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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

[X]

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2002

OR

[   ]

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

For the transition period from ___________ to ___________

Commission file number: 000-31121

AVISTAR COMMUNICATIONS CORPORATION
(Exact name of registrant as specified in its charter)

DELAWARE (State or other jurisdiction of incorporation or organization)		88-0463156 (I.R.S. Employer Identification Number)

555 TWIN DOLPHIN DRIVE, SUITE 360, REDWOOD SHORES, CA 94065
(Address of Principal Executive Offices) (Zip Code)

Registrant’s telephone number, including area code: (650) 610-2900

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 and Exchange Act of 1934 during the preceding 12 months (or for 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   [   ]

At September 30, 2002, 25,285,433 shares of common stock of the Registrant were outstanding.

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AVISTAR COMMUNICATIONS CORPORATION

INDEX

						PAGE NO.
PART I.				FINANCIAL INFORMATION
Item 1.				Financial Statements			3
				Condensed Consolidated Balance Sheets			3
				Condensed Consolidated Statements of Operations			4
				Condensed Consolidated Statement of Stockholders’ Equity			5
				Condensed Consolidated Statements of Cash Flows			6
				Notes to Condensed Consolidated Financial Statements			7
Item 2.				Management’s Discussion and Analysis of Financial Condition and Results of Operations			14
				Factors Affecting Future Operating Results			21
Item 3.				Quantitative and Qualitative Disclosures About Market Risk			29
Item 4.				Controls and Procedures			29
PART II.				OTHER INFORMATION
Item 1.				Legal Proceedings			30
Item 5.				Other Information			30
Item 6.				Exhibits and Reports on Form 8-K			30
SIGNATURES							31

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PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS
as of September 30, 2002 and December 31, 2001
(in thousands, except share data)

					September 30,				December 31,
					2002				2001
					(unaudited)
Assets:
	Current assets:
		Cash and cash equivalents			$	5,456			$	7,455
		Short-term investments				3,367				5,831
		Accounts receivable, net of allowance for doubtful accounts of $187 at September 30, 2002 and $232 at December 31, 2001				1,064				2,760
		Inventories, including inventory shipped to customer sites, not yet installed of $140 at September 30, 2002 and $262 at December 31, 2001				1,055				1,096
		Prepaid expenses and other current assets				805				1,121
		Total current assets				11,747				18,263
	Property and equipment, net					437				599
	Other assets					411				403
			Total assets		$	12,595			$	19,265
Liabilities and Stockholders’ Equity:
	Current liabilities:
		Bank overdraft			$	—			$	149
		Accounts payable				285				633
		Deferred revenue and customer deposits				1,060				1,205
		Accrued liabilities and other				1,315				2,237
			Total current liabilities			2,660				4,224
	Stockholders’ equity:
		Common stock, $0.001 par value; 250,000,000 shares authorized at September 30, 2002 and December 31, 2001; 25,285,433 and 25,196,478 shares outstanding at September 30, 2002 and December 31, 2001, respectively				26				26
		Treasury stock, 1,179,625 and 1,166,125 shares at September 30, 2002 and December 31, 2001, respectively				(51	)			(40	)
	Additional paid-in-capital					80,226				80,039
	Deferred stock compensation					(200	)			(493	)
	Cumulative other comprehensive income					19				79
	Accumulated deficit					(70,085	)			(64,570	)
		Total stockholders’ equity				9,935				15,041
			Total liabilities and stockholders’ equity		$	12,595			$	19,265

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

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AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
for the three and nine months ended September 30, 2002 and 2001
(in thousands, except per share data)

