Back to GetFilings.com

Table of Contents

SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the quarterly period ended June 30, 2003

OR

For the transition period from ___________ to ___________

Commission file number: 000-31121

AVISTAR COMMUNICATIONS CORPORATION

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 [  ]

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

Yes [  ]     No [X]

At June 30, 2003, 25,330,821 shares of common stock of the Registrant were outstanding.

Table of Contents

AVISTAR COMMUNICATIONS CORPORATION

INDEX

2

Table of Contents

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS
as of June 30, 2003 and December 31, 2002
(in thousands, except share and per share data)

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

3

Table of Contents

AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
for the three and six months ended June 30, 2003 and 2002
(in thousands, except per share data)

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

4

Table of Contents

AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
for the six months ended June 30, 2003 and 2002
(in thousands)

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

5

Table of Contents

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 facilitates 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 June 30, 2003 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.

     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 $77.3 million as of June 30, 2003. 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, but not limited to, the costs and timing of its expansion of product development efforts and the success of these development efforts, the costs and timing of its expansion of sales and marketing activities, the extent to which its existing and new products gain market acceptance, competing technological and market developments, the costs involved in maintaining, enforcing and defending patent claims and other intellectual property rights, the level and timing of revenue and other factors. The Company may need to raise additional funds, and additional financing may not be available on favorable terms, if at all. If the Company cannot raise additional funds, if needed, on acceptable terms, 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 the Company’s business, financial condition, results of operations and ability to continue 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 stockholders may be diluted and such equity securities may have rights, preferences or privileges senior to those of the holders of the Company’s common stock. Debt financing, if available, may involve significant fees, interest payment obligations and restrictive covenants. Strategic arrangements, if necessary to raise additional funds, may require us to relinquish our rights to certain of our technologies or products.

6

Table of Contents

2.     Summary of Significant Accounting Policies

Unaudited Interim Financial Information

     The financial statements filed 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, 2002 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, 2002 included in the Company’s annual report on Form 10-K filed with the Securities and Exchange Commission on March 25, 2003.

Use of Estimates

     The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of 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 June 30, 2003 and December 31, 2002 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. As of June 30, 2003, there was no difference between the cost and fair value of the Company’s investments.

Supplemental Cash Flow Information

     During the six months ended June 30, 2003 and 2002, 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 six months ended June 30, 2003 and 2002:

7

Table of Contents

     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 June 30, 2003, approximately 90% of accounts receivable were concentrated with two customers, each of whom represented more than 10% of the Company’s total accounts receivable balance. As of December 31, 2002, approximately 65% of accounts receivable were concentrated with one customer.

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 June 30, 2003 and December 31, 2002, the Company had billed approximately $145,000 and $50,000, 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”, and SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions.” The Company recognizes 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 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 revenue is 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, “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 rate 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 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.

8

Table of Contents

     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.

Stock-Based Compensation

     The Company applies the intrinsic-value-based method of accounting for stock-based compensation prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations including FASB Interpretation No. 44, Accounting for Certain Transactions involving Stock Compensation, an interpretation of APB Opinion No. 25, issued in March 2000, to account for its fixed-plan stock options. Under this method, compensation expense is recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. SFAS No. 123, Accounting for Stock-Based Compensation, established accounting and disclosure requirements using a fair-value-based method of accounting for stock-based employee compensation plans. As allowed by SFAS No. 123, the Company has elected to continue to apply the intrinsic-value-based method of accounting described above, and has adopted only the disclosure requirements of SFAS No. 123. The following table illustrates the effect on net income if the fair-value-based method had been applied to all outstanding and unvested awards in each period (in thousands, except per share date).

     The fair value of options granted for the three months ended June 30, 2003 and 2002 is estimated on the date of grant using the following assumptions:

Recent Accounting Pronouncements

     In November 2002, the Emerging Issues Task Force (EITF) of the Financial Accounting Standards Board (FASB) reached a consensus on Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” EITF Issue No. 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The provisions of EITF Issue No. 00-21 will apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The Company is currently evaluating the effect that the adoption of EITF Issue No. 00-21 on its financial position or results of operations.

9

Table of Contents

     In December 2002, the FASB issued SFAS 148, “Summary of Statement No. 148 Accounting for Stock-Based Compensation-Transition and Disclosure-an Amendment of FASB Statement No. 123.” SFAS 148 amends SFAS 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS 148 amends the disclosure requirements of SFAS 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company has adopted the disclosure requirements of SFAS 148.

     In April 2003, the FASB issued SFAS No. 149, “Amendments of Statement 133 on Derivative Instruments and Hedging Activities,” which amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS No. 133. This statement is effective for contracts entered into or modified after June 30, 2003, with certain exceptions, and for hedging relationships designated after June 30, 2003.

     In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity,” which establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. Financial instruments that are within the scope of the statement, which previously were often classified as equity, must now be classified as liabilities. This statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise shall be effective at the beginning of the first interim period beginning after June 15, 2003.

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 was available on a non-formula basis, and the remainder was limited to 80% of the Company’s eligible accounts receivable. As collateral under this Loan and Security Agreement, the Company granted a first priority security interest in all of the Company’s assets, excluding intellectual property. The revolving line of credit and the equipment term loan required certain covenants to be met. On December 15, 2002, the Company entered into an amendment to the Loan and Security Agreement to increase the maximum funds available thereunder to $6.0 million and extend the term of the agreement. The amended Loan and Security Agreement, as further amended in March 2003, has an expiration date of February 27, 2004. The agreement, as amended, retains a first priority security interest in all of the Company’s assets, excluding intellectual property. Furthermore, Gerald Burnett, Chairman and Chief Executive Officer of the Company, has provided a collateralized guarantee to the financial institution, assuring payment of the Company’s obligations under the agreement. As a consequence, restrictive covenants from the original Loan and Security agreement have been deleted in the amendment, except for a quick ratio covenant, allowing the Company greater access to the full amount of the facility. In addition, Gerald Burnett has committed to provide funds up to $6.0 million (inclusive of any funds drawn by the Company under the Loan and Security Agreement and subject to his collateralized guarantee of the Company’s obligations thereunder) through February 27, 2004 in the event that the full $6.0 million under the Loan and Security Agreement is not available to the Company for any reason. As of June 30, 2003, the Company has borrowed $750,000 under this line of credit, and additionally, the Company was eligible to borrow up to an additional $5.25 million under the line of credit.

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 six months ended June 30, 2003 and 2002, payments of approximately $150,000 and $80,000, respectively, were made to WSGR for legal services provided to the Company.

     During the six months ended June 30, 2003 and 2002, payments for consulting fees of approximately $100,000 and $110,000, 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.

     Gerald Burnett, Chairman and Chief Executive Officer of the Company has provided a collateralized guarantee, assuring payment of the Company’s obligations under a Loan and Security Agreement with a financial institution dated February 27, 2002, as amended. In addition, Gerald Burnett has committed to provide funds up to $6.0 million (inclusive of any funds drawn by the Company under the Loan and Security Agreement and subject to his collateralized guarantee of the Company’s obligations thereunder) through February 27, 2004 in the event that the full $6.0 million under the Loan and Security Agreement is not available to the Company for any reason.

10

Table of Contents

5. Legal Proceedings

     On September 23, 2002, CPI, a wholly owned subsidiary of the Company, filed a patent infringement lawsuit against Polycom, Inc., alleging that several Polycom videoconferencing products infringe four patents of CPI. Polycom responded to CPI’s claims on November 14, 2002, at which time it both answered the complaint and asserted counterclaims against CPI for non-infringement, invalidity and unenforceability. On January 31, 2003, Polycom filed a motion with the court requesting permission to amend its counterclaims to incorporate claims of alleged infringements by Avistar Communications of four PictureTel patents that Polycom has told us it has had assigned to it. A hearing was held on March 7, 2003, at which time the judge granted Polycom’s motion to amend its counterclaims. Three of the four counterclaims for patent infringement relate to equipment provided to Avistar by a third-party and Avistar’s agreement with that third-party supplier provides for indemnification of Avistar by that third party. A trial date for CPI’s claims against Polycom and Polycom’s counterclaims has not yet been set. The three counterclaims involving the third party were dropped on June 23, 2003, subsequent to an agreement between Polycom and the third party.

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 convertible preferred stock, outstanding stock options and shares subject to repurchase from the calculation of diluted net loss per share for the three and six months ended June 30, 2003 and 2002, because all such securities are antidilutive. Accordingly, diluted net loss per share approximates basic net loss per share for all periods presented.

     The total number of shares excluded from the calculations of diluted net loss per share was 1,387,694 and 2,602,136 for the three months ended June 30, 2003 and 2002, respectively, and 824,191 and 4,122,949 for the six months ended June 30, 2003 and 2002, 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 as two operating segments: (1) the design, development, manufacturing, 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, software development 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, monitors the Company’s operations based upon the information reflected in the following table (in thousands):

11

Table of Contents

     International revenue, which consists of sales to customers with operations principally in Western Europe and Asia, comprised 65% and 45% of total revenue for the three months ended June 30, 2003 and 2002, respectively. International revenue comprised 57% and 49% for the six months ended June 30, 2003 and 2002, respectively. For the three months ended June 30, 2003 and 2002, international revenues to customers in the United Kingdom accounted for 47% and 28%, respectively, of total revenue. For the six months ended June 30, 2003 and 2002, international revenues from customers in the United Kingdom accounted for 22% and 29%, respectively, of total revenue. All of the Company’s sales are currently billed in United States dollars. The Company had no significant net sales or long-lived assets in any country other than in the United States for any period presented.

12

Table of Contents

     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, 2002, as filed with the Securities and Exchange Commission on March 25, 2003.

     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”, “intends”, “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. We are under no duty to update any of the forward-looking statements after the date of this report on Form 10-Q to conform our prior statements to actual results.

Overview

     We develop, market and support an integrated suite of video-enabled vBusiness applications, all powered by our 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. Our 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 their enterprise, and between enterprises to enhance relationships with customers, suppliers and partners. Using AvistarVOS software and leveraging video, telephony and Internet networking standards, our 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. We engage in the design, development, manufacturing, sale and marketing of networked video communications products, and associated support services and Collaboration Properties, Inc., or CPI, 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 June 30, 2003, CPI had not entered into any such third party licensing agreements.

Critical Accounting Policies

     The preparation of these unaudited 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 Consolidated Financial Statements:

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

Revenue Recognition

13

Table of Contents

     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 38% for the three-month period ended June 30, 2003 and 45% for the three-month period ended June 30, 2002. Product revenue as a percentage of total revenue was 44% for the six-month period ended June 30, 2003 and 51% for the six-month period ended June 30, 2002.

     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 revenue is recognized upon completion of installation 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. 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 rate 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, “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. For the six months ended June 30, 2003, we recorded revenue of approximately $1.9 million, or 61% of total revenue, from Deutsche Bank AG and its affiliates. No other customers individually accounted for greater than 10% of our total revenue for the six months ended June 30, 2003. For the six months ended June 30, 2002, we recorded revenue of approximately $2.9 million, or 62% of total revenue, from Deutsche Bank AG and its affiliates. No other customers individually accounted for greater than 10% of our total revenue for the six months ended June 30, 2002. 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 of 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 57% of total revenue for the six months ended June 30, 2003, and 49% for the six months ended June 30, 2002.

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 characteristics of our accounts receivable by aging category. If the allowance for doubtful accounts was understated, our operating income could be significantly reduced. The impact of any such change or deviation may be increased by our reliance on a relatively small number of customers for a large portion of our total revenue. As of June 30, 2003, approximately 90% of our accounts receivable balance was concentrated with two customers, each of whom represented more than 10% of our total accounts receivable. As of December 31, 2002, approximately 65% of our accounts receivable were concentrated with one customer.

Valuation of Inventories

     We 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, which would negatively effect our operating income for such period.

14

Table of Contents

Results of Operations

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

COMPARISON OF THE THREE AND SIX MONTHS ENDED JUNE 30, 2003 AND 2002

Revenue

     Total revenue decreased by 25.8% to $1.5 million for the three months ended June 30, 2003 from $2.0 million for the three months ended June 30, 2002 and decreased by 33% to $3.1 million for the six months ended June 30, 2003 from $4.7 million for the six months ended June 30, 2002. The decrease in the three and six month periods was due primarily to lower product sales, reflecting continued weakness in the United States and global economies, particularly in the financial services sector. This weakness has led to a continued delay in procurement decisions and increasingly constrained technology spending among our existing and potential customers.

     For the three months ended June 30, 2003, revenue from two customers accounted for 75% of total revenue, each of whom accounted for greater than 10% of our total revenue. For the three months ended June 30, 2002, revenue from one customer accounted for 66% of our total revenue. No other customers individually accounted for greater than 10% of our total revenue for the three months ended June 30, 2002. For the six months ended June 30, 2003, revenue from one customers accounted for 61% of total revenue. No other customers individually accounted for greater than 10% of our total revenue for the three months ended June 30, 2003. For the six months ended June 30, 2002, revenue from one customer accounted for 62% of our total revenue. No other customers individually accounted for greater than 10% of our total revenue for the three months ended June 30, 2002. The level of sales to any customer may vary from quarter to quarter. We expect that there will be significant customer concentration in future quarters. The loss of any one of those customers would have a material adverse impact on our financial condition and operating results.

Cost of Revenue

     The cost of revenue declined by 24.9% to $0.9 million for the three months ended June 30, 2003 from $1.2 million for the three months ended June 30, 2002 and decreased by 26.5% to $1.8 million for the six months ended June 30, 2003 from $2.5 million for the six months ended June 30, 2002. Cost of product revenue declined by 40.0% to $0.3 million for the three months ended June 30, 2003

15

Table of Contents

from $0.5 million for the three months ended June 30, 2002 and decreased by 44.5% to $0.7 million for the six months ended June 30, 2003 from $1.3 million for the six months ended June 30, 2002. This decline in cost of product revenue was directly due to the lower level of product sales and the associated direct product costs. Cost of service revenue declined by 12.6% to $0.6 million for the three months ended June 30, 2003 from $0.6 million for the three months ended June 30, 2002 and decreased by 8.0% to $1.1 million for the six months ended June 30, 2003 from $1.2 million for the six months ended June 30, 2002. This decline in cost of service revenue was due primarily to declines in the fixed components of the cost of service revenue, including a reduction in personnel and personnel related expenses, partially offset by an increase in costs related to software development contracts.

Gross Margin

     Gross margin as a percentage of revenue decreased to 41.0% for the three months ended June 30, 2003 from 41.8% for the three months ended June 30, 2002, and decreased to 41.9% for the six months ended June 30, 2003 from 47.1% for the six months ended June 30, 2002. The decreases in the three and six month periods ended June 30, 2003 relative to the same periods in 2002 were due primarily to the lower overall revenue base, which provided more limited coverage of the fixed components of the cost of sales. Product gross margin as a percentage of total product revenue increased slightly to 44.8% for the three month period ended June 30, 2003 compared to 42.0% for the three month period ended June 30, 2002, and increased slightly to 48.9% for the six months ended June 30, 2003 compared to 47.8% for the six months ended June 30, 2002. Services gross margin as a percentage of total service revenue decreased to 38.6% for the three months ended June 30, 2003 compared to 41.6% for the three months ended June 30, 2002, and decreased to 36.5% for the six months ended June 30, 2003 compared to 46.3% for the six months ended June 30, 2002 due primarily to a decrease in services revenue, which provided more limited coverage of the fixed components of the cost of our maintenance services, and an increase in costs related to software development contracts, partially offset by the decline in personnel and personnel related expenses.

Operating expenses

     Research and development. Research and development expenses decreased by 34.6% to $0.6 million for the three months ended June 30, 2003 from $0.9 million for the three months ended June 30, 2002, and decreased by 37.3% to $1.3 million for the six months ended June 30, 2003 from $2.1 million for the six months ended June 30, 2002. The decrease was due to decreases in personnel related expenses, outside services and external consulting expenses and reduced capital expenditures, offset in part by increased software development costs.

     Sales and marketing. Sales and marketing expenses increased slightly by 5.6% to $0.9 million for the three months ended June 30, 2003 from $0.9 million for the three months ended June 30, 2002, and remained flat at $1.9 million for the six months ended June 30, 2003 compared to the six months ended June 30, 2002.

     General and administrative. General and administrative expenses increased by 32.9% to $1.5 million for the three months ended June 30, 2003 from $1.1 million for the three months ended June 30, 2002, and increased by 44.8% to $3.2 million for the six months ended June 30, 2003 from $2.2 million for the six months ended June 30, 2002. The increase was due primarily to an increase in legal fees.

     Amortization of deferred stock compensation. Amortization of deferred stock compensation decreased by 51.6% to $45,000 for the three months ended June 30, 2003 from $93,000 for the three months ended June 30, 2002, and decreased by 58.9% to $90,000 for the six months ended June 30, 2003 from $219,000 for the six months ended June 30, 2002. The decrease was due to the completion of option amortization, and the forfeitures of stock options by employees no longer with our company.

Other Income (Expense)

     Other income, net decreased by 98.7% to $4,000 for the three months ended June 30, 2003 from $297,000 for the three months ended June 30, 2002, and decreased 95.3% to $18,000 for the six months ended June 30, 2003 from $384,000 for the six months ended June 30, 2002 due to a declining balance of cash, cash equivalents and short-term investments with lower rates of return on cash, cash equivalents and short-term investments, and the net grant proceeds received in the three month period ending June 30, 2002 from the New York disaster relief program associated with the events of September 11, 2001 of approximately $230,000.

Liquidity and Capital Resources

16

Table of Contents

     We have funded our operations since inception primarily from product and services revenue, the net proceeds of $31.3 million from our August 2000 initial public offering of Common Stock, lines of credit with related parties and financial institutions, and, to a lesser extent, the proceeds of approximately $6.4 million from the sale of Series B Preferred Stock in December 1999.

     We had cash and cash equivalents of $3.6 million as of June 30, 2003 compared to cash and cash equivalents of $4.8 million and short-term investments of $2.4 million as of December 31, 2002. For the six months ended June 30, 2003 we had an overall net cash outflow of $1.1 million, resulting primarily from net cash used in operations of $4.3 million, offset partially by the net cash provided by investing activities of $2.4 million and the net cash provided by financing activities of $0.8 million. The net cash used in operating activities of $4.3 million resulted from a net loss of $5.2 million, an increase in accounts receivable of $0.4 million, offset by an increase in accounts payable of $0.4 million, a decrease in prepaid expenses and other current assets of $0.3 million and an increase in deferred revenue and customer deposits of $0.2 million. The net cash provided by investing activities resulted from the net sale of short-term investments of $2.4 million. The net cash provided by financing activities resulted from the draw on our line of credit of $0.8 million.

     At June 30, 2003, we had open purchase orders and other contractual obligations of approximately $0.6 million, primarily related to inventory purchases. We also have commitments that consist of obligations under our operating leases. These purchase order commitments and contractual obligations are reflected in our financial statements once goods or services have been received or payments related to the obligations become due.

     The following table represents our future commitments under minimum annual lease payments as of June 30, 2003 (in thousands):

     We rent our current office facility in Redwood Shores, California under a non-cancelable operating lease that expires in 2003.

     On February 27, 2002, we 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 was available on a non-formula basis and the remainder was limited to 80% of our eligible accounts receivable. As collateral under this Loan and Security Agreement, we granted a first priority security interest in all our assets, excluding intellectual property. The revolving line of credit and the equipment term loan required certain covenants to be met. On December 15, 2002, we entered into an amendment to the Loan and Security Agreement to increase the maximum funds available thereunder to $6.0 million and extend the term of the agreement. The amended Loan and Security Agreement, as further amended in March 2003, has an expiration date of February 27, 2004. The agreement, as amended, retains a first priority security interest in all our assets, excluding intellectual property. Gerald Burnett, our Chairman and Chief Executive Officer, has provided a collateralized guarantee to the financial institution, assuring payment of our obligations under the agreement and as a consequence, a number of restrictive covenants from the original Loan and Security agreement have been deleted in the amendment, except for a quick ratio covenant, allowing us greater access to the full amount of the facility. In addition, Gerald Burnett has committed to provide funds up to $6.0 million (inclusive of any funds drawn by us under the Loan and Security Agreement and subject to his collateralized guarantee of our obligations thereunder) through February 27, 2004 in the event that the full $6.0 million under the Loan and Security Agreement is not available to us for any reason. As of June 30, 2003, we have borrowed $750,000 million under this line of credit, and additionally, we were eligible to borrow up to an additional $5.25 million.

     We intend to continue to invest in the development of new products and enhancements to our existing products. We currently believe that existing cash and cash equivalents balances, short-term investments and available borrowings under the Loan and Security Agreement, as amended, and the commitment from our CEO will provide us with sufficient funds to finance our operations for the next 12 months. Our 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

17

Table of Contents

and timing of our product development efforts and the success of these development efforts, the costs and timing of our sales and marketing activities, the extent to which our 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 including, without limitation, the costs and result of CPI’s litigation with Polycom and other factors, all of which may impact our ability to achieve and maintain profitability.

     We expect that we will need to arrange for the availability of additional funding prior to the expiration of the Loan and Security Agreement, either through the execution of an extension of the Loan and Security Agreement or through other means, in order to meet our future business requirements. Additional funds and additional financing may not be available on favorable terms, or at all. If we are unable to obtain additional funding on acceptable terms, we may not be able to develop or enhance our products, take advantage of future opportunities, or respond to competitive pressures or unanticipated requirements, which could seriously harm our business, financial condition, results of operations and ability to continue operations. Furthermore, any additional equity financing may be dilutive to stockholders and such equity securities may have rights, preferences or privileges senior to those of the holders of our common stock, and debt financing, if available, may involve significant fees, interest payment obligations and restrictive covenants. Strategic arrangements, if necessary to raise additional funds, may require us to relinquish our rights to certain of our technologies or products.

Recent Accounting Pronouncements

     In November 2002, the EITF reached a consensus on Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” EITF Issue No. 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The provisions of EITF Issue No. 00-21 will apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. We are currently evaluating the effect that the adoption of EITF Issue No. 00-21 but do not expect it to have a material impact on our financial position or results of operations.

     In December 2002, the FASB issued SFAS 148, “Summary of Statement No. 148 Accounting for Stock-Based Compensation-Transition and Disclosure-an Amendment of FASB Statement No. 123.” SFAS 148 amends SFAS 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS 148 amends the disclosure requirements of SFAS 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. We have adopted the disclosure requirements of SFAS 148.

     In April 2003, the FASB issued SFAS No. 149, “Amendments of Statement 133 on Derivative Instruments and Hedging Activities,” which amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS No. 133. This statement is effective for contracts entered into or modified after June 30, 2003, with certain exceptions, and for hedging relationships designated after June 30, 2003. We do not expect adoption of SFAS No. 149 to have a material impact on our condensed consolidated financial statements.

     In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity,” which establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. Financial instruments that are within the scope of the statement, which previously were often classified as equity, must now be classified as liabilities. This statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise shall be effective at the beginning of the first interim period beginning after June 15, 2003. We do not expect adoption of SFAS No. 150 to have a material impact on our condensed consolidated financial statements.

Factors Affecting Future Operating Results

     Our market is in the early stages of development, and our system may not be widely accepted.

     Our ability to achieve profitability depends in large part on the widespread adoption of networked video communications systems. If the market for our system fails to grow or grows more slowly than we anticipate, we may not be able to increase revenue or achieve profitability. The market for our system is relatively new and evolving. We will have to devote substantial resources to educating prospective customers about the uses and benefits of our system. Our efforts to educate potential customers may not result in our system achieving market acceptance. In addition, businesses that have invested or may invest substantial resources in video products may be reluctant or slow to adopt our system. Similarly, customers using existing information systems in which they have made significant investments may refuse to adopt our system if they perceive that our offerings will not complement their existing systems.

18

Table of Contents

Consequently, the conversion from traditional methods of communication to the extensive use of networked video may not occur as rapidly as we wish.

     We have incurred substantial losses in the past and may not be profitable in the future.

     We incurred net losses of $5.2 million for the six months ended June 30, 2003, $7.6 million for the year 2002, and $7.9 million for the year 2001. As of June 30, 2003, our accumulated deficit was $77.3 million. Our revenue may not increase, or even remain at its current level. In addition, our operating expenses may increase as we continue to develop our business in the future. As a result, to become profitable, we will need to increase our revenue by increasing sales to existing customers and by attracting additional customers. If our expenses increase more rapidly than our revenue, or if revenue and expense levels remain the same, we may never become profitable. If we fail to achieve our plan of generating positive cash flow from operations over the next 18 months, we may be required to raise additional funds, and additional financing may not be available on favorable terms, if at all. Although our Chairman and Chief Executive Officer has guaranteed our Loan and Security Agreement, we cannot be certain that he will continue to do so.

     We cannot predict whether or when we will become profitable. If we do become profitable, we may not be able to sustain or increase profitability on a quarterly or annual basis. In addition, if we fail to reach profitability or to sustain or grow our profits within the time frame expected by investors, the market price of our common stock may be adversely impacted.

     General economic conditions have and may continue to impact our revenues and harm our business.

     The economic environment in the United States is such that industries are continuing to delay or reduce technology purchases. These conditions have negatively affected our business in 2003 and 2002, and will in the future if these conditions persist. The outlook for the video communications industry is uncertain and it is very difficult to predict how long the current environment will last. Slower growth among our customers, tightening of customers’ operating budgets, retrenchment in the capital markets and other general economic factors all have had and could continue to have a materially adverse effect on our revenue, capital resources, financial condition and results of operations.

     We have filed a complaint alleging patent infringement against Polycom, Inc. The prosecution of this lawsuit could require us to expend significant financial and managerial resources and may have a material negative impact on our business. If we do not prevail, we may be required to pay monetary damages.

     On September 23, 2002, CPI, our wholly-owned subsidiary, commenced a patent infringement lawsuit against Polycom, Inc. alleging that several Polycom videoconferencing products infringe four patents held by CPI. The suit was filed in the United States District Court for the Northern District of California. The four patents involved are U.S. Patent Nos. 5,867,654, 5,896,500, 6,212,547 and 6,343,314. These patents cover technologies relating to video and data conferencing over unshielded twisted pair (UTP) networks, distributed call-state management, separate monitors for simultaneous computer-based data sharing and videoconferencing and remote participant hold and disconnect functions in multi-party conferencing. Polycom responded to CPI’s claims on November 14, 2002, at which time it both answered the complaint and asserted counterclaims against CPI for non-infringement, invalidity and unenforceability. On January 31, 2003 Polycom filed a motion with the court requesting permission to amend its counterclaims to incorporate claims of alleged infringements by Avistar Communications of four PictureTel patents that Polycom has told us it has had assigned to it. A hearing was held on March 7, 2003, at which time the judge granted Polycom’s motion to amend its counterclaims. Three of the four counterclaims for patent infringement relate to equipment provided to Avistar by a third-party and Avistar’s agreement with that third-party supplier provides for indemnification of Avistar by that third party. A trial date for CPI’s claims against Polycom and Polycom’s counterclaims has not yet been set. The prosecution of this lawsuit and the defense of the Polycom counterclaim may require us to expend significant financial and managerial resources and therefore may have a material negative impact on our business. The duration and ultimate outcome of this litigation are uncertain. In addition, an adverse judgment, if entered against CPI or Avistar, could require CPI or Avistar to pay substantial compensation and/or damages to Polycom, which could harm our business, financial position and results of operations and cause our stock price to decline substantially. Litigation such as this suit can take years to resolve and can be expensive to prosecute and defend. Regardless of the outcome, the prosecution of CPI’s claims and defense of the counterclaims in this lawsuit may require us to obtain additional financing. The three counterclaims involving the third party were dropped on June 23, 2003, subsequent to an agreement between Polycom and the third party.