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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

For the quarterly period ended September 30, 2009

or

For the transition period from             to            

Commission file number 000-51995

ETELOS, INC.

(Exact name of registrant as specified in its charter)

(425) 458-4510

(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o  No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o  No x

As of September 30, 2009, 24,826,360 shares of the issuer’s common stock, par value $0.01 per share, were outstanding.

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EXPLANATORY NOTE

On February 8, 2007, Tripath Technology Inc., a Delaware corporation (“Tripath”) filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code. On February 1, 2008, the bankruptcy court issued an order confirming approval of the Plan of Reorganization, including the merger and the transfer of all of Tripath’s existing assets into a separate bankruptcy estate and the discharge of all of Tripath’s liabilities.  The Plan of Reorganization also contemplated the merger of Etelos, Incorporated, a Washington corporation (“Etelos-WA”) with Tripath.   The overall impact of the confirmed Plan of Reorganization was for Tripath to emerge from the bankruptcy proceeding with no assets and no liabilities as a shell corporation and for all issued and outstanding securities of and interests in Tripath, including debentures, stock options (including, but not limited to, all stock options granted to employees), warrants, and other shares of common stock to be canceled and extinguished.

On April 23, 2008, Tripath filed a Current Report on Form 8-K announcing, among other things, that Etelos-WA merged with and into Tripath, and that the surviving corporation changed its name to Etelos, Inc. and its fiscal year end to December 31.  The effective date of the merger was April 22, 2008, and Etelos, Inc., as the surviving corporation, will conduct the business and operations previously conducted by Etelos-WA.  In connection with the merger, all outstanding shares of Etelos-WA common stock were converted into shares of Etelos, Inc. common stock on a three for one ratio: one share of Etelos, Inc. common stock for every three shares of common stock of Etelos-WA.  Also in connection with the merger, (i) all outstanding shares of preferred stock of Etelos-WA were converted into shares of common stock of Etelos, Inc., (ii) Etelos, Inc. issued an aggregate of 5,010,000 shares of its common stock to the secured and unsecured creditors of Tripath and (iii) all the shares of Tripath were cancelled.  Prior to the merger, Tripath was a shell corporation and in accordance with the Plan of Reorganization had no assets or liabilities.  While Tripath acquired all the outstanding preferred and common stock of Etelos-WA, for accounting purposes, the acquisition has been treated as a recapitalization of Etelos-WA with Etelos-WA as the acquirer (a reverse acquisition).  The historical financial statements prior to April 22, 2008, are those of Etelos-WA and the description of the business contained in this report as well as the one contained in the financial statements reflect the operations of Etelos-WA for the quarterly and twelve month periods ended December 31, 2008 and 2007.

Also, on April 23, 2008, Etelos, Inc., formerly Tripath, amended its certificate of incorporation with the state of Delaware to change its total authorized shares of stock to 300,000,000 shares, of which 250,000,000 shares are designated “common stock” with a par value of $0.01 per share and 50,000,000 shares are designated “preferred stock” with a par value of $0.01 per share.  The preferred stock may be issued from time to time in one or more series, each of such series to consist of such number of shares and to have such terms, rights, powers and preferences, and the qualifications and limitations with respect thereto, as stated in the resolutions providing for the issue of such series adopted by the board of directors.

Information concerning number of shares outstanding for Etelos, Inc. including the conversion prices and number of shares issuable upon conversion of convertible securities and exercise prices of warrants and stock options and the number of shares issuable upon exercise of such options and warrants, has been adjusted to reflect the three for one conversion ratio effected in connection with the merger as if it had occurred for all periods presented.

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Etelos, Inc.

Quarterly Report on Form 10-Q

For the Quarterly Period Ended September 30, 2009

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FORWARD LOOKING STATEMENTS

In this report, unless the context indicates otherwise, the terms “Etelos,” “Company,” “we,” “us,” and “our” refer to Etelos, Inc., a Delaware corporation.

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, or the “Securities Act,” and Section 21E of the Securities Exchange Act of 1934 or the “Exchange Act.”  These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from historical results or anticipated results, including those set forth under the heading “Risk Factors” and elsewhere in, or incorporated by reference into, this report.

In some cases, you can identify forward looking statements by terms such as “may,” “intend,” “might,” “will,” “should,” “could,” “would,” “expect,” “believe,” “anticipate,” “estimate,” “predict,” “potential,” or the negative of these terms.  These terms and similar expressions are intended to identify forward-looking statements.  Such statements are subject to certain risks and uncertainties, which could cause actual results to differ materially from those projected.  The forward-looking statements in this report are based upon management’s current expectations and belief, which management believes are reasonable.  In addition, we cannot assess the impact of each factor on our business or the extent to which any factor or combination of factors, or factors we are aware of, may cause actual results to differ materially from those contained in any forward looking statements.  You are cautioned not to place undue reliance on any forward-looking statements.  These statements represent our estimates and assumptions only as of the date of this report.  Except to the extent required by federal securities laws, we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

You should be aware that our actual results could differ materially from those contained in the forward-looking statements due to a number of factors, including:

·                                          our ability to obtain future financing or funds when needed;

·                                          new competitors are likely to emerge and new technologies may further increase competition;

·                                          our operating costs may increase beyond our current expectations and we may be unable to fully implement our current business plan;

·                                          our ability to successfully obtain a diverse customer base;

·                                          our ability to protect our intellectual property through patents, trademarks, copyrights and confidentiality agreements;

·                                          our ability to attract and retain a qualified employee base;

·                                          our ability to respond to new developments in technology and new applications of existing technology before our competitors;

·                                          acquisitions, business combinations, strategic partnerships, divestures, and other significant transactions may involve additional uncertainties;

·                                          our ability to maintain and execute a successful business strategy; and

·                                          we face other risks described from time to time in periodic and current reports we file with the United States Securities and Exchange Commission, or the “SEC.”

Other risks and uncertainties include such factors as market acceptance and market demand for our products and services, pricing, the changing regulatory environment, the effect of our accounting policies, potential seasonality, industry trends, adequacy of our financial resources to execute our business plan, our ability to attract, retain and motivate key technical, marketing and management personnel, possible disruption in commercial activities occasioned by terrorist activity and armed conflict, and other risk factors detailed in this report and our other SEC filings.  You should consider carefully the statements under “Item 1A. Risk Factors” in Part II and other sections of this report, which address additional factors that could cause our actual results to differ from those set forth in the forward-looking statements and could materially and adversely affect our business, operating results and financial condition.  All subsequent written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the applicable cautionary statements.

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PART I—FINANCIAL INFORMATION

ITEM 1. - FINANCIAL STATEMENTS (UNAUDITED)

ETELOS, INC.

CONDENSED BALANCE SHEETS

(in thousands, except share data)

(Unaudited)

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

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ETELOS, INC.

CONDENSED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(Unaudited)

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

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ETELOS, INC.

CONDENSED STATEMENTS OF STOCKHOLDERS’ DEFICIT

(in thousands, except share data)

(Unaudited)

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

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ETELOS, INCORPORATED

CONDENSED STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited)

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

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NOTES TO FINANCIAL STATEMENTS

1. Organization

On February 8, 2007, Tripath Technology Inc., a Delaware corporation (“Tripath”) filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code. On February 1, 2008, the bankruptcy court issued an order confirming approval of the Plan of Reorganization, including the merger and the transfer of all of Tripath’s existing assets into a separate bankruptcy estate and the discharge of all of Tripath’s liabilities.  The Plan of Reorganization also contemplated the merger of Etelos, Incorporated, a Washington corporation (“Etelos-WA”) with Tripath.  The overall impact of the confirmed Plan of Reorganization was for Tripath to emerge from the bankruptcy proceeding with no assets and no liabilities as a shell corporation and for all issued and outstanding securities of and interests in Tripath, including debentures, stock options (including, but not limited to, all stock options granted to employees), warrants, and other shares of common stock to be canceled and extinguished.

On April 23, 2008, Tripath filed a Current Report on Form 8-K announcing, among other things, that Etelos-WA merged with and into Tripath (the “Merger”), and that the surviving corporation changed its name to Etelos, Inc. and its fiscal year end to December 31.  The effective date of the Merger was April 22, 2008, and Etelos, Inc., as the surviving corporation, will conduct the business and operations previously conducted by Etelos-WA.  In connection with the Merger, all outstanding shares of Etelos-WA common stock were converted into shares of Etelos, Inc. common stock on a three for one ratio: one share of Etelos Inc. common stock for every three shares of common stock of Etelos-WA.  Also in connection with the Merger, (i) all outstanding shares of preferred stock of Etelos-WA were converted into shares of common stock of Etelos, Inc., (ii) Etelos, Inc. issued an aggregate of 5,010,000 shares of its common stock to the secured and unsecured creditors of Tripath and (iii) all the shares of Tripath Technology were cancelled. Also on April 23, 2008, Etelos, Inc., formerly Tripath, amended its articles of incorporation with the state of Delaware to change its total authorized shares of stock to 300,000,000 shares, of which 250,000,000 shares are designated “Common Stock” with a par value of $0.01 per share and 50,000,000 shares are designated “Preferred Stock” with a par value of $0.01 per share.  The Preferred Stock may be issued from time to time in one or more series, each of such series to consist of such number of shares and to have such terms, rights, powers and preferences, and the qualifications and limitations with respect thereto, as stated in the resolutions providing for the issue of such series adopted by the board of directors.

