WASHINGTON, D.C. 20549

 

FORM 10-Q

 

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

 

For the quarterly period ended June 30, 2004

 

OR

 

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

 

For the transition period from                 to                

 

Commission file number:  000-31121

 

AVISTAR COMMUNICATIONS CORPORATION

(Exact name of registrant as specified in its charter)

 

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities and Exchange Act of 1934 during the preceding 12 months (or for shorter period that the registrant was required to file such reports); and (2) has been subject to such filing requirements for the past 90 days.

 

Yes ý      No o

 

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

 

Yes o      No ý

 

At June 30, 2004, 33,277,038 shares of common stock of the Registrant were outstanding.

 

 

AVISTAR COMMUNICATIONS CORPORATION

 

INDEX

 

PART I.	FINANCIAL INFORMATION
Item 1.	Financial Statements (unaudited)
	Condensed Consolidated Balance Sheets
	Condensed Consolidated Statements of Operations
	Condensed Consolidated Statements of Cash Flows
	Notes to Condensed Consolidated Financial Statements
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Factors Affecting Future Operating Results
Item 3.	Quantitative and Qualitative Disclosures About Market Risk
Item 4.	Controls and Procedures
PART II.	OTHER INFORMATION
Item 1.	Legal Proceedings
Item 4.	Submission of Matters to a Vote of Security Holders
Item 5.	Other Information
Item 6.	Exhibits
SIGNATURES

 

2

 

PART I - FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED BALANCE SHEETS

as of June 30, 2004 and December 31, 2003

(in thousands, except share and per share data)

 

		June 30, 2004			December 31, 2003
		(unaudited)
Assets:
Current assets:
Cash and cash equivalents		$	5,896		$	5,438
Accounts receivable, net of allowance for doubtful accounts of $29 at June 30, 2004 and $44 at December 31, 2003		764			695
Inventories, including inventory shipped to customers’ sites, not yet installed of $39 at June 30, 2004 and $41 at December 31, 2003		731			937
Prepaid expenses and other current assets		325			515
Total current assets		7,716			7,585
Property and equipment, net		346			352
Other assets		291			291
Total assets		$	8,353		$	8,228
Liabilities and Stockholders’ Equity:
Current liabilities:
Accounts payable		$	1,114		$	941
Deferred revenue and customer deposits		1,082			671
Accrued liabilities and other		1,332			1,125
Total current liabilities		3,528			2,737
Stockholders’ equity:
Common stock, $0.001 par value; 250,000,000 shares authorized at June 30, 2004 and December 31, 2003; 34,456,663 and 31,390,383 shares issued at June 30, 2004 and December 31, 2003, respectively		34			31
Less: treasury common stock, 1,179,625 shares at June 30, 2004 and December 31, 2003, at cost		(51		)	(51		)
Additional paid-in-capital		89,930			86,278
Accumulated deficit		(85,088		)	(80,767		)
Total stockholders’ equity		4,825			5,491
Total liabilities and stockholders’ equity		$	8,353		$	8,228

 

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

 

3

 

AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

for the three and six months ended June 30, 2004 and 2003

(in thousands, except per share data)

 

		Three Months Ended						Six Months Ended
		June 30, 2004			June 30, 2003			June 30, 2004			June 30, 2003
		(unaudited)						(unaudited)
Revenue:
Product		$	914		$	569		$	1,476		$	1,370
Services, maintenance and support		762			916			1,604			1,778
Total revenue		1,676			1,485			3,080			3,148
Cost of revenue:
Product		364			314			656			700
Services, maintenance and support		461			562			943			1,129
Total cost of revenue		825			876			1,599			1,829
Gross margin		851			609			1,481			1,319
Operating Expenses:
Research and development		632			615			1,256			1,311
Sales and marketing		669			944			1,277			1,915
General and administrative		1,794			1,480			3,299			3,182
Amortization of deferred stock compensation *		—			45			—			90
Total operating expenses		3,095			3,084			5,832			6,498
Loss from operations		(2,244		)	(2,475		)	(4,351		)	(5,179		)
Other income (expense):
Interest income		16			9			29			28
Other income (expense), net		(5		)	(5		)	1			(10		)
Total other income, net		11			4			30			18
Net loss		$	(2,233	)	$	(2,471	)	$	(4,321	)	$	(5,161	)
Net loss per share - basic and diluted		$	(0.07	)	$	(0.10	)	$	(0.14	)	$	(0.20	)
Weighted average shares used in calculating basic and diluted net loss per share		33,277			25,343			31,864			25,332
* Amortization of deferred stock compensation excluded from the following expenses:
Cost of revenue		$	—		$	5		$	—		$	10
Research and development		—			4			—			8
Sales and marketing		—			35			—			70
General and administrative		—			1			—			2
		$	—		$	45		$	—		$	90

 

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

 

4

 

AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

for the six months ended June 30, 2004 and 2003

(in thousands)

 

		Six Months Ended
		June 30, 2004			June 30, 2003
		(unaudited)
Cash Flows from Operating Activities:
Net loss		$	(4,321	)	$	(5,161	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation		141			105
Stock-based compensation		—			90
Compensation on options issued to consultants		12			19
Provision for doubtful accounts		25			65
Changes in current assets and liabilities:
Accounts receivable		(94		)	(368		)
Inventories		206			131
Prepaid expenses and other current assets		190			300
Accounts payable		173			407
Deferred revenue and customer deposits		411			187
Accrued liabilities and other		207			(78		)
Net cash used in operating activities		(3,050		)	(4,303		)
Cash Flows from Investing Activities:
Sale of short-term investments		—			2,400
Purchase of property and equipment		(135		)	(32		)
Net cash provided by (used in) investing activities		(135		)	2,368
Cash Flows from Financing Activities:
Proceeds from issuance of common stock		3,643			48
Proceeds from draw on line of credit		—			750
Net cash provided by financing activities		3,643			798
Net increase (decrease) in cash and cash equivalents		458			(1,137		)
Cash and cash equivalents, beginning of period		5,438			4,783
Cash and cash equivalents, end of period		$	5,896		$	3,646
Supplemental Cash Flow Information:
Cash paid for income taxes		$	14		$	—

 

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

 

5

 

AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

 

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

 

Business

 

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

 

Basis of Presentation

 

The unaudited balance sheet as of June 30, 2004 presents the consolidated financial position of Avistar and its two wholly-owned operating subsidiaries, Avistar Systems U.K. Limited (ASUK) and CPI, after elimination of all intercompany accounts and transactions.  The consolidated results are referred to, collectively, as those of Avistar or the Company in these notes.

 

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

 

The Company’s fiscal year end is December 31.

 

Risks and Uncertainties

 

The markets for the Company’s products and services are still in the early stages of development.  Some of the Company’s products utilize changing and emerging technologies. As is typical in industries of this nature, demand and market acceptance are subject to a high level of uncertainty, particularly when there are adverse conditions in the economy.  Acceptance of the Company’s products over time is critical to the Company’s success.  The Company’s prospects must be evaluated in light of difficulties encountered by it and its competitors in further developing this evolving marketplace. The Company has generated losses since inception and had an accumulated deficit of $85.1 million as of June 30, 2004.  The Company’s operating results may fluctuate significantly in the future as a result of a variety of factors, including, but not limited to, the economic environment, the adoption of different distribution channels, and the timing of new product announcements by the Company or its competitors.

 

The Company’s future liquidity and capital requirements will depend upon numerous factors, including, but not limited to, the costs and timing of its expansion of product development efforts and the success of these development efforts, the costs and timing of its expansion of sales and marketing activities, the extent to which its existing and new products gain market acceptance, competing technological and market developments, the costs involved in maintaining, enforcing and defending patent claims and other intellectual property rights, especially the costs associated with the Company’s current litigation with Polycom, Inc., the level and timing of revenue and other factors.  The Company may need to raise additional funds in the future, and additional financing may not be available on favorable terms, if at all.  If the Company cannot raise funds, if needed, on acceptable terms, the Company may not be able to develop or enhance its products, take advantage of future opportunities or respond to competitive pressures or unanticipated requirements, which could seriously harm the Company’s business, financial condition, results of operations and ability to continue operations. If additional funds are raised through the issuance of equity securities, the Company’s net tangible book value per share is likely to decrease, the percentage ownership of then current stockholders may be diluted and such equity securities may have rights, preferences or privileges senior to those of the holders of the Company’s common stock.  Debt financing, if available, may involve significant fees, interest payment obligations and restrictive covenants. Strategic arrangements, if necessary to raise additional funds, may require us to relinquish our rights to certain of our technologies or products.

 

6

 

2.     Summary of Significant Accounting Policies

 

Unaudited Interim Financial Information

 

The financial statements filed in this report have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. The December 31, 2003 Condensed Consolidated Balance Sheet was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America.

 

In the opinion of management, the unaudited financial statements furnished in this report reflect all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of the results of operations for the interim periods covered and of the Company’s financial position as of the interim balance sheet date. The results of operations for the interim periods are not necessarily indicative of the results for the entire year. These financial statements should be read in conjunction with the Company’s audited consolidated financial statements and the accompanying notes for the year ended December 31, 2003, included in the Company’s annual report on Form 10-K/A filed with the Securities and Exchange Commission on March 26, 2004.

 

Use of Estimates

 

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the period.  Actual results could differ from those estimates.

 

Cash and Cash Equivalents and Short Term Investments

 

The Company considers all investment instruments purchased with a remaining maturity of three months or less to be cash equivalents. The Company’s cash equivalents at June 30, 2004 and December 31, 2003 consisted of money market funds and short-term securities.  The fair value of the Company’s investments was determined based on quoted market prices at the reporting date for those instruments.  As of June 30, 2004, there was no difference between the cost and fair value of the Company’s investments.

 

Supplemental Cash Flow Information

 

During the six months ended June 30, 2004, the Company paid approximately $14,000 in income taxes. During the six months ended June 30, 2004, no cash was paid for interest. During the three months ended June 30, 2003, no cash was paid for income taxes or interest.

 

Significant Concentrations

 

A relatively small number of customers accounted for a significant percentage of the Company’s net sales. Sales to these customers as a percentage of total sales were as follows for the three and six months ended June 30, 2004 and 2003:

 

 

* Less than 10%

 

Any change in the relationship with these customers could have a potentially adverse effect on the Company’s financial position.

 

Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of temporary cash investments and trade receivables. The Company has cash and investment policies that limit the amount of credit exposure to any one

 

7

 

financial institution and restrict placement of these investments to financial institutions evaluated as highly credit worthy.  Concentration of credit risk with respect to trade receivables relate to those trade receivables from both United States and foreign customers of Avistar.  As of June 30, 2004, approximately 78% of accounts receivable were concentrated with four customers, each of whom represented more than 10% of the Company’s total accounts receivable balance. As of December 31, 2003, approximately 89% of accounts receivable were concentrated with one customer. No other customers individually accounted for greater than 10% of total accounts receivable as of December 31, 2003.

 

Inventories

 

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

 

 

Inventory shipped to customer sites, not yet installed, represents product shipped to customer sites pending completion of the installation process by the Company. As of June 30, 2004 and December 31, 2003, the Company had billed approximately $75,000 and $57,000, respectively, to customers related to these shipments, but did not record the revenue, as the installations had not been completed and confirmed by the customer.  Although customers are billed in accordance with customer agreements, these deferred revenue amounts are netted against accounts receivable until the customer confirms installation.

 

Revenue Recognition and Deferred Revenue

 

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

 

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

 

The price charged for maintenance and/or support is defined in the product contract, and is based on a fixed price for both hardware and software components as stipulated in the customer agreement.  Customers have the option to renew the maintenance and/or support arrangement in subsequent periods at the same rate as paid in the initial year.  Revenue from maintenance and support services is deferred and recognized pro-rata over the maintenance and/or support term, which is typically one year in length.  Payments for services made in advance of the provision of services are recorded as deferred revenue and customer deposits in the accompanying balance sheets.  Training services are offered together with and independently of the purchase of product.  The value of training services provided with the purchase of product is determined based on the price charged when such services are sold separately. Training revenue is recognized upon performance of the service.

 

The Company recognizes service revenue from development contracts in accordance with SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.” Revenue related to contracts for development is recognized using the

 

8

 

percentage of completion method, when all of the following conditions are met: a contract exists with the customer at a fixed price, the Company has fulfilled all of its material contractual obligations to the customer for each deliverable of the contract, verification of completion of the deliverable has been received, and collection of the receivable is probable.  The amounts billed to customers in excess of revenues earned to date are deferred and recorded as deferred revenue and customer deposits in the accompanying balance sheets.  Assumptions used for recording revenue and earnings are adjusted in the period of change to reflect revisions in contract value and estimated costs to complete the contract.  Any anticipated losses on contracts in progress are charged to earnings when identified.

 

Stock-Based Compensation

 

The Company applies the intrinsic-value-based method of accounting for stock-based compensation prescribed by Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees”, and related interpretations including Financial Accounting Standards Board (FASB) Interpretation No. 44, “Accounting for Certain Transactions involving Stock Compensation, an interpretation of APB Opinion No. 25”, to account for its fixed-plan stock options. Under this method, compensation expense is recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation”, established accounting and disclosure requirements using a fair-value-based method of accounting for stock-based employee compensation plans. As allowed by SFAS No. 123, and as amended by SFAS 148, Accounting for Stock-Based Compensation - Transition and Disclosure — An Amendment of FASB Statement No. 123”, the Company has elected to continue to apply the intrinsic-value-based method of accounting described above, and has adopted only the disclosure requirements of SFAS No. 123 and SFAS No. 148. The following table illustrates the effect on net income if the fair-value-based method had been applied to all outstanding and unvested awards in each period (in thousands, except per share data).

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2004			2003			2004			2003
Net loss, as reported		$	(2,233	)	$	(2,471	)	$	(4,321	)	$	(5,161	)
Add stock – based employee compensation expense included in reported net loss, net of tax		—			45			—			90
Deduct total stock-based employee compensation expense determined under fair-value-based method for all awards, net of tax		(471		)	(1,078		)	(922		)	(2,078		)
Pro forma net loss		$	(2,704	)	$	(3,504	)	$	(5,243	)	$	(7,149	)
Basic and diluted loss per share
As reported		$	(0.07	)	$	(0.10	)	$	(0.14	)	$	(0.20	)
Pro forma		$	(0.08	)	$	(0.14	)	$	(0.16	)	$	(0.28	)

 

The fair value of options granted for the three and six months ended June 30, 2004 and 2003 is estimated on the date of grant using the following assumptions:

 

		2004		2003
Expected dividend		0	%	0	%
Average risk-free interest rate		3.5	%	2.9	%
Expected volatility		237	%	187	%
Expected term (in years)		4		4

 

Recent Accounting Pronouncements

 

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

 

In March 2004, the FASB issued EITF Issue No. 03-1 (“EITF 03-1”), “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”. EITF 03-1 includes new guidance for evaluating and recording impairment losses on debt and

 

9

 

equity instruments, as well as new disclosure requirements for investments that are deemed to be temporarily impaired. The accounting guidance provided in EITF 03-1 is effective for reporting periods beginning after June 15, 2004, while the disclosure requirements for debt and equity securities accounted for under FASB Statement No. 115, “Accounting for Certain Investments in Debt and Equity Securities”, are effective for annual periods ending after December 15, 2003. The Company does not expect the adoption of EITF 03-1 will have a material impact on its financial position, results of operations or cash flows.

 

3. Line of Credit

 

On February 27, 2002, the Company entered into a Loan and Security Agreement with a financial institution for a revolving line of credit.  As collateral under this Loan and Security Agreement, the Company granted a first priority interest in all of the Company’s assets, excluding intellectual property.  On December 16, 2002, Gerald Burnett, Chairman and Chief Executive Officer of the Company, provided a collateralized guarantee, assuring payment of the Company’s obligations under the agreement and as a consequence, restrictive covenants from the original Loan and Security agreement were deleted in the amendment, except for a quick ratio and loan to value covenant, allowing the Company greater access to the full amount of the facility.  On February 27, 2004, the Loan and Security Agreement was amended to change the maximum borrowings under the line to $3.5 million, subject to certain quick ratio and loan to value covenants, and to extend the term of the Loan and Security Agreement to February 27, 2005.  In connection with this amendment, Dr. Burnett’s collateralized guarantee was amended to reduce the amount of such guarantee to $3.5 million.  As of June 30, 2004, the Company had no outstanding borrowings under the line of credit and was eligible to borrow up to $3.5 million.

 

4.  Related Party Transactions

 

Robert P. Latta, a member of the law firm Wilson Sonsini Goodrich & Rosati, Professional Corporation (WSGR), has served as a director of the Company since February 2001.  Mr. Latta and WSGR have represented the Company and its predecessors as corporate counsel since 1997.  During the six months ended June 30, 2004 and 2003, payments of approximately $51,000 and $150,000, respectively, were made to WSGR for legal services provided to the Company.

 

During the six months ended June 30, 2003, payments for consulting fees of approximately $100,000 were made to R. Stephen Heinrichs, a former officer of the Company, who is also a member of the Board of Directors, pursuant to a Separation Agreement between Mr. Heinrichs and the Company dated April 26, 2001. During the six months ended June 30, 2004, no payments for consulting fees were made to R. Stephen Heinrichs.

 

5.   Legal Proceedings

 

On September 23, 2002, CPI, the Company’s wholly-owned subsidiary, commenced a patent infringement lawsuit against Polycom, Inc. alleging that several Polycom videoconferencing products infringe four patents held by CPI. The suit was filed in the United States District Court for the Northern District of California.  The four patents involved are U.S. Patent Nos. 5,867,654, 5,896,500, 6,212,547 and 6,343,314.  These patents cover technologies relating to video and data conferencing over unshielded twisted pair (UTP) networks, distributed call-state management, separate monitors for simultaneous computer-based data sharing and videoconferencing and remote participant hold and disconnect functions in multi-party conferencing. Polycom responded to CPI’s claims on November 14, 2002, at which time it both answered the complaint and asserted counterclaims against CPI for non-infringement, invalidity and unenforceability.  On January 31, 2003, Polycom filed a motion with the court, which was subsequently granted by the court on March 7, 2003, requesting permission to amend its counterclaims to incorporate claims of alleged infringements by Avistar Communications of four PictureTel patents that Polycom has told us it has had assigned to it. Three of the four counterclaims involved a third party, and these three counterclaims were dropped by Polycom on June 23, 2003, subsequent to an agreement between Polycom and the third party.  On August 9, 2003, CPI and Polycom filed motions for summary judgment with the court, seeking judgment as a matter of law concerning CPI’s ability to qualify for “small entity status” in the filing of its four patents being asserted against Polycom.  On October 17, 2003, the court denied Polycom’s motion for summary judgment and granted CPI’s motion for summary judgment, thereby negating Polycom’s defense of unenforceablity concerning CPI’s having filed these patents as a “small entity.”

 

Briefings on claims construction issues and a hearing before the presiding judge (Markman hearing) took place on March 8, 2004, and the presiding judge issued her ruling on March 23, 2004. A trial date for CPI’s claims against Polycom and Polycom’s counterclaim has been set for January 10, 2005.  The prosecution of this lawsuit and the defense of the Polycom counterclaim have required and may continue to require the Company and CPI to expend significant financial and managerial resources and therefore may have a material negative impact on the Company and CPI.  Expenses associated with the litigation have risen as trial approaches

 

10

 

to now comprise a significant portion of our quarterly operating expense. The duration and ultimate outcome of this litigation are uncertain.

 

6.     Net Loss Per Share

 

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

 

In accordance with SFAS 128, basic net loss per share has been computed using the weighted average number of shares of common stock outstanding during the period.  Diluted net loss per share is computed on the basis of the weighted average number of shares and potential common shares outstanding during the period. Potential common shares result from the assumed exercise of outstanding stock options that have a dilutive effect when applying the treasury stock method.  The Company has excluded all outstanding stock options from the calculation of diluted net loss per share for the three and six months ended June 30, 2004 and 2003, because all such securities are antidilutive (owing to the fact that the Company is in loss position).  Accordingly, diluted net loss per share approximates basic net loss per share for all periods presented.

 

The total number of shares excluded from the calculations of diluted net loss per share were 4,218,749 and 1,387,694 for the three months ended June 30, 2004 and 2003, respectively, and 3,760,880 and 824,191 for the six months ended June 30, 2004 and 2003, respectively.

 

7.  Segment Reporting

 

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

 

 

11

 

 

International revenue, which consists of sales to customers with operations principally in Western Europe and Asia, comprised 52% and 65% of total revenue for the three months ended June 30, 2004 and 2003, respectively.  International revenue comprised 53% and 57% of total revenue for the six months ended June 30, 2004 and 2003, respectively.  For the three months ended June 30, 2004 and 2003, international revenues from customers in the United Kingdom accounted for 28% and 47%, respectively, of total revenue.  For the six months ended June 30, 2004 and 2003, international revenues from customers in the United Kingdom accounted for 34% and 22%, respectively, of total revenue.  All of the Company’s sales are currently billed in United States dollars. The Company had no significant long-lived assets in any country other than in the United States for any period presented.

 

12

 

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

 

The following discussion should be read in conjunction with the Unaudited Condensed Consolidated Interim Financial Statements and the Notes thereto included elsewhere herein, and the Audited Consolidated Financial Statements contained in our Annual Report on Form 10-K/A for the year ended December 31, 2003, as filed with the Securities and Exchange Commission on March 26, 2004.

 

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

 

Although we believe that the expectations reflected in the forward looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements.  We are under no duty to update any of the forward-looking statements after the date of this report on Form 10-Q in order to conform our prior statements to actual results.

 

Overview

 

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

 

We operate in two segments.  We engage in the design, development, manufacturing, sale and marketing of networked video communications products, and associated support services, and Collaboration Properties, Inc. (CPI), our wholly-owned subsidiary, engages in the prosecution, maintenance, support and licensing of the intellectual property that we have developed, some of which is used in our products. Although several separate negotiations are in process, as of June 30, 2004, CPI had not entered into any such third party licensing agreements.

 

Critical Accounting Policies

 

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

 

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

 

•                  Revenue recognition;

•                  Valuation of accounts receivable; and

•                  Valuation of inventories.

 

13

 

Revenue Recognition

 

We derive product revenue principally from the sale and licensing of our video-enabled networked communications system, consisting of a suite of Avistar-designed software and hardware products, including third party components.  In addition, we derive revenue from fees for installation, maintenance, support, training services and software development.

 

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

 

Valuation of Accounts Receivable

 

Estimates are used in determining our allowance for doubtful accounts and are based on our historical collection experience, historical write-offs, current trends and the credit quality of our customer base and the characteristics of our accounts receivable by aging category.  If the allowance for doubtful accounts was understated, our operating income could be reduced. The impact of any such change or deviation may be increased by our reliance on a relatively small number of customers for a large portion of our total revenue. As of June 30, 2004, approximately 78% of our accounts receivable balance was concentrated with four customers, each of whom represented more than 10% of our total accounts receivable.  As of December 31, 2003, approximately 89% of our accounts receivable were concentrated with one customer.

 

Valuation of Inventories

 

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

 

Emerging Accounting Developments

 

On March 31, 2004, the Financial Accounting Standards Board, or FASB, issued its exposure draft, “Share-Based Payment,” which is a proposed amendment to the FASB’s Statement No. 123, “Accounting for Stock-Based Compensation,” or SFAS 123.  Generally, the approach in the exposure draft is similar to the approach described in SFAS 123.  However, the exposure draft would require all share-based payments to employees, including grants of employee stock options and the right to purchase shares under our employee stock purchase plan, to be recognized in our income statement based on their fair values.  There are a number of issues that are not resolved in the exposure draft, including the final methodology for calculating fair value.  The FASB expects to issue a final standard late in 2004 that would be effective in 2005.  The pro forma impact of the adoption of SFAS 123 on our historical financial statements is included in the condensed notes to the condensed consolidated financial statements presented elsewhere in this Form 10-Q.  We expect to continue to grant stock-based compensation to employees. The impact of the new standard, when and if issued, may have a material impact on our future results of operations.

 

14

 

Results of Operations

 

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

 

		PERCENTAGE OF TOTAL REVENUE
		THREE MONTHS ENDED JUNE 30,				SIX MONTHS ENDED JUNE 30,
		2004		2003		2004		2003
Revenue:
Product		55	%	38	%	48	%	44	%
Services, maintenance and support		45		62		52		56
Total revenue		100		100		100		100
Cost of revenue:
Product		22		21		21		22
Services, maintenance and support		28		38		31		36
Total cost of revenue		49		59		52		58
Gross margin		51		41		48		42
Operating expenses:
Research and development		38		41		41		42
Sales and marketing		40		64		41		61
General and administrative		107		100		107		101
Amortization of deferred stock compensation		—		3		—		3
Total operating expenses		185		208		189		206
Loss from operations		(134	)	(167	)	(141	)	(165	)
Other income (expense):
Interest income		1		1		1		1
Other income (expense), net		—		—		—		—
Total other income		1		1		1		1
Net loss		(133	)%	(166	)%	(140	)%	(164	)%

 

COMPARISON OF THE THREE AND SIX MONTHS ENDED JUNE 30, 2004 AND 2003

 

Revenue

 

Total revenue increased by 13% to $1.7 million for the three months ended June 30, 2004 from $1.5 million for the three months ended June 30, 2003 and remained level at $3.1 million for the six months ended June 30, 2004 and June 30, 2003. The increase in the three-month period ended June 30, 2004 was due primarily to an increase in product sales, specifically from new customers, offset by the reduction in software development revenue as a result of a software development contract completed during the three months ended June 30, 2003.

 

For the three months ended June 30, 2004, revenue from two customers accounted for 62% of total revenue, each of whom accounted for greater than 10% of total revenue. For the three months ended June 30, 2003, revenue from two customers accounted for 75% of total revenue, each of whom accounted for greater than 10% of our total revenue. For the six months ended June 30, 2004, revenue from two customers accounted for 68% of total revenue, each of whom accounted for greater than 10% of total revenue. For the six months ended June 30, 2003, revenue from one customers accounted for 61% of total revenue. No other customers individually accounted for greater than 10% of our total revenue for the six months ended June 30, 2003.  The level of sales to any customer may vary from quarter to quarter.  We expect that there will be significant customer concentration in future quarters.  The loss of any one of those customers would have a material adverse impact on our financial condition and operating results.

 

Cost of Revenue

 

The total cost of revenue declined slightly by 6% to $0.8 million for the three months ended June 30, 2004 from $0.9 million for the three months ended June 30, 2003 and decreased by 13% to $1.6 million for the six months ended June 30, 2004 from $1.8 million for the six months ended June 30, 2003.  Cost of product revenue increased by 16% to $0.4 million for the three months ended June 30, 2004 from $0.3 million for the three months ended June 30, 2003 and decreased slightly by 6% to $656,000 for the six months ended June 30, 2004 from $700,000 for the six months ended June 30, 2004.  This increase in cost of product revenue for the three month period ended June 30, 2004 was primarily due to the increased level of product sales and the associated direct product costs,

 

15

 

offset, to a lesser extent, by a reduction in the fixed component of product costs, due in part to our reduced occupancy costs. Cost of service revenue decreased by 18% to $0.5 million for the three months ended June 30, 2004 from $0.6 million for the three months ended June 30, 2003 and decreased by 16% to $0.9 million for the six months ended June 30, 2004 from $1.1 million for the six months ended June 30, 2003.  This decline in cost of service revenue for the three and six month periods ended June 30, 2004 was primarily due to the reduction in software development contract costs associated with the decrease in software development revenue. In addition, the decline in cost of service revenue for the three and six month periods ended June 30, 2004 was due to a reduction in maintenance and support costs caused by the consolidation of our support center operations into our corporate headquarters and the associated closure of two outlying facilities.

 

Gross Margin

 

Gross margin as a percentage of revenue increased to 51% for the three months ended June 30, 2004 from 41% for the three months ended June 30, 2003 and increased to 48% for the six months ended June 30, 2004 from 42% for the six months ended June 30, 2003. The increase was due primarily to the increase in product gross margin. Product gross margin as a percentage of total product revenue increased to 60% for the three-month period ended June 30, 2004 compared to 45% for the three-month period ended June 30, 2003 and 56% for the six-month period ended June 30, 2004 compared to 49% for the six-month period ended June 30, 2003.  The increase in product gross margin for the three and six month periods ended June 30, 2004 was due primarily to the increased product revenue, which resulted in greater coverage of the fixed component of the cost of product sales. Services gross margin as a percentage of total service revenue increased slightly to 40% for the three months June 30, 2004 from 39% for the three months ended June 30, 2003 and increased to 41% for the six months ended June 30, 2004 from 37% for the six months ended June 30, 2003. The increase in services gross margin during the six months ended June 30, 2004 was due to the decrease in software development contract margin, which is generally at a lower rate than product or other services margins, and the decline in maintenance and support costs caused by the consolidation of our support center into our corporate headquarters and the associated closure of two outlying facilities.

 

Operating expenses

 

Research and development. Research and development expenses remained level at $0.6 million and $1.3 million for the three and six months ended June 30, 2004 and 2003, respectively.

 

Sales and marketing. Sales and marketing expenses decreased by 29% to $0.7 million for the three months ended June 30, 2004 from $0.9 million for the three months ended June 30, 2003 and decreased by 33% to $1.3 million for the six months ended June 30, 2004 from $1.9 million for the six months ended June 30, 2003. The decrease was due to the reduction in personnel and personnel related expenses, as a result of a 30% reduction in staffing levels in sales and marketing, and a reduction in property lease costs.

 

General and administrative. General and administrative expenses increased by 21% to $1.8 million for the three months ended June 30, 2004 from $1.5 million for the three months ended June 30, 2003 and increased slightly by 4% to $3.3 million for the six months ended June 30, 2004 from $3.2 million for the six months ended June 20, 2003. The increase was due primarily to legal fees associated with ongoing litigation with Polycom, Inc.

 

Amortization of deferred stock compensation. Amortization of deferred stock compensation decreased by 100% to $0 for the three months ended June 30, 2004 from $45,000 for the three months ended June 30, 2003 and decreased by 100% to $0 for the six months ended June 30, 2004 from $90,000 for the six months ended June 30, 2003. The decrease was due to the completion of pre-IPO option award amortization and the forfeitures of stock options by employees no longer with our company.

 

Other Income (Expense)

 

Other income, net increased by 175% to $11,000 for the three months ended June 30, 2004 from $4,000 for the three months ended June 30, 2003 and increased by 67% to $30,000 for the six months ended June 30, 2004 from $18,000 for the six months ended June 30, 2003. The increases were due primarily to increases in our cash and cash equivalents as a result of our private equity financing activities completed in October 2003 and March 2004.

 

Liquidity and Capital Resources

 

We have funded our operations since inception primarily from product and services revenue, the net proceeds of $31.3 million from our August 2000 initial public offering of common stock, lines of credit with related parties and financial institutions, the

 

16

 

proceeds of approximately $6.4 million from the sale of Series B preferred stock in December 1999 and the proceeds of approximately $5.7 million and $3.6 million from the private sale of our common stock in October 2003 and March 2004, respectively.

 

We had cash and cash equivalents of $5.9 million as of June 30, 2004 compared to cash and cash equivalents of $5.4 million as of December 31, 2003.  For the six months ended June 30, 2004 we had an overall net cash inflow of $0.5 million, resulting primarily from net cash proceeds from issuance of common stock of $3.6 million, offset by net cash used in operations of $3.1 million.  The net cash proceeds from issuance of common stock is due to the private sale of 3,000,000 shares of our common stock to Fuller & Thaler Asset Management, Inc., at a price per share of $1.20 in March 2004. The net cash used in operating activities of $3.1 million resulted from a net loss of $4.3 million, an increase in accounts receivable of $0.1 million, offset by an increase in deferred revenue and customer deposits of $0.4 million, an increase in accounts payable and accrued liabilities and other of $0.4 million, a decrease in inventories of $0.2 million and a decrease in prepaid expenses of $0.2 million.

 

At June 30, 2004, we had open purchase orders and other contractual obligations of approximately $0.6 million, primarily related to inventory purchases. We also have commitments that consist of obligations under our operating leases. These purchase order commitments and contractual obligations are reflected in our financial statements once goods or services have been received or payments related to the obligations become due.

 

The following table represents our future commitments under minimum annual operating lease payments as of June 30, 2004 (in thousands):

 

 

In July 2003, we entered into a non-cancelable operating lease to remain at our current office facility in Redwood Shores, California. The new operating lease commenced on October 1, 2003 and expires on September 30, 2007. The commitments for this new lease are reflected in the table above. The previous operating lease expired on September 30, 2003.

 

On February 27, 2002, we entered into a Loan and Security Agreement with a financial institution for a revolving line of credit.  As collateral under this Loan and Security Agreement, we granted a first priority security interest in all of our assets, excluding intellectual property.  On December 16, 2002, Gerald Burnett, our Chairman and Chief Executive Officer provided a collateralized guarantee, assuring payment of our obligations under the agreement and as a consequence, restrictive covenants from the original Loan and Security agreement were deleted in the amendment, except for a quick ratio and loan to value covenant, allowing us greater access to the full amount of the facility.  On February 27, 2004, the Loan and Security Agreement was amended to change the maximum borrowings under the line to $3.5 million, subject to certain quick ratio and loan to value covenants, and to extend the term of the Loan and Security Agreement to February 27, 2005.  In connection with this amendment, Dr. Burnett’s collateralized guarantee was amended to reduce the amount of such guarantee to $3.5 million.  As of June 30, 2004, we had no outstanding borrowings under the line of credit and we were eligible to borrow up to $3.5 million. On February 27, 2004, Dr. Burnett provided us with a further commitment to provide us with a loan of up to $2.0 million in the event that at least $2.0 million was not available to us under the line of credit or an alternate financing arrangement.  This additional commitment was subject to dollar for dollar reduction in the event that a financing event would occur providing us with comparable funding, or other net addition to our working capital.

 

On October 15, 2003, we completed the private sale of 4,615,385 shares of our common stock to Gerald J. Burnett and members of his family at a price per share of $1.30.  The net proceeds of this private financing, after deducting expenses of the financing, were approximately $5.7 million. Under the terms of the private placement, Dr. Burnett agreed to certain restrictions on 1,602,847 of the 3,661,539 shares purchased by him.  These restrictions require Dr. Burnett to vote such shares in the same proportion as our outstanding common stock not beneficially owned by Dr. Burnett.

 

On March 26, 2004, we completed the private sale of 3,000,000 shares of our common stock to funds affiliated with Fuller & Thaler Asset Management, Inc., at a price per share of $1.20.  The net proceeds of this private financing after deducting expenses of the financing were approximately $3.6 million. As a consequence of this private financing, Dr. Burnett’s commitment to provide us

 

17

 

with a loan of up to $2.0 million in the event that at least $2.0 million was not available to us under the line of credit was automatically terminated by its terms and the number of shares held by Dr. Burnett from the October 15, 2003 financing that had voting restrictions was reduced proportionally from 1,602,847 shares to 141,152 shares.

 

We intend to continue to invest in the development of new products and enhancements to our existing products.  We may need to arrange for the availability of additional funding before or upon the expiration of the Loan and Security Agreement on February 27, 2005, either through the execution of an extension of the Loan and Security Agreement or through other means, in order to meet our operating and capital requirements for the next twelve months.  Additional funds and additional financing may not be available on favorable terms, or at all. If we are unable to obtain additional funding on acceptable terms, we may not be able to develop or enhance our products, take advantage of future opportunities, or respond to competitive pressures or unanticipated requirements, which could seriously harm our business, financial condition, results of operations and ability to continue operations.  Furthermore, any additional equity financing may be dilutive to our stockholders and such equity securities may have rights, preferences or privileges senior to those of the holders of our common stock, and debt financing, if available, may involve significant fees, interest payment obligations and restrictive covenants. Strategic arrangements, if necessary to raise additional funds, may require us to relinquish our rights to certain of our technologies or products.

 

Our future liquidity and capital requirements will depend upon numerous factors, including without limitation, general economic conditions and conditions in the financial services industry in particular, the level and timing of revenue, the costs and timing of our product development efforts and the success of these development efforts, the costs and timing of our sales and marketing activities, the extent to which our existing and new products gain market acceptance, competing technological and market developments, the costs involved in maintaining and enforcing patent claims and other intellectual property rights including, without limitation, the costs and result of CPI’s litigation with Polycom and other factors, all of which may impact our ability to achieve and maintain profitability.

 

On July 27, 2004, we announced that our Board of Directors approved the reactivation of a share repurchase plan approved and implemented in March of 2001.  Under that plan, our management was authorized to repurchase up to $2.0 million dollars of Avistar stock in the open market from time to time. Actual purchases to date have not been significant.  The re-authorization allows us to acquire shares with an aggregate purchase price of up to $100,000 dollars under the prior program, through the month of August 2004, as deemed appropriate by our management.

 

Recent Accounting Pronouncements

 

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

 

In March 2004, the FASB issued EITF Issue No. 03-1 (“EITF 03-1”), “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”. EITF 03-1 includes new guidance for evaluating and recording impairment losses on debt and equity instruments, as well as new disclosure requirements for investments that are deemed to be temporarily impaired. The accounting guidance provided in EITF 03-1 is effective for reporting periods beginning after June 15, 2004, while the disclosure requirements for debt and equity securities accounted for under FASB Statement No. 115, “Accounting for Certain Investments in Debt and Equity Securities”, are effective for annual periods ending after December 15, 2003. We do not expect the adoption of EITF 03-1 to have a material impact on our financial position, results of operations or cash flows.

 

Factors Affecting Future Operating Results

 

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

 

Our ability to achieve profitability depends in part on the widespread adoption of networked video communications systems and the adoption of our video operating system in particular.  If the market for our system fails to grow or grows more slowly than we anticipate, we may not be able to increase revenue or achieve profitability. The market for our system is relatively new and evolving.  We have to devote substantial resources to educating prospective customers about the uses and benefits of our system.  Our efforts to educate potential customers may not result in our system achieving broad market acceptance.  In addition, businesses that have

 

18

 

invested or may invest substantial resources in other video products may be reluctant or slow to adopt our system.  Similarly, customers using existing information systems in which they have made significant investments may refuse to adopt our system if they perceive that our offerings will not complement their existing systems.  Consequently, the conversion from traditional methods of communication to the extensive use of networked video may not occur as rapidly as we wish.

 

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

 

We incurred net losses of $4.3 million for the six months ended June 30, 2004, $8.6 million for the year 2003, and $7.6 million for the year 2002.  As of June 30, 2004, our accumulated deficit was $85.1 million.  Our revenue may not increase, or even remain at its current level.  In addition, our operating expenses may increase as we continue to develop our business in the future.  As a result, to become profitable, we will need to increase our revenue by increasing sales to existing customers and by attracting additional customers.  If our expenses increase more rapidly than our revenue, or if revenue and expense levels remain the same, we may never become profitable. We cannot predict whether or when we will become profitable.  If we do become profitable, we may not be able to sustain or increase profitability on a quarterly or annual basis.  In addition, if we fail to reach profitability or to sustain or grow our profits within the time frame expected by investors, the market price of our common stock may be adversely impacted.

 

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

 

The international economic slowdown and the downturn in the investment banking industry that began in the year 2000 has negatively affected our business in 2001, 2002, 2003 and 2004, and may continue to do so in the future.  During this period, the investment banking industry suffered a sharp decline, which caused many of our existing and potential customers to cancel or delay orders for our products.  If our customers and potential customers continue to delay ordering our products, we will fall short of our revenue expectations for 2004 and beyond.  The outlook for the video communications industry is uncertain.  Slower growth among our customers, tightening of customers’ operating budgets, retrenchment in the capital markets and other general economic factors all have had and could in the future have a materially adverse effect on our revenue, capital resources, financial condition and results of operations.

 

We have filed a complaint alleging patent infringement against Polycom, Inc.  The prosecution of this lawsuit could require us to expend significant financial and managerial resources and may have a material negative impact on our business.

 

On September 23, 2002, CPI, our wholly-owned subsidiary, commenced a patent infringement lawsuit against Polycom, Inc. alleging that several Polycom videoconferencing products infringe four patents held by CPI. The suit was filed in the United States District Court for the Northern District of California.  The four patents involved are U.S. Patent Nos. 5,867,654, 5,896,500, 6,212,547 and 6,343,314.  These patents cover technologies relating to video and data conferencing over unshielded twisted pair (UTP) networks, distributed call-state management, separate monitors for simultaneous computer-based data sharing and videoconferencing and remote participant hold and disconnect functions in multi-party conferencing. Polycom responded to CPI’s claims on November 14, 2002, at which time it both answered the complaint and asserted counterclaims against CPI for non-infringement, invalidity and unenforceability. On January 31, 2003, Polycom filed a motion with the court, which was subsequently granted by the court on March 7, 2003, requesting permission to amend its counterclaims to incorporate claims of alleged infringements by Avistar Communications of four PictureTel patents that Polycom has told us it has had assigned to it. Three of the four counterclaims involved a third party, and Polycom dropped these three counterclaims on June 23, 2003, subsequent to an agreement between Polycom and the third party.  On August 9, 2003, CPI and Polycom filed motions for summary judgment with the court, seeking judgment as a matter of law concerning CPI’s ability to qualify for “small entity status” in the filing of its four patents being asserted against Polycom.  On October 17, 2003, the court denied Polycom’s motion for summary judgment and granted CPI’s motion for summary judgment, thereby negating Polycom’s defense of unenforceability concerning CPI’s having filed these patents as a “small entity.”

 

Briefings on claims construction issues and a hearing before the presiding judge (Markman hearing) took place on March 8, 2004, and the presiding judge issued her ruling on March 23, 2004. A trial date for CPI’s claims against Polycom and Polycom’s counterclaim has been set for January 10, 2005.  The prosecution of this lawsuit and the defense of the Polycom counterclaim have required and may continue to require Avistar and CPI to expend significant financial and managerial resources and therefore may have a material negative impact on Avistar and CPI.  Expenses associated with the litigation have risen as trial approaches to now comprise a significant portion of our quarterly operating expense. We anticipate this higher rate of spending to continue until final adjudication of the respective claims of the parties. The duration and ultimate outcome of this litigation are uncertain.

 

Our expected future working capital needs may require that we seek additional debt or equity funding which, if not available, could cause our business to suffer.

 

19

 

Our future liquidity and working capital requirements will depend upon numerous factors, including:

 

•                  general economic conditions and conditions in the financial services industry in particular;

•                  the level and timing of our revenue;

•                  the costs and timing of product development efforts and the success of these development efforts;

•                  the costs and timing of sales and marketing activities;

•                  the extent to which our existing and new products gain market acceptance;

•                  competing technological and market developments;

•                  the costs involved in maintaining and enforcing patent claims and other IP rights, including the costs associated with CPI’s litigation with Polycom; and

•                  available borrowings under line of credit arrangements and other factors.

 

We may need to arrange for the availability of additional funding in order to meet our future business requirements.  If we are unable to obtain additional funding when needed on acceptable terms, we may not be able to develop or enhance our products, take advantage of future opportunities, respond to competitive pressures or unanticipated requirements, or finance our litigation with Polycom, which could seriously harm our business, financial condition, results of operations and ability to continue operations.  There can be no assurance that such funding will be available on terms attractive to us, or at all.  Furthermore, any additional equity financing may be dilutive to stockholders and such equity securities may have rights, preferences or privileges senior to those of the holders of our common stock, and debt financing, if available, may involve restrictive covenants. Strategic arrangements, if necessary to raise additional funds, may require us to relinquish our rights to certain of our technologies or products.

 

Our lengthy sales cycle to acquire new customers or large follow-on orders may cause our quarterly operating results to vary significantly and make it more difficult to forecast our revenue.

 

We have generally experienced a product sales cycle of four to nine months for new customers or large follow-on orders due to the time needed to educate customers about the uses and benefits of our system, and the significant investment decisions that our prospective customers must make when they decide to buy our system.  Many of our prospective customers have neither budgeted expenses for networked video communications systems, or for personnel specifically dedicated to the procurement, installation or support of these systems.  As a result, our customers spend a substantial amount of time in performing internal reviews and obtaining capital expenditure approvals before purchasing our system. Recent economic conditions have contributed to additional deliberation, and an associated delay in the sales cycle.

 

Our lengthy sales cycle is one of the factors that has caused, and may in the future continue to cause, our operating results to vary significantly from quarter to quarter and year to year.  This makes it difficult for us to forecast revenue, and could cause volatility in the market price of our common stock.  A lost or delayed order could result in lower revenue than expected in a particular quarter or year.

 

Since a majority of our revenue has come from follow-on orders, our financial performance could be harmed if we fail to obtain follow-on orders in the future.

 

Our customers typically place limited initial orders for our networked video communications system, as they seek to evaluate its usefulness and value.  Our strategy is to pursue additional and larger follow-on orders after these initial orders.  Revenue generated from follow-on orders accounted for approximately 81% and 94% of our revenue for the six months ended June 30, 2004 and 2003, respectively.  Economic conditions have contributed to decreases in our clients’ capital spending in the past, and we have experienced a decrease in the size and number of follow-on orders.  Our future financial performance depends on successful initial installations of our system and successful generation of follow-on orders as the Avistar network expands within a customer organization.  If our system does not meet the needs and expectations of customers, we may not be able to generate follow-on orders.

 

Because we depend on a few customers for a majority of our revenue, the loss of one or more of them could cause a significant decrease in our revenue.

 

We have historically derived the majority of our revenue from a limited number of customers, particularly Deutsche Bank AG and UBS Warburg LLC and their affiliates.  Collectively, these customers accounted for 68% of our revenue for the six months ended June 30, 2004. No other customers individually contributed great than 10% of our total revenue for the six months ended June 30,

 

20

 

2004.  For the six months ended June 30, 2003, Deutsche Bank AG and its affiliates accounted for 61% of our revenue. No other customer individually contributed greater than 10% of our total revenue for the six months ended June 30, 2003. These contributions reflects the acquisition by Deutsche Bank and UBS Warburg LLC of other financial services firms that were previously Avistar customers, as well as the purchase of Avistar technology by Deutsche Bank for new accounts as part of Deutsche Bank’s client connectivity program and/or joint ventures. We expect to continue to depend upon a limited number of customers for a substantial portion of our revenue.  As of June 30, 2004, approximately 78% of our accounts receivable were concentrated with four customers, each of whom represented more than 10% of our total accounts receivable.  As of December 31, 2003, approximately 89% of our accounts receivable were concentrated with one customer.

 

The loss of a major customer or the reduction, delay or cancellation of orders from one or more of our significant customers could cause our revenue to decline and our losses to increase.  Because we currently depend on a limited number of customers with lengthy budgeting cycles and unpredictable buying patterns, our revenue from quarter to quarter or year to year may be volatile.  Adverse changes in our revenue or operating results as a result of these budgeting cycles or any other reduction in capital expenditures by our large customers could substantially reduce the trading price of our common stock.

 

We may not be able to modify and improve our products in a timely and cost effective manner to respond to technological change and customer demands.

 

Future hardware and software platforms embodying new technologies and the emergence of new industry standards and customer requirements could render our system non-competitive or even obsolete.  The market for our system is characterized by:

 

•                  rapid technological change;

•                  significant development costs;

•                  changes in the requirements of our customers and their communities of users;

•                  evolving industry standards; and

•                  transition to Internet protocol connectivity for video at the desktop, with increasing availability of bandwidth.

 

Our system is designed to work with a variety of hardware and software configurations and data networking infrastructures used by our customers.  The majority of these customer networks rely on Microsoft Windows servers.  However, our software may not operate correctly on other hardware and software platforms or with other programming languages, database environments and systems that our customers use.  Also, we must constantly modify and improve our system to keep pace with changes made to our customers’ platforms, data networking infrastructures, and their evolving ability to transport video and other applications.  This may result in uncertainty relating to the timing and nature of our new release announcements, introductions or modifications, which in turn may cause confusion in the market, with a potentially harmful effect on our business.  If we fail to promptly modify or improve our system in response to evolving industry standards or customers’ demands, our system could become less competitive, which would harm our financial condition and reputation.

 

Difficulties or delays in installing our products, fulfilling software development, or delivering other professional service contracts could harm our revenue and margins.

 

We recognize revenue upon the installation of our system in those cases where we are responsible for installation, which often entails working with sophisticated software and computing and communications systems. If we experience difficulties with installation or do not meet deadlines due to delays caused by our customers or ourselves, we could be required to devote more customer support, technical and other resources to a particular installation.  If we encounter delays in installing our products for new or existing customers or installation requires significant amounts of our professional services support, our revenue recognition could be delayed, our costs could increase and our margins could suffer.

 

Competition could reduce our market share and decrease our revenue.

 

Currently, our competition comes from many other kinds of companies, including communication equipment, integrated solution, broadcast video and stand-alone point solution providers. Within the video-enabled network communications market, we compete primarily against Polycom, Tandberg Inc. and VCON Telecommunications Ltd. We believe we may face increasing competition in the future from alternative video communications solutions that employ new technologies or new combinations of technologies from companies such as Cisco Systems, Inc., Hewlett-Packard Company, Microsoft Corporation, RealNetworks, Inc. and WebEx Communications, Inc., that enable web-based or network-based video communications with low-cost digital camera systems. The market in which we operate is highly competitive.  In addition, because our industry is relatively new and one which is characterized

 

21

 

by rapid technological change, evolving user needs, developing industry standards and protocols and the frequent introduction of new products and services, it is difficult for us to predict whether or when new competing technologies or new competitors will enter our market.

 

We expect competition to increase in the future from existing competitors and from new market entrants with products that may be less expensive than ours or that may provide better performance or additional features not currently provided by our products.  Many of our current and potential competitors have substantially greater financial, technical, manufacturing, marketing, distribution and other resources, greater name recognition and market presence, longer operating histories, lower cost structures and larger customer bases than we do.  As a result, they may be able to adapt more quickly to new or emerging technologies and changes in customer requirements.

 

We may be required to reduce prices or increase spending in response to competition in order to retain or attract customers, pursue new market opportunities or invest in additional research and development efforts.  As a result, our revenue, margins and market share may be harmed.  We cannot assure you that we will be able to compete successfully against current and future competitors, or that competitive pressures faced by us will not harm our business, financial condition and results of operations.

 

Infringement of our proprietary rights could affect our competitive position, harm our reputation or cost us money.

 

We regard our system as open but proprietary. In an effort to protect our proprietary rights, we rely primarily on a combination of patent, copyright, trademark and trade secret laws, as well as licensing, non-disclosure and other agreements with our consultants, suppliers, customers and employees.  However, these laws and agreements provide only limited protection of our proprietary rights. In addition, we may not have signed agreements in every case and the contractual provisions that are in place and the protection they produce may not provide us with adequate protection in all circumstances.  Although CPI holds patents and has filed patent applications covering some of the inventions embodied in our systems, our means of protecting our proprietary rights may not be adequate. It may be possible for a third party to copy or otherwise obtain and use our technology without authorization and without our detection.  In the event that we believe a third party is infringing our intellectual property rights, an infringement claim brought by us could, regardless of the outcome, result in substantial cost to us, divert our management’s attention and resources, be time consuming to prosecute and result in unpredictable damage awards.  A third party may also develop similar technology independently, without infringing upon our patents and copyrights.  In addition, the laws of some countries in which we sell our system may not protect our software and intellectual property rights to the same extent as the laws of the United States or other countries where we hold patents.  Unauthorized copying, use or reverse engineering of our system could harm our business, financial condition or results of operations.

 

Infringement claims could require us to expend significant financial and managerial resources.

 

A third party could claim that our technology infringes upon its proprietary rights.  As the number of software systems in our target market increases and the functionality of these systems overlap, we believe that the number of infringement suits filed by software developers may increase.  At a hearing held on March 7, 2003, the judge in the existing lawsuit in which CPI is claiming that Polycom infringes four CPI patents granted Polycom’s motion to amend its counterclaims to include claims of alleged infringements by Avistar Communications of four PictureTel patents that Polycom has told us it has had assigned to it.  Three of the four counterclaims for patent infringement related to equipment provided to Avistar by a third-party. These three counterclaims involving the third party were dropped on June 23, 2003, subsequent to an agreement between Polycom and the third party.

 

The prosecution of this lawsuit and the defense of the Polycom counterclaim have required and may continue to require Avistar and CPI to expend significant financial and managerial resources and therefore may have a material negative impact on Avistar and CPI.

 

Our system could have defects for which we could be held liable for, and which could result in lost revenue, increased costs, loss of our credibility or delay in the further acceptance of our system in the market.

 

Our system may contain errors or defects, especially when new products are introduced or when new versions are released.  Despite internal system testing, we have in the past discovered software errors in some of the versions of our system after their introduction.  Errors in new systems or versions could be found after commencement of commercial shipments, and this could result in additional development costs, diversion of technical and other resources from our other development efforts or the loss of credibility with current or future customers.  Any of these events could result in a loss of revenue or a delay in market acceptance of our system and could harm our reputation.

 

22

 

In addition, we have warranted to some of our customers that our software is free of viruses.  If a virus infects a customer’s computer software, the customer could assert claims against us, which, regardless of their merits, could be costly to defend and could require us to pay damages and potentially harm our reputation.

 

Our license agreements with our customers typically contain provisions designed to limit our exposure to potential product liability and certain contract claims.  Our license agreements also typically limit a customer’s entire remedy to either a refund of the price paid or modification of our system to satisfy our warranty.  However, these provisions vary as to their terms and may not be effective under the laws of some jurisdictions.  Although we maintain product liability (“errors and omissions”) insurance coverage, we cannot assure you that such coverage will be adequate.  A product liability, warranty or other claim could harm our business, financial condition and/or results of operations.  Performance interruptions at a customer’s site could negatively affect the demand for our system or give rise to claims against us.

 

The third party software we license with our system may also contain errors or defects for which we do not maintain insurance.  Typically, our license agreements transfer any warranty from the third party to our customers to the extent permitted.  Product liability, warranty or other claims brought against us with respect to such warranties could, regardless of their merits, harm our business, financial condition or results of operations.

 

The loss of any of our outside contract manufacturers or third party equipment suppliers that produce key components of our system could significantly disrupt our manufacturing and new product development process.

 

We depend on outside contract manufacturers to produce components of our systems.  A significant portion of our compression and decompression product, or gateway product, is currently supplied by a single source, Tandberg, Inc.  In addition, we depend on various third party suppliers for the cameras, microphones, speakers and monitors that we install at desktops and in conference rooms as a part of each video communications network system.  Two of these contract manufacturers, SAE Materials Inc. and Pacific Corporation, are single source suppliers for key components of our products.  Another supplier, Equator Technologies Inc., is our only current source of a component used in our IP gateway product. Our reliance on these third parties involves a number of risks, including:

 

•                  the possible unavailability of critical services and components on a timely basis, on commercially reasonable terms or at all;

•                  if the components necessary for our system were to become unavailable, the need to qualify new or alternative components for our use or reconfigure our system and manufacturing process could be lengthy and expensive;

•                  the likelihood that, if particular components were not available, we would suffer an interruption in the manufacture and shipment of our systems until these components or alternatives become available;

•                  reduced control by us over the quality and cost of our system and over our ability to respond to unanticipated changes and increases in customer orders, and conversely, price changes from suppliers if committed volumes are not met; and

•                  the possible unavailability of, or interruption in, access to some technologies due to infringement claims, production/supply issues or other hindrances.

 

If these manufacturers or suppliers cease to provide us with the assistance or the components necessary for the operation of our business, we may not be able to identify alternate sources in a timely fashion.  Any transition to alternate manufacturers or suppliers would likely result in operational problems and increased expenses and could cause delays in the shipment of or otherwise limit our ability to provide our products.  We cannot assure you that we would be able to enter into agreements with new manufacturers or suppliers on commercially reasonable terms, or at all.  Any disruption in product flow may limit our revenue, delay our product development, seriously harm our competitive position and/or result in additional costs or cancellation of orders by our customers.

 

If we are unable to expand our direct sales force and/or add distribution channels, our business will suffer.

 

To increase our revenue, we must increase the size of our direct sales force and add indirect distribution channels, such as systems integrators, product partners and/or value-added resellers, and/or effect sales through our customers.  If we are unable to maintain or increase our direct sales force or add indirect distribution channels due to our own cost constraints, limited availability of qualified personnel or other reasons, our future revenue growth may be limited and our future operating results may suffer.  We cannot assure you that we will be successful in attracting, integrating, motivating and retaining sales personnel.  Furthermore, it can take several months before a new hire becomes a productive member of our sales force.  The loss of existing direct and/or indirect salespeople, or the failure of new salespeople and/or indirect sales partners to develop the necessary skills in a timely manner, could reduce our revenue growth.

 

23

 

We may not be able to retain our existing key personnel, or hire and retain the additional personnel that we need to sustain and grow our business.

 

Our products and technologies are complex, and to successfully implement our business strategy and manage our business, an in-depth understanding of video communication and collaboration technologies and their potential uses is required.  We depend on the continued services of our executive officers and other key personnel.  We do not have long-term employment agreements with our executive officers or other key personnel and we do not carry any “key man” life insurance.  The loss of the services of any of our executive officers or key personnel could harm our business, financial condition and results of operations.

 

We need to attract and retain highly skilled technical and managerial personnel for whom there is intense competition.  If we are unable to attract and retain qualified technical and managerial personnel due to our own cost constraints, limited availability of qualified personnel or other reasons, our results of operations could suffer and we may never achieve profitability.  The failure of new personnel to develop the necessary skills in a timely manner could harm our business.

 

Our plans call for growth in our business, and our inability to achieve or manage growth could harm our business.

 

Failure to achieve or manage growth effectively will harm our business, financial condition and operating results.  Furthermore, in order to remain competitive or to expand our business, we may find it necessary or desirable in the future to acquire other businesses, products or technologies. If we identify an appropriate acquisition candidate, we may not be able to negotiate the terms of the acquisition successfully, to finance the acquisition or to integrate the acquired businesses, products or technologies into our existing business and operations.  In addition, completing a potential acquisition and integrating an acquired business may strain our resources and require significant management time.

 

Our international operations expose us to potential tariffs and other trade barriers, unexpected changes in foreign regulatory requirements and laws and economic and political instability, as well as other risks that could adversely affect our results of operations.

 

International revenue, which consists of sales to customers with operations principally in Western Europe and Asia, comprised 53% of total revenue for the six months ended June 30, 2004 and 57% for the six months ended June 30, 2003.  Some of the risks we may encounter in conducting international business activities include the following:

 

•                  tariffs and other trade barriers;

•                  unexpected changes in foreign regulatory requirements and laws;

•                  economic and political instability;

•                  increased risk of infringement claims;

•                  protection of our intellectual property;

•                  restrictions on the repatriation of funds;

•                  potentially adverse tax consequences;

•                  timing, cost and potential difficulty of adapting our system to the local language standards in those foreign countries that do not use the English language;

•                  fluctuations in foreign currencies; and

•                  limitations in communications infrastructures in some foreign countries.

 

International political instability may increase our cost of doing business and disrupt our business.

 

Increased international political instability, evidenced by the threat or occurrence of terrorist attacks, enhanced national security measures and/or sustained military action may halt or hinder our ability to do business, may increase our costs and may adversely affect our stock price. This increased instability has had and may continue to have negative effects on financial markets, including significant price and volume fluctuations in securities markets. If this international political instability continues or escalates, our business and results of operations could be harmed and the market price of our common stock could decline.

 

If our customers do not perceive our system or services to be effective or of high quality, our brand and name recognition would suffer.

 

24

 

We believe that establishing and maintaining brand and name recognition is critical for attracting and expanding our targeted customer base.  We also believe that the importance of reputation and name recognition will increase as competition in our market increases.  Promotion and enhancement of our name will depend on the success of our marketing efforts, and on our ability to continue to provide high quality systems and services, neither of which can be assured.  If our customers do not perceive our system or services to be effective or of high quality, our brand and name recognition will suffer, which would harm our business.

 

We may not meet the continued listing criteria for the NASDAQ SmallCap Market, which could materially adversely affect the price and liquidity of our stock, our business and our financial condition.

 

Continued listing on The NASDAQ SmallCap Market requires, among other criteria, that the minimum closing bid price of our common stock not fall below $1.00 for 30 consecutive trading days. On June 21, 2004, we received notification from The NASDAQ Stock Market that we are out of compliance with the minimum closing bid price requirement of $1.00 per share set forth in Marketplace Rule 4310(c)(4). Therefore, our common stock may be delisted from trading on The NASDAQ SmallCap Market on or about December 20, 2004 if the minimum closing bid price of our common stock does not equal or exceed $1.00 for a minimum of ten consecutive trading days.  If we fail to achieve ten consecutive trading days with a minimum closing bid price of $1.00, but demonstrate at the end of this grace period that we are in compliance with The NASDAQ SmallCap Market initial listing standards (that is, either $750,000 net income for the most recently completed fiscal year, stockholders’ equity of $5 million or market capitalization of $50 million), we may be allowed an additional 180-day grace period to meet the $1.00 minimum closing bid price requirement, or until June 18, 2005.  As of June 30, 2004, we did not meet the initial listing standards of The NASDAQ SmallCap Market.  In the event that we are unable to raise additional equity investment, we expect that may also be out of compliance with The NASDAQ SmallCap Market’s continued listing requirement that we maintain stockholders equity of at least $2.5 million, a market capitalization of at least $35 million or annual net income of at least $500,000.  If we do not satisfy the continued listing requirements prior to the expiration of applicable grace periods, we may attempt to seek review of The NASDAQ Stock Market’s decision to delist our stock, or may apply for quotation of our common stock on any other organized market on which the shares may be eligible for trading. There can be no assurance that our common stock will satisfy the requirements for continued listing on The NASDAQ SmallCap Market.

 

If we are unable to continue to list our common stock for trading on The NASDAQ SmallCap Market, there may be an adverse impact on the market price and liquidity of our common stock, and our stock may be subject to the “penny stock rules” contained in Section 15(g) of the Securities Exchange Act of 1934, as amended, and the rules promulgated there under.  Delisting of our common stock from The NASDAQ SmallCap Market could also materially adversely affect our business, including, among other things: our ability to raise additional financing to fund our operations; our ability to attract and retain customers; and our ability to attract and retain personnel, including management personnel.  In addition, if we were unable to list our common stock for trading on NASDAQ, many institutional investors would no longer be able to retain their interests in and/or make further investments in our common stock because of their internal rules and protocols.

 

Our common stock has been and will likely continue to be subject to substantial price and volume fluctuations due to a number of factors, many of which will be beyond our control, that may prevent our stockholders from reselling our common stock at a profit.

 

The trading price of our common stock has in the past been and could in the future be subject to significant fluctuations in response to:

 

•                  general trends in the equities market, and/or trends in the technology sector

•                  quarterly variations in our results of operations;

•                  announcements regarding our product developments;

•                  announcements of technological innovations or new products by us, our customers or competitors;

•                  announcements of competitive product introductions by our competitors or our customers;

•                  sales or the perception in the market of possible sales of a large number of shares of our common stock by our directors, officers, employees or principal stockholders; and

•                  developments or disputes concerning patents or proprietary rights, including our litigation with Polycom, or other events.

 

If our revenue and results of operations are below the expectations of public market securities analysts or investors, then significant fluctuations in the market price of our common stock could occur.  In addition, the securities markets have, from time to time, experienced significant price and volume fluctuations, which have particularly affected the market prices for high technology

 

25

 

companies, and which often are unrelated and disproportionate to the operating performance of particular companies.  These broad market fluctuations, as well as general economic, political and market conditions, may negatively affect the market price of our common stock.

 

If our share price is volatile, we may be the target of securities litigation, which is costly and time-consuming to defend.

 

In the past, following periods of market volatility in the price of a company’s securities, security holders have often instituted class action litigation. Many technology companies have been subject to this type of litigation.  Our share price has, in the past, experienced price volatility, and may continue to do so in the future. If the market value of our common stock experiences adverse fluctuations and we become involved in this type of litigation, regardless of the merits or outcome, we could incur substantial legal costs and our management’s attention could be diverted, causing our business, financial condition and operating results to suffer.

 

Provisions of our certificate of incorporation, our bylaws and Delaware law may make it difficult for a third party to acquire us, despite the possible benefits to our stockholders.

 

Our certificate of incorporation, our bylaws and Delaware law contain provisions that may inhibit changes in our control that are not approved by our Board of Directors.  For example, the Board of Directors has the authority to issue up to 10,000,000 shares of preferred stock and to determine the terms of this preferred stock, without any further vote or action on the part of the stockholders.

 

These provisions may have the effect of delaying, deferring or preventing a change in our control despite possible benefits to our stockholders, may discourage bids at a premium over the market price of our common stock, and may adversely affect the market price of our common stock and the voting and other rights of our stockholders.

 

Our principal stockholders can exercise a controlling influence over our business affairs, and they may make business decisions with which you disagree that will affect the value of your investment.

 

Our executive officers, directors and entities affiliated with them, in the aggregate, beneficially owned approximately 65% of our common stock as of June 30, 2004.  If they were to act together, these stockholders would be able to exercise control over most matters requiring approval by our stockholders, including the election of directors and approval of significant corporate transactions.  These actions may be taken even if they are opposed by other investors.  This concentration of ownership may also have the effect of delaying or preventing a change in control of our company, which could cause the market price of our common stock to decline.

 

26

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

 

We develop products primarily in the United States and sell those products primarily in North America, Europe and Asia. International revenue, which consists of sales to customers with operations principally in Western Europe and Asia, comprised 53% of total revenue for the three months ended June 30, 2004 and 65% for the three months ended June 30, 2003.  International revenue comprised 53% of total revenue for the six months ended June 30, 2004 and 57% for the six months ended June 30, 2003. As a result, our financial condition could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets.  As all of our sales are currently made in United States dollars, a strengthening of the United States dollar could make our products less competitive in foreign markets.  We do not use derivative financial instruments for speculative or trading purposes, nor do we engage in any foreign currency hedging transactions.

 

Our interest income is sensitive to changes in the general level of United States interest rates, particularly since the majority of our investments are in short-term instruments.  There has not been a material change in our exposure to interest rate and foreign currency risk since the date of our annual report on Form 10-K/A for the year ended December 31, 2003 filed with the Securities and Exchange Commission on March 26, 2004.

 

Cash and Cash Equivalents

 

Cash equivalents consist primarily of commercial paper and money market and municipal bond funds acquired with remaining maturity periods of three months or less and are stated at cost, plus accrued interest that approximates market value.  We would not expect our operating results or cash flow to be significantly impacted by the effect of sudden changes in market interest rates given the nature of our short-term investments.

 

The following table provides information about our investment portfolio.  For investment securities, the table presents cash and cash equivalents and related weighted average interest rates by category at June 30, 2004.

 

 

Item 4. Controls and Procedures

 

(a) Evaluation of disclosure controls and procedures: Our management evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the Exchange Act)) are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

 

(b) Changes in internal control over financial reporting: There was no change in our internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

27

 

PART II - OTHER INFORMATION

 

Item 1. Legal Proceedings

 

On September 23, 2002, CPI, our wholly-owned subsidiary, commenced a patent infringement lawsuit against Polycom, Inc. alleging that several Polycom videoconferencing products infringe four patents held by CPI. The suit was filed in the United States District Court for the Northern District of California.  The four patents involved are U.S. Patent Nos. 5,867,654, 5,896,500, 6,212,547 and 6,343,314.  These patents cover technologies relating to video and data conferencing over unshielded twisted pair (UTP) networks, distributed call-state management, separate monitors for simultaneous computer-based data sharing and videoconferencing and remote participant hold and disconnect functions in multi-party conferencing. Polycom responded to CPI’s claims on November 14, 2002, at which time it both answered the complaint and asserted counterclaims against CPI for non-infringement, invalidity and unenforceability On January 31, 2003, Polycom filed a motion with the court, which was subsequently granted by the court on March 7, 2003, requesting permission to amend its counterclaims to incorporate claims of alleged infringements by Avistar Communications of four PictureTel patents that Polycom has told us it has had assigned to it. Three of the four counterclaims involved a third party, and Polycom dropped these three counterclaims on June 23, 2003, subsequent to an agreement between Polycom and the third party.  On August 9, 2003, CPI and Polycom filed motions for summary judgment with the court, seeking judgment as a matter of law concerning CPI’s ability to qualify for “small entity status” in the filing of its four patents being asserted against Polycom.  On October 17, 2003 the court denied Polycom’s motion for summary judgment and granted CPI’s motion for summary judgment, thereby negating Polycom’s defense of unenforceability concerning CPI’s having filed these patents as a “small entity.”

 

Briefings on claims construction issues and a hearing before the presiding judge (Markman hearing) took place on March 8, 2004, and the presiding judge issued her ruling on March 23, 2004. A trial date for CPI’s claims against Polycom and Polycom’s counterclaim has been set for January 10, 2005.  The prosecution of this lawsuit and the defense of the Polycom counterclaim have required and may continue to require the Company and CPI to expend significant financial and managerial resources and therefore may have a material negative impact on the Company and CPI.  Expenses associated with the litigation have risen as trial approaches to now comprise a significant portion of our quarterly operating expense. We anticipate this higher rate of spending to continue until final adjudication of the respective claims of the parties. The duration and ultimate outcome of this litigation are uncertain.

 

Item 4. Submission Of Matters to a Vote of Security Holders

 

At our Annual Meeting of Stockholders held June 2, 2004, our stockholders approved the following matters:

 

1.                    A proposal to elect seven (7) directors of the Company to serve for the ensuing year and until their successors are elected or until such director’s earlier resignation or removal.

 

Nominee		For		Against		Withheld
Gerald J. Burnett		24,448,617		—		942,302
William L. Campbell		24,450,947		—		941,302
R. Stephen Heinrichs		40,829,871		—		2,269,364
Robert P. Latta		23,475,521		—		942,302
Robert M. Metcalfe		26,629,054		—		10,300
David M. Solo		26,631,387		—		9,300
James W. Zeigon		26,629,054		—		10,300

 

2.                    A proposal to ratify the appointment of KPMG LLP as our independent auditors for the fiscal year ending December 31, 2004.

 

 

28

 

Item 5. Other Information

 

Continued listing on The NASDAQ SmallCap Market requires, among other criteria, that the minimum closing bid price of our common stock not fall below $1.00 for 30 consecutive trading days. On June 21, 2004, we received notification from The NASDAQ Stock Market that we are out of compliance with the minimum closing bid price requirement of $1.00 per share set forth in Marketplace Rule 4310(c)(4). Therefore, our common stock may be delisted from trading on The NASDAQ SmallCap Market on or about December 20, 2004 if the minimum closing bid price of our common stock does not equal or exceed $1.00 for a minimum of ten consecutive trading days.  If we fail to achieve ten consecutive trading days with a minimum closing bid price of $1.00, but demonstrate at the end of this grace period that we are in compliance with The NASDAQ SmallCap Market initial listing standards (that is, either $750,000 net income for the most recently completed fiscal year, stockholders’ equity of $5 million or market capitalization of $50 million), we may be allowed an additional 180-day grace period to meet the $1.00 minimum closing bid price requirement, or until June 18, 2005.  As of June 30, 2004, we did not meet the initial listing standards of The NASDAQ SmallCap Market.  In the event that we are unable to raise additional equity investment, we expect that may also be out of compliance with The NASDAQ SmallCap Market’s continued listing requirement that we maintain stockholders equity of at least $2.5 million, a market capitalization of at least $35 million or annual net income of at least $500,000.  If we do not satisfy the continued listing requirements prior to the expiration of applicable grace periods, we may attempt to seek review of The NASDAQ Stock Market’s decision to delist our stock, or may apply for quotation of our common stock on any other organized market on which the shares may be eligible for trading. There can be no assurance that our common stock will satisfy the requirements for continued listing on The NASDAQ SmallCap Market.

 

29

 

Item 6. Exhibits

(a)

 

31.1		Rule 13a-14(a)/15d-14(a) Certification by the Chief Executive Officer.
31.2		Rule 13a-14(a)/15d-14(a) Certification by the Chief Financial Officer.
32.1		Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350,  as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

30

 

SIGNATURES

 

Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized, on this 16th day of August 2004.

 

	AVISTAR COMMUNICATIONS CORPORATION
	By:	/s/ GERALD J. BURNETT
		Gerald J. Burnett
		Chief Executive Officer, President and
		Chairman (Principal Executive Officer)
	By:	/s/ ROBERT J. HABIG
		Robert J. Habig
		Chief Financial Officer
		(Principal Financial and Accounting Officer)

 

31

 

EXHIBIT INDEX

 

Exhibit No.		Description
31.1		Rule 13a-14(a)/15d-14(a) Certification by the Chief Executive Officer.
31.2		Rule 13a-14(a)/15d-14(a) Certification by the Chief Financial Officer.
32.1		Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

32