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

**Washington, D.C. 20549**

** **

**FORM 10-Q**

 

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

** **

# **For thequarterly period ended March 31, 2005, or**

# ** **

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

 

**For the transition period from           to           .**

** **

**Commission File Number 1-11860**

** **

**FocusEnhancements, Inc.**

(Name of Issuer in its Charter)

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

 

**1370 Dell Ave**

**Campbell, CA 95008**

(Address of Principal Executive Offices)

 

**(408) 866-8300**

(Issuer’s Telephone Number, Including Area Code)

 

Securities registered pursuant to Section 12(b) of Act:

 

Title of Each Class

**Common Stock, $0.01 par value**

 

Name of Exchange on which Registered

**NASDAQ**

 

Securities registered pursuant to Section 12(g) of the Act: **None**

 

Check whetherthe Issuer (1) has filed all reports required to be filed by Section 13 or 15(d) of theSecurities  Exchange Act of 1934 duringthe preceding 12 months (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 by check mark whetherthe registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act). oYes  No ý

 

As of the close of business May 12,2005, there were 60.0 million shares of Focus Enhancement’s common stock issuedand outstanding.

 

 

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**FOCUS ENHANCEMENTS, INC.**

 

**INDEX**

 
| ** **                              | ** **                                                                                  | **Page**   |
|-----------------------------------------|---------------------------------------------------------------------------------------------|------------|
| ** **                              | ** **                                                                                  | **Number** |
|                                    |                                                                                        |
| **PART I - FINANCIAL INFORMATION** | 3                                                                                           |
| ** **                              | ** **                                                                                  |
| **Item 1.**                             | Financial  Statements:                                                                      | 3          |
|                                    | Condensed Consolidated Statements of  Operations                                            | 3          |
|                                    | Condensed Consolidated Balance Sheets                                                       | 4          |
|                                    | Condensed Consolidated Statements of Cash  Flows                                            | 5          |
|                                    | Notes to Condensed Consolidated Financial Statements                                        | 6          |
|                                    |                                                                                        |
| **Item 2.**                             | Management’s Discussion and Analysis of  Financial Condition and Results of Operations | 17         |
|                                    |                                                                                        |
| **Item 3.**                             | Quantitative and Qualitative Disclosures  about Market Risk                                 | 31         |
|                                    |                                                                                        |
| **Item 4.**                             | Controls and Procedures                                                                     | 31         |
|                                    |                                                                                        |
| **PART II - OTHER INFORMATION**    | ** **                                                                                  |
| ** **                              | ** **                                                                                  |
| **Item 1.**                             | Legal  Proceedings                                                                          | 32         |
|                                    |                                                                                        |
| **Item 2.**                             | Unregistered  Sales of Equity Securities and Use of Proceeds                                | 32         |
|                                    |                                                                                        |
| **Item 3.**                             | Defaults  Upon Senior Securities                                                            | 32         |
|                                    |                                                                                        |
| **Item 4.**                             | Submission  of Matters to a Vote of Security Holders                                        | 32         |
|                                    |                                                                                        |
| **Item 5.**                             | Other  Information                                                                          | 32         |
|                                    |                                                                                        |
| **Item 6.**                             | Exhibits                                                                                    | 32         |
| ** **                              | ** **                                                                                  |
| **SIGNATURES**                          | 33                                                                                          |
|                                    |                                                                                        |       |
| **CERTIFICATIONS**                      |                                                                                        |

 

----

 

**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**  | ** ** |
|-------------------------------------------------------|------------|-------------------------|------------|
| ** **                                            | ** ** | **March 31, 2005** | ** ** | **March 31, 2004** | ** ** |
|                                                  |       |                    |       |   |   |
| Net revenue                                           |       | $                       | 5,455      |   | $ | 4,094 |   |
| Cost of revenue                                       |       | 3,700                   |       | 2,780 |   |
| Gross margin                                          |       | 1,755                   |       | 1,314 |   |
|                                                  |       |                    |       |   |   |
| Operating expenses:                                   |       |                    |       |   |   |
| Sales, marketing and support                          |       | 1,424                   |       | 1,054 |   |
| General and administrative                            |       | 1,001                   |       | 557 |   |
| Research and development                              |       | 3,942                   |       | 1,106 |   |
| Amortization of intangible assets                     |       | 149                     |       | 146 |   |
|                                                  |       | 6,516                   |       | 2,863 |   |
| Loss from operations                                  |       | (4,761                  | )          | (1,549 | ) |
| Interest expense, net                                 |       | (13                     | )          | (46 | ) |
| Other income                                          |       | —                  |       | 6 |   |
| Loss before income taxes                              |       | (4,774                  | )          | (1,589 | ) |
| Income tax expense                                    |       | 4                       |       | — |   |
| Net loss                                              |       | $                       | (4,778     | ) | $ | (1,589 | ) |
|                                                  |       |                    |       |   |   |
| Net loss per share                                    |       |                    |       |   |   |
| Basic and diluted                                     |       | $                       | (0.08      | ) | $ | (0.04 | ) |
|                                                  |       |                    |       |   |   |
| Weighted average common and common equivalent  shares |       |                    |       |   |   |
| Basic and diluted                                     |       | 59,081                  |       | 42,905 |   |

 

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

 

3

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**FocusEnhancements, Inc.**

**Condensed Consolidated Balance Sheets**

(In thousands, except share and per share amounts)

(Unaudited)

 
| ** **                                                                                                                                                                                      | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                      | ** ** | **2005**           | ** ** | **2004**              | ** ** |
| **Assets**                                                                                                                                                                                      |       |               |       |                  |       |
|                                                                                                                                                                                            |       |               |       |                  |       |
| Current assets:                                                                                                                                                                                 |       |               |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                       |       | $                  | 3,515      |                  | $          | 3,380 |   |
| Accounts receivable, net of allowances of  $446 and $443                                                                                                                                        |       | 2,972              |       | 3,273                 |       |
| Inventories                                                                                                                                                                                     |       | 4,099              |       | 3,941                 |       |
| Prepaid expenses and other current assets                                                                                                                                                       |       | 521                |       | 473                   |       |
| Restricted cash                                                                                                                                                                                 |       | 20                 |       | 312                   |       |
| Total current assets                                                                                                                                                                            |       | 11,127             |       | 11,379                |       |
|                                                                                                                                                                                            |       |               |       |                  |       |
| Long-term assets:                                                                                                                                                                               |       |               |       |                  |       |
| Property and equipment, net                                                                                                                                                                     |       | 1,396              |       | 1,116                 |       |
| Other assets                                                                                                                                                                                    |       | 52                 |       | 62                    |       |
| Intangible assets, net                                                                                                                                                                          |       | 1,383              |       | 1,577                 |       |
| Goodwill                                                                                                                                                                                        |       | 13,191             |       | 13,191                |       |
|                                                                                                                                                                                            |       |               |       |                  |       |
|                                                                                                                                                                                            |       | $                  | 27,149     |                  | $          | 27,325 |   |
|                                                                                                                                                                                            |       |               |       |                  |       |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                                  |       |               |       |                  |       |
|                                                                                                                                                                                            |       |               |       |                  |       |
| Current liabilities:                                                                                                                                                                            |       |               |       |                  |       |
| Accounts payable                                                                                                                                                                                |       | $                  | 4,092      |                  | $          | 2,555 |   |
| Borrowings under lines of credit                                                                                                                                                                |       | 2,723              |       | 567                   |       |
| Current portion of long-term debt                                                                                                                                                               |       | 52                 |       | 55                    |       |
| Current portion of capital lease  obligations                                                                                                                                                   |       | 70                 |       | 22                    |       |
| Accrued liabilities                                                                                                                                                                             |       | 2,938              |       | 2,634                 |       |
| Total current liabilities                                                                                                                                                                       |       | 9,875              |       | 5,833                 |       |
|                                                                                                                                                                                            |       |               |       |                  |       |
| Long-term liabilities:                                                                                                                                                                          |       |               |       |                  |       |
| Long-term debt, net of current portion                                                                                                                                                          |       | 153                |       | 174                   |       |
| Capital lease obligations, net of current  portion                                                                                                                                              |       | 58                 |       | —                |       |
| Other liabilities                                                                                                                                                                               |       | 73                 |       | —                |       |
| Total long-term liabilities                                                                                                                                                                     |       | 284                |       | 174                   |       |
|                                                                                                                                                                                            |       |               |       |                  |       |
| Stockholders’ equity:                                                                                                                                                                      |       |               |       |                  |       |
| Preferred stock, $0.01 par value;  authorized 3,000,000 shares; 3,161 shares issued at March 31, 2005 and  December 31, 2004, respectively (aggregate liquidation preference  $3,917) |       | —             |       | —                |       |
| Common stock, $0.01 par value; 100,000,000  shares authorized, 60,454,525 and 60,412,591 shares issued at March 31,  2005 and December 31, 2004, respectively                         |       | 597                |       | 597                   |       |
| Additional paid-in capital                                                                                                                                                                      |       | 96,198             |       | 95,463                |       |
| Accumulated deficit                                                                                                                                                                             |       | (78,784            | )          | (74,006               | )          |
| Deferred stock-based compensation                                                                                                                                                               |       | (265               | )          | —                |       |
| Accumulated other comprehensive income  (loss)                                                                                                                                                  |       | (6                 | )          | 14                    |       |
| Treasury stock at cost, 497,500 shares at  March 31, 2005 and December 31, 2004, respectively                                                                                         |       | (750               | )          | (750                  | )          |
| Total stockholders’ equity                                                                                                                                                                 |       | 16,990             |       | 21,318                |       |
|                                                                                                                                                                                            |       |               |       |                  |       |
|                                                                                                                                                                                            |       | $                  | 27,149     |                  | $          | 27,325 |   |

