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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

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

Internet Pictures Corporation

3160 Crow Canyon Road
San Ramon, California 94583
(Address of principal executive offices, zip code)

Registrant’s telephone number, including area code: (925) 242-4002

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]

7,557,241 shares of $0.001 par value common stock outstanding as of July 31, 2003.

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INTERNET PICTURES CORPORATION
FORM 10-Q
FOR THE QUARTER ENDED JUNE 30, 2003
INDEX

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PART I—FINANCIAL INFORMATION

Recalculation of Earnings Per Share

This Form 10-Q of Internet Pictures Corporation (“iPIX,” “we,” “us,” “our,” or the “Company”) reflects the Form 10-K/A filed August 14, 2003 to reflect the recalculation of our earnings (loss) per common share for the year ended December 31, 2002 and for each of the quarterly periods in the year then ended and reflects the Form 10-Q/A filed August 14, 2003 for the quarter March 31, 2003. Other than as expressly stated herein, the information prior to April 1, 2003 in this Form 10-Q does not reflect any subsequent information or events other than the recalculation detailed below. The only changes to our previously filed Form 10-Q for the quarter ended March 31, 2002 relate to the recalculations discussed below.

The Company has revised its unaudited financial statements for the three and six months ended June 30, 2002 and the three months ended March 31, 2003 to reflect the impact of the cumulative dividend and participation rights of the Company’s convertible preferred stock on the calculation of earnings (loss) per common share for those periods. The cumulative dividend, whether or not declared, has been reflected as a reduction in net income (loss) to calculate net income (loss) available to common shareholders. In addition, the participation right of the preferred stock has been considered in the calculation of basic earnings (loss) per common share, if dilutive, using the if converted method or the two class method, if more dilutive. The revision of earnings (loss) per common share for the periods indicated above had no effect on reported revenues, gross profit, net income (loss) or cash balances in any of the periods. The effect of the restatement of earnings (loss) per common share is as follows:

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Item 1. Condensed Consolidated Financial Statements

INTERNET PICTURES CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS

See accompanying notes to the unaudited condensed consolidated financial statements.

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INTERNET PICTURES CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

See accompanying notes to the unaudited condensed consolidated financial statements.

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INTERNET PICTURES CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

See accompanying notes to the unaudited condensed consolidated financial statements

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

The accompanying unaudited condensed consolidated financial statements include the accounts of Internet Pictures Corporation and its wholly-owned subsidiaries, Interactive Pictures Corporation, Interactive Pictures UK Limited, Internet Pictures (Canada), Inc. and PW Technology, Inc. The consolidation of these entities will collectively be referred to as the Company or iPIX. All significant intercompany balances and transactions have been eliminated.

We have prepared these financial statements, 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 generally accepted accounting principles have been omitted. The unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in our audited financial statements as of and for the year ended December 31, 2002.

The information furnished reflects all adjustments which management believes are necessary for a fair presentation of our financial position as of June 30, 2003 and the results of our operations for the three and six month periods ended June 30, 2002 and 2003 and our cash flows for the six month periods ended June 30, 2002 and 2003. All such adjustments are of a normal recurring nature. The results of operations for the three and six month periods ended June 30, 2002 and 2003 are not necessarily indicative of the results to be expected for the respective full years.

2.     AGREEMENT WITH eBAY

On June 27, 2003, we signed an amended license agreement with eBay. The following is a summary of the provisions of Amendment No. 3 to the Visual Content Services Agreement between iPIX and eBay. Amendment No. 3 should be read together with the Visual Content Services Agreement dated April 19, 2000, Amendment No. 1 and Amendment No. 2 to the Visual Content Services Agreement, all of which were filed as Exhibits to our Form 10-Q filed on October 31, 2001. A copy of Amendment No. 3 is filed as an exhibit to our Form 8-K filed on June 27, 2003.

Our Visual Content Services Agreement with eBay remains unchanged through the contract period, which will expire by its terms on September 30, 2003. Under the terms of Amendment No. 3, eBay will pay us $8.0 million and other consideration based on certain service and licensing options granted to eBay for a perpetual, non-exclusive license to the our Rimfire Imaging technology. eBay paid us $3.0 million in the quarter ended June 30, 2003 upon the execution of Amendment No. 3, as required. The $3.0 million is included in deferred revenue at June 30, 2003 because certain obligations associated with the license and services agreed to in the amendment had not been delivered at that date. Remaining amounts due under Amendment No. 3 are payable on future dates in conjunction with certain delivery obligations.