Prior to the Merger, Tripath was a shell corporation and in accordance with the Plan of Reorganization had no assets or liabilities.  While Tripath acquired all the outstanding preferred and common stock of Etelos-WA, for accounting purposes, the acquisition has been treated as a recapitalization of Etelos-WA with Etelos-WA as the acquirer (a reverse acquisition).  The historical financial statements prior to April 22, 2008, are those of Etelos-WA.

The 5,010,000 shares of Etelos, Inc. common stock were valued at $2.63 per share, the estimated fair value of the common stock on the date of the Merger, which resulted in a charge to operations of $13.2 million included in the caption Merger Related Costs in the accompanying Statement of Operations.  Etelos, Inc. believes that these shares were issued primarily for past services provided to Etelos-WA by the secured creditors and the release of the secured and unsecured creditors claims against Tripath.

Information concerning number of shares outstanding for Etelos, Inc. including the conversion prices and number of shares issuable upon conversion of convertible securities and exercise prices of warrants and stock options and the number of shares issuable upon exercise of the options and warrants, has been adjusted to reflect this stock split for all periods presented.  Also, the stockholders’ deficit section of the accompanying balance sheet has been adjusted to reflect the legal capital structure of Tripath adjusted for the change in authorized shares of common and preferred stock.

2.  The Company

As used herein, unless the context requires otherwise, the terms the “Company” or “Etelos” refers to Etelos, Inc., the corporation that survived the Merger.

Etelos has a Web Application distribution platform delivering Web Applications for businesses.  Etelos provides a Software-as-a-Service (SaaS) ecosystem for building, distributing, and using Web Applications, including a marketplace to deploy and support them.  Unlike other cloud computing and Platform-as-a-Service (PaaS) solutions, Etelos enables software manufacturers to migrate existing applications or create new applications, then package, distribute, host, bill, market and support their SaaS enabled applications through multiple private label applications marketplaces.

Etelos has developed products for Web Applications, which include open standards-based tools for Web developers, businesses and individual users such as the Etelos Application ServerTM (EASTM) and the Etelos Development EnvironmentTM (EDETM).  EAS and EDE support many common programming languages and also support the English Application Scripting Engine (EASETM), a simple-to-use open standards-based scripting language developed by the Company.  In order to support broader adoption of its products,

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EASE and other components of the EDE are made available to developers at market appropriate pricing.  This is done to support the development of new Web Applications and the migration of existing Web Applications into the Etelos ecosystem where there are tools and other support mechanisms for the marketing, distribution, and support of these applications.  Etelos generally receives a transaction fee or subscription fee for transactions that occur within the Etelos ecosystem either via the Etelos Marketplace™ pursuant to Storefront Operating Agreements, or in third-party branded Marketplaces operated by Etelos pursuant to Marketplace Partner Agreements (sometimes referred to as “an Etelos Marketplace” or, collectively, as “the Etelos Marketplaces”).  Most customers in Etelos Marketplaces pay a subscription fee, which revenue Etelos shares with Syndication Partners and Marketplace Partners; this revenue share is calculated as a percentage of gross revenues from the sale of subscriptions to customers of Syndication Partner products and service in the Etelos Marketplaces.

3. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying condensed financial statements include our accounts as of September 30, 2009, and December 31, 2008, and for the nine months ended September 30, 2009 and 2008. The accompanying condensed balance sheet as of December 31, 2008, has been derived from the audited balance sheet in the Company’s annual report on Form 10-K for the fiscal year ended December 31, 2008. These condensed financial statements have been prepared by management, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission, or SEC. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. The Company has performed an evaluation of subsequent events through the date of filing of the financial statements.

In the opinion of management, all adjustments (which consist of normal recurring adjustments, except as disclosed herein) necessary to fairly present the financial position, results of operations and cash flows for the interim periods presented have been included. The results of operations for the quarter ended September 30, 2009, and the nine months ended September 30, 2009, are not necessarily indicative of the results to be expected for the full year or for any future periods.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates, and such differences could affect the results of operations reported in future periods and such differences could be material.  These financial statements should be read in conjunction with the audited financial statements and accompanying notes included in the Company’s annual report on Form 10-K for the fiscal year ended December 31, 2008.  Certain prior period amounts have been reclassified to conform to the present period presentation.

During the third quarter of 2009, the Company adopted the new Accounting Standards Codification (“ASC”) as issued by FASB.  The ASC has become the authoritative source of US GAAP recognized by FASB to be applied by non-governmental entities.  The ASC is not intended to amend or change US GAAP.  The adoption of the ASC did not have a material impact on the Company’s financial statements.

Concentration of Credit Risk

Financial instruments that potentially subject the Company to concentration of credit risk consist primarily of cash, cash equivalents, and accounts receivable.  Cash and cash equivalents are maintained in federally-insured banks in the United States of America.  Deposits in such banks may exceed US federally-insured limits and be subject to the current risks and uncertainties of dealing with such US banks. Etelos maintains the majority of cash balances and all short-term investments with one financial institution.

The Company’s accounts receivables are derived primarily from customers.  For the nine months ended September 30, 2009, three customers accounted for 88% of the Company’s revenue in the period. One customer accounted for 100% of the Company’s accounts receivable as of September 30, 2009.

Allowance for Doubtful Accounts

The Company provides, when appropriate, an allowance for doubtful accounts to ensure trade receivables are not overstated due to un-collectability. The collectability of the Company’s receivables is evaluated based on a variety of factors, including the length of time receivables are past due, indication of the customer’s willingness to pay, significant one-time events, and historical experience. As of September 30, 2009, and December 31, 2008, the Company determined that an allowance for doubtful accounts was not necessary or warranted.

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Deferred Revenue

Deferred revenue represents money received or promised but not recognized as revenue because the work has not been completed or the software subscription has been fully delivered, and therefore is deferred until the work is completed or the software subscription is fully delivered when it is then transferred to the appropriate revenue account.

Property and Equipment

Property, furniture, and equipment are stated at historical cost less accumulated depreciation and amortization. Depreciation and amortization are computed on a straight-line basis over the estimated useful lives of the assets, which the Company currently believes are three to five years.

Fair Value of Financial Instruments

The Company’s balance sheet includes the following financial instruments: cash, accounts receivable, accounts payable, and accrued liabilities. The Company considers the carrying amount of working capital items to approximate the fair value for these financial instruments because of the relatively short period of time between origination of the instruments and their expected realization.

Research and Development and Software Development Costs

Research and development expenses consist primarily of salaries, payroll taxes, benefits, and related expenditures for technology, software development, project management, and support personnel. Costs related to the research and development of new products, services and enhancements to existing products are expensed as provided for by ASC 985-20 “Costs of Software to be Sold, Leased, or Marketed” (ASC 985-20). Under ASC 985-20, costs incurred in the research and development of new software products are expensed as incurred until technological feasibility is established. Research and development costs are capitalized beginning when a product’s technological feasibility has been established and ending when the product is available for general release to customers. Technological feasibility is reached when the product reaches the working model stage. To date, products and enhancements have generally reached technological feasibility and have been released for sale at substantially the same time and all research and development costs have been expensed.

ASC 350-40 “Internal-Use Software” (ASC 350-40), which applies to SaaS business model, are met for the capitalization of software development cost.  Under ASC 350-40, software development costs, including costs incurred to purchase third party software, are capitalized beginning when the Company has determined certain factors are present, including, among others, that technology exists to achieve the performance requirements, buy versus internal development decisions have been made, and the Company’s management has authorized the funding for the project. Capitalization of software development costs ceases when the software is substantially complete and is ready for its intended use.  To date, no software development costs incurred have met the criteria set forth in ASC 350-40 for capitalization.

Revenue Recognition

Etelos distributes Web Applications and it Marketplace Platform as a subscription service using the SaaS or software-on-demand business model and allow third parties to offer their products or services through storefronts in an Etelos Marketplace, and to advertise on its web site or in its magazine for a fee.  It also license certain of its software products under perpetual and term licenses.  Revenues are recognized on these service and licensing transactions using the criteria in ASC 605-10, “Revenue Recognition”, (ASC 605-10) and ASC 985-605, “Software Revenue Recognition” (ASC 985-605), respectively, which both provide that revenue may be recognized when all of the following are met:

·                                          persuasive evidence of an arrangement exists,

·                                          the product or service has been delivered,

·                                          the fee is fixed or determinable, and

·                                          collection of the resulting receivable is reasonably assured or probable.

For the SaaS business model, persuasive evidence is generally an acceptance by the customer of a binding agreement and authorization by the customer to charge a credit card; delivery generally occurs over the term of the subscription agreement related to the SaaS; and the fee is fixed and collection reasonably assured when the customer’s credit card is charged.  Accordingly, revenue is recognized over the period the SaaS is provided.

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For software licensed under term or perpetual agreements, persuasive evidence of an arrangement is evidenced by a binding agreement signed by the customer and delivery generally occurs upon delivery of the software to a common carrier. If a significant portion of a fee is due after our normal payment terms of typically 30 days, then we recognize revenue as the fees become due. If the Company determines that collection of a fee is not reasonably assured, then it defers the fees and recognizes revenue upon cash receipt, provided that all other revenue recognition criteria are met.

Advertising on the Company’s web site is recognized as revenue over the period the advertisement appears on its web site and advertising presented in its magazine is recognized upon publication of the magazine provided the other criteria for revenue recognition set forth above have been met.

Arrangements for which the fees are not deemed reasonably assured for collection are recognized upon cash collection.

Stock Based Compensation

The Company, under ASC 718-10, “Compensation — Stock Compensation” (ASC 718-10) is applying the “modified prospective method” and used the Black-Scholes Merton model to value all new stock based compensation awards granted starting January 1, 2007, and for any modification, cancellation, or repurchase of awards granted prior to January 1, 2007.  As a result, the Company has recorded compensation cost in the statement of operations based on the fair value of the award for the requisite service period. ASC 718-10 also requires the Company to estimate forfeitures in calculating the expense relating to share-based compensation as opposed to only recognizing these forfeitures and the corresponding reduction in expense as they occur. This resulted in $106 thousand and $73 thousand of expense for the nine months ended September 30, 2009 and 2008, respectively.

ASC 718-10 requires the cash flows resulting from the tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options to be classified as financing cash flows. Due to its loss position, there were no such tax benefits during the nine months ended September 30, 2009 and 2008. Prior to the adoption of ASC 718-10, those benefits would have been reported as operating cash flows had we received any tax benefits related to stock option exercises.

Income Taxes

The Company accounts for income taxes in accordance with ASC 740-10, “Income Taxes” (ASC 740-10) which utilizes the liability method of accounting for income taxes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amount of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized.

The Company has adopted the provisions of ASC 740-10-25, “Income Taxes — Overall — Recognition” (ASC 740-10-25). The Company did not have any unrecognized tax benefits and there was no effect on its financial condition or results of operations as a result of implementing ASC 740-10-25.

The Company files income tax returns in the United States of America federal jurisdiction and various state jurisdictions in the United States of America.  The Company does not believe that there will be any material changes in its unrecognized tax positions over the next twelve months.  The Company believes that its income tax filing positions and deductions would be sustained on audit and does not anticipate any adjustments that will result in a material adverse effect on the Company’s financial position, results of operations, or cash flow.  Therefore, no reserves for uncertain income tax positions have been recorded pursuant to ASC 740-10-25.  In addition, the Company did not record a cumulative effect adjustment related to the adoption of ASC 740-10-25.

The Company’s policy is to recognize interest and penalties accrued on any unrecognized tax benefits as a component of income tax expense.  As of the date of the adoption of ASC 740-10-25, the Company did not have any accrued interest or penalties associated with any unrecognized tax benefits, nor was any such interest expense recognized during the nine months ended September 30, 2009 and 2008, or the year ended December 31, 2008.  The Company’s effective tax rate differs from the federal statutory rate primarily due to increases in its deferred income tax valuation allowance.

Net Income (Loss) per Share

Basic net income (loss) per share is computed by dividing the net loss available to common stockholders for the period by the weighted average number of shares of common stock outstanding during the period, excluding any unvested restricted stock that is subject to repurchase. Diluted net income per share is computed using the weighted average number of common shares and, if dilutive, potential common shares outstanding during the period. Potential common shares consist of unvested restricted stock (using

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the treasury stock method), the incremental common shares issuable upon the exercise of stock options and warrants (using the treasury stock method) and the conversion of the Company’s convertible notes and debentures (using the if-converted method).  As their effect is antidilutive, 108,731 and 4,480,911 shares of common stock exercisable under outstanding employee stock options, 9,864,444 and 611,111 shares of common stock exercisable under outstanding warrants, 11,191,424 and 6,426,074 shares of common stock issuable upon conversion of the outstanding convertible notes payable and debentures, as of, and for the nine months ended September 30, 2009 and 2008, respectively, have been excluded from this calculation.  The average exercise price of outstanding employee stock options to purchase the Company’s common stock is $0.22 and $0.23, respectively, at September 30, 2009 and 2008. The average exercise price of outstanding warrants to purchase the Company’s common stock is $0.45 and $1.80, respectively, at September 30, 2009 and 2008.

The following table sets forth the computation of basic and diluted net loss per share for the periods presented (in thousands, except per share amounts):

Use of Estimates

The preparation of the financial statements in conformity with accounting principles generally accepted in the United States of America 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 reporting period. Actual results could differ from those estimates.

Segment Reporting

The Company has one operating segment because the Company is not organized into multiple segments for the purpose of making operating decisions or for assessing performance. The chief operating decision maker evaluates performance, makes operating decisions, and allocates resources based on financial data consistent with the presentation in the accompanying financial statements.

4. Going Concern

The financial statements have been prepared with the assumption that the Company will continue as a going concern.  The Company has experienced net losses of $4.7 million and $22.2 million for the nine months ended September 30, 2009 and 2008, respectively, and has a total stockholders’ deficit of $11.9 million and $10.8 million, as of September 30, 2009, and December 31, 2008, respectively, all of which raise substantial doubt about its ability to continue as a going concern. The financial statements do not include any adjustments relating to the recoverability and classification of asset carrying amounts or the amount and classification of liabilities that might arise should it be unable to continue as a going concern.

Management has supported current operations by raising additional operating cash through the private sale of convertible debentures and notes payable and preferred stock. This has provided the cash inflows to continue the Company’s business plan, but has not resulted in significant improvement in its financial position or results of operations.  Management also has substantially reduced

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operating expenses by termination of employees and other reductions in operating expenses.  Alternatives being pursued to improve the Company’s cash flow used in operations include (1) raising additional working capital through additional sale of preferred stock, common stock and/or debt and (2) reducing cash operating expenses to levels that are in line with current revenues.  The first alternative could result in substantial dilution to existing shareholders. There can be no assurance that the Company’s current financial position can be improved, that it can raise additional working capital, or that it can achieve positive cash flows from operations. The Company’s long-term viability as a going concern is dependent upon its ability to (1) locate sources of debt or equity funding to meet current commitments and near-term future working capital requirements and (2) achieve profitability and ultimately generate sufficient cash flow from operations to sustain its continuing operations.

The Company’s cash balance including proceeds from its recent debt financings and preferred stock financing may not be sufficient to fund operations beyond June 2010.  If cash reserves are not sufficient to sustain operations, then management plans to further reduce operating expenses and/or raise additional capital by selling shares of capital stock or other securities that could result in substantial dilution to existing shareholders.  However, there are no commitments or arrangements for future financings in place at this time and the Company can give no assurance that such capital will be available on favorable terms, or at all.  The Company may need additional financing thereafter until it can achieve profitability.  If it cannot, then it will be forced to further curtail operations or possibly be forced to evaluate a sale or liquidation of assets.  Even if it is successful in raising additional funds, there is no assurance regarding the terms of any additional investment.

On September 30, 2009, the Company issued convertible debentures (the “10% Senior Secured Debentures”) with a principal amount of $2.0 million, warrants to purchase 5,250,000 shares of the Company’s common stock, and 750,000 shares of common stock in exchange for $0.8 million in cash and the cancellation of $1.2 million in promissory notes and accrued interest.  Seventy-five percent of the 10% Senior Secured Debentures are held by Enable Capital Management LLC or its affiliates (“Enable Capital”).  Enable Capital beneficially owns more than 10% of the Company’s common stock. Under the terms of the securities purchase agreement pursuant to which the 10% Senior Secured Debentures were issued, subject to the satisfaction of certain covenants and conditions, the Company has the right, at any time after December 15, 2009 and before January 15, 2010, to require the purchasers of the 10% Senior Secured Debentures to purchase an aggregate of $1.0 million in additional principal amount of 10% Senior Secured Debentures.  At September 30, 2009, the purchasers of the 10% Senior Secured Debentures executed and delivered all documents in the transaction except for funding of $500,000 which was paid in full subsequent to the period end. The $500,000 of funding was recorded as an Other Receivable in the accompanying condensed balance sheet as of September 30, 2009.

5.  Recently Issued Accounting Standards

In October 2009, the FASB issued new accounting guidance related to the revenue recognition of multiple element arrangements. The new guidance states that if vendor specific objective evidence or third party evidence for deliverables in an arrangement cannot be determined, companies will be required to develop a best estimate of the selling price to separate deliverables and allocate arrangement consideration using the relative selling price method. The accounting guidance will be applied prospectively and will become effective for the Company during the first quarter of fiscal 2011. Early adoption is allowed. The Company is currently evaluating the impact of this accounting guidance on its financial statements.

6. Convertible Notes and Debentures and Embedded Derivative and Warrant Liability

Convertible notes and debentures comprise (in thousands):

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6% Convertible Notes

During the period August 2007 to October 2007, the Company issued 6% convertible notes (the “6% Convertible Notes”) with a face value of $3,326 thousand at an original issue discount of 10 percent with detachable warrants to purchase shares of its common stock in exchange for $3,024 thousand.  These notes matured on March 31, 2009, with interest due and payable on February 1, 2008, and on the last day of each calendar quarter thereafter. The Company was required to make payments on the outstanding principal balance beginning September 1, 2008, and on the 1st day of each calendar quarter thereafter. The default interest rate was 8 percent. The notes and unpaid interest are convertible into shares of the Company’s common stock at the option of the holder or involuntarily upon the occurrence of certain financing events. As of December 31, 2008, and September 30, 2009, $1,562 thousand of the face value of the 6% Convertible Notes had been converted to 2,083 thousand shares of the Company’s common stock and $1,764 thousand remain outstanding. The Company failed to make required interest and principal payments as of December 31, 2008, and through September 30, 2009. Accordingly, the Company was and remains in default under the terms of the notes, which resulted in all principal and interest related to the notes becoming due and payable to the holders. As a result, the Company classified all amounts due related to the 6% Convertible Notes as current liabilities as at December 31, 2008, and September 30, 2009.

In addition, the purchasers of the 6% Convertible Notes received warrants to purchase 1,080,000 shares of the Company’s common stock at an exercise price of $0.12. At December 31, 2008, all of these warrants had been exercised or expired and none are outstanding.

January 2008 Debentures — Prior to Restructuring on June 30, 2009 (see below)

On January 31, 2008, the Company issued convertible debentures (the “January 2008 Debentures”) with a principal amount of $2 million and detachable warrants to purchase 222,222 shares of its common stock in exchange for $1.9 million.  The January 2008 Debentures are all held by Enable Capital. Enable Capital beneficially owns more than 10% of the Company’s common stock.  The January 2008 Debentures are due on January 31, 2010, and bear interest at 6 percent per annum payable semiannually on January 1 and July 1, commencing July 1, 2008.  Monthly principal payments equal to 1/18th of the principal amount were to begin on September 1, 2008.  The Company had the right to pay interest and monthly principal payments in cash, or upon notice to the holders and compliance with certain equity conditions, it can pay all or a portion of any such payment in common stock valued at a price equal to the lesser of the then effective conversion price or 85 percent of the average of the volume weighted average price per share for its common stock for the 10 consecutive trading days immediately prior to the applicable payment date.  The equity conditions that it must meet include having a currently effective registration statement covering the shares of common stock issuable upon conversion of the debenture, and having the daily dollar trading volume for its common stock exceed $250,000 for each of the 20 consecutive trading days before the date in question.  The January 2008 Debentures and any accrued interest are convertible at anytime at the discretion of the holder at a conversion price per share of $1.35, subject to a cap on the beneficial ownership of its shares of common stock by the holder and its affiliates following such conversion. The conversion price is adjusted upon a stock split, reverse stock split, or upon issuance of stock dividends, whereby the conversion price would be adjusted to ensure that the holder would be receiving the same number of shares, as though the conversion right had been exercised prior to the triggering event.  Further, the conversion price is adjusted if common stock or equivalents are subsequently sold or re-priced at a price below the conversion price or rights, options or warrants are issued to holders of its common stock entitling them to purchase common stock at prices lower than the volume weighted average price on the date issued.

The Company has the option to redeem the January 2008 Debentures before their maturity by payment in cash of an amount equal to 120 percent of the then outstanding principal amount, plus accrued interest and other charges, and the right to force conversion of the debentures if the average of the volume weighted average price of its common stock exceeds $3.39 for 20 trading days out of a consecutive 30 trading day period.  This redemption option and forced conversion right are subject to the Company meeting certain equity conditions, including having the daily dollar trading volume for its common stock exceed $250 thousand for each of the 20 consecutive trading days before the date in question and having a currently effective registration statement covering the shares of common stock issuable upon conversion of the debentures and the forced conversion option, subject to the applicable cap on the beneficial ownership of its shares of common stock by the holder and its affiliates following such conversion.  The January 2008 Debentures are collateralized by substantially all the assets of the Company.

The January 2008 Debentures impose certain covenants on the Company, including restrictions against incurring additional indebtedness, creating any liens on its property, amending its certificate of incorporation or bylaws, redeeming or paying dividends on shares of our outstanding common stock, and entering into certain related party transactions.  The January 2008 Debentures also define certain events of default, including, without limitation, failure to make a payment obligation, failure to observe other covenants of the debenture or related agreements (subject to applicable cure periods), breach of representation or warranty, bankruptcy, default under another significant contract or credit obligation, delisting of its common stock, a change in control, failure to secure and maintain an effective registration statement covering the resale of the common stock underlying the debentures and the warrants, or failure to deliver share certificates in a timely manner.  In the event of default, the holders of the January 2008 Debentures have the

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right to accelerate all amounts outstanding under the debentures and demand payment of a mandatory default amount equal to 130 percent of the amount outstanding plus accrued interest and expenses. The Company failed to make required interest and principal payments on the January 2008 Debentures beginning with the payment due on September 30, 2008 and through June 30, 2009. Accordingly, the Company is in default under the terms of the January 2008 Debentures, and the holders have the right to demand that the default amount equal to 130% of the amount outstanding plus accrued interest be paid to the holders. As of December 31, 2008 and June 30, 2009, the Company classified all amounts due related to the January 2008 Debentures as current liabilities, and the holders had not elected to exercise their rights arising from the Company’s default.

The detachable warrants, which are fully exercisable, to purchase 222,222 shares of our common stock, expire in January 2011 and are exercisable at a price of $1.80 per share, subject to adjustment.  As of September 30, 2009, none of these warrants had been exercised.

Restructuring of January 2008 Debentures

On June 30, 2009, the Company executed an agreement to restructure the January 2008 Debentures. Under the terms of the agreement, the maturity of the debentures was extended to December 31, 2012; the outstanding interest as of June 30, 2009, and interest that would have been earned under the original terms of the Debentures was added to principal as of June 30, 2009; the interest rate was reduced to 0% until September 30, 2010; the monthly amortizing redemption payment schedule was eliminated and replaced with a requirement to pay interest only on a semi-annual basis beginning January 1, 2011, and to pay principal at maturity; the option to make principal and interest payments in shares of common stock instead of cash was removed; the anti-dilution provisions were modified so that the conversion price cannot be reduced below $0.10 as a result of subsequent equity sales; the registration rights agreement entered into in conjunction with the debentures was terminated; the optional redemption amount was reduced to 100% of the then outstanding principal amount plus accrued but unpaid interest and plus all liquidated damages and other amounts due; and all past defaults were waived. Additionally, the warrants issued in conjunction with the debentures were modified so that the warrant may be exchanged for a share of common stock on a 1:1 basis, and were modified to eliminate the anti-dilution provisions afforded for subsequent equity sales at a price lower than the original conversion price. No direct fees were either charged by or received from the debenture holders for the restructuring.

The Company evaluated the restructuring of the January 2008 Debentures, under the guidance in ASC 470-50 “Debt — Modifications and Extinguishments” (ASC 470-50) as of June 30, 2009. The Company concluded that the restructuring of the January 2008 Debentures met the definition of an extinguishment of debt as the terms of the modified debentures were substantially different from the original terms. Accordingly, the Company recorded the difference between the fair value and carrying value of the January 2008 Debentures as a loss on extinguishment of debt of $300 thousand in earnings for the six months ended June 30, 2009.

Additionally, as part of the restructuring of the January 2008 Debentures, the outstanding accrued interest of $170 thousand as of June 30, 2009, was reclassified to outstanding principal, and the interest that was to have been earned under the original terms of the debentures from July 1, 2009, through September 30, 2010, of $150 thousand was recorded as an increase to outstanding principal with the corresponding debit amount being recorded as Accreting Interest on Convertible Notes Payable. This interest amount will be accreted to earnings over the revised maturity date of the January 2008 Debentures using the effective interest method.

The Company recorded a debt premium of $300 thousand related to the difference between the fair value and the revised principal amount of the January 2008 Debentures, along with the increase in the fair value of the embedded conversion option of $50 thousand as a debt discount, and debt issuance costs related to fees incurred by the Company from service providers related to the restructuring of the January 2008 Debentures of $9 thousand were capitalized as Debt Issuance Costs. These items will be accreted or amortized to earnings over the revised maturity date of the January 2008 Debentures using the effective interest method.

April 2008 Debentures — Prior to Restructuring on June 30, 2009 (see below)

On April 22, 2008, the Company issued convertible debentures (the “April 2008 Debentures”) with a principal amount of $3.5 million and detachable warrants to purchase 388,889 shares of our common stock in exchange for $3.4 million.  The April 2008 Debentures are all held by Enable Capital.  Enable Capital beneficially owns more than 10% of the Company’s common stock.  The April 2008 Debentures are due on April 30, 2010, and have identical terms and conditions to the January 2008 Debentures described above. The Company failed to make required interest and principal payments on the April 2008 Debentures beginning with the payment due on September 30, 2008, and through June 30, 2009. Accordingly, the Company is in default under the terms of the April 2008 Debentures, and the holders have the right to demand that the default amount equal to 130% of the amount outstanding plus accrued interest be paid to the holders. As of December 31, 2008 and June 30, 2009, the Company classified all amounts due related to the April 2008 Debentures as current liabilities, and the holders had not elected to exercise their rights arising from the Company’s default.

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The detachable warrants, which are fully exercisable, to purchase 388,889 shares of our common stock, expire in April 2011 and are exercisable at a price of $1.80 per share, subject to adjustment.  As of September 30, 2009, none of these warrants had been exercised.

In connection with the January 2008 Debentures and the April 2008 Debentures, the Company also entered into a registration rights agreement with the investors, pursuant to which it agreed to file a registration statement covering the resale of the shares of common stock that may be issued to such investors upon the conversion of the debentures, payment in kind, and the exercise of the related warrants.  The Company agreed to maintain the effectiveness of the registration statement (subject to certain limitations) for a period of time until the holders can sell the underlying common stock without volume restrictions under Rule 144 of the Securities Act of 1933, or the Securities Act. If the registration statement is not declared effective by an agreed to date, or if the Company fail to maintain the effectiveness of the registration statement, then the Company is required to pay to each investor, as partial liquidated damages, cash equal to 1.0 percent of the aggregate purchase price paid by such investor for the securities purchased in the financing and then held by such investor, and must pay to such investor 1 percent for each subsequent 30-day period that the default remains uncured, up to a maximum aggregate liquidated damages amount of 10 percent of the aggregate purchase price paid by the holders of the debentures.

The Company’s registration statement was effective July 31, 2008, which was eight days after the deadline in the registration rights agreements. However, the penalties for this delay were waived in the agreement to restructure the January 2008 and April 2008 Debentures on June 30, 2009.

Restructuring of January 2008 and April 2008 Debentures

On June 30, 2009, the Company executed an agreement to restructure the January 2008 and April 2008 Debentures. Under the terms of the agreement, the maturity of these debentures was extended to December 31, 2012; the outstanding interest as of June 30, 2009, and interest that would have been earned under the original terms of the debentures was added to principal as of June 30, 2009; the interest rate was reduced to 0% until September 30, 2010; the monthly amortizing redemption payment schedule was eliminated and replaced with a requirement to pay interest only on a semi-annual basis beginning January 1, 2011, and to pay principal at maturity; the option to make principal and interest payments in shares of common stock instead of cash was removed; the anti-dilution provisions were modified so that the conversion price cannot be reduced below $0.10 as a result of subsequent equity sales; the registration rights agreement entered into in conjunction with these debentures was terminated; the optional redemption amount was reduced to 100% of the then outstanding principal amount plus accrued but unpaid interest and plus all liquidated damages and other amounts due; and all past defaults were waived. Additionally, the warrants issued in conjunction with these debentures were modified so that the warrant may be exchanged for a share of common stock on a 1:1 basis, and were modified to eliminate the anti-dilution provisions afforded for subsequent equity sales at a price lower than the original exercise price. No direct fees were either charged by or received from the debenture holders for the restructuring.

The Company evaluated the restructuring of these debentures under the guidance of ASC 470-50 “Debt — Modifications and Extinguishments” (ASC 470-50) as of June 30, 2009.  The Company concluded that the restructuring of the January 2008 Debentures met the definition of an extinguishment of debt, as the terms of the modified debentures were substantially different from the original terms.  Accordingly, the Company recorded the difference between the fair value and carrying value of the January 2008 Debentures as a loss on extinguishment of debt of $300 thousand in earnings for the six months ended June 30, 2009.

The Company concluded that the restructuring of the April 2008 Debentures did not meet the definition of an extinguishment of debt as the terms of the modified debentures were not substantially different from the original terms. However, as the April 2008 Debentures included an embedded conversion feature, the Company is required to account for any increase in the fair value of the embedded conversion option immediately prior to and immediately after the transaction as a debt discount with the credit being recorded as additional paid in capital. Accordingly, the Company recorded the increase in the fair value of the embedded conversion option of $80 thousand as a debt discount that will be amortized over the revised maturity date of the April 2008 Debentures using the effective interest method.

The Company recorded a debt premium of $300 thousand related to the difference between the fair value and the revised principal amount of the January 2008 Debentures, along with the increase in the fair value of the embedded conversion option of $50 thousand as a debt discount, and debt issuance costs related to fees incurred by the Company from service providers related to the restructuring of the January 2008 Debentures of $9 thousand were capitalized as Debt Issuance Costs. These items will be accreted or amortized to earnings over the revised maturity date of the January 2008 Debentures using the effective interest method.

Additionally, as part of the restructuring of the April 2008 Debentures, the outstanding accrued interest of $420 thousand as of June 30, 2009, was reclassified to outstanding principal, and the aggregate interest that would have accrued under the original terms of the debentures from July 1, 2009, through September 30, 2010, of $413 thousand was recorded as an increase to outstanding principal with the corresponding debit amount being recorded as Accreting Interest on Convertible Notes Payable. This interest amount will be accreted to earnings over the revised maturity date of these Debentures using the effective interest method.

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10% Senior Secured Debentures

On September 30, 2009, the Company issued 10% Senior Secured Debentures with a principal amount of $2.0 million, warrants to purchase 5,250,000 shares of our common stock, and 750,000 shares of our common stock in exchange for $0.8 million in cash and the cancellation of $1.2 million in promissory notes and accrued interest.  Seventy-five percent of the 10% Senior Secured Debentures are held by Enable Capital.  Enable Capital beneficially owns more than 10% of the Company’s common stock.  The 10% Senior Secured Debentures are due on September 30, 2011, and bear interest at 10 percent per annum payable quarterly on January 1, April 1, July 1, and October 1, commencing January 1, 2010.  The principal amount is due on maturity.  The 10% Senior Secured Debentures are convertible at anytime at the discretion of the holder at a conversion price per share of $0.50, subject to a cap on the beneficial ownership of its shares of common stock by the holders and their affiliates following such conversion. The conversion price is adjusted upon a stock split, reverse stock split, or upon issuance of stock dividends, whereby the conversion price would be adjusted to ensure that the holder would be receiving the same number of shares, as though the conversion right had been exercised prior to the triggering event.  Further, the conversion price is adjusted if common stock or equivalents are subsequently sold or re-priced at a price below the conversion price, or rights, options or warrants are issued to holders of its common stock entitling them to purchase common stock at prices lower than the volume weighted average price on the date issued, with a floor for the conversion price of $0.10 per share.

The Company has the option to redeem the 10% Senior Secured Debentures before their maturity by payment in cash of an amount equal to 100 percent of the then outstanding principal amount, plus outstanding accrued interest and other charges, and all interest that would have accrued if the outstanding principal amount had remained outstanding through maturity.  This redemption option is subject to the Company meeting certain equity conditions, including having the daily dollar trading volume for its common stock exceed $250 thousand for each of the 20 consecutive trading days before the date in question and having a currently effective registration statement covering the shares of common stock issuable upon conversion of the debentures, subject to the applicable cap on the beneficial ownership of its shares of common stock by the holders and their affiliates following such conversion.  The 10% Senior Secured Debentures are collateralized by substantially all the assets of the Company.

The 10% Senior Secured Debentures impose certain covenants on the Company, including restrictions against incurring additional indebtedness, creating any liens on its property, amending its certificate of incorporation or bylaws, redeeming or paying dividends on shares of our outstanding common stock, and entering into certain related party transactions.  The 10% Senior Secured Debentures also define certain events of default, including, without limitation, failure to make a payment obligation, failure to observe other covenants of the debenture or related agreements (subject to applicable cure periods), breach of representation or warranty, bankruptcy, default under another significant contract or credit obligation, delisting of its common stock, a change in control, failure to secure and maintain an effective registration statement covering the resale of the common stock underlying the debentures and the warrants, or failure to deliver share certificates in a timely manner.  In the event of default, the holders of the 10% Senior Secured Debentures have the right to accelerate all amounts outstanding under the debentures and demand payment of a mandatory default amount equal to the greater of (i) the outstanding principal amount plus all accrued and unpaid interest divided by the conversion price multiplied by the volume weighted average price or (ii) 120 percent of the amount outstanding, plus accrued interest and expenses, and all interest that would have accrued if the then outstanding principal amount had remained outstanding through maturity. Additionally the mandatory default amount would also include all other amounts, costs, expenses and liquidated damages due in respect of the debentures.

The detachable warrants, which are fully exercisable, to purchase 3,000,000 and 2,250,000 shares of our common stock, expire in September 2014 and September 2016, respectively, and are exercisable at a price of $0.60 and $0.01 per share, respectively, subject to adjustment.  The warrants may be exchanged for a share of common stock on a 1:1 basis, and the warrants that expire in September 2014 include a floor on the exercise price of $0.10 per share.  As of September 30, 2009, none of these warrants had been exercised.

As part of the issuance of the 10% Senior Secured Debentures, the Company exchanged existing promissory notes with an aggregate principal amount of $1,150 thousand, including the $250 thousand promissory note issued in July 2009, for a like portion of 10% Senior Secured Debentures. The Company evaluated the restructuring of these promissory notes under the guidance in ASC 470-50 “Debt — Modifications and Extinguishments” (ASC 470-50) as of September 30, 2009. The Company concluded that the restructuring of the various promissory notes met the definition of an extinguishment of debt as the terms of the 10% Senior Secured Debentures were substantially different from the original terms of the promissory notes due to the insertion of a conversion feature. Accordingly, the Company recorded the difference between the fair value of the 10% Senior Secured Debentures and carrying value of the promissory notes as a loss on extinguishment of debt of $288 thousand in earnings for the nine months ended September 30, 2009, including the remaining unamortized debt discount recorded on the July 2009 promissory note of $68 thousand.

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The Company recorded a debt premium of $220 thousand related to the difference between the fair value and the principal amount of the 10% Senior Secured Debentures, and debt issuance costs related to fees incurred by the Company of $25 thousand were capitalized as Debt Issuance Costs. Additionally, the Company recognized a further debt discount due to a beneficial conversion feature on the issuance of the 10% Senior Secured Debentures of $776 thousand.  These items will be accreted or amortized to earnings over the maturity date of the 10% Senior Secured Debentures using the interest method.

At September 30, 2009, the purchasers of the 10% Senior Secured Debentures executed and delivered all documents in the transaction except for funding of $500,000 which was paid subsequent to the end of the period. The $500,000 of funding was recorded as an Other Receivable in the accompanying condensed balance sheet as of September 30, 2009.

Embedded Derivatives

The Company has evaluated the embedded derivatives included in the 6% Convertible Notes, the January 2008 and April 2008 Debentures, and the 10% Senior Secured Debentures, consisting of the conversion features and certain put and call features described above, under the guidance in ASC 815-10 “Derivatives and Hedging” (ASC 815-10) on the issuance date of the Convertible Notes, the January 2008 and April 2008 Debentures, and the 10% Senior Secured Debentures, and on each subsequent reporting date.  The purpose of the evaluation is to determine whether the embedded derivatives need to be bifurcated from the debt host and accounted for as a derivative at their estimated fair value as a liability at the date of issuance and thereafter, adjusted to estimated fair value with a charge or credit to the Company’s statement of operations.  ASC 815-10 generally indicates that if the conversion features are (i) indexed to the Company’s capital stock under the guidance in ASC 815-40-15, “Derivatives and Hedging — Contracts in Entity’s Own Equity — Scope and Scope Exceptions” (ASC 815-40-15), and (ii) would be classified as equity if a freestanding derivative under the guidance in ASC 815-40-25 “Derivatives and Hedging — Contracts in Entity’s Own Equity — Recognition” (ASC 815-40-25) then the embedded derivatives need not be bifurcated from the debt host.  ASC 815-40-25 generally requires, among other factors, that (i) the Company can settle the derivative in cash or its own stock, at its option, (ii) settlement can be made in unregistered shares, and (iii) the Company has sufficient authorized shares to issue shares of its common stock for all equity instruments convertible to or which can be exercised for its capital stock.  ASC 815-10 also provides guidance on when put and call features included in a debt host agreement are not clearly and closely related to the debt host must be bifurcated and recorded as a liability.  The January 2008 and April 2008 Debentures, and the 10% Senior Secured Debentures include put and call features.

Embedded Derivatives — 6% Convertible Notes

Prior to the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the conversion features embedded in the 6% Convertible Notes met the criteria in ASC 815-10 at issuance and through April 21, 2008, the day prior to the merger with Tripath, because the conversion to the Company’s common stock could only be settled in its capital stock, the capital stock could be unregistered and the sufficiency of the authorized shares was under the Company’s control as it could control the outcome of a shareholder vote to increase the authorized shares.  However, on the date of the merger with Tripath, April 22, 2008, the Company concluded it no longer had control to ensure the sufficiency of its authorized shares of common stock and recorded the conversion features embedded in the 6% Convertible Notes with an estimated fair value of $3,674 thousand and recorded the amount as Warrant and Derivative Liability. At December 31, 2008, and June 30, 2009, the estimated fair value of the conversion features was subsequently revalued to $2 thousand and $0 thousand, with the related credit of $3,672 and $2 thousand included in the Company’s statement of operations in interest expense for the year ended December 31, 2008, and the six months ended June 30, 2009, respectively. The Company determined the estimated fair value of the conversion features on April 22 and December 31, 2008, and June 30, 2009, by using the Black-Scholes Merton valuation model and the following assumptions: fair value of the Company’s common stock of $2.91, $0.33, and $0.36, respectively, per share; terms of 0.95, 0.25, and 0 years, respectively; risk free interest rates of 1.82%, 0.11% and 0.0%, respectively; and volatility of 47.16%, 73.59%, and 0.0%, respectively. Probabilities were then applied to the outputs using the Matlab Monte Carlo Simulation of the Company’s stock prices to arrive at a value for the conversion options.

Upon the restructuring of the Company’s January and April Debentures on June 30, 2009, the Company concluded that the conversion features embedded in the 6% Convertible Notes met the criteria in ASC 815-10 to be accounted for as an equity instrument because the Company had control to ensure the sufficiency of its authorized shares of common stock, as the modified anti-dilution provisions relating to the January 2008 and April 2008 Debentures include a floor on the conversion price adjustment as a result of any subsequent equity sales. Due to the change in classification from liability to equity, the Company recorded a reclassification of the fair value as of June 30, 2009 to additional paid in capital of $0 thousand. As of September 30, 2009, the Company continues to conclude that the conversion features embedded in the 6% Convertible Notes meet the criteria in ASC 815-10 to be accounted for as an equity instrument.

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Embedded Derivatives — January 2008 and April 2008 Debentures

Prior to the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the conversion features embedded in the January 2008 Debentures met the criteria in ASC 815-10 at issuance and through April 21, 2008, the day prior to the merger with Tripath, and therefore, were not bifurcated from the debt host because the conversion to the Company’s common stock could only be settled in its common stock, the common stock could be unregistered and the sufficiency of the authorized shares was under the Company’s control as it could control the outcome of a shareholder vote to increase the authorized shares.  However, on the date of the merger with Tripath, April 22, 2008, the Company concluded it no longer had control to ensure the sufficiency of its authorized shares of common stock nor could it settle the conversion feature in unregistered shares. Therefore, the Company recorded the conversion features embedded in the January 2008 Debentures with an estimated fair value of $896 thousand and recorded the amount as Warrant and Derivative Liability.  At December 31, 2008, and June 30, 2009, the estimated fair value of the conversion feature was subsequently revalued to $5 thousand and $2 thousand, respectively, with the related credit of $891 thousand and $3 thousand included in the Company’s statement of operations in interest expense for the year ended December 31, 2008, and the six months ended June 30, 2009. The Company determined the estimated fair value of the conversion options on April 22 and December 31, 2008, and June 30, 2009, using the Black-Scholes Merton valuation model and the following assumptions: fair value of the Company’s common stock of $2.91, $0.33, and $0.36, respectively, per share; terms of 1.75 years, 1.08 years, and 0.58 years, respectively; risk free interest rates of 1.84%, 0.40%, and 0.39%, respectively; and volatility of 47.16% 65.48%, and 48.84%, respectively.  Probabilities were then applied to the outputs using the Matlab Monte Carlo Simulation of the Company’s stock prices to arrive at a value for the conversion options.

Prior to the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the conversion features embedded in the April 2008 Debentures should be bifurcated from the debt host and recorded as liabilities because the conversion features must be settled in registered shares and that due to the Merger with Tripath the Company no longer had control over a shareholder vote to ensure the sufficiency of its authorized shares of common stock. The estimated fair value of the embedded conversion features was $1,507 thousand at April 22, 2008, and recorded in the line entitled “Warrant and derivative liability” in the accompanying Balance Sheet. At December 31, 2008, and June 30, 2009, the estimated fair value of the embedded conversion features was subsequently revalued to $10 thousand and $2 thousand, respectively, with the related credit of $1,497 thousand and $8 thousand included in the Company’s statement of operations in interest expense for the year ended December 31, 2008, and the six months ended June 30, 2009, respectively. The Company determined the estimated fair value of the conversion options on April 22 and December 31, 2008, and June 30, 2009, using the Black-Scholes Merton valuation model and the following assumptions: fair value of the Company’s common stock of $2.91, $0.33, and $0.36, respectively, per share; terms of 2, 1.33, and 0.83 years, respectively; risk free interest rates of 1.87%, 2.24%, and 0.49%, respectively; and volatility of 49.00%, 61.48%, and 58.72%, respectively.  Probabilities were then applied to the outputs using the Matlab Monte Carlo Simulation of the Company’s stock prices to arrive at a value for the conversion options.

Upon the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the conversion features embedded in the January 2008 and April 2008 Debentures met the criteria in ASC 815-10 to be accounted for as an equity instrument because the Company had control to ensure the sufficiency of its authorized shares of common stock, as the modified anti-dilution provisions relating to the January 2008 and April 2008 Debentures include a floor on the conversion price adjustment as a result of any subsequent equity sales, and because the conversion features no longer are required to be settled in registered shares. Due to the change in classification from liability to equity, the Company recorded a reclassification of the fair value of the conversion features embedded in the January 2008 and April 2008 Debentures as of June 30, 2009, to additional paid in capital of $0 thousand and $2 thousand, respectively. As of September 30, 2009, the Company continues to conclude that the conversion features embedded in the 6% Convertible Notes meet the criteria in ASC 815-10 to be accounted for as an equity instrument.

The Company also concluded that the put and call in the January 2008 and April 2008 Debentures were embedded derivatives that were not clearly and closely related to the debt host and therefore should be bifurcated from the debt host along with the conversion features and recorded as a liability at their estimated fair value at issuance.  The Company determined the net fair value of the put and call embedded in the January 2008 and April 2008 Debentures on April 22 and December 31, 2008 to be de minimus.

As of September 30, 2009, the Company concluded that the put and call features embedded in the January 2008 and April 2008 Debentures continue to be not clearly and closely related to the debt host and therefore should be bifurcated from the debt host and recorded as a liability at their estimated fair value. The Company determined the net fair value of the put and call to be $91 thousand and $157 thousand for the January 2008 and April 2008 Debentures, respectively, with the related debit of $91 thousand and $157 thousand, respectively, included in the Company’s statement of operations in interest expense for the nine months ended September 30, 2009. The Company determined the estimated fair value of the put on September 30, 2009, using the Black-Scholes Merton valuation model and the following assumptions: fair value and exercise price of the put embedded in the January 2008 and April 2008 Debentures equivalent to 130% of the outstanding principal and accrued interest of $3,015,858 and $5,216,312, respectively; term of 3.25 years to the maturity date of December 31, 2012; risk free interest rate of 1.56%; and volatility of 14.91% which was determined using the volatility of the Bank Prime Lending Rate. The Company determined the estimated fair value of the call on September 30, 2009, using the Black-Scholes Merton valuation model and the following assumptions: fair value and exercise

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price of the call embedded in the January 2008 and April 2008 Debentures equivalent to 100% of the outstanding principal and accrued interest of $2,319,890 and $4,012,548, respectively; term of 3.25 years to the maturity date of December 31, 2012; risk free interest rate of 1.56%; and volatility of 14.91% which was determined using the volatility of the Bank Prime Lending Rate.

Embedded Derivatives — 10% Senior Secured Debentures

Upon the issuance of the 10% Senior Secured Debentures on September 30, 2009, the Company concluded that the conversion features embedded in the 10% Senior Secured Debentures met the criteria in ASC 815-10 to be accounted for as an equity instrument even though the 10% Senior Secured Debentures include a reset provision on the conversion price and is considered non-conventional debt, because the Company has control to ensure the sufficiency of its authorized shares of common stock, as the debentures include a floor on the conversion price adjustment, and because the conversion features are not required to be settled in registered shares.

The Company also concluded that the put and call in the 10% Senior Secured Debentures were embedded derivatives that were not clearly and closely related to the debt host and therefore should be bifurcated from the debt host and recorded as a liability at their estimated fair value at issuance.  The Company determined the net fair value of the put and call embedded in the 10% Senior Secured Debentures on September 31, 2009 to be $45 thousand, and recorded a discount on the debentures that will be amortized as interest expense over the life of the debentures using the interest method.

The Company determined the estimated fair value of the put on September 30, 2009, using the Black-Scholes Merton valuation model and the following assumptions: fair value and exercise price of the put embedded in the 10% Senior Secured Debentures equivalent to 120% of the outstanding principal and accrued interest expected to be earned to maturity of $2,800,000; term of 2.0 years to the maturity date of September 30, 2011; risk free interest rate of 0.95%; and volatility of 18.31% which was determined using the volatility of the Bank Prime Lending Rate. The Company determined the estimated fair value of the call on September 30, 2009, using the Black-Scholes Merton valuation model and the following assumptions: fair value and exercise price of the call embedded in the 10% Senior Secured Debentures equivalent to 100% of the outstanding principal and accrued interest expected to be earned to maturity of $2,400,000; term of 2.0 years to the maturity date of September 30, 2011; risk free interest rate of 0.95%; and volatility of 18.31% which was determined using the volatility of the Bank Prime Lending Rate.

Warrants Issued in Connection with January 2008 and April 2008 Debentures

Effective with the issuance of the January 2008 and April 2008 Debentures, the Company issued warrants to purchase 222,222 and 388,889 shares, respectively, of the Company’s common stock at an exercise price of $1.80 per share, subject to adjustment, which warrants have a term of three years.

The Company evaluated the terms and conditions of the warrants issued with the January 2008 and April 2008 Debentures under the guidance in ASC 815-40-25 and ASC 815-40-15 to determine whether the warrants should be accounted for as equity or a liability and thereafter adjusted to their respective estimated fair value at each reporting date.

Prior to the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the warrants issued with the January 2008 Debentures met the criteria in ASC 815-40-25 and ASC 815-40-15 at issuance and through April 22, 2008, and therefore, were accounted for as equity because the warrants could only be settled by issuance of the Company’s common stock, the common stock could be unregistered, and the sufficiency of the authorized shares was under the Company’s control as it could control the outcome of a shareholder vote to increase the authorized shares.  However, on the date of the merger with Tripath, April 22, 2008, the Company concluded it no longer had control to ensure the sufficiency of its authorized shares of common stock nor could it settle the warrants in unregistered shares and therefore, recorded the estimated value fair value of the warrants of $320 thousand asWarrant and Derivative Liability.  At December 31, 2008, and June 30, 2009, the estimated fair value of the warrants was revalued to $1 thousand and $1 thousand, respectively, with the related credit of $319 thousand and $0 thousand included in the Company’s statement of operations in interest expense for the year ended December 31, 2008, and the six months ended June 30, 2009, respectively. The Company determined the estimated fair value of the warrants on April 22 and December 31, 2008, and June 30, 2009, by using the Black-Scholes Merton valuation model and the following assumptions: fair value of the Company’s common stock of $2.91, $0.33, and $0.36, respectively, per share; terms of 2.5, 2.08 and 1.58 years, respectively; risk free interest rates of 2.54%, 0.78%, and 0.88%, respectively; and volatility of 47.81%, 56.98%, and 59.34%, respectively.

Prior to the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the warrants issued with the April 2008 Debentures did not meet the criteria in ASC 815-40-25 and ASC 815-40-15 at issuance because it no longer had control to ensure the sufficiency of its authorized shares of common stock nor could it settle the warrants in unregistered shares and therefore, recorded the estimated value fair value of the warrants of $590 thousand as Warrant and Derivative Liability.  At December 31, 2008, and June 30, 2009, the estimated fair value of the warrants was revalued to $4 thousand and $2 thousand with the related credit of $586 thousand and $2 thousand included in the Company’s statement of operations in interest expense for the year ended December 31, 2008, and the six months ended June 30, 2009, respectively. The Company determined the estimated fair value of

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the warrants on April 22 and December 31, 2008, and June 30, 2009, by using the Black-Scholes Merton valuation model and the following assumptions: fair value of the Company’s common stock of $2.91, $0.33, and $0.36, respectively, per share; terms of 3, 2.33, and 1.83 years, respectively; risk free interest rates of 2.43%, 0.84%, and 1.02%, respectively; and volatility of 49.17%, 62.44%, and 57.08%, respectively.

Upon the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the warrants issued with the January 2008 and April 2008 Debentures met the criteria in ASC 815-40-25 and ASC 815-40-15 to be accounted for as equity because the Company had control to ensure the sufficiency of its authorized shares of common stock,.  The Company reached this conclusion because the conversion price of the January 2008 and April 2008 Debentures that was subject to adjustment due to price-based anti-dilution provisions was modified to include a floor on the conversion price adjustment as a result of any subsequent equity sales, and therefore the Company was able to conclude that has a sufficient authorized but unissued number of shares to settle all outstanding contracts requiring settlement in shares. Due to the change in classification from liability to equity, the Company recorded a reclassification of the fair value as of June 30, 2009, to additional paid in capital of $1 thousand and $2 thousand, respectively. As of September 30, 2009, the Company continues to conclude that the warrants issued with the January 2008 and April 2008 Debentures meet the criteria in ASC 815-10 to be accounted for as an equity instrument.

