UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

Commission file number 0-22190

Verso Technologies, Inc.

(Exact Name of Registrant as Specified in Its Charter)

400 Galleria Parkway

Suite 300

Atlanta, GA 30339

(Address of Principal Executive Offices)

678-589-3750

(Registrant’s Telephone Number, Including Area Code)

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act: common stock, $0.01 par value per share

      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 þ          o

      Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.          þ

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

      As of June 30, 2004, the aggregate market value of the voting and non-voting common equity held by non-affiliates, based upon the last reported sale price of such common equity of the registrant as of such date as reported by The Nasdaq Stock Market, was $225,949,131.

      As of March 18, 2005, 133,439,697 shares of common stock of the registrant were outstanding.

DOCUMENTS INCORPORATED BY REFERENCE:

None.

PART I

Note Regarding Forward-Looking Statements

      Certain statements contained in this Annual Report on Form 10-K (this “Annual Report”), including, without limitation, in the sections herein titled “Business” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” or incorporated herein by reference, that are not statements of historical facts are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. The words “believe,” “expect,” “anticipate,” “intend,” “will” and similar expressions are examples of words that identify forward-looking statements. Forward-looking statements include, without limitation, statements regarding our future financial position, business strategy and expected cost savings. These forward-looking statements are based on our current beliefs, as well as assumptions we have made based upon information currently available to us.

      Each forward-looking statement reflects our current view of future events and is subject to risks, uncertainties and other factors that could cause actual results to differ materially from any results expressed or implied by our forward-looking statements. Important factors that could cause actual results to differ materially from the results expressed or implied by any forward-looking statements include: the volatility of the price of our common stock, par value $0.01 per share (the “Common Stock”); our ability to fund future growth; our ability to become profitable; our ability to attract and retain qualified personnel; general economic conditions of the telecommunications market; market demand for and market acceptance of our products; legal claims against us, including, but not limited to, claims of patent infringement; our ability to protect our intellectual property; defects in our products; our obligations to indemnify our customers; our exposure to risks inherent in international operations; our dependence on contract manufacturers and suppliers; general economic and business conditions; other risks and uncertainties included in the section of this Annual Report titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Risk Factors”; and other factors disclosed in our other filings made with the Securities and Exchange Commission (the “SEC”).

      All forward-looking statements relating to the matters described in this Annual Report and attributable to us or to persons acting on our behalf are expressly qualified in their entirety by such factors. We have no obligation to publicly update or revise these forward-looking statements to reflect new information, future events, or otherwise, except as required by applicable federal securities laws, and we caution you not to place undue reliance on these forward-looking statements.

General

      Verso Technologies, Inc., a Minnesota corporation (the “Company”), develops and markets next-generation converged packet-based solutions to service providers, and through service providers and systems integrators, to enterprises. These solutions are intended to increase overall network efficiency by lowering data and communications costs and creating new revenue enhancing opportunities for the Company’s customers. The Company focuses on softswitch and software-based converged packet-based solutions that use next-generation protocols such as voice over Internet protocol (“VoIP”), as well as other advanced protocols. The Company is creating open and scalable solutions that are compatible with industry standards and are in emerging high growth areas in domestic and international telecommunications markets.

      The Company’s headquarters is located at 400 Galleria Parkway, Suite 300, Atlanta, Georgia 30339, and the Company’s telephone number at that location is (678) 589-3500. The Company maintains a worldwide web address at www.verso.com. The Company makes available free of charge through the investors section of the Company’s website at www.verso.com the annual, quarterly and current reports, and amendments thereto, which the Company files with, or furnishes to, the SEC. Such reports and amendments are available on the Company’s website as soon as reasonably practical after the Company has filed such reports with, or furnished such reports to, the SEC.

      The Company’s continuing operations include two separate business segments: (i) the Packet-based Technologies Group, which includes the Company’s softswitching division and NetPerformer divisions, and the Company’s subsidiary TeleMate.Net Software, Inc. (“TeleMate.Net”); and (ii) the Advanced Applications Services Group, which includes the Company’s technical applications support group. The Packet-based Technologies Group includes domestic and international sales of hardware and software, integration, applications and technical training and support. The Packet-based Technologies Group offers hardware-based solutions (which include software) for companies seeking to build private, packet-based voice and data networks. In addition, the Packet-based Technologies Group offers software-based solutions for Internet access and usage management that include call accounting and usage reporting for Internet protocol network devices. The Advanced Applications Services Group includes outsourced technical application services and application installation and training services to outside customers, as well as customers of the Company’s Packet-based Technologies Group.

Packet-based Technologies Group

      The Packet-based Technologies Group develops softswitch and software-based converged packet solutions that use next generation protocols such as VoIP, as well other advanced protocols for specialized applications such as satellite transmission. In addition, the Packet-based Technologies Group offers customer premise gateway technology, all based on next-generation, open standards. These solutions enable service providers to deploy highly efficient converged communication networks which are more cost-effective to operate than traditional circuit-based networks and which enhance revenues by supporting innovative, high margin services. The Packet-based Technologies Group differentiates its solutions portfolio from those of the Company’s competitors by providing a complete, end-to-end solution that includes Class 4 and Class 5 switching technologies that provide networking infrastructure for the Company’s customer’s softswitch-based networks from the central core to the edge of the network. In addition, the Packet-based Technologies Group offers applications such as pre-paid and post-paid billing and provisioning.

      In the first quarter of 2003, the Company acquired substantially all of the operating assets of Clarent Corporation, a pioneer in packet-based technology. Today, the Clarent® product line supports a variety of diverse business applications from enterprise managed services and retail calling cards to wholesale Internet protocol (“IP”) telephony, IP network clearing services, international long distance and residential dial tone services. In 2004, the Company’s primary base of customers of the Packet-based Technologies Group consisted of emerging international service providers and domestic rural carriers, as well as a base of large, international Tier I telecommunications carriers and Internet service providers (“ISPs”). In an effort by the Company to sell to larger customers and to close larger individual carrier sales, the Company has been bundling its products into packaged solutions, a strategy that the Company hopes will result in larger initial sales and greater long-term opportunity. The Company is leveraging its worldwide installed base of customers, representing several million VoIP ports, towards sales of the Company’s newest Edge Access solutions.

      In August 2004, the Company began working with WSECI, Inc., formerly known as Jacksonville Technology Associates, Inc. (“WSECI”), to resell WSECI’s open and next-generation based pre-paid and post-paid solution called I-Master Application Solution. This solution is scalable to Tier 1 and Tier 2 carriers and is compatible with other equipment provider’s technologies, including the Company’s technologies, and, as such, presents a larger market opportunity for the Company. In February 2005, the Company entered into a definitive agreement to acquire substantially all the operating assets of WSECI. The Company expects that the acquisition will close by March 31, 2005.

      For the year ended December 31, 2004, revenue from the Packet-based Technologies Group was $20.5 million, or 64%, of the Company’s consolidated revenue. Summarized financial information for the Company’s Packet-based Technologies Group is set forth in Note 15 to the Company’s consolidated financial statements for the year ended December 31, 2004, which statements are contained elsewhere in this Annual Report.

The Market for the Packet-based Technologies Group

      In today’s competitive telecommunications marketplace, service providers are increasingly challenged to lower operating costs while enhancing service capabilities. Burdened by the high costs of continuing to build, manage and maintain separate voice and data networks, service providers have begun to combine voice and data services onto converged IP based network infrastructures that leverage the low cost delivery of IP networks while delivering the high reliability and voice quality standards of the circuit-switched, public switched telephone network (“PSTN”). At the same time, these new infrastructures are enabling service providers to launch new, innovative services that help them differentiate themselves and enhance their revenue potential. These new applications are driving widespread adoption of converged packet-based technology among large, Tier 1 service providers in developed markets like North America and Europe, as well as in emerging carriers in Asia-Pacific and elsewhere around the developing world.

      Meanwhile, deregulation and privatization of the global telecommunications industry continues to drive demand for converged packet-based technology for small, emerging, international service providers that are not encumbered by massive, legacy time division multiplexing networks. More flexible and more agile than larger carriers, these emerging service providers are opening up large, previously untapped markets like Africa and the Middle East, driving much of the worldwide VoIP spending as they launch traditional voice services through a variety of wholesale and retail business models.

      As the global business environment becomes increasingly competitive, enterprises and government entities of all sizes are driven by a common desire to lower operational costs, improve productivity, increase customer retention and speed time to market. Many enterprises depend on their technology infrastructures to help them achieve these business goals. To that end, enterprises are migrating their legacy voice and data systems into single, converged networks that enable more efficient use of resources and easier integration of distributed, disparate resources, including applications, equipment and people. As adoption of enterprise VoIP technology continues, so does demand for new IP-centric tools that enable businesses to manage and enhance the performance, utilization and efficiency of their evolving communication infrastructures.

Packet-based Technologies Group: Products and Solutions

      The Company’s Clarent® Edge Access Softswitch Solution enables traditional and alternative telecommunications service providers to deliver residential and advanced enterprise managed services over the “last mile” of any IP communications network, opening the door to new business and revenue opportunities. The solution supports IP connectivity via H.323, media gateway control protocol, and session initiation protocol (“SIP”) for interoperability with a wide range of access gateways as well as customer premise gateways (“CPGs”) and IP handsets. Additionally, the Company’s products support VoIP over newer access technologies such as broadband cable, xDSL and wireless local loop. Components of this solution include:

      In 2004, the Company introduced Clarent Class 5 Call Manager versions 3.1 and 3.2, which further expanded the Company’s opportunity at the network edge by providing key features such as High Availability, NAT traversal, Voice Mail, End User Web Portal, and Pre-paid for VoIP subscribers. These newly-introduced features expanded the Company’s opportunity to lower data communications costs and create new

revenue enhancing opportunities for its customers. These features are further discussed in the section of this Annual Report titled “Business — Research and Development.”

      The Company’s Clarent® PSTN Access Softswitch Solution seamlessly facilitates the migration to VoIP, allowing carriers to preserve and leverage existing telecom investments to realize lower operating costs and lower overall total cost of ownership. A significantly more cost-effective and scalable alternative to traditional tandem circuit switches, this Unix-based, software-centric, modular tandem trunking solution enables wholesale transport and termination of voice traffic over global IP networks. Components of this solution include:

      In 2004, the Company introduced Clarent Class 4 Call Manager version 2.0, which further expanded the Company’s opportunity in this market by providing key features such as compatibility with (i) the legacy PSTN Advance Intelligent Network; (ii) the BHG2500 universal gateway, which quadrupled the media gateway port density thereby allowing greater network capacity; (iii) SS7 signaling; (iv) media server capabilities in the same chassis, thereby increasing operational utilization; and (v) ANSI SS7 for US deployments.

      The Company’s NetPerformer line of integrated access routers enables multi-site carriers and enterprises to lower communications costs, alleviate bandwidth constraints, reduce network complexity and extend telecom services to remote locations with poor or non-existent telecom infrastructures. This versatile line of products enables information technology managers to integrate mission critical networks and applications across their enterprise, regardless of where they are in the VoIP migration process. In addition, NetPerformer enables enterprises to dramatically reduce telecom costs by eliminating monthly fees associated with tie lines that link remote offices to corporate headquarters and eliminate the toll charges on inter-office long distance calls. In 2004, the Company announced support for Global System for Mobile Communication (“GSM”) Abis/ Ater, an industry protocol for wireless transmission. This additional functionality coupled with the existing support for the GSM A and E interfaces allows the NetPerformer to be integrated into the key portions of GSM networks. The NetPerformer offers GSM operators a cost effective solution for reducing the bandwidth required by their GSM network thus lowering the carrier’s operating expenses.

      As stated above, the Company is a reseller of WSECI’s I-Master Application Solution and has entered into a definitive agreement to purchase substantially all of WSECI’s operating assets, including the I-Master Application Solution. The I-Master Application Solution enables service providers and carriers to launch multiple voice and next-generation services while maintaining the revenue assurance associated with a pre-paid model. This pre-paid solution platform is based on open standards, meaning that it can integrate with many existing next-generation equipment provider’s technologies, including the technologies of Cisco Systems, Inc., Veraz Networks, Inc., Gallery IP Telephony, Inc., Sonus Networks, Inc., Siemens AG and others.

      This solution is scalable to Tier 1 and Tier 2 carriers and is compatible with other equipment provider’s technologies, such as the Company’s technologies, and, as such, presents a larger market opportunity for the Company. In addition to direct marketing campaigns, the Company plans to exploit the multi-vendor interoperability by marketing this product in opportunities lead by other vendors providing the customer with a complete vertical solution to increase the Company’s market penetration. In addition, the solution offers real-time authentication for the revenue enhancing voice and data services, including:

      The Company’s TeleMate voice network intelligence software enables centralized management, control and cost allocation of enterprise voice network resources. TeleMate captures and consolidates data from any enterprise private branch exchange (“PBX”), IP — PBX, or telephony switching device and delivers intelligence reports that help managers improve resource allocation, identify usage trends, prevent fraud and meet regulatory reporting requirements.

      NetSpective® enables enterprises to monitor, filter and/or report on usage of critical IP network resources. With a comprehensive set of feature functionality that tracks Internet activity and detects usage of a variety of web-based applications, including peer-to-peer, instant messaging, online chat and streaming media, NetSpective helps enterprises, governments, schools and libraries maintain control of critical network resources and facilitate compliance with filtering and communications tracking regulations.

      In the third quarter of 2004, the Company launched its NetAuditor for reporting and analysis of NetSpective Corp. in addition to analysis of log files from Cisco Systems, Inc.’s PIX firewalls, Checkpoint’s Firewall 1 and Microsoft Corp.’s ISA Proxy.

Advanced Applications Services Group

      The Company’s Advanced Applications Services Group consists of the Company’s technical applications support group and includes outsourced technical application services and application installation and training services to outside customers and customers of the Company’s Packet-based Technologies Group.

      The Company’s Advanced Applications Services Group delivers full-service, custom technical support to customers that want to ensure satisfaction with each end-user technology interaction and supports all of the Company’s product lines, allowing the Company to better leverage resources while ensuring the highest level of customer support. The Company’s Advanced Applications Services Group delivers 24 x 7 help desk support, Tier I, II and III product support, in-sourcing, on-site deployment services, hardware and software training, and project management resources in support of over 21,000 end-users and more than 1,200 internet hot spots around the world.

Customers

      In 2004, the Company’s primary base of customers in the Packet-based Technologies Group included incumbent carriers outside the United States (Tier 1), and emerging or rural domestic and international

alternative carriers (Tiers 2 and 3) in the United States and abroad, particularly those service providers seeking to roll-out telecommunications networks based on converged packet-based technology.

      In the Packet-based Technologies Group, there was a demand for its softswitch solutions from incumbent carriers and competitive carriers in high-growth international markets such as Europe, Asia, India, Africa and the Middle East during 2004.

      In addition, the Company continued expanding its largely indirect distribution channel, both domestically and internationally during 2004. Demand for NetPerformer’s integrated voice and data access over satellite capability, especially with the introduction of GSM capability, strengthened the Company’s relationship with a major satellite integrator in regions in Europe, the Middle East and Africa and drove new sales to a leading global satellite provider.

      The Company’s TeleMate voice network intelligence software and NetSpective Internet Content Filtering solution is used by several thousand large to mid-size enterprises as well as government agencies to manage communications cost, network efficiency and network policy and to protect their network.

      Currently, the Company’s Advanced Applications Services Group provides services to over 21,000 end-users. The Company’s largest client of these services is InterContinental Hotels Group PLC, which has been a customer of the Company since 1992.

      During the year ended December 31, 2004, InterContinental Hotels Group PLC, a customer of the Company’s Advanced Application Services Group, accounted for 17% of the Company’s total revenue and Telepassport (Hellas) S.A., a customer of the Company’s Packet-based Technologies Group, accounted for 14% of the Company’s total revenue. During the year ended December 31, 2003, InterContinental Hotels Group PLC accounted for 17% of the Company’s total revenue.

