Telanetix,Inc - FORM 10-Q - November 10, 2011

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EX-10.3 - Telanetix,Inc	ex10-3.htm
EX-32.1 - Telanetix,Inc	ex32-1.htm
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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

x	Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2011

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 000-51995

TELANETIX, INC.

(Exact name of registrant as specified in its charter)

Delaware		77-0622733
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

11201 SE 8th Street, Suite 200 Bellevue, Washington		98004
(Address of principal executive offices)		(Zip Code)

(206) 621-3500

(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer", "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o

Accelerated filer o

Non-accelerated filer o

Smaller reporting company x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o Nox

As of November 9, 2011, 4,820,098 shares (post reverse stock split) of the issuer's common stock, par value $0.0001 per share, were outstanding. The common stock is the issuer's only class of stock currently outstanding.

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Telanetix, Inc.

Quarterly Report on Form 10-Q

For the Three Months Ended September 30, 2011

TABLE OF CONTENTS

		Page

EXPLANATORY NOTE		3

FORWARD LOOKING STATEMENTS		3

PART I - FINANCIAL INFORMATION

Item 1.	FINANCIAL STATEMENTS	4
Item 2.	MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	20
Item 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	30
Item 4.	CONTROLS AND PROCEDURES	30

PART II - OTHER INFORMATION

Item 1.	LEGAL PROCEEDINGS	31
Item 1A.	RISK FACTORS	31
Item 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	42
Item 3.	DEFAULTS UPON SENIOR SECURITIES	42
Item 4.	(REMOVED AND RESERVED)	42
Item 5.	OTHER INFORMATION	42
Item 6.	EXHIBITS	42

SIGNATURES		43
EXHIBIT INDEX		44

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EXPLANATORY NOTE

In this report, unless the context indicates otherwise, the terms "Telanetix," "Company," "we," "us," and "our" refer to Telanetix, Inc., a Delaware corporation, and its wholly-owned subsidiaries.

On June 1, 2011, the Company effected a 1 to 75 reverse stock split of its authorized common stock and preferred stock. The number of shares outstanding has been adjusted retrospectively to reflect the reverse stock split in all periods presented. Also, the exercise price and the number of common shares issuable under the Company’s share-based compensation plans and the authorized and issued share capital have been adjusted retrospectively to reflect the reverse stock split.

FORWARD LOOKING STATEMENTS

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, or the "Securities Act," and Section 21E of the Securities Exchange Act of 1934 or the "Exchange Act." In some cases, you can identify forward looking statements by terms such as "may," "intend," "might," "will," "should," "could," "would," "expect," "believe," "anticipate," "estimate," "predict," "potential," or the negative of these terms. These terms and similar expressions are intended to identify forward-looking statements. Such statements are subject to certain risks and uncertainties, which could cause actual results to differ materially from those projected, including those set forth under the heading "Risk Factors" and elsewhere in, or incorporated by reference into, this report.

The forward-looking statements in this report are based upon management's current expectations, which management believes are reasonable. We cannot assess the impact of each factor on our business or the extent to which any factor or combination of factors, or factors we are unaware of, may cause actual results to differ materially from those contained in any forward-looking statements. You are cautioned not to place undue reliance on any forward-looking statements. These statements represent our estimates and assumptions only as of the date of this Quarterly Report on Form 10-Q. Except to the extent required by federal securities laws, we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

You should be aware that our actual results could differ materially from those contained in the forward-looking statements due to a number of factors, including:

·	new competitors and new technologies may further increase competition;

·	our operating costs may increase beyond our current expectations and we may be unable to fully implement our current business plan;

·	our ability to obtain future financing or funds when needed;

·	our ability to successfully obtain a diverse customer base;

·	our ability to protect our intellectual property through patents, trademarks, copyrights and confidentiality agreements;

·	our ability to attract and retain a qualified employee base;

·	our ability to respond to new developments in technology and new applications of existing technology before our competitors;

·	acquisitions, business combinations, strategic partnerships, divestures, and other significant transactions may involve additional uncertainties; and

·	our ability to maintain and execute a successful business strategy.

You should consider carefully the statements under "Item 1A. Risk Factors" in Part II of this report and other sections of this report, which address factors that could cause our actual results to differ from those set forth in the forward-looking statements and could materially and adversely affect our business, operating results and financial condition. All subsequent written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the applicable cautionary statements.

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PART I--FINANCIAL INFORMATION

Item 1. FINANCIAL STATEMENTS

TELANETIX, INC.

Condensed Consolidated Balance Sheets

	September 30, 2011			December 31, 2010
	(Unaudited)
ASSETS
Current assets
Cash	$	1,707,254		$	2,330,111
Accounts receivable, net		1,930,198			1,590,022
Inventory		133,454			182,924
Prepaid expenses and other current assets		363,215			530,548
Total current assets		4,134,121			4,633,605
Property and equipment, net		2,155,836			2,641,731
Goodwill		7,044,864			7,044,864
Purchased intangibles, net		9,528,337			11,178,337
Other assets		446,073			583,632
Total assets	$	23,309,231		$	26,082,169

LIABILITIES AND STOCKHOLDERS' DEFICIT
Current liabilities
Accounts payable	$	1,716,510		$	1,609,488
Accrued liabilities		2,517,304			2,326,465
Deferred revenue		1,059,696			1,016,021
Income tax payable		33,408			225,000
Current portion of capital lease obligations		333,214			404,710
Current portion of long-term debt		2,951,106			1,200,000
Total current liabilities		8,611,238			6,781,684
Non-current liabilities
Deferred revenue, net of current portion		193,224			253,798
Capital lease obligations, net of current portion		264,829			116,251
Long-term, accounts payable		47,748			—
Long-term debt, net of current portion		4,939,806			5,291,539
Total non-current liabilities		5,445,607			5,661,588
Total liabilities		14,056,845			12,443,272
Stockholders' equity (deficit)
Common stock, $.0001 par value; Authorized: 8,000,000 shares; Issued and outstanding: 4,820,098 and 4,594,262 at September, 2011 and December 31, 2010, respectively (1)		482			34,457
Additional paid in capital		43,982,973			43,569,588
Warrants		56,953			56,953
Accumulated deficit		(34,788,022	)		(30,022,101	)
Total stockholders' equity		9,252,386			13,638,897
Total liabilities and stockholders' equity	$	23,309,231		$	26,082,169

--------------------------------

(1) Prior year disclosures adjusted for the impact of the 1 for 75 reverse stock split as discussed in Note 2.

The accompanying notes are an integral part of these condensed consolidated financial statements.

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TELANETIX, INC.

Condensed Consolidated Statements of Operations

(Unaudited)

	Three months ended September 30,						Nine months ended September 30,
	2011			2010			2011			2010

Revenues	$	7,254,405		$	6,873,268		$	21,183,708		$	21,819,576

Cost of revenues		3,003,187			3,070,391			8,865,016			9,266,342

Gross profit		4,251,218			3,802,877			12,318,692			12,553,234

Operating expenses
Selling and marketing		1,749,676			1,838,702			5,225,081			5,221,806
General and administrative		2,088,608			1,957,668			5,828,805			5,810,206
Research, development and engineering		480,090			636,800			1,423,226			2,070,512
Depreciation		160,227			153,152			472,111			443,704
Amortization of purchased intangibles		550,000			550,000			1,650,000			1,650,000
Total operating expenses		5,028,601			5,136,322			14,599,223			15,196,228

Operating loss		(777,383	)		(1,333,445	)		(2,280,531	)		(2,642,994	)

Other income (expense)
Interest income		17			260			214			523
Interest expense		(721,676	)		(895,908	)		(2,485,604	)		(2,472,069	)
Gain/(Loss) on debt extinguishment		—			16,510,854			—			16,510,854
Change in fair market value of derivative liabilities		—			—			—			790,648
Total other income (expense)		(721,659	)		15,615,206			(2,485,390	)		14,829,956

Income (loss) from continuing operations before taxes		(1,499,042	)		14,281,761			(4,765,921	)		12,186,962

Income tax expense		—			(37,500	)		—			(37,500	)

Income (loss) from continuing operations		(1,499,042	)		14,244,261			(4,765,921	)		12,149,462

Loss from discontinued operations		—			—			—			(269,733	)

Net income (loss)	$	(1,499,042	)	$	14,244,261		$	(4,765,921	)	$	11,879,729

Net income (loss) per share – basic and diluted
Continuing operations	$	(0.31	)	$	3.71		$	(1.01	)	$	7.74
Discontinued operations		—			—			—			(0.17	)
Net income (loss) per share(1)	$	(0.31	)	$	3.71		$	(1.01	)	$	7.57

Weighted average shares outstanding – basic and diluted(1)		4,820,098			3,835,833			4,723,311			1,569,350

(1) Prior year disclosures adjusted for the impact of the 1 for 75 reverse stock split as discussed in Note 2.

The accompanying notes are an integral part of these condensed consolidated financial statements.

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TELANETIX, INC.

Condensed Consolidated Statements of Cash Flows

(Unaudited)

	Nine Months Ended September 30,
	2011			2010
Cash flows from operating activities:
Net loss	$	(4,765,921	)	$	11,879,729
Adjustments to reconcile net loss to cash provided by operating activities:
Provision for doubtful accounts		(44,480	)		(111,168	)
Depreciation		1,356,913			1,328,830
Gain on debt extinguishment		—			(16,510,854	)
Loss from discontinued operations		—			269,733
(Gain) loss on disposal of fixed assets		(5,273	)		165,570
Amortization of deferred financing costs		154,941			66,823
Amortization of intangible assets		1,650,000			1,650,000
Stock based compensation		379,410			974,773
Amortization of note discounts		1,490,981			1,888,228
Non-cash interest expense		508,392			211,403
Change in fair value of derivative liabilities		—			(790,648	)
Changes in assets and liabilities:
Accounts receivable		(295,696	)		280,093
Inventory		49,470			70,744
Prepaid expenses and other assets		149,951			(71,862	)
Accounts payable and accrued expenses		154,016			(173,442	)
Accrued interest		—			218,930
Deferred revenue		(16,899	)		115,511
Net cash provided by operating activities		765,805			1,462,393

Cash flows from investing activities:
Purchase of property and equipment		(372,403	)		(586,259	)
Proceeds from disposal of fixed assets		8,693			26,503
Net cash used by investing activities		(363,710	)		(559,756	)

Cash flows from financing activities:
Payments on capital leases		(424,952	)		(588,825	)
Proceeds from senior secured financing		—			10,500,000
Payments on senior secured financing		(600,000	)
Payments on convertible debenture		—			(7,500,000	)
Payments of financing fees		—			(1,408,510	)
Net cash (used)/provided by financing activities		(1,024,952	)		1,002,665

Cash flows from discontinued operations:
Net cash used by operating activities of discontinued operations		—			(126,235	)
Net used by discontinued operations		—			(126,235	)

Net increase/(decrease) in cash		(622,857	)		1,779,067
Cash at beginning of the period		2,330,111			493,413
Cash at end of the period	$	1,707,254		$	2,272,480

Supplemental disclosures of cash flow information:
Interest paid	$	331,291		$	86,246

Non-cash investing and financing activities:
Property and equipment acquired through capital leases	$	502,034		$	169,517
Bonuses paid in stock	$	—		$	490,678

The accompanying notes are an integral part of these condensed consolidated financial statements.

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TELANETIX, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Description of Business

The Company is an IP communications company. Through its AccessLine-branded VoIP Services, the Company provides customers with a range of business phone services and applications. At the core of these business phone services are proprietary software components, all of which are developed internally and loaded on standard commercial grade servers. AccessLine phone services can be delivered with a variety of hosted features configured to meet the application needs of the customer. By delivering business phone service to the market in this manner, the Company's VoIP Services offer flexibility to customers and can serve a variety of business sizes.

AccessLine offers the following hosted VoIP Services: Digital Phone System (DPS), SIP Trunking Service and individual phone services. DPS replaces a customer's existing telephone lines with a VoIP alternative. It is sold as a complete solution where the Company bundles software applications and hosted network services with business-class phone equipment that is manufactured by third parties. This service is targeted at small to medium sized businesses looking for a fully integrated solution that does not require expert assistance to install; the customer has the ability to select the number of locations, number of phone stations (up to 100), number of phone lines, and types of phones and phone numbers.

SIP Trunking Service is for larger businesses that already have their own PBX equipment and is targeted at those businesses with large calling volumes looking for cost effective alternatives to traditional carrier offerings. SIP Trunking Service does not include user equipment such as business phones, and can support businesses with hundreds of employees.

As part of its individual phone service product offerings, AccessLine offers a variety of other phone services, including, conferencing calling services, toll-free services, an automated attendant service with afterhours answering that routes calls based on specific business needs, find-me and follow-me services, a full featured voice mail system that contacts a customer via an email or cell phone text message the moment such customer receives a new voice mail or fax, and the ability to manage faxes online.

The Company's revenues principally consist of: monthly recurring fees, activation, and usage fees from the communication services and solutions outlined above. Some revenue is generated by one-time equipment charges associated with the Company’s DPS solution.

2. Basis of Presentation

The accompanying unaudited financial statements, consisting of the consolidated balance sheet as of September 30, 2011, the consolidated statements of operations for the three and nine months ended September 30, 2011 and 2010, and the consolidated statements of cash flows for the nine months ended September 30, 2011 and 2010, have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and in accordance with the instructions to Form 10-Q. Accordingly, these condensed consolidated financial statements do not include all of the information and footnotes typically found in the audited consolidated financial statements and footnotes thereto included in the Company's Annual Report on Form 10-K. In the opinion of management, all adjustments (primarily consisting of normal recurring adjustments) considered necessary for a fair statement have been included. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2010.

The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities and equity and disclosure of contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates include those related to the allowance for doubtful accounts; valuation of inventories; valuation of goodwill, intangible assets and property and equipment; valuation of stock based compensation expense; the valuation of conversion features; and other contingencies. Management evaluates these estimates on an on-going basis. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates under different assumptions or conditions. Operating results for the three and nine months ended September 30, 2011, are not necessarily indicative of the results that may be expected for the full fiscal year ending December 31, 2011.

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On June 1, 2011, the Company effected a 1 for 75 reverse stock split of its authorized common stock and preferred stock. As a result, the number of shares of common stock outstanding has been adjusted retrospectively to reflect the reverse stock split in all periods presented. Also, the exercise price and the number of common shares issuable under the Company’s share-based compensation plans and the authorized and issued share capital have been adjusted retrospectively to reflect the reverse stock split.

Liquidity:

The Company's cash balance as of September 30, 2011 was $1.7 million. At that time, the Company had accounts receivable of $1.9 million and a working capital deficit of $4.5 million. However, current liabilities include certain items that will likely settle without future cash payments or otherwise not require significant expenditures by the Company including: deferred revenue of $1.1 million (primarily deferred up front customer activation fees), deferred rent of $0.1 million and accrued vacation of $0.5 million. The aforementioned items represent $1.7 million of total current liabilities as of September 30, 2011.

Current liabilities as of September 30, 2011 also include debt payments on the 2010 notes, due and payable to our majority shareholder, of $3.0 million. Additionally, based on an amendment, related to the cancellation of the Rights Offering, effected in August 2011 (see Note 5), interest in the amount $609,995 is due to be paid over the next twelve months through September of 2012. Any substantial inability to execute our business plan could negatively impact our ability to make payments in accordance with the contractual terms. Further, the 2010 notes include financial covenants the Company must meet on a quarterly basis. The Company was in compliance with all covenants at September 30, 2011. Any potential inability to maintain compliance with the financial covenants or successfully obtain a waiver, if a violation occurs, could result in an event of default as defined in the Hale Securities Purchase Agreement and negatively impact the Company’s ability to finance its operations.

The Company does not anticipate being in a positive working capital position in the next twelve months. However, if the Company continues to generate revenues and gross profits consistent with its growth for 2011 year to date and maintain control of its variable operating expenses, the Company believes that its existing capital, together with anticipated cash flows from operations, will be sufficient to finance its operations through at least September 30, 2012.

Reclassifications:

Certain previously reported amounts have been reclassified to conform to the current year’s presentation. The reclassifications had no effect on previously reported net losses.