					Three Months Ended								Nine Months Ended
					September 30,				September 30,				September 30,				September 30,
					2002				2001				2002				2001
					(unaudited)								(unaudited)
Revenue:
	Product				$	1,206			$	1,719			$	3,628			$	8,854
	Services, maintenance and support					1,136				1,310				3,415				3,800
		Total revenue				2,342				3,029				7,043				12,654
Cost of revenue:
	Product					503				857				1,751				3,745
	Services, maintenance and support					567				578				1,809				2,113
		Total cost of revenue				1,070				1,435				3,560				5,858
		Gross margin				1,272				1,594				3,483				6,796
Operating Expenses:
	Research and development					894				1,146				2,984				4,073
	Sales and marketing					875				1,278				2,782				4,791
	General and administrative					1,179				1,105				3,376				4,069
	Amortization of deferred stock compensation *					74				155				293				706
		Total operating expenses				3,022				3,684				9,435				13,639
		Loss from operations				(1,750	)			(2,090	)			(5,952	)			(6,843	)
Other income (expense):
	Interest expense					—				—				—				(2	)
	Interest income					58				157				222				643
	Other, net					(5	)			(4	)			215				23
			Total other income (expense), net			53				153				437				664
Net loss					$	(1,697	)		$	(1,937	)		$	(5,515	)		$	(6,179	)
Net loss per share — basic and diluted					$	(0.07	)		$	(0.08	)		$	(0.22	)		$	(0.25	)
Weighted average shares used in calculating basic and diluted net loss per share						25,273				25,145				25,252				25,159
* Amortization of deferred stock compensation excluded from the following expenses:
	Cost of revenue				$	7			$	18			$	35			$	98
	Research and development					6				14				26				83
	Sales and marketing					60				120				226				508
	General and administrative					1				3				6				17
					$	74			$	155			$	293			$	706

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

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AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
for the nine months ended September 30, 2002 (unaudited)
(in thousands, except share amounts)

																														Cumulative
		Common Stock								Treasury Stock								Additional								Deferred				Other				Total
																		Paid-In				Stock				Comprehensive				Accumulated				Stockholders'
		Shares				Amount				Shares				Amount				Capital				Compensation				Income				Deficit				Equity
Balances at December 31, 2001			26,362,603			$	26				1,166,125			$	(40	)		$	80,039			$	(493	)		$	79			$	(64,570	)		$	15,041
Issuance of common stock to employees pursuant to employee stock purchase plan			98,305				—				—				—				109				—				—				—				109
Issuance of common stock to employees pursuant to exercise of options			4,150				—				—				—				4				—				—				—				4
Purchase of common stock pursuant to stock repurchase program			—				—				13,500				(11	)			—				—				—				—				(11	)
Non-employee stock-based compensation			—				—				—				—				74				—				—				—				74
Amortization of deferred stock compensation			—				—				—				—				—				293				—				—				293
Unrealized loss on short-term investments			—				—				—				—				—				—				(60	)			—				(60	)
Net loss			—				—				—				—				—				—				—				(5,515	)			(5,515	)
Balances at September 30, 2002			26,465,058			$	26				1,179,625			$	(51	)		$	80,226			$	(200	)		$	19			$	(70,085	)		$	9,935

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

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AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
for the nine months ended September 30, 2002 and 2001
(in thousands)

						Nine Months Ended
						September 30,				September 30,
						2002				2001
						(unaudited)
Cash Flows from Operating Activities:
		Net loss				$	(5,515	)		$	(6,179	)
		Adjustments to reconcile net loss to net cash used in operating activities:
			Depreciation				261				130
			Stock-based compensation				367				706
			Provision for doubtful accounts				140				50
			Changes in current assets and liabilities:
				Accounts receivable			1,556				688
				Inventories			41				512
				Prepaid expenses and other current assets			316				32
				Other assets			(8	)			(173	)
				Accounts payable			(348	)			(902	)
				Deferred revenue and customer deposits			(145	)			(435	)
				Accrued liabilities and other			(922	)			(400	)
	Net cash used in operating activities						(4,257	)			(5,971	)
Cash Flows from Investing Activities:
	Purchase of short-term investments						—				(5,225	)
	Sale of short-term investments						2,404				—
	Purchase of property and equipment						(99	)			(507	)
Net cash provided by (used in) investing activities							2,305				(5,732	)
Cash Flows from Financing Activities:
	Decrease in bank overdraft						(149	)			—
	Proceeds from issuance of common stock						113				253
	Repurchases of common stock						(11	)			(34	)
	Net cash provided by (used in) financing activities						(47	)			219
	Net decrease in cash and cash equivalents						(1,999	)			(11,484	)
	Cash and cash equivalents, beginning of period						7,455				21,660
	Cash and cash equivalents, end of period					$	5,456			$	10,176

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

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AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

1. Business, Basis of Presentation, and Risks and Uncertainties

Business

     Avistar Communications Corporation (“Avistar” or the “Company”) provides the Avistar vBusiness integrated suite of video-enabled applications, including networked video communications software and hardware products and services. Avistar’s products include applications for interactive video calling, content creation and publishing, broadcast video and video-on-demand, as well as data sharing, directory services and network management. Avistar designs, develops, markets, sells, manufactures and/or assembles and installs and supports its products. Avistar’s real-time and non-real-time products are based upon its architecture and Video Operating System (AvistarVOS™) platform, which facilitate distribution over local and wide area networks using telephony or internet services as appropriate. Avistar’s services include software development, consulting, implementation, training, maintenance and support. In addition, Avistar seeks to prosecute, maintain, support and license the intellectual property developed by the Company through its wholly-owned subsidiary, Collaboration Properties, Inc., a Nevada corporation (CPI).

Basis of Presentation

     The unaudited balance sheet as of September 30, 2002 presents the consolidated financial position of Avistar and its two wholly-owned operating subsidiaries, Avistar Systems U.K. Limited (“ASUK”) and CPI after elimination of all intercompany accounts and transactions. The consolidated results are referred to, collectively, as those of Avistar or the Company in these notes.

     The functional currency of ASUK is the United States dollar. Accordingly, all gains and losses resulting from those transactions denominated in currencies other than the United States dollar are included in the statements of operations. All amounts included herein are unaudited unless otherwise specified.

     The Company’s fiscal year coincides with the calendar year ending on December 31. Certain reclassifications were made to the prior year presentation to conform to the current period presentation.

Risks and Uncertainties

     The markets for the Company’s products and services are in the early stages of development. Some of the Company’s products utilize changing and emerging technologies. As is typical in industries of this nature, demand and market acceptance are subject to a high level of uncertainty, particularly when there are adverse conditions in the economy. Acceptance of the Company’s products, over time, is critical to the Company’s success. The Company’s prospects must be evaluated in light of difficulties encountered by it and its competitors in further developing this evolving marketplace. The Company has generated losses since inception and had an accumulated deficit of $70.1 million as of September 30, 2002. The Company’s operating results may fluctuate significantly in the future as a result of a variety of factors, including, but not limited to, the economic environment, the adoption of different distribution channels, and the timing of new product announcements by the Company or its competitors.

     The Company’s future liquidity and capital requirements will depend upon numerous factors, including without limitation, general economic conditions and conditions in the financial services industry in particular, the level and timing of revenue, the costs and timing of the Company’s product development efforts and the success of these development efforts, the costs and timing of the Company’s sales and marketing activities, the extent to which the Company’s existing and new products gain market acceptance, competing technological and market developments, the costs involved in maintaining and enforcing patent claims and other intellectual property rights, and other factors, all of which impact the Company’s ability to achieve and maintain profitability. The Company’s management estimates that it will need to establish access to additional funding within the next four months in order to continue its efforts to implement its business plan (refer to Footnote 8 for discussion of Loan and Security Agreement letter of commitment dated October 10, 2002).

     If the Company is unable to raise funds on acceptable terms when and as required, the Company may not be able to develop or enhance its products, take advantage of future opportunities, or respond to competitive pressures or unanticipated requirements, which could seriously harm its business, financial condition, and results of operations. If additional funds are raised through the issuance of equity securities, the Company’s net tangible book value per share is likely to decrease, the percentage ownership of then current

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stockholders will be diluted, and such equity securities may have rights, preferences or privileges senior to those of the holders of our common stock.

2. Summary of Significant Accounting Policies

Unaudited Interim Financial Information

     The financial statements furnished in this report have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. The December 31, 2001 Condensed Consolidated Balance Sheet was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America.

     In the opinion of management, the unaudited financial statements furnished in this report reflect all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of the results of operations for the interim periods covered and of the Company’s financial position as of the interim balance sheet date. The results of operations for the interim periods are not necessarily indicative of the results for the entire year. These financial statements should be read in conjunction with the Company’s audited consolidated financial statements and the accompanying notes for the year ended December 31, 2001 included in the Company’s annual report on Form 10-K filed with the Securities and Exchange Commission on March 21, 2002.

Use of Estimates

     The preparation of 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 and liabilities, and disclose contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the period. Actual results could differ from those estimates.

Cash and Cash Equivalents and Short Term Investments

     The Company considers all investment instruments purchased with a remaining maturity of three months or less to be cash equivalents. The Company’s cash equivalents at September 30, 2002 and December 31, 2001 consisted of money market funds and short-term securities. The Company has classified all investments not classified as cash equivalents as short term since it has the intent and ability to redeem them within one year. The Company classifies its short-term investments as available for sale with unrealized gains or losses reported as a separate component of stockholders’ equity. The fair value of the Company’s investments was determined based on quoted market prices at the reporting date for those instruments.

Supplemental Cash Flow Information

     During the nine months ended September 30, 2002 and 2001, no cash was paid for income taxes or interest.

Significant Concentrations

     A relatively small number of customers accounted for a significant percentage of the Company’s net sales. Sales to these customers as a percentage of sales were as follows for the three and nine months ended September 30, 2002 and 2001:

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     Any change in the relationship with these customers could have a potentially adverse effect on the Company’s financial position and/or results of operations.

     Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of temporary cash investments and trade receivables. The Company has cash and investment policies that limit the amount of credit exposure to any one financial institution and restrict placement of these investments to financial institutions evaluated as highly credit worthy. Concentration of credit risk with respect to trade receivables relate to those trade receivables from both United States and foreign entities. As of September 30, 2002, approximately 67% of accounts receivable was concentrated with three customers who each represented greater than 10% of the Company’s total accounts receivable balance. As of December 31, 2001, approximately 49% of accounts receivable was concentrated with two customers who each represented greater than 10% of the Company’s total accounts receivable balance.

Inventories

     Inventories are stated at the lower of cost (first-in, first-out method) or market. When required, provisions are made to reduce excess and obsolete inventories to their estimated net realizable value. Inventories consisted of the following (in thousands):

     Inventory shipped to customer sites, not yet installed, represents product shipped to customer sites pending completion of the installation process by the Company. As of September 30, 2002 and December 31, 2001, the Company had billed approximately $0.3 million and $0.6 million, respectively, to customers related to these shipments, but did not record the revenue, as the installations had not been completed and confirmed by the customer. Although customers are billed in accordance with customer agreements, these deferred revenue amounts are netted against accounts receivable until the customer confirms installation.

Revenue Recognition and Deferred Revenue

     The Company recognizes revenue in accordance with Statement of Position (“SOP”) 97-2, “Software Revenue Recognition” (SOP 97-2), and SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions.” The Company recognizes revenues from product sales when all of the following conditions are met: the product has been shipped, an arrangement exists with the customer at a fixed price and the Company has the right to invoice the customer, collection of the receivable is probable, and the Company has fulfilled all of its material contractual obligations to the customer.

     When the Company provides installation services, the product and installation revenues are recognized upon completion of the installation process and receipt of customer confirmation, subject to the satisfaction of the revenue recognition criteria described above. When the customer or a third party provides installation services, the product revenue is recognized upon shipment, subject to satisfaction of the revenue recognition criteria described above. Payment for product is due upon shipment, subject to specific payment terms. Payment for installation and professional services are due upon providing the services, subject to specific payment terms. If payments for systems are made in advance of the completion of installation, such amounts are deferred and recorded as deferred revenue and customer deposits in the accompanying balance sheets until installation has occurred and the customer has provided confirmation. Reimbursements received for out-of-pocket expenses incurred during installation and support services, which have not been significant to date, are recognized as revenue in accordance with Emerging Issues Task Force (EITF) Issue No. 01-14 (EITF 01-14), “Income Statement Characterization of Reimbursements Received for “Out of Pocket” Expenses Incurred.”

     The price charged for maintenance and/or support is defined in the contract, and is based on a percentage of product list prices as stipulated in the customer agreement. Customers have the option to renew the maintenance and/or support arrangement in subsequent periods at the same percentage as paid in the initial year. Revenue from maintenance and support services is deferred and recognized pro-rata over the maintenance and/or support term, which is typically one year in length. Payments for services made in advance of the provision of services are recorded as deferred revenue and customer deposits in the accompanying balance sheets. Training

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services are offered independent of the purchase of product. The value of these training courses is determined based on the price charged when such services are sold separately, and training revenue is recognized upon performance of the service.

     The Company recognizes service revenue from software development contracts in accordance with SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.” Revenue related to contracts for software development is recognized using the percentage of completion method, when all of the following conditions are met: a contract exists with the customer at a fixed price, the Company has fulfilled all of its material contractual obligations to the customer for each deliverable of the contract, verification of completion of the deliverable has been received, and collection of the receivable is probable. The amounts billed to customers in excess of revenues recognized to date are deferred and recorded as deferred revenue and customer deposits in the accompanying balance sheets. Assumptions used for recording revenue and earnings are adjusted in the period of change to reflect revisions in contract value and estimated costs to complete the contract. Any anticipated losses on contracts in progress are charged to earnings when identified.

Recent Accounting Pronouncements

     In April 2002, the FASB issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections Business Combinations.” The provisions of SFAS No. 145 relating to the rescission of SFAS No. 4 are effective for financial statements issued for fiscal years beginning after May 15, 2002, and the provisions relating to SFAS No. 13 are effective for transactions occurring after May 15, 2002. SFAS No. 145 rescinds SFAS No. 4, Reporting Gains and Losses from Extinguishment of Debt, and an amendment of that Statement, SFAS No. 64, Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements. SFAS No. 145 also rescinds SFAS No. 44, Accounting for Intangible Assets of Motor Carriers, and amends SFAS No. 13, Accounting for Leases, to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. SFAS No. 145 also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. The Company does not expect the adoption to have a significant impact on the Company’s financial position or results of operations.

     In July 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS No. 146 revises the accounting for specified employee and contract terminations that are part of restructuring activities. Companies will be able to record a liability for a cost associated with an exit or disposal activity only when the liability is incurred and can be measured at fair value. Commitment to an exit plan or a plan of disposal expresses only management’s intended future actions and therefore, does not meet the requirement for recognizing a liability and related expense. This Statement only applies to termination benefits offered for a specific termination event or a specified period. It will not affect accounting for the costs to terminate a capital lease. The Company is required to adopt this statement for exit or disposal activities initiated after December 31, 2002. The Company does not expect the adoption to have a significant impact on the Company’s financial position or results of operations.

3. Line of Credit

     On February 27, 2002, the Company entered into a Loan and Security Agreement with a financial institution to borrow up to $4.5 million as a revolving line of credit and $0.5 million as an equipment term loan. The first $1.0 million of the revolving line is available on a non-formula basis, and the remainder is limited to 80% of the Company’s eligible accounts receivable. The equipment term loan is limited to 100% of the purchase price of eligible equipment. As collateral under this Loan and Security Agreement, the Company granted a first priority interest in all its assets to the lender, excluding intellectual property. The revolving line of credit, which expires on February 26, 2003, and the equipment term loan, which expires on November 30, 2004, require certain covenants to be met, including maintenance of a $3.0 million cash balance at the financial institution. Interest on borrowed amounts is payable at the bank’s prime rate plus 0.25%. As of September 30, 2002, the Company did not have any outstanding borrowings under this line of credit (refer to Footnote 8 for discussion of Loan and Security Agreement letter of commitment dated October 10, 2002).

4. Related Party Transactions

     Robert P. Latta, a member of the law firm Wilson Sonsini Goodrich & Rosati, Professional Corporation (“WSGR”), has served as a director of the Company since February 2001. Mr. Latta and WSGR have represented the Company and its predecessors as corporate counsel since 1997. During the nine months ended September 30, 2002 and 2001, payments of approximately $125,000 and $224,000, respectively, were made to WSGR for legal services provided to the Company.

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     During the nine months ended September 30, 2002 and 2001, payments for consulting fees of approximately $165,000 and $73,000, respectively, were made to R. Stephen Heinrichs, a former officer of the Company, who is also a member of the Board of Directors, pursuant to a Separation Agreement between Mr. Heinrichs and the Company dated April 26, 2001.

5. Legal Proceedings

     On September 23, 2002, CPI, the Company’s wholly owned subsidiary, filed a patent infringement lawsuit against Polycom, Inc., alleging that several Polycom videoconferencing products infringe four patents of CPI.

6. Net Loss Per Share

     Basic and diluted net loss per share of common stock is presented in conformity with SFAS No. 128 (“SFAS 128”), “Earnings Per Share,” for all periods presented.

     In accordance with SFAS 128, basic net loss per share has been computed using the weighted average number of shares of common stock outstanding during the period, less shares subject to repurchase. Diluted net loss per share is computed on the basis of the weighted average number of shares and common equivalent shares outstanding during the period. Common equivalent shares result from the assumed exercise of outstanding stock options that have a dilutive effect when applying the treasury stock method. The Company has excluded all outstanding stock options and shares subject to repurchase from the calculation of diluted net loss per share for the three and nine months ended September 30, 2002 and 2001, because all such securities are antidilutive. Accordingly, diluted net loss per share is the same as basic net loss per share for all periods presented.

     The total number of common equivalent shares excluded from the calculations of diluted net loss per share was 136,231 and 531,170 for the three months ended September 30, 2002 and 2001, respectively, and 269,039 and 824,871 for the nine months ended September 30, 2002 and 2001, respectively.

7. Segment Reporting

     Disclosure of segments is presented in accordance with SFAS No. 131 (“SFAS 131”), “Disclosures About Segments of an Enterprise and Related Information.” SFAS 131 establishes standards for disclosures regarding operating segments, products and services, geographic areas and major customers. The Company is organized and operates in two operating segments: (1) the design, development, manufacture, sale and marketing of networked video communications products (Avistar) and (2) the prosecution, maintenance, support and licensing of the intellectual property used in the Company’s products (CPI). Service revenue relates mainly to the maintenance, support, training and installation of products and is included in Avistar for purposes of reporting and decision-making. Avistar also engages in the corporate functions and provides financing and services to the subsidiaries. The Company’s chief operating decision maker, its Chief Executive Officer (“CEO”), monitors the Company’s operations based upon the information reflected in the following table (in thousands):

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     International revenue, which consists of sales to customers with operations principally in Western Europe and Asia, comprised 57% and 48% of total revenue for the three months ended September 30, 2002 and 2001, respectively. International revenue comprised 52% and 47% of total revenue for the nine months ended September 30, 2002 and 2001, respectively. For the three months ended September 30, 2002 and 2001, international revenues to customers in the United Kingdom accounted for 25% and 29%, respectively, of total revenue. For the nine months ended September 30, 2002 and 2001, international revenues to customers in the United Kingdom accounted for 27% of total revenue in both periods. All of the Company’s sales are currently billed in United States dollars. The Company had no significant long-lived assets in any country other than in the United States for any period presented.

8. Subsequent Event

     On October 10, 2002, we entered into a commitment letter with the financial institution party to the Loan and Security Agreement dated February 27, 2002. This commitment letter, which is subject to negotiation and signing of definitive agreements by the parties, provides for the amendment of the Loan and Security Agreement to increase the maximum funds available thereunder to $6.0 million and extend the term of the agreement. Furthermore, the commitment letter provides as a condition to the execution of the definitive

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agreement, that Gerald Burnett, Chairman and CEO of the Company, personally guarantee payment of our obligations under the agreement.

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     Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

     The following discussion should be read in conjunction with the Unaudited Condensed Consolidated Interim Financial Statements and the Notes thereto included elsewhere herein, and the audited consolidated financial statements contained in our Annual Report on Form 10-K for the year ended December 31, 2001, as filed with the Securities and Exchange Commission on March 21, 2002.

     Certain statements in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” are forward looking statements. These statements relate to future events or our future financial performance and involve known and unknown risks, uncertainties and other factors that may cause our or our industry’s actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by the forward looking statements. These risks and other factors include those listed under “Factors Affecting Future Operating Results” elsewhere in this report on Form 10-Q. In some cases, you can identify forward looking statements by terminology such as “may”, “will”, “should”, “expects”, “plans”, “anticipates”, “believes”, “estimates”, “predicts”, “potential”, “continue” or the negative of these terms, or other comparable terminology. These statements are only predictions. Actual events or results may differ materially. In evaluating these statements, you should specifically consider various factors, including the risks outlined under “Factors Affecting Future Operating Results.” These factors may cause our actual results to differ materially from any forward looking statement.

     Although we believe that the expectations reflected in the forward looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of these forward looking statements. We are under no duty to update any of the forward-looking statements to conform our prior statements to actual results after the date of this report on Form 10-Q.

Overview

     We develop, market and support the Avistar vBusiness integrated suite of video-enabled applications, all powered by the AvistarVOS™ software. From the desktop, we deliver TV-quality interactive video calling, content creation and publishing, broadcast origination and distribution, video-on-demand, and integrated data sharing. The Avistar video and data collaboration applications are all managed by the AvistarVOS video operating system. Our customers use our system to improve productivity and communication within the enterprise and to enhance relationships with customers, suppliers and partners. Using AvistarVOS software and leveraging video, telephony and Internet networking standards, Avistar applications are designed to be scalable, reliable, cost effective, easy to use, and capable of evolving with communications networks as bandwidth increases and as new standards and protocols emerge. We sell our system directly to enterprises in selected strategic vertical markets, and have focused initially on the financial services and manufacturing industries. Our objective is to establish our technology as the standard for networked video.

     We operate in two segments. Avistar Communications Corporation engages in the design, development, manufacturing, sale and marketing of networked video communications products, and associated support services, and Collaboration Properties, Inc., our wholly owned subsidiary, engages in the prosecution, maintenance, support and licensing of the intellectual property that we have developed, some of which is used in our products. As of September 30, 2002, CPI had not entered into any such third party licensing agreements.

Critical Accounting Policies

     The preparation of these Condensed Consolidated Interim Financial Statements in accordance with accounting principles generally accepted in the United States requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We base our estimates on historical experience and assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.

     We believe the following critical accounting policies, among others, affect our more significant judgments and estimates used in the preparation of our Condensed Consolidated Interim Financial Statements:

	•		Revenue recognition;
	•		Valuation of accounts receivable; and
	•		Valuation of inventories.

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     These critical accounting policies are discussed below.

Revenue

     We derive product revenue principally from the sale and licensing of our video-enabled networked communications system, consisting of a suite of Avistar-designed software and hardware products, including third party components. In addition, we derive revenue from fees for installation, maintenance, support, training services and software development. Product revenue as a percentage of total revenue was 51% for the three-month period ended September 30, 2002, and 57% for the three-month period ended September 30, 2001. Product revenue as a percentage of total revenue was 51% for the nine-month period ended September 30, 2002 and 70% for the nine-month period ended September 30, 2001.

     We recognize revenue from product sales when all of the following conditions are met: the product has been shipped, an arrangement exists with the customer at a fixed price and we have the right to invoice the customer, collection of the receivable is probable, and we have fulfilled all of our material contractual obligations to the customer. When we provide installation services, the product and installation revenues are recognized upon completion of installation and receipt of customer acceptance, subject to the satisfaction of the revenue recognition criteria described above. The price charged for maintenance and/or support services is stipulated in the customer contract and is based on a percentage of product revenue. Customers have the option to renew the maintenance and/or support services in subsequent periods at the same percentage as paid in the initial year. Revenue from maintenance and support is recognized pro-rata over the maintenance and/or support term, which is typically one year in length. Training services are offered independently of the purchase of product. The value of these training services is determined based on the price charged when such services are sold separately, and training revenue is recognized upon performance of the service. We recognize service revenue from software development contracts using the percentage of completion method, when all of the following conditions are met: a contract exists with the customer at a fixed price, we have fulfilled all of our material contractual obligations to the customer for a deliverable of the contract, verification of completion of the deliverable has been received, and collection of the receivable is probable. Reimbursements received for out-of-pocket expenses incurred during installation and support services, which have not been significant to date, are recognized as revenue in accordance with Emerging Issues Task Force (EITF) Issue No. 01-14 (EITF 01-14), “Income Statement Characterization of Reimbursements Received for “Out of Pocket” Expenses Incurred.”

     To date, a significant portion of our revenue has resulted from sales to a limited number of customers, particularly Deutsche Bank and JP Morgan Chase and their affiliates. For the nine months ended September 30, 2002, we recorded revenue of approximately $4.7 million, or 67% of total revenue, from these customers, who each generated greater than 10% of our total revenue. For the nine months ended September 30, 2001, we recorded revenue of approximately $7.3 million, or 58% of total revenue, from Deutsche Bank and UBS Warburg LLC and their affiliates, who each generated greater than 10% of our total revenue. We anticipate that our revenue, and therefore, our operating results for any given period, will continue to depend to a significant extent on a limited number of customers. As a result, the loss or a reduction in sales to any one of these customers would have a significant adverse impact on our operations and financial performance.

     International revenue, which consists of sales to customers with operations principally in Western Europe and Asia, comprised 52% of total revenue for the nine months ended September 30, 2002, and 47% for the nine months ended September 30, 2001. For the nine months ended September 30, 2002 and 2001, international revenues to customers in the United Kingdom accounted for 27% of total revenue.

Cost of Revenue

     Our cost of revenue consists of the cost of product, services, maintenance and support, and includes compensation for distribution personnel and the cost of third party components, the cost of compensation for installation, maintenance, support, training and engineering personnel, and other costs related to facilities and office equipment for professional services, technical support and training personnel. We recognize product costs when the revenue from the sale of such products is recorded, and costs of installation, maintenance, support and training services as we incur those expenses.

Operating Expenses

     We generally recognize our operating expenses as we incur them in three operational categories: research and development, sales and marketing, and general and administrative. Our operating expenses also include amortization of our deferred stock compensation charges related to stock options granted prior to our initial public offering. These charges are amortized on a straight-line basis over the vesting period of the options, generally four years. Our research and development expenses consist primarily of compensation

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expenses for our personnel, patent and licensing costs. Due to uncertainties about the estimated future economic benefits and lives of our patents and patent applications, all related patent costs are expensed as incurred. Our sales and marketing expenses consist primarily of compensation, commissions and travel expenses, and other internal and outside marketing expenses. Our general and administrative expenses consist primarily of compensation for our administrative and financial personnel, and a number of non-allocable costs, including insurance, professional fees, legal fees, accounting fees and provision for doubtful accounts receivable balances.

     We allocate the total cost of overhead and facilities to each of the functional areas that use overhead and facilities, based upon the number of employees assigned to each of these areas. These allocated charges include facilities rent, utilities, telecommunications, and depreciation expense for property and equipment.

     Amortization of deferred stock compensation relates to stock options issued to employees, and represents the difference between the exercise price of options granted to employees and the grant-date fair value of our common stock. Based on the outstanding options at December 31, 2001, we anticipate recording charges of approximately $358,000 in 2002 and $135,000 in 2003 to record the remainder of the costs associated with these grants. Future compensation expense may be decreased in a period of forfeiture for any accrued but unvested compensation arising from the early termination of an option holder’s services. In addition, we have granted options to acquire shares of common stock to non-employees who have provided consulting services. For the three months ended September 30, 2002, we recognized an expense of $7,000 related to these non-employee options. For the three months ended September 30, 2001, we did not recognize expense related to non-employee options. For the nine months ended September 30, 2002, we recognized an expense of $74,000 related to these non-employee options, and for the nine months ended September 30, 2001, we recognized an expense of $31,000 related to these non-employee options. Pursuant to the provisions of SFAS No. 123, the fair value of non-employee options issued was determined based on the fair value of the consideration received, where such amount was reliably measurable, or the fair value of the equity instruments issued, in which case, the fair value was estimated as services were provided using the Black-Scholes option pricing model.

Valuation of Accounts Receivable

     Estimates are used in determining our allowance for doubtful accounts and are based on our historical collection experience, historical write-offs, current trends and the credit quality of our customer base, and the make-up of our accounts receivable by aging category. If the allowance for doubtful accounts was understated, our operating income could be significantly reduced. As of September 30, 2002, approximately 67% of accounts receivable were concentrated with three customers, who each represented greater than 10% of our total accounts receivable balance. As of December 31, 2001, approximately 49% of accounts receivable were concentrated with two customers, who each represented greater than 10% of our total accounts receivable.

Valuation of Inventories

     We currently record a provision for obsolete or excess inventory for models that are no longer manufactured, or are at risk of being replaced with new versions of our product. In determining the allowance for obsolete or excess inventory, we look at our forecasted demand versus quantities on hand and commitments. Any significant unanticipated changes in demand or technological developments could have a significant impact on the value of our inventory and commitments, and our reported results. If actual market conditions are less favorable than those projected, additional inventory write-downs, provision for purchase commitments, and charges against earnings may be required.

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Results of Operations

     The following table sets forth data expressed as a percentage of total revenue for the periods indicated.