Sales and Marketing

      The Company’s sales and marketing organization is responsible for building brand awareness, identifying key markets, and developing innovative products and services to meet the evolving demands of the marketplace. Another objective of the marketing effort is to stimulate the demand for services through a broad range of marketing communications and public relations activities. Primary communication vehicles include advertising, tradeshows, direct response programs, event sponsorship and websites.

      The Company seeks to achieve broader market penetration of its solutions in primarily three ways: expanding international distribution; pursuing new markets and customers, including ISPs, IP telephony service providers and pre-paid service bureaus; and selling new, next-generation communication solutions to its current base of customers.

      In the Packet-based Technologies Group, sales are accomplished primarily through an indirect channel, and to a lesser degree, a direct sales force. The are approximately 30 sales and sales support personnel located throughout the United States, Canada, the United Kingdom, India, France, Italy, China and the United Arab Emirates. The sales force is primarily responsible for cultivating strong relationships with systems integrators and distributors throughout the world and supporting them in the sales process. The Company has approximately 50 active value-added resellers and intends to grow that number. The Company has also developed a steering committee for its indirect channel partners in an effort to gain better awareness of its brand.

Competition

      The Company believes that one of its competitive strengths is its ability to offer an end-to-end solution that leverages synergy across its product lines. Through both internal development efforts and strategic acquisitions, the Company continues to add intellectual property and innovative, patented technologies that deliver greater value to its worldwide base of customers.

      The market for application-based telephony services is intensely competitive, subject to rapid technological change and significantly affected by new product introductions and market entrants. In the market for the

Company’s gateway solutions, the Company’s primary sources of competition include Class 4 and Class 5 solution providers, vendors of networking and telecommunications equipment, and telephony applications companies that bundle their offering with third-party equipment. Some competitors, especially networking and telecommunications equipment vendors, such as Lucent Technologies Inc., Cisco Systems, Inc., Huwaei Technologies, Sonus Networks, Inc. and Nortel Networks Ltd., have significantly greater financial resources and broader customer relationships than does the Company. Other public companies, such as Tekelec and VocalTec Communications Ltd., are focusing on market opportunities similar to market opportunities on which the Company focuses, as are a number of smaller, private companies, including Nuera Communications, Inc., Voiceware Systems Corporation and iSoftel Ltd.

      The Company’s NetPerformer product lines compete with the products of communications solutions providers such as Cisco Systems, Inc., Motorola, Inc., Vanguard Systems, Inc. and Memotec, as well as telecommunications equipment manufacturers such as Avaya, Inc., Nortel Networks, Inc., Ericsson and Toshiba Corporation.

      The Company’s TeleMate Voice Network Intelligence Software product competes with a number of products from companies such as MTS IntegraTRAK, MicroTel International, Inc., ISI Telemanagement Solutions, Inc., and Veramark Technologies, Inc.

      The Company’s NetSpective products compete with filtering products from providers such as WebTrends Corporation, 8e6 Technologies, SurfControl PLC, St. Bernard Software, Inc and Websense, Inc.

      The Company’s Advanced Applications Services Group competes with companies that provide integrated, multi-channel customer contact centers, including APAC Customer Services, Inc., ClientLogic Corporation, Convergys Corporation and SITEL Corporation as well as competing with in-house solutions.

Intellectual Property Rights

      The Company regards its copyrights, trade secrets and other intellectual property as critical to its success. Unauthorized use of the Company’s intellectual property by third parties may damage its brand and its reputation. The Company relies on trademark and copyright law, trade secret protection, and confidentiality, license and other agreements with its employees, customers, partners and others to protect its intellectual property rights. Despite precautions, it may be possible for third parties to obtain and use the Company’s intellectual property without the Company’s authorization. Furthermore, the validity, enforceability and scope of protection of intellectual property in Internet-related industries are still evolving. The laws of some foreign countries do not protect intellectual property to the same extent as do the laws of the United States.

      The Company cannot be certain that its services and the finished products that it delivers do not or will not infringe valid patents, copyrights, trademarks or other intellectual property rights held by third parties. The Company may be subject to legal proceedings and claims from time to time relating to the Company’s intellectual property other than in the ordinary course of business. Successful infringement claims against the Company may result in substantial monetary liability or may materially disrupt the conduct of the Company’s business.

      On September 18, 2001, U.S. Patent No. 6,292,801 was issued to TeleMate.Net, which the Company acquired in November 2001 by means of a merger. The patent covers technology developed by TeleMate.Net for tracking PBX, VoIP and IP traffic from a variety of network sources and correlating communications activity with a database of user accounts. The patented techniques are employed in several of TeleMate.Net’s products, including TeleMate.Net’s call accounting and NetSpective Internet access management solutions. This technology allows users to combine statistics from diverse networks sources to create cohesive network information and reporting. This unique technology for aggregating and correlating network data from different vendors and device types has application to the VoIP softswitch, Operation Support System (“OSS”) and billing markets. The patented processes allow the Company’s OSS software to gather billing, reporting and maintenance from a variety of data sources and vendors’ products, in addition to its own.

      On February 12, 2003, pursuant to the Company’s acquisition of substantially all of the operating assets of Clarent Corporation on such date, the Company acquired the following U.S. Patents: Dynamic Forward Error Correction Algorithm for Internet Telephone, No. 6,167,060, issued on December 26, 2000; System and Method for Real-Time Data and Voice Transmission over an Internet Network, No. 6,477,164, issued on November 5, 2002; Internet Telephone System with Dynamically Varying Codec, No. 6,356,545, issued on March 12, 2002; and System and Method for Roaming Billing, No. 6,453,030, issued on September 17, 2002.

      The Company also has several patent applications pending relating to its VoIP products and to certain products the Company acquired from Clarent Corporation pursuant to the Company’s acquisition of substantially all of the operating assets of Clarent Corporation on February 12, 2003.

Research and Development

      The Company believes that one of its competitive strengths is the synergy across its product lines, which enables the Company to accelerate the development of new technologies, the delivery of new products and expansion into new markets. Through both internal development efforts and strategic acquisitions, the Company continues to add intellectual property and innovative, patented technologies that deliver greater value to its worldwide base of customers.

      The Company’s research and development expenses totaled $7.0 million for the year ended December 31, 2004.

      In the Packet-based Technologies Group, the research and development initiatives centered around introducing softswitch features targeted toward carriers of broader scope, including dynamic resource allocation, expanding interoperability and third-party vendor integration, continuing the enhancement of performance and reliability. In 2003, the Company introduced Clarent Class 5 Call Manager version 3.0, which interoperates with most enterprise-class hardware and allows carriers to deploy high margin enterprise managed services, further expanding the Company’s opportunity at the network edge.

      In 2004, the Company introduced key enhancements to the Clarent Class 5 Call Manager based on market trends and key customer requirements. The newly-introduced features expanded the Company’s opportunity to lower the data communications costs and create new revenue enhancing opportunities for its customers. In addition to the enhancements to the Clarent Class 5 Call Manager, the Company introduced two new products and established key partnerships to provide further value to customers. These enhancements included further standards-based compliance by adding support for SIP based endpoints with top revenue generating CLASS features. This enhancement augments the Clarent Class 5 Call Manager’s support of MGCP and H.323 VoIP protocols. Enhanced features such as Pre-paid for VoIP subscribers, Integrated Voice Mail, and 3-way conference calling gives service providers further revenue generating opportunities while enhanced high availability improves quality of service within the service providers VoIP network.

      The Company also introduced the Subscriber Portal product which allows consumers to control their own phone account behavior from a web-based browser as well as view account and phone usage information. The introduction of this product allows service providers to offer enhanced services not currently available with PSTN phone service as well as reduces operational costs by putting more control into the consumers’ hands. In addition to the Company’s Subscriber Portal, the Company also introduced the Border Agent product. The Border Agent provides network address translation traversal for SIP and MGCP endpoints. This is a critical component for broadband service providers enabling them to offer residential VoIP services without enduring the expense of a traditional session border controller.

      In 2004, the Company also introduced key enhancements to its Class 4 Call Manager providing tandem network capabilities within the core of the service providers network, including international and national long distance. The key feature enhancements included integration with a service providers existing Intelligent Network (“IN”) infrastructure through support of the TCAP protocol. This enables service providers to leverage their existing investment in IN services while reducing the cost associated with training existing personnel on new service platforms. In addition to IN support, a number of operational efficiency

enhancements were made allowing service providers to better manage and troubleshoot problems within their VoIP network.

      These key enhancements to the Clarent Distributed Softswitch comprising of the Clarent Class 5 Call Manager and Clarent Class 4 Call Manager enable service providers to increase top line consumer revenues through enhanced service offerings while simultaneously increasing bottom line profitability by reducing operational expenses within the service provider’s network.

      In 2004, the Company introduced Clarent Class 4 Call Manager version 2.0, which further expanded the Company’s opportunity in this market by providing key features such as compatibility with the legacy PSTN Advance Intelligent Network, the BHG2500 universal gateway which quadrupled the media gateway port density as well as added SS7 signaling and media server capabilities in the same chassis, and ANSI SS7 for US deployments.

      In 2004, the Company announced support for GSM Abis/Ater for the NetPerformer solution. This allows the NetPerformer to offer GSM operators a cost effective solution for reducing the bandwidth required by their GSM network.

Employees

      As of February 11, 2005, the Company had 244 domestic employees, 170 of whom are located at the Company’s headquarters in Atlanta, Georgia, including 114 in the Advanced Applications Services Group, 43 of whom are located at the Company’s Clarent operations in Littleton, Colorado and the balance are located throughout the United States. As of February 11, 2005, the Company had 69 international employees, 47 of whom are located at the Company’s NetPerformer operations in Montreal, Canada, and 22 international employees who conduct the Company’s sales efforts throughout the rest of the world.

Background

      The Company was incorporated in Minnesota on March 20, 1984. Until 2001, the Company historically operated a value-added reseller (“VAR”) business and an associated network performance management consulting and integration practice. The Company also operated a Hospitality Services Group (“HSG”), which provided technology solutions to lodging, restaurant, and energy management customers. Over the years, the Company has moved away from these lines of business and now focuses on providing the products and services offered by its Packet-based Technologies Group and its Advanced Application Services Group. During the last five years, the Company’s business developed as described below.

      Early in 2000, the Company’s Board of Directors (the “Board”) decided to explore the sale of all or a portion of the Company’s HSG, which consisted of the Company’s lodging business, its restaurant solutions business and its energy management business. Subsequently, the operations of HSG were classified as discontinued operations, and each of the operating units of HSG was sold between late 2000 and early 2001. The sale of these operating units included all of the operations of (i) Sulcus Hospitality Technologies Corp., which the Company acquired in 1999; and (ii) Encore Systems, Inc., Global Systems and Support, Inc. and Five Star Systems, Inc. (collectively, the “Encore Group”), which the Company acquired in 1998, except for the Company’s customer response center services.

      In September 2000, the Company acquired Cereus Technology Partners, Inc. (“Cereus”) in a merger transaction. Cereus provided end-to-end e-business and business-to-business technology solutions, including e-business strategy, network consulting and hosting and application integration. In connection with the acquisition of Cereus, the Company changed its name to “Verso Technologies, Inc.”

      In November 2000, the Company acquired MessageClick, Inc. (“MessageClick”) in a merger transaction. The acquisition of MessageClick provided the Company with a propriety unified communications application delivered as an ASP. In the second quarter of 2001, the Company decided to discontinue offering its MessageClick application and to refocus the development of the MessageClick application to be offered as a licensed software product. The Company has since focused its overall strategy on pursuing the market for

next-generation communications, and therefore, the development of the MessageClick application as a license product is currently dormant.

      In July 2001, the Company acquired all of the outstanding capital stock of NACT Telecommunications, Inc., now known as Provo Pre-paid (Delaware) Corp. (“NACT”). The Company’s acquisition of NACT in July 2001 was the Company’s first significant investment in the area of next-generation communications. The acquisition of NACT and its portfolio of products and services allowed the Company to begin to offer proprietary, integrated, switching solutions for communications service providers seeking turn-key, pre-paid telecommunications solutions. The acquisition of NACT was funded by a $15 million investment by TeleMate.Net, as contemplated by the Company’s merger agreement with TeleMate.Net. On January 21, 2005, the Company sold substantially all of the operating assets of its NACT business. In connection with the sale, “NACT Telecommunications, Inc.” changed its name to “Provo Pre paid (Delaware) Corp.”

      On November 16, 2001, the Company acquired TeleMate.Net by means of a merger, pursuant to which TeleMate.Net became a wholly-owned subsidiary of the Company. TeleMate.Net develops proprietary Internet access, voice and IP network usage management, and intelligence applications that enable businesses to monitor, analyze, and manage the use of their internal network resources. As a result of the acquisition of TeleMate.Net, the Company added next-generation applications and application development competencies to the Company’s solutions portfolio.

      During the quarter ended December 31, 2001, and in keeping with the Company’s focus on providing next-generation communications solutions, the Company determined that its VAR business and associated network performance management consulting and integration practice were not strategic to the Company’s ongoing objectives and, therefore, decided to discontinue capital and human resource investment in these businesses. Accordingly, the Company elected to report its VAR and associated consulting and integration operations as discontinued operations by early adoption of Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”), which is intended to allow a company to more clearly communicate a change in its business that results from a decision to dispose of non-strategic operations.

      On October 1, 2002, the Company purchased a 51% interest in Shanghai BeTrue Infotech Co., Ltd. (“BeTrue”) for $100,000, with $50,000 paid at closing, $25,000 paid on December 30, 2002, and $25,000 paid on March 30, 2003. Upon closing the transaction, the Company contributed to the joint venture certain next-generation communication equipment and software valued at approximately $236,000 and $50,000, respectively. Additionally, the Company contributed to BeTrue $25,000 on December 30, 2002, and $25,000 on March 30, 2003. The remaining 49% interest in BeTrue is owned by Shanghai Tangsheng Investments & Development Co. Ltd. (“Shanghai Tangsheng”). BeTrue provides VoIP and satellite network solutions, including systems integration, project implementation, technical support, consulting and training to leading telecommunications companies in China and the Asia-Pacific region. The Company plans to leverage BeTrue’s sales channels and support infrastructure capabilities, including pre- and post- sales support. Due to shared decision-making between the Company and Shanghai Tangsheng, the results for BeTrue are recorded as an equity investment rather than consolidated in the Company’s results.

      On February 12, 2003, the Company acquired substantially all operating assets and related liabilities of Clarent Corporation. The assets purchased from Clarent Corporation include the following key products: next-generation switching and call control software; high density media gateways; multi-service access devices, signaling and announcement servers; network management systems; and high demand telephony applications based on packet-switched technology. Specifically, the Company acquired the Clarent Softswitch and NetPerformer products in connection with this acquisition.

      On September 26, 2003, the Company acquired MCK Communications, Inc., now known as Needham (Delaware) Corp. (“MCK”), by means of a merger, pursuant to which MCK became a wholly-owned subsidiary of the Company. MCK provided products that deliver distributed voice communications by enabling businesses to extend the functionality and applications of their business telephone systems from the main office to outlying offices, remote call centers, teleworkers and mobile employees over public and private networks. On January 21, 2005, the Company sold substantially all of the operating assets of its MCK

business, including (i) the assets which allow legacy digital business telephone handsets to be used in a voice network using public/ private IP-based, circuit-switched, frame relay or wireless technology network and (ii) the products that enable call recording of legacy business telephone systems in non-packet environments. In connection with the sale, “MCK Communications, Inc.” changes its name to “Needham (Delaware) Corp.”

      On February 23, 2005, the Company entered into a definitive agreement to acquire substantially all of the operating assets of WSECI, a provider of an Internet protocol-based applications platform which enables the deployment of multiple voice and next-generation services to the carrier market. The Company expects that the acquisition will close by March 31, 2005.

      The Company is headquartered in Atlanta, Georgia, where the Company currently leases 45,000 square feet of space, which is used for the Company’s corporate offices, the TeleMate.Net operations and the Company’s Advanced Application Services Group. The Company is obligated to pay rent on this space of approximately $114,000 per month, plus a share of operating expenses, through January 2010. Further, the Company is also obligated through January 2010 to pay rent of $30,000 per month with respect to an additional 13,000 square feet of space at the Atlanta facility, the cost of which is included in discontinued operations. The Company has subleased this 13,000 square feet of space at the Atlanta facility for $18,200 per month through November 2006 and $12,900 per month from December 2006 through January 2010.

      In connection with the Company’s disposition of its NACT business, NACT assigned to the purchaser thereof all of NACT’s interest in a lease for approximately 40,000 square feet of office space in Provo, Utah, which had been used to operate the NACT business, a component of the Company’s Packet-based Technologies Group. The purchaser has agreed to pay all amounts owed under the lease; however, NACT’s payment obligations under the lease have not been terminated and the Company’s guaranty of such obligations remains in place. The lease expires in December 2009, and the rent thereunder is $48,600 per month.

      In connection with the purchase of substantially all of the operating assets of Clarent Corporation in February 2003, the Company assumed two leases for real property located in Quebec, Canada. Pursuant to the first lease, the Company leases approximately 18,000 square feet of office and laboratory space for software research and development purposes related to the Company’s operations related to the NetPerformer products, a component of the Company’s Packet-based Technologies Group. The Company is obligated to pay rent of approximately $13,600 per month through the termination of the lease in October 2006. The Company subsequently assigned the second lease to Clarent Canada Ltd., a wholly-owned subsidiary of the Company which the Company acquired pursuant to the purchase (“Clarent Canada”). Pursuant to the second lease, Clarent Canada leases approximately 10,000 square feet of office, warehouse and storage space for commercial and manufacturing purposes also related to the Company’s operations related to the NetPerformer products. Clarent Canada is obligated to pay $4,600 per month, plus a share of operating expenses, until the lease terminates in May 2007.

      Also in connection with the purchase of substantially all of the operating assets of Clarent Corporation in February 2003, the Company entered into a lease for 23,000 square feet of space in Littleton, Colorado, which space is used for office space and research and development purposes for the Company’s operations primarily related to the softswitch solution products, a component of the Company’s Packet-based Technologies Group. Pursuant to this lease, the Company is obligated to pay rent of approximately $30,900 per month, plus a share of operating expenses, until the lease terminates in January 2006.

      MCK is obligated through May 31, 2007 on a lease for 48,886 square feet of office space in Needham, Massachusetts, which served as MCK’s headquarters before it was acquired by the Company, at rent of $113,900 per month. MCK has subleased all of such space through May 31, 2007, at a rent of $78,900 per month. This lease obligation was not assigned in connection with the sale of substantially all of the operating assets of the Company’s MCK business in January 2005, and MCK remains obligated to make all payments under the lease. A $1.5 million letter of credit secures the obligations.

      The Company believes that its leased facilities are adequate to meet its current needs and that additional facilities are available to the Company to meet its expansion needs for the foreseeable future.

      From time to time, the Company is involved in litigation with customers, vendors, suppliers and others in the ordinary course of business, and a number of such claims may exist at any given time. All such existing proceedings are not expected to have a material adverse impact on the Company’s results of operations or financial condition. In addition, the Company or its subsidiaries are a party to the proceedings discussed below.

      In December 2001, a complaint was filed in the Southern District of New York seeking an unspecified amount of damages on behalf of an alleged class of persons who purchased shares of MCK’s common stock between the date of MCK’s initial public offering and December 6, 2000. The complaint named as defendants MCK and certain of its former officers and other parties as underwriters of its initial public offering (the “MCK defendants”). The plaintiffs allege, among other things, that MCK’s prospectus, contained in the Registration Statement on Form S-1 filed with the SEC, was materially false and misleading because it failed to disclose that the investment banks which underwrote MCK’s initial public offering of securities and others received undisclosed and excessive brokerage commissions, and required investors to agree to buy shares of securities after the initial public offering was completed at predetermined prices as a precondition to obtaining initial public offering allocations. The plaintiffs further allege that these actions artificially inflated the price of MCK’s common stock after the initial public offering. This case is one of many with substantially similar allegations known as the “Laddering Cases” filed before the Southern District of New York against a variety of unrelated issuers (the “Issuers”), directors and officers (the “Laddering Directors and Officers”) and underwriters (the “Underwriters”), and have been consolidated for pre-trial purposes before one judge to assist with administration. A motion to dismiss addressing issues common to the companies and individuals who have been sued in these actions was filed in July 2002. After a hearing on the motion to dismiss the Court, on February 19, 2003, denied dismissal of the claims against MCK as well as other Issuers. Although MCK believes that the claims asserted are meritless, MCK and other Issuers have negotiated a tentative settlement with the plaintiffs. The terms of the tentative settlement agreement provide, among other things, that (i) the insurers of the Issuers will deliver a surety undertaking in the amount of $1 billion payable to the plaintiffs to settle the actions against all Issuers and the Laddering Directors and Officers; (ii) each Issuer will assign to a litigation trust, for the benefit of the plaintiffs, any claims it may have against its Underwriters in the initial public offering for excess compensation in the form of fees or commissions paid to such Underwriters by their customers for allocation of initial public offering shares; (iii) the plaintiffs will release all claims against the Issuers and the Laddering Directors and Officers asserted or which could have been asserted in the actions arising out of the factual allegations of the amended complaints; and (iv) appropriate releases and bar orders and, if necessary, judgment reductions, will be entered to preclude the Underwriters and any non-settling defendants from recovering any amounts from the settling Issuers or the Laddering Directors and Officers by way of contribution or indemnification. Prior to the Company’s acquisition of MCK, MCK’s board of directors voted to approve the tentative settlement. On February 15, 2005, the judge presiding over the Laddering Cases granted preliminary approval of the proposed settlement, subject to the Issuers submitting a revised proposed settlement to the Court. The proposed settlement is subject to final approval by the court. No provision was recorded for this matter in the financial statements of MCK prepared prior to its acquisition by the Company because MCK believed that its portion of the proposed settlement would be paid by its insurance carrier. The Company agrees with MCK’s treatment of this matter.

      MCK has been named a defendant in a lawsuit filed in Norfolk County, Massachusetts by Entrata Communications, Inc. (“Entrata”). Entrata Communications, Inc. v. Superwire.com, Inc. and MCK arises out of a dispute between Entrata and one of its largest shareholders, Superwire.com, Inc. (“Superwire”). Pursuant to a contract with Entrata, MCK was obligated to pay Entrata $750,000 in early 2002. In order to take advantage of a $100,000 discount offered for early payment, MCK paid Entrata $650,000 in November 2001, in full satisfaction of its contractual obligations. The funds were placed in escrow with Superwire’s California law firm, Jeffers, Shaff & Falk, LLP (“JSF”), which agreed not to disburse the funds until the

dispute between Entrata and Superwire had been resolved. Nevertheless, Entrata contends that it never received the funds from MCK and that the funds were diverted to Superwire and JSF. Through the lawsuit, Entrata seeks to recover from both MCK and Superwire the $750,000 that MCK would have owed in 2002. MCK has asserted counterclaims against Entrata, and cross-claims against Superwire, for fraud and breach of contract. On October 11, 2002, Superwire and Entrata filed cross-motions for summary judgment against each other. The court denied both motions on March 13, 2003. Following denial of the cross-motions for summary judgment, MCK filed a motion to add JSF and two of its partners, Barry D. Falk and Mark R. Ziebell, as third-party defendants. The court had given the parties until March 17, 2004 to complete discovery. Before the completion of the discovery period, Entrata filed a Chapter 7 bankruptcy proceeding pursuant to the United States Bankruptcy Code. MCK has not as of yet been notified by the trustee of Entrata’s estate as to whether the trustee will pursue the claims against MCK. If such claims are pursued, then the Company intends to defend such claims and prosecute its counterclaims and third-party claims. No amounts, other than the original payment, were provided for this matter in the financial statements of MCK prepared prior to its acquisition by the Company. The Company believes that the claim against MCK is without merit, and no amount has been accrued for this matter at December 31, 2004.

      The Annual Meeting of Shareholders of the Company was held on December 17, 2004, in Atlanta, Georgia (the “Meeting”). At the Meeting, the shareholders of the Company voted on proposals to (i) elect a Board of eight directors to serve until the Company’s next annual meeting of shareholders and until their successors are elected and qualified; (ii) approve an amendment to the Company’s 1999 Stock Incentive Plan, as amended (the “Incentive Plan”), to increase the number of shares of Common Stock underlying the Incentive Plan from 15,000,000 to 17,500,000; (iii) approve an amendment to the Company’s 1999 Employee Stock Purchase Plan (the “Purchase Plan”) to increase the number of shares of Common Stock underlying the Purchase Plan from 1,000,000 to 2,000,000; and (iv) ratify the appointment of Grant Thornton LLP as the independent auditors of the Company for the year ending December 31, 2004. Each of the foregoing proposals was approved by the Company’s shareholders at the Meeting.

      The results of the vote on the proposal to elect directors were as follows:

      There were no abstentions or broker non-votes with respect to the election of any of the director nominees listed above.

      The results of the vote on the proposal to amend the Incentive Plan were as follows: 31,890,014 votes FOR, 10,367,875 votes AGAINST, and 1,336,361 votes ABSTAINED. There were 75,048,246 broker non-votes on the proposal to amend the Incentive Plan.

      The results of the vote on the proposal to amend the Purchase Plan were as follows: 36,667,526 votes FOR, 5,632,260 votes AGAINST, and 1,294,496 votes ABSTAINED. There were 75,048,246 broker non-votes on the proposal to amend the Purchase Plan.

      The results of the vote on the proposal to ratify the appointment of Grant Thornton LLP were as follows: 116,444,545 votes FOR, 1,185,316 votes AGAINST, and 1,012,634 votes ABSTAINED. There was one broker non-vote on the proposal to ratify the appointment of Grant Thornton LLP.

      The foregoing proposals were set forth and described in the Notice of Annual Meeting of Shareholders and Proxy Statement of the Company dated November 19, 2004.

      Pursuant to General Instruction G (3) of Form 10-K under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), the information regarding the Company’s executive officers required by Item 401 of Regulation S-K is hereby included in Part I of this Annual Report.

      The following table sets forth the name of each executive officer of the Company, the office held by such officer and the age, as of March 11, 2005, of such officer:

      Certain additional information concerning the individuals named above is set forth below:

      Steven A. Odom has served as the Chief Executive Officer and a director of the Company since September 2000 and as the Chairman of the Board since December 2000. From January 2000 to September 2000, Mr. Odom served as the Chairman of the Board and the Chief Executive Officer of Cereus. From 1994 until June 1998, Mr. Odom served as Chief Executive Officer of World Access, Inc., a provider of voice, data and Internet products and services around the world (“World Access”). From November 1994 until November 1999, Mr. Odom also served as Chairman of the Board of World Access. From 1990 until 1994, Mr. Odom was a private investor in several companies, including World Access and its predecessor. From 1987 until 1990, he served as President of the PCS Division of Executone Information Systems in Atlanta, Georgia, a public company that manufactured and distributed telephone systems. From 1983 until 1987, Mr. Odom was Chairman and Chief Executive Officer of Data Contract Company, Inc., a manufacturer of telephone switching equipment and intelligent pay telephones, which he founded in 1983. From 1974 until 1983, he served as the Executive Vice President of Instrument Repair Service, a private company co-founded by Mr. Odom in 1974 that repaired test instruments for local exchange carriers.

      Lewis Jaffe has served as President and Chief Operating Officer of the Company since November 3, 2004. From August 2002 to November 2004, Mr. Jaffe was a self-employed public speaker and consultant. From April 2002 until August 2002, Mr. Jaffe served as the interim President of Glowpoint, Inc., a publicly-traded video products and services company. From July 2000 to July 2003, Mr. Jaffe served as an independent consultant to Glowpoint, Inc. From June 2000 to March 2002, Mr. Jaffe served as President and Chief Operating Officer of PictureTel Corporation, a publicly-traded videoconferencing company. From September 1998 to June 2000, Mr. Jaffe served as a managing director in the Boston office of Arthur Andersen LLP in its global finance practice. From January 1997 to March 1998, Mr. Jaffe served as President of C Systems, LLC, a designer and manufacturer of mobile military shelters, housing, communication, radar and missile launch systems. Mr. Jaffe served as a member of the Board of Directors for Glowpoint, Inc. from September 2001 to July 2003, the Board of Directors of Media 100 Inc. from June 2003 through November 2004 and the Turnaround Management Association of New England from September 1999 through November 2004. He currently is on the Board of Directors of two public companies, ACT Teleconferencing, Inc. and Benihana Inc., and two private companies, Travizon Inc. and Pixion, Inc.

      Juliet M. Reising has served as Executive Vice President, Chief Financial Officer, Treasurer, Secretary and a director of the Company since September 2000. Ms. Reising also served as Executive Vice President,

Chief Financial Officer and a director of Cereus from March 2000 to September 2000. From February 1999 to March 2000, Ms. Reising served as Chief Financial Officer of MindSpring Enterprises, Inc., an Internet service provider that merged with EarthLink, Inc. in February 2000. From September 1998 to February 1999, Ms. Reising served as Chief Financial Officer of AvData, Inc., a network management services company acquired by ITC DeltaCom, Inc. in 1999. From September 1997 to September 1998, Ms. Reising served as Vice President and Chief Financial Officer for Composit Communications International, Inc., an international software development company. From August 1995 to September 1997, she served as Vice President and Chief Financial Officer of InterServ Services Corporation, which was merged with Aegis Communications, Inc. in 1997. Ms. Reising started her career with Ernst & Young LLP in Atlanta, Georgia, where she received her certified public accountant license.

      Montgomery Bannerman has served as Senior Vice President, Strategic Initiatives of the Company since November 19, 2004. From November 2003 to September 2004, Mr. Bannerman served as Vice President Strategy for Universal Access Inc., a provider of outsourced network services. From January 2000 to October 2003, Mr. Bannerman served as Senior Vice President and Chief Technology Officer of Terremark Worldwide, Inc., a network access provider of telecommunications services. Mr. Bannerman founded IXS.NET, a provider of integrated VoIP network platforms in Asia, in 1996 and DSP.NET, a commercial ISP in northern California, in 1993.

      There are no family relationships among any of the executive officers or directors of the Company. Except as disclosed in the applicable employment agreements discussed in Item 11 of this Annual Report “Executive Compensation — Employment Agreements” and as disclosed in Item 13 of this Annual Report “Certain Relationships and Related Transactions,” no arrangement or understanding exists between any executive officer and any other person pursuant to which any executive officer was selected to serve as an executive officer. To the best of the Company’s knowledge, (i) there are no material proceedings to which any executive officer of the Company is a party, or has a material interest, adverse to the Company; and (ii) there have been no events under any bankruptcy act, no criminal proceedings and no judgments or injunctions that are material to the evaluation of the ability or integrity of any executive officer during the past five years. Executive officers of the Company are elected or appointed by the Board and hold office until their successors are elected and qualified, or until their death, resignation or removal, subject to the terms of applicable employment agreements or arrangements.

PART II

      The Common Stock is currently traded on The Nasdaq SmallCap Market under the symbol “VRSO.” Prior to September 13, 2002, the Common Stock was traded on the Nasdaq National Market under the same symbol, and from February 17, 2000 to October 1, 2000, the Common Stock was traded on The Nasdaq National Market under the symbol “ELTX.” Prior to February 17, 2000, the Common Stock was traded on The Nasdaq SmallCap Market under the same symbol. The following table sets forth the quarterly high and low bid prices for the Common Stock for the periods indicated below, as reported by The Nasdaq SmallCap Market. The stock prices set forth below do not include adjustments for retail mark-ups, markdowns or commissions, and represent inter-dealer prices and do not necessarily represent actual transactions.

      As of March 18, 2005, there were approximately 1,701 holders of record of the Common Stock.

      The Company has never declared or paid cash dividends on the Common Stock. The Company currently intends to retain any earnings for use in its operations and does not anticipate paying cash dividends on the Common Stock in the foreseeable future. In addition, the Company’s credit facility with Silicon Valley Bank, the Company’s primary lender, and the terms of the Company’s outstanding 6% senior unsecured convertible debentures prohibit the payment of cash dividends on the Common Stock.

      On November 3, 2004, the Company issued to Mr. Jaffe a (i) ten-year option to purchase 500,000 shares of Common Stock at an exercise price of $0.53 per share; (ii) ten-year option to purchase 250,000 shares of Common Stock at an exercise price of $0.75 per share; and (iii) ten-year option to purchase 250,000 shares of Common Stock at an exercise price of $1.25. Each option vests with respect to 25% of the underlying shares of Common Stock on each of November 3, 2005, November 3, 2006, November 3, 2007, and November 3, 2008; provided, however, that each of the option vest in its entirety upon a change of control of the Company. The options were issued to Mr. Jaffe in connection with his appointment as the Company’s President and Chief Operating Officer. The options issued to Mr. Jaffe were issued without registration under the Securities Act of 1933, as amended (the “Securities Act”). In reliance upon the exemption from registration set forth in Section 4(2) of the Securities Act (“Section 4(2)”). The Company based such reliance upon factual representations Mr. Jaffe made to the Company regarding his investment interest and sophistication, among other things.

      On November 19, 2004, the Company issued to Mr. Bannerman a ten-year option to purchase 250,000 shares of Common Stock at an exercise price of $0.69 per share. The option vests with respect to 25% of the underlying shares of Common Stock on each of November 19, 2005, November 19, 2006, November 19, 2007, and November 19, 2008. The option was issued to Mr. Bannerman in connection with his appointment as the Company’s Senior Vice President, Strategic Initiatives. The option issued to Mr. Bannerman was issued without registration under the Securities Act in reliance upon the exemption from registration set forth in Section 4(2). The Company based that reliance on factual representations Mr. Bannerman made to the Company regarding his investment intent and sophistication, among other things.

      The following selected financial data should be read in conjunction with the Company’s financial statements and related notes thereto, set forth in Item 15 hereof, and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” set forth in Item 7 hereof. The statement of operations data and the balance sheet data have been derived from the audited consolidated financial statements of the Company. The historical results are not necessarily indicative of future results. All amounts in thousands except per share data.

Overview

      The Company is a communications technology and solutions provider for communications service providers and enterprises seeking to implement application-based telephony services, Internet usage

management tools and outsourced customer support services. The Company’s continuing operations include two separate business segments: (i) the Packet-based Technologies Group, which includes the Company’s softswitching and NetPerformer divisions (the two businesses acquired from Clarent Corporation in February 2003) and the Company’s subsidiary TeleMate.Net; and (ii) the Advanced Applications Services Group, which includes the Company’s technical applications support group. The Packet-based Technologies Group includes domestic and international sales of hardware and software, integration, applications and technical training and support. The Packet-based Technologies Group offers hardware-based solutions (which include software) for companies seeking to build private, packet-based voice and data networks, and software-based solutions for Internet access and usage management that include call accounting and usage reporting for IP network devices. The Advanced Applications Services Group includes outsourced technical application services and application installation and training services to outside customers, as well as customers of the Company’s Packet-based Technologies Group.

      Since 2001, the Company has been selling products to the carrier market and focusing its strategic direction on developing and marketing next-generation communications products. The Company’s current business was built on acquisitions made by the Company by leveraging the economic downturn in the telecommunications area. In the first quarter of 2003, the Company acquired substantially all of the operating assets of Clarent Corporation, which provided the Company with patented VoIP technologies for both the carrier and enterprise markets (primarily serving international markets) and significantly increased the Company’s market share in the worldwide softswitch market.

      The Company’s strategy through 2003 was to add next-generation communications products to its suite of products through strategic acquisitions and to leverage these operations through cost reductions to enhance cash flow. With the acquisition of substantially all of the operating assets of Clarent Corporation, the Company moved its growth strategy toward international markets. International revenue increased to 43% of the Company’s consolidated revenues for 2004 from 0% of the Company’s consolidated revenues for 2002. As the acquisition of substantially all of the operating assets of Clarent Corporation was funded primarily by short-term seller financing, generating cash flow from operations during 2003 was required to meet the debt repayment obligations. As such, the Company leveraged its combined operations, reducing sales, general and administrative costs (as compared to costs prior to the acquisition), while preserving the research and development expenditures, which are vital to the Company’s long-term growth and viability.

      In 2004, the Company began moving towards an open standards platform. In 2004, the Company significantly increased its expenditures for sales and marketing to focus on long-term sustainable revenue growth. In the first quarter of 2004, the Company completed a private placement raising approximately $16.5 million, net of expenses, to fund the expanded sales and marketing programs. As expected, these additional expenditures significantly increased the operating loss from continuing operations in 2004 as compared to 2003.

      In January 2005, the Company sold substantially all of the operating assets of its NACT and MCK businesses to better focus the Company’s capital and management resources on areas which the Company believes have greater potential given its strategy to focus on next-generation network and solutions to improve cash utilization. In addition, the Company disposed of its NACT business because the Company wanted to move toward an open-standards, pre-paid next-generation solution that could better address growing market opportunities and enable the Company to offer a competitive product for Tier 1 and Tier 2 carriers. The Company believes that the I-Master platform, which the Company entered into a definitive agreement to acquire from WSECI in February 2005 after forming a strategic partnership with WSECI in the latter half of 2004, permits the Company to offer a better solution. The Company expects the acquisition to close by March 31, 2005. Further, the Company disposed of its MCK business because the Company intends to focus on next-generation solutions for service providers and the products of the MCK business did not fit that profile. The operations of the NACT and MCK businesses have been reclassified as discontinued operations in the Company’s consolidated financial statements. The Company’s discontinued operations previously included its legacy VAR business.

      The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, including MCK, TeleMate.Net, NACT and Clarent Canada.

      The Company believes that the foregoing events significantly affect the comparability of the Company’s results of operations from year to year. You should read the following discussion of the Company’s results of operations and financial condition in conjunction with the Company’s consolidated financial statements and related notes thereto included in Item 15 of this Annual Report.

Results of Operations

      For the year ended December 31, 2004, the Company’s net loss totaled $38.8 million, or $0.29 per share, compared with a net loss of $18.3 million, or $0.18 per share, for the same period in 2003. The 2004 results included $1.4 million in reorganization costs and a loss from discontinued operations of $20.0 million. The 2003 results included $159,000 in reorganization costs and a loss from discontinued operations of $14.1 million.

      For the year ended December 31, 2004, the Company’s loss from continuing operations totaled $18.8 million, or $0.14 per share, compared with a net loss of $4.2 million, or $0.04 per share, for 2003. The 2004 results included $1.4 million in reorganization costs. The 2003 results included $159,000 in reorganization costs.

      Total revenue was $32.3 million in the year ended December 31, 2004, reflecting a 15% decrease from 2003. Product revenue decreased from $19.3 million in 2003 to $15.5 million in 2004, primarily due to a decrease in the Company’s softswitch and NetPerformer product sales. In 2004, the Company restructured its sales force, including the sales leadership, to facilitate a cross product line selling strategy at a time when the telecommunication market was soft in many of the emerging telecommunication markets that the Company was targeting and was moving from upgrading class 4 tandem switches to revenue generating applications and class 5 line side switching. In addition, the Company moved from selling products to selling a complete solution to address the changes in the telecommunication market. These solution sales require longer sales cycles than the Company previously anticipated, which had an impact on 2004 revenue performance. Despite an increase in sales opportunities, actual revenues decreased for 2004. Services revenue was $16.7 million in the year ended December 31, 2004, reflecting an 11% decrease from the same period in 2003, primarily due to revenue from the Advanced Application Services Group and the TeleMate products. The decrease in revenue from the Advanced Application Services Group was attributable primarily to a decline in revenue from its largest customer due to that customer’s conversion to a new software platform, the support of which is primarily handled by the software vendor, net of new customers added. Gross profit decreased by $6.1 million in the year ended December 31, 2004, and was 47% of revenue in 2004, compared with 56% of revenue for 2003. The decrease in gross profit dollars resulted from the decrease in revenues with certain fixed product costs and increased service costs in the Advanced Application Services Group due to transition costs related to its largest customer moving to new software and to adding new customers.

      Total operating expenses incurred in continuing operations for the year ended December 31, 2004 were $33.2 million, an increase of $8.9 million compared to the same period in 2003. The increase is primarily attributable to the following items: increases in general and administrative expenses of $2.8 million, sales and marketing expenses of $2.8 million, research and development expenses of $2.1 million, depreciation expense of $350,000 and reorganization costs of $1.3 million offset by a decrease in amortization of deferred compensation of $345,000.

      The increase in general and administrative expenses resulted primarily from the increase in professional fees, the vast majority of which related to the implementation of Section 404 of the Sarbanes-Oxley Act of 2002, bad debt expense primarily related to one customer in the Packet-based Technology Group, a full year of expenses for the centralized accounting function, and insurance and telecommunications costs.

      The increase in sales and marketing expenses resulted from the Company’s expansion of its sales force and marketing programs in 2004.

      The increase in research and development is related to the planned increase in research and development activities in the Company’s softswitching and NetPerformer divisions.

      The increase in depreciation expense is primarily related to capital expenditures of approximately $2.0 million and $801,000 during 2004 and 2003, respectively, offset by decreases related to fully-depreciated assets. Capital expenditures are primarily depreciated on a straight-line basis over an estimated useful life of three years.

      Intangible amortization is related to the amortization of the customer relationship costs related to the 1998 acquisition of Encore Group.

      The $345,000 decrease in amortization of deferred compensation primarily related to the termination of certain options and full vesting of other options outstanding since the Company’s acquisitions of TeleMate.Net in November 2001 and Cereus in September 2000. The deferred compensation represents the intrinsic value of the TeleMate.Net and Cereus unvested options outstanding at the date of the acquisitions of TeleMate.Net and Cereus and is amortized over the remaining vesting period of the options.

      In the first quarter of 2004, the Company terminated the employment of a senior executive. In the fourth quarter of 2004, the Company initiated a restructuring plan to improve operational efficiencies and financial performance and eliminated 20 positions held by employees. As a result of these actions, the Company recorded reorganization costs of $1.4 million during the year ended December 31, 2004, including $570,000 of non-cash stock compensation expense. Annualized savings beginning in the first quarter of 2005 are expected to be approximately $1.9 million.

      In the first and third quarters of 2003, the Company announced reorganizations to accommodate the acquisition of substantially all of the operating assets of Clarent Corporation and, as a part of its effort to consolidate functions and improve operational efficiencies, the Company eliminated eight positions held by employees. As a result of these actions, the Company recorded reorganization costs of $159,000 during the year ended December 31, 2003. The reorganization costs consist of severance costs and non-cash stock compensation expense related primarily to the acceleration of vesting of options. Annualized savings were expected to be approximately $755,000.

      As a percent of revenue, operating expenses from continuing operations were 103% during the year ended December 31, 2004, up from 64% for the same period in 2003.

      Other income was $259,000 during the year ended December 31, 2004, compared with $314,000 for the same period in 2003. Other income during the years ended December 31, 2004 and 2003 was primarily related to the sale of non-operating assets.

      Equity in income of investment was $56,000 during the year ended December 31, 2004, compared to $73,000 in 2003. These amounts represent the Company’s portion of BeTrue’s income for each of these years. Due to the shared decision making between the Company and its equity partner, the results of BeTrue are treated as an equity investment rather than being consolidated.

      Net interest expense was $1.1 million during the year ended December 31, 2004, a decrease of $471,000 compared to the same period in 2003. The decrease was attributable to the repayment of the short-term notes related to the acquisition of substantially all of the operating assets from Clarent Corporation.

      Total revenue from the Company’s Packet-based Technologies Group was $20.5 million in the year ended December 31, 2004, an 18% decrease from the same period in 2003. The net decrease in revenue is attributable to softswitching and NetPerformer product sales. In 2004, the Company restructured its sales force, including the sales leadership, to facilitate a cross product line selling strategy at a time when the telecommunication market was soft in many of the emerging telecommunication markets that the Company was targeting and was moving from upgrading class 4 tandem switches to revenue generating applications and class 5 line side switching. In addition, the Company moved from selling products to selling a complete solution to address the changes in the telecommunication market. These solution sales require longer sales cycles than the Company previously anticipated, which had an impact on 2004 revenue performance. Despite a rise in sales opportunities, actual revenues declined in 2004.

      Gross profit decreased by $4.0 million in the year ended December 31, 2004, and was 54% of revenue, a decrease from 60% of revenue in the same period in 2003. The decrease in gross profit dollars is attributable to the decrease in revenue. The decrease in gross margin is due to a decline in revenues in relation to fixed departmental costs (primarily personnel and related costs) related to the production and support departments, inventory obsolescence adjustments and the addition of international support personnel and related expenses.

      Allocated operating expenses incurred in the Packet-based Technologies Group for the year ended December 31, 2004, were $18.3 million, an increase of $5.1 million compared to the same period in 2003. The increase in general and administrative expenses reflects a full year’s expense since the Company’s acquisition of substantially all of the operating assets of Clarent Corporation in February 2003 and an increase in bad debt expense primarily attributable to one customer. The increase in sales and marketing expenses resulted from the Company’s expansion of its sales force and marketing programs in 2004. The increase in research and development related to the planned increase in research and development activities at the Company’s softswitching and NetPerformer divisions. As a percent of revenue, operating expenses for the Packet-based Technologies Group were 89% during the year ended December 31, 2004, up from 52% during the same period in 2003. The increase in the percentage is attributable to the increase in sales and marketing and research and development spending coupled with lower revenue.

      Total revenue for the Company’s Advanced Applications Services Group was $11.7 million in the year ended December 31, 2004, a 10% decrease from the same period in 2003. The decrease in revenue is related to a decrease in installation services, rebillable travel and outsourced services for hospitality related customers.

      Gross profit decreased by $2.0 million in the year ended December 31, 2004, and was 34% of revenue, compared with 46% of revenue in the same period in 2003. The decrease in gross profit dollars and gross margin is due to increased personnel and related costs related to the Advanced Applications Services Group’s performance of consulting work to assist its largest customer in its conversion to a new software platform.

      Allocated operating expenses incurred in Advanced Applications Services Group for the year ended December 31, 2004, were $1.2 million, an increase of $169,000 compared to the same period in 2003. The increase in general and administrative expenses primarily relate to an increase in personnel and related costs and bad debt expense.

      In January 2005, the Company sold substantially all of the operating assets of its NACT and MCK businesses to better focus the Company’s capital and management resources on areas which the Company believes have greater potential given its strategy to focus on next-generation network and solutions to improve cash utilization. In addition, the Company disposed of its NACT business because the Company wanted to move toward an open-standards, pre-paid next-generation solution that could better address growing market opportunities and enable the Company to offer a competitive product for Tier 1 and Tier 2 carriers. The Company believes that the I-Master platform, which the Company entered into a definitive agreement to acquire from WSECI in February 2005 after forming a strategic partnership with WSECI in the latter half of 2004, permits the Company to offer a better solution. The Company expects the acquisition to close by March 31, 2005. Further, the Company disposed of its MCK business because the Company intends to focus on next-generation solutions for service providers and the products of the MCK business did not fit that profile. The operations of the NACT and MCK businesses have been reclassified as discontinued operations in the Company’s consolidated financial statements.

      Summary operating results of the discontinued operations (in thousands) are as follows:

      The operating loss from discontinued operations for the year ended December 31, 2004 includes depreciation of $979,000 and amortization of intangibles of $1.6 million. The operating loss from discontinued operations for the year ended December 31, 2003 includes depreciation of $972,000, amortization of intangibles of $910,000 and write-down of goodwill of $10.9 million.

      The write-down of goodwill relates to the Company’s acquisition of MCK in September 2003. In April 2003, the Company negotiated the original agreement to purchase MCK in which the MCK stockholders would be entitled to receive approximately 20.0 million shares of Common Stock which was valued at $13.0 million, based on the volume weighted average closing price per share of Common Stock as reported on The Nasdaq SmallCap Market for the 20 trading day period beginning March 19, 2003 and ending April 15, 2003. As part of the original agreement, the Company was to receive $7.5 million in cash. The terms of the agreement were amended on June 13, 2003. Under the amended terms, MCK stockholders were entitled to receive approximately 18.3 million shares of Common Stock and the cash MCK was required to have at the closing of the merger was reduced from $7.5 million to approximately $6.4 million. Although the number of shares of Common Stock to be issued in the merger was reduced by the amendment, the amendment changed the measurement date for valuing such shares. As a result of the increase in the price of Common Stock, prior to June 13, 2003, the revised valuation for the shares of Common Stock to be issued in the merger increased to $24.1 million. As a result of this increase in value, the goodwill recorded in the merger was impaired upon closing the merger. The Company completed an impairment analysis in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”). Based upon this analysis, the Company recorded a write-off of approximately $10.9 million during the year ended December 31, 2003.

      For the year ended December 31, 2003, the Company’s net loss totaled $18.3 million, or $0.18 per share, compared with a net loss of $2.7 million, or $0.03 per share, for the same period in 2002. The 2003 results included $407,000 in amortization of intangibles, $780,000 in amortization of deferred compensation, $159,000 in reorganization costs and a loss from discontinued operations of $14.1 million. The 2002 results included $1.2 million in amortization of deferred compensation, $324,000 in reorganization costs and income from discontinued operations of $2.0 million.

      For the year ended December 31, 2003, the Company’s net loss from continuing operations totaled $4.2 million, or $0.04 per share, compared with a net loss of $4.7 million, or $0.06 per share, for 2002. The 2003 results included $407,000 in amortization of intangibles, $780,000 in amortization of deferred compensation and $159,000 in reorganization costs. The 2002 results included $1.2 million in amortization of deferred compensation and $324,000 in reorganization costs.

      Total revenue was $38.1 million in the year ended December 31, 2003, reflecting a 106% increase from 2002. Product revenue increased from $1.5 million to $19.3 million primarily related to softswitch and NetPerformer product sales following the Company’s acquisition of substantially all the operating assets of Clarent Corporation in February 2003. Services revenue was $18.8 million in the year ended December 31, 2003, reflecting an 11% increase from the same period in 2002. Gross profit increased by $11.2 million in the year ended December 31, 2003, and was 56% of revenue in 2003, compared with 54% of revenue for 2002. The increase in gross profit dollars resulted primarily from the increase in revenues. The increase in gross profit percentage is related to the increase in the proportion of revenue from the Packet-based Technologies Group, which had a higher margin than the Advanced Application Services Group.

      Total operating expenses incurred in continuing operations for the year ended December 31, 2003, were $24.2 million, an increase of $10.3 million compared to the same period in 2002. The increase is primarily attributable to the following items: increases in general and administrative expenses of $2.4 million, sales and marketing expenses of $3.4 million, research and development expenses of $4.4 million, depreciation expense of $405,000 and amortization of intangibles of $240,000 offset by a decreases in amortization of deferred compensation of $393,000 and reorganization costs of $165,000.

      The increase in general and administrative expenses resulted from the addition of personnel and related costs related to the acquisition of substantially all the operating assets of Clarent Corporation totaling approximately $1.6 million and an increase in corporate general and administrative expenses of approximately $871,000. The increase in corporate general and administrative expenses resulted primarily from increases in personnel related costs, insurance and travel related to the acquisition of substantially all of the operating assets of Clarent Corporation during 2003.

      The increase in sales and marketing expenses resulted from the addition of personnel and related costs related to the acquisition of substantially all the operating assets of Clarent Corporation, totaling $4.2 million offset by overall decreased expenses related to on-going cost reduction initiatives of $807,000.

      The increase in research and development is primarily related to research and development activities at the Company’s softswitching division and NetPerformer division of $4.1 million.

      The increase in depreciation expense is primarily related to the fixed assets of $2.0 million recorded in connection with the acquisition of substantially all the operating assets of Clarent Corporation and the increases related to capital expenditures of approximately $801,000 and $113,000 during 2003 and 2002, respectively, offset by decreases related to fully-depreciated assets. Capital expenditures are primarily depreciated on a straight-line basis over an estimated useful life of three years.

      The increase in intangible amortization is primarily related to the amortization of the customer relationship costs related to the 1998 acquisition of Encore Group as recorded in the fourth quarter of 2002 as a result of the earn-out component of that acquisition.

      The $393,000 decrease in amortization of deferred compensation primarily related to the termination of certain options and full vesting of other options outstanding since the Company’s acquisitions of TeleMate.Net in November 2001 and Cereus in September 2000. The deferred compensation represents the intrinsic value of the TeleMate.Net and Cereus unvested options outstanding at the date of the acquisitions of TeleMate.Net and Cereus and is amortized over the remaining vesting period of the options.

      In the first and third quarters of 2003, the Company announced reorganizations to accommodate the acquisition of substantially all of the operating assets of Clarent Corporation, and as a part of its effort to consolidate functions and improve operational efficiencies, the Company eliminated eight positions held by employees. As a result of these actions, the Company recorded reorganization costs of $159,000 during the year ended December 31, 2003. The reorganization costs consist of severance costs and non-cash stock compensation expense related primarily to the acceleration of vesting of options. Annualized savings were expected to be approximately $755,000.

      In the third and fourth quarters of 2002, the Company implemented several restructuring plans as a part of its effort to improve operational efficiencies and financial performance and eliminated 42 positions held by employees. As a result of these actions, the Company recorded reorganization costs of $324,000. Annualized savings beginning in the first quarter of 2003 are expected to be approximately $2.8 million.

      As a percent of revenue, operating expenses from continuing operations were 64% during the year ended December 31, 2003, down from 76% for the same period in 2002.

      Other income was $314,000 during the year ended December 31, 2003, compared with $263,000 for the same period in 2002. Included in other income during the year ended December 31, 2003 was $323,000 of non-recurring transactions related to the sale of non-operating assets. Included in other income during the year ended December 31, 2002 was $254,000 of non-recurring transactions related to health insurance proceeds and sale of non-operating assets.

      Equity in income of investment was $73,000 during the year ended December 31, 2003, compared to equity in loss of investment of $5,000 in 2002. This amount represents the Company’s portion of BeTrue’s income or losses since the Company’s acquisition of a 51% interest in BeTrue on October 1, 2002. Due to the shared decision making between the Company and its equity partner, the results of BeTrue are treated as an equity investment rather than being consolidated.

      Net interest expense was $1.5 million during the year ended December 31, 2003, an increase of $368,000 compared to the same period in 2002. The increase was attributable to increased borrowings on the Company’s credit facility with Silicon Valley Bank and notes payable for the acquisition of substantially all of the operating assets of Clarent Corporation, net of interest income on notes receivable from shareholders.

      The Company recorded an income tax benefit of $200,000 during the year ended December 31, 2002, due to the reversal of a previously accrued exposure item no longer deemed necessary.

      Total revenue from the Company’s Packet-based Technologies Group was $25.1 million in the year ended December 31, 2003, a 323% increase from 2002. The revenue is attributable to softswitching and NetPerformer product sales following the acquisition of substantially all the operating assets of Clarent Corporation in February 2003.

      Gross profit increased by $10.9 million in the year ended December 31, 2003 and was 60% of revenue compared with 71% for 2002. The Company’s addition of Clarent’s softswitching and NetPerformer divisions

in February 2003 was the primary cause of the increase in gross profit. The decrease in gross margin percentage relates to the addition of Clarent’s softswitching and NetPerformer divisions which sells at lower margins than the Packet-based Technologies Group had previously experienced.

      Allocated operating expenses incurred in the Packet-based Technologies Group for the year ended December 31, 2003 were $13.2 million. The general and administrative expenses, sales and marketing and research and development expenses reflect the Company’s acquisition of substantially all of the operating assets of Clarent Corporation in February 2003. As a percent of revenue, allocated operating expenses for Packet-based Technologies Group were 52% during the year ended December 31, 2003, down from 59% during the same period in 2002. The decrease in percentage is primarily attributable to the addition of the operations of the Company’s softswitching and NetPerformer divisions in 2003.

      Total revenue for the Company’s Advanced Applications Services Group was $13.0 million in the year ended December 31, 2003, a 4% increase from the same period in 2002. The increase in revenue is related to an increase in installation services and rebillable travel.

      Gross profit increased by $267,000 in the year ended December 31, 2003, and was 46% of revenue in 2003 and 2002. The increase in gross profit dollars is related to the increase in revenue.

      Allocated operating expenses incurred in Advanced Applications Services Group for the year ended December 31, 2003, were $1.0 million, a decrease of $358,000 compared to the same period in 2002. The decrease in general and administrative and sales and marketing expenses primarily relate to a decrease in personnel and related costs.

      In January 2005, the Company sold substantially all of the operating assets of its NACT and MCK businesses to better focus the Company’s capital and management resources on areas which the Company believes have greater potential given its strategy to focus on next-generation network and solutions to improve cash utilization. In addition, the Company disposed of its NACT business because the Company wanted to move toward an open-standards, pre-paid next-generation solution that could better address growing market opportunities and enable the Company to offer a competitive product for Tier 1 and Tier 2 carriers. The Company believes that the I-Master platform, which the Company entered into a definitive agreement to acquire from WSECI in February 2005 after forming a strategic partnership with WSECI in the latter half of 2004, permits the Company to offer a better solution. The Company expects the acquisition to close by March 31, 2005. Further, the Company disposed of its MCK business because the Company intends to focus on next-generation solutions for service providers and the products of the MCK business did not fit that profile. The operations of the NACT and MCK businesses have been reclassified as discontinued operations in the Company’s consolidated financial statements. These businesses were added to the Company’s legacy VAR business (which was reported as discontinued operations in 2001) for a combined presentation of discontinued operations, and the consolidated financial statements have been reclassified to segregate the net assets and operating results of these businesses.

      Summary operating results of the discontinued operations (in thousands) are as follows:

      The operating loss from discontinued operations for the year ended December 31, 2003 includes depreciation of $971,000, amortization of intangibles of $910,000 and write-down of goodwill of $10.9 million. The operating loss from discontinued operations for the year ended December 31, 2002 includes depreciation of $1.2 million, amortization of intangibles of $592,000 and a gain on early retirement of debt of $350,000.

      The write-down of goodwill relates to the Company’s acquisition of MCK in September 2003. In April 2003, the Company negotiated the original agreement to purchase MCK in which the MCK stockholders would be entitled to receive approximately 20.0 million shares of Common Stock which was valued at $13.0 million, based on the volume weighted average closing price per share of Common Stock as reported on The Nasdaq SmallCap Market for the 20 trading day period beginning March 19, 2003 and ending April 15, 2003. As part of the original agreement, the Company was to receive $7.5 million in cash. The terms of the agreement were amended on June 13, 2003. Under the amended terms, MCK stockholders were entitled to receive approximately 18.3 million shares of Common Stock and the cash MCK was required to have at the closing of the merger was reduced from $7.5 million to approximately $6.4 million. Although the number of shares of Common Stock to be issued in the merger was reduced by the amendment, the amendment changed the measurement date for valuing such shares. As a result of the increase in the price of Common Stock, prior to June 13, 2003, the revised valuation for the shares of Common Stock to be issued in the merger increased to $24.1 million. As a result of this increase in value, the goodwill recorded in the merger was impaired upon closing the merger. The Company completed an impairment analysis in accordance with SFAS No. 142. Based upon this analysis, the Company recorded a write-off of approximately $10.9 million during the year ended December 31, 2003.

      In November 2002, the Company negotiated the early retirement of the remaining $1.75 million plus accrued interest due on the note made by the Company on April 25, 2002, in favor of WA Telcom Products Co., Inc., in connection with the Company’s acquisition of NACT in July 2001. The Company paid $1.4 million plus accrued interest and recognized a gain on early retirement of debt of $350,000.

Critical Accounting Policies

      The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles requires management to make judgments, assumptions and estimates that affect the amounts reported in the consolidated financial statements and accompanying notes. Factors that could affect the Company’s future operating results and cause actual results to vary from expectations include, but are not limited to, lower than anticipated growth from existing customers, an inability to attract new customers, an inability to successfully integrate acquisitions and technology changes, or a decline in the financial stability of the Company’s customers. Negative developments in these or other risk factors could have a material adverse affect on the Company’s financial position and results of operations. A summary of the Company’s critical accounting policies follows:

      The Company is required to estimate the collectibility of its trade receivables. Considerable judgment is required in assessing the ultimate realization of these receivables, including the creditworthiness of each

customer. The evaluation is based on credit information and collection history concerning the customer up and through the determination date. The Company determines the allowance for doubtful accounts based on a specific review of outstanding customer balances and a general reserve based upon aging of customer accounts and write-off history. Significant changes in required reserves have been recorded in recent periods and may occur in the future due to the current telecommunications and general economic environments and updates to the customer credit information and collection activity.

      The Company is required to state its inventories at the lower of cost or market. In assessing the ultimate realization of inventories, the Company makes judgments as to future demand requirements based on recent historical usage and compares that with the current inventory levels. The Company has recorded changes in net realizable values in recent periods due to impact of current and future technology trends and changes in strategic direction, such as discontinuances of product lines, as well as, changes in market conditions due to changes in demand requirements. It is possible that changes in the net realizable value of inventory may continue to occur in the future due to the current market conditions.

      The Company currently has significant deferred tax assets, which are subject to periodic recoverability assessment. Realization of the Company’s deferred tax assets is principally dependant upon achievement of projected future taxable income. The Company’s judgments regarding future profitability may change due to market conditions, its ability to continue to successfully execute its strategic plan and other factors. These changes, if any, may require possible material adjustments to these deferred tax asset balances. Due to the uncertainty of the Company’s ability to recognize the entire tax benefit, the Company established an offsetting provision for the tax assets.

      The Company is subject to proceedings, lawsuits and other claims related to labor, product and other matters. The Company is required to assess the likelihood of any adverse judgments or outcomes to these matters, as well as, potential ranges of probable losses. A determination of the amount of reserves required, if any, for these contingencies is made by the Company with assistance of its legal counsel after careful analysis of each individual issue based upon the then-current facts and circumstances and discussions with legal counsel. The required reserves may change in the future due to new developments in each matter or changes in approach such as a change in settlement strategy in dealing with these matters.

      Goodwill represents the excess of costs over fair value of assets of businesses acquired. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but instead are tested for impairment at least annually in accordance with provisions of SFAS No. 142. Significant estimates are made with respect to the impairment testing. SFAS No. 142 also requires that intangible assets with estimable useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS No. 144.

      In accordance with SFAS No. 144, long-lived assets, such as property, plant and equipment and purchased assets subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Significant estimates are made with respect to recoverability and fair value assessments.

Liquidity and Capital Resources

      Liquidity is the measurement of the Company’s ability to have adequate cash or access to cash at all times in order to meet financial obligations when due, as well as to fund corporate expansion and other activities. Historically, the Company has met its liquidity requirements through a combination of cash provided by debt from third party lenders, issuances of debt and equity securities, purchases of other businesses and the sale of discontinued businesses and acquisitions.

      At December 31, 2004, the Company had a positive working capital position (excess of current assets over current liabilities) of $7.6 million compared to a positive working capital position of $12.7 million at December 31, 2003. The Company’s cash and cash equivalents totaled $4.2 million at December 31, 2004, and $7.7 million at December 31, 2003. Total long-term debt, net of discount, was $2.7 million at December 31, 2004 and $6.6 million at December 31, 2003. At December 31, 2004 and 2003, the Company had no borrowings under its credit facility with Silicon Valley Bank. The Company’s borrowing availability under its credit facility at December 31, 2004 was $5.0 million. (This amount is adjusted for the effect of the disposals of the NACT and MCK businesses on the Company’s borrowing availability.) The Company has an outstanding stand-by letter of credit in the amount of $1.7 million at December 31, 2004 which would reduce borrowing capacity under the credit facility.

      On February 12, 2003, the Company acquired substantially all the business assets and assumed certain related liabilities of Clarent Corporation for $9.8 million in notes. At the closing of the acquisition, the Company issued three promissory notes to Clarent Corporation: a $5.0 million secured note due February 13, 2004, which has been paid in full; a $1.8 million non-interest bearing unsecured, which has been paid in full; and a $3.0 million secured note due February 12, 2008, which bears interest at 5% per annum, discounted at 7.5% per annum. The assets the Company purchased from Clarent Corporation secure the secured note.

      Cash used in the Company’s continuing operations in the year ended December 31, 2004 totaled approximately $16.8 million compared with cash used by continuing operations of $1.6 million for 2003. The Company’s use of cash in continuing operations during 2004 resulted primarily from cash used for changes in current operating assets and liabilities of approximately $2.9 million and cash used by continuing operations of $13.9 million (net loss from continuing operations of $18.8 million reduced by non-cash charges totaling $4.9 million, including depreciation and amortization of $3.7 million, provision for doubtful accounts of $494,000 and stock-related reorganization costs of $570,000). The cash provided by the Company’s continuing operations during 2003 resulted primarily from cash used by changes in current operating assets and liabilities of approximately $1.0 million and cash used by continuing operations of $599,000 (net loss from continuing operations of $4.2 million reduced by non-cash charges totaling $3.8 million, including depreciation and amortization of $3.7 million and provision for doubtful accounts of $86,000).

      Cash provided by the Company’s discontinued operations from operating activities for the year ended December 31, 2004, totaled $1.4 million compared with cash provided by discontinued operations of $190,000 for 2003.

      Cash provided by investing activities for continuing operations totaled approximately $269,000 in the year ended December 31, 2004, compared to cash used in investing activities for continuing operations of $1.6 million in the same period of 2003. During the years ended December 31, 2004 and 2003, restricted cash decreased by $2.3 million and $88,000, respectively. The Company spent $2.0 million and $801,000 on capital expenditures in the year ended December 31, 2004 and 2003, respectively. In 2003, the Company spent $906,000 related to the acquisition of substantially all of the operating assets of Clarent Corporation.

      Cash used in investing activities for discontinued operations totaled approximately $4.6 million in the year ended December 31, 2004, compared to cash provided by investing activities for discontinued operations of $8.1 million in the same period of 2003. The Company spent $321,000 and $680,000 on capital expenditures in the year ended December 31, 2004 and 2003, respectively. The Company also invested $533,000 on

purchased software development costs in the year ended December 31, 2003. During 2003, the Company received $9.3 million in cash related to the acquisition of MCK.

      Cash provided by financing activities for continuing operations totaled approximately $16.3 million in the year ended December 31, 2004, compared to $1.3 million for 2003. Net proceeds from a private placement of $16.5 million and proceeds from the issuance of the Common Stock related to the exercise of options of $175,000 were offset by a payment of $350,000 on the notes payable in 2004 for the purchase of substantially all of the operating assets of Clarent Corporation. The Company received $1.8 million in payments of notes receivable from shareholders, received proceeds from the issuance of Common Stock related to the exercise of stock options of $2.0 million and proceeds from the issuance of Common Stock related to the exercise of warrants of $4.8 million and paid $800,000 on the Company’s credit facility and $6.5 million on the notes payable for the purchase of substantially all of the operating assets of Clarent Corporation in 2003.

Contractual Obligations and Commercial Commitments

      The following summarizes the Company’s future contractual obligations at December 31, 2004 (in thousands):

      Note, this table excludes interest expense and sublease rentals and assumes that leases are not renewed

      The Company remains a guarantor on a lease through December 2009 used in the operations of the NACT business, which the Company sold in January 2005. The total commitment related to this lease is approximately $3.0 million.

      The Company has two outstanding stand-by letters of credit totaling $1.7 million at December 31, 2004.

Sources of Cash

      For 2005, the Company expects that its primary sources of cash will be from issuances of equity or debt securities, cash on hand, borrowings under its credit facility with Silicon Valley Bank and other sources. In February 2005, the Company issued in a private placement $13.5 million of senior unsecured convertible debentures due February 2009, Series A warrants exercisable for 10.8 million shares of Common Stock and Series B warrants exercisable for 10.0 million shares of Common Stock. Interest accrues on the senior unsecured convertible debentures at 6% per annum and is payable on a quarterly basis beginning April 2005 and principal is payable on a quarterly basis beginning August 2006. The Company received approximately $10.9 million, net of expenses and net of $1.6 million in restricted cash. The Company expects that its current operations will not generate positive income from continuing operations before interest, taxes, depreciation, amortization of intangibles and amortization of deferred compensation for the next year as the Company continues to invest in sales and marketing and research and development costs. However, the Company believes that it will have sufficient liquidity from its cash on-hand, the cash raised in the private placement and its unused credit facility to meet its current financial obligations during 2005.

      The credit facility with Silicon Valley Bank, however, is subject to certain financial covenants (including a minimum excess availability covenant) and limitations on the Company’s ability to access funds under the credit facility. In March 2005, the Company and Silicon Valley Bank further amended the credit facility to add a tangible net worth covenant. If the Company is in violation of the credit facility, or does not have sufficient eligible accounts receivable and inventory to support the level of borrowings it may need, then the Company may be unable to draw on the credit facility to the extent necessary. To the extent the Company does not have borrowing availability under the credit facility, the Company may be required to obtain additional sources of capital, sell assets, obtain an amendment to the credit facility or otherwise restructure its outstanding indebtedness. Additional borrowings other than pursuant to the credit facility must be approved by Silicon Valley Bank. If the Company is unable to obtain additional capital, sell assets, obtain an amendment to the credit facility or otherwise restructure its outstanding indebtedness, then the Company may not be able to meet its obligations.

      The Company’s short-term cash needs are for working capital, including cash operating losses, capital expenditures, payments on the convertible subordinated debentures due November 2005 totaling $4.5 million, interest payments on the 6% senior unsecured convertible debentures and payments related to discontinued operations. At December 31, 2004, liabilities of discontinued operations included $2.4 million in lease payments related to discontinued operations. The Company expects to pay out approximately $622,000 related to lease payments, net of sublease rentals for discontinued operations, in the next twelve months.

      The Company’s long-term cash needs are related to the costs of growing its current business as well as prospective businesses to be acquired, including capital expenditures and working capital. In addition, the Company will begin payment of the senior unsecured convertible debentures in August 2006 and the secured note payable made by the Company in connection with the acquisition of substantially all of the operating assets of Clarent Corporation in February 2008. The Company expects to meet these cash needs through cash from operations, if any, cash on hand, borrowings under the credit facility or other debt facilities, if available, as well as through possible issuances of equity or debt securities. If sufficient borrowing capacity under a working capital line of credit is unavailable (or if the Company is unable to restructure its existing credit facility in the event that the Company requires additional borrowing capacity), or if the Company is otherwise unable to obtain additional capital or sell assets, then the Company may not be able to meet its obligations and growth plans.

Risk Factors

      The stock market in general, and the market for technology companies in particular, has experienced extreme volatility that has often been unrelated to the operating performance of particular companies. From January 1, 2002 to September 12, 2002, the per share closing price of the Common Stock on The Nasdaq National Market fluctuated from a high of $1.79 to a low of $0.26. From September 13, 2002 to March 23, 2005, the per share closing price of the Common Stock on The Nasdaq SmallCap Market fluctuated from a high of $5.07 to a low of $0.26. The Company believes that the volatility of the price of the Common Stock does not solely relate to the Company’s performance and is broadly consistent with volatility experienced in the Company’s industry. Fluctuations may result from, among other reasons, responses to operating results, announcements by competitors, regulatory changes, economic changes, market valuation of technology firms and general market conditions.

      In addition, in order to respond to competitive developments, the Company may from time to time make pricing, service or marketing decisions that could harm its business. Also, the Company’s operating results in one or more future quarters may fall below the expectations of securities analysts and investors. In either case, the trading price of the Common Stock would likely decline.

      The trading price of the Common Stock could continue to be subject to wide fluctuations in response to these or other factors, many of which are beyond the Company’s control. If the market price of the Common Stock decreases, then shareholders may not be able to sell their shares of Common Stock at a profit.

      The Company’s business strategy calls for growth internally as well as through acquisitions. The Company has invested substantial funds in its sales and marketing efforts in order to grow revenues. This strategy to increase sales and marketing resources, as well as other strategies for growth internally which the Company may implement now or in the future, will require funding for additional personnel, capital expenditures, working capital and other expenses. Financing may not be available to the Company on favorable terms or at all. If adequate funds are not available on acceptable terms, then the Company may not be able to meet its business objectives for expansion, which, in turn, could harm the Company’s business, results of operations and financial condition. In addition, if the Company raises additional funds through the issuance of equity or convertible debt securities, then the percentage ownership of the Company’s shareholders will be reduced, and any new securities could have rights, preferences and privileges senior to those of the Common Stock. Furthermore, if the Company raises capital or acquires businesses by incurring indebtedness, then the Company will become subject to the risks associated with indebtedness, including interest rate fluctuations and any financial or other covenants that the Company’s lender may require. Moreover, if the Company’s strategy to invest in its sales and marketing efforts in order to grow revenues does not produce the desired result, then the Company will have incurred significant expenses for which it may or may not have obtained adequate funding to cover.

      The Company has a history of net losses, including net losses of $38.8 million for the 2004 fiscal year, $18.3 million for the 2003 fiscal year, $2.7 million for the 2002 fiscal year and $147.6 million for the 2001 fiscal year. As of December 31, 2004, the Company had an accumulated deficit of $311.9 million. Further, developing the Company’s business strategy and expanding the Company’s services will require significant additional capital and other expenditures. Accordingly, if the Company is not able to increase its revenue, then it may never generate sufficient revenues to achieve or sustain profitability.

      The Common Stock is currently quoted on The Nasdaq SmallCap Market. The Company must satisfy certain minimum listing maintenance requirements to maintain such quotation, including a series of financial tests relating to shareholders equity or net income or market value, public float, number of market makers and shareholders, market capitalization, and maintaining a minimum bid price of $1.00 per share for the Common Stock.

      On November 11, 2004, The Nasdaq Stock Market notified the Company that for the last 30 consecutive business days the bid price for the Common Stock had closed below the minimum $1.00 per share requirement for continued inclusion of the Common Stock on The Nasdaq SmallCap Market as required by Marketplace Rule 4310(c)(4) (the “Rule”). In accordance with Marketplace Rule 4310(c)(8)(D), the Company has 180 calendar days, or until May 10, 2005, to regain compliance with the Rule. The Company may regain compliance with the Rule if the bid price of the Common Stock closes at $1.00 per share or more for a minimum of 10 consecutive business days at anytime before May 10, 2005. If compliance with the Rule cannot be demonstrated by May 10, 2005 and, except for the bid price requirement, the Company meets The Nasdaq SmallCap initial listing criteria set forth in Marketplace Rule 4310(c), then the Company will have an additional 180 calendar day compliance period in which to demonstrate compliance with the Rule. The Company believes that it currently meets all of the initial listing requirements for The Nasdaq SmallCap Market, except for the bid price requirement. If the Company does not regain compliance with the Rule prior to May 10, 2005 and is not eligible for the additional compliance period, then The Nasdaq Stock Market will notify the Company that the Common Stock will be delisted.

      If the Common Stock is delisted from The Nasdaq SmallCap Market, then the Common Stock may trade on the Over-the-Counter-Bulletin Board, which is viewed by most investors as a less desirable and less liquid market place. Delisting from The Nasdaq SmallCap Market could make trading the Common Stock more difficult for the Company’s investors, leading to declines in share price. Delisting of the Common Stock

would also make it more difficult and expensive for the Company to raise additional capital. Furthermore, delisting of the Common Stock is an event of default under the Company’s credit facility with the Company’s primary lender, the Company’s outstanding 7.5% convertible debentures, 6% senior unsecured convertible debentures and, through certain cross default provisions, the Loan and Security Agreement the Company entered into with Clarent Corporation in connection with the Company’s acquisition of substantially all of the business assets, and certain related liabilities, of Clarent Corporation on February 12, 2003.

      The Company believes that its success depends largely on its ability to attract and retain highly skilled and qualified technical, managerial and marketing personnel. Competition for highly skilled engineering, sales, marketing and support personnel is intense because there are a limited number of people available with the necessary technical skills and an understanding of the markets which the Company serves. Workforce reductions by the Company during 2002, 2003 and 2004 may adversely affect the Company’s ability to retain its current employees and recruit new employees. The inability to hire or retain qualified personnel could hinder the Company’s ability to implement its business strategy and harm its business.

      The Company’s business is subject to global economic conditions and, in particular, to market conditions in the telecommunications industry. The Company’s operations could be adversely affected if capital spending from telecommunications service providers does not grow or were to decline. If global economic conditions worsen, or if the prolonged slowdown in the telecommunications industry continues, then the Company may experience adverse operating results.

      The Company’s industry is characterized by the need for continued investment in research and development. If the Company fails to invest sufficiently in research and development, then the Company’s products could become less attractive to potential customers, which could have a material adverse effect on the Company’s results of operations and financial condition. As a result of the Company’s need to maintain or increase its spending levels in this area, the Company’s operating results could be materially harmed if the Company’s net sales fall below expectations. In addition, as a result of the need for research and development and technological innovation, the Company’s operating costs may increase in the future.

      While the Company believes there is a significant growth opportunity in providing converged communications solutions to its customers, there is no assurance that this technology will be widely accepted or that a viable market for the Company’s products will fully develop or be sustainable. If this market does not develop, or develops more slowly than expected, then the Company may not be able to sell its products in significant volume, or at all. Due to the intense competition in this market and the recent introduction of this technology, there is no assurance that the Company will succeed in this evolving marketplace.

      The Company’s industry is technology intensive. As the number of competitors in the Company’s target markets increases and the functionality of the products produced by such competitors further overlaps, third parties may claim that the technology the Company develops or licenses infringes their proprietary rights. As an example, in February 2003, the Company purchased from Clarent Corporation certain assets and technology, including a certain product which contained a component that was alleged by a third party to infringe upon the third party’s patent. Any claims against the Company or any of its subsidiaries may affect

the Company’s business, results of operations and financial condition. Any infringement claims, even those without merit, could require the Company to pay damages or settlement amounts or could require the Company to develop non-infringing technology or enter into costly royalty or licensing agreements to avoid service implementation delays. Any litigation or potential litigation could result in product delays, increased costs or both. In addition, the cost of litigation and the resulting distraction of the Company’s management resources could have a material adverse effect on the Company’s results of operations and financial condition. If successful, a claim of product infringement could deprive the Company of the technology it needs altogether.

      The Company’s success depends in part upon the protection of the Company’s proprietary application software and hardware products. The Company has taken steps that it believes are adequate to establish, protect and enforce its intellectual property rights. The Company cannot assure you that these efforts will be adequate. Despite the Company’s efforts to protect the Company’s proprietary rights, unauthorized parties may attempt to copy or otherwise obtain rights to use the Company’s products or technology.

      The Company has pending several patent applications related to its VoIP products. There can be no assurance that these patents will be issued. Even if these patents are issued, the limited legal protection afforded by patent, trademark, trade secret and copyright laws may not be sufficient to protect the Company’s proprietary rights to the intellectual property covered by these patents.

      Furthermore, the laws of many foreign countries in which the Company does business do not protect intellectual property rights to the same extent or in the same manner as do the laws of the United States. In addition, it is necessary to file for patent protection in foreign countries in order to obtain legal protection of technology in those countries. Although the Company has implemented and will continue to implement protective measures in other countries, these efforts may not be successful or may be cost prohibitive. Additionally, even if the Company’s domestic and international efforts are successful, the Company’s competitors may independently develop non-infringing technologies that are substantially similar or superior to the Company’s technologies.

      The Company’s business strategy calls for the development of new products and product enhancements which may from time to time contain defects or result in failures that the Company did not detect or anticipate when introducing such products or enhancements to the market. In addition, the markets in which the Company’s products are used are characterized by a wide variety of standard and non-standard configurations and by errors, failures and bugs in third-party platforms that can impede proper operation of the Company’s products. Despite product testing by the Company, defects may still be discovered in some new products or enhancements after the products or enhancements are delivered to customers. The occurrence of these defects could result in product returns, adverse publicity, loss of or delays in market acceptance of the Company’s products, delays or cessation of service to the Company’s customers or legal claims by customers against the Company.

      To the extent that contractual provisions that limit the Company’s exposure to legal claims are unenforceable or such claims are not covered by insurance, a successful products liability claim could have a material adverse effect on the Company’s business, results of operations and financial condition.

      In the course of the Company’s business, the Company may agree to indemnify its customers against claims made against them by third parties for patent infringement related to equipment purchased from the

Company. Any payments made in respect of these indemnification obligations could have a material adverse effect on the Company’s business, results of operations and financial condition.

      As a result of the Company’s acquisition of substantially all of the operating assets of Clarent Corporation in February 2003, the Company now offers products which it could not offer previously, including Class 5 softswitch products and Enterprise VoIP routers. The markets for these products are relatively new, unpredictable and evolving rapidly. Lack of acceptance in the marketplace for these new products could have a material adverse effect on the Company’s business, results of operations and financial condition.

      International sales represented 43% of the Company’s revenues for the year ended December 31, 2004. Furthermore, the Company expects sales to international markets to increase as a percentage of revenues in the future. International sales are subject to a number of risks, including changes in foreign government regulations, laws, and communications standards; export license requirements; currency fluctuations, tariffs and taxes; other trade barriers; difficulty in collecting accounts receivable; longer accounts receivable collection cycles; difficulty in managing across disparate geographic areas; difficulties in hiring qualified local personnel; difficulties associated with enforcing agreements and collecting receivables through foreign legal systems; expenses associated with localizing products for foreign markets; and political and economic instability, including disruptions of cash flow and normal business operations that may result from terrorist attacks or armed conflict.

      If the relative value of the U.S. dollar in comparison to the currency of the Company’s foreign customers should increase, then the resulting effective price increase of the Company’s products to these foreign customers could result in decreased sales. In addition, to the extent that general economic downturns in particular countries or regions impact the Company’s customers, the ability of these customers to purchase the Company’s products could be adversely affected, especially for some of the more significant projects. Payment cycles for international customers can be longer than those for customers in the United States. The foreign markets for the Company’s products may develop more slowly than currently anticipated. Also, the Company’s ability to expand the sale of certain of its products internationally is limited by the necessity of obtaining regulatory approval in new countries.

      The Company anticipates that its non-Canadian, foreign sales will generally be invoiced in U.S. dollars and does not currently plan to engage in foreign currency hedging transactions. As the Company expands its international operations, however, it may allow payment in foreign currencies and exposure to losses in foreign currency transactions may increase. The Company may choose to limit any currency exposure through the purchase of forward foreign exchange contracts or other hedging strategies, which strategies, if employed, may not be successful.

      The Company currently uses contract manufacturers to manufacture a significant portion of its products. The Company’s reliance on contract manufacturers involves a number of risks, including the absence of adequate capacity, the unavailability of, or interruptions in access to, necessary manufacturing processes and reduced control over delivery schedules. If the Company’s manufacturers are unable or unwilling to continue manufacturing the Company’s products and components in required volumes, then the Company will have to identify one or more acceptable alternative manufacturers. Furthermore, the use of new manufacturers may cause significant interruptions in supply if the new manufacturers have difficulty manufacturing products to the Company’s specifications. Further, the introduction of new manufacturers may increase the variance in the quality of the Company’s products. In addition, the Company relies upon third-party suppliers of specialty

components and intellectual property used in its products. It is possible that a component needed to complete the manufacture of the Company’s products may not be available at acceptable prices or on a timely basis, if at all. Inadequate supplies of components, or the loss of intellectual property rights, could affect the Company’s ability to deliver products to its customers. Any significant interruption in the supply of the Company’s products would result in the reduction of product sales to customers, which in turn could permanently harm the Company’s reputation in the industry.

      The Company may be subject to claims involving how the Company conducts its business or the market for or issuance of the Common Stock or other securities. Any such claims against the Company may affect its business, results of operations and financial condition. Such claims, including those without merit, could require the Company to pay damages or settlement amounts and would require a substantial amount of time and attention from the Company’s senior management, as well as considerable legal expenses. Although the Company does not anticipate that its activities would warrant such claims, there is no assurance that such claims will not be made.

      The Company uses an indirect sales model to derive a substantial portion of its revenue. Failure to generate revenue as expected from this channel could have a material adverse effect on the Company’s results of operations and financial condition.

      No channel partner or distributor is obligated to purchase additional products or services from the Company. Accordingly, present and future partners may terminate their purchasing arrangements with the Company or significantly reduce or delay their orders. Any termination, change, reduction or delay in orders could have a material adverse effect on the Company’s results of operations and financial condition. In addition, the Company currently has varying distribution, marketing and development arrangements with its partners. There is no assurance that the Company will continue to enjoy the support and cooperation that it has historically experienced from these parties or their associated distribution channels. Also, there is no certainty that these parties will continue to offer the Company’s products in their sales portfolio. It is possible that these vendors may seek to offer broader product lines and solutions that are competitive with the Company’s products. In addition, they may change their distribution models which could negatively impact revenues of the Company. Furthermore, the Company must correctly anticipate the price, performance and functionality requirements of these partners and must successfully develop products that meet end user requirements and make these products available on a timely basis and in sufficient quantities in order to sustain and grow its business.

      The success of the Company depends to a significant degree upon its continued relationships with leading technology suppliers. The standards for telephony equipment and data networks are evolving, and the Company’s products may not be compatible with new technology standards that may emerge. If the Company is unable to provide its customers with interoperable solutions, then they may make purchases from vendors who provide the requisite product interoperability. This could have a material adverse effect on the Company’s results of operations and financial condition.

Market Risk

      The Company is exposed to various market risks, including changes in interest rates and foreign currency exchange rates. Market risk is the potential loss arising from adverse changes in market rates and prices, such as interest rates and foreign currency exchange rates. The Company does not enter into derivatives or other

financial instruments for trading or speculative purposes. The Company has also not entered into financial instruments to manage and reduce the impact of changes in interest rates and foreign currency exchange rates although the Company may enter into such transactions in the future.

Interest Rate Risks

      The Company’s notes payable and convertible subordinated debentures at December 31, 2004, carry interest rates which are fixed. The Company’s line of credit with Silicon Valley Bank carries interest rates which vary with the prime rate. Accordingly, if the Company has any indebtedness outstanding under its line of credit with Silicon Valley Bank, then any increases in Silicon Valley Bank’s prime rate will reduce the Company’s earnings. At December 31, 2004, the Company did not have any indebtedness outstanding under its line of credit with Silicon Valley Bank.

Foreign Currency Risks

      Products sold outside of the United States of America are transacted in U.S. dollars and, therefore, the Company is not exposed to foreign currency exchange risk. Transactions with Clarent Canada and Verso Technologies (UK) Limited, an indirect, wholly owned subsidiary of the Company, present foreign currency exchange risk. The principal transactions are personnel and related costs. The intercompany balance is denominated in U.S. dollars and changes in foreign currency rates would result in foreign currency gains and losses. Using the intercompany balance at December 31, 2004, a 10% strengthening of the U.S. dollar against the Canadian dollar and the British pound would result in a foreign currency transaction loss of approximately $43,000. To date, foreign exchange gains and losses have not been significant.

      The financial statements required to be filed with this Annual Report are filed under Item 15 hereof and are listed on the “Index to Consolidated Financial Statements and Related Reports” on page F-1 hereof.

Quarterly Financial Data (Unaudited)

      The following table presents unaudited quarterly statements of operations data for each quarter of the Company’s last two completed fiscal years. The unaudited quarterly financial statements have been prepared on substantially the same basis as the audited financial statements contained elsewhere in this Annual Report. In the opinion of the Company’s management, the unaudited financial statements include all adjustments, consisting only of normal recurring adjustments that management considers to be necessary to fairly present this information when read in conjunction with the Company’s consolidated financial statements and related

notes appearing elsewhere in this Annual Report. The results of operations for any quarter are not necessarily indicative of the results to be expected for any future period.

      None.

      The Company’s Chief Executive Officer and Chief Financial Officer have evaluated the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) or 15d-15(e) of the Exchange Act), as of the end of the period covered by this Annual Report, as required by paragraph (b) of Rules 13a-15 or 15d-15 of the Exchange Act. Based on such evaluation, such officers have concluded that, as of the end of the period covered by this Annual Report, the Company’s disclosure controls and procedures are effective in alerting them on a timely basis to material information relating to the Company and its consolidated subsidiaries required to be included in the Company’s periodic filings under the Exchange Act.

      Management’s Annual Report on Internal Control Over Financial Reporting (“Management’s Report”) appears in the F- pages of this Annual Report and is listed on the “Index to Financial Statements and Related Reports” on page F-1 hereof.

      The Attestation Report of the Registered Public Accounting Firm follows Management’s Report appears in the F- pages of this Annual Report and is listed on the “Index to Financial Statements and Related Reports” on page F-1 hereof.

      During the quarter ended December 31, 2004, there was not any change in the Company’s internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Rules 13a-15 or 15d-15 of the Exchange Act that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

      None.

PART III

Board of Directors

      Set forth below is certain information, as of March 11, 2005, concerning each of the directors of the Company. Each of the individuals listed below shall serve as a director of the Company until the next annual meeting of the Company’s shareholders and until their successors have been elected and qualified, or until their resignation, death or removal.

      Certain additional information concerning the individuals named above is set forth below:

      Paul R. Garcia, age 52, has served as a director of the Company since April 2003. Mr. Garcia also currently serves as a member of the Company’s audit committee (the “Audit Committee”) and compensation committee (the “Compensation Committee”). Mr. Garcia has served as a director, President and Chief Executive Officer of Global Payments Inc. since February 2001. Mr. Garcia also currently serves as Chairman of the Board of Global Payments Inc. From June 1999 to January 2001, he served as Chief Executive Officer of NDC eCommerce. From March 1997 to September 1998, he served as President and Chief Executive Officer of Productivity Point International. From 1995 to 1997, he served as Group President of First Data Card Services.

      Gary H. Heck, age 60, has served as a director of the Company since September 2000. From February 23, 2004, to November 3, 2004, Mr. Heck also served as the Company’s President and Chief Operating Officer. Mr. Heck also served as a member of the Compensation Committee until February 24, 2004. From January 2000 to September 2000, Mr. Heck served as a director of Cereus. Mr. Heck has been a consultant since 1989, most recently serving as a Managing Partner and a co-founder of PacifiCom, a consulting services company. From 1987 until 1989, Mr. Heck was President and Chief Executive Officer of Telematics Products, Inc., a telecommunications products company. From 1983 until 1987, he held various executive positions at Pacific Telesis Corporation, one of the nation’s largest Regional Bell Operating Companies, and completed his tenure as a corporate officer of several subsidiaries of Pacific Telesis and as Chief Executive Officer of PacTel Products Corporation. From 1977 until 1983, Mr. Heck was a Division Manager and District Manager at AT&T Corporation, where he was responsible for sales and marketing programs. From 1967 until 1977, Mr. Heck held various positions at Pacific Telephone & Telegraph.

      Amy L. Newmark, age 47, has served as a director of the Company since September 2000. Ms. Newmark also currently serves as a member of the Compensation Committee. From January 2000 to September 2000, Ms. Newmark served as a director of Cereus. Ms. Newmark is a private investor in the technology, Internet and telecommunications fields. From 1995 to 1997, she served as Executive Vice President of Strategic Planning at Winstar Communications, Inc. Prior to 1995, Ms. Newmark served as the general partner of Information Age Partners, L.P., a hedge fund investing primarily in technology and emerging growth companies. Before that, Ms. Newmark was a securities analyst specializing in telecommunications and technology companies.

      Stephen E. Raville, age 57, has served as a director of the Company since October 1997. Mr. Raville also currently serves as the Chairman of the Audit Committee. Since 1996, Mr. Raville has served as Chief Executive Officer and Chairman of the Board of Telscape Communications, Inc. Mr. Raville is also President and controlling shareholder of First Southeastern Corporation., a private investment company he formed in 1992. In 1983, Mr. Raville founded TA Communications, a long-distance telephone company, and served as its President, Chief Executive Officer and Chairman of the Board. In 1985, in conjunction with a merger between TA Communications and Advanced Telecommunications Corporation, Mr. Raville became Chairman and Chief Executive Officer of Advanced Telecommunications until the merger of Advanced Telecommunications into MCI WorldCom, Inc. in late 1992. Mr. Raville also currently serves as a director of the Cleveland Group, Inc.

      Dr. James A. Verbrugge, age 64, has served as a director of the Company since November 3, 2004. Dr. Verbrugge is Emeritus Professor of Finance in the Terry College of Business at the University of Georgia. He is also the Director of the Center for Strategic Risk Management at the University of Georgia. From 1976 to 2001, he was the Chairman of the Department of Banking and Finance in the Terry College of Business, and he held the Chair of Banking from 1992-2002. He is a member of the Board of Directors of each of eResource Capital Group, Inc., Crown Crafts, Inc. and Tri-S Security Corporation, and also serves on the boards of two private companies. Dr. Verbrugge also serves as a member of Tri-S Security Corporation’s audit committee and compensation committee.

      The biographical information for Mr. Odom and Ms. Reising is set forth in Item 4.5 of Part I of this Annual Report.

      There are no family relationships among any of the executive officers or directors of the Company. No arrangement or understanding exists between any director and any other person pursuant to which any director was selected to serve as a director. To the best of the Company’s knowledge, (i) there are no material proceedings to which any director of the Company is a party, or has a material interest, adverse to the Company; and (ii) there have been no events under any bankruptcy act, no criminal proceedings and no judgments or injunctions that are material to the evaluation of the ability or integrity of any of the directors during the past five years.

Executive Officers

      The information with respect to the Company’s executive officers is set forth in Item 4.5 of Part I of this Annual Report.

Audit Committee and Audit Committee Financial Expert

      The Company has a separately-designated standing Audit Committee established in accordance with Section 3(a)(58)(A) of the Exchange Act. The members of the Audit Committee are Messrs. Garcia, Raville and Verbrugge.

      The Board has determined that the Audit Committee’s chairperson, Mr. Raville, is an “audit committee financial expert” as such term is defined in Item 401(h) of Regulation S-K. Mr. Raville meets the independence requirements of Rule 4200(a)(15) of the National Association of Securities Dealers’ listing standards.