Recent Accounting Pronouncements:

In January 2010, the FASB issued guidance that requires reporting entities to make new disclosures about recurring or nonrecurring fair-value measurements including significant transfers into and out of Level 1 and Level 2 fair-value measurements and information on purchases, sales, issuances, and settlements on a gross basis in the reconciliation of Level 3 fair-value measurements. See Note 5 – Fair Value Measurement for a discussion regarding Level 1, 2 and 3 fair-value measurements. The guidance is effective for annual reporting periods beginning after December 15, 2009, except for Level 3 reconciliation disclosures which are effective for annual periods beginning after December 15, 2010. The adoption of this guidance did not have a material impact on the Company's consolidated financial statements.

In December 2010, FASB issued ASU 2010-28, "Intangibles-Goodwill and Other (Topic 350): When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts (a consensus of the FASB Emerging Issues Task Force)." ASU 2010-28 provides amendments to Topic 350 that modifies Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. As a result, goodwill impairments may be reported sooner than under current practice. ASU 2010-28 is effective for fiscal years and interim periods within those years, beginning after December 15, 2010, with early adoption not permitted. The adoption of ASU 2010-28 did not have a material impact on the Company's consolidated results of operation and financial condition.

3. Discontinued Operation

During the three and nine months ended September 30, 2010 the Company incurred $0.0 million and $0.3 million, respectively, in discontinued operations related to the wind down of the Company's telepresence video conferencing product line.

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4. Recapitalization

Debenture Repurchase

On June 30, 2010, the Company entered into a securities purchase agreement with the holders of its outstanding debentures in the principal amount of $29.6 million. Under the terms of the agreement, the Company repurchased all of its outstanding debentures in exchange for payment of $7.5 million in cash, the holders of the Company's debentures exchanged all outstanding warrants they held for shares of the Company's common stock and the Company issued to such holders an additional number of shares of common stock, such that the holders collectively beneficially owned approximately 221,333 shares of common stock immediately following the completion of the transactions contemplated by the agreement. The Company paid the $7.5 million from the proceeds of its senior secured note private placement described below.

After giving effect to the transactions contemplated by the debenture repurchase described above and the transactions contemplated by the senior secured note private placement described below, the Company currently has $10.5 million of senior secured notes outstanding and all of its previously issued debentures, which had a principal amount of $29.6 million, were cancelled.

Senior Secured Note Private Placement

On June 30, 2010, the Company entered into a securities purchase agreement (the "Hale Securities Purchase Agreement") with affiliates of Hale Capital Management, LP (collectively, "Hale"), pursuant to which in exchange for $10.5 million, the Company issued to Hale $10.5 million of senior secured notes (the "2010 notes"), and 3,833,356 shares of its common stock. The carrying value assigned to the debt and equity was based on the relative fair value of each component as determined by a third party valuation specialist. The allocation between debt and equity resulted in a $5.7 million debt discount which will be amortized over the term of the 2010 notes using the effective interest method. A summary of the material terms of the 2010 notes is set forth in Note 5—2010 Notes, below.

Under the terms of the Hale Securities Purchase Agreement, the Company agreed to conduct a rights offering. In connection with the rights offering, depending on the amount of capital it raised, the Company and Hale agreed that the Company would either redeem up to $3.0 million of principal of the 2010 notes or that Hale would exchange up to $3.0 million of principal of the 2010 notes for shares of the Company's common stock. As discussed below the Company has cancelled the rights offering and no longer has any obligation to conduct the same.

In August 2011, the independent directors of the Company approved, and the Company and Hale entered into a settlement agreement, pursuant to which (1) Hale released the Company from any obligation to conduct the rights offering, and (2) the Company released Hale from its "backstop" obligation to convert up to $3.0 million of the 2010 notes into common stock. As a result of the amendment, the original principal amount of the 2010 notes outstanding remained at approximately $10.5 million, plus interest that was accrued to principal through September 30, 2011. In addition, under the settlement agreement, Hale granted the Company the right to defer cash payment of the interest on up to $3.0 million of principal (plus associated “PIK Interest”) through June 30, 2012 and to have any such amounts added to principal. The Company's scheduled payment obligations under the 2010 notes, assuming that it pays all of the interest current, will average approximately $300,000 per month through September 30, 2012 and will average approximately $415,000 per month for the remaining twenty-one months until maturity.

The Company agreed to a number of provisions in the Hale Securities Purchase Agreement that protect Hale's investment, including:

Most Favored Nation. For so long as the 2010 notes are outstanding and until Hale ceases to own at least ten percent of the Company's outstanding common stock, if the Company (i) issues debt on terms that are more favorable than the terms of the 2010 notes, or (ii) issues common stock, preferred stock, equivalents or any other equity security on terms more favorable than those set out in the Hale Securities Purchase Agreement, then the terms of the 2010 notes and/or the Hale Securities Purchase Agreement shall automatically be amended such that Hale receives the benefit of the more favorable terms.

Right of First Refusal. For so long as the 2010 notes are outstanding and until Hale ceases to own at least ten percent of the Company's outstanding common stock, Hale shall have a right of first refusal on any subsequent placement that the Company makes of common stock or common stock equivalents or any securities convertible into or exchangeable or exercisable for shares of its common stock.

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Fundamental Transactions. For so long as the 2010 notes are outstanding and thereafter for as long as any of the Hale purchasers continue to own at least twenty percent of the common stock that they purchased under the Hale Securities Purchase Agreement, the Company cannot effect a transaction in which it consolidates or merges with another entity, conveys all or substantially all of its assets, permit another person or group to acquire more than fifty percent of its voting stock, or reorganize or reclassify its common stock without the majority consent Hale. Additionally, the Company cannot effect such a transaction without obtaining the foregoing requisite consent if such transaction would trigger the most favored nation provision in the Hale Securities Purchase Agreement described above or if such transaction would otherwise involve the issuance of any equity securities or the incurrence of debt at a price that is less than the price paid in connection with the transaction consummated pursuant under the Hale Securities Purchase Agreement.

Post-Closing Adjustment Shares. If at any time prior to July 2, 2012, the Company is required to make payment on certain identified contingent liabilities up to an aggregate amount of $769,539, then it will issue additional shares of common stock to Hale, such that the total percentage ownership of its fully diluted common stock immediately after the payment of such liabilities will equal the same percentage ownership that Hale would have had if the contingent payable had been paid prior to the closing under the Hale Securities Purchase Agreement. To date $214,052 of these contingent liabilities have been incurred as expenses. Accordingly, in April of 2011 we issued to Hale an additional 225,576 shares of our common stock under the terms of the Hale Securities Purchase Agreement.

Registration Rights Agreement

In connection with the Hale Securities Purchase Agreement, the Company entered into a registration rights agreement with Hale pursuant to which the Company agreed to file a registration statement with the SEC for the resale of the shares issued and issuable to Hale under the Hale Securities Purchase Agreement. The Company filed the registration statement with the SEC on September 30, 2010. The registration rights agreement contains penalty provisions in the event that the Company failed to secure the effectiveness of the registration statement by November 29, 2010, fails to file other registration statements the Company is required to file under the terms of the registration rights agreement in a timely manner or if the Company fails to maintain the effectiveness of any registration statement it is required to file under the terms of the registration rights agreement until the shares issued to Hale are sold or can be sold under Rule 144 without restriction or limitation (including volume restrictions) and without the requirement that the Company be in compliance with Rule 144(c)(1). In the event of any such failure, and in addition to other remedies available to Hale, the Company agreed to pay Hale as liquidated damages an amount equal to 1% of the purchase price for the shares to be registered in such registration statement. Such payments are due on the date we fail to comply with our obligation and every 30th day thereafter (pro-rated for periods totaling less than 30 days) until such failure is cured. The registration statement covering the resale of the shares issued to Hale has not been declared effective. Hale and the Company have agreed to amend the term “Initial Effectiveness Deadline” set forth in Section 1(o) of the Registration Rights Agreement to read in its entirety as follows “Initial Effectiveness Deadline” means November 30, 2011.

Impact of Debenture Repurchase and Senior Secured Note Private Placement

In connection with the Hale Securities Purchase Agreement, on July 2, 2010, the Company received gross proceeds of $10.5 million. The Company incurred expenses of approximately $1.5 million in connection with the transactions contemplated by the Hale Securities Purchase Agreement, resulting in net proceeds of approximately $9.0 million. The Company used $7.5 million of these proceeds to repurchase its outstanding debentures and allotted the remaining $1.5 million for working capital purposes, including advertising and distribution programs for its Digital Phone Service products.

Merriman Curhan Ford acted as the Company's financial advisor in the transaction and was paid a fee of $682,500 in connection with the transaction. The Company also issued to Merriman Curhan Ford warrants to purchase 31,152 shares of its common stock. The warrants are exercisable at $2.889 per share for a period of 5 years.

Stock Award Agreements

As a condition to the completion of the transactions contemplated by the Hale Securities Purchase Agreement, on July 2, 2010, the Company entered into stock award agreements with its employees who had earned compensation under its senior management incentive plans that had yet to be paid. The stock award agreements were entered into to eliminate all accrued and unpaid incentive compensation owed to those employees. Under the terms of the stock award agreements, each employee received 30% of his or her accrued incentive compensation in cash, which amounts were being withheld to pay applicable withholding taxes, and the balance in unregistered shares of the Company's common stock, calculated on the basis of one share being issued for every $2.889 of incentive compensation owed. In the aggregate, the Company paid $147,230 in cash and issued 118,912 shares of its common stock to employees in cancellation of $490,768 of earned and unpaid incentive compensation.

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Tax Impact of the Recapitalization

During the quarter ended September 30, 2010, the Company recorded a one-time tax gain related to the Recapitalization. The provision relates to state income taxes resulting from the tax gain on debt restructure. For Federal purposes, the Company expects the net operating loss carry-forwards to fully offset the debt restructure gain, resulting in no tax expense for Federal income tax purposes. Excluding the debt restructure gain, the Company continues to incur losses from operations. Accordingly, the Company expects to continue to record a full valuation allowance against its remaining net deferred tax assets until the Company sustains an appropriate level of taxable income through improved operations. In October 2010, the State of California revised its laws to suspend the use of net operating loss carryovers for the 2010 and 2011 tax years. The estimated impact of this legal change resulted in California state income tax expense of approximately $225,000 in 2010.

5. The 2010 Notes

The following summarizes other terms of the 2010 notes as follows:

Term. The 2010 notes are due and payable on July 2, 2014.

Interest. Interest accrues at a rate equal to the prime rate as published in The Wall Street Journal as of the first business day of each interest period plus 4.75% per annum and is payable at the end of each month, with the first payment due on July 31, 2010. Through June 30, 2011, the Company had the option to defer the monthly interest payments otherwise due and have the amount of deferred interest added to the principal balance of the 2010 notes. In connection with the August 2011 amendment to the 2010 notes, through June 30, 2012, the Company has the option to defer the monthly interest payments otherwise due on $3.0 million of the 2010 notes and have any such amount of deferred interest added to the principal balance of the 2010 notes.

Principal Payment. In July 2011 and continuing for the 11 months thereafter, principal payments of $200,000 per month are due on the last day of each month. Thereafter, the Company is required to pay principal in a monthly amount equal to the sum of (a) $383,702 and (b) the quotient determined by dividing the (i) aggregate amount of interest added to the principal amount by (ii) 24. Any remaining principal amount, if not paid earlier, is due and payable on July 2, 2014.

August 2011 Amendment. As discussed in more detail below under the heading entitled, "Rights Offering," the Company had the right to redeem up to $3.0 million of the 2010 notes prior to maturity. In August 2011, the Company and Hale amended the Hale Securities Purchase Agreement to (1) cancel the Company's obligation to conduct the rights offering, and (2) cancel Hale’s obligation to convert up to $3.0 million of the 2010 notes into common stock. As a result of the amendment, the original principal amount of the 2010 notes outstanding remained at approximately $10.5 million, plus interest that was accrued to principal through September 30, 2011. The Company's scheduled payment obligations under the 2010 notes will average approximately $300,000 per month through September 30, 2012 and average approximately $415,000 per month for the remaining 21 months until maturity.

No Conversion Rights. The 2010 notes are not convertible.

Security. The 2010 notes are secured by all of the Company's assets under the terms of a pledge and security agreement that the Company and its subsidiaries entered into with Hale. Each of the Company's subsidiaries also entered into guarantees in favor of Hale, pursuant to which each subsidiary guaranteed the complete payment and performance by the Company of its obligations under the 2010 notes and related agreements.

Covenants. The 2010 notes impose certain covenants on the Company, including: restrictions against incurring additional indebtedness, creating any liens on its property, entering into a change in control transaction, redeeming or paying dividends on shares of its outstanding common stock, entering into certain related party transactions, changing the nature of its business, making or investing in a joint venture, disposing of any of its assets outside of the ordinary course of business, effecting any subsequent offering of debt or equity, amending its articles of incorporation or bylaws, limiting its ability to enter into lease arrangements.

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Events of Default. The 2010 notes define certain events of default, including: failure to make a payment obligation under the 2010 notes, failure to pay other indebtedness when due if the amount exceeds $250,000, bankruptcy, entry of a judgment against the Company in excess of $250,000 which is not discharged or covered by insurance, failure to observe other covenants of the 2010 notes or related agreements (subject to applicable cure periods), breach of representation or warranty, failure of Hale’s security documents to be binding and enforceable, and casualty loss of any of the Company's assets that would have a material adverse effect on its business, and failure to meet 80% of quarterly financial targets from its annual operating budget, including cash, revenues and EBITDA. In the event of default, additional default interest of 4% will accrue on the outstanding balance. In addition, in the event of default, the Company may be required to redeem all or any portion of the 2010 notes at a price equal to 125% of the sum of the principal amount that such holder requests that it redeems plus accrued but unpaid interest on such principal amount plus any accrued and unpaid late charges with respect to such principal and interest. The Company was in compliance with all covenants at September 30, 2011. Any potential inability to maintain compliance with the financial covenants or successfully obtain a waiver, if a violation occurs, could result in an event of default as defined in the Hale Securities Purchase Agreement and negatively impact the Company’s ability to finance its operations.

Change of Control. The Company is required to obtain the consent of the holders of the 2010 notes representing at least a majority of the aggregate principal amount of the 2010 notes then outstanding in order to enter into a change of control transaction. If such consent is obtained, the holders of the 2010 notes may require the Company to redeem all or any portion of such notes at a price equal to 125% of the sum of the principal amount that such holder requests that it redeems plus accrued but unpaid interest on such principal amount plus any accrued and unpaid late charges with respect to such principal and interest.

Rights Offering, Under the terms of the Hale Securities Purchase Agreement, the Company agreed to conduct a rights offering pursuant to which it would distribute at no charge to holders of its common stock non-transferable subscription rights to purchase up to an aggregate of 1,038,414 shares of common stock at a subscription price of $2.889 per share. Under the terms of the 2010 notes, the Company agreed to use the gross proceeds of the rights offering to redeem an aggregate of up to $3.0 million of principal amount of the 2010 notes. To the extent the gross proceeds of the rights offering were less than $3.0 million, the Company and Hale agreed that Hale would exchange the principal amount to be redeemed (up to $3.0 million) for shares of our common stock at an exchange price equal to the subscription price of the subscription rights. The Company paid Hale an aggregate of $60,000 in consideration of the foregoing. In addition, the Company agreed to pay Hale upon completion of the rights offering an amount of cash equal to the accrued and unpaid interest in respect of the principal amount of the 2010 notes redeemed or exchanged for shares of common stock in connection with the rights offering. As discussed below the Company has cancelled the rights offering and related obligations.

The following table summarizes information relative to the 2010 notes at September 30, 2011:

	September 30, 2011
Face value of debt	$	10,500,000
Plus: accreted interest		935,455
Less: principal payments		(600,000)
Less: unamortized debt discounts		(2,944,543	)
2010 notes, net of discounts		7,890,912
Less current portion		(2,951,106	)
2010 notes, long term portion	$	4,939,806

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Aggregate annual aggregate principal payments of long-term debt plus accreted interest for the periods ending December 31st are stated below:

2011	$	600,000
2012	$	3,502,213
2013	$	4,604,426
2014	$	2,128,816
Total	$	10,835,455

The value assigned to the debt and related discount and equity associated with issuance of the Recapitalization were calculated by an independent valuation firm using relative fair values.