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In addition, eBay has the option to extend the Rimfire Imaging services under the Visual Services Content Agreement after September 30, 2003 for up to four additional months for a minimum monthly payment of $0.45 million, plus additional consideration based on the monthly volume of image submissions. We may also transfer to eBay, at eBay’s option, a Rimfire Imaging environment developed by us specifically for eBay in exchange for payment of $2.0 million. eBay has also agreed to terminate certain leases under which we leased computer equipment from eBay. In addition, we have given eBay an option to purchase computer equipment and other assets, which relate to the eBay Rimfire Imaging service. We have also agreed to work with eBay and some of our third party service providers to efficiently transition appropriate services to eBay allowing us to continue to focus on our base of existing and new customers.

On June 27, 2003, our agreement with eBay was amended. eBay is the largest customer of the technology represented by our goodwill. Due to Amendment No. 3 of our agreement with eBay, we preformed an impairment analysis of goodwill at June 30, 2003 and no impairment existed. However, at the end of the amended agreement with eBay we may incur a significant impairment of our goodwill.

We believe that transaction fees from eBay will continue to increase as a percentage of our total revenue through September 30, 2003 as more eBay customers utilize our services on the eBay auction Web site. Although eBay has an option to request us to extend our services and provide additional assistance in transferring operating and program management responsibilities to them after September 30, 2003, we can not give any assurance that such an option will be exercised. As a result, we may not provide any services to eBay after September 30, 2003, which would have a material effect on our business, financial position, results of operations or cash flows.

In addition, if we experience significant changes in the terms of our relationships with other current or prospective customers, delays in payments from customers or the subsequent loss of another major customer, it may have a material adverse effect on our business, financial position, results of operations or cash flows.

3.     CASH EQUIVALENTS, RESTRICTED CASH AND SHORT TERM INVESTMENTS

We consider all highly liquid debt instruments with a remaining maturity at date of purchase of three months or less to be cash equivalents.

At June 30, 2003, we had a $1.4 million short term investment which matures on June 19, 2004 and has been provided as collateral for certain capital lease obligations and, accordingly, classified as restricted cash and short term investments. We will renew the investment for successive short term periods until the capital lease obligation restrictions are removed. At December 31, 2002, restricted cash also included $1.4 million related to accrued customer deposits which were paid in full during the quarter ended March 31, 2003.

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4.     EQUITY

During the six months ended June 30, 2003, we issued 533,429 shares of common stock upon exercise of stock options, 12,767 shares under our employee stock purchase program and 35,455 shares upon the conversion of Series B Preferred Stock. The total proceeds from the option exercises and employee stock purchases were $1.0 million. We do not receive any proceeds upon the conversion of Series B Preferred Stock.

5.     INCOME (LOSS) PER COMMON SHARE

Recalculation of Income (loss) per Common Share

The Company has revised its unaudited financial statements for the three and six months ended June 30, 2002 and the three months ended March 31, 2003 to reflect the impact of the cumulative dividend and participation rights of the Company’s convertible preferred stock on the calculation of earnings (loss) per common share for those periods. The cumulative dividend, whether or not declared, has been reflected as a reduction in net income (loss) to calculate net income (loss) available to common shareholders. In addition, the participation right of the preferred stock has been considered in the calculation of basic earnings (loss) per common share, if dilutive, using the if converted method or the two class method, if more dilutive. The revision of earnings (loss) per common share for the periods indicated above had no effect on reported revenues, gross profit, net income (loss) or cash balances in any of the periods. The effect of the restatement of earnings (loss) per common share is as follows:

Basic income (loss) per common share is computed by dividing net income (loss) available to common stockholders for the period by the weighted average number of shares of common stock outstanding. Net income (loss) available to common stockholders is calculated as the net income (loss) less cumulative preferred stock dividends for the period. If dilutive, the participation right of the preferred stock is reflected in the calculation of basic income (loss) per share using the “if converted” method or the two class method, if more dilutive. Diluted income (loss) per common share is computed by dividing net income (loss) for the period by the weighted average number of shares of common stock outstanding plus, if dilutive, potential common stock outstanding during the period.