      Pursuant to the regulations of the SEC, a person who is determined to be an audit committee financial expert will not be deemed an expert for any purpose, including, without limitation, for purposes of Section 11 of the Securities Act, as a result of being designated or identified as an audit committee financial expert pursuant to Item 401 of Regulation S-K. Furthermore, the designation or identification of a person as an audit committee financial expert pursuant to Item 401 of Regulation S-K does not impose on such person any duties, obligations or liability that are greater than the duties, obligations and liability imposed on such person as a member of the Audit Committee or the Board in the absence of such designation or identification. Moreover, the designation or identification of a person as an audit committee financial expert pursuant to Item 401 of Regulation S-K does not affect the duties, obligations or liability of any other member of the Audit Committee or Board.

Code of Ethics

      The Board has adopted a Code of Ethics and Conduct that applies to all of the Company’s employees, including the Company’s Chief Executive Officer, Chief Operating Officer, Chief Financial Officer and Corporate Controller. The Company shall provide to any person without charge, upon request, a copy of the Company’s Code of Ethics and Conduct. Such requests should be directed to the Secretary of Verso Technologies, Inc. at 400 Galleria Parkway, Suite 300, Atlanta, Georgia 30339.

Section 16(a) Beneficial Ownership Reporting Compliance

      Section 16(a) of the Exchange Act requires the Company’s directors and executive officers, and all persons (“Reporting Persons”) who beneficially own more than 10% of the outstanding shares of Common Stock, to file with the SEC initial reports of ownership and reports of changes in ownership of the Common Stock and other equity securities of the Company. Reporting Persons are also required to furnish the Company with copies of all Section 16(a) forms they file. To the Company’s knowledge, based solely upon a review of the copies of such forms furnished to the Company for the year ended December 31, 2004, and the information provided to the Company by Reporting Persons of the Company, no Reporting Person failed to file the forms required by Section 16(a) of the Exchange Act on a timely basis.

Director Compensation

      The Company reimburses directors for out-of-pocket expenses incurred in attending Board or committee meetings. In addition, non-employee directors are eligible to receive grants of stock options under the Incentive Plan.

Executive Compensation

      The following table sets forth the cash and non-cash compensation for each of the last three fiscal years awarded to or earned by each person who served as the Chief Executive Officer of the Company during the year ended December 31, 2004, as well as for other executive officers of the Company and its subsidiaries whose salary and bonus exceeded $100,000 during the year ended December 31, 2004 (the “Named Executive Officers”).

Summary Compensation Table

Option Grants in Last Fiscal Year

      The following table sets forth information with respect to options granted under the Incentive Plan to the Named Executive Officers for the year ended December 31, 2004.

Aggregated Option Exercises in the Last Fiscal Year and Fiscal Year-End Option Values

      The following table sets forth information concerning the value at December 31, 2004, of the unexercised options held by each of the Named Executive Officers. The value of unexercised options reflects the increase in market value of the Common Stock from the date of grant through December 31, 2004. No Named Executive Officer exercised any options during the year ended December 31, 2004.

Employment Agreements

      On September 29, 2000, the Company entered into an Executive Employment Agreement with Mr. Odom, pursuant to which Mr. Odom has agreed to serve as the Chief Executive Officer of the Company for a term of three years. The agreement provides for: (i) a term which will be automatically renewed for an additional one-year term unless either party gives notice to the other of its intention not to so renew at least 90 days prior to the termination of the then-current term; (ii) the payment of a specified base salary and an annual bonus in the discretion of the Board; (iii) a prohibition against Mr. Odom’s disclosure of confidential information for a period of two years following termination; and (iv) continuation of Mr. Odom’s salary and the benefits for the 24 months following his termination by the Company without cause or by him for “good reason.” Effective January 16, 2001, Mr. Odom’s base salary under the agreement was increased to $450,000. Effective November 1, 2002, Mr. Odom’s base salary under the agreement was reduced to $405,000 until May 1, 2003, when his base salary under the agreement returned to $450,000. Effective November 1, 2004, Mr. Odom agreed voluntarily to reduce his base salary to $405,000 per year.

      On September 29, 2000, the Company entered into an Executive Employment Agreement with Ms. Reising, pursuant to which Ms. Reising has agreed to serve as the Executive Vice President and Chief Financial Officer of the Company for a term of three years for a base salary at an annual rate per year of $175,000 through and including March 23, 2001, and at an annual rate per year of $200,000 thereafter. The agreement provides for: (i) a term which will be automatically renewed for an additional one-year term unless either party gives notice to the other of its intention not to so renew at least 90 days prior to the termination of the then-current term; (ii) the payment of a specified base salary and an annual bonus in the discretion of the Board; (iii) a prohibition against Ms. Reising’s disclosure of confidential information for a period of two years following termination; and (iv) continuation of Ms. Reising’s salary and the benefits for the 24 months following her termination by the Company without cause or by her for “good reason.” Effective January 1, 2001, and March 1, 2002, Ms. Reising’s base salary under the agreement was increased to $225,000 and

$270,000, respectively. Effective November 1, 2002, Ms. Reising’s base salary under the agreement was reduced to $243,000 until May 1, 2003, when her base salary under the agreement returned to $270,000. Effective November 1, 2004, Ms. Reising agreed voluntarily to reduce her base salary to $250,000 per year.

      On November 3, 2004, the Company hired Mr. Jaffe to serve as the Company’s President and Chief Operating Officer. In exchange for serving as the Company’s President and Chief Operating Officer, the Company agreed to pay Mr. Jaffe base salary at a rate of $250,000 per year through December 31, 2004; provided, however, that after such date his base salary may increase to up to $350,000 per year if the Company achieves certain benchmarks. If certain of the benchmarks are achieved, then the Company shall pay Mr. Jaffe an achievement bonus of $100,000. In the discretion of the Board, Mr. Jaffe may be awarded annual bonuses on terms no less favorable than those awarded to other executive officers of the Company. The Company agreed to provide Mr. Jaffe with corporate housing through June 30, 2005, and agreed to reimburse Mr. Jaffe up to $20,000 for costs and expenses incurred by him in connection with his relocation to Atlanta, Georgia. Mr. Jaffe shall also receive such other benefits as other executives of the Company receive. If Mr. Jaffe’s employment with the Company is terminated by the Company (i) without cause after May 2, 2005, then Mr. Jaffe shall continue to receive the base salary then in effect and other benefits for a period of one year after such termination; and (ii) in connection with a change of control of the Company, then Mr. Jaffe shall receive the base salary then in effect and other benefits for a period of at least one year, and up to two years, after such termination, depending upon the stock price of Common Stock upon such termination. Mr. Jaffe’s salary is currently $300,000 per year.

      On September 29, 2000, the Company entered into an Executive Employment Agreement with Mr. Logsdon, pursuant to which Mr. Logsdon agreed to serve as the President and Chief Operating Officer of the Company for a term of three years for a base salary at an annual rate per year of $175,000 through and including February 1, 2001, and at an annual rate per year of $225,000 thereafter. The agreement provides for: (i) a term which will be automatically renewed for an additional one-year term unless either party gives notice to the other of its intention not to so renew at least 90 days prior to the termination of the then-current term; (ii) the payment of a specified base salary and an annual bonus in the discretion of the Board; (iii) a prohibition against Mr. Logsdon’s disclosure of confidential information for a period of two years following termination; and (iv) continuation of Mr. Logsdon’s salary and the benefits for 24 months following his termination by the Company without cause or by him for “good reason.” Effective January 1, 2001, Mr. Logsdon’s base salary under the agreement was increased to $270,000. Effective November 1, 2002, Mr. Logsdon’s base salary under the agreement was reduced to $243,000 until May 1, 2003, when his base salary under the agreement returned to $270,000. Effective as of February 23, 2004, Mr. Logsdon ceased serving as President, Chief Operating Officer and a director of the Company. Consequently, Mr. Logsdon is entitled to receive certain payments and benefits in accordance with section 10.1(ii) of his Executive Employment Agreement with the Company.

Compensation Committee Interlocks and Insider Participation

      From January 1, 2004 through February 23, 2004, the Compensation Committee of the Board was comprised of non-employee directors Ms. Newmark and Mr. Heck. From February 24, 2004 through December 31, 2004, the Compensation Committee was comprised of non-employee directors Ms. Newmark and Mr. Garcia. Mr. Heck was selected as President and Chief Operating Officer of the Company effective February 23, 2004 and, as a result, ceased serving as a member of the Compensation Committee on February 24, 2004. Mr. Garcia was appointed as a member of the Compensation Committee on February 24, 2004.

      In the second quarter of 2002, PacifiCom, a consulting firm in which Mr. Heck is a partner, provided to the Company consulting services relating to performance management. In exchange for such services, in December 2002 and January 2003, the Company issued to Mr. Heck and his partner options to purchase an aggregate of 125,000 and 15,000 shares of Common Stock, respectively, with exercise prices equal to the fair market value of the Common Stock on the date of grant. The services provided by PacifiCom had a fair market value in excess of the options granted to Mr. Heck and his partner for such services.

Equity Compensation Plan Information

      The following table sets forth information regarding equity compensation plans under which the Common Stock is authorized for issuance as of December 31, 2004.

Beneficial Ownership

      The following table sets forth information regarding the beneficial ownership of Common Stock as of March 18, 2005, by (i) each shareholder who is known by the Company to own beneficially more than 5% of the outstanding Common Stock; (ii) each director; (iii) each Named Executive Officer; and (iv) all executive officers and directors of the Company as a group. All beneficial ownership information reported below is based upon publicly available information and certain additional information known to the Company.

      Descriptions of the employment arrangements between the Company and each of Messrs. Odom, Jaffe and Logsdon and Ms. Reising are set forth in Item 11 of this Annual Report “Executive Compensation — Employment Agreements.”

      As noted above, in the second quarter of 2002, PacifiCom, a consulting firm in which Mr. Heck, a director of the Company and a member of the Compensation Committee, is a partner, provided to the Company consulting services relating to management performance. In exchange for such services, in December 2002 and January 2003, the Company issued to Mr. Heck and his partner options to purchase an aggregate of 125,000 and 15,000 shares of Common Stock, respectively, with exercise prices equal to the fair market value of the Common Stock on the date of grant. The services provided by PacifiCom had a fair market value in excess of the options granted to Mr. Heck and his partner for such services.

      Effective February 23, 2004, the Company hired Mr. Heck to serve as President and Chief Operating Officer of the Company at an annual salary of $270,000. On March 1, 2004, in connection with Mr. Heck’s employment, the Company issued to Mr. Heck an option to purchase 100,000 shares of Common Stock at an exercise price of $1.82 per share. The option was issued pursuant to the Incentive Plan and vested in its entirety on September 1, 2004. Mr. Heck resigned his positions as the President and Chief Operating Officer of the Company on November 3, 2004.

      In connection with the appointment of Mr. Jaffe as the Company’s President and Chief Operating Officer, on November 3, 2004 the Board granted to Mr. Jaffe (i) a ten-year option to purchase 500,000 shares of the Common Stock at an exercise price of $0.53 per share; (ii) a ten-year option to purchase 250,000 shares of Common Stock at an exercise price of $0.75 per share; and (iii) a ten-year option to purchase 250,000 shares of Common Stock at an exercise price of $1.25 per share. Each option vests with respect to 25% of the underlying shares on each of November 3, 2005, November 3, 2006, November 3, 2007 and November 3, 2008; provided, however that each option vests in its entirety upon a change of control of the Company.

      In connection with Mr. Bannerman’s appointment as the Company’s Senior Vice President, Strategic Initiatives, on November 19, 2004 the Company issued to Mr. Bannerman a ten-year option to

purchase 250,000 shares of Common Stock at an exercise price of $0.69 per share. The option vests with respect to 25% of the underlying shares of Common Stock on each of November 19, 2005, November 19, 2006, November 19, 2007, and November 19, 2008.

      There are no material relationships between the Company and its directors or executive officers except as previously discussed herein. In the ordinary course of business and from time to time, the Company and its affiliates and subsidiaries may do business with each other.

      On June 7, 2004, the Company dismissed KPMG LLP as its principal accountants. The Company engaged Grant Thornton LLP as the Company’s new independent registered public accountants as of June 7, 2004.

Audit Fees

      Grant Thornton LLP billed $171,500 for fiscal year 2004, and KPMG LLP billed $15,000 and $284,500 for fiscal years 2004 and 2003, respectively, for professional services rendered by such firms for the audit of the Company’s annual consolidated financial statements and review of the interim consolidated financial statements included in quarterly reports, and services that are normally provided by such firms in connection with statutory and regulatory filings or engagements.

Audit-Related Fees

      Grant Thornton LLP billed $211,100 for fiscal year 2004, and KPMG LLP billed $122,475 for fiscal year 2003, respectively, for Section 404 of the Sarbanes-Oxley Act of 2002, assurance and related services that are reasonably related to the performance of the audit or review of the Company’s consolidated financial statements and are not reported under “Audit Fees.” These services include consultations concerning certain financial accounting and reporting standards.

Tax Fees

      KPMG LLP billed $91,381 for fiscal year 2003 for professional services rendered by such firms for tax compliance, tax advice and tax planning. These services include assistance regarding federal, state and local tax compliance, tax audit defense, custom and duties and acquisitions and divestitures tax planning.

All Other Fees

      Neither Grant Thornton LLP nor KPMG LLP billed for, nor rendered professional services to the Company during, fiscal years 2004 or 2003 for any services that are not included in the above classifications.

Policy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of Independent Auditors

      The Audit Committee is required to pre-approve the audit and non-audit services performed by the Company’s independent auditors. The Audit Committee has adopted a policy which provides for general pre-approval of specified Audit, Audit-Related, Tax and Other Services that do not exceed enumerated dollar amounts. The policy also provides that, unless a type of service to be provided by the independent auditors has received general pre-approval, it will require specific pre-approval by the Audit Committee.

      The Audit Committee has determined the Audit, Audit-Related, Tax and Other Services that are the basis for general pre-approval by the Audit Committee. The enumerated dollar amounts at which such general pre-approval will apply are currently under consideration by the Audit Committee. Until the Audit Committee has determined such enumerated dollar amounts, all services performed by the Company’s independent auditors will require the specific pre-approval of the Audit Committee.

      (a) Lists of certain documents filed herewith as part of this Annual Report may be found as follows:

      (b) Reports on Form 8-K.

      During the quarter ended December 31, 2004, the Company filed with the SEC the following Current Reports on Form 8-K:

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND RELATED REPORTS

      The following consolidated financial statements, financial statement schedule, report of registered public accounting firm and related reports regarding internal controls are included herein on the pages indicated:

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors

Verso Technologies, Inc.

      We have audited the accompanying balance sheet of Verso Technologies, Inc. as of December 31, 2004, and the related statements of income, stockholders’ equity and cash flows for the year then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.

      We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

      In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Verso Technologies, Inc. as of December 31, 2004, and the results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.

      Our audit was conducted for the purpose of forming an opinion on the basic financial statements taken as a whole. The Schedule II for the year ended December 31, 2004, is presented for purposes of additional analysis and is not a required part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic consolidated financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole.

      We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Verso Technologies, Inc.’s internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) and our report dated March 4, 2005 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.

Atlanta, Georgia

March 4, 2005

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors

Verso Technologies, Inc.:

      We have audited the accompanying consolidated balance sheet of Verso Technologies, Inc. and subsidiaries (the “Company”) as of December 31, 2003, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the years in the two-year period ended December 31, 2003. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

      We conducted our audits in accordance with the standards of the Public Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

      In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Verso Technologies, Inc. and subsidiaries as of December 31, 2003, and the results of their operations and their cash flows for each of the years in the two-year period ended December 31, 2003, in conformity with U.S. generally accepted accounting principles.

      As discussed in note 2 to the consolidated financial statements, Verso Technologies, Inc. and subsidiaries adopted the provisions of Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” in 2002.

Atlanta, Georgia

February 27, 2004

except as to note 5,

which is as of March 16, 2005

VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

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

VERSO TECHNOLOGIES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS