |                   |       |   |   |   |   |
| Weighted average number of shares used in  per share calculations: |       |                   |       |                   |       |   |   |   |   |
| Basic and diluted                                                  |       | 59,893                 |       | 50,027                 |       | 59,487 |   | 46,466 |   |

 

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)

 
| ** **                                                                                                                                                                                        | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                                                                        |       |                    |       |                        |       |
|                                                                                                                                                                                              |       |                    |       |                        |       |
| Current assets:                                                                                                                                                                                   |       |                    |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                         |       | $                       | 3,941      |                        | $          | 3,380 |   |
| Accounts receivable, net of allowances of  $416 and $443                                                                                                                                          |       | 3,213                   |       | 3,273                       |       |
| Inventories                                                                                                                                                                                       |       | 4,174                   |       | 3,941                       |       |
| Prepaid expenses and other current assets                                                                                                                                                         |       | 536                     |       | 473                         |       |
| Restricted cash                                                                                                                                                                                   |       | —                  |       | 312                         |       |
| Total current assets                                                                                                                                                                              |       | 11,864                  |       | 11,379                      |       |
|                                                                                                                                                                                              |       |                    |       |                        |       |
| Long-term assets:                                                                                                                                                                                 |       |                    |       |                        |       |
| Property and equipment, net                                                                                                                                                                       |       | 1,304                   |       | 1,116                       |       |
| Other assets                                                                                                                                                                                      |       | 53                      |       | 62                          |       |
| Intangible assets, net                                                                                                                                                                            |       | 1,211                   |       | 1,577                       |       |
| Goodwill                                                                                                                                                                                          |       | 13,191                  |       | 13,191                      |       |
|                                                                                                                                                                                              |       | $                       | 27,623     |                        | $          | 27,325 |   |
|                                                                                                                                                                                              |       |                    |       |                        |       |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                                    |       |                    |       |                        |       |
|                                                                                                                                                                                              |       |                    |       |                        |       |
| Current liabilities:                                                                                                                                                                              |       |                    |       |                        |       |
| Accounts payable                                                                                                                                                                                  |       | $                       | 3,820      |                        | $          | 2,555 |   |
| Borrowings under lines of credit                                                                                                                                                                  |       | 2,763                   |       | 567                         |       |
| Current portion of long-term debt                                                                                                                                                                 |       | 44                      |       | 55                          |       |
| Current portion of capital lease obligations                                                                                                                                                      |       | 64                      |       | 22                          |       |
| Accrued liabilities                                                                                                                                                                               |       | 3,294                   |       | 2,634                       |       |
| Total current liabilities                                                                                                                                                                         |       | 9,985                   |       | 5,833                       |       |
|                                                                                                                                                                                              |       |                    |       |                        |       |
| Long-term liabilities:                                                                                                                                                                            |       |                    |       |                        |       |
| Long-term debt, net of current portion                                                                                                                                                            |       | 2,641                   |       | 174                         |       |
| Capital lease obligations, net of current  portion                                                                                                                                                |       | 39                      |       | —                      |       |
| Other liabilities                                                                                                                                                                                 |       | 74                      |       | —                      |       |
| Total liabilities                                                                                                                                                                                 |       | 12,739                  |       | 6,007                       |       |
|                                                                                                                                                                                              |       |                    |       |                        |       |
| Stockholders’ equity:                                                                                                                                                                        |       |                    |       |                        |       |
| Preferred stock, $0.01 par value;  authorized 3,000,000 shares; 3,161 shares issued at June 30, 2005 and  December 31, 2004, respectively (aggregate liquidation preference of  $3,917) |       | —                  |       | —                      |       |
| Common stock, $0.01 par value; 100,000,000  shares authorized, 62,868,807 and 60,412,591 shares issued at June 30,  2005 and December 31, 2004, respectively                            |       | 621                     |       | 597                         |       |
| Treasury stock at cost, 497,500 shares at  June 30, 2005 and December 31, 2004, respectively                                                                                            |       | (750                    | )          | (750                        | )          |
| Additional paid-in capital                                                                                                                                                                        |       | 97,965                  |       | 95,463                      |       |
| Deferred stock-based compensation                                                                                                                                                                 |       | (248                    | )          | —                      |       |
| Accumulated other comprehensive income                                                                                                                                                            |       | 19                      |       | 14                          |       |
| Accumulated deficit                                                                                                                                                                               |       | (82,723                 | )          | (74,006                     | )          |
| Total stockholders’ equity                                                                                                                                                                   |       | 14,884                  |       | 21,318                      |       |
|                                                                                                                                                                                              |       | $                       | 27,623     |                        | $          | 27,325 |   |

 

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

 

3

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**Focus Enhancements, Inc.**

**CondensedConsolidated Statements of Cash Flows**

(In thousands)

(Unaudited)

 
| ** **                                                                                      | ** ** | **Six Months Ended**   | ** ** |
|-------------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                      | ** ** | **June 30, 2005** | ** ** | **June 30, 2004** | ** ** |
| Cash flows from operating activities:                                                           |       |                   |       |   |   |
| Net loss                                                                                        |       | $                      | (8,717     | ) | $ | (4,179 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities:                    |       |                   |       |   |   |
| Depreciation and amortization                                                                   |       | 672                    |       | 457 |   |
| Stock-based compensation and non-cash  warrant expense                                          |       | 88                     |       | 32 |   |
| Amortization of debt issuance costs                                                             |       | 40                     |       | — |   |
| Changes in assets and liabilities:                                                              |       |                   |       |   |   |
| Decrease (increase) in accounts receivable                                                      |       | (28                    | )          | 272 |   |
| Decrease (increase) in inventories                                                              |       | (298                   | )          | 1,016 |   |
| Decrease (increase) in prepaid expenses and  other assets                                       |       | (47                    | )          | 154 |   |
| Increase (decrease) in accounts payable                                                         |       | 1,311                  |       | (429 | ) |
| Increase in accrued liabilities                                                                 |       | 887                    |       | 343 |   |
| Net cash used in operating activities                                                           |       | (6,092                 | )          | (2,334 | ) |
|                                                                                            |       |                   |       |   |   |
| Cash flows from investing activities:                                                           |       |                   |       |   |   |
| Acquisition of COMO Computer and Motion  GmbH net of cash acquired                              |       | —                 |       | (5 | ) |
| Acquisition of Visual Circuits Corporation                                                      |       | —                 |       | (440 | ) |
| Decrease in restricted cash                                                                     |       | 294                    |       | — |   |
| Purchases of property and equipment                                                             |       | (503                   | )          | (206 | ) |
| Net cash used in investing activities                                                           |       | (209                   | )          | (651 | ) |
|                                                                                            |       |                   |       |   |   |
| Cash flows from financing activities:                                                           |       |                   |       |   |   |
| Borrowings from term loan                                                                       |       | 2,500                  |       | — |   |
| Borrowings under lines of credit                                                                |       | 2,600                  |       | — |   |
| Repayments under lines of credit                                                                |       | (360                   | )          | — |   |
| Net proceeds from private offerings of  common stock                                            |       | 1,607                  |       | 5,191 |   |
| Proceeds from issuance of escrow stock  related to acquisition of COMO Computer and Motion GmbH |       | 310                    |       | — |   |
| Reimbursement of transaction costs related  to acquisition of Visual Circuits Corporation       |       | 225                    |       | — |   |
| Payments of short-term debt                                                                     |       | (19                    | )          | (149 | ) |
| Proceeds from exercise of common stock  options and warrants                                    |       | 10                     |       | 155 |   |
| Net cash provided by financing activities                                                       |       | 6,873                  |       | 5,197 |   |
|                                                                                            |       |                   |       |   |   |
| Effect of exchange rate changes on cash                                                         |       | (11                    | )          | 57 |   |
|                                                                                            |       |                   |       |   |   |
| Increase in cash and cash equivalents                                                           |       | 561                    |       | 2,269 |   |
| Cash and cash equivalents at beginning of  period                                               |       | 3,380                  |       | 3,731 |   |
| Cash and cash equivalents at end of period                                                      |       | $                      | 3,941      |   | $ | 6,000 |   |