6. Fair Value Measurements

Fair value is defined as an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions, the authoritative guidance establishes a three-tier value hierarchy, which prioritizes the inputs used in measuring fair value as follows: (Level 1) observable inputs such as quoted prices in active markets; (Level 2) inputs other than the quoted prices in active markets that are observable either directly or indirectly; and (Level 3) unobservable inputs in which there is little or no market data, which require us to develop our own assumptions. This hierarchy requires companies to use observable market data, when available, and to minimize the use of unobservable inputs when determining fair value.

On July 2, 2010, in connection with the Recapitalization, the Company repurchased all of its then-outstanding debentures and converted all of its then-outstanding warrants that were issued in connection with such debentures. As a result, the Company eliminated the beneficial conversion feature derivative liability. Prior to the recapitalization the Company recorded a liability related to the beneficial conversion features, which was revalued at fair value at the end of each quarter with the gain or loss being recognized in the consolidated statement of operations. See Note 7 – Convertible Debentures.

7. Convertible Debentures

As discussed in Note 4 – Recapitalization, on July 2, 2010, the Company repurchased all of the debentures that were the subject of the May 2009 Securities and Exchange Amendment Agreements (“Amendment Agreement”) and all of the Company’s warrants there were subject of the Amendment Agreement were cancelled. The terms of the debentures, prior to their repurchase and cancellation, were as follows:

Term. The convertible debentures were due and payable on June 30, 2014.

Interest. When originally issued, interest accrued at the rate of 12.0% per annum and was payable monthly, commencing on August 1, 2008. In December 2008, the parties agreed to amend the interest payment provisions to eliminate monthly interest payments and to provide that interest was payable quarterly at the rate of (i) 0% per annum from October 1, 2008 until September 30, 2009, (ii) 13.5% per annum from October 1, 2009 until September 30, 2012 and (iii) 18% per annum from October 1, 2012 until maturity. In May 2009, the parties again agreed to amend the interest payment provisions to reduce the interest rate to 0% through June 30, 2011 and then to 5% per annum thereafter.

Principal Payment. The principal amount of the convertible debenture, if not paid earlier, was due and payable on June 30, 2014.

Payments of Interest. Interest payments, as amended in May 2009, were due quarterly on January 1, April 1, July 1 and October 1, commencing on October 1, 2011. Interest payments are required to be paid in cash.

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Early Redemption. The Company had the right to redeem the convertible debentures before their maturity by payment in cash of the then outstanding principal amount plus (i) accrued but unpaid interest, (ii) an amount equal to all interest that would have accrued if the principal amount subject to such redemption had remained outstanding through the maturity date and (iii) all liquidated damages and other amounts due in respect of the debenture. To redeem the convertible debentures the Company was required to meet certain equity conditions. The payment of the convertible debentures would occur on the 10th day following the date the Company gave the holders notice of the Company's intent to redeem the convertible debentures. The Company agreed to honor any notices of conversion received from a holder before the payoff date of the convertible debentures.

Voluntary Conversion by Holder. When originally issued, the debentures were convertible at any time at the discretion of the holder at a conversion price per share of $93.75, subject to adjustment including full-ratchet, anti-dilution protection. The conversion price was reduced to $30.00 with the December 2008 amendment and further reduced to $22.50 with the May 2009 amendment.

Forced Conversion. Subject to compliance with certain equity conditions, the Company also has the right to force conversion if the VWAP for its common stock exceeded 200% of the then effective conversion price for 20 trading days out of a consecutive 30 trading day period. Any forced conversion is subject to the Company meeting certain equity conditions and is subject to a 4.99% cap on the beneficial ownership of the Company’s shares of common stock by the holder and its affiliates following such conversion.

Covenants. The convertible debentures imposed certain covenants on the Company, including restrictions against incurring additional indebtedness, creating any liens on the Company’s property, amending its certificate of incorporation or bylaws, redeeming or paying dividends on shares of its outstanding common stock, and entering into certain related party transactions. The convertible debentures defined certain events of default, including without limitation failure to make a payment obligation, failure to observe other covenants of the convertible debenture or related agreements (subject to applicable cure periods), breach of representation or warranty, bankruptcy, default under another significant contract or credit obligation, delisting of the Company's common stock, a change in control, failure to be in compliance with Rule 144(c)(1) for more than 20 consecutive days, or more than an aggregate of 45 days in any 12 month period, or if any other conditions exist for such a period of time that the holder is unable to sell the shares issuable upon conversion of the debenture pursuant to Rule 144 without volume or manner of sale restrictions, or failure to deliver share certificates in a timely manner. In the event of default, the holders of the convertible debentures had the right to accelerate all amounts outstanding under the debenture and demand payment of a mandatory default amount equal to 130% of the amount outstanding plus accrued interest and expenses.

Under the terms of the Amendment Agreement in May 2009, the Company also agreed to add certain covenants to the Debentures including a requirement to maintain at least $300,000 in cash at all times while the Debentures are outstanding, to sustain a level of gross revenue each quarter equal to at least 80% of the average gross revenue for the trailing two quarters, and commencing with the period ended June 30, 2009, to maintain a positive adjusted EBITDA in each rolling two quarter period. For example, ending June 30, 2010, the sum of the three-month adjusted EBITDA of the three months ended December 31, 2009 and the three months ended June 30, 2010 must be at least $0.00 or greater. Adjusted EBITDA is calculated by taking the Company’s net income for the applicable period, and adding to that amount the sum of the following: (i) any provision for (or less any benefit from) income taxes, plus (ii) any deduction for interest expense, net of interest income, plus (iii) depreciation and amortization expense, plus (iv) non-cash expenses (such as stock-based compensation and warrant compensation), plus (v) expenses related to changes in fair market value of warrant and beneficial conversion features, plus (vi) expenses related to impairment of tangible and intangible assets. The Company was in compliance with all covenants at June 30, 2010.

Security. The Company’s performance of its obligations under the convertible debentures was secured by all of the Company's assets under the terms of the amended and restated security agreement the Company and its subsidiaries entered into with the holders of the June 2008 debentures. Each of the Company's subsidiaries also entered into guarantees in favor of the debenture holders, pursuant to which each subsidiary guaranteed the complete payment and performance by the Company of its obligations under the debentures and related agreements.

The unamortized discounts on the convertible debentures issued in December 2006, August 2007 and March 2008 were carried forward as discounts on the convertible debentures issued in June 2008, and would have been amortized to interest expense through June 30, 2014. The discounts on the convertible debentures issued in August 2008 and December 2008 would have been amortized to interest expense through June 30, 2014. The change in the fair market value of the beneficial conversion feature liability as a result of the decrease of the conversion price of the debentures from $30.00 to $22.50 per the Amendment Agreement was recorded as additional debt discount of $4.0 million on May 8, 2009.

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As discussed above under the caption “interest”, when originally issued, interest accrued at the rate of 12.0% per annum and was payable monthly, commencing on August 1, 2008. In December 2008, the parties agreed to amend the interest payment provisions to eliminate monthly interest payments and to provide that interest was payable quarterly at the rate of (i) 0% per annum from October 1, 2008 until September 30, 2009, (ii) 13.5% per annum from October 1, 2009 until September 30, 2012 and (iii) 18% per annum from October 1, 2012 until maturity. In May 2009, the parties again agreed to amend the interest payment provisions to reduce the interest rate to 0% through June 30, 2011 and then to 5% per annum thereafter. The Company recorded interest expense for the three and six months ended June 30, 2010, at the effective interest rate of the convertible debentures during that period.

For each reporting period that the convertible debentures were outstanding, the Company assessed the value of its convertible debentures that were accounted for as derivative financial instruments indexed to and potentially settled in its own stock. At June 30, 2010, the Company determined that the beneficial conversion feature in the convertible debentures represented an embedded derivative liability. Accordingly, the Company bifurcated the embedded conversion feature and accounted for it as a derivative liability because the conversion price and ultimate number of shares could be adjusted if the Company subsequently issued common stock at a lower price and it was deemed possible the Company could have to net cash settle the contract if there were not enough authorized shares to issue upon conversion.

The convertible debentures contained embedded derivative features, which were accounted for at fair value as a compound embedded derivative at June 30, 2010. This compound embedded derivative included the following material features: (1) the standard conversion feature of the debentures; (2) a reset of the conversion price condition for subsequent equity sales; (3) the Company’s ability to pay interest in cash or shares of its common stock; (4) optional redemption at the Company’s election; (5) forced conversion; (6) holder’s restriction on conversion; and (7) a default put right.

The Company, with the assistance of an independent valuation firm, calculated the fair value of the compound embedded derivative associated with the convertible debentures utilizing a complex, customized Monte Carlo simulation model suitable to value path dependent American options. The model uses the risk neutral methodology adapted to value corporate securities. This model utilized subjective and theoretical assumptions that can materially affect fair values from period to period.

At September 30, 2010, the Company recorded beneficial conversion liabilities of $0.00 million. For the three and nine months ended September 30, 2010, the Company recognized other income of $0.0 million and other income of $0.8 million, respectively, related to the change in fair market value of the beneficial conversion liabilities.

All of the Company’s debentures were repurchased and cancelled as of July 2, 2010, and the beneficial conversion feature derivative liability was eliminated.

8. Warrants and Warrant Liabilities

In connection with its various financings through December 2008, the Company issued warrants to purchase shares of common stock in conjunction with the sale of its convertible debentures. The Company issued such warrants in December 2006, February 2007, August 2007, March 2008, August 2008 and December 2008. In May 2009, the Company restructured the terms of the then-outstanding debentures and all of the Company’s then-outstanding warrants issued in connections with the Debentures pursuant to the terms of the Amendment Agreement. In connection with the Recapitalization, the Company repurchased all of its then-outstanding debentures and cancelled substantially all of its then-outstanding warrants. See Note 7 – Convertible Debentures.

Under the terms of the Amendment Agreement, the holders of the then-outstanding warrants were granted the right to exchange their outstanding warrants for shares of the Company’s common stock at the rate of 1.063 shares of common stock, subject to adjustment for stock splits and dividends. In exchange, the price-based anti-dilution protection under the warrants was eliminated. Previously the exercise price of the warrants would decrease, and the number of shares issuable upon exercise would increase, generally, each time the Company issued common stock or common stock equivalents at a price less than the exercise price of the warrants. The Amendment Agreement eliminated the potential for future price-based dilution from the warrants, and accordingly, the warrants are no longer a derivative liability and their value as of May 8, 2009, was reclassed to equity.

On July 2, 2010, in connection with the Recapitalization, the Company eliminated all of the warrants it issued in connection with debentures and none of those warrants were outstanding as of December 31, 2010. See Note 7 – Convertible Debentures.

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There were 36,661 shares subject to warrants at a weighted average exercise price of $22.84 as of September 30, 2011 and December 31, 2010.

The following table summarizes information about warrants outstanding at September 30, 2011:

Exercise Prices		Number of Shares Subject to Outstanding Warrants and Exercisable	Weighted Average Remaining Contractual Life (years)
$	2.90	31,152	3.75
$	93.75	1,400	1.67
$	129.75	2,667	1.49
$	144.00	1,042	1.49
$	300.00	400	1.38
		36,661

9. Business Risks and Credit Concentration

The Company’s cash is maintained with a limited number of commercial banks, and is invested in the form of demand deposit accounts. Deposits in these institutions may exceed the amount of FDIC insurance provided on such deposits.

The Company markets its products to resellers and end-users primarily in the United States. Management performs ongoing credit evaluations of the Company’s customers and maintains an allowance for potential credit losses. There can be no assurance that the Company’s credit loss experience will remain at or near historic levels. One customer accounted for 14% of gross accounts receivable at September 30, 2011. One customer accounted for 12% of gross accounts receivable at September 30, 2010.

No one customer accounted for more than 10% of the Company’s revenue during the three and nine months ended September 30, 2011 or September 30, 2010. During the first quarter of 2010, the Company received notice from two of its customers that they would be terminating service during the course of 2010. This service is an older product offering that had been in place with these customers for several years. The Company had known for some time that the customers would move away from the service eventually and the revenue generated by these customers had been declining over recent years. Revenue received from these customers accounted for approximately 0.00% during the three and nine months ended September 30, 2011, as compared to 2% and 9% of revenue during the three and nine months ended September 30, 2010.

The Company relies on primarily one third party network service provider for network services. If this service provider failed to perform on its obligations to the Company, such failure could materially impact future operating results, financial position and cash flows.

10. Commitments and Contingencies

Leases

The Company has non-cancelable operating and capital leases for corporate facilities and equipment.

Minimum Third Party Network Service Provider Commitments

The Company has a contract with a third party network service provider that facilitates interconnects with a number of third party network service providers. The contract contains a minimum usage guarantee of $0.2 million per monthly billing cycle and expires in July 2012. The cancellation terms are a ninety (90) day written notice prior to the extended term expiring.

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Litigation

From time to time and in the course of business, the Company may become involved in various legal proceedings seeking monetary damages and other relief. The amount of the ultimate liability, if any, from such claims cannot be determined. However, in the opinion of management, there are no legal claims currently pending or threatened against the Company that would be likely to have a material adverse effect on its financial position, results of operations or cash flows.

11. Stock Based Compensation

Stock Option Plan

The Company maintains two equity plans: the 2005 Equity Incentive Plan (the “2005 Plan”) and the 2010 Stock Incentive Plan (the “2010 Plan”).

The 2005 Plan, which was approved by the Company’s stockholders in August 2006, permits the Company to grant shares of common stock and options to purchase shares of common stock to the Company’s employees for up 66,667 shares of common stock. The Company believes that such awards better align the interests of its employees with those of its stockholders. Option awards are generally granted with an exercise price that equals the market price of the Company's stock at the date of grant; these option awards generally vest based on 3 years of continuous service and have 10-year contractual terms. On November 8, 2007, the Board of Directors approved an amendment to the 2005 Plan to increase the number of shares of common stock available for grant to 113,333 shares. On December 11, 2008, the Board of Directors approved an additional amendment to the 2005 Plan to increase the number of shares of common stock available for grant to 206,667 shares. At September 30, 2011 there were 126,792 options outstanding under the 2005 plan. The Board of Directors has indicated that it does not intend to make any further option grants under the 2005 Plan.

The 2010 Plan, which was approved by the Company’s stockholders in July 2010, permits the Company to grant options to purchase, and other stock-based awards covering, in the aggregate 1,189,198 shares of the Company’s common stock to the Company’s employees, directors or consultants. The Company believes that such awards will aid in recruiting and retaining key employees, directors or consultants and to motivate such employees, directors or consultants to exert their best effort on behalf of the Company. Option awards are granted in four Tranches with Tranche 1 shares having an option price of $3.00 per share and Tranches 2, 3, and 4 having an option price of $5.778 per share. Tranche 1 option awards vest fifty percent (50%) of the awarded shares upon Hale receiving cash proceeds in return on its Invested Capital in the Company and its subsidiaries which cash proceeds equal no less than one times its Invested Capital (as defined in the 2010 Plan) plus a four percent (4%) annual return on such Invested Capital, compounded annually (the “Tranche 1 Return”). Notwithstanding the foregoing and the failure of Hale to have achieved the Tranche I Return, Tranche 1 shares shall vest with respect to ten percent (10%) of such Tranche 1 shares on each of the first, second, and third anniversaries of the Effective Date, irrespective of whether such Tranche 1 shares were issued as of such dates subject to the Participant’s continued employment in good standing with the Company on each such anniversary. Tranche 2 option awards vest sixteen and sixty-fifth one hundredths percent (16.65%) upon Hale receiving cash proceeds in return on its Invested Capital in the Company and its subsidiaries which cash proceeds equal no less than two times its Invested Capital plus four percent (4%) annual return on such Invested Capital, compounded annually and subject to the Participant’s continued employment in good standing with the Company on the Tranche 2 vesting date. Tranche 3 option awards vest sixteen and sixty-fifth one hundredths percent (16.65%) upon Hale receiving cash proceeds in return on its Invested Capital in the Company and its subsidiaries which cash proceeds equal no less than three times its Invested Capital plus four percent (4%) annual return on such Invested Capital, compounded annually and subject to the Participant’s continued employment in good standing with the Company on the Tranche 3 vesting date. Tranche 4 option awards vest sixteen and seventieth one hundredths percent (16.67%) upon Hale receiving cash proceeds in return on its Invested Capital in the Company and its subsidiaries which cash proceeds equal no less than four times its Invested Capital plus four percent (4%) annual return on such Invested Capital, compounded annually and subject to the Participant’s continued employment in good standing with the Company on the Tranche 4 vesting date. Option under the 2010 Plan shall be exercisable at such time and upon such terms and conditions as may be determined by the Compensation Committee of the Company’s Board of Directors, but in no event shall an Option be exercisable more than ten years after the date it is granted.

An amendment to the 2010 Plan (the “2010 Plan Amendment”) was approved by the Company’s stockholders and became effective in May 2011. The 2010 Plan Amendment was adopted in connection with the terms of the Hale Securities Purchase Agreement dated June 30, 2010. Pursuant to Section 1(e) of the Hale Securities Purchase Agreement the Company agreed to grant shares of common stock to Hale, in the event that the Company received a notice that it is obligated to pay certain specified contingent liabilities within two years of the closing (a “Contingent Share Issuance”). The Company received such notice in April 2011, and in accordance with the terms of the Hale Securities Purchase Agreement, the Company issued an aggregate of 225,576 shares of common stock to Hale. The Hale Securities Purchase Agreement provides that in the event of a Contingent Share Issuance a proportionate adjustment would be made to the number of shares of our common stock reserved under the 2010 Plan. Based on the Contingent Share Issuance, the Company’s board of directors approved an increase in the number of shares of common stock subject to the 2010 Plan from 1,189,198 to 1,232,121 shares. In addition the 2010 Plan Amendment provides that the maximum aggregate number of shares available for issuance under the Plan will increase automatically by one share for every four shares issued in any future Contingent Share Issuance up to a maximum of 1,493,333 shares.

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A summary of option activity under the 2005 Plan and 2010 Plan as of September 30, 2011 is presented below:

	Shares			Weighted-Average Exercise Price
Outstanding at December 31, 2010		954,979		$	6.00
Granted		322,998			4.40
Exercised		—			—
Forfeited or expired		(191,680	)		4.45
Outstanding at September 30, 2011		1,086,297		$	5.66

The options outstanding and currently exercisable by exercise price at September 30, 2011 are as follows:

		Stock options outstanding				Stock Options Exercisable
Range of Exercise Prices		Number Outstanding	Weighted-Average Remaining Contractual Term (Years)	Weighted-Average Exercise Price		Number Exercisable	Weighted-Average Remaining Contractual Term (Years)	Weighted-Average Exercise Price
$	3.00 to 4.50	483,103	9.24	$	3.00	66,579	8.65	$	3.02
$	4.50 to 7.50	586,467	8.58	$	5.67	106,024	5.21	$	5.20
$	7.50 to 11.25	11,313	3.78	$	7.90	11,291	3.77	$	7.89
$	191.22 to 262.43	5,414	5.84	$	221.91	5,414	5.84	$	221.91
		1,086,297	8.81	$	5.58	189,308	6.35	$	10.79

As of September 30, 2011, 189,308 options were exercisable at an aggregate average exercise price of $10.79. The aggregate intrinsic value of stock options outstanding and stock options exercisable at September 30, 2011 was less than $0.1 million.

As of September 30, 2011, total compensation cost related to non-vested stock options not yet recognized was $2.4 million. Of the $2.4 million, $1.0 million is expected to be recognized ratably over the next three years, and such amount includes stock options with contingent vesting which it is deemed probable that such options will become exercisable. The remaining $1.4 million is related to stock options in Tranches 2, 3 and 4 with contingent vesting that will be recognized when it is probable that such options will become exercisable.

Valuation and Expense Information

The Company measures and recognizes compensation expense for all share-based payment awards made to employees and directors based upon estimated fair values. The following table summarizes stock-based compensation expense recorded for the three and nine months ended September 30, 2011 and 2010, and its allocation within the Consolidated Statements of Operations:

	Three months ended September 30,				Nine months ended September 30,
	2011		2010		2011		2010
Selling and marketing	$	32,023	$	148,458	$	94,957	$	210,950
General and administrative		56,207		407,964		157,199		548,032
Research and development		40,736		127,189		127,254		215,791
Stock based compensation included in continuing operations		128,966		683,611		379,410		974,773
Stock based compensation in discontinued operations		-		-		-		143,498
Total stock-based compensation expense related to employee equity awards		128,966		683.,611		379,410		1,118,271

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Valuation Assumptions:

The Company uses the Black Scholes option pricing model in determining its option expense. The weighted-average estimated fair value of employee stock options granted during the nine months ended September 30, 2011 was $2.38 per share. There were 130,668 options granted during the three months ended September 30, 2011.

As the stock-based compensation expense recognized in the Consolidated Statements of Operations is based on awards ultimately expected to vest, such amounts have been reduced for estimated forfeitures estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

12. Computation of Net Loss Per Share

Basic net loss per share is based upon the weighted average number of common shares outstanding. Diluted net loss per share is based on the assumption that all potential common stock equivalents (convertible preferred stock, convertible debentures, stock options, and warrants) are converted or exercised. The calculation of diluted net loss per share excludes potential common stock equivalents if the effect is anti-dilutive. The Company's weighted average common shares outstanding for basic and dilutive are the same because the effect of the potential common stock equivalents is anti-dilutive. The Company has the following dilutive common stock equivalents for the three and nine months ended September 30, 2011 and 2010, which were excluded from the net loss per share calculation because their effect is anti-dilutive.

	Three months ended September 30,				Nine months ended September 30,
	2011		2010		2011		2010
Stock Options		1,086,297		135,347		1,086,297		135,347
Warrants		36,661		36,661		36,661		36,661
Total		1,122,958		172,008		1,122,958		172,008

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Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

The following discussion of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and the related notes and other financial information appearing elsewhere in this report. Readers are also urged to carefully review and consider the various disclosures made by us that attempt to advise interested parties of the factors that affect our business, including without limitation, the disclosures made under "Item 1A. Risk Factors" included in Part II of this report.

Overview

Business

We are an IP communications company, offering a range of communications solutions from hosted IP voice and conferencing products to text and data collaboration products and services. Our subsidiary, AccessLine, offers the following hosted VoIP Services: Digital Phone Service, SIP Trunking Service and Individual Phone Services.

Digital Phone Service replaces a customer's existing telephone lines with a VoIP alternative. It is sold as a complete solution where we bundle our software applications and hosted network services with business-class phone equipment which is manufactured by third parties. The service is designed to be easy to install, set-up and use, and at a lower cost than traditional phone service. This service is targeted at small to medium sized businesses looking for a fully integrated solution that does not require expert assistance to install; the customer has the ability to select the number of phone stations (from 1 to 100), number of phone lines (from 1 to 100) and types of phone numbers.

SIP Trunking Service is for larger businesses that already have their own PBX equipment and is targeted at those businesses with large calling volumes looking for cost effective alternatives to traditional carrier offerings. SIP Trunking Service does not include user equipment such as business phones. The service involves routing calls over internet data networks to avoid tariffs and reduce expenses for larger enterprises. This service can support businesses with hundreds of employees.

As part of its Individual Phone Service product offerings, AccessLine offers a variety of other phone services, including, conferencing calling services, toll-free service plans, a virtual phone system with an after-hours answering service that routes calls based on specific business needs, find-me and follow-me services, a full featured voice mail system that instantly contacts a customer via an email or cell phone text message the moment such customer receives a new voice mail or fax, and the ability to manage faxes from virtually anywhere.

Our revenues principally consist of: monthly recurring service charges, activation, and usage fees from communication solutions, which include mobility solutions, PBX enhancements, single number solutions, unified messaging, voice messaging, paging, and bundled solutions of phone equipment and service.

We differentiate our VoIP Services on the bases of the quality of our service, the comprehensiveness of our solutions and the quality of our customer support. Our engineers have refined our network infrastructure and our software to provide, robust, scalable, and reliable solutions. We have written substantially all of the software used in our network and applications. As a result, we have greater accessibility to the software, a greater understanding of its function, and believe that we can respond more quickly in the development of new features and functions or to customize an application to meet customer demand. This level of understanding has allowed us to simplify the user experience for our customers, such as our Digital Phone System, which can be self-installed by the customer. Our network architecture is designed to provide redundancy, with multiple failover layers, and scalability. Finally, we have also written tools that augment and enhance our customer support functions, providing greater access to information and accelerating our call response rates.

Recapitalization

Our overriding objective is to grow revenue while achieving operating profitability and generating cash from operations. In 2010 we addressed this objective through the growth in our core voice businesses and a recapitalization that substantially reduced our outstanding debt, and provided additional working capital.

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We experienced growth in revenue and gross profit for our AccessLine division in 2011. Our increased revenue during 2011 was due, in part, to greater efficiency in our advertising and also through our success in selling our SIP Trunking Service through direct and agent channels. Our Digital Phone Service continues to grow month over month. We increased our year-to-date gross profit percentage through our continued progress in optimizing our network configuration. Additionally, we have reduced operating expenses, in part, through reducing our staffing levels.

Debenture Repurchase

On June 30, 2010, we entered into a securities purchase agreement with the holders of our outstanding debentures in the principal amount of $29.6 million. Under the terms of the agreement, we repurchased and cancelled all of our outstanding debentures in exchange for payment of $7.5 million in cash. Additionally, the holder of the debentures exchanged all outstanding warrants they held for shares of our common stock and we issued to such holders an additional number of shares of our common stock, such that the holders collectively and beneficially owned approximately 221,333 shares of our common stock immediately following the completion of the transactions contemplated by the agreement. We paid $7.5 million from the proceeds of our senior secured note private placement described below.

After giving effect to the transactions contemplated by the debenture repurchase described above and the transactions contemplated by the senior secured note private placement described below, we currently have $10.5 million of senior secured notes outstanding and all our previously issued debentures, which had a principal balance of $29.6 million, were cancelled.

Senior Secured Notes Private Placement

On June 30, 2010, we entered into a securities purchase agreement, which we refer to as the “Hale Securities Purchase Agreement” in this report, with affiliates of Hale Capital Management, LP, whom we refer to collectively as “Hale” in this report, pursuant to which, in exchange for $10.5 million, we issued to Hale $10.5 million of senior secured notes, which we refer to as the “2010 notes” in this report, and 3,833,356 unregistered shares of our common stock. For a summary of material terms of the 2010 notes see “Commitments and Contingencies” below.

We agreed to a number of provisions in the Hale Securities Purchase Agreement that protect Hale’s investment, including:

Most Favored Nation. For so long as the 2010 notes are outstanding and until Hale ceases to own ten percent of our outstanding common stock, if we (i) issue debt on terms that are more favorable than the terms of the 2010 notes, or (ii) issue common stock, preferred stock, equivalents or any other equity security on terms more favorable than those set out in the Hale Securities Purchase Agreement, then the terms of the 2010 notes and/or the Hale Securities Purchase Agreement shall automatically be amended such that Hale receives the benefit of the more favorable terms.

Right of First Refusal. For so long as the 2010 notes are outstanding and until Hale ceases to own ten percent of our outstanding common stock, Hale shall have a right of first refusal on any subsequent placement that we make of common stock or common stock equivalents or any securities convertible into or exchangeable or exercisable for shares of our common stock.

Fundamental Transactions. For so long as the 2010 notes are outstanding and thereafter for as long as any of the Hale purchasers continue to own twenty percent of the common stock that they purchased under the Hale Securities Purchase Agreement, we cannot effect a transaction in which we consolidate or merge with another entity, convey all or substantially all of our assets, permit another person or group to acquire more than fifty percent of our voting stock, or reorganize or reclassify our common stock without the majority consent of Hale. Additionally, we cannot effect such a transaction without obtaining the foregoing requisite consent if such transaction would trigger the most favored nation provision in the Hale Securities Purchase Agreement described above or if such transaction would otherwise involve the issuance of any equity securities or the incurrence of debt at a price that is less than the price paid in connection with the transaction consummated pursuant under the Hale Securities Purchase Agreement.

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Post-Closing Adjustment Shares. If at any time prior to July 2, 2012, we are required to make payment on certain identified contingent liabilities up to an aggregate amount of $769,539, then we will issue additional shares of common stock to Hale, such that the total percentage ownership of our fully diluted common stock immediately after the payment of such liabilities will equal the same percentage ownership that Hale would have had if the contingent payable had been paid prior to the closing under the Hale Securities Purchase Agreement. To date $214,052 of these contingent liabilities have incurred as expenses. Accordingly, in April 2011 we issued to Hale an additional 225,576 shares of our common stock under the terms of the Hale Securities Purchase Agreement

Registration Rights Agreement

In connection with the Hale Securities Purchase Agreement, we entered into a registration rights agreement with Hale pursuant to which we have agreed to file a registration statement with the SEC for the resale of the shares issued and issuable to Hale under the Hale Securities Purchase Agreement. We filed that registration statement on September 30, 2010. The registration rights agreement contains penalty provisions in the event that we fail to secure the effectiveness of that registration statement by November 29, 2010, fail to file other registration statements we are required to file under the terms of the registration rights agreement in a timely manner or if we fail to maintain the effectiveness of any registration statement we are required to file under the terms of the registration rights agreement until the shares issued to Hale are sold or can be sold under Rule 144 without restriction or limitation (including volume restrictions) and without the requirement that our company be in compliance with Rule 144 (c)(1). In the event of any such failure, and in addition to other remedies available to Hale, we agreed to pay Hale as liquidated damages and amount equal to 1% of the purchase price for the share to be registered in such registration statement. Such payments are due on the date we fail to comply with our obligation and every 30th day thereafter (pro-rated for periods totaling less than 30 days) until such failure is cured. The registration statement covering the resale of the shares issued to Hale has not been declared effective. Hale and the Company have agreed to amend the term “Initial Effectiveness Deadline” set forth in Section 1(o) of the Registration Rights Agreement to read in its entirety as follows: “Initial Effectiveness Deadline” means November 30, 2011.

Impact of Debenture Repurchase and Senior Secured Note Private Placement

In connection with the Hale Securities Purchase Agreement we received gross proceeds of $10.5 million. We incurred expenses of $1.5 million in connection with the transaction contemplated by the Hale Securities Purchase Agreement, resulting in net proceeds of approximately $9.0 million. We used $7.5 million of these proceeds to repurchase our outstanding debentures and allotted the remaining $1.5 million for working capital purposes, including advertising and distribution programs for its Digital Phone Service products

Merriman Curhan Ford acted as our financial advisor in the transaction and we paid them a fee of $682,500 in connection with the transaction. We also issued Merriman Curhan Ford warrants to purchase 31,152 shares of our common stock. The warrants are exercisable at $2.889 per share for a period of 5 years.

Stock Award Agreements

As a condition to the completion of the transactions contemplated by the Hale Securities Purchase Agreement, on July 2, 2010, we entered into stock award agreements with our employees who had earned compensation under our senior management incentive plans that had yet to be paid. The stock award agreements were entered into to eliminate all accrued and unpaid incentive compensation owed to those employees. Under the terms of the stock award agreements, each employee received 30% of his or her accrued incentive compensation in cash, which amounts are being withheld to pay applicable withholding taxes, and the balance in unregistered shares of or common stock, calculated on the basis of one share being issued for every $2.889 of incentive compensation owed. In the aggregate, we paid $147,230 in cash and we issued 118,912 shares of our common stock to employees in cancellation of $490,768 of earned and unpaid incentive compensation.

Rights Offering

Under the terms of the Hale Securities Purchase Agreement, we agreed to conduct a rights offering pursuant to which we would distribute at no charge to holders of our common stock non-transferable subscription rights to purchase up to an aggregate 1,038,414 share our common stock at a subscription price of $2.889 per share. Under the terms of the 2010 notes, we agreed to use the gross proceeds of the rights offering to redeem an aggregate of up to $3.0 million of principle amount of such notes. To the extent the gross proceeds of the rights offering were less than $3.0 million, we and Hale agreed that Hale would exchange the principle amount to be redeemed (up to $3 million) for shares of our common stock at an exchange price equal to the subscription price of the subscription rights. We paid Hale an aggregate of $60,000 in consideration for the foregoing. In addition, we agreed to pay Hale upon completion of the rights offered an amount of cash equal to the accrued and unpaid interest in respect of the principal amount of the senior secured notes redeemed or exchanged for shares of common stock in connection with the rights offering. As discussed below the Company has cancelled the rights offering and related obligations.

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In August 2011, the independent directors of the Company approved, and the Company and Hale entered into a settlement agreement, pursuant to which (1) Hale released the Company from any obligation to conduct the rights offering, and (2) the Company released Hale from its "backstop" obligation to convert up to $3.0 million of the 2010 notes into common stock. As a result of the amendment, the original principal amount of the 2010 notes outstanding remained at approximately $10.5 million, plus interest that was accrued to principal through September 30, 2011. In addition, under the settlement agreement, Hale granted the Company the right to defer cash payment of the interest on up to $3.0 million of principal (plus associated “PIK Interest”) through June, 2012 and to have any such amounts added to principal. The Company's scheduled payment obligations under the 2010 notes, assuming that it pays all of the interest current, will average approximately $300,000 per month through September 30, 2012 and will average approximately $415,000 per month for the remaining twenty-one months until maturity.

Recent Developments

During 2010 and the first nine months of 2011 our focus has been on driving our core business of next generation VOIP Services including our Digital Phone Service and our SIP Trunking Service. Our network infrastructure is scalable and capable of supporting significant additional services, without substantial capital expenditure. As we generate additional revenues, we can distribute the fixed cost elements of our business over a greater revenue base, and increase gross profit.

During the third quarter of 2011, we continued the growth of our Digital Phone Service and our SIP Trunking Service which grew by 50 percent over revenues for those products during the same period in 2010. Digital Phone Service and our SIP Trunking service will continue to be core to growth of our revenues going forward. Efforts are being made to expand the related distribution channels to increase penetration into these markets and increase revenues.

Overall revenues for the third quarter of 2011 increased compared to the same period of 2010 as the increases in our core Digital Phone Service and SIP Trunking Service were more than offset by the loss of revenue related to certain Legacy products. During the three months ended September 30, 2010, we received notice from two of our significant Legacy customers that they would be terminating our service during the last quarter of 2010. These services constituted an older product offering, that had been in place with these customers for several years. We had known for some time that the customers would move away from the service eventually and the revenue generated by these customers had been declining over recent years. That discontinuation did occur and we did not generate any revenues from those Legacy products in the third quarter of 2011. Consequently, we will not experience any further erosion of revenues related to Legacy product sales.

If we can continue to generate revenues and gross profits in our Digital Phone Service and SIP Trunking Service products consistent with our growth during 2011 year to date and we maintain control of our operating expenses, we believe that our existing capital, taking into account the effect of the two transactions that recapitalized our debt, will be sufficient to finance our operations through September 30, 2012. However, we have limited financial resources. Significant decreases in revenues or increases in operating costs could impact our ability to fund our operations. We do not currently have any sources of credit available to us. See “Liquidity and Capital Resources” below.

Results of Operations

Third Quarter of Fiscal 2011 Compared to Third Quarter of Fiscal 2010

Revenues, Cost of Revenues and Gross Profit

							Increase/(Decrease)
	2011			2010			Dollars			Percent
Three Months Ended September 30:
Revenues	$	7,254,405		$	6,873,268		$	381,137			5.5	%
Cost of revenues		3,003,187			3,070,391			(67,204	)		(2.2	%)
Gross profit		4,251,218			3,802,877			448,341			11.8	%
Gross profit percentage		58.6	%		55.3	%

Nine Months Ended September 30:
Revenues	$	21,183,708		$	21,819,576		$	(635,868	)		(2.9	%)
Cost of revenues		8,865,016			9,266,342			(401,326	)		(4.3	%)
Gross profit		12,318,692			12,553,234			(234,542	)		(1.9	%)
Gross profit percentage		58.2	%		57.5	%

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Net revenues for the three months ended September 30, 2011 were $7.3 million, an increase of $0.4 million, or 5.5% over the same period in 2010. Net revenues for the nine months ended September 30, 2011 were $21.2 million, a decrease of $0.6 million, or 2.9% over the same period in 2010. Net revenues increased in the three months ended September 30, 2011 as a result of increased sales in Digital Phone Service, SIP Trunking Service and Voice Volume Services offset by a decline in Individual Services. Net revenues declined for the nine month period as the result of the discontinuation of our Legacy products in 2010. This decrease was offset by increases in Digital Phone Service and SIP Trunking Services. Net Revenues from our Legacy products amounted to $1.3 million and $5.5 million for the three and nine months ended September 30, 2010. Revenue grew in Digital Phone Service and SIP Trunking Service in the three and nine months ended September 30, 2011 and we expect this growth to continue to be strong throughout the last quarter of 2011.

Cost of revenues for the three months ended September 30, 2011 were $3.0 million, a decrease of less than $0.1 million, or 2.2%, over the same period in 2010. Cost of revenues for the nine months ended September 30, 2011 were $8.9 million, a decrease of $0.4 million, or 4.3% over the same period in 2010. Cost of revenues decreased as a result of the change in product mix and variable costs.

Gross profit for the three months ended September 30, 2011 was $4.3 million, an increase of $0.4 million, or 11.8%, over the same period in 2010. Gross profit for the nine months ended September 30, 2011 was $12.3 million, a decrease $0.2 million, or 1.9% over the same period in 2010. Gross profit percentage was 58.2% for the nine months ended September 30, 2011 as compared to 57.5% in the same period in 2010.

Selling and Marketing Expenses

Selling and marketing expenses for the three months ended September 30, 2011 were $1.8 million, a decrease of less than $0.1 million or 4.8%, over the same period in 2010. Selling and marketing expenses in both the nine months ended September 30, and 2010 were $5.2 million The decrease from the third quarter of 2010 was primarily due to a decrease in advertising and marketing expenses. We anticipate that selling and marketing expenses for fiscal year 2011 will be higher than those incurred in fiscal year 2010 as we increase our advertising expense in our effort to increase market share and to promote our Digital Phone Service product line.

General and Administrative Expenses

General and administrative expenses for the three months ended September 30, 2011 were $2.1 million, an increase of $0.1 million or 6.7%, over the same period in 2010. General and administrative expenses in both the nine months ended September 30, 2011 and 2010 were $5.8 million. The increase for the three months ended September 30, 2011 is primarily a result of general legal expenses.

Research, Development and Engineering Expenses

Research, development and engineering expenses for the three months ended September 30, 2011 were $0.5 million, a decrease of $0.2 million or 24.6%, over the same period in 2010. Research, development and engineering expenses for the nine months ended September 30, 2011 were $1.4 million, a decrease of $0.6 million or 31.3%, over the same period in 2010. Research and development expenses decreased in 2011 because we capitalized a larger percentage of payroll and related costs that were attributable to the design, coding, and testing of our software developed for internal use than we did in the same period in the prior year and as a corollary we incurred lower payroll related expenses.

Depreciation Expense

Depreciation expense for the three months ended September 30, 2011 and September 30, 2010 was $0.2 million. Depreciation for the nine months ended September 30, 2011 was $0.5 million a slight increase over the same period in 2010. The increase is primarily attributable to additional capital leases on network equipment during the nine months ended September 30, 2011

Amortization of Purchased Intangibles

We recorded $1.7 million of amortization expense in both the nine months ended September 30, 2011 and 2010, related to the amortization of intangible assets acquired in the AccessLine acquisition.

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Interest Expense

Interest expense was $0.7 and $0.9 million for the three months ended September 30, 2011 and September 30, 2010, respectively. Interest expense in both the nine months ended September 30, 2011 and 2010 was $2.5 million. Interest expense includes stated interest, amortization of note discounts, amortization of deferred financing costs, and interest on capital leases.

Interest was payable on our debentures quarterly at the rate of (i) 0% per annum from October 1, 2008 until September 30, 2009, (ii) 13.5% per annum from October 1, 2009 until September 30, 2012 and (iii) 18% per annum from October 1, 2012 until maturity. In May 2009, interest payment provisions were amended to reduce the interest rate to 0% through September 30, 2011 and then to 5% per annum thereafter. We recorded interest expense for the three months ended June 30, 2010 at the effective rate of the debentures during the period.

On June 30, 2010, we entered into a securities purchase agreement with holders of our outstanding debentures in the principal amount of $29.6 million. Under the terms of the agreement, we repurchased and cancelled all of our outstanding debentures in exchange for payment of $7.5 million in cash. Additionally, the holders of our debentures exchanged all outstanding warrants they held for shares of our common stock and we issued to such holders an additional number of shares of our common stock, such that the holders collectively beneficially owned approximately 221,333 shares of our common stock immediately following the completion of the transactions contemplated by the agreement.

Concurrently with the repurchase of our debentures, we entered into the Hale Securities Purchase Agreement, pursuant to which we issued $10.5 million in principal of 2010 notes. Interest accrues on the 2010 notes at a rate equal to the prime rate as published in the Wall Street Journal as of the first business day of each interest period plus 4.75% per annum and is payable at the end of each month, with the first payment due on July 31, 2010. Through June 30, 2011, we had the option to defer the monthly interest payments otherwise due and have the amount of interest deferred added to the principal balance of the 2010 notes. The Company elected to defer interest on the 2010 notes at all available times during 2010 and 2011. In connection with the August 2011 amendment to the 2010 notes, through June 30, 2012, the Company has the option to defer the monthly interest payments otherwise due on $3.0 million of the 2010 notes and have any such amount of deferred interest added to the principal balance of the 2010 notes.

Change in Fair Value of Warrant and Beneficial Conversion Liabilities

Change in Fair Value of Warrant and Beneficial Conversion Liabilities was $0.00 for the three and nine months ended September 30, 2011 and income of $0.0 million and $0.8 million related to the beneficial conversion liabilities for the three and nine months ended September 30, 2010.

In connection with the Recapitalization, on July 2, 2010, all of our convertible debentures were repurchased and cancelled and the related conversion feature was eliminated. For the nine months ended September 30, 2011 and September 30, 2010, the company recognized $0.0 and $0.8 million, respectively related to the change in fair market value of the beneficial conversion liabilities.

Discontinued Operations

As a result of the sale of our system integration business in October 2009, and the termination of the Digital Presence video conferencing product line, we reported our video segment results as discontinued operations in 2010. The $0.0 million and $0.3 million of expenses incurred during the three and nine months ended September 30, 2010, relate to the wind down of our Digital Presence product line. No expenses were incurred during the three and nine months ended September 30, 2011.

Provision for Income Taxes

No provision for income taxes has been recorded because we have experienced net losses from inception through September 30, 2011. As of December 31, 2010, we had net operating loss carry forwards (“NOL’s”), net of section 382 limitations, of approximately $46 million, some of which, if not utilized, will begin expiring in the current year. Our ability to utilize the NOL carry forwards is dependent upon generating taxable income. We have recorded a corresponding valuation allowance to offset the deferred tax assets as it is more likely than not that the deferred tax assets will not be realized.

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Liquidity and Capital Resources

Current liabilities as of September 30, 2011 also include debt payments on the 2010 notes, due and payable to our majority shareholder, of $3.0 million. Additionally, based on an amendment, related to the cancellation of the Rights Offering, effected in August 2011 (see Note 5), interest in the amount $609,995 is due to be paid over the next twelve months through September of 2012. Any substantial inability to execute our business plan could negatively impact our ability to make payments in accordance with the contractual terms. Further, the 2010 Notes include financial covenants the Company must meet on a quarterly basis. The Company was in compliance with all covenants at September 30, 2011. Any potential inability to maintain compliance with the financial covenants or successfully obtain a waiver, if a violation occurs, could result in an event of default as defined in the agreement and negatively impact the Company’s ability to finance its operations.

Cash generated by continuing operations during the nine months ended September 30, 2011 was $0.8 million. This was primarily the result of cash generated from operations of $0.8 million as the net loss from continuing operations of $4.8 million was more than offset by the following non-cash charges: amortization of note discounts of $1.5 million; amortization of intangible assets of $1.7 million; depreciation expense of $1.4 million (which includes depreciation expense of $0.3 million in cost of sales); non-cash interest of $0.5 million and stock compensation expense of $0.4 million. The remaining $0.1 million of cash was provided by the changes in working capital.

Net cash used by investing activities during the nine months ended September 30, 2011 was $0.4 million, which consisted primarily of purchases of property and equipment.

Net cash used by financing activities was $1.0 million during the nine months ended September 30, 2011, $0.4 million of which was related to payments on our capital leases and $0.6 million was related to payment on the 2010 notes.

If we can continue to generate revenue and gross profit in our Digital Phone Service and SIP Trunking Service products consistent with our growth in 2011 year to date, and we continue to maintain control of our variable operating expenses, we believe that our existing capital, together with anticipated cash flows from operations, will be sufficient to finance our operations through September 30, 2012.

We do not currently have any unused credit arrangement or open credit facility available to us. The 2010 notes are secured by a lien on all of our assets, and the terms of those notes restrict our ability to borrow funds, pledge our assets as security for any such borrowing or raise additional capital by selling shares of capital stock or other equity or debt securities, without the consent of the holders of the 2010 notes.

If our cash reserves prove insufficient to sustain operations, we plan to raise additional capital by selling shares of capital stock or other equity or debt securities. However, there are no commitments or arrangements for future financings in place at this time, and we can give no assurance that such capital will be available on favorable terms or at all.

Commitments and Contingencies

Leases

We have non-cancelable operating and capital leases for corporate facilities and equipment.

Future minimum rental payments required under non-cancelable operating and capital leases are as follows:

	Operating Leases		Capital Leases
2011		416,389		126,698
2012		1,490,787		312,136
2013		298,673		134,846
2014		45,753		66,573
2015		26,690		-
Total minimum lease payments	$	2,278,292		640,253
Less amount representing interest				(42,210	)
Present value of minimum lease payments				598,043
Less current portion				(333,214	)
			$	264,829

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The 2010 Notes

In connection with the Recapitalization, on July 2, 2010, we issued $10.5 million in principal amount of 2010 notes. The following summarizes the terms of the 2010 notes:

Term. The 2010 notes are due and payable on July 2, 2014.

Interest. Interest accrues at a rate equal to the prime rate as published in The Wall Street Journal as of the first business day of each interest period plus 4.75% per annum and is payable at the end of each month, with the first payment due on July 2, 2010. Through June 30, 2011, we had the option to defer the monthly interest payments otherwise due and have the amount of interest deferred added to the principal balance of the 2010 notes. In connection with the August 2011 amendment to the 2010 notes, through June 30, 2012, the Company has the option to defer the monthly interest payments otherwise due on $3.0 million of the 2010 notes and have any such amount of deferred interest added to the principal balance of the 2010 notes.

Principal Payment. In July 2011 and continuing for 11 months thereafter, principal payments of $200,000 per month are due on the last day of each month. Thereafter, we are required to pay principal in a monthly amount equal to the sum of (a) $383,702and (b) the quotient determined by dividing the (i) aggregate amount of interest added to the principal amount by (ii) 24. Any remaining principal amount, if not paid earlier, is due and payable on July 2, 2014.

August 2011 Amendment. We had the right to redeem up to $3.0 million of the 2010 notes prior to maturity in connection with the rights offering. In August 2011, the Company and Hale amended the Hale Securities Purchase Agreement to (i) cancel the Company's obligation to conduct the rights offering, and (2) cancel Hale's obligation to convert up to $3.0 million of the 2010 notes into common stock. As a result of the amendment, the original principal amount of the 2010 notes outstanding remained at approximately $10.5 million, plus interest that was accrued to principal through September 30, 2011. The Company's scheduled payment obligations under the 2010 notes will average approximately $300,000 per month through September 30, 2012 and average approximately $415,000 per month for the remaining twenty-one months until maturity.

No Conversion Rights. The 2010 notes are not convertible.

Security. The 2010 notes are secured by all our assets under the terms of a pledge and security agreement and we and our subsidiaries entered into with Hale. Each of our subsidiaries also entered into guarantees in favor of Hale, pursuant to which each subsidiary guaranteed the complete payment and performance by us of our obligation under the 2010 notes and related agreements.

Covenants. The 2010 notes impose certain covenants on us, including: restrictions against incurring additional indebtedness, creating any liens on our property, entering into a change in control transaction, redeeming or paying dividends on shares of our outstanding common stock, entering into certain related party transactions, changing the nature of our business, making or investing in a joint venture, disposing of any of our assets outside of the ordinary course of business, effecting any subsequent offering of debt or equity, amending our articles of incorporation or bylaws, and limiting our ability to enter into lease arrangements.

Events of Default. The 2010 notes define certain events of default, including; failure to make a payment obligation under the 2010 notes, failure to pay other indebtedness when due if the amount exceeds $250,000, bankruptcy, entry of a judgment against us in excess of $250,000 which is not discharged or covered by insurance, failure to observe other covenants of the 2010 notes or related agreements (subject to applicable cure periods), breach of representation or warranty, failure of Hale’s security documents to be binding and enforceable, and casualty loss of any of our assets that would have a material adverse effect on our business, and failure to meet 80% of quarterly financial targets from our annual operating budget, including cash, revenue and EBITDA. In the event of default, additional default interest of 4% will accrue on the outstanding balance. In addition, in the event of default, we may be required to redeem all or any portion of the 2010 notes at a price equal to 125% of the sum of the principal amount that such holder requests that we redeem plus accrued but unpaid interest on such principal amount plus any accrued and unpaid late charges with respect to such principal and interest.

Change of Control. We are required to obtain the consent of the holders of the 2010 notes representing at least a majority of the aggregate principal amount of the 2010 notes then outstanding in order to enter into a change of control transaction. If such consent is obtained the holders of the 2010 notes may require us to redeem all or any portion of such notes at a price equal to 125% of the sum of the principal amount that such holder requests that we redeem plus accrued but unpaid interest on such principal amount plus any accrued and unpaid late charges with respect to such principal and interest.

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Minimum Third Party Network Service Provider Commitments

We have a contract with a third party network service provider that facilitates interconnectivity with a number of third party network service providers. The contract contains a minimum usage guarantee of $0.2 million per monthly billing cycle and expires in July 2012. The cancellation terms are a 90 day written notice prior to the then current term expiring.

Critical Accounting Policies Involving Management Estimates and Assumptions

Our discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements. The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities and equity and disclosure of contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates include those related to the allowance for doubtful accounts; valuation of inventories; valuation of goodwill, intangible assets and property and equipment; valuation of stock based compensation expense, the valuation of warrants and conversion features; and other contingencies. We evaluate our estimates on an ongoing basis. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates under different assumptions or conditions.

There have been no material changes to our critical accounting policies, estimates, or judgments from those discussed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2010. The following is a discussion of certain of the accounting policies that require management to make estimates and assumptions where the impact of those estimates and assumptions may have a substantial impact on our financial position and results of operations.

Internally Developed Software:

The Company capitalizes payroll and related costs that are directly attributable to the design, coding, and testing of the Company's software developed for internal use. Internally developed software costs, which are included in property and equipment, are amortized on a straight-line basis over an estimated useful life of two years.

Goodwill:

Goodwill is not amortized but is regularly reviewed for potential impairment. The identification and measurement of goodwill impairment involves the estimation of the fair value of our reporting units. The estimates of fair value of reporting units are based on the best information available as of the date of the assessment, which primarily incorporate management assumptions about expected future cash flows. Future cash flows can be affected by changes in industry or market conditions or the rate and extent to which anticipated synergies or cost savings are realized with newly acquired entities.

Impairment of Long-Lived Assets:

Purchased intangible assets with finite lives are amortized using the straight-line method over the estimated economic lives of the assets, which range from five to ten years. Purchased intangible assets determined to have indefinite useful lives are not amortized. Long-lived assets, including intangible assets with finite lives, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Determination of recoverability is based on an estimate of undiscounted future cash flows resulting from the use of the asset and its eventual disposition. Measurement of an impairment loss for long-lived assets that management expects to hold and use is based on the fair value of the asset. Long-lived assets to be disposed of are reported at the lower of carrying amount or fair value less costs to sell.

Revenue Recognition:

Revenues from continuing operations are derived primarily from monthly recurring fees, which are recognized over the month the service is provided, activation fees, which are deferred and recognized over the estimated life of the customer relationship, and fees from usage, which are recognized as the service is provided.

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Revenues from our discontinued Digital Presence segment were recognized when persuasive evidence of an arrangement existed, title was transferred, product payment was not contingent upon performance of installation or service obligation, the price was fixed or determinable, and collectability was reasonably assured. In instances where final acceptance of the product or service was specified by the customer, revenue was deferred until all acceptance criteria was met. Additionally, extended service revenue on hardware and software products was recognized ratably over the service period, generally one year.

Income Taxes:

We account for income taxes using the asset and liability method, which recognizes deferred tax assets and liabilities determined based on the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. Valuation allowances are established to reduce deferred tax assets when, based on available objective evidence, it is more likely than not that the benefit of such assets will not be realized. In addition, FASB guidance requires us to recognize in the consolidated financial statements only those tax positions determined to be more likely than not of being sustained.

Derivative Financial Instruments

We do not use derivative instruments to hedge exposures to cash flow, market or foreign currency risks.

We review the terms of convertible debt and equity instruments the Company issues to determine whether there are embedded derivative instruments, including the embedded conversion option, that are required to be bifurcated and accounted for separately as a derivative financial instrument. In circumstances where the convertible instrument contains more than one embedded derivative instrument, including the conversion option, that is required to be bifurcated, the bifurcated derivative instruments are accounted for as a single, compound derivative instrument. Also, in connection with the sale of convertible debt and equity instruments, we may issue freestanding warrants that may, depending on their terms, be accounted for as derivative instrument liabilities, rather than as equity.

Bifurcated embedded derivatives are initially recorded at fair value and are then revalued at each reporting date with changes in the fair value reported as non-operating income or expense. When the convertible debt or equity instruments contain embedded derivative instruments that are to be bifurcated and accounted for as liabilities, the total proceeds allocated to the convertible host instruments are first allocated to the fair value of all the bifurcated derivative instruments. The remaining proceeds, if any, are then allocated to the convertible instruments themselves, usually resulting in those instruments being recorded at a discount from their face amount.

The discount from the face value of the convertible debt, together with the stated interest on the instrument, is amortized over the life of the instrument through periodic charges to income, using the effective interest method.

Stock Based Compensation:

We measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost is recognized in the Consolidated Statement of Operations over the period during which the employee is required to provide service in exchange for the award – the requisite service period. No compensation cost is recognized for equity instruments for which employees do not render the requisite service. The grant-date fair value of employee share options and similar instruments is estimated using option-pricing models adjusted for the unique characteristics of those instruments.

Recent Accounting Pronouncements

See “Note 2 – Basis of Presentation” of the Notes to the Condensed Consolidated Financial Statements included in "Item 1. Financial Statements” of Part I of this report.

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Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of Regulation S-K promulgated under the Securities Act.

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Under the rules and regulations of the Securities and Exchange Commission, as a smaller reporting company we are not required to provide the information required by this Item.

Item 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

Our disclosure controls and procedures are designed to provide reasonable assurances that material information related to our company is recorded, processed, summarized and reported within the time periods specified in the SEC rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Our Chief Executive Officer and Chief Financial Officer have determined that as of September 30, 2011, our disclosure controls were effective at that "reasonable assurance" level.

Changes In Internal Controls over Financial Reporting.

No changes were made in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act) during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II – OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS

From time to time, we may be involved in litigation relating to claims arising out of our operations in the normal course of business, including claims of alleged infringement, misuse or misappropriation of intellectual property rights of third parties. As of the date of this report, we are not a party to any litigation that we believe would have a material adverse effect on our business operations or financial condition.

Item 1A. RISK FACTORS

This report includes forward-looking statements about our business and results of operations that are subject to risks and uncertainties. See "Forward-Looking Statements," above. Factors that could cause or contribute to such differences include those discussed below. In addition to the risk factors discussed below, we are also subject to additional risks and uncertainties not presently known to us or that we currently deem immaterial. If any of these known or unknown risks or uncertainties actually occur, our business could be harmed substantially.

Risks Related To Our Financial Condition

The impact of the current economic climate and tight financing markets may impact consumer demand for our products and services.

Many of our existing and target customers are in the small and medium business sector. Although we believe our products and services are less costly than traditional telephone services, these businesses are more likely to be significantly affected by economic downturns than larger, more established businesses. Additionally, these customers often have limited discretionary funds, which they may choose to spend on items other than our products and services. If small and medium businesses experience economic hardship, it could negatively affect the overall demand for our products and services, could cause delay and lengthen sales cycles and could cause our revenue to decline.

Although we maintain allowances for returns and doubtful accounts for estimated losses resulting from product returns and the inability of our customers to make required payments, and such losses have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience the same return and bad debt rates that we have in the past, especially given the current economic conditions. Additionally, challenging economic conditions could have a negative impact on the results of our operations.

We have experienced significant losses to date and may require additional capital to fund our operations. The current financial climate may make it more difficult to secure financing, if we need it. If our business model is not successful, or if we are unable to generate sufficient revenue to offset our expenditures, we may not become profitable, and the value of your investment may decline.

We had net income of $10.3 million for the year ended December 31, 2010, which was primarily attributable to a non-recurring gain on debt extinguishment of $16.5 million. We incurred a loss of $8.1 million for the year ended December 31, 2009. We have an accumulated deficit of $34.8 million at September 30, 2011. In order to achieve sustainable profitability we will have to continue to develop innovative products with a strong value proposition, provide convenient and reliable service, expand our customer base and strictly manage our operating expenses. We cannot be sure that we will be successful in meeting these challenges. If we are unable to do so, our business will not be successful.

We believe our cash balance, together with anticipated cash flows from operations, is sufficient to fund our operations through September 30, 2012. However, if we are unable to generate sufficient revenues to pay our expenses, we will need to raise additional funds to continue our operations. We have historically financed our operations through private equity and debt financings. Recent economic turmoil and severe lack of liquidity in the debt capital markets together with volatility and rapidly falling prices in the equity capital markets have severely and adversely affected capital raising opportunities. In addition, we issued $10.5 million of senior secured notes, which we refer to as the “2010 notes,” in connection with the recapitalization in July 2010. The terms of the 2010 notes restrict our ability to borrow funds, pledge our assets as security for any borrowing or raise additional capital by selling shares of capital stock or other equity or debt securities, without the consent of the holders of the 2010 notes. We do not have any commitments for financing at this time, and financing may not be available to us on favorable terms, if at all. If we are unable to obtain debt or equity financing in amounts sufficient to fund our operations, if necessary, we will be forced to suspend or curtail our operations.

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At the time we issued the 2010 notes, the company expected to be able to redeem up to $3.0 million in principal of the 2010 notes by pursuing the Rights Offering (see Notes 4 and 5 to the financial statements above). As part of an amendment to the Hale Securities Purchase Agreement entered into in August of 2011, the company was released from its obligation to pursue the Rights Offering and Hale was released from its obligation to “backstop” up to $3.0 million of the Rights Offering by redeeming that portion of principal of the 2010 notes for common stock of the company. An effect of this amendment is that the company retains $3.0 million of the Hale indebtedness, which it must service and did not expect to be subject to at the time the Hale Securities Purchase Agreement was effected. While the company and its board believe that the amendment was in the best interests of the company and all of its shareholders, the additional debt service negatively affects the company’s cash position.

The sale of the shares of our common stock acquired in private placements could cause the price of our common stock to decline.

In our July 2010 recapitalization we issued a total of 4,170,684 shares of our common stock to affiliates of Hale. We are required to file one or more registration statements covering the resale of the shares of common stock sold to Hale in our private placement transaction. If and when such registration statements are declared effective, the holder of those shares will be able to sell. Generally, the holders of the securities convertible or exercisable into our common stock will be able to sell the common stock issued upon conversion or exercise under Rule 144 adopted under the Securities Act of 1933, (as amended, the “Securities Act”). As part of the amendment to the Hale Securities Purchase Agreement, the company and Hale agreed to extend the period by which any such registration statement must be declared effective to November 30, 2011. As such, you should expect a significant number of such shares of common stock to be sold. Depending upon market liquidity at the time our common stock is resold by the holders thereof, such re-sales could cause the trading price of our common stock to decline. In addition, the sale of a substantial number of shares of our common stock, or anticipation of such sales, could make it more difficult for us to sell equity or equity-related securities in the future at a time and at a price that we might otherwise wish to effect sales.

We have significant indebtedness and agreed to certain restrictions on our operations.

We currently owe, in the aggregate, approximately $11.6 million in principal payments on the 2010 notes. The 2010 notes, all of which are held by Hale, contain covenants that impose significant restrictions on us, including restrictions on our ability to issue debt or equity securities, restrictions against incurring additional indebtedness, creating any liens on our property, amending our certificate of incorporation or bylaws, redeeming or paying dividends on shares of our outstanding common stock, and entering into certain related party transactions.

Our ability to comply with these provisions may be affected by changes in our business condition or results of our operations, or other events beyond our control. The breach of any of these covenants could result in a default under the 2010 notes, permitting the holders to accelerate the maturity of the 2010 notes and demand repayment in full which could impair our ability to operate or cause us to seek bankruptcy protection.

All of the 2010 notes are held by one investor and its affiliates, and that investor will be able to control any waivers or amendments to the terms of the 2010 notes and exercise rights and remedies with respect to the 2010 notes.

Hale holds all of the 2010 notes. Under the terms of the Hale Securities Purchase Agreement, certain amendments or waivers must be approved by the holders of a majority of the outstanding principal amount of the 2010 notes. Consequently, Hale will have sole authority to approve or not approve any amendment or waiver. In addition, Hale will have sole authority to exercise any rights or remedies available to it under the terms of the 2010 notes.

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Our failure to repay the 2010 notes could result in substantial penalties against us, and legal action that could substantially impair our operations.

The 2010 notes accrue interest at a rate equal to the prime rate plus 4.75% per annum, which is payable at the end of each month. Through June 30, 2011, we had the option to defer the monthly interest payments otherwise due and to have the amount of interest deferred added to the principal balance. We elected to defer all such interest. It will be an event of default under the 2010 notes if we are unable to make payments thereunder when and as required. Other events of default under the 2010 notes include; failure pay other indebtedness when due if the amount exceeds $250,000, bankruptcy, entry of a judgment against us in excess of $250,000 which is not discharged or covered by insurance, failure to observe other covenants of the 2010 notes or related agreements (subject to applicable cure periods), breach of representation or warranty, failure of security documents entered into in connection with the issuance of the 2010 notes to be binding and enforceable, and casualty loss of any of our assets that would have a material adverse effect on our business, and failure to meet 80% of quarterly financial targets from our annual operating budget, including cash, revenues and earnings before interest, taxes, depreciation and amortization, or EBITDA. In the event of default, additional default interest of 4% will accrue on the outstanding balance of the 2010 notes. In addition, in the event of default, we may be required to redeem all or any portion of the 2010 notes at a price equal to 125% of the sum of the principal amount that such holder requests that we redeem plus accrued but unpaid interest on such principal amount plus any accrued and unpaid late charges with respect to such principal and interest. If we were unable to repay the default amount when and as required, the holder could commence legal action against us. Any such action could impose significant costs on us and require us to curtail or cease operations.

Our failure to secure registration of the common stock and maintain such registration could result in monetary damages.

Under the terms of the registration rights agreement we entered into in connection with the Hale Securities Purchase Agreement, we agreed to file registration statements covering the resale of the shares of common stock we sold to Hale by specified deadlines, to have such registration statements declared effective by specified deadlines, and to maintain the effectiveness of such registration statements to permit the resale of all the share of common stock we agreed to register for resale. The registration rights agreement contains penalty provisions in the event that we fail to comply with the foregoing. For example, if we did not file the registration statement that we filed on September 30, 2010 by September 30, 2010, or if such registration statement was not declared effective by November 30, 2011 (per amendment), or if we fail to file other registration statements we are required to file under the terms of the registration rights agreement in a timely manner or if we fail to maintain the effectiveness of any registration statement we file under the registration rights agreement until the shares issued in our 2010 note private placement are sold or can be sold under Rule 144 without restriction or limitation (including volume restrictions) and without the requirement that our company be in compliance with Rule 144(c)(1), then, as partial relief for the damages to any holder or registrable securities by reason of any such delay in or reduction of its ability to sell the shares of common stock, and in addition to any other remedies available to such holder, we agreed to pay liquidated damages in an amount of 1% of the aggregate purchase price of such holder’s registrable securities included in such registration statement that are then owned by such holder. Such payments are due on the date we fail to comply with our obligation and every 30th day thereafter (pro rated for period totaling less than 30 days) until such failure is cured. The registration statements covering the resale of the common stock have not been declared effective. To date, the investor and its affiliates, have waived all initial registration statement effectiveness deadlines, and we amended the registration rights agreement to extend the registration statement effectiveness deadline to November 30, 2011.

Our ability to use our net operating loss carryforwards may be limited.

As of September 30, 2011, we had net operating loss carryforwards of approximately $6.1 million, some of which, if not utilized, will begin expiring in 2011. Our ability to utilize the net operating loss carryforwards is dependent upon generating taxable income. We have recorded a corresponding valuation allowance to offset the deferred tax assets as it is more likely than not that the deferred tax assets will not be realized. Section 382 of the U.S. Internal Revenue Code of 1986, as amended, generally imposes an annual limitation on the amount of net operating loss carryforwards that may be used to offset taxable income when a corporation has undergone significant changes in stock ownership.

Risks Related to Our Business

We face competition from much larger and well-established companies.

We face competition from much larger and well-established companies. In addition, our competition is not only from other independent VoIP providers, but also from traditional telephone companies, wireless companies, cable companies, competitive local exchange carriers and alternative voice communication providers. Some of our competitors have greater financial resources, production, sales, marketing, engineering and other capabilities with which to develop, manufacture, market and sell their products, and more experience in research and development than we have. As a result, our competitors may have greater credibility with our existing and potential customers. Further, because most of our target market is already purchasing communications services from one or more of our competitors, our success is dependent upon our ability to attract customers away from their existing providers.

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In addition, other established or new companies may develop or market technologies or products competitive with, or superior to, ours. We cannot assure you that our competitors will not succeed in developing or marketing technologies or products that are more effective or commercially attractive than ours or that would render our products and services obsolete. Our success will depend in large part on our ability to maintain a competitive position with our products and services.

Lower than expected market acceptance of our products or services would negatively impact our business.

We continue to develop and introduce new products. End-users will not begin to use our products or services unless they determine that our products and services are reliable, cost-effective and an effective means of communication. These and other factors may affect the rate and level of market acceptance of our products and services, including:

	•	our price relative to competing products or services or alternative means of communication;
	•	effectiveness of our sales and marketing efforts;
	•	perception by our targeted end-users of our systems' reliability, efficacy and benefits compared to competing technologies;
	•	willingness of our targeted end-users to adopt new technologies; and
	•	development of new products and technologies by our competitors.

If our products and services do not achieve market acceptance, our ability to achieve any level of profitability would be harmed and our stock price would decline.

Price competition would negatively impact our business.

Our profitability could be negatively affected as a result of competitive price pressures in the sale of unified communications products, which could cause us to reduce the price of our products or services. Any such reduction could have an adverse impact on our margins and profitability. Our competitors may also offer bundled service arrangements offering a broader product or service offering despite the technical merits or advantages of our products. Moreover, our competitors' financial resources may allow them to offer services at prices below cost or even for free to maintain and gain market share or otherwise improve their competitive positions. Any of these competitive factors could make it more difficult for us to attract and retain customers, cause us to lower our prices in order to compete resulting in lower gross profit and lower profitability.

We depend on contract manufacturers to manufacture substantially all of our products, and any delay or interruption in manufacturing by these contract manufacturers would result in delayed or reduced shipments to our customers and may harm our business.

We bundle certain of our services with telephone and network hardware that we acquire from third parties. We do not have long-term purchase agreements with our contract manufacturers and we depend on a concentrated group of contract manufacturers for a substantial portion of manufacturing our products. There can be no assurance that our contract manufacturers will be able or willing to reliably manufacture our products, in volumes, on a cost-effective basis or in a timely manner. If we cannot compete effectively for the business of these contract manufacturers, or if any of the contract manufacturers experience financial or other difficulties in their businesses, our revenue and our business could be adversely affected. In particular, if one of our contract manufacturers decides to cease doing business with us or becomes subject to bankruptcy proceedings, we may not be able to obtain any of our products made by the contract manufacturer, which could be detrimental to our business

We could be liable for breaches of security on our web site, fraudulent activities of our users, or the failure of third-party vendors to deliver credit card transaction processing services.

A fundamental requirement for operating an Internet-based, worldwide voice communications service and electronically billing our customers is the secure transmission of confidential information and media over public networks. Although we have developed systems and processes that are designed to protect consumer information and prevent fraudulent credit card transactions and other security breaches, failure to mitigate such fraud or breaches may adversely affect our operating results. The law relating to the liability of providers of online payment services is currently unsettled and states may enact their own rules with which we may not comply. We rely on third party providers to process and guarantee payments made by our subscribers up to certain limits, and we may be unable to prevent our customers from fraudulently receiving goods and services. Our liability risk will increase if a larger fraction of our transactions involve fraudulent or disputed credit card transactions. Any costs we incur as a result of fraudulent or disputed transactions could harm our business. In addition, the functionality of our current billing system relies on certain third-party vendors delivering services. If these vendors are unable or unwilling to provide services, we will not be able to charge for our services in a timely or scalable fashion, which could significantly decrease our revenue and have a material adverse effect on our business, financial condition and operating results.

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We have historically experienced losses due to subscriber fraud and theft of service and may again in the future.

In the past, subscribers have obtained access to our service without paying for monthly service and international toll calls by unlawfully using our authorization codes or by submitting fraudulent credit card information. To date, such losses from unauthorized credit card transactions and theft of service have not been significant. We have implemented anti-fraud procedures in order to control losses relating to these practices, but these procedures may not be adequate to effectively limit all of our exposure in the future from fraud. If our procedures are not effective, consumer fraud and theft of service could significantly decrease our revenue and have a material adverse effect on our business, financial condition and operating results.

System disruptions could cause delays or interruptions of our service, which could cause us to lose customers or incur additional expenses.

Our success depends on our ability to provide reliable service. Although we have designed our network service to minimize the possibility of service disruptions or other outages, our service may be disrupted by problems on our system, such as malfunctions in our software or other facilities, overloading of our network and problems with the systems of competitors with which we interconnect, such as physical damage to telephone lines and power surges and outages. Although we have experienced isolated power disruptions and other outages for short time periods, we have not had system-wide disruptions of a sufficient duration or magnitude that had a significant impact on our customers or our business. Any significant disruption in our ability to provide reliable service could cause us to lose customers and incur additional expenses.

Business disruptions, including disruptions caused by security breaches, extreme weather, terrorism or other disasters, could harm our future operating results.

The day-to-day operation of our business is highly dependent on the integrity of our communications and information technology systems, and on our ability to protect those systems from damage or interruptions by events beyond our control. Sabotage, computer viruses or other infiltration by third parties could damage our systems. Such events could disrupt our service, damage our facilities, damage our reputation, and cause us to lose customers, among other things, and could harm our results of operations. In addition, a catastrophic event could materially harm our operating results and financial condition. Catastrophic events could include a terrorist attack on the United States, or major natural disasters, extreme weather, earthquake, fire, or similar event that affects our central offices, corporate headquarters, network operations center or network equipment. We believe that communications infrastructures, such as the one on which we rely, may be vulnerable in the case of such an event, and our markets, which are metropolitan markets, or Tier 1 markets, may be more likely to be the targets of terrorist activity.

We may experience delays in introducing products or services to the market and our products or services may contain defects which could seriously harm our results of operations.

We may experience delays in introducing new or enhanced products or services to the market. Such delays, whether caused by factors such as unforeseen technology issues or otherwise, could negatively impact our sales revenue in the relevant period. In addition, we may terminate new product, service or enhancement development efforts prior to any introduction of a new product, service or enhancement. Any delays for new offerings currently under development or any product defect issues or product recalls could adversely affect the market acceptance of our products or services, our ability to compete effectively in the market, and our reputation, and therefore, could lead to decreased sales and could seriously harm our results of operations.

It may be difficult for us to identify the source of the problem when there is a network problem.

We must successfully integrate our service with products from third party vendors and carriers. When network problems occur, it may be difficult for us to identify its source. This may result in the loss of market acceptance of our products and we may incur expenses in connection with any necessary corrections.

Decreasing telecommunications rates may diminish or eliminate our competitive pricing advantage in the VoIP business.

Telecommunications rates in the markets in which we do business have and may continue to decrease, which may eliminate the competitive pricing advantage of our services. Customers who use our services to benefit from our current pricing advantage may switch to other providers if such pricing advantage diminishes. Further, continued rate decreases by our competitors may require us to lower our rates, which will reduce or possibly eliminate any gross profit from our services.

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We rely on third party network service providers for certain aspects of our VoIP business.

Rather than deploying our own network, we leverage the infrastructure of third party service providers to provide telephone numbers, public switched telephone network, or PSTN, call termination and origination services, and local number portability for our customers. Though this has lowered our operating costs in the short term, it has also reduced our operating flexibility and ability to make timely service changes. If any of the third party service providers stop providing the services on which we depend, the delay in switching the underlying services to another service provider, if available, and qualifying this new service could adversely affect our business.

While we believe that we have good relationships with our current service providers, we can give no assurance that they will continue to supply cost-effective services to us in the future or that we will be successful in signing up alternative or additional providers. Although we believe we could replace our current providers, if necessary, our ability to provide service to our customers would be impacted during this timeframe, which could adversely affect our business.

Our growth may be limited by certain aspects of our VoIP service.

Our VoIP services are not the same in all respects as those provided by traditional telephone service providers. For example:

	•	In some cases, we utilize a data circuit rather than traditional wireline voice circuits to interconnect to existing customer equipment. This requires the additional use of a modem and gateway on the customer's premises, which is an unfamiliar concept for many of our customers.
	•	Our emergency calling service is different.
	•	Our customers may experience higher dropped-call rates and other call quality issues because our services depend on data networks rather than traditional voice networks and these services have more single points of failure than traditional wireline networks.
	•	Our customers cannot accept collect calls.
	•	Our services are interrupted in the event of a power outage or if Internet access is interrupted.

Because our continued growth depends on our target market adopting our services, our ability to adequately address significant differences through our technology, customer services, marketing and sales efforts is important. If potential customers do not accept the differences between our service and traditional telephone service, they may not subscribe to our VoIP services and our business would be adversely affected.

Our growth in the VoIP business may be negatively affected if we are unable to improve our process for local number portability provisioning.

Local number portability, which is considered an important feature by many customers, allows a customer to retain their existing telephone numbers when subscribing to our services. The customer must maintain their existing telephone service during the number transfer process. Although we are taking steps to reduce how long the process takes, currently the process of transferring numbers can take 20 business days or longer. By comparison, generally, transferring wireless telephone numbers among wireless service providers takes several hours, and transferring wireline telephone numbers among traditional wireline service providers takes a few days. The additional time our process takes is due to our reliance on third party carriers to transfer the numbers and any delay by the existing telephone service provider may contribute to the process. If we fail to reduce the amount of time the process takes, our ability to acquire new customers or retain existing customers may suffer.

Our success in the VoIP business also depends on our ability to handle a large number of simultaneous calls.

We expect the volume of simultaneous calls to increase significantly as our customer base grows. Our network hardware and software may not be able to accommodate this additional volume. This could result in a decreased level of operating performance, disruption of service and a loss of customers, any of which could adversely affect our business.

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A higher rate of customer terminations would reduce our revenue or require us to spend more money to grow our customer base in the VoIP business.

We must acquire new customers on an ongoing basis to maintain our existing level of customers and revenues due to customers that terminate our service. As a result, marketing expense is an ongoing requirement of our business. If our churn rate increases, we will have to acquire even more new customers to maintain our existing revenues. We incur significant costs to acquire new customers, and those costs are an important factor in achieving future profitability. Therefore, if we are unsuccessful in retaining customers or are required to spend significant amounts to acquire new customers, our revenue could decrease and our net losses could increase.

Our success also depends on third parties in our distribution channels.

We currently sell our products both directly to customers and through resellers. We may not be successful in developing additional distribution relationships. Agreements with distribution partners generally provide for one-time or recurring commissions based on our list prices, and do not require minimum purchases or restrict development or distribution of competitive products. Therefore, entities that distribute our products may compete with us. In addition, distributors and resellers may not dedicate sufficient resources or give sufficient priority to selling our products. Our failure to develop new distribution channels, the loss of a distribution relationship or a decline in the efforts of a reseller or distributor could adversely affect our business.

We need to retain key personnel to support our products and ongoing operations.

The development and marketing of our products will continue to place a significant strain on our limited personnel, management, and other resources. Our future success depends upon the continued services of our executive officers and other key employees who have critical industry experience and relationships that we rely on to implement our business plan. The loss of the services of any of our officers or key employees could delay the development and introduction of, and negatively impact our ability to sell our products which could adversely affect our financial results and impair our growth. We currently do not maintain key person life insurance policies on any of our employees.

Risks Relating to Our Industry

We face risks associated with our products and services and their development, including new product or service introductions and transitions.

The communications market is going through a period of rapid technological changes and frequent introduction of new and enhanced products, a recent example is Skype for business, which may result in products or services that are superior to ours. To compete successfully in this market, we must continue to design, develop, manufacture, and sell new and enhanced products and services that provide increasingly higher levels of performance and reliability at lower cost and respond to customer expectations. Our success in designing, developing, manufacturing, and selling such products and services will depend on a variety of factors, including:

	•	our ability to timely identify new technologies and implement product design and development;
	•	the scalability of our software products; and
	•	our ability to successfully implement service features mandated by federal and state law.

If we are unable to anticipate or keep pace with changes in the marketplace and the direction of technological innovation and customer demands, our products or services may become less useful or obsolete and our operating results will suffer. Additionally, properly addressing the complexities associated with compatibility issues, sales force training, and technical and sales support are also factors that may affect our success.

Because the communications industry is characterized by competing intellectual property, we may be sued for violating the intellectual property rights of others.

The communications industry is susceptible to litigation over patent and other intellectual property rights. Determining whether a product infringes a patent involves complex legal and factual issues, and the outcome of patent litigation actions is often uncertain. We have not conducted an extensive search of patents issued to third parties, and no assurance can be given that third party patents containing claims covering our products, parts of our products, technology or methods do not exist, have not been filed, or could not be filed or issued.

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From time to time, we have received, and may continue to receive in the future, notices of claims of infringement, or potential infringement, of other parties' proprietary rights. If we become subject to a patent infringement or other intellectual property lawsuit and if the relevant patents or other intellectual property were upheld as valid and enforceable and we were found to infringe or violate the terms of a license to which we are a party, we could be prevented from selling our products unless we could obtain a license or were able to redesign the product to avoid infringement. If we were unable to obtain a license or successfully redesign our products, we might be prevented from selling our products. If there is an allegation or determination that we have infringed the intellectual property rights of a third party, we may be required to pay damages, or a settlement or ongoing royalties. In these circumstances, we may be unable to sell our products at competitive prices or at all, our business and operating results could be harmed and our stock price may decline.

Inability to protect our proprietary technology would disrupt our business.

We rely in part on patent, trademark, copyright, and trade secret law, and nondisclosure agreements to protect our intellectual property in the United States and abroad. As of September 30, 2011, we had two patents relating to telecommunications and security. We cannot provide any assurance that these patents or any patents that we may secure in the future will be sufficient to provide commercial advantage for our products. We may not be able to protect our proprietary rights in the United States or abroad, and competitors may independently develop technologies that are similar or superior to our technology, duplicate our technology or design around any patent of ours. Moreover, litigation may be necessary in the future to enforce our intellectual property rights. Such litigation could result in substantial costs and diversion of management time and resources and could adversely affect our business.

Our VoIP products must comply with industry standards, which are evolving.

Market acceptance of VoIP is, in part, dependent upon the adoption of industry standards so that products from various manufacturers can interoperate. Currently, industry leaders do not agree on which standards should be used for a particular application, and the standards continue to change. Our VoIP telephony products rely significantly on communication standards (e.g., SIP and MGCP) and network standards (e.g., TCP/IP and UDP) to interoperate with equipment of other vendors. As standards change, we may have to modify our existing products or develop and support new versions of our products. The failure of our products and services to comply, or delays in compliance, with industry standards could delay or interrupt production of our VoIP products or harm the perception and adoption rates of our service, any of which would adversely affect our business.

Future regulation of VoIP services could limit our growth.

The VoIP industry may be subject to increased regulation. In addition, established telecommunication companies may devote substantial lobbying efforts to influence the regulation of the VoIP industry in a manner that is contrary to our interests. Increased regulation and additional regulatory funding obligations at the federal and state level could require us to either increase the retail price for our VoIP services, which would make us less competitive, or absorb such costs, which would decrease our profit margins.

Our emergency and 911 calling services differ from those offered by traditional telephone service providers and may expose us to significant liability in the VoIP business.

Traditional telephone service providers route emergency calls over a dedicated infrastructure directly to an emergency services dispatcher in the caller's area. Generally, the dispatcher automatically receives the caller's phone number and location information. Our 911 service, where offered, operates in a similar manner. However, the only location information that our 911 service can transmit to an emergency service dispatcher is the information that our customers have registered with us. A customer's registered location may be different from the customer's actual location at the time of the call, and the customer, in those instances, would have to verbally inform the emergency services dispatcher of his or her actual location at the time of the call.

The operation of our 911 service may vary depending on the specific location of the customer. In some areas, emergency calls are delivered with the caller's address or callback number. In other areas the emergency call may be delivered without the caller’s address or callback number. In some cases calls may be delivered to a call center that is run by a third-party provider, and the call center operator will coordinate connecting the caller to the appropriate Public Safety Answering Point or emergency services provider and providing the customer's service location and phone number to those local authorities. In late July 2008, the "New and Emerging Technologies 911 Improvement Act of 2008" was enacted. This law provides public safety, interconnected VoIP providers and others involved in handling 911 calls the same liability protections when handling 911 calls from interconnected VoIP users as from mobile or wired telephone service users. We do not know what effect this law will have on our 911 solution at this time. Also, we may be exposed to liability for 911 calls made prior to the adoption of this new law although we are unaware of any such liability.

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Delays our customers encounter when making emergency services calls and any inability of the answering point to automatically recognize the caller's location or telephone number can result in life threatening consequences. In addition, if a customer experiences an Internet or power outage or network failure, the customer will not be able to reach an emergency services provider using our services. Customers may attempt to hold us responsible for any loss, damage, personal injury or death suffered as a result of any failure of our 911 services and, unlike traditional wireline and wireless telephone providers, with the exception of the 2008 Act mentioned above, we know of no other state or federal provisions that currently indemnify or limit our liability for connecting and carrying emergency 911 phone calls over IP networks.

If we fail to comply with FCC regulations requiring us to provide E911 services, we may be subject to significant fines or penalties in the VoIP business.

In May 2005, the FCC required VoIP providers that interconnect with the PSTN to provide E911 service. On November 7, 2005, the Enforcement Bureau of the FCC issued a notice stating the information required to be submitted to the FCC in E911 compliance letters due by November 28, 2005. In this notice, the Enforcement Bureau stated that, although it would not require providers that had not achieved full E911 compliance by November 28, 2005 to discontinue the provision of VoIP services to any existing customers, it did expect that such providers would discontinue marketing VoIP services, and accepting new customers for their services, in all areas where they are not transmitting 911 calls to the appropriate PSAP in full compliance with the FCC's rules. On November 28, 2005, we filed our E911 compliance report. On March 12, 2007, we received a letter from the Enforcement Bureau requesting that we file an updated E911 Status Report no later than April 11, 2007. On April 11, 2007, we responded to the FCC and indicated that (i) 95.4% of our VoIP subscribers receive 911 service in full compliance with the FCC’s rules, (ii) we do not accept new VoIP customers in areas where it is not possible to provide 911 service in compliance with the FCC rules, (iii) we currently serve only a very small number of existing subscribers in areas where we have not yet deployed a 911 network solution that is fully compliant with the FCC’s regulations and were provisioned with new service after November 28, 2005, and (iv) we have procedures in place to ensure that no new subscribers are being provisioned in non-compliant areas.

The FCC may determine that services we may offer based on nomadic emergency calling do not satisfy the requirements of its VoIP E911 order because, in some instances, a nomadic emergency calling solution may require that we route an emergency call to a national emergency call center instead of connecting subscribers directly to a local PSAP through a dedicated connection and through the appropriate selective router. The FCC may issue further guidance on compliance requirements in the future that might require us to disconnect those subscribers not receiving access to emergency services in a manner consistent with the VoIP E911 order. The effect of such disconnections, monetary penalties, cease and desist orders or other enforcement actions initiated by the FCC or other agency or task force against us could have a material adverse effect on our financial position, results of operations, cash flows or business reputation. On June 1, 2007, the FCC released a Notice of Proposed Rulemaking in which they tentatively conclude that all VoIP service providers that allow customers to use their service in more than one location (nomadic VoIP service providers) must utilize an automatic location technology that meets the same accuracy standards which apply to providers of commercial mobile radio services (mobile phone service providers). The outcome of this proceeding cannot be determined at this time and we may or may not be able to comply with any such obligations that may be adopted. At present, we currently have no means to automatically confirm the physical location of a subscriber if the service is such that the subscriber is connected via the Internet. The FCC's VoIP E911 order has increased our cost of doing business and may adversely affect our ability to deliver our service to new and existing customers in all geographic regions or to nomadic customers who move to a location where emergency calling services compliant with the FCC's mandates are unavailable. We cannot guarantee that emergency calling service consistent with the VoIP E911 order will be available to all of our subscribers. The FCC's current VoIP E911 order, follow-on orders or clarifications, or their impact on our customers due to service price increases or other factors, could have a material adverse affect on our business, financial position and results of operations.

Our inability to comply with the requirements of federal law enforcement agencies could adversely affect our VoIP business.

Broadband Internet access services and VoIP services are subject to Communications Assistance for Law Enforcement Act or CALEA. Currently, our CALEA solution is fully deployed in our network. However, we could be subject to an enforcement action by the FCC or law enforcement agencies for any delays related to meeting, or if we fail to comply with, any current or future CALEA obligations. Such enforcement actions could subject us to fines, cease and desist orders, or other penalties, any of which could adversely affect our business.

Our inability to comply with the requirements of federal and other regulations related to customer proprietary network information could adversely affect our VoIP business.

We are subject to the customer proprietary network information, or CPNI, rules. CPNI includes information such as the phone numbers called by a consumer; the frequency, duration, and timing of such calls; and services purchased by the consumer, such as call waiting, call forwarding, and caller ID. Under the current rules, generally, except in connection with providing existing services to a customer, carriers may not use CPNI without customer consent. We do not currently use our customer's CPNI in a manner which would require us to obtain consent, but if we do in the future, we will be required to adhere to specific CPNI rules. If we fail to comply with any current or future CPNI rules, we could be subject to enforcement action or other penalties, any of which could adversely affect our business.

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Our VoIP business may suffer if we fail to comply with funding requirements of state or federal funds, or if our customers cancel service due to the impact of these price increases to their service.

Currently, VoIP providers must contribute to the federal USF. There is a risk that states may attempt to assert state USF contribution requirements and other state and local charges. In addition, VoIP providers are subject to Section 225 of the Communications Act, which requires contribution to the TRS fund and requires VoIP providers to offer 711 abbreviated dialing for access to relay services. Although we contribute to the TRS fund, we have not yet implemented a solution for the 711 abbreviated dialing requirement. We cannot predict the impact of these types of obligations on our business or our ability to comply with them. We will likely pass these additional costs on to our customers and the impact of this price increase or our inability to recoup our costs or liabilities or other factors could adversely affect our business. We may be subject to enforcement actions if we are not able to comply with these new requirements.

We may be subject to liabilities for past telecom taxes, sales taxes, surcharges and fees.

We collect telecom taxes, sales taxes, surcharges and fees from our customers. The amounts collected from our customers are remitted to the proper authorities. While we believe we have collected and remitted appropriately, it is possible that substantial claims for back taxes may be asserted against us, which could adversely affect our business financial condition or operating results. In addition, future expansion of our service, along with other aspects of our evolving business, may result in additional tax obligations. One or more taxing authorities may seek to impose sales, use or other tax collection obligations on us. We have received inquiries or demands from numerous state authorities and may be subjected to audit at any time. A successful assertion by one or more taxing authorities that we should collect sales, use or other taxes on the sale of our services could result in substantial tax liabilities for past sales, could decrease our ability to compete with traditional telephone companies, and could adversely affect our business.

Our ability to offer new VoIP services outside the United States is subject to the local regulatory environment.

The regulations and laws applicable to the VoIP market outside the United States are various and often complicated and uncertain. Because of our relationship with certain resellers, some countries may assert that we are required to register as a provider in their country. The failure by us, our customers or our resellers to comply with applicable laws and regulations could adversely affect our business.

Risks Related to the Market for Our Common Stock

We may experience significant fluctuations in the market price of our common stock.

The market price of our common stock may experience significant fluctuations. These fluctuations may be unrelated or out of proportion to our operating performance, and could harm our stock price. Any negative change in the public's perception of the prospects of companies that employ similar technology or sell into similar markets could also depress our stock price, regardless of our actual results.

The market price of our common stock may be significantly affected by a variety of factors, including:

	•	announcements of new products, product enhancements, new services or service enhancements by us or our competitors;
	•	announcements of strategic alliances or significant agreements by us or by our competitors;
	•	technological innovations by us or our competitors;
	•	quarterly variations in our results of operations;
	•	acquisition of one of our competitors by a significantly larger company;
	•	general market conditions or market conditions specific to technology industries;
	•	sales of large blocks of our common stock; and
	•	domestic and international macroeconomic factors.

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Hale owns a majority of our stock and has the right to appoint a majority of our directors, which ownership and board control gives them significant influence over our business.

As of September 30, 2011, we had 4,820,098 shares of common stock outstanding. Hale owns approximately 84% of our outstanding common stock. Accordingly, Hale has control over the outcome of matters submitted to our stockholders for approval, including the election of directors. Hale’s significant ownership also could affect the market price of our common stock by, for example, delaying, deferring or preventing a change in corporate control, impeding a merger, consolidation, takeover or other business combination involving us, or discouraging a potential acquirer from making a tender offer or otherwise attempting to obtain control of us. In addition, Hale has the right to appoint three members to our five member board of directors.

An investment in our company may be diluted in the future as a result of the issuance of additional securities.

Under the terms of the Hale Securities Purchase Agreement, we agreed to issue additional shares to Hale in the event that we are required to make payment, at any time prior to July 2, 2012, on certain identified contingent liabilities up to an aggregate amount of $769,539, such that the total percentage ownership of its fully diluted common stock immediately after the payment of such liabilities will equal the same percentage ownership that Hale would have had if the contingent payable had been paid prior to the recapitalization transaction. To date $214,052of these contingent liabilities have been fixed and incurred as expenses. Accordingly, in March 2011 we issued to Hale an additional 225,576 shares of our common stock under the terms of the Hale Securities Purchase Agreement. We anticipate that some portion of the remaining contingent liabilities will be fixed and incurred but we cannot be certain of the amount of the timing. If and when they are incurred, we will be compelled under the terms of the Hale Securities Purchase Agreement to issue additional shares to Hale. The issuance of such additional shares, as further explained in the risk factor above, could result in substantial dilution to current stockholders.

Finally, if we determine that we need to raise additional capital to fund our business plan, we may, issue additional shares of common stock or securities convertible, exchangeable or exercisable into common stock, which could further result in substantial dilution to current stockholder. No arrangements for any such offering exist, and no assurance can be given concerning the terms of any future offering or that we will be successful in issuing common stock or other securities at all. If adequate funds are not available, we may not be able to continue our operations or implement our planned additional research and development activities, any of which would adversely affect our results of operations and financial condition.

We have never paid dividends on our common stock, and we do not anticipate paying any dividends in the foreseeable future.

We have paid no cash dividends on our common stock to date. In addition, we are currently restricted from paying any dividends on our common stock under the terms of the 2010 notes. Even absent such restriction, we currently intend to retain our future earnings, if any, to fund the development and growth of our business. In addition, the terms of any future debt or credit facility, if any, may preclude us from paying dividends. As a result, capital appreciation, if any, of our common stock will be our stockholders’ sole source of gain for the foreseeable future.

Our common stock is quoted on the OTC Bulletin Board, which may be detrimental to investors.

Our common stock is currently quoted on the OTC Bulletin Board. Stocks quoted on the OTC Bulletin Board generally have limited trading volume and exhibit a wide spread between the bid/ask quotation. Accordingly, you may not be able to sell your shares quickly or at the market price if trading in our stock is not active.

Our common stock is subject to penny stock rules.

Our common stock is subject to Rule 15g-1 through 15g-9 under the Exchange Act, which imposes certain sales practice requirements on broker-dealers who sell our common stock to persons other than established customers and "accredited investors" (generally, individuals with a net worth in excess of $1,000,000, excluding the value of such person’s primary residence, or annual incomes exceeding $200,000 (or $300,000 together with their spouse)). For transactions covered by this rule, a broker-dealer must make a special suitability determination for the purchaser and have received the purchaser's written consent to the transaction prior to the sale. This rule adversely affects the ability of broker-dealers to sell our common stock and purchasers of our common stock to sell their shares of such common stock. Additionally, our common stock is subject to the SEC regulations for "penny stock." Penny stock includes any non-NASDAQ equity security that has a market price of less than $5.00 per share, subject to certain exceptions. The regulations require that prior to any non-exempt buy/sell transaction in a penny stock, a disclosure schedule set forth by the SEC relating to the penny stock market must be delivered to the purchaser of such penny stock. This disclosure must include the amount of commissions payable to both the broker-dealer and the registered representative and current price quotations for the common stock. The regulations also require that monthly statements be sent to holders of penny stock which disclose recent price information for the penny stock and information of the limited market for penny stocks. These requirements adversely affect the market liquidity of our common stock.

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Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None.

Item 3. DEFAULTS UPON SENIOR SECURITIES

None.

Item 4. (REMOVED AND RESERVED)

Item 5. OTHER INFORMATION

On November 9, 2011, the Compensation Committee of the Board of Directors of the company acted by unanimous written consent to increase the base salary of AccessLine’s Chief Operating Officer, Mr. Rob Cain, from $150,000 annually to $200,000 annually. No other provisions of Mr. Cain’s employment agreement were changed.

Item 6. EXHIBITS

See the exhibit index immediately following the signature page of this report.

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SIGNATURES

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

	TELANETIX, INC.
	/s/ Paul C. Bogonis
Date: November 10, 2011	Paul C. Bogonis, Chief Financial Officer
	(Duly Authorized Officer and Principal Financial Officer)

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EXHIBIT INDEX

Exhibit No.		Description
10.1		Letter Agreement dated July 11, 2011, between Telanetix, Inc. and Paul C. Bogonis (incorporated herein by reference to the registrant's Form 8-K filed on July 14, 2011)
10.2		Confidential Settlement Agreement dated July 8, 2011, between Telanetix, Inc. and J. Paul Quinn (incorporated herein by reference to the registrant's Form 8-K filed on July 14, 2011)
10.3		Letter Agreement dated November 9, 2011 between Telanetix, Inc. and Rob Cain
31.1		Certification of Principal Executive Officer pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2		Certification of Principal Financial Officer pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1		Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2		Certification of Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101.INS*		XBRL Instance Document
101.SCH*		XBRL Taxonomy Extension Schema Document
101.CAL*		XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF*		XBRL Taxonomy Extension Definition Linkbase Document
101.LAB*		XBRL Taxonomy Extension Label Linkbase Document

Pursuant to Rule 406T of Regulation S-T, the Interactive Data Files on Exhibit 101 hereto are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Securities and Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.

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Telanetix,Inc - FORM 10-Q - November 10, 2011

Attached files

Telanetix,Inc Reports