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The following table sets forth the computation of basic and dilutive loss per common share for the periods indicated (restated for 2002):

The following table sets forth potential common shares that are not included in the diluted net loss per common share calculation because to do so would be antidilutive for the three and six month periods ended June 30, 2002 and 2003:

Not included in the table above, were the following rights to purchase common stock where the average exercise price was greater than the average common share price and accordingly excluded from diluted net earnings per common share for the three and six month periods ended June 30, 2002 and 2003:

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6. RESTRUCTURING AND OTHER

During the six months ended June 30, 2003, the following payments were made against the restructuring accrual:

7. STOCK-BASED COMPENSATION — FAIR VALUE DISCLOSURES

We comply with the disclosure provisions of Financial Accounting Standards Board Statement of Financial Accounting Standards No. 123 “Accounting for Stock-based Compensation” (“FAS 123”). We have elected, however, to continue accounting for stock-based compensation issued to employees using Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”). Under APB 25, compensation expense is based on the difference, if any, on the date of grant, between the fair value of our stock and the exercise price of the option. Stock and other equity instruments issued to non-employees have been accounted for in accordance with FAS 123 and Emerging Issues Task Force Issue No. 96-18, “Accounting for Equity Instruments Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods, or Services,” and have been valued using the Black-Scholes model.

Pro forma information regarding our net income (loss) is required by FAS 123 and FAS 148 “Accounting for Stock-Based Compensation, Transition and Disclosure”, and has been determined as if we had accounted for the stock options under the fair value method of FAS 123.

The computations for pro forma basic and diluted loss per share follow (restated for 2002):

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Grants under the Employee Stock Purchase Plan (“ESPP”) have a look-back feature and a 15% discount and accordingly under FAS 123 would have had compensation expense calculated as a result. The fair value disclosure associated with the ESPP grants is included in the fair value pro-forma information above.

8. COMMITMENTS AND CONTINGENCIES

Commitments

The table below shows our contractual obligations as of June 30, 2003:

Contingencies

See Item 3, Legal Proceedings, in our annual report on Form 10-K for discussion of litigation that has been dismissed against us but is subject to appeal. We are not currently a party to any legal proceedings the adverse outcome of which, individually or in the aggregate, we believe could have a material adverse effect on our business, financial condition, results of operations or cash flows.

9. SEGMENTS

We currently have three reportable segments. The accounting policies of the segments are the same as those of the Company. Management evaluates the performance of the segments and allocates resources to them based on evaluations of the segment’s revenues and gross profit. There are no inter-segment revenues. We do not make allocations of corporate costs to the individual segments and do not identify separate assets of the segments in making decisions regarding the performance or the allocation of resources to them.

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Information about the reported segments is as follows:

10. EFFECT OF NEW ACCOUNTING PRONOUNCEMENTS

In November 2002, the FASB issued FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”). FIN 45 requires that a liability be recorded in the guarantor’s balance sheet upon issuance of a guarantee. In addition, FIN 45 requires disclosures about the guarantees that an entity has issued, including a reconciliation of changes in the entity’s product warranty liabilities. The initial recognition and initial measurement provisions of FIN 45 were applicable on a prospective basis to guarantees issued or modified after December 31, 2002, while the disclosure requirements were applicable in 2002. The adoption of FIN 45 did not have a material impact on our results of operation or financial condition and did not result in any additional liabilities as of June 30, 2003 associated with guarantees covered by this interpretation. In addition to guarantees, we have entered into agreements indemnifying certain parties with respect to our potential infringement of other party’s intellectual property. Due to the nature of the indemnifications, our maximum exposure under these agreements cannot be estimated. We have not recorded any amounts for FIN 45 indemnities because they are not probable, immaterial or not estimable at this time.

As permitted under Delaware law, we have agreements whereby our officers and directors are indemnified for certain events or occurrences while the officer or director is, or was, serving at our request in such capacity. The term of the indemnification period is for the officer’s or director’s term in such capacity. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have a director and officer insurance policy that limits our exposure and enables us to recover a portion of any future amounts paid. As a result of our insurance policy coverage, we believe the estimated fair value of these indemnification agreements is minimal. Our director and officer indemnification agreements were grandfathered under the provisions of FIN 45 as they were in effect prior to December 31, 2002. We have not recorded any amounts for these indemnities because they are not probable or estimable at this time.

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In November 2002, the EITF reached consensus on Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” (“EITF 00-21”). EITF 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 00-21 will apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. We do not believe that the adoption of this standard will have a material effect on our financial position or results of operations.

In January 2003, the FASB issued FIN No. 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51” (“FIN 46”). FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. We do not believe that the adoption of this standard will have a material effect on our financial position or results of operations.

In May 2003, the FASB issued FAS No. 150, “Accounting For Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“FAS 150”). FAS 150 establishes standards for how an issuer classifies and measures 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). Many of those instruments were previously classified as equity. FAS 150 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 FAS 150 for the first fiscal 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 FAS 150 and still existing at the beginning of the interim period of adoption. Restatement is not permitted. We will adopt FAS 150 in the quarter ending September 30, 2003 and the adoption of FAS 150 will not have a material impact on our financial statements.

11. CONCENTRATIONS OF CREDIT RISK

Financial instruments that potentially subject us to a concentration of credit risk consist of cash, cash equivalents, short term investments and accounts receivable. Cash, cash equivalents and short term investments are deposited with high quality financial institutions. Our accounts receivable are derived from revenue earned from customers located in the U.S. and abroad. We perform ongoing credit evaluations of our customers’ financial condition and we do not require collateral from our customers.

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The following table summarizes the revenue from customers in excess of 10% of total revenues:

At June 30, 2003, Homestore and eBay represented 3% and 84% of accounts receivable, respectively. All amounts due from Homestore and eBay as of June 30, 2003, were collected during July 2003. At December 31, 2002, Homestore and eBay represented 0% and 83% of accounts receivable, respectively.

12. LIQUIDATION PREFERENCE AND PREFERRED STOCK DIVIDENDS

On September 26, 2001, Image Investor Portfolio, a separate series of Memphis Angels, LLC (“Image”) and certain strategic investors completed the purchase of 1,115,080 shares of the Series B Preferred Stock for total consideration of $22.3 million.

Each share of the Series B Preferred Stock is convertible into approximately 9.2 shares of our Common Stock and is entitled to vote on matters submitted to holders of Common Stock on an as-converted basis. At any time that the holders of the Series B Preferred Stock hold more than 50% of our voting stock, a voluntary liquidation, dissolution or winding up of the Company must be approved by at least five of the seven members of our board of directors.

Holders of Series B Preferred Stock, in preference to holders of any other series of Preferred Stock and in preference to the holders of Common Stock (collectively, “Junior Securities”), accrue dividends at the rate of eight percent (8%) of the price paid per annum on each outstanding share of Series B Preferred Stock (“Series B Dividends”). The Series B Dividends are cumulative, accrue daily and shall by payable, when and if declared by the Board, upon conversion or as an accretion to the Liquidation Preference, as defined below. Accrued Series B Dividends may be paid in cash or common stock, at the election of the Series B Preferred stockholder. Holders of Series B Preferred Stock participate on an as-if converted basis in any common stock dividends.

Upon any liquidation event, before any distribution or payment shall be made to the holders of any Junior Securities, the holders of Series B Preferred Stock shall be entitled to be paid out of the assets of the Company legally available for distribution, or the consideration received in such Transaction, an amount per share of Series B Preferred Stock equal to the price paid plus all accrued and unpaid Series B Dividends for each share of Series B Preferred Stock held by them (the “Liquidation Preference”). If, upon any such liquidation event, the assets of the Company are insufficient to make payment in full to all holders of Series B Preferred Stock of the Liquidation Preference, then such assets shall be distributed among the holders of Series B Preferred Stock at the time outstanding, ratably in proportion to the full amounts to which they would otherwise be respectively entitled.

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As of June 30, 2003, the Liquidation Preference was $25.4 million, which includes the $3.1 million in accrued dividends in arrears on the Series B Preferred Stock which have not been declared to be paid.

In June 2003, certain investors converted Series B Preferred Stock into 35,455 shares of common stock in accordance with the conversion terms of the Series B Preferred Stock. In conjunction with the conversion we paid them $11 thousand in dividends accrued through the date of conversion as required under the conversion terms of the Series B Preferred Stock.

13. RELATED PARTY TRANSACTIONS

During 2001, our CEO at that time, Mr. James M. Phillips resigned as our chairman and chief executive officer. Pursuant to a separation agreement, Mr. Phillips received a severance payment in the amount of $1.3 million, in the following increments: (i) $0.2 million was paid on May 25, 2001; (ii) $0.2 million was paid on September 1, 2001; (iii) $0.2 million was paid on January 1, 2002; (iv) $0.2 million was paid on June 1, 2002; (v) $0.2 million was paid on January 2, 2003; (vi) $0.2 million was paid on June 2, 2003 and (vii) $0.1 million will be paid on or before September 1, 2003.

IPIX International

In the third quarter of 2002, we entered into license, distribution and trademark agreements with Soroof International, a Saudi Arabia-based corporation (“Soroof”). Under the agreements, Soroof is the exclusive distributor for iPIX immersive still products, including the iPIX GPS Mapping System, outside of North America and Asia through its newly established entity, iPIX International (“iPIX-I”). The agreement, effective July 1, 2002, expires December 31, 2007, unless renewed. iPIX-I has an exclusive license to develop integrated solutions for markets including real estate, travel and tourism and other markets in which online marketing is critical. We will also provide certain hosting services during the term of the agreements. Soroof has committed to certain minimum quarterly royalties during the term of the agreement. Should these minimum royalties not be met, we have the right to terminate our agreements with Soroof.

We have a minority equity interest in iPIX-I, however, we do not have the ability to exercise significant influence over iPIX-I operations. We account for our investment in iPIX-I on the cost basis. We did not make any capital contributions to iPIX-I and we have no commitments to fund iPIX-I. We do have the right, however, but not the obligation, to purchase iPIX-I from Soroof after December 31, 2005 for consideration as defined in the agreements. During the three months ended June 30, 2003, we held discussions with Soroof relating to the terms of these agreements. These discussions are continuing. We did not recognize any revenue from iPIX-I in the three months ended June 30, 2003. During the six months ended June 30, 2003, we recognized $0.2 million of revenue under these agreements.

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Transactions with eBay, Inc.

Pursuant to an agreement dated April 19, 2000, as amended, we provide to eBay, Inc., which currently beneficially owns more than 10% of our common stock (5% fully diluted), image management services to eBay’s online auction Web sites. Pursuant to that agreement, we issued eBay a warrant to purchase 60,000 shares of Common Stock at an exercise price of $203.80 per share. The warrant expires on April 19, 2010. Under this agreement, we generated revenues of $5.6 million and $11.1 million for the six months ended June 30, 2002 and 2003, respectively. We generated revenues of $3.0 million and $5.7 million for the three months ended June 30, 2002 and 2003, respectively. Under this agreement, we were required to pay marketing fees to eBay of $16.0 million over a two-year period. As of September 26, 2001, we had paid $9.5 million of the $16.0 million commitment and we agreed to extend the additional $6.5 million of payments through September 2003. As of June 30, 2003, we have $1.0 million of the commitment remaining. In accordance with EITF 01-09 “Accounting for consideration given by a vendor to a customer (including a reseller of the vendor’s products)”, $1.0 million of these fees were offset against revenue which represented the excess over the fair value of the benefit received during the six months ended June 30, 2003.

In 2001 and 2002, we sold to eBay, and eBay leased back to us, certain computer equipment utilized to provide image management services to eBay and other customers. The purchase price for the equipment was approximately $5.3 million. The transactions resulted in no gain or loss to iPIX. Pursuant to lease schedules covering this equipment, we would have paid eBay annual lease payments of approximately $0.9 million, $0.8 million and $0.1 million in the duration of 2003, 2004 and 2005, respectively. In the six months ended June 30, 2003, we paid eBay $1.0 million pursuant to these lease schedules. As part of the third amendment to our agreement with eBay, eBay agreed to exchange the equipment underlying these leases as final payment after we satisfactorily perform certain transition services, which is expected to occur either in the fourth quarter of 2003 or in the first quarter of 2004.

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

The following discussion is intended to assist in the understanding and assessment of significant changes and trends related to our results of operations and our financial condition together with our consolidated subsidiaries. This discussion and analysis should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report filed on Form 10-K. Historical results and percentage relationships set forth in the statement of operations, including trends which might appear, are not necessarily indicative of future operations.

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OVERVIEW

We are focused on three businesses providing:

	(1)		outsourced imaging services to facilitate online transactions in the auction, classifieds and real estate markets (“Transaction Services”);
	(2)		immersive imaging solutions for the real estate, travel and visual documentation markets (“Immersive still solutions”); and
	(3)		180-degree and 360-degree video surveillance for the security and observation markets (“Immersive video solutions”).

Our Transaction Services’ products and services include the capture, processing, management and distribution of images and related data. Revenues from online auctions and classifieds are primarily transaction based. Our transaction services involve designing, building and managing an image management infrastructure as well as leasing spaces from state-of-the-art co-location facilities with access to telecommunications bandwidth. Since these services are capital intensive, a high percentage of the costs associated with transaction services are fixed and accordingly the margins from transaction services are highly dependent upon asset utilization. Substantially all of our recurring revenue is derived from transaction fees generated by our Rimfire service. In particular, eBay and Homestore are our largest Rimfire customers. eBay represented approximately 85% of our total revenue and approximately 95% of Rimfire services revenue for the six months ended June 30, 2003 and 87% of total revenue and 94% of Rimfire service revenue for the second quarter of 2003. Homestore represented approximately 22% of total revenue and 17% of Rimfire service revenue for the first six months of 2002, but less than 10% of total revenue and Rimfire service revenue for the first three months and first six months of 2003.

On June 27, 2003, we signed an amended license agreement with eBay. Our Visual Content Services Agreement with eBay remains unchanged through the contract period, which will expire on September 30, 2003. Under the terms of Amendment No. 3, eBay will pay us $8.0 million and other consideration based on certain service and licensing options granted to eBay for a perpetual, non-exclusive restricted use license to our Rimfire Imaging technology.

In addition, eBay has the option to extend the Rimfire Imaging services after September 30, 2003 for up to four additional months for a minimum monthly payment of $0.45 million, plus additional consideration based on the monthly volume of image submissions. We may also transfer to eBay, at eBay’s future option, a Rimfire Imaging environment developed by us specifically for eBay in exchange for a payment of $2.0 million. eBay has also agreed to terminate certain leases under which we leased computer equipment from eBay. In addition, we have given eBay an option to purchase computer equipment and other assets, which relate to the eBay Rimfire Imaging service. We have also agreed to work with eBay and some of our third party service providers to efficiently transition appropriate services to eBay allowing us to continue to focus on our base of existing and new customers.

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We believe that transaction fees from eBay will continue to increase as a percentage of our total revenue through September 30, 2003 as more eBay customers utilize our services on the eBay auction Web site. Although eBay has an option to request us to extend our services and provide additional assistance in transferring operating and program management responsibilities to them after September 30, 2003, we can not give any assurance that such an option will be exercised. As a result, we may not provide any services to eBay after September 30, 2003, which may have a material adverse effect on our business, financial position, results of operations or cash flows.

We continue to diversify and add additional Transaction Services customers and are currently targeting image management for publications, online and off line classified advertising and other business opportunities. If we fail to add significant customers in this segment of our business, our results of operations could be adversely affected.

Our immersive technology primarily generates revenues in two ways: licenses of software and re-sale of camera equipment. We utilize iPIX keys to license our immersive still technology to capture and save a single immersive image. We also offer time-based seat or user licenses which permit an unlimited number of immersive images to be captured and saved within a specific time period, usually a year. Our immersive video technology, which may be off-line or online, may be purchased on a per-unit basis or a per-year license. We sell our immersive products and services primarily into the real estate, security and observation and visual documentation markets. The cost of sales for our licenses is low in proportion to the related revenue. The cost of sales for the sale of camera equipment has generally been 50% to 75% of related revenues. We continue to develop our immersive imaging business for the security and observation market.

In the third quarter of 2002, we entered into license, distribution and trademark agreements with Soroof International, a Saudi Arabia-based corporation (“Soroof”). Under the agreements, Soroof is the exclusive distributor for iPIX immersive still products, including the iPIX GPS Mapping System, outside of North America and Asia through its newly established entity, iPIX International (“iPIX-I”). iPIX-I represented approximately 0% of Immersive revenue for the second quarter of 2003 and 19% of Immersive revenue for the six months ended June 30, 2003. Homestore represented approximately 16% of Immersive revenue for the second quarter of 2003 and 21% of Immersive revenue for the six months ended June 30, 2003.

CRITICAL ACCOUNTING POLICIES

Financial Reporting Release 60 issued by the Securities and Exchange Commission (“SEC”) requires all registrants to discuss critical accounting policies or methods used in the preparation of the financial statements. The notes to the consolidated financial statements included in our Annual Report filed on Form 10-K include a summary of the significant accounting policies and methods used in the preparation of our consolidated financial statements. Further, we have made a number of estimates and assumptions that affect reported amounts of assets, liabilities, revenues and expenses and actual results may differ from those estimates. Those areas that require the greatest degree of management judgment include revenue recognition, adequacy of the allowance for doubtful accounts, goodwill and significant accruals.

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We believe that full consideration has been given to all relevant circumstances that we may be subject to, and our financial statements accurately reflect management’s best estimate of the results of operations, financial position and cash flows for the periods presented. We believe the following represent our critical accounting policies:

Revenue Recognition

We recognize revenue in accordance with SOP 97-2, “Software Revenue Recognition,” and SAB 101, “Revenue Recognition in Financial Statements.” Transaction revenues are recognized as transactions are performed provided there was persuasive evidence of an arrangement, the fee was fixed or determinable and collection of the resulting receivable was reasonably assured. Initial license fees are recognized when a contract exists, the fee is fixed or determinable, software delivery has occurred and collection of the receivable is reasonably assured. If there are continuing obligations, then we recognize license revenue ratably over the life of the contract. As there are significant continuing undelivered obligations at June 30, 2003 under the Amendment No. 3 to the Visual Content Services Agreement with eBay, we have deferred all license revenue under the amendment at June 30, 2003.

Product revenue is recognized upon shipment or delivery provided there are no uncertainties surrounding product acceptance or significant vendor obligations, persuasive evidence of an arrangement exists, the fees are fixed or determinable and collection is reasonably assured.

Royalties derived from desktop imaging products are recognized as revenues upon receipt of the royalty sell-through reports from customers, which are generally in the quarter following the quarter in which the sale by the customer took place.

Revenues generated from professional services are recognized as the related services are performed. When such professional services are combined with on-going transaction services or are deemed to be essential to the functionality of the delivered software product, revenue from the entire arrangement is recognized while the transaction services are performed, on a percentage of completion method or not until the contract is completed in accordance with SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts,” and ARB 45, “Long-Term Construction-Type Contracts.”

Allowances for Doubtful Accounts

Significant management judgments and estimates must be made and used in connection with establishing the doubtful account allowances in any accounting period. Management specifically analyzes accounts receivable and historical bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in our customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. Material differences could result in the amount and timing of expense recorded if management had different judgment or utilized different estimates.

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Goodwill

Under United States generally accepted accounting principles, we evaluate goodwill for impairment on an annual basis and on an interim basis if events or changes in circumstances between annual impairment tests indicate that the asset might be impaired. In assessing the recoverability of our goodwill, we must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the goodwill. These estimates include forecasted revenues and operating expenses, which are inherently difficult to predict. If these estimates or their related assumptions change in the future, we may be required to record impairment charges for these assets. We believe that the accounting estimate related to goodwill is a “critical accounting estimate” because (1) it requires Company management to make assumptions about fair values and (2) the impact of recognizing an impairment could be material to our financial position, as well as our results of operations. Management’s assumptions about fair values require significant judgment because broad economic factors, industry factors and technology considerations can result in variable and volatile fair values. On June 27, 2003, our agreement with eBay was amended. eBay is the largest customer of the technology represented by our goodwill. Due to Amendment No. 3 of our agreement with eBay, we preformed an impairment analysis of goodwill at June 30, 2003 and no impairment existed. However, at the end of the amended agreement with eBay we may incur a significant impairment of our goodwill.

Significant Accruals, including Restructuring Charges and Sales Tax

We recorded restructuring charges associated with vacated facilities. The key assumptions associated with these charges include the timing and amount of sub-lease income. In addition, in establishing and providing for sales tax accruals, we make judgments based on the actual tax laws and guidance. While management believes that its judgments and interpretations regarding tax liabilities are appropriate, significant differences in actual experience may materially affect our future financial results.

RESTRUCTURING ACTIONS

During the six months ending June 30, 2003, the following payments were made against our restructuring accrual: