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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For The Quarterly Period Ended September 30, 2003

OR

For the transition period from       to

Commission file number 000-23305

FIRST VIRTUAL COMMUNICATIONS, INC.

3200 Bridge Parkway, Suite 202
Redwood City, CA 94065
(Address of principal executive offices)

(650) 801-6500
(Registrant’s telephone number, including area code)

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

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [  ] No [X]

     The number of shares of Common Stock outstanding as of November 13, 2003 was 14,511,311.

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First Virtual Communications, Inc.
Form 10-Q

Index

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PART 1. FINANCIAL INFORMATION

Item 1. Financial Statements

First Virtual Communications, Inc.
Condensed Consolidated Balance Sheets
(in thousands, except share and per share data; unaudited)

See accompanying notes to condensed consolidated financial statements.

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First Virtual Communications, Inc.
Condensed Consolidated Statements of Operations
(in thousands, except per share data; unaudited)

See accompanying notes to condensed consolidated financial statements.

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First Virtual Communications, Inc.
Condensed Consolidated Statements of Cash Flows
(in thousands; unaudited)

See accompanying notes to condensed consolidated financial statements.

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First Virtual Communications, Inc.

Notes to Unaudited Condensed Consolidated Financial Statements

1. Basis of Presentation

     First Virtual Communications, Inc. (the “Company”) has prepared the accompanying financial data for the quarterly period ended September 30, 2003 pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). 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.

     In the opinion of management, the accompanying condensed consolidated financial statements contain all normal and recurring adjustments necessary to present fairly the Company’s consolidated financial position as of September 30, 2003, consolidated results of operations for the three and nine months ended September 30, 2003 and 2002, and consolidated cash flow activities for the nine months ended September 30, 2003 and 2002.

     The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. Actual results may differ from those estimates.

     The results of operations for the three and nine months ended September 30, 2003 are not necessarily indicative of the results to be expected for the full year. The information included in this Quarterly Report on Form 10-Q should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the consolidated financial statements and notes thereto included in the Company’s 2002 Annual Report on Form 10-K.

     The unaudited condensed consolidated balance sheet at December 31, 2002 that has been derived from the audited consolidated financial statements at that date does not include all of the information and footnotes required by generally accepted accounting principles in the United States of America for complete financial statements.

     On June 26, 2003 the Company’s Board of Directors approved a 1-for-5 reverse split of the Company’s common stock, effective at 5:00 pm EDT on June 27, 2003, with trading commencing on a post-reverse stock split basis on market open on Monday June 30, 2003. The reverse split was previously approved by the stockholders at the Company’s June 13, 2003 Annual Stockholders Meeting. As of 5:00 pm EDT on June 27, 2003, each five shares of the Company’s outstanding common stock was automatically combined and converted into one share of common stock. In addition, the Company made adjustments to its outstanding options and warrants to reflect the reverse stock split. All outstanding common stock and outstanding option and warrant numbers reflected in this Quarterly Report, reflect the 1-for-5 reverse stock split.

Concentrations of credit risk

     Revenue during the three and nine months ended September 30, 2003 and 2002 and accounts receivable as of September 30, 2003 and December 31, 2002 of customers comprising more than 10% of revenue or receivable are summarized as follows:

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2. Stock Based Compensation

     As of September 30, 2003, the Company maintained stock option plans under which the Company may grant incentive stock options and non-qualified stock options to employees, consultants and non-employee directors. The Company has chosen to account for those plans under the recognition and measurement principles of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations.

     The following table illustrates the effect on net income and earnings per share during the three and nine months ended September 30, 2003 and 2002 if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation (in thousands, except per share data):

     In December 2002, the Financial Accounting Standard Board issued Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure - an amendment of SFAS 123” (SFAS 148). This statement amends SFAS 123 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, this statement amends the disclosure requirements of SFAS 123 to require 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 annual disclosure provisions of SFAS 148 and adopted the interim disclosure provisions for financial reports beginning with the quarter ended December 31, 2002.

     The weighted-average estimated grant-date fair value of options granted under the Company’s various stock option plans was $0.88 and $1.23, respectively, during the three months ended September 30, 2003 and 2002, and $0.82 and $1.95, respectively, during the nine months ended September 30, 2003 and 2002. The fair value of each stock option on the date of grant was determined using the Black-Scholes model with the following assumptions:

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     On July 25, 2003, the Company offered a voluntary employee stock option exchange program to its employees and members of its board of directors. Under the exchange offer, eligible employees and members of the board of directors had the opportunity to exchange their outstanding stock options for new options to be granted under the Company’s 1999 Equity Incentive Plan and 1997 Equity Incentive Plan, pursuant to the terms of the replacement option agreements between the Company and its employees and members of the board of directors. Under the exchange offer, all outstanding options were eligible options. The replacement options will represent an option to purchase one share of the Company’s common stock for each option to purchase three shares of the Company’s common stock exchanged; provided, however, that under the exchange offer, options granted in the six-month period immediately preceding the offer date that were cancelled due to the participation in the offer will be replaced by the same number of replacement options. The replacement options will be granted on the replacement grant date, February 23, 2004 and will have an exercise price at least equal to the fair market value of First Virtual Communications’ common stock on that date. The new options will vest in equivalent monthly increments over a 24 month period commencing with the replacement grant date. Replacement options granted to employees located outside the United States may be subject to different vesting and other terms than those described above.

3. Additional consideration for Acquisition of FVC.COM (UK) Ltd.

     In May 1999, the Company acquired a controlling interest in FVC.COM (UK) Ltd., a distributor of the Company’s products in the United Kingdom and the Middle East. The Company acquired 52% of the outstanding stock of a newly incorporated holding company that owned 100% of the shares of this entity, in exchange for a cash payment of $750,000. The transaction was accounted for as a purchase; accordingly, the purchase price was allocated to the assets acquired and liabilities assumed based upon their estimated fair market values at the date of acquisition.

     In July 2002, the Company acquired the remaining 48% interest of FVC.COM (UK) Ltd. in a transaction accounted for as a purchase business combination. The purchase price was comprised of cash consideration of $437,000, including direct acquisition costs of $178,000 for legal and consulting fees. Contingent on certain events, the purchase price further increased by $35,000 based on (1) a percentage of the gross profit of the United Kingdom sales territory for the period from June 1, 2002 to December 31, 2002 and (2) the results of collection of certain receivables outstanding as of the acquisition date. Subsequent to the year ended December 31, 2002, the Company fully collected the residual balance of the receivables as of the acquisition date. In the quarter ended March 31, 2003, the purchase price increased by $98,000, for a total final cash consideration of $570,000. The purchase price was allocated to the assets acquired and liabilities assumed based upon their estimated fair market values at the date of acquisition. At the acquisition date, the book value of the assets and liabilities acquired approximated fair value. As a result, the purchase price was allocated to goodwill. In the second quarter of 2003, the Company made the aggregate additional consideration payment of $132,000.

4. Non-recurring Charges

     During the nine months ended September 30, 2003, the Company incurred $838,000 of non-recurring charges related to the relocation of the Company’s California office from Santa Clara to Redwood City and the closure of the Company’s India operations. The company incurred no non-recurring charges during the three months ended September 30, 2003 and 2002.

     The non-recurring charges for the nine months ended September 2003 and 2002 were as follows (in thousands):

5. Short Term Investments

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     Management determines the appropriate classification of short-term investments in marketable securities at the time of purchase and re-evaluates such designation as of each balance sheet date. Available-for-sale securities are stated at fair value as determined by the most recently traded price of each security at the balance sheet date. The net unrealized gains or losses on available-for-sale securities are reported as a component of comprehensive loss, net of tax. The specific identification method is used to compute the realized gains and losses on debt and equity securities.

     The Company regularly monitors and evaluates the realizable value of its marketable securities. If events and circumstances indicate that a decline in the value of these assets has occurred and is other than temporary, the Company records a charge to investment income (expense). At September 30, 2003, all short-term investments have been classified as “available-for-sale securities.”

     Marketable securities are comprised as follows (in thousands):

     As of September 30, 2003, the Company’s available-for-sale securities had contractual maturities of less than one year. Available- for-sale securities are comprised as follows at September 30, 2003 and December 31, 2002 (in thousands):

6. Inventory

     Inventories as of September 30, 2003 and December 31, 2002 were (in thousands):

     The Company notified its customers in May 2003 that it will no longer offer legacy ATM hardware products. All remaining inventory of those products have been written off and the Company intends to dispose of those products by the end of 2003.

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7. Net Loss Per Share

     Basic loss per share is based on the weighted-average number of common shares outstanding excluding contingently issuable or returnable shares, such as shares of unvested restricted common stock. Diluted loss per share is based on the weighted-average number of common shares outstanding and dilutive potential common shares outstanding.

     As a result of the losses incurred by the Company for the three and nine months ended September 30, 2003 and 2002, all potential common shares were anti-dilutive and were excluded from the diluted net loss per share calculations for such periods.

     The following table summarizes securities outstanding that were not included in the calculations of diluted net loss per share for the three and nine months ended September 30, 2003 and 2002, since their inclusion would be anti-dilutive (in thousands):

     The common stock warrants are exercisable at $1.35 to $32.65 per share and expire at various times from June 8, 2005 through September 28, 2008. The stock options outstanding at September 30, 2003 had a weighted average exercise price per share of $7.09 and expire beginning in June 2004 through September 2013.

8. Warranties

     The Company primarily sells software products. We provide for future warranty costs upon product delivery or from the purchase date. The specific terms and conditions of those warranties vary depending upon the product sold, the country in which the customers are located and agreements we have with various customers.

     Software products generally carry a 90-day warranty on the software media from the date of delivery or purchase. Otherwise, software products are sold on an as-is basis. Longer warranty periods may be provided on a contract-by-contract basis and are limited. Our liability under these warranties is to replace defective media and in some cases to provide a corrected copy of any portion of the software found not to be in substantial compliance with the published specifications in the product documentation. In such cases, if the Company is unable to make the products conform with published specifications, the Company may be obligated to refund the amount actually paid by customers.

     Factors that affect our warranty liability include the number of units sold, historical experience and management’s judgment regarding anticipated rates of warranty claims and cost per claim. We assess the adequacy of our recorded warranty liabilities every quarter and make adjustments to the liability if necessary. The Company has gone through the transition from being primarily a hardware-based company to a software-based company, subsequent to the acquisition of CUseeMe Networks on June 19, 2001, and has discontinued offering hardware products to the marketplace other than products currently in fully reserved inventory, which the Company expects will be disposed of by the end of 2003.

     Changes in our warranty liability, which is included as a component of “Accrued liabilities” on the Consolidated Balance Sheet, during the nine months ended September 30, 2003 were as follows (in thousands):

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9. Comprehensive Loss

     Comprehensive loss is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources, including foreign currency translation adjustments and unrealized gains and losses on marketable securities.

     Components of accumulated other comprehensive loss consist of the following (in thousands):

     Comprehensive losses for the three and nine-month periods ended September 30, 2003 and 2002 were as follows (in thousands):

10. Litigation

     On February 11, 2003, the Company received an adversarial complaint filed by Visitalk.com in connection with Visitalk.com’s reorganization proceedings in the United States Bankruptcy Court District of Arizona, alleging that CUseeMe Networks, which was acquired by the Company on June 19, 2001, breached a 1999 Strategic Partnership Agreement and sought damages of $435,000. In April, the Company responded to the complaint with a Motion to Stay Proceedings and to compel Matter to Proceed to Arbitration. In June 2003, the parties reached a mutual agreement to dismiss the adversarial action with prejudice, exchange a mutual general release of all claims and waive attorney’s fees and costs. The parties have executed a formal settlement agreement which will not become effective until approved by the Bankruptcy Court.

11. New Accounting Pronouncements

     In May 2003, the Financial Accounting Standard Board issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” This Statement establishes standards for how an issuer classifies and measures in its statement of financial position certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances) because that financial instrument embodies an obligation of the issuer. This Statement is effective for financial instruments entered into or modified after May 31, 2003 and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003, except for mandatorily redeemable financial instruments of nonpublic entities. For nonpublic entities, mandatorily redeemable financial instruments are subject to the provisions of this Statement for the first period beginning after December 15, 2003. It is to be implemented by reporting the cumulative effect of a change in an accounting principle for financial instruments created before the issuance date of the statement and still existing at the beginning of the interim period of adoption. The impact of the effective provisions of SFAS No. 150 has not had a material impact on the Company’s financial statements. The Company continues to assess the possible impact of potential changes to this pronouncement as and when they are announced.

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12. Subsequent Events

     On September 30, 2003, the Company entered into an Equity Investment Agreement with Net One Systems Co., Ltd. (“Net One”). Pursuant to the agreement, Net One was authorized to return approximately $1.5 million of products previously purchased from the Company, net of $75,000 of expenses, in exchange for shares of common stock of the Company. The Company had not recognized these prior shipments as revenue, but had recorded the transactions as deferred revenue. On October 8, 2003, the Company issued 642,921 shares of the Company’s common stock to Net One at $2.45 per share as consideration for the returned products. The $112,000 cost of the products to be returned was recorded as a charge to cost of revenue.

     On November 7, 2003, the Company entered into definitive agreements to sell approximately 5.7 million shares of common stock in a private placement with institutional investors, priced at $1.79 per share. The transaction closed on November 12, 2003, resulting in gross proceeds to the Company of approximately $10.3 million, or approximately $9.3 million net of placement fees and expenses. Investors in the private placement also received warrants to purchase up to 2.9 million shares of common stock at an exercise price of $1.79 per share. The warrants have a five year life.

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

     The following discussion of the financial condition and results of operations of First Virtual Communications, Inc. should be read in conjunction with the Unaudited Condensed Consolidated Financial Statements and the Notes thereto included in Item 1 of this Quarterly Report on Form 10-Q, and “Management’s Discussion and Analysis of Financial condition and Results of Operations” contained in our Annual Report on Form 10-K as filed with the Securities and Exchange Commission, or SEC, on April 15, 2003.

     In addition to the historical information contained in this Quarterly Report, this Quarterly Report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, that involve risks and uncertainties. These forward looking statements include, without limitation, statements containing the words “believes,” “anticipates,” “expects,” “intends” and words of similar import. Such forward-looking statements will have known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the Company, or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Such factors include, among others: the Company’s variability of operating results, market acceptance of rich media web conferencing technology, rich media web conferencing and collaboration technology dependence on IP-based networks and other technologies, the Company’s potential inability to maintain business relationships with telecommunications carriers, distributors and suppliers, rapid technological changes, competition and consolidation in the web conferencing industry, the Company’s ability to satisfy the continued listing requirements of the Nasdaq SmallCap market, the importance of attracting and retaining personnel, management of the Company’s growth, cost pressures in the web conferencing industry, dependence on key employees, and other risk factors set forth below and described in this Quarterly Report on Form 10-Q and in other documents the Company files with the SEC. The Company assumes no obligation to update any forward-looking statements contained herein. The Company’s expectations and the events, conditions and circumstances on which these forward-looking statements are based, may change.

Overview

     The Company delivers integrated, software technologies for rich media web conferencing and collaboration solutions. The Company combines its expertise in networking systems, real-time audio and video technology, and web-based collaboration to provide integrated voice, video, data, text and streaming media solutions for a wide range of rich media enterprise applications, including web conferences, broadcasts, video-on-demand, videoconferences and video calls over converged multi-service networks. The Company was incorporated in California in October 1993 and reincorporated in Delaware in December 1997. The Company first shipped its products in 1995.

     On June 19, 2001, the Company and CUseeMe Networks completed a merger, pursuant to which CUseeMe Networks became a wholly owned subsidiary of the Company. The Company is now able to provide a broad range of integrated rich media web conferencing solutions that run seamlessly across multiple network types to enterprise customers and service providers worldwide.

     In the three and nine months ended September 30, 2003, the Company recorded $5.4 million and $16.6 million in revenue, respectively, a decrease of 12% and 14% compared to the same periods of the previous year. The Company derived its revenue in the

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three and nine months ended September 30, 2003 and fiscal 2002 from sales to distributors, original equipment manufacturers, or OEMs, value-added resellers, or VARS, federal government agencies, enterprise customers and telecommunications service providers.

     The following table summarizes the percentage of total revenue by enterprise customers and service providers during the three and nine months ended September 30, 2003 and 2002:

     The Company’s internal sales and marketing force qualifies and stimulates end-user demand, and manages the Company’s strategic relationships with its distribution partners, including OEMs, VARs and systems integrators. At September 30, 2003 and 2002, one customer accounted for 27% and 26%, respectively, of total accounts receivable. For the three and nine months ended September 30, 2003, one customer accounted for 30% and 18%, respectively, of total revenue. One customer accounted for 24% of total revenue for the three months ended September 30, 2002. Two customers accounted for 10% of the total revenue for the nine months ended September 30, 2002.

     The Company maintains sales offices in the United Kingdom, France, Germany, Italy, China and Japan, and distributes its products in both Europe and Asia through resellers and distributors in more than 25 countries. The Company’s revenue from international sales represented 33% and 31% respectively, of its total revenue in the three months ended September 30, 2003 and 2002 and 37% and 30%, of its total revenue in the nine months ended September 30, 2003 and 2002, respectively. The Company expects that revenue from shipments to customers outside of the United States will continue to represent a significant portion of its future revenue. In addition, the Company believes that a small portion of its sales through OEMs, resellers and integrators are ultimately sold to international end-users. Revenue from the Company’s international operations are subject to various risks, including seasonality, longer payment cycles, changes in regulatory requirements and tariffs, reduced protection of intellectual property rights, political and economic instability, and currency risks, among others. To date, the Company has not engaged in any foreign currency hedging activity.

Critical Accounting Policies

     There have been no material changes to our critical accounting policies and estimates as disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002.

Results of Operations

     The following table sets forth certain items from the Company’s condensed consolidated statements of operations as a percentage of total revenue for the periods indicated:

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