 

 

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

 

4

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**Focus Enhancements, Inc.**

 

**Notes toCondensed 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 June 30, 2005 and for the three and sixmonths ended June 30, 2005 and 2004 are unaudited and should be read inconjunction with the audited consolidated financial statements for the yearended 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 for thethree and six months ended June 30, 2005 are not necessarily indicative ofthe results that may be expected for any future period. Certain itemspreviously reported in specific financial statement captions have beenreclassified. Such reclassifications have not impacted previously reported netloss 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 June 30,2004, although the second quarter of fiscal year 2004 ended on July 4,2004. 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*, whereby compensationcost is the excess, if any, of the quoted market price of the stock at thegrant date over the amount an employee must pay to acquire the stock. Stockoptions issued under Focus’ stock option plans have no intrinsic value at grantdate. Accordingly, under APB Opinion No. 25, no compensation cost isrecognized.

 

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:

 
| **(In thousands, except per-share  data)**                                   | ** ** | **Three Months Ended** | ** ** | **Six Months Ended**   | ** ** |
|------------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                   | ** ** | **June 30, 2005** | ** ** | **June 30, 2004** | ** ** | **June 30, 2005** | ** ** | **June 30, 2004** | ** ** |
|                                                                         |       |                   |       |                   |       |   |   |   |   |
| Reported net loss                                                            |       | $                      | (3,939     | )                      | $          | (2,590 | ) | $ | (8,717 | ) | $ | (4,179 | ) |
| Deduct: Stock-based compensation expense  determined under fair value method |       | (318                   | )          | (306                   | )          | (687 | ) | (579 | ) |
|                                                                         |       |                   |       |                   |       |   |   |   |   |
| Pro forma net loss                                                           |       | $                      | (4,257     | )                      | $          | (2,896 | ) | $ | (9,404 | ) | $ | (4,758 | ) |
|                                                                         |       |                   |       |                   |       |   |   |   |   |
| Basic and diluted reported net loss per  share                               |       | $                      | (0.07      | )                      | $          | (0.05 | ) | $ | (0.15 | ) | $ | (0.09 | ) |
|                                                                         |       |                   |       |                   |       |   |   |   |   |
| Basic and diluted pro forma net loss per  share                              |       | $                      | (0.07      | )                      | $          | (0.06 | ) | $ | (0.16 | ) | $ | (0.10 | ) |

 

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. Optionsto purchase 7,831,179 and 6,261,153 shares of common stock, unvested shares ofrestricted stock of 245,000 and zero, warrants to purchase 4,160,621 and1,369,914 shares of common stock and 3,161 shares of preferred stockconvertible into 3,161,000 shares of common stock were outstanding at June 30,2005 and 2004, respectively, but were not included in the computation ofdiluted net loss per share as the effect would have been anti-dilutive.

 

**4.**                                      Significant Customers

 

Sales to one customer accounted for 10% ofFocus’ revenue in the three months ended June 30, 2005. No customeraccounted for more than 10% of Focus’ revenue in the six months ended June 30,2005. One customer accounted for 16% of Focus’ revenue in thethree months ended June 30, 2004. In the six months ended June 30,2004, two customers with sales in excess of 10% of Focus’ revenue accounted for26% of revenue.

 

One customer had an accounts receivablebalance of 18% of Focus’ accounts receivable at June 30, 2005.

 

**5.**                                      Management’s Plans

 

The accompanying consolidated financial statements have been preparedon a going concern basis, which contemplates the realization of assets and thesatisfaction of liabilities in the normal course of business. For the sixmonths ended June 30, 2005 and the year ended December 31, 2004,Focus incurred net losses of $8.7 million and $11.0 million, respectively, andused net cash in operating activities of $6.1 million and $9.4 million,respectively. These results indicate that Focus may potentially be unable tocontinue as a going concern.

 

The consolidated financial statements do not include any adjustmentsrelating to the recoverability and classification of recordedasset amounts or the amounts and classification of liabilities that might benecessary 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 beno assurance that management’s new product plans will result in substantialincreases in Focus’ revenue.

 

Management believes that Focus will need toobtain additional financing and/or find a partner to fund operations before theend of 2005 in order to meet all currently planned expenditures and cashrequirements through the first customer sampling of its Ultra Wideband (“UWB”)chips. Such financing terms could include debt and/or equity instruments.Depending upon the results of this sampling program, customers’ adoption andacceptance of the UWB products, the profitability of its Systems business, andFocus’ efforts to partner with another entity to market the chips on awidespread commercial basis, Focus may need to raise further capital in 2006for the widespread commercial deployment of 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 in Kiel, Germany, pursuant to which COMO became a wholly-ownedsubsidiary of Focus. The acquisition was accounted for as a purchase businesscombination at a total cost of approximately $1.0 million. Under the terms ofthe agreement, Focus acquired COMO through the issuance of 185,066 shares ofits common stock and approximately $359,000 in cash to COMO’s shareholders.Focus was also required to issue up to an additional 46,266 shares of itscommon stock to COMO’s shareholders, in the event certain conditions were metat the end of 2004 and 2005. These relevant conditions were met at the end of2004, and accordingly, 23,234 shares were issued to COMO’s former shareholdersin March 2005. Additionally, Focus issued 610,096 common shares, held inescrow, to COMO’s two former shareholders who became employees of Focus – seeNote 11, “Stockholders’ Equity”. In connection with this transaction, Focuspaid vFinance Investments, Inc. (a related party), 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 of Reorganization(“Reorganization Agreement”). The transaction was accounted for as a purchasebusiness combination at a total cost of approximately $8.9 million. Founded in1991, Visual Circuits is a manufacturer and developer of integrated hardware,software and network products that manage, schedule, distribute, store andpresent digital video in a wide range of commercial media applications.

 

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

 

7

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transaction, Focus paid vFinance Investments, Inc.,(a related party) a success fee of $168,000 and 80,000 shares of Focus’ commonstock.

 

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 valuedthrough interviews, analysis of data provided by the Visual Circuits business concerningdevelopment projects, their stage of development, the time and resources neededto complete them, if applicable, their expected income generating ability andassociated risks. The income approach, which includes an analysis of the cashflows, and risks associated with achieving such cash flows, was the primarytechnique utilized in valuing the developed technology and 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 Focusmay be adversely affected in future periods. Goodwill represents the excess ofthe purchase price over the fair value of the underlying net identifiableassets.

 

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

 

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

 

8

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| **(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:

 
| **(In thousands)**  | ** ** | **June 30, 2005** | ** ** |
|---------------------|------------|------------------------|------------|
| ** **          | ** ** | **Gross Amount**       | ** ** | **Accumulated  Amortization** | ** ** | **Net  Amount** | ** ** |
|                |       |                   |       |   |   |   |   |
| Existing technology |       | $                      | 3,945      |   | $ | (2,734 | ) | $ | 1,211 |   |
| Tradename           |       | 176                    |       | (176 | ) | — |   |
|                |       |                   |       |   |   |   |   |
|                |       | $                      | 4,121      |   | $ | (2,910 | ) | $ | 1,211 |   |

 
| ** **          | ** ** | **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 six months ended June 30, 2005, amortizationexpense was $172,000 and $366,000, respectively, of which $45,000 and $90,000were recorded in cost of revenue. For the three and six months ended June 30,2004, amortization expense was $243,000 and $407,000, respectively, of which $40,000and $58,000 were recorded in cost of revenue.

 

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

 
| **(In thousands)**                       | ** ** | **Amortization** | ** ** |
|------------------------------------------|------------|------------------|------------|
|                                     |       |             |       |
| Six months ending December 31, 2005 |       | $                | 345        |   |
| Fiscal year 2006                         |       | 681              |       |
| Fiscal year 2007                         |       | 185              |       |
|                                     |       |             |       |
| Total                                    |       | $                | 1,211      |   |

 

9

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**8.****                                      Inventories**

 

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

 

(In thousands)

 
| ** **      | ** ** | **June 30, 2005** | ** ** | **December 31, 2004** | ** ** |
|-----------------|------------|------------------------|------------|----------------------------|------------|
|            |       |                   |       |                       |       |
| Raw materials   |       | $                      | 2,815      |                       | $          | 2,308 |   |
| Work in process |       | 286                    |       | 51                         |       |
| Finished goods  |       | 1,073                  |       | 1,582                      |       |
|            |       |                   |       |                       |       |
|            |       | $                      | 4,174      |                       | $          | 3,941 |   |

 

**9.**                                      Borrowings

 

(In thousands)

 
| ** **                                | ** ** | **June 30, 2005** | ** ** | **December 31, 2004** | ** ** |
|-------------------------------------------|------------|------------------------|------------|----------------------------|------------|
|                                      |       |                   |       |                       |       |
| Short-term debt:                          |       |                   |       |                       |       |
| Current portion of notes payable to bank  |       | $                      | 44         |                       | $          | 55 |   |
| COMO line of credit                       |       | 163                    |       | 567                        |       |
| Accounts receivable-based line of credit  |       | 2,600                  |       | —                     |       |
|                                      |       | 2,807                  |       | 622                        |       |
| Long-term debt:                           |       |                   |       |                       |       |
| Term loan                                 |       | 2,500                  |       | —                     |       |
| Notes payable to bank (long-term portion) |       | 141                    |       | 174                        |       |
|                                      |       |                   |       |                       |       |
|                                      |       | $                      | 5,448      |                       | $          | 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 $167,000 and $18,000 aredenominated in Euros and are scheduled to be repaid through December 2011and December 2005, respectively, at an average interest rate of 6% per annum.However, the bank reviews COMO’s financial results in connection with thesenotes and reserves the right to call these notes due at its discretion.

 

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 reviews COMO’sfinancial results in assessing future extensions of credit. At June 30,2005, the Euro equivalent of $145,000 was available to borrow under thisfacility.

 

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.

 

10

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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 expiresin November 2005 and is collateralized by a personal guarantee from CarlBerg, a Company director and shareholder. In connection with this credit line,the bank has obtained a first priority security interest in Focus’ accountsreceivable 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 liquidity ratios andoperating results. Borrowings under the credit line bear interest at a rate ofprime plus 1%, which equated to 7.25% at June 30, 2005. In connection withthis line of credit, Focus issued warrants to the bank to purchase 77,186shares of Focus’ common stock at an exercise price of $1.17 per share. Thewarrants were valued at $76,000 using the Black-Scholes option-pricing modeland are being amortized to interest expense over the term of the credit line.During the three and six months ended June 30, 2005, $18,000 and $40,000were amortized to interest expense. At June 30, 2005, there was anoutstanding balance of $2.6 million on this credit line and Focus had theability to borrow an additional $199,000.

 

Term Loan

 

On June 28,2005, Focus signed a term loan agreement with Greater Bay Bank under which Focus can borrow up to $2.5million. 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% (7.25% as of June 30, 2005). In connectionwith Mr. Berg’s personal guarantee, Focus issued Mr. Berg a warrantto purchase 100,000 shares of common stock at an exercise price of $0.81per share, which expires on June 28, 2009. Focus recorded a charge of$42,000 to general and administrative expenses based on the fair value of thiswarrant, determined using the Black-Scholes option-pricing model. At June 30, 2005, there was anoutstanding balance of $2.5 million under this 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.

 

On October 1, 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 six monthsended June 30, 2005, $672,000 and $1.5 million, respectively, was chargedto research and development expense based on the level of effort incurred bythe third party and $672,000 was included within other accrued liabilities at June 30,2005.

 

Leases

 

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

 

Minimum leasecommitments at June 30, 2005 were as follows:

 

11

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| **(In thousands)**                       | ** ** | **Lease Commitments** | ** ** |
|------------------------------------------|------------|-----------------------|------------|
|                                     |       |                  |       |
| Six months ending December 31, 2005 |       | $                     | 262        |   |
| 2006                                     |       | 591                   |       |
| 2007                                     |       | 572                   |       |
| 2008                                     |       | 193                   |       |
| 2009                                     |       | 190                   |       |
| 2010                                     |       | 114                   |       |
|                                     |       |                  |       |
|                                     |       | $                     | 1,922      |   |

 

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 indemnificationprovisions are 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 June 30,2005. As a result, no liability has been recorded with respect to suchindemnifications as of June 30, 2005.

 

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 June 30, 2005,Focus had issued non-cancelable purchase orders for approximately $2.3 millionto purchase finished goods from its contract manufacturers, and had notincurred any significant liability for finished goods in excess of currentcustomer demand 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.

 

12

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**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 March 2005, 200,000 of theescrow shares were sold for net proceeds of $191,000 and in June 2005 anadditional 176,500 of the escrow shares were sold for net proceeds of $119,000.The proceeds from the sale of such shares were remitted to Focus by the Sellersand recorded as an increase in additional paid-in capital. The note receivablefrom the Sellers is not recorded in the accompanying condensed consolidatedfinancial statements, as it will be cancelled upon receipt of the proceeds fromthe 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.

 

As of June 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                       |       |
| Restricted stock                               |       | 245                         |       |
| Options to purchase common stock               |       | 7,831                       |       |
| Preferred Stock convertible into common  stock |       | 3,161                       |       |
|                                           |       |                        |       |
|                                           |       | 15,398                      |       |

 

13

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**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 June 30, 2005, Focus owed Samsung $314,000under 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 to purchase100,000 shares of common stock at an exercise price of $0.81 per shareand which expires on June 28, 2009. The warrant was valued at $42,000using the Black-Scholes option-pricing model and was charged to general andadministrative 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 three and six months ended June 30, 2005, Focus paid Dolby totalroyalties of $4,000 and $7,000, respectively, which were recorded in cost ofrevenue.

 

**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.

 

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

 

14

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| ** **                                  | ** ** | **Three Months Ended June 30, 2004** | ** ** |
|---------------------------------------------|------------|-------------------------------------------|------------|
| **(In thousands)**                          | ** ** | **Systems**                               | ** ** | **Semiconductor** | ** ** | **Total** | ** ** |
|                                        |       |                                      |       |   |   |   |   |
| Net revenue                                 |       | $                                         | 4,273      |   | $ | 751 |   | $ | 5,024 |   |
| Cost of revenue                             |       | 2,780                                     |       | 483 |   | 3,263 |   |
| Gross margin                                |       | 1,493                                     |       | 268 |   | 1,761 |   |
|                                        |       |                                      |       |   |   |   |   |
| Operating expenses:                         |       |                                      |       |   |   |   |   |
| Sales, marketing and support                |       | 999                                       |       | 274 |   | 1,273 |   |
| General and administrative                  |       | 670                                       |       | 238 |   | 908 |   |
| Research and development                    |       | 896                                       |       | 770 |   | 1,666 |   |
| Amortization of intangible assets           |       | 86                                        |       | 117 |   | 203 |   |
| In-process research and development expense |       | 300                                       |       | — |   | 300 |   |
|                                        |       | 2,951                                     |       | 1,399 |   | 4,350 |   |
| Loss from operations                        |       | $                                         | (1,458     | ) | $ | (1,131 | ) | $ | (2,589 | ) |

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

 
| ** **                                  | ** ** | **Six Months Ended June 30, 2004** | ** ** |
|---------------------------------------------|------------|-----------------------------------------|------------|
| **(In thousands)**                          | ** ** | **Systems**                             | ** ** | **Semiconductor** | ** ** | **Total** | ** ** |
|                                        |       |                                    |       |   |   |   |   |
| Net revenue                                 |       | $                                       | 7,120      |   | $ | 1,998 |   | $ | 9,118 |   |
| Cost of revenue                             |       | 4,684                                   |       | 1,359 |   | 6,043 |   |
| Gross margin                                |       | 2,436                                   |       | 639 |   | 3,075 |   |
|                                        |       |                                    |       |   |   |   |   |
| Operating expenses:                         |       |                                    |       |   |   |   |   |
| Sales, marketing and support                |       | 1,840                                   |       | 487 |   | 2,327 |   |
| General and administrative                  |       | 1,057                                   |       | 408 |   | 1,465 |   |
| Research and development                    |       | 1,467                                   |       | 1,305 |   | 2,772 |   |
| Amortization of intangible assets           |       | 195                                     |       | 154 |   | 349 |   |
| In-process research and development expense |       | 300                                     |       | — |   | 300 |   |
|                                        |       | 4,859                                   |       | 2,354 |   | 7,213 |   |
| Loss from operations                        |       | $                                       | (2,423     | ) | $ | (1,715 | ) | $ | (4,138 | ) |

 

15

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**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 effects of adopting SFAS 123R, theprovisions of these two statements differ in some important respects. Theactual effects of adopting SFAS 123R will be dependent on numerous factorsincluding, but not limited to, the valuation model chosen by Focus to valuestock-based awards; the assumed award forfeiture rate; the accounting policiesadopted concerning the method of recognizing the fair value of awards over therequisite service period; and the transition method (as described below) chosenfor 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, financialstatements for prior periods shall be adjusted to give effect to thefair-value-based method of accounting for awards on a consistent basis with thepro forma disclosures required for those periods under the original SFAS No. 123.

 

16

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

#### ** **

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 operationsand financial condition have varied and may in the future vary significantlyfrom those stated in any forward-looking statements.  Factors that may cause such differencesinclude, without limitation, the availability of capital to fund our futurecash needs, reliance on major customers, history of operating losses, marketacceptance of our products, technological obsolescence, competition, successfulintegration of acquisitions, component supply problems and protection ofproprietary information, as well as the accuracy of our internal estimates ofrevenue and operating expense levels. For a discussion of these factors and some of the factors that mightcause such a difference see also “ - Risk Factors.”  These factors should be considered inevaluating the forward-looking statements, and undue reliance should not be placedon such statements. We do not undertake, and specifically disclaim anyobligation, to update any forward-looking statements to reflect occurrences orunanticipated events or circumstances after the date of such statements.

 

**RESULTS OF OPERATIONS**

 

#### **Net revenue**

 
| ** **                 | ** ** | **Three Months Ended** | ** ** | ** **             | ** ** | ** **   | ** ** |
|----------------------------|------------|------------------------|------------|------------------------|------------|--------------|------------|
| **(Dollars in thousands)** | ** ** | **June 30, 2005** | ** ** | **June 30, 2004** | ** ** | **Increase** | ** ** |
|                       |       |                   |       |                   |       |         |       |   |   |
| System products            |       | $                      | 5,278      |                   | $          | 4,273        |       | $ | 1,005 |   | 23.5 | % |
| Semiconductor products     |       | 855                    |       | 751                    |       | 104          |       | 13.8 | % |
|                       |       |                   |       |                   |       |         |       |   |   |
|                       |       | $                      | 6,133      |                   | $          | 5,024        |       | $ | 1,109 |   | 22.1 | % |

 

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| ** **                 | ** ** | **Six Months Ended**   | ** ** | ** **             | ** ** | ** **               | ** ** |
|----------------------------|------------|------------------------|------------|------------------------|------------|--------------------------|------------|
| **(Dollars in thousands)** | ** ** | **June 30, 2005** | ** ** | **June 30, 2004** | ** ** | **Increase/ (decrease)** | ** ** |
|                       |       |                   |       |                   |       |                     |       |   |   |
| System products            |       | $                      | 10,242     |                   | $          | 7,120                    |       | $ | 3,122 |   | 43.8 | % |
| Semiconductor products     |       | 1,346                  |       | 1,998                  |       | (652                     | )          | -32.6 | % |
|                       |       |                   |       |                   |       |                     |       |   |   |
|                       |       | $                      | 11,588     |                   | $          | 9,118                    |       | $ | 2,470 |   | 27.1 | % |

 

Revenue forthe three months ended June 30, 2005 was $6.1 million, an increase of $1.1million compared with the three months ended June 30, 2004. Revenue forthe six months ended June 30, 2005 was $11.6 million, an increase of $2.5million compared with the six months ended June 30, 2004.

 

For the threemonths ended June 30, 2005, sales of system products to distributors,retailers and Value Added Resellers were approximately $5.3 million compared to$4.3 million for the same period in 2004, an increase of $1.0 million. For thesix months ended June 30, 2005, sales of our system products wereapproximately $10.2 million compared to $7.1 million for the same period in2004, an increase of $3.1 million. This increase in sales of our systemsproducts in both the three- and six-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 conversiontechnology. The increase in revenue of systems products in the six-month periodalso reflects sales of approximately $2.6 million of products acquired throughthe acquisitions of COMO Computer & Motion GmbH (“COMO”) in February 2004and Visual Circuits Corporation (“Visual Circuits”) in May 2004.

 

Sales ofsemiconductor products to distributors and OEM customers of approximately$855,000 in the three months ended June 30, 2005 increased slightly whencompared to $751,000 in the comparative period in 2004. The $652,000 decreasein sales of semiconductor products in the six-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 it’s Xbox. In January 2004,Microsoft ceased placing significant orders for our FS454 product.

 

As of June 30,2005, we had a sales order backlog of approximately $2.4 million, an increaseof $473,000 when compared to the first quarter of 2005.

 

Sales to one customer accounted for 10% ofour revenue in the three months ended June 30, 2005. No customer accountedfor more than 10% of our revenue in the six months ended June 30, 2005. Onecustomer accounted for 16% of our revenue in the three months ended June 30,2004. In the six months ended June 30, 2004, two customers with sales inexcess of 10% of our revenue accounted for 26% of our total revenue.

 

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#### **Gross margin**

 
| ** **                 | ** ** | **Three Months Ended** | ** ** | ** **             | ** ** |
|----------------------------|------------|------------------------|------------|------------------------|------------|
| **(Dollars in thousands)** | ** ** | **June 30, 2005** | ** ** | **June 30, 2004** | ** ** | **Increase** | ** ** |
|                       |       |                   |       |                   |       |   |   |
| Gross margin               |       | $                      | 2,389      |                   | $          | 1,761 |   | $ | 628 |   |
|                       |       |                   |       |                   |       |   |   |
| Gross margin rate          |       | 39.0                   | %          | 35.1                   | %          | 3.9 | % |
|                            |            |                        |            |                        |            |  |  |  |  |  |

 
| ** **                 | ** ** | **Six Months Ended**   | ** ** | ** **             | ** ** |
|----------------------------|------------|------------------------|------------|------------------------|------------|
| **(Dollars in thousands)** | ** ** | **June 30, 2005** | ** ** | **June 30, 2004** | ** ** | **Increase** | ** ** |
|                       |       |                   |       |                   |       |   |   |
| Gross margin               |       | $                      | 4,144      |                   | $          | 3,075 |   | $ | 1,069 |   |
|                       |       |                   |       |                   |       |   |   |
| Gross margin rate          |       | 35.8                   | %          | 33.7                   | %          | 2.1 | % |
|                            |            |                        |            |                        |            |  |  |  |  |  |

 

Our grossmargin rate in the three months ended June 30, 2005 increased by 3.9percentage points to 39.0% from 35.1% in the three months ended June 30,2004. Our gross margin rate in the six months ended June 30, 2005increased to 35.8% from 33.7% in the six months ended June 30, 2004, anincrease of 2.1 percentage points.

 

The increase in the gross margin rate in thethree- and six-month periods mainly reflects increased sales volumes, a chargeof $140,000 in the three months ended June 30, 2004 associated with a fairvalue adjustment to Visual Circuits’ inventory upon acquisition and an accrual inthe three months ended June 30, 2004 of $100,000 for a royalty payment based onthe achievement of certain sales volumes. The increase in the gross margin ratein the six-month period also reflects the below average gross margin businessthat we conducted with Microsoft in the three months ended March 31, 2004,which did not occur in three or six months ended June 30, 2005. Sales toMicrosoft were made at a gross profit margin percentage of less than 30%,primarily as a result of volume discounts provided.

 

**Operating expenses**

 
| **(Dollars in thousands)**          | ** ** | **Three Months Ended** | ** ** | ** **             | ** ** | ** **                | ** ** |
|-------------------------------------|------------|------------------------|------------|------------------------|------------|---------------------------|------------|
| ** **                          | ** ** | **June 30, 2005** | ** ** | **June 30, 2004** | ** ** | **Increase / (decrease)** | ** ** |
| ** **                          | ** ** | ** **             | ** ** | **% of**               | ** ** | ** **                | ** ** | **% of** | ** ** | ** ** | ** ** | **% of** | ** ** |
| ** **                          | ** ** | ** **             | ** ** | **revenue**            | ** ** | ** **                | ** ** | **revenue** | ** ** | ** ** | ** ** | **revenue** | ** ** |
|                                |       |                   |       |                   |       |                      |       |   |   |   |   |   |   |
| Sales, marketing and support        |       | $                      | 1,751      |                   | 28.6       | %                         | $          | 1,273 |   | 25.3 | % | $ | 478 |   | 3.3 | % |
| General and administrative          |       | 994                    |       | 16.2                   | %          | 908                       |       | 18.1 | % | 86 |   | -1.9 | % |
| Research and development            |       | 3,341                  |       | 54.5                   | %          | 1,666                     |       | 33.2 | % | 1,675 |   | 21.3 | % |
| Amortization of intangible assets   |       | 127                    |       | 2.1                    | %          | 203                       |       | 4.0 | % | (76 | ) | -1.9 | % |
| In-process research and development |       | —                 |       | 0.0                    | %          | 300                       |       | 6.0 | % | (300 | ) | -6.0 | % |
|                                |       |                   |       |                   |       |                      |       |   |   |   |   |   |   |
|                                |       | $                      | 6,213      |                   | 101.3      | %                         | $          | 4,350 |   | 86.6 | % | $ | 1,863 |   | 14.7 | % |

 

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| **(Dollars in thousands)**          | ** ** | **Six Months Ended**   | ** ** | ** **             | ** ** | ** **                | ** ** |
|-------------------------------------|------------|------------------------|------------|------------------------|------------|---------------------------|------------|
| ** **                          | ** ** | **June 30, 2005** | ** ** | **June 30, 2004** | ** ** | **Increase / (decrease)** | ** ** |
| ** **                          | ** ** | ** **             | ** ** | **% of**               | ** ** | ** **                | ** ** | **% of** | ** ** | ** ** | ** ** | **% of** | ** ** |
| ** **                          | ** ** | ** **             | ** ** | **revenue**            | ** ** | ** **                | ** ** | **revenue** | ** ** | ** ** | ** ** | **revenue** | ** ** |
|                                |       |                   |       |                   |       |                      |       |   |   |   |   |   |   |
| Sales, marketing and support        |       | $                      | 3,175      |                   | 27.4       | %                         | $          | 2,327 |   | 25.5 | % | $ | 848 |   | 1.9 | % |
| General and administrative          |       | 1,995                  |       | 17.2                   | %          | 1,465                     |       | 16.1 | % | 530 |   | 1.1 | % |
| Research and development            |       | 7,283                  |       | 62.8                   | %          | 2,772                     |       | 30.4 | % | 4,511 |   | 32.4 | % |
| Amortization of intangible assets   |       | 276                    |       | 2.4                    | %          | 349                       |       | 3.8 | % | (73 | ) | -1.4 | % |
| In-process research and development |       | —                 |       | 0.0                    | %          | 300                       |       | 3.3 | % | (300 | ) | -3.3 | % |
|                                |       |                   |       |                   |       |                      |       |   |   |   |   |   |   |
|                                |       | $                      | 12,729     |                   | 109.8      | %                         | $          | 7,213 |   | 79.1 | % | $ | 5,516 |   | 30.7 | % |
|                                     |            |                        |            |                        |            |                           |            |  |  |  |  |  |  |  |  |  |  |

 

Sales,marketing and support 

 

Sales,marketing and support expenses for the three months ended June 30, 2005were $1.8 million compared to $1.3 million in the three months ended June 30,2004, an increase of $478,000. Sales, marketing and support expenses for thesix months ended June 30, 2005 were $3.2 million, compared to $2.3 millionfor the six months ended June 30, 2004, an increase of $848,000.

 

The increasein sales, marketing and support expenses in the three- and six-month periodsmainly reflects additional headcount in our business development group andadvertising expense associated with recent introductions of our new mixerproducts and the FS-4. An increase in commission expense also contributed tothe increase in sales and marketing expense in the three- and six-month periodsand reflects the increase in revenue in these periods. The increase in sales,marketing and support expenses in the six-month period also reflects, to alesser extent, the inclusion of Visual Circuits sales and marketing expensesfor the entire period. Visual Circuits expenses were only partially included inthe prior year’s six-month period as the Visual Circuits acquisition occurredon May 28, 2004

 

General andadministrative 

 

General andadministrative expenses for the three months ended June 30, 2005 were$994,000, compared to $908,000 in the three months ended June 30, 2004, anincrease of $86,000. General and administrative expenses for the six monthsended June 30, 2005 were $2.0 million, compared to $1.5 million for thesix months ended June 30, 2004, an increase of $530,000.

 

The increasein general and administrative expenses in the three-month period is mainly dueto higher salary expense, the fair value of warrants issued to Carl Berg, aCompany director and shareholder, in connection with his guarantee of a termloan and an increase in auditing fees, partially offset by a decrease in legalfees and public relations fees. The increase in salary expense reflects theinclusion of Visual Circuits expenses for the entire period and one additionalhire in our Semiconductor group. In addition to these factors, the increase ingeneral and administrative expenses in the six-month period also reflects COMO’sexpenses being only partially included in the prior year’s six-month period asthe COMO acquisition occurred on February 27, 2004.

 

Research anddevelopment 

 

Research anddevelopment expenses for the three months ended June 30, 2005 were $3.3million, compared to $1.7 million in the three months ended June 30, 2004,an increase of $1.7 million. Research and development expenses for the sixmonths ended June 30, 2005 were $7.3 million, compared to $2.8 million forthe six months ended June 30, 2004, an increase of $4.5 million.

 

The increasein research and development expenses in the three- and six-month periods mainlyreflects our investment in Ultra Wideband (“UWB”) technology, which resulted inan increase in research and development expenses of $1.6 million and $3.9million in the three and six months ended June 30, 2005, respectively.This increase in our investment in UWB consisted mainly of an increase insemiconductor design service fees of $942,000 and $2.6 million in the three

 

20

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and six monthsended June 30, 2005, respectively, and to increased personnel costsreflecting additional headcount. The acquisition of Visual Circuits contributedto a $600,000 increase in research and development expenses in the six-monthperiod as these expenses were not comparatively included as the acquisitionoccurred on May 28, 2004.

 

Amortization of Intangible Assets

 

Amortization expense was recorded as follows:

 
| ** **         | ** ** | **Three Months Ended** | ** ** | **Increase/**          | ** ** |
|--------------------|------------|------------------------|------------|------------------------|------------|
| **(In thousands)** | ** ** | **June 30, 2005** | ** ** | **June 30, 2004** | ** ** | **(Decrease)** | ** ** |
|               |       |                   |       |                   |       |   |   |
| Cost of revenue    |       | $                      | 45         |                   | $          | 40 |   | $ | 5 |   |
| Operating expenses |       | 127                    |       | 203                    |       | (76 | ) |
|               |       |                   |       |                   |       |   |   |
|               |       | $                      | 172        |                   | $          | 243 |   | $ | (71 | ) |

 
| ** **         | ** ** | **Six Months Ended**   | ** ** | **Increase/**          | ** ** |
|--------------------|------------|------------------------|------------|------------------------|------------|
| **(In thousands)** | ** ** | **June 30, 2005** | ** ** | **June 30, 2004** | ** ** | **(Decrease)** | ** ** |
|               |       |                   |       |                   |       |   |   |
| Cost of revenue    |       | $                      | 90         |                   | $          | 58 |   | $ | 32 |   |
| Operating expenses |       | 276                    |       | 349                    |       | (73 | ) |
|               |       |                   |       |                   |       |   |   |
|               |       | $                      | 366        |                   | $          | 407 |   | $ | (41 | ) |

 

Amortizationexpense for the three months ended June 30, 2005 was $172,000, a decreaseof $71,000 from $243,000 for the three months ended June 30, 2004.Amortization expense for the six months ended June 30, 2005 was $366,000,a decrease of $41,000 from $407,000 for the six months ended June 30,2004.

 

The decrease in amortizationexpense reflects the completion of amortization on certain intangible assets,partially offset by an increase in amortization expense associated with theintangible assets that resulted from the acquisitions of COMO in February 2004and Visual Circuits in May 2004.

 

In-Processresearch and development

 

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

 

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

 
| ** **                  | ** ** | **Three Months Ended** | ** ** | **Increase /**         | ** ** |
|-----------------------------|------------|------------------------|------------|------------------------|------------|
| **(Dollars in thousands)**  | ** ** | **June 30, 2005** | ** ** | **June 30, 2004** | ** ** | **(Decrease)** | ** ** |
|                        |       |                   |       |                   |       |   |   |
| Interest expense, net       |       | $                      | (68        | )                      | $          | (14 | ) | $ | 54 |   |
|                        |       |                   |       |                   |       |   |   |
| Other income (expense), net |       | (40                    | )          | 14                     |       | (54 | ) |
|                             |            |                        |            |                        |            |  |  |  |  |  |

 
| ** **                  | ** ** | **Six Months Ended**   | ** ** | **Increase /**         | ** ** |
|-----------------------------|------------|------------------------|------------|------------------------|------------|
| **(Dollars in thousands)**  | ** ** | **June 30, 2005** | ** ** | **June 30, 2004** | ** ** | **(Decrease)** | ** ** |
|                        |       |                   |       |                   |       |   |   |
| Interest expense, net       |       | $                      | (81        | )                      | $          | (60 | ) | $ | 21 |   |
|                        |       |                   |       |                   |       |   |   |
| Other income (expense), net |       | (40                    | )          | 20                     |       | (60 | ) |
|                             |            |                        |            |                        |            |  |  |  |  |  |

 

Net interestexpense for the three months ended June 30, 2005 was $68,000, compared to$14,000 in the three months ended June 30, 2004. Net interest expense forthe six months ended June 30, 2005 was $81,000, compared to $60,000

 

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in the sixmonths ended June 30, 2004. The increase in net interest expense in boththe three- and six-month periods reflects interest expense associated with ouraccounts receivable-based line of credit and to a lesser extent, our term loan,both of which were not outstanding in the three and six months ended June 30,2004. The increase in net interest expense in the six-month period waspartially offset by interest expense in the three months ended March 31,2004 on convertible promissory notes, which were outstanding until theirconversion in March 2004 into common and preferred stock.

 

Other income(expense) for the three and six months ended June 30, 2005 consists mainlyof a $52,000 expense associated with exchange rate differences related totransactions denominated in Euros. Other income (expense) for the three and sixmonths ended June 30, 2004 primarily consists of income related to thesettlement of vendor obligations for less than original amounts.

 

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**LIQUIDITYAND CAPITAL RESOURCES**

 

Theaccompanying condensed consolidated financial statements have been prepared ona going concern basis, which contemplates the realization of assets and thesatisfaction of liabilities in the normal course of business. For the sixmonths ended June 30, 2005 and the year ended December 31, 2004, weincurred net losses of $8.7 million and $11.0 million, respectively, and usedcash in operating activities of $6.1 million, and $9.4 million, respectively.These factors indicate that we may potentially be unable to continue as a goingconcern.

 

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 be required,and ultimately to return to profitability and significant positive cash 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)** | ** ** | **June 30, 2005** | ** ** | **December 31, 2004** | ** ** |
|----------------------------|------------|------------------------|------------|----------------------------|------------|
|                       |       |                   |       |                       |       |
| Cash and cash equivalents  |       | $                      | 3,941      |                       | $          | 3,380 |   |
|                       |       |                   |       |                       |       |
| Working capital            |       | $                      | 1,879      |                       | $          | 5,546 |   |

 
| ** **                                | ** ** | **Six Months Ended**   | ** ** |
|-------------------------------------------|------------|------------------------|------------|
| ** **                                | ** ** | **June 30, 2005** | ** ** | **June 30, 2004** | ** ** |
|                                      |       |                   |       |   |   |
| Days sales outstanding (DSO)              |       | 47.1                   |       | 54.7 |   |
|                                      |       |                   |       |   |   |
| Inventory turns - annualized              |       | 3.6                    |       | 4.2 |   |
|                                      |       |                   |       |   |   |
| Net cash used in operating activities     |       | $                      | (6,092     | ) | $ | (2,334 | ) |
| Net cash used in investing activities     |       | $                      | (209       | ) | $ | (651 | ) |
| Net cash provided by financing activities |       | $                      | 6,873      |   | $ | 5,197 |   |

 

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Net cash usedin operating activities

 
| **(In thousands)**                                        | ** ** | **Six Months Ended**       | ** ** | ** **                 | ** ** |
|-----------------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                                                | ** ** | **June 30, 2005**     | ** ** | **June 30, 2004**     | ** ** | **Change in** | ** ** |
| ** **                                                | ** ** | **cash (used)/  provided** | ** ** | **cash (used)/  provided** | ** ** | **cash (used)/  provided** | ** ** |
|                                                      |       |                       |       |                       |       |   |   |
| Net loss                                                  |       | $                          | (8,717     | )                          | $          | (4,179 | ) | $ | (4,538 | ) |
| Non-cash income statement items                           |       | 800                        |       | 489                        |       | 311 |   |
| Decrease (increase) in accounts receivable                |       | (28                        | )          | 272                        |       | (300 | ) |
| Decrease (increase) in inventories                        |       | (298                       | )          | 1,016                      |       | (1,314 | ) |
| Decrease (increase) in prepaid expenses and  other assets |       | (47                        | )          | 154                        |       | (201 | ) |
| Increase (decrease) in accounts payable                   |       | 1,311                      |       | (429                       | )          | 1,740 |   |
| Increase in accrued liabilities                           |       | 887                        |       | 343                        |       | 544 |   |
|                                                      |       |                       |       |                       |       |   |   |
|                                                      |       | $                          | (6,092     | )                          | $          | (2,334 | ) | $ | (3,758 | ) |

 

Net cash usedin operating activities for the six months ended June 30, 2005 and 2004was $6.1 million and $2.3 million, respectively. The increase in net cash usedin operating activities mainly reflects an increase in the net loss as well asan increase in cash used for inventories, partially offset by an increase incash provided from accounts payable and accrued liabilities. The decrease incash provided by inventories reflects significant decreases in our inventoriesbalance in the six months ended June 30, 2004 as a result of a decrease inFS454 production and related sales, which were primarily to Microsoft. Theincrease in cash provided by accounts payable and accrued liabilities reflectstiming of payments and research and development expense accruals related to ourinvestment in UWB technology.

 

One customerhad an accounts receivable balance in excess of 10% of our total accountsreceivable at June 30, 2005 and this customer accounted for 18% of ourtotal accounts receivable at that date.

 

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 $209,000 for the six months ended June 30,2005, compared to $651,000 for the six months ended June 30, 2004. Thedecrease in cash used in investing activities mainly reflects transaction costsincurred during the six months ended June 30, 2004 with respect to theacquisitions of Visual Circuits and COMO and a decrease in our restricted cashbalance at COMO in the six months ending June 30, 2005, partially offsetby an increase in capital expenditures primarily related to our investment inUWB technology.

 

Net cashprovided by financing activities

 

Net cashprovided by financing activities was $6.9 million for the six months ended June 30,2005, compared to $5.2 million for the six months ended June 30, 2004. Netcash from financing activities in the six months ended June 30, 2005consisted 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 $310,000 from the sale of escrow shares and thereimbursement of acquisition fees by Visual Circuits Corporation Liquidating Trustrelated to the acquisition of Visual Circuits, partially offset by repaymentsof $360,000 related to our German subsidiary’s line of credit balance. Net cashfrom financing activities in the six months ended June 30, 2004 primarilyreflects net proceeds of $5.2 million received in April 2004 from aprivate equity placement transaction.

 

**CapitalResources and Liquidity Outlook**

 

We haveincurred losses and used net cash in operating activities for the six monthsended June 30, 2005 and each of the

 

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two years inthe period ended December 31, 2004, and as such, have been dependent uponraising money for short- and long-term cash needs through debt, proceeds fromthe exercise of options and warrants, and the sale of our common stock inprivate placements. For the year ended December 31, 2004, we receivedapproximately $10.7 million in proceeds from the sale of approximately 10.5million shares of our common stock in private placement transactions. For the sixmonths ended June 30, 2005, we received approximately $1.6 million in netproceeds from the sale of approximately 2.4 million shares of our common stockin a private placement transaction.

 

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 June 30, 2005, there was an outstanding balance on this creditline of the maximum available amount of $2.6 million.

 

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 million accountsreceivable based secured line of credit that we have with this same bank.Interest is payable under this loan at prime plus 1% (7.25% as of June 30,2005). At June 30, 2005, there was an outstanding balance under this termloan of the maximum amount of $2.5 million.

 

At June 30,2005, our German subsidiary – COMO – had outstanding debt obligations thatconsisted of notes payable of $185,000 and borrowings under a line of credit of$163,000, both of which are denominated in Euros and were assumed in connectionwith the 2004 acquisition of COMO. Although the notes payable are scheduled tobe repaid through 2011, the bank reviews COMO’s financial results in connectionwith these notes and reserves the right to call these notes due at itsdiscretion. At June 30, 2005, we had the ability to borrow an additional$145,000 under this line of credit.

 

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. Therecan be no assurance that management’s new product plans will result insubstantial increases in our revenue.

 

We believe that we will require additional financing and/or need tofind a partner to fund operations before the end of 2005 in order to meet allcurrently planned expenditures and cash requirements through the first customersampling of our UWB chips. Such financing terms could include debt and/orequity instruments. Depending upon the results of this sampling program,customers’ adoption and acceptance of the UWB products, the profitability ofour Systems business, and our efforts to partner with another entity to marketthe chips on a widespread commercial basis, we may need to raise furthercapital 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 withoutunduly diluting the equity interests of our current stockholders.

 

Summary ofCertain Contractual Obligations as of June 30, 2005

 

25

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(Inthousands)

 
| ** **                        | ** ** | **< 1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **> 5 years** | ** ** | **Total** | ** ** |
|-----------------------------------|------------|-----------------|------------|---------------|------------|---------------|------------|------------------|------------|-----------|------------|
|                              |       |            |       |          |       |          |       |             |       |      |       |
| Capital and operating leases      |       | $               | 554        |          | $          | 936           |       | $                | 416        |      | $          | 16 |   | $ | 1,922 |   |
| Inventory purchase commitments    |       | 2,266           |       | —        |       | —        |       | —           |       | 2,266     |       |
| Notes payable                     |       | 44              |       | 51            |       | 51            |       | 39               |       | 185       |       |
| Interest expense on notes payable |       | 8               |       | 7             |       | 4             |       | 1                |       | 20        |       |
| Term loan                         |       | —          |       | 2,500         |       | —        |       | —           |       | 2,500     |       |
| Interest expense on term loan     |       | 181             |       | 91            |       | —        |       | —           |       | 272       |       |
| Lines of credit                   |       | 2,763           |       | —        |       | —        |       | —           |       | 2,763     |       |
|                              |       |            |       |          |       |          |       |             |       |      |       |
|                              |       | $               | 5,816      |          | $          | 3,585         |       | $                | 471        |      | $          | 56 |   | $ | 9,928 |   |

 

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**RISK FACTORS**

** **

**Risks Relatedto Our Business**

 

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

** **

As of June 30,2005, we had an accumulated deficit of $82.7 million. We incurred net losses of$8.7 million, $11.0 million and $1.7 million for the six months ended June 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 ourfinancial statements for the year ended December 31, 2004 with respect tosubstantial doubt about our ability to continue as a going concern. Thefinancial statements do not include any adjustments that might result from theoutcome of that uncertainty.

 

**We may need toraise additional capital through equities 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.

 

We completedthe acquisitions of COMO and Visual Circuits in the first and second quartersof 2004, respectively. These acquisitions were effected through the issuance ofcommon stock, and the businesses associated with these acquisitions are notcurrently profitable.

 

**Our common stockcurrently does not meet the minimum bid price requirement to remain listed onthe Nasdaq SmallCap Market. If we were to be delisted, it could make trading inour stock more difficult.**

** **

Our voting common stockis traded on the Nasdaq SmallCap Market. There are various quantitative listingrequirements for a company to remain listed on the Nasdaq SmallCap 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 Stock Market notified us that for the previous 30 consecutive businessdays, the bid price of our common stock had closed below the minimum $1.00 pershare price requirement for continued inclusion under Nasdaq Marketplace Rules.

 

We have until October 31,2005 to regain compliance with the Nasdaq SmallCap Market $1.00 minimum bidprice rule. If at any time before October 31, 2005, the bid price of ourcommon stock closes at $1.00 or more per share for a minimum of 10 consecutivebusiness days, Nasdaq will notify us that we are in compliance with the Rules.If we do not regain compliance within the allotted compliance period, includingany extensions that may be granted by Nasdaq, Nasdaq will notify us that ourcommon stock will be delisted from The Nasdaq SmallCap Market, eliminatingthe only established trading market for our shares. We would then be entitledto appeal this determination to a Nasdaq Listing Qualifications Panel andrequest a hearing.

 

In the eventwe are delisted from the Nasdaq SmallCap 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 listing requirementsof those quotation systems. As a result, an investor might find it moredifficult to trade, or to obtain accurate price quotations for, such shares.Delisting might also reduce the visibility, liquidity, and price of our votingcommon 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. At December 31, 2003, we had anaggregate of approximately $4.4 million in debt and accrued interestoutstanding to Mr. Berg. On March 19, 2004, Mr. Berg convertedthis debt and accrued interest to common and preferred stock. Additionally, Mr. Berghas provided a personal guarantee to Samsung Semiconductor Inc., our contractedASIC manufacturer, to secure our working capital requirements for ASIC purchaseorder fulfillment and a personal guarantee to Greater Bay Bank in connectionwith our $4 million accounts receivable-based line of credit and $2.5 millionterm loan. In connection with these guarantees, Mr. Berg maintains asecurity interest in all the company’s assets, subject to the bank’s lien onour accounts 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 August 10,2005, we had 3,161 shares of preferred shares issued and outstanding, and4,160,621 warrants, 245,000 shares of unvested restricted stock and 7,705,940options, which are all exercisable into shares of common stock. The 3,161shares of preferred stock are convertible into 3,161,000 shares of our votingcommon stock. Furthermore, at August 10, 2005, 784,341 additional sharesof common stock were available for grant to our employees, officers, directorsand consultants under our current stock option and incentive plans. We also mayissue additional shares in acquisitions. Any additional grant of options underexisting or future plans or issuance of shares in connection with anacquisition will further dilute existing stockholders.

 

**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 ourmanagement and employees, increase our expenses and adversely affect theresults of operations. Furthermore, we may incur indebtedness or issue equitysecurities to pay for any future acquisitions and/or pay for the legal,accounting or finders fees, typically associated with an acquisition. Theissuance of equity securities could be dilutive to our existing stockholders.In addition, the accounting treatment for any acquisition transaction mayresult in significant goodwill and intangible assets, which, if impaired, willnegatively affect our consolidated results of operations. The accountingtreatment for any potential acquisition may also result in a charge forin-process research and development expense, as was the case with theacquisition of Visual Circuits, which will negatively affect our consolidatedresults 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 48% 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.

 

**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 sixmonths ended June 30, 2005, our five largest customers in aggregateprovided 29% of our total revenues and as of June 30, 2005 comprised 43%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 June 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 theshort product life cycles in the markets for our products, any delay orunanticipated difficulty associated with new product introductions or productenhancements could cause us to lose customers and damage our competitiveposition.  Prior delays have resultedfrom 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

•                        respond totechnological 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, 2004 and August 10, 2005, the per shareprice has fluctuated between $0.60 and $2.87 per share, closing at $0.83 on August 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.

 

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

 

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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, evolvingindustry standards and significant price erosion over the life of a product.Competition is fragmented with several hundred manufacturers supplying avariety of products to this market. We anticipate increased competition in thevideo post-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 unableto reduce cost of sales and operating expenses at a rate and to a levelconsistent with such a future adverse sales environment. If we must undertakefurther expense reductions, we may incur significant incremental specialcharges associated with such expense reductions that are disproportionate tosales, thereby adversely affecting our business, financial condition andoperating results. Adverse economic conditions could decrease demand for ourproducts, increase delinquencies in payments and otherwise have an adverseimpact on our business.

 

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**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 and ExchangeCommission financial filings, prohibitions on certain loans to offices anddirectors, 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. Compliance with therequirements 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 June 30, 2005, we did not hold anyshort-term investments that would be exposed to market risk from adversemovements in interest rates.

 

At June 30, 2005, our outstanding debt obligations consisted of notes payable of $185,000, a term loan of $2.5 million and borrowings under lines of credit of $2.8 million. The average interest rate applicable to these debt obligations is 7.3% 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 June 30, 2005 and 2004.

 

**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’ second 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 is required to meet the requirements of the Sarbanes-Oxley Act by December 31,2006.

 

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**PART II - OTHER INFORMATION**

 

**Item 1.****                                   Legalproceedings**

From time to time, Focus is party to certainother claims and legal proceedings that arise in the ordinary course ofbusiness of which, in the opinion of management, do not have a material adverseeffect on Focus’ financial position or results of operation.

 

**Item 2.****                                   Changesin securities**

On June 28,2005, we issued a warrant to Carl Berg, a director of the Company, to purchase100,000 shares of our common stock at a purchase price of $0.81 per share inconnection with Mr. Berg’s personal guarantee of a term loan issued to theCompany. The warrant was issued pursuant to section 4(2) of theSecurities Act based on the nature of the investor and certain representationsmade to us. The warrant was immediately exercisable and expires four years fromthe date of grant.

 

**Item 3.****                                   Defaultsupon senior securities**

None.

 

**Item 4.****                                   Submissionof matters to a vote of security holders**

None.

 

**Item 5.****                                   Otherinformation**

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

 

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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.

 

 
| August 12, 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)        |                          |
|                      |                                       |                               |        |  |  |  |  |  |

 

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