 

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

 

4

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**Focus Enhancements, Inc.**

**Condensed Consolidated Statements of CashFlows**

(In thousands)

(Unaudited)

 
| ** **                                                                                         | ** ** | **Three Months Ended,** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                                         | ** ** | **March 31, 2005** | ** ** | **March 31, 2004** | ** ** |
| Cash flows from operating activities:                                                              |       |                    |       |   |   |
| Net loss                                                                                           |       | $                       | (4,778     | ) | $ | (1,589 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities:                       |       |                    |       |   |   |
| Depreciation and amortization                                                                      |       | 329                     |       | 189 |   |
| Stock-based compensation                                                                           |       | 30                      |       | — |   |
| Changes in assets and liabilities:                                                                 |       |                    |       |   |   |
| Decrease in accounts receivable                                                                    |       | 262                     |       | 903 |   |
| Decrease (increase) in inventories                                                                 |       | (184                    | )          | 555 |   |
| Increase in prepaid expenses and other  assets                                                     |       | (49                     | )          | (124 | ) |
| Increase (decrease) in accounts payable                                                            |       | 1,567                   |       | (695 | ) |
| Increase (decrease) in accrued liabilities                                                         |       | 531                     |       | (136 | ) |
| Net cash used in operating activities                                                              |       | (2,292                  | )          | (897 | ) |
|                                                                                               |       |                    |       |   |   |
| Cash flows from investing activities:                                                              |       |                    |       |   |   |
| Decrease in restricted cash                                                                        |       | 279                     |       | — |   |
| Acquisition costs related to Visual  Circuits Corporation                                          |       | —                  |       | (194 | ) |
| Purchases of property and equipment                                                                |       | (420                    | )          | (15 | ) |
| Acquisition of COMO Computer and Motion  GmbH net of cash acquired                                 |       | —                  |       | (3 | ) |
| Net cash used in investing activities                                                              |       | (141                    | )          | (212 | ) |
|                                                                                               |       |                    |       |   |   |
| Cash flows from financing activities:                                                              |       |                    |       |   |   |
| Borrowings under lines of credit                                                                   |       | 2,493                   |       | — |   |
| Repayments of lines of credit                                                                      |       | (311                    | )          | — |   |
| Payments of short-term debt                                                                        |       | (11                     | )          | — |   |
| Repayment of transaction costs related to  acquisition of Visual Circuits Corporation              |       | 225                     |       | — |   |
| Proceeds from issuance of escrow stock  related to acquisition of COMO Computer and Motion GmbH    |       | 191                     |       | — |   |
| Proceeds from exercise of common stock  options, net of issuance costs                             |       | (14                     | )          | 79 |   |
| Net cash provided by financing activities                                                          |       | 2,573                   |       | 79 |   |
|                                                                                               |       |                    |       |   |   |
| Effect of exchange rate changes on cash and  cash equivalents                                      |       | 12                      |       | — |   |
|                                                                                               |       |                    |       |   |   |
| Increase (decrease) in cash and cash  equivalents                                                  |       | 152                     |       | (1,030 | ) |
| Cash and cash equivalents at beginning of  period                                                  |       | 3,363                   |       | 3,731 |   |
| Cash and cash equivalents at end of period                                                         |       | $                       | 3,515      |   | $ | 2,701 |   |
|                                                                                               |       |                    |       |   |   |
| Non-Cash Activity                                                                                  |       |                    |       |   |   |
|                                                                                               |       |                    |       |   |   |
| Conversion of notes payable and accrued  interest to related party into common and preferred stock |       | $                       | —     |   | $ | 4,454 |   |

 

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

 

5

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**Notes****to Condensed Consolidated Financial Statements**

 

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

 

The condensed consolidated financial statements of Focus Enhancements, Inc.(“Focus” or “the Company”) as of March 31, 2005 and for the three-monthperiods ended March 31, 2005 and March 31, 2004 are unaudited andshould be read in conjunction with the audited consolidated financialstatements for the year ended December 31, 2004, included in Focus’ AnnualReport on Form 10-K/A for the year ended December 31, 2004.

 

In the opinion of management, the condensedconsolidated financial statements include all adjustments (consisting only ofnormal recurring adjustments) necessary for a fair presentation of Focus’financial position, operating results and cash flows for the periods presented.The results of operations and cash flows for the three months ended March 31,2005 are not necessarily indicative of the results that may be expected for anyfuture period. Certain items previously reported in specific financialstatement captions have been reclassified. Such reclassifications have notimpacted previously reported net loss amounts.

 

During the first quarter of 2005, Focusconverted from a 13-week quarter that ended on the last Sunday of the period toa calendar quarter. For convenience, the comparative results in theaccompanying condensed consolidated statements of operations and condensedconsolidated statements of cash flows are shown as ending on March 31,2004, although the first quarter of fiscal year 2004 ended on April 4,2004. The change in the quarter end did not have a material impact on thereported operating results or financial position of Focus.

 

**2.****             Consolidationand Foreign Currency Translation**

 

The interim unaudited condensed consolidatedfinancial statements include Focus’ accounts and those of its wholly-ownedsubsidiaries. All intercompany accounts and transactions have been eliminatedupon consolidation.

 

The functional currency of Focus’ foreignsubsidiary, COMO Computer & Motion GmbH (“COMO” – see Note 6, “BusinessCombinations”), is the Euro.Gains and losses resulting from the translation of COMO’s financial statementsare reported as a separate component of stockholders’ equity.  Gains and losses resulting from foreigncurrency transactions are included in net loss.

** **

**3.****            ****Pro Forma Stock Compensation Expense**

 

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

 

Focus has elected to continue with theaccounting prescribed in APB Opinion No. 25 and, as a result, must makepro forma disclosures of net income (loss) and net income (loss) per share andother disclosures as if the fair value based method of accounting had beenapplied. The estimated fair value of the options is amortized to expense overthe vesting period of the option. The following table presents the effect onreported net loss and net loss per share of accounting for employee stockoptions under the fair value method:

 

6

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| ** **                                                                                              | ** ** | **Three Months Ended**  | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| **(In thousands, except per share  data)**                                                              | ** ** | **March 31, 2005** | ** ** | **March 31, 2004** | ** ** |
|                                                                                                    |       |                    |       |   |   |
| Reported net loss                                                                                       |       | $                       | (4,778     | ) | $ | (1,589 | ) |
| Stock-based compensation determined under  fair value method for all awards, net of related tax effects |       | (369                    | )          | (273 | ) |
|                                                                                                    |       |                    |       |   |   |
| Pro forma net loss                                                                                      |       | $                       | (5,147     | ) | $ | (1,862 | ) |
|                                                                                                    |       |                    |       |   |   |
| Reported net loss per share                                                                             |       | $                       | (0.08      | ) | $ | (0.04 | ) |
| Stock-based compensation determined under  fair value method for all awards, net of related tax effects |       | (0.01                   | )          | (0.00 | ) |
|                                                                                                    |       |                    |       |   |   |
| Basic and diluted pro forma net loss per  share                                                         |       | $                       | (0.09      | ) | $ | (0.04 | ) |

 

Common stockequivalents have been excluded from all calculations of net loss per share andpro forma net loss per share for the periods presented because the effect ofincluding them would be anti-dilutive.

 

**4.**             Significant Customers

 

Sales to one customer accounted for 15% of Focus’total revenue in the three months ended March 31, 2005. Three customershad sales in excess in of 10% of Focus’ revenue in the three months ended March 31,2004. The aggregate sales to these three customers accounted for 47% of ourtotal revenue in 2004.

 

Two customers had accounts receivablebalances in excess of 10% of Focus’ total accounts receivable at March 31,2005. These customers accounted for 25% of Focus’ total accounts receivable atthat date.

 

**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 threemonths ended March 31, 2005 and the year ended December 31, 2004,Focus incurred net losses of $4.8 million and $11.0 million, respectively, andused net cash in operating activities of $2.3 million and $9.4 million,respectively. These results indicate that Focus may potentially be unable tocontinue as a going concern.

 

Theconsolidated financial statements do not include any adjustments relating tothe recoverability and classification of recorded asset amountsor the amounts and classification of liabilities that might be necessary shouldFocus be unable to continue as a going concern. Focus’ continuation as a goingconcern is dependent upon its ability to generate sufficient cash flows to meetits obligations on a timely basis, to obtain additional financing as may berequired, and ultimately to return to profitability and significant positivecash flows.

 

Focus has historically met cash needs from the proceeds of debt, thesale of common stock in private placements and the exercise of employee stockoptions and warrants. Management continues to assess its product lines in lightof technology trends and economic conditions, to identify how to enhanceexisting product lines or create new distribution channels.

 

Focus’ management anticipates that Focus will need to obtain additionalfinancing and/or find a partner to fund operations before the end of the secondquarter of 2005 in order to meet all currently planned expenditures and cashrequirements through the first customer sampling of its Ultra Wideband (“UWB”)chips. Depending upon the results of this sampling program, the profitabilityof the Systems business, and Focus’ efforts to partner with another entity tomarket the chips commercially, Focus may need to raise further capital for thewidespread commercial deployment of UWB.

 

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

 

7

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

 

COMO Computer & Motion GmbH

 

On February 27, 2004, Focus completed the acquisition of 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, manufactures and distributes digitalvideo solutions. COMO’s results of operations are included in Focus’ financialstatements from the date of acquisition, and the assets and liabilities wererecorded based on their fair values as of the date of acquisition. There wereno employee stock options or warrants assumed as a result of theacquisition. Pro forma results of operations have not been presentedbecause the effect of the acquisition was not material to Focus’ financialposition or results of operations.

 

The purchase price of approximately $1.0 million, consisting of 185,066shares of Focus common stock issued to the COMO shareholders, the fair value ofthe 46,266 earn-out shares, 30,000 shares of Focus common stock issued tovFinance, cash paid to the COMO shareholders of $359,000, and acquisition costsof approximately $220,000, has been allocated based on the estimated fair valueof net tangible and intangible assets acquired, and liabilities assumed. Theearn-out shares are included in the purchase price because Focus managementbelieves it is probable that the conditions under which such shares wouldbecome payable will be met. The value of the 610,096 common shares issued toCOMO’s two shareholders and held in escrow are not included in the purchaseprice - see Note 11, “Stockholders’ Equity”. A summary of the allocation of thepurchase price to the assets acquired 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 a straight-line basis over anestimated useful life of three years.

 

Visual Circuits Corporation

 

On May 28, 2004, Focus acquired substantially all the assets andassumed certain liabilities of Visual Circuits Corporation (“Visual Circuits”)pursuant to an Agreement and Plan of Reorganization (“Reorganization Agreement”).The transaction was accounted for as a purchase business combination at a totalcost of approximately $8.9 million. Founded in 1991, Visual Circuits is amanufacturer and developer of integrated hardware, software and network productsthat manage, schedule, distribute, store and present digital video in a widerange of commercial media applications.

 

Under the terms of the Reorganization Agreement, Visual Circuits,located in Minneapolis, Minnesota, received 3,805,453 shares of voting commonstock of Focus, including approximately 380,000 shares placed in escrow for therecovery by Focus of any losses resulting from the breach of covenants byVisual Circuits. In connection with this transaction, Focus paid vFinanceInvestments, Inc., (a related party) a success fee of $168,000 and 80,000shares of Focus’ common stock.

 

8

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Visual Circuits’ results of operations are included in Focus’ financialstatements from the date of acquisition, and the assets and liabilities wererecorded based on their fair values as of the date of acquisition. There wereno employee stock options or warrants assumed as a result of the acquisition.

 

The purchase price of approximately $8.9 million consisted of the fairvalue of the shares of Focus common stock issued to Visual Circuits, excludinga portion of the escrow shares associated with amounts owed by Visual Circuitsto Focus (see Note 11, “Stockholders’ Equity”), 80,000 shares distributed tovFinance Investments, Inc., and acquisition costs of approximately$440,000. The acquisition costs consisted of financial advisory, legal andaccounting 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 tangible net assetsacquired represent the historical net assets of Visual Circuits’ business as ofMay 28, 2004. As required under purchase accounting, the assets andliabilities 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 businessconcerning development projects, their stage of development, the time andresources needed to complete them, if applicable, their expected incomegenerating ability and associated risks. The income approach, which includes ananalysis of the cash flows, and risks associated with achieving such cashflows, was the primary technique utilized in valuing the developed technologyand IPRD.

 

Wheredevelopment projects had reached technological feasibility, they wereclassified as developed technology and the value assigned to developedtechnology was capitalized. The developed technology is being amortized on astraight-line basis over its estimated useful life of three years.

 

Where the development projects had notreached technological feasibility and had no future alternative uses, they wereclassified as IPRD. Of the total purchase price, $300,000 was allocated toIPRD, which was expensed upon the consummation of the Reorganization Agreementin the second quarter of 2004. The value was determined by estimating theexpected cash flows from the projects once commercially viable, discounting thenet cash flows back to their present value and then applying a percentage ofcompletion to the calculated value. If the projects are not successfullydeveloped, the sales and profitability of Focus may be adversely affected infuture periods. Goodwill represents the excess of the purchase price over thefair value of the underlying net identifiable assets.

 

 

9

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**7.****             Goodwill and Intangible Assets**

 

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

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

 

The following tables provide a summary of thecarrying amounts of intangible assets:

 
| ** **          | ** ** | **March 31, 2005** | ** ** |
|---------------------|------------|-------------------------|------------|
| ** **          | ** ** | ** **              | ** ** | **Accumulated** | ** ** | **Net** | ** ** |
| **(In thousands)**  | ** ** | **Gross Amount**        | ** ** | **Amortization** | ** ** | **Amount** | ** ** |
|                |       |                    |       |   |   |   |   |
| Existing technology |       | $                       | 3,945      |   | $ | (2,562 | ) | $ | 1,383 |   |
|                     |            |                         |            |  |  |  |  |  |  |  |

 
| ** **          | ** ** | **December 31, 2004** | ** ** |
|---------------------|------------|----------------------------|------------|
| ** **          | ** ** | ** **                 | ** ** | **Accumulated** | ** ** | **Net** | ** ** |
| ** **          | ** ** | **Gross Amount**           | ** ** | **Amortization** | ** ** | **Amount** | ** ** |
|                |       |                       |       |   |   |   |   |
| Existing technology |       | $                          | 3,945      |   | $ | (2,370 | ) | $ | 1,575 |   |
| Tradename           |       | 176                        |       | (174 | ) | 2 |   |
|                |       |                       |       |   |   |   |   |
|                |       | $                          | 4,121      |   | $ | (2,544 | ) | $ | 1,577 |   |

 

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

 
| **(In thousands)**                        | ** ** | **Amortization** | ** ** |
|-------------------------------------------|------------|------------------|------------|
|                                      |       |             |       |
| Nine months ending December 31, 2005 |       | $                | 517        |   |
| Fiscal year 2006                          |       | 681              |       |
| Fiscal year 2007                          |       | 185              |       |
|                                      |       |             |       |
|                                      |       | $                | 1,383      |   |

 

 

10

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**8.****             Inventories**

 

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

 
| **(In thousands)** | ** ** | **March 31, 2005** | ** ** | **December 31, 2004** | ** ** |
|--------------------|------------|-------------------------|------------|----------------------------|------------|
|               |       |                    |       |                       |       |
| Raw materials      |       | $                       | 2,154      |                       | $          | 2,308 |   |
| Work in process    |       | 373                     |       | 51                         |       |
| Finished goods     |       | 1,572                   |       | 1,582                      |       |
|               |       |                    |       |                       |       |
|               |       | $                       | 4,099      |                       | $          | 3,941 |   |

 

**9.**             Borrowings

 
| **(In thousands)**                        | ** ** | **March 31, 2005** | ** ** | **December 31, 2004** | ** ** |
|-------------------------------------------|------------|-------------------------|------------|----------------------------|------------|
|                                      |       |                    |       |                       |       |
| Short-term debt:                          |       |                    |       |                       |       |
| Current portion of notes payable to bank  |       | $                       | 52         |                       | $          | 55 |   |
| COMO line of credit                       |       | 230                     |       | 567                        |       |
| Accounts receivable-based line of credit  |       | 2,493                   |       | —                     |       |
|                                      |       | 2,775                   |       | 622                        |       |
| Long-term debt:                           |       |                    |       |                       |       |
| Notes payable to bank (long-term portion) |       | 153                     |       | 174                        |       |
|                                      |       |                    |       |                       |       |
|                                      |       | $                       | 2,928      |                       | $          | 796 |   |

 

Short- andlong-term bank debt and the COMO line of credit were assumed by Focus as aresult of the acquisition of COMO in February 2004 – see Note 6, “BusinessCombinations”. The notes payable and line of credit are with a local Germanbank.

 

The notespayable to a bank, consisting of two notes of $181,000 and $24,000 aredenominated in Euros and are scheduled to be repaid through December 2011and December 2005, respectively, at an average interest rate of 6% perannum. However, the bank reviews COMO’s financial results in connection withthese notes and reserves the right to call these notes due at its discretion.

 

In connectionwith the COMO line of credit, Focus’ German subsidiary - COMO, maintains a cashbalance with the lending institution, which is reported as restricted cash onFocus’ balance sheet. Interest is payable on this line of credit at a rate of10% per annum. There are no financial covenants applicable to this creditfacility, nor is there an applicable maturity date. However, the bank reviewsCOMO’s financial results in assessing future extensions of credit. At March 31,2005, there were no further borrowings available under this facility.

 

The notespayable and COMO line of credit are secured 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.

 

AccountsReceivable-Based Line of Credit

 

In November 2004,Focus obtained a $4.0 million line of credit under which it can borrow up to90% of its eligible outstanding accounts receivable. The credit line expires inNovember 2005 and is secured by a personal guarantee from Carl Berg, aCompany director and shareholder. In connection with this credit line, the bankhas obtained a first priority security interest in Focus’ accounts receivablethrough an agreement with Mr. Berg, which enables Mr. Berg to retainhis existing security interest in all of Focus’ assets while subordinating hisinterest 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 6.75% at March 31, 2005. In connectionwith this line of credit, Focus issued warrants to the bank to purchase 77,186shares of Focus’ common stock at an exercise price of approximately $1.17 pershare. The warrants were valued at $76,000 using the Black-Scholesoption-pricing

 

11

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model and arebeing amortized to interest expense over the term of the credit line. At March 31,2005, there was an outstanding balance of $2.5 million on this credit line andFocus had the ability to borrow an additional $95,000.

 

**10.**          Commitments and Contingencies

 

Research and Development Agreements

 

In June 2004,Focus entered into a development and license agreement under which Focus agreedto pay $664,000 to a third party for engineering services and the rights tocertain intellectual property that will be used in the research and developmentof UWB technology. Such amount was expensed to research and development ratablyover the development period from June 2004 to January 2005 based onthe level of effort incurred by the third party. A total of $16,000 wasexpensed in the three months ended March 31, 2005. Payments were made uponthe achievement of specific development milestones by the third party, whichwere completed in January 2005.

 

On October 1,2004, Focus entered into a design services contract under which Focus agreed topay $2.9 million to a third party for the design and development of highperformance UWB integrated circuits. Payments are made upon the completion ofspecific milestones by the third party, which are expected to be completed by December 2005.For the three months ended March 31, 2005, $850,000 was charged toresearch and development expense based on the level of effort incurred by thethird party and $175,000 was included within other accrued liabilities at March 31,2005.

 

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 March 31, 2005 were as follows:

 
| **(In thousands)**                        | ** ** | **Lease Commitments** | ** ** |
|-------------------------------------------|------------|-----------------------|------------|
|                                      |       |                  |       |
| Nine months ending December 31, 2005 |       | $                     | 369        |   |
| 2006                                      |       | 540                   |       |
| 2007                                      |       | 523                   |       |
| 2008                                      |       | 183                   |       |
| 2009                                      |       | 192                   |       |
|                                      |       |                  |       |
|                                      |       | $                     | 1,807      |   |

 

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 March 31,2005. As a result, no liability has been recorded with respect to suchindemnifications as of March 31, 2005.

 

12

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Inventory PurchaseCommitments

 

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

 

At March 31, 2005,Focus had issued non-cancelable purchase orders for approximately $1.9 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.

 

**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. The proceeds from thesale of such shares were remitted to Focus by the Sellers and recorded as anincrease in paid-in capital. The note receivable from the Sellers is notrecorded in the accompanying condensed consolidated financial statements, as itwill be cancelled upon receipt of the proceeds from the sale of the remainingEscrow 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. If VCC did not remit this settlement amount by February 15,2005, then the settlement amount owed was to have been increased in $20,000increments on a monthly basis if not paid on the fifteenth of each subsequentmonth to a maximum of $305,000, if the then existing settlement amount was notrepaid by May 15, 2005. If any amount owed remained unpaid after May 15,2005, Focus had the right to recover such amounts in exchange for Focus commonstock held in escrow, based on a reduced exchange rate of $1.15 per share. Thereceivable from VCC was not recorded in the accompanying consolidated balancesheet at December 31, 2004, as the recourse available to Focus in theevent of default was limited to the shares held in escrow. On February 15,2005, Focus collected the amount owed of $225,000 and recorded the proceeds asan increase in capital at that date.

** **

 

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As of March 31, 2005, Focus was obligated under certaincircumstances, to issue the following additional shares of common stock pursuantto derivative securities, instruments or agreements:

 
| **(In thousands)**                             | ** ** | **Shares of  Common Stock** | ** ** |
|------------------------------------------------|------------|-----------------------------|------------|
|                                           |       |                        |       |
| Warrants to purchase common stock              |       | 3,312                       |       |
| Options to purchase common stock               |       | 7,707                       |       |
| Preferred Stock convertible into common  stock |       | 3,161                       |       |
|                                           |       |                        |       |
|                                           |       | 14,180                      |       |

 

**12.****          Related PartyTransactions**

** **

Carl Berg

 

In December 2002,Mr. Berg, a Company director and shareholder, provided SamsungSemiconductor Inc., Focus’ contracted ASIC manufacturer, with a personalguarantee to secure Focus’ working capital requirements for ASIC purchase orderfulfillment. Mr. Berg agreed to provide the personal guarantee on Focus’behalf without additional cost or collateral, as Mr. Berg maintains asecured priority interest in substantially all of Focus’ assets. At March 31,2005, Focus owed Samsung $11,000 under net 30 terms.

 

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

 

Dolby Laboratories Inc.

 

N. William Jasper Jr., who is the Chairman of Focus’ Board ofDirectors, is also the President and Chief Executive Officer of DolbyLaboratories, Inc. (“Dolby”), a signal processing technology 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 months ended March 31, 2005, Focus paid Dolby $3,000 inroyalties, which were recorded in cost of revenue.

 

**13.**          Business Segment Information

 

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

 

 

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

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

 
| ** **                        | ** ** | **Three Months Ended March 31, 2004** |       |
|-----------------------------------|------------|--------------------------------------------|------------|
| ** **                        | ** ** | **Systems**                                | ** ** | **Semiconductor** | ** ** | **Total** | ** ** |
|                              |       |                                       |       |   |   |   |   |
| Net revenue                       |       | $                                          | 2,847      |   | $ | 1,247 |   | $ | 4,094 |   |
| Cost of revenue                   |       | 1,904                                      |       | 876 |   | 2,780 |   |
| Gross margin                      |       | 943                                        |       | 371 |   | 1,314 |   |
|                              |       |                                       |       |   |   |   |   |
| Operating expenses:               |       |                                       |       |   |   |   |   |
| Sales, marketing and support      |       | 844                                        |       | 210 |   | 1,054 |   |
| General and administrative        |       | 387                                        |       | 170 |   | 557 |   |
| Research and development          |       | 571                                        |       | 535 |   | 1,106 |   |
| Amortization of intangible assets |       | 109                                        |       | 37 |   | 146 |   |
|                              |       | 1,911                                      |       | 952 |   | 2,863 |   |
| Loss from operations              |       | $                                          |  (968 | ) | $ |  (581 | ) | $ |  (1,549 | ) |

 

**14.****          Recent Accounting 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 FASB issued SFAS No. 123 (revised 2004), *Share-BasedPayment* (“SFAS 123R”). SFAS 123R eliminates the alternative ofapplying the intrinsic value measurement provisions of Opinion 25 to stockcompensation awards issued to employees. Rather, the new standard requiresenterprises to measure the cost of employee services received in exchange foran award of equity instruments based on the grant-date fair value of the award.That cost will be recognized over the period during which an employee isrequired to provide services in exchange for the award, known as the requisiteservice 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 loss per share ifFocus had applied the fair value recognition provisions of original SFAS No. 123on stock compensation awards (rather than applying the intrinsic valuemeasurement provisions of Opinion 25) are disclosed in Note 3, “Pro Forma StockCompensation Expense”. Although such pro forma effects of applying the originalSFAS 123 may be indicative of the effects of adopting SFAS 123R, the provisionsof these two statements differ in some important respects. The actual effectsof adopting SFAS 123R will be dependent on numerous factors including, but notlimited to, the valuation model chosen by Focus to value stock-based awards;the assumed award forfeiture rate; the accounting policies adopted concerningthe method of recognizing the fair value of awards over the requisite serviceperiod; and the transition method (as described below) chosen for adopting SFAS123R.

 

15

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SFAS 123R will be effective for Focus’ fiscal quarter beginning January 1,2006, and requires the use of the Modified Prospective Application Method.Under this method, SFAS 123R is applied to new awards and to awards modified,repurchased, or cancelled after the effective date. Additionally, compensationcost for the portion of awards for which the requisite service has not beenrendered (such as unvested options) that is outstanding as of the date ofadoption shall be recognized as the remaining requisite services are rendered.The compensation cost relating to unvested awards at the date of adoption shallbe based on the grant-date fair value of those awards as calculated for proforma disclosures under the original SFAS No. 123. In addition, companiesmay use the Modified Retrospective Application Method. This method may beapplied to all prior years for which the original SFAS No. 123 waseffective or only to prior interim periods in the year of initial adoption. Ifthe Modified Retrospective Application Method is applied, financial statementsfor prior periods shall be adjusted to give effect to the fair-value-basedmethod of accounting for awards on a consistent basis with the pro formadisclosures required for those periods under the original SFAS No. 123.

 

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#### **Item  2. Management’s Discussion andAnalysis of Financial Condition and Results of Operations**

 

The following information should be read inconjunction with the condensed consolidated financial statements and notesthereto in Part I, Item 1 of this Quarterly Report and with Management’sDiscussion and Analysis of Financial Condition and Results of Operationscontained in Focus’ Annual Report on Form 10-K/A for the year ended December 31,2004.

 

**CertainFactors That May Affect Future Results**

** **

Discussions of certain matters inthis Quarterly Report on Form 10-Q may constitute forward-lookingstatements within the meaning of the Section 27A of the Securities Act of1933, as amended, and Section 21E of the Securities and Exchange Act of1934, as amended (the “Exchange Act”), and as such, may involve risks anduncertainties.  Forward-lookingstatements, which are based on certain assumptions and describe future plans,strategies, and expectations, are generally identifiable by the use of words orphrases such as “believe”, “plan”, “expect”, “intend”, “anticipate”, “estimate”,“project”, “forecast”, “may increase”, “may fluctuate”, “may improve” andsimilar expressions or future or conditional verbs such as “will”, “should”, “would”,and “could”.

 

In particular, statements contained in thisdocument that are not historical facts (including, but not limited to,statements concerning anticipated revenues, anticipated operating expenselevels, 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, the unpredictability of costs to develop newtechnologies, as well as the accuracy of our internal estimates of revenue andoperating expense levels.  For adiscussion of these factors and some of the factors that might cause such adifference see also “ - Risks Factors.” These factors should be considered in evaluating the forward-lookingstatements, and undue reliance should not be placed on such statements. We donot undertake, and specifically disclaims any obligation, to update anyforward-looking statements to reflect occurrences or unanticipated events orcircumstances after the date of such statements.

 

**RESULTS OF OPERATIONS**

 

#### **Net revenue**

 
| ** **                 | ** ** | **Three Months Ended**  | ** ** | ** **              | ** ** | ** **                | ** ** |
|----------------------------|------------|-------------------------|------------|-------------------------|------------|---------------------------|------------|
| **(Dollars in thousands)** | ** ** | **March 31, 2005** | ** ** | **March 31, 2004** | ** ** | **Increase / (decrease)** | ** ** | **% increase / (decrease)** | ** ** |
|                       |       |                    |       |                    |       |                      |       |   |   |
| System products            |       | $                       | 4,964      |                    | $          | 2,847                     |       | $ | 2,117 |   | 74.4 | % |
| Semiconductor products     |       | 491                     |       | 1,247                   |       | (756                      | )          | -60.6 | % |
|                       |       |                    |       |                    |       |                      |       |   |   |
|                       |       | $                       | 5,455      |                    | $          | 4,094                     |       | $ | 1,361 |   | 33.2 | % |

 

Revenue for the three monthsended March 31, 2005 was $5.5 million, an increase of $1.4 million, or 33percent, compared with the three months ended March 31, 2004.  The increase in revenue from sales of systemsproducts was partially offset by a decrease in revenue from sales of oursemiconductor products.

 

For the three months ended March 31,2005, net sales of system products to distributors, retailers and Value AddedResellers, were approximately $5.0 million compared to $2.8 million for thesame period in 2004, an increase of $2.2 million. This increase in sales of oursystems products mainly reflects sales of products of approximately $2.5million resulting from the acquisitions of COMO Computer & Motion GmbH(“COMO”) in February 2004 and Visual Circuits

 

17

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Corporation (“Visual Circuits”)in May 2004, as well as the introduction of a new variation of FireStore –the FS-4, partially offset by a decrease in sales of our consumer scanconversion and home theater products. Our consumer scan conversion productsales have decreased as an increasing number of personal computers andtelevisions now incorporate scan conversion technology.

 

Sales of semiconductor productsto distributors and OEM customers were approximately $491,000 in the threemonths ended March 31, 2005, compared to $1.2 million for the same periodin 2004, a decrease of $756,000. This decrease mainly reflects reduced sales ofour FS454 chip, which was included in Microsoft’s Xbox, in the three monthsended March 31, 2004. In January 2004, Microsoft ceased placingorders for our FS454 product. Shipments of the FS454, which were primarily tothis significant customer, represented $1.0 million, or 25%, of our totalrevenues for the three months ended March 31, 2004.

 

As of March 31, 2005, wehad a sales order backlog of approximately $1.9 million, an increase of$441,000 when compared to the fourth quarter of 2004.

 

Sales to one customer accounted for 15% of our total revenue in thethree months ended March 31, 2005. Three customers had sales in excess inof 10% of our revenue in the three months ended March 31, 2004. Theaggregate sales to these three customers accounted for 47% of our total revenuein 2004.

 

#### **Gross margin**

 
| ** **                 | ** ** | **Three Months Ended**  | ** ** | ** **              | ** ** |
|----------------------------|------------|-------------------------|------------|-------------------------|------------|
| **(Dollars in thousands)** | ** ** | **March 31, 2005** | ** ** | **March 31, 2004** | ** ** | **Increase** | ** ** |
|                       |       |                    |       |                    |       |   |   |
| Gross margin               |       | $                       | 1,755      |                    | $          | 1,314 |   | $ | 441 |   |
|                       |       |                    |       |                    |       |   |   |
| Gross margin rate          |       | 32.2                    | %          | 32.1                    | %          | 0.1 | % |
|                            |            |                         |            |                         |            |  |  |  |  |  |

 

Our gross margin rate for the three months ended March 31, 2005increased slightly to 32.2% from 32.1% for the three months ended March 31,2004, an increase of 0.1 of a percentage point. This increase in the grossmargin rate reflects the below average gross margin business that we conductedwith Microsoft in the three months ended March 31, 2004, which did notoccur in the three months ended March 31, 2005, partially offset byinventory obsolescence charges of approximately $134,000 in the three monthsended March 31, 2005. Sales to Microsoft were made at a gross profitmargin percentage of less than 30%, primarily as a result of volume discountsprovided.

 

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**Operating expenses**

 
| ** **                        | ** ** | **Three Months Ended**  | ** ** | ** **              | ** ** | ** **                | ** ** |
|-----------------------------------|------------|-------------------------|------------|-------------------------|------------|---------------------------|------------|
| ** **                        | ** ** | **March 31, 2005** | ** ** | **March 31, 2004** | ** ** | **Increase / (decrease)** | ** ** |
| ** **                        | ** ** | ** **              | ** ** | **% of**                | ** ** | ** **                | ** ** | **% of** | ** ** | ** ** | ** ** | **% of** | ** ** |
| **(Dollars in thousands)**        | ** ** | ** **              | ** ** | **revenue**             | ** ** | ** **                | ** ** | **revenue** | ** ** | ** ** | ** ** | **revenue** | ** ** |
|                              |       |                    |       |                    |       |                      |       |   |   |   |   |   |   |
| Sales, marketing and support      |       | $                       | 1,424      |                    | 26.1       | %                         | $          | 1,054 |   | 25.7 | % | $ | 370 |   | 0.4 | % |
| General and administrative        |       | 1,001                   |       | 18.4                    | %          | 557                       |       | 13.6 | % | 444 |   | 4.8 | % |
| Research and development          |       | 3,942                   |       | 72.3                    | %          | 1,106                     |       | 27.0 | % | 2,836 |   | 45.3 | % |
| Amortization of intangible assets |       | 149                     |       | 2.7                     | %          | 146                       |       | 3.6 | % | 3 |   | -0.9 | % |
|                              |       |                    |       |                    |       |                      |       |   |   |   |   |   |   |
|                              |       | $                       | 6,516      |                    | 119.5      | %                         | $          | 2,863 |   | 69.9 | % | $ | 3,653 |   | 49.6 | % |

 

Sales, marketing and support 

 

Sales, marketing and supportexpenses for the three months ended March 31, 2005 were $1.4 million, anincrease of $370,000 from $1.1 million in the three months ended March 31,2004.

 

This increase in sales andmarketing expense mainly reflects the inclusion of COMO sales and marketingexpenses for the entire period and an increase in sales and marketing costsassociated with the expansion of our business development group. COMO’s expenseswere only partially included in the prior year’s three-month period as the COMOacquisition occurred on February 28, 2004. An increase in commissionexpense of $109,000 and advertising expense of $72,000 also contributed to theincrease in sales and marketing expense. The increase in commission expensereflects an increase in revenue in the three months ended March 31, 2005compared to the same quarter in 2004 and the increase in advertising expensereflects recent introductions of our new mixer products and the FS-4.

 

General and administrative 

 

General and administrativeexpenses for the three months ended March 31, 2005 were $1.0 million, anincrease of $444,000 from $557,000 for the three months ended March 31,2004.

 

The increase in general andadministrative expenses was mainly due to the addition of four employees, andto a lesser extent, an increase in auditing fees of $67,000 and legal fees of$35,000.

 

Research and development 

 

Research and developmentexpenses for the three months ended March 31, 2005 were $3.9 million, anincrease of $2.8 million from $1.1 million for the three months ended March 31,2004.

 

The increase in research anddevelopment expenses mainly reflects our investment in UWB and the acquisitionof Visual Circuits in May of 2004. Our investment in UWB technologyresulted in an increase in research and development expense of $2.3 million,reflecting an increase in semiconductor design service fees of $1.7 million inthe three months ended March 31, 2005 compared to the same quarter in 2004and the hiring of an additional 29 employees. We will need significantadditional capital to continue to fund the development of this technology - seeNote 5, “Management’s Plans”. The acquisition of Visual Circuits in May 2004resulted in a headcount increase of 13 employees and contributed to a $423,000increase in research and development expense.

 

Amortization

 

Amortization expense for thethree months ended March 31, 2005 was $149,000, an increase of $3,000 from$146,000 for the three months ended March 31, 2004. The increase reflectsan increase in amortization expense associated with the intangible assets thatresulted from the acquisitions of COMO in February 2004 and VisualCircuits in May 2004, partially offset by the completion of amortizationon certain intangible assets.

 

19

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** **

**Interestexpense, net and Other income, net**

 
| ** **                 | ** ** | **Three Months Ended**  | ** ** | ** **              | ** ** | ** **   | ** ** |
|----------------------------|------------|-------------------------|------------|-------------------------|------------|--------------|------------|
| **(Dollars in thousands)** | ** ** | **March 31, 2005** | ** ** | **March 31, 2004** | ** ** | **Decrease** | ** ** | **% Decrease** | ** ** |
|                       |       |                    |       |                    |       |         |       |   |   |
| Interest expense, net      |       | $                       | (13        | )                       | $          | (46          | )          | $ | (33 | ) | -71.7 | % |
|                       |       |                    |       |                    |       |         |       |   |   |
| Other income, net          |       | —                  |       | 6                       |       | (6           | )          | n/a |   |
|                            |            |                         |            |                         |            |              |            |  |  |  |  |  |

 

Net interest expense for thethree months ended March 31, 2005 was $13,000, compared to $46,000 in thethree months ended March 31, 2004. The decrease in net interest expensereflects the conversion of the convertible promissory notes that wereoutstanding until March 2004 into common and preferred stock, partiallyoffset by interest expense associated with our accounts receivable-based lineof credit and with the short- and long-term debt assumed with the acquisitionof COMO in February 2004.

 

20

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**LIQUIDITY ANDCAPITAL RESOURCES**

** **

The accompanying condensedconsolidated financial statements have been prepared on a going concern basis,which contemplates the realization of assets and the satisfaction ofliabilities in the normal course of business. For the three months ended March 31,2005 and the year ended December 31, 2004, we incurred net losses of $4.8million and $11.0 million, respectively, and used cash in operating activitiesof $2.3 million, and $9.4 million, respectively. These factors indicate that wemay potentially be unable to continue as a going concern.

 

The consolidated financialstatements do not include any adjustments relating to the recoverability andclassification of recorded asset amounts or the amounts and classification ofliabilities that might be necessary should we be unable to continue as a goingconcern. Our continuation as a going concern is dependent upon our ability togenerate sufficient cash flows to meet our obligations on a timely basis, toobtain additional financing as may be required, and ultimately to return toprofitability and significant positive cash flows.

 

Since inception, we havefinanced our operations primarily through the public and private sale of commonstock, proceeds from the exercise of options and warrants, short-termborrowings from private lenders, and favorable credit arrangements with vendorsand suppliers.

 

**First Quarterof Fiscal Year 2005 compared to the First Quarter of Fiscal Year 2004**

** **
| ** **                 | ** ** | **As of or for Three Months Ended** | ** ** |
|----------------------------|------------|-------------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **March 31, 2005**             | ** ** | **December 31, 2004** | ** ** |
|                       |       |                                |       |   |   |
| Cash and cash equivalents  |       | $                                   | 3,515      |   | $ | 3,380 |   |
|                       |       |                                |       |   |   |
| Working capital            |       | $                                   | 1,252      |   | $ | 5,546 |   |

 
| ** **                                | ** ** | **March 31, 2005** | ** ** | **March 31, 2004** | ** ** |
|-------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
|                                      |       |                    |       |                    |       |
| Days sales outstanding (DSO)              |       | 49.0                    |       | 36.5                    |       |
|                                      |       |                    |       |                    |       |
| Inventory turns - annualized              |       | 3.6                     |       | 3.5                     |       |
|                                      |       |                    |       |                    |       |
| Net cash used in operating activities     |       | $                       | (2,292     | )                       | $          | (897 | ) |
| Net cash used in investing activities     |       | $                       | (141       | )                       | $          | (212 | ) |
| Net cash provided by financing activities |       | $                       | 2,573      |                    | $          | 79 |   |

 

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Net cash used in operatingactivities

 
| ** **                                     | ** ** | **Three Months Ended,** | ** ** | ** **              | ** ** |
|------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                     | ** ** | **March 31, 2005** | ** ** | **March 31, 2004** | ** ** | **Change in** | ** ** |
| ** **                                     | ** ** | **cash (used),**        | ** ** | **cash (used),**        | ** ** | **cash (used),** | ** ** |
| **(In thousands)**                             | ** ** | **provided**            | ** ** | **provided**            | ** ** | **provided** | ** ** |
|                                           |       |                    |       |                    |       |   |   |
| Net loss                                       |       | $                       | (4,778     | )                       | $          | (1,589 | ) | $ | (3,189 | ) |
| Non-cash income statement items                |       | 359                     |       | 189                     |       | 170 |   |
| Decrease in accounts receivable                |       | 262                     |       | 903                     |       | (641 | ) |
| Decrease (increase) in inventories             |       | (184                    | )          | 555                     |       | (739 | ) |
| Increase in prepaid expenses and other  assets |       | (49                     | )          | (124                    | )          | 75 |   |
| Increase (decrease) in accounts payable        |       | 1,567                   |       | (695                    | )          | 2,262 |   |
| Increase (decrease) in accrued liabilities     |       | 531                     |       | (136                    | )          | 667 |   |
|                                           |       |                    |       |                    |       |   |   |
|                                           |       | $                       | (2,292     | )                       | $          | (897 | ) | $ | (1,395 | ) |

 

Net cash used in operatingactivities for the three months ended March 31, 2005 and 2004 was $2.3million and $897,000, respectively. The increase in net cash used in operatingactivities mainly reflects an increase in the net loss, partially offset by anincrease in cash provided from accounts payable and accrued liabilities. Theincrease in cash provided by accounts payable and accrued liabilities reflectstiming of payments and research and development expenses related to ourinvestment in UWB technology.

 

Two customers had accountsreceivable balances in excess of 10% of our total accounts receivable at March 31,2005 and those customers accounted for 25% of our total accounts receivable atthat date.

 

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

 

Net cash used in investingactivities

 

Net cash used in investingactivities was $141,000 for the three months ended March 31, 2005,compared to $212,000 used in the three months ended March 31, 2004. Thedecrease in cash used in investing activities mainly reflects a decrease in ourrestricted cash balance at COMO (see Note 9, “Borrowings”) and fees paid in thethree months ended March 31, 2004 related to the acquisition of VisualCircuits in May 2004, partially offset by an increase in purchases ofequipment and design tools related to our investment in UWB technology.

 

Net cash provided by financingactivities

 

Net cash provided by financingactivities was $2.6 million for the three months ended March 31, 2005,compared to $79,000 for the three months ended March 31, 2004. Theincrease mainly reflected borrowings of $2.5 million under our accountsreceivable-based line of credit, proceeds of $191,000 from the sale of escrowshares (see Note 11, “Stockholders’ Equity”) and the reimbursement ofacquisition fees by Visual Circuits Corporation Liquidating Trust related tothe acquisition of Visual Circuits, partially offset by repayments of $311,000related to our German subsidiary’s line of credit balance.

 

**CapitalResources and Liquidity Outlook**

** **

We have incurred losses andused net cash in operating activities for the three months ended March 31,2005 and each of the two years in the period ended December 31, 2004, andas such, have been dependent upon raising money for short- and long-term cashneeds through debt, proceeds from the exercise of options and warrants, and thesale of our common stock in private placements. For the year ended December 31,2004, we received approximately $10.7 million in proceeds from the sale ofapproximately 10.5 million shares our common stock in private placementtransactions.

 

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In November 2004 weobtained a $4.0 million credit line under which we can borrow up to 90% of oureligible 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 March 31, 2005, there was an outstanding balance of $2.5million on this credit line and we had the ability to borrow an additional$95,000.

 

At March 31, 2005, ourGerman subsidiary–COMO–had outstanding debt obligations that consisted of notespayable of $205,000 and borrowings under a line of credit of $230,000, both ofwhich are denominated in Euros and were assumed in connection with theacquisition of COMO – see Note 9, “Borrowings”. Although the notes payable arescheduled to be repaid through 2011, the bank reviews COMO’s financial resultsin connection with these notes and reserves the right to call these notes dueat its discretion.

 

In addition to regularly reviewing our cost structure, we have recentlyannounced new product introductions and are continually reviewing our productlines to identify how to enhance existing, or create new, distributionchannels. There can be no assurances as to the amount of revenue these newproducts will produce.

 

We anticipate that we will need to obtain additional financing and/orfind a partner to fund operations before the end of the second quarter of 2005in order to meet all currently planned expenditures and cash requirementsthrough the first customer sampling of our UWB chips. Such financing termscould include debt and/or equity instruments. Our first chip is currentlyexpected to be available for sampling by August 31, 2005, and the secondof our chips is anticipated for sampling in the fourth quarter of 2005.Depending upon the results of this sampling program, the profitability of oursystems business, and our efforts to partner with another entity to market thechips commercially, we may need to raise further capital for the widespread commercialdeployment of UWB.

 

While we have been successful in the past in raising sufficient capitalto fund our operations, there can be no assurance that we will obtainsufficient financing in the future on acceptable terms to continue operations,or if we do obtain such funding, that we can do so without unduly diluting theequity interests of our current stockholders.

 

Summary ofCertain Contractual Obligations as of March 31, 2005

 
| **(In thousands)**                | ** ** | **< 1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **> 5 years** | ** ** | **Total** | ** ** |
|-----------------------------------|------------|-----------------|------------|---------------|------------|---------------|------------|------------------|------------|-----------|------------|
|                              |       |            |       |          |       |          |       |             |       |      |       |
| Operating leases                  |       | $               | 503        |          | $          | 974           |       | $                | 330        |      | $          | — |   | $ | 1,807 |   |
| Inventory purchase commitments    |       | 1,879           |       | —        |       | —        |       | —           |       | 1,879     |       |
| Notes payable                     |       | 52              |       | 55            |       | 55            |       | 43               |       | 205       |       |
| Interest expense on notes payable |       | 8               |       | 9             |       | 5             |       | 2                |       | 24        |       |
| Lines of credit                   |       | 2,723           |       | —        |       | —        |       | —           |       | 2,723     |       |
|                              |       |            |       |          |       |          |       |             |       |      |       |
|                              |       | $               | 5,165      |          | $          | 1,038         |       | $                | 390        |      | $          | 45 |   | $ | 6,638 |   |

 

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**RISK FACTORS**

** **

You should carefully consider the following risks relating to ourbusiness and our common stock, together with the other information describedelsewhere in this prospectus. If any of the following risks actually occur, ourbusiness, results of operations and financial condition could be materiallyaffected, the trading price of our common stock could decline, and you mightlose all or part of your investment.

 

**Risks Related to Our Business**

 

**We have a long history of operating losses.**

** **

As of March 31, 2005, wehad an accumulated deficit of $78.8 million. We incurred net losses of $4.8million, $11.0 million and $1.7 million for the three months ended March 31,2005 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 will need to raise additional capital,which, if through equity securities placements, will result in further dilutionof existing and future stockholders.**

** **

Historically, we have met our short- and long-term extra cash needsthrough debt and the sale of common stock in private placements, because cashflow from operations has been insufficient to fund our operations.

 

Future capital requirements will depend on many factors, including cashflow from operations, continued progress in research and development programs,competing technological and market developments, and our ability to market ourproducts successfully. There can be no assurance that sufficient funds will beraised. Moreover, any equity financing or convertible debt would result indilution to our existing stockholders and could have a negative effect on themarket price of our common stock. Furthermore, any additional debt financingwill result in higher interest expense.

 

We completed the acquisitionsof COMO and Visual Circuits in the first and second quarters of 2004,respectively. These acquisitions were effected through the issuance of commonstock, and the businesses associated with these acquisitions are not currentlyprofitable.

 

**Our common stock currently does not meet theminimum bid price requirement to remain listed on the Nasdaq SmallCap Market.If we were to be delisted, it could make trading in our stock more difficult.**

** **

Our voting common stock is traded on the NasdaqSmallCap Market. There are various quantitative listing requirements for acompany to remain listed on the Nasdaq SmallCap Market, including maintaining aminimum bid price of $1.00 per share of common stock and maintainingstockholders’ 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 regaincompliance with the Nasdaq SmallCap Market $1.00 minimum bid price rule. If atany time before October 31, 2005, the bid price of our common stock closesat $1.00 or more per share for a minimum of 10 consecutive business days,Nasdaq will notify us that we are in compliance with the Rules. If we do not regaincompliance within the allotted compliance period, including any extensions thatmay be granted by Nasdaq, Nasdaq will notify us that our common stock will bedelisted 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 listingrequirements of those quotation systems. As a result, an investor might find itmore difficult to trade, or to obtain accurate price quotations for, suchshares. Delisting might also reduce the visibility, liquidity, and price of ourvoting common stock.

 

**We are dependent upon a significant shareholderto meet our financing needs and there can be no assurance that this shareholderwill continue to provide financing.**

** **

We have relied upon the abilityof Carl Berg, a director and significant owner of our common stock, for interimfinancing needs. At December 31, 2003, we had an aggregate ofapproximately $4.4 million in debt and accrued interest outstanding to Mr. Berg.On March 19, 2004, Mr. Berg converted this debt and accrued interestto common and preferred stock. Additionally, Mr. Berg has provided apersonal guarantee to Samsung Semiconductor Inc., our contracted ASICmanufacturer, to secure our working capital requirements for ASIC purchaseorder fulfillment and a personal guarantee to Greater Bay Bank in connectionwith our recent $4 million accounts receivable-based line of credit. Mr. Bergmaintains a security interest in all the company’s assets, subject to the bank’slien on our accounts receivable. There can be no assurances that Mr. Bergwill continue to provide such interim financing or personal guarantees, shouldwe need additional funds or increased credit facilities with our vendors.

 

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

** **

At March 31, 2005, we had3,161 shares of preferred shares issued and outstanding, and 3.3 millionwarrants and 7.7 million options, which are all exercisable into shares ofcommon stock. The 3,161 shares of preferred stock are convertible intoapproximately 3.2 million shares of our voting common stock. Furthermore, at March 31,2005, 821,000 additional shares of common stock were available for grant to ouremployees, officers, directors and consultants under our current stock optionand incentive plans. We also may issue additional shares in acquisitions. Anyadditional grant of options under existing or future plans or issuance ofshares in connection with an acquisition will further dilute existingstockholders.

 

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**Any acquisitions of companies or technologies byus, including our acquisitions of COMO and Visual Circuits in 2004, may resultin distraction of our management and disruptions to our business.**

** **

We may acquire or make investments in complementary businesses,technologies, services or products if appropriate opportunities arise, as wasthe case in February 2004 when we acquired the stock of COMO and in May 2004when we acquired substantially all the assets of Visual Circuits. Fromtime-to-time, we may engage in discussions and negotiations with companiesregarding the possibility of acquiring or investing in their businesses,products, services or technologies. We may not be able to identify suitableacquisition or investment candidates in the future, or if we do identifysuitable candidates, we may not be able to make such acquisitions orinvestments 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. Inaddition, the accounting treatment for any acquisition transaction may resultin 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 certain vendors for a significant portionof our manufacturing.**

** **

**Approximately41% of the components for our products are manufactured on a turnkey basis bythree vendors: Furthertech Company Ltd., BTW Inc. and Samsung SemiconductorInc. In addition, a single vendor in Mexico assembles certain of our products.If these vendors experience production or shipping problems for any reason, wein turn could experience delays in the production and shipping of our products,which would have an adverse effect on our results of operations.**

** **

**We are dependent on our suppliers.**

** **

We purchase all of our partsfrom outside suppliers and from time-to-time experience delays in obtainingsome components or peripheral devices. Additionally, we are dependent on solesource suppliers for certain components. There can be no assurance that labor problems, supply shortages orproduct discontinuations will not occur in the future, which couldsignificantly increase the cost, or delay shipment, of our products, which inturn could adversely affect our results of operations.

 

**If we fail to meet certain covenants in our credit facility,we may not be able to draw down on such facility and our ability to finance ouroperations could be adversely affected*.***

*** ***

Wehave a $4.0 million credit line under which we can borrow up to 90% of oureligible outstanding accounts receivable. The various agreements in connectionwith such credit line require us to maintain certain covenants. For example, weare required to maintain certain financial covenants, including maintenance ofcertain liquidity ratios and operating results. In the event we are not able toobtain a waiver for any covenant violation, and/or remain out of compliancewith a particular covenant, we will not be able to draw down on the line ofcredit, which could have a material adverse impact on our financial conditionand results of operation.

 

Furthermore,the restrictions contained in the line of credit documents, as well as theterms of other indebtedness we may incur from time-to-time, could limit ourability to plan for or react to market conditions or meet capital needs orotherwise restrict our activities or business plans. These restrictions couldalso adversely affect our ability to finance our operations or other capitalneeds, or to engage in other business activities that would be in our interest.

 

**We depend ona few customers for a high percentage of our revenues and the loss or failureto pay of any one of these customers could result in a substantial decline inour revenues and profits.**

** **

For the three months ended March 31,2005, five customers in aggregate provided 33% of our total revenues and as of

 

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March 31, 2005 comprised40% of our accounts receivable balance. We presently have no reason to believethat these customers lack the financial resources to pay. We do not havelong-term contracts requiring any customer to purchase any minimum amount ofproducts. There can be no assurance that we will continue to receive orders ofthe same magnitude as in the past from existing customers or will be able tomarket our current or proposed products to new customers. The loss of any majorcustomer, the failure of any such identified customer to pay us, or todiscontinue issuance of additional purchase orders, would have a materialadverse effect on our revenues, results of operation, and business as a whole,absent the timely replacement of the associated revenues and profit marginsassociated with such business. Furthermore, many of our products are dependentupon the overall success of our customers’ products, over which we often haveno control.

 

**Our quarterly financial results are subject tosignificant fluctuations.**

** **

We have been unable in the pastto accurately forecast our operating expenses or revenues. Revenues currentlydepend heavily on volatile customer purchasing patterns. If actual revenues areless than projected revenues, we may be unable to reduce expensesproportionately, and our operating results, cash flows and liquidity wouldlikely 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 our markets arecharacterized by extensive research and development and rapid technologicalchange resulting in short product life cycles. Development by others of new orimproved products, processes or technologies may make our products or proposedproducts obsolete or less competitive. We must devote substantial efforts andfinancial resources to enhance our existing products and to develop newproducts, including our significant investment in UWB technology. To fund suchongoing research and development, we will require a significant influx ofadditional capital. There can be no assurance that we will succeed with theseefforts. Failure to effectively develop such products, notably our UWBtechnology, could have a material adverse effect on our financial condition andresults of operations.

 

**We may not be able to protect our proprietaryinformation.**

** **

As of March 31, 2005 weheld six patents and four pending applications, one of which combined fiveprevious 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.

 

We believe our products andother proprietary rights do not infringe upon the proprietary rights orproducts of third parties. There can be no assurance, however, that thirdparties will not assert infringement claims against us or that such assertionswill not result in costly litigation or require us to license intellectualproprietary rights from third parties. In addition, there can be no assurancethat any such licenses would be available on terms acceptable to us, if at all.

 

**Delays in product development could adverselyaffect our market position or customer relationships.**

** **

We have experienced delays inproduct development in the past and may experience similar delays in thefuture.  Given the short product lifecycles in the markets for our products, any delay or unanticipated difficultyassociated with new product introductions or product enhancements could causeus to lose customers and damage our competitive position.  Prior delays have resulted from numerousfactors, 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;

 

26

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•      unanticipatedengineering complexity;

•      undetectederrors or failures in software and hardware; and

•      delaysin the acceptance or shipment of products by customers.

 

The development of new, technologicallyadvanced products, including our significant investment in UWB, is a complexand uncertain process requiring high levels of innovation and highly skilledengineering and development personnel, as well as the accurate anticipation oftechnological and market trends. In order to compete, we must be able todeliver products to customers that are highly reliable, operate with thecustomer’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 are unable to respond to rapidtechnological change in a timely manner, then we may lose customers to ourcompetitors.**

** **

To remain competitive, we mustcontinue to enhance and improve the responsiveness, functionality and featuresof our products.  Our industry ischaracterized by rapid technological change, changes in user and customerrequirements and preferences and frequent new product and serviceintroductions. If competitors introduce products and services embodying newtechnologies, or if new industry standards and practices emerge, then ourexisting proprietary technology and systems may become obsolete.  Our future success will depend on our abilityto do the following:

 

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

•        enhanceour existing technologies;

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

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

 

To develop our proprietarytechnology entails significant technical and business risks. We may use newtechnologies ineffectively, or we may fail to adapt our proprietary technology andtransaction processing systems to customer requirements or emerging industrystandards. If we face material delays in introducing new services, products andenhancements, then our customers may forego the use of our services and usethose of our competitors.

 

**We typicallyoperate without a significant amount of backlog, which could have an adverseimpact on our operating results**.

 

We typically operate with asmall amount of backlog. Accordingly, we generally do not have a materialbacklog of unfilled orders, and revenues in any quarter are substantiallydependent on orders booked in that quarter. Any significant weakening incurrent customer demand would therefore have, and has had in the past, analmost immediate adverse impact on our operating results.

 

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**Our commonstock price is volatile.**

 

The market price for our voting common stock isvolatile and has fluctuated significantly to date. For example, between January 1,2004 and March 31, 2005, the per share price has fluctuated between $0.85and $2.87 per share, closing at $0.77 on May 12, 2005. The trading priceof our voting common stock is likely to continue to be highly volatile andsubject to wide fluctuations in response to factors including 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, the securities markets have experiencedextreme price and volume fluctuations in recent times, and the market prices ofthe securities of technology companies have been especially volatile. Thesebroad market and industry factors may adversely affect the market price ofcommon stock, regardless of actual operating performance. In the past,following periods of volatility in the market price of stock, many companieshave been the object of securities class action litigation, including us. If weare sued in a securities class action, then it could result in additionalsubstantial costs and a diversion of management’s attention and resources.

 

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

** **

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

 

We are in the process of evaluating the impact of thisdirective on our business and have not yet estimated the potential costs ofcompliance.

 

**Risks Related to Our Industry**

 

**International sales are subject tosignificant risk.**

** **

Our revenues from outside theUnited States are subject to inherent risks related thereto, including currencyrate fluctuations, the general economic and political conditions in eachcountry. There can be no assurance that an economic or currency crisisexperienced in certain parts of the world will not reduce demand for ourproducts and therefore have a

 

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material adverse effect on ourrevenue or operating results.

 

**Our businesses are very competitive.**

** **

The computer peripheral markets are extremelycompetitive and are characterized by significant price erosion over the life ofa product. We currently compete with other developers of video conversionproducts and with video-graphic integrated circuit developers. Many of ourcompetitors have greater market recognition and greater financial, technical,marketing and human resources. Although we are not currently aware of anyannouncements by our competitors that would have a material impact on ouroperations, there can be no assurance that we will be able to competesuccessfully against existing companies or new entrants to the marketplace.

 

The video production equipment market is highlycompetitive and is characterized by rapid technological change, new productdevelopment and obsolescence, evolving industry standards and significant priceerosion over the life of a product. Competition is fragmented with severalhundred manufacturers supplying a variety of products to this market. Weanticipate increased competition in the video post-production equipment market fromboth existing manufacturers and new market entrants. Increased competitioncould result in price reductions, reduced margins and loss of market share, anyof which could materially and adversely affect our business, financialcondition and results of operations. There can be no assurance that we will beable to compete successfully against current and future competitors in thismarket.

 

Often our competitors havegreater financial, technical, marketing, sales and customer support resources,greater name recognition and larger installed customer bases than we possess.In addition, some of our competitors also offer a wide variety of videoequipment, including professional video tape recorders, video cameras and otherrelated equipment. In some cases, these competitors may have a competitiveadvantage based upon their ability to bundle their equipment in certain largesystem sales.

 

**We are exposed to general economic conditionsthat have resulted in significantly reduced sales levels.  If we experience adverse economic conditionsour business, financial condition and operating results could be adverselyimpacted.**

** **

If we experience adverseeconomic conditions in the United States and throughout the world, we maycontinue to experience a material adverse impact on our business, operatingresults, and financial condition. We have taken actions and charges to reduceour cost of sales and operating expenses in order to address adverse economicconditions. A prolonged continuation or worsening of sales trends may requireadditional actions and charges to reduce cost of sales and operating expensesin subsequent quarters. We may be unable to reduce cost of sales and operatingexpenses at a rate and to a level consistent with such a future adverse salesenvironment. If we must undertake further expense reductions, we may incursignificant incremental special charges associated with such expense reductionsthat are disproportionate to sales, thereby adversely affecting our business,financial condition and operating results. Adverse economic conditions coulddecrease demand for our products, increase delinquencies in payments andotherwise have an adverse impact on our business.

 

**Recent corporate bankruptcies, accountingirregularities, and alleged insider wrong doings have negatively affectedgeneral confidence in the stock markets and the economy, causing the UnitedStates Congress to enact sweeping legislation, which will increase the costs ofcompliance.**

** **

In an effort to address growinginvestor concerns, the United States Congress passed, and on July 30,2002, President Bush signed into law, the Sarbanes-Oxley Act of 2002. Thissweeping legislation primarily impacts investors, the public accountingprofession, public companies, including corporate duties and responsibilities,and securities analysts. Some highlights include establishment of a newindependent oversight board for public accounting firms, enhanced disclosureand internal control requirements for public companies and their insiders,required certification by CEO’s and CFO’s of Securities and Exchange Commission(“SEC”) 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.

 

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**We are exposed to potential risks from legislation requiring companiesto evaluate financial controls under Section 404 of the Sarbanes-Oxley Actof 2002.**

** **

Section 404 of theSarbanes-Oxley Act of 2002 requires that we evaluate and report on our systemof internal controls. We will be required to meet the requirements of theSarbanes-Oxley Act by December 31, 2005 if we are deemed to be anaccelerated filer on June 30, 2005, otherwise we must meet therequirements by December 31, 2006. We have prepared an internal plan ofaction for compliance with the requirements of Section 404, which includesa timeline and scheduled activities. Compliance with the requirements of Section 404is expected to be expensive and time-consuming. If we fail to complete thisevaluation in a timely manner, or if our independent registered publicaccounting firm cannot timely attest to our evaluation, we could be subject toregulatory scrutiny and a loss of public confidence in our internal controls.In addition, any failure to implement required new or improved controls, ordifficulties encountered in their implementation, could harm our operatingresults or cause us to fail to meet our reporting obligations.

 

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** **

**Item 3. Quantitative and QualitativeDisclosures about Market Risk**

 

**InterestRate Risk**

 

At March 31, 2005, we did not hold any short-term investments thatwould be exposed to market risk from adverse movements in interest rates.

 

At March 31, 2005, our outstanding debt obligations consisted of notes payable of $205,000 and borrowings under lines of credit of $2.7 million – see Note 9, “Borrowings”. The average interest rate applicable to these debt obligations is 7.0% 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 $7,000 on a quarterly basis.

 

**ForeignCurrency Risk**

 

Gains or losses related to foreign exchange currency transactions werenot material for the periods ended March 31, 2005 and March 31, 2004.

 

**Item 4. Controls and Procedures**

** **

Management of the Company, with the participation of the President andChief Executive Officer and the Chief Financial Officer (its principalexecutive officer and principal financial officer, respectively), evaluatedFocus’ disclosure controls and procedures as of the end of the period coveredby this Report.

 

Based on that evaluation, the President and Chief Executive Officer andthe Chief Financial Officer have concluded that, as of the end of the periodcovered by this Report, Focus’ disclosure controls and procedures are effectiveto ensure that information required to be disclosed by Focus in the reportsfiled or submitted by it under the Securities Exchange Act of 1934, as amended,is recorded, processed, summarized and reported within the time periods specifiedin the SEC’s rules and forms, and include controls and procedures designedto ensure that information required to be disclosed by Focus in such reports isaccumulated and communicated to Focus’ management, including the President andChief Executive Officer and the Chief Financial Officer of Focus, asappropriate to allow timely decisions regarding required disclosure.

 

There was no change in Focus’internal control over financial reporting that occurred during Focus’ firstfiscal quarter of 2005 that has materially affected, or is reasonably likely tomaterially affect, Focus’ internal control over financial reporting.

 

Focus will be required toevaluate its internal controls over financial reporting in order to comply withthe requirements of the Sarbanes-Oxley Act of 2002 and expects to incursignificant costs in meeting these requirements. We estimate the external costsinvolved in meeting these requirements to be approximately $650,000. Focus isrequired to meet the requirements of the Sarbanes-Oxley Act by December 31,2005 if it is deemed to be an accelerated filer based on market capitalizationon June 30, 2005, otherwise the requirements must be met by December 31,2006.

 

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**PART II - OTHER INFORMATION**

** **

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

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

 

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

(a) to(e)         None.

 

**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) Certificationof CEO

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

 

 
| May 16, 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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