Warrants Issued in Connection with 10% Senior Secured Debentures

Effective with the issuance of the 10% Senior Secured Debentures, the Company issued Series I and Series II warrants to purchase 3,000,000 and 2,250,000 shares, respectively, of the Company’s common stock at exercise prices of $0.60 and $0.01 per share, respectively, subject to adjustment, and with terms of five and seven years, respectively.

The Company evaluated the terms and conditions of the warrants issued with the 10% Senior Secured Debentures under the guidance in ASC 815-40-25 and ASC 815-40-15 to determine whether the detachable warrants should be accounted for as equity or a liability and thereafter adjusted to their respective estimated fair value at each reporting date.

On September 30, 2009, the Company concluded that the Series I and Series II warrants issued with the 10% Senior Secured Debentures met the criteria in ASC 815-40-25 and ASC 815-40-15 at issuance, and therefore, were accounted for as equity because the warrants could only be settled by issuance of the Company’s common stock, the common stock could be unregistered, and the sufficiency of the authorized shares was under the Company’s control. The Company determined the fair value of the Series I and Series II warrants on September 31, 2009 to be $424 thousand and $565 thousand, respectively, and recorded a discount on the debentures that will be amortized as interest expense over the life of the debentures using the interest method.

The Company determined the estimated fair value of the Series I warrants on September 30, 2009, using the Black-Scholes Merton valuation model and the following assumptions: fair value of the Company’s common stock of $0.78; exercise price of $0.60; term of 5.0 years; risk free interest rate of 2.31%; and volatility of 54.11%. The Company determined the estimated fair value of the Series II warrants on September 30, 2009, using the Black-Scholes Merton valuation model and the following assumptions: fair value of the Company’s common stock of $0.78; exercise price of $0.01; term of 7.0 years; risk free interest rate of 2.93%; and volatility of 57.83%.

Warrants Issued in Connection with Other Notes Payable and Notes Payable to Related Parties

Effective with the issuance of promissory notes on February 23, March 31, and July 9, 2009, the Company issued warrants to purchase 26,667, 133,333, and 500,000 shares, respectively, of the Company’s common stock at an exercise price of $0.75 per share, which warrants have a term of three, three, and five years, respectively.

The Company evaluated the terms and conditions of these warrants under the guidance in ASC 815-40-25 and ASC 815-40-15 to determine whether the warrants should be accounted for as equity or a liability and thereafter adjusted to their respective estimated fair value at each reporting date.

Prior to the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the warrant issued with the promissory note in February 2009, did not meet the criteria in ASC 815-10 at issuance because the Company did not have control to ensure the sufficiency of its authorized shares of common stock and therefore, recorded the estimated value fair value of the warrant of $36 thousand as Warrant and Derivative Liability.  At June 30, 2009, the estimated fair value of the warrant was revalued to $1 thousand with the related credit of $35 thousand included in the Company’s statement of operations in interest expense for the six months ended June 30, 2009. The Company determined the estimated fair value of the warrant on February 23 and June 30, 2009, by using the Black-Scholes Merton valuation model and the following assumptions: fair value of the Company’s common stock of $2.01 and $0.36, respectively, per share; terms of 3 and 2.67 years, respectively; risk free interest rates of 1.34% and 1.46%, respectively; and volatility of 53.63% and 52.58%, respectively.

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The fair value of the warrant recorded upon issuance was treated as a discount on other notes payable, and was amortized over the life of the promissory note, which matured on May 31, 2009, using the interest method. During the six months ended June 30, 2009, $36 thousand of the discount was amortized to interest expense.

Upon the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the warrants issued with the promissory note in February 2009 met the criteria in ASC 815-40-25 and ASC 815-40-15 to be accounted for as equity because the Company had control to ensure the sufficiency of its authorized shares of common stock. The Company reached this conclusion because the conversion price of the January 2008 and April 2008 Debentures that was subject to adjustment due to price-based anti-dilution provisions was modified to include a floor on the conversion price adjustment as a result of any subsequent equity sales, and therefore the Company was able to conclude that it has a sufficient authorized but unissued number of shares to settle all outstanding contracts requiring settlement in shares. Due to the change in classification from liability to equity, the Company recorded a reclassification of the fair value as of June 30, 2009 to additional paid in capital of $1 thousand. As of September 30, 2009, the Company continues to conclude that the warrants issued with the promissory note in February 2009 should be accounted for as equity. The February 2009 promissory note was cancelled on September 30, 2009 in exchange for 10% Senior Secured Debentures.

Prior to the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the warrant issued with the promissory note in March 2009, did not meet the criteria in ASC 815-10 at issuance because the Company did not have control to ensure the sufficiency of its authorized shares of common stock and therefore, recorded the estimated value fair value of the warrant of $83 thousand as Warrant and Derivative Liability.  At June 30, 2009, the estimated fair value of the warrant was revalued to $7 thousand with the related credit of $76 thousand included in the Company’s statement of operations in interest expense for the six months ended June 30, 2009.  The Company determined the estimated fair value of the warrant on March 31 and June 30, 2009, by using the Black-Scholes Merton valuation model and the following assumptions: fair value of the Company’s common stock of $1.20 and $0.36 per share, respectively; term of 3 and 2.75 years, respectively; risk free interest rate of 1.15% and 1.51%, respectively; and volatility of 53.28% and 51.87%, respectively.

The fair value of the warrant recorded upon issuance was treated as a discount on notes payable to related parties, and will be amortized over the life of the promissory note, which is due to mature on October 31, 2009, using the interest method. During the six months ended June 30, 2009, $35 thousand of the discount was amortized to interest expense.

Upon the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the warrants issued with the promissory note in March 2009 met the criteria in ASC 815-40-25 and ASC 815-40-15 to be accounted for as an equity instrument because the Company had control to ensure the sufficiency of its authorized shares of common stock. The Company reached this conclusion because the conversion price of the January 2008 and April 2008 Debentures that was subject to adjustment due to price-based anti-dilution provisions was modified to include a floor on the conversion price adjustment as a result of any subsequent equity sales, and therefore the Company was able to conclude that it has a sufficient authorized but unissued number of shares to settle all outstanding contracts requiring settlement in shares.  Due to the change in classification from liability to equity, the Company recorded a reclassification of the fair value as of June 30, 2009 to additional paid in capital of $7 thousand. As of September 30, 2009, the Company continues to conclude that the warrants issued with the promissory note in March 2009 should be accounted for as equity. The March 2009 promissory note was cancelled on September 30, 2009 in exchange for 10% Senior Secured Debentures.

The Company concluded that the warrant issued with the promissory note in July 2009 met the criteria in ASC 815-40-25 and ASC 815-40-15 at issuance, and therefore, was accounted for as equity because the warrants could only be settled by issuance of the Company’s common stock, the common stock could be unregistered, and the sufficiency of the authorized shares was under the Company’s control. The Company determined the fair value of the warrant on issuance to be $110 thousand and recorded a discount on the promissory note that will be amortized as interest expense over the life of the promissory note using the interest method. During the nine months ended September 30, 2009, the Company amortized $42 thousand in the Company’s statement of operations as interest expense. The July 2009 promissory note was cancelled on September 30, 2009 in exchange for 10% Senior Secured Debentures. As a result, the remaining unamortized debt discount of $68 thousand was written off as part of the loss on extinguishment of debt,

The Company determined the estimated fair value of the warrant on issuance, using the Black-Scholes Merton valuation model and the following assumptions: fair value of the Company’s common stock of $0.55; exercise price of $0.75; term of 5.0 years; risk free interest rate of 2.34%; and volatility of 53.68%.

Warrants issued with New Series A Preferred Stock

In October 2008 and as amended in December 2008, the Board of Directors authorized the designation and issuance of up to 3,333,333 shares of New Series A Convertible Preferred Stock (the “New Series A Preferred Stock”), and the offering of up to $2,500,000 of New Series A Preferred Stock and a number of warrants with an exercise price of $0.75 equal to 100% of the number of

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shares purchased by each purchaser. Through the nine months ended September 30, 2009, and the period ending December 31, 2008, respectively, the Company closed a round of financing for the sale of 10,000 and 833,333 shares, respectively, of its New Series A Preferred Stock at $0.75 per share, for an aggregate purchase price of $7.5 thousand and $625 thousand, respectively, and warrants to purchase 10,000 and 833,333 shares of common stock of the Company, respectively, at an exercise price of $0.75 per share, and a three year term. The lead investor of this financing was Daniel J.A. Kolke, the Company’s founder, chairman, chief executive officer, acting chief financial officer, and chief technology officer, with participation from two of the Company’s directors and other prior investors. The holders of the January 2008 Debentures and the April 2008 Debentures consented to this financing, but did not participate.

The Company concluded at the date of issuance and through the reporting date that the embedded conversion features in the New Series A Preferred Stock should not be bifurcated from the equity host as they were clearly and closely related to the equity host. Also during the year ended December 31, 2008, the Company recorded a beneficial conversion feature related to the New Series A Preferred Stock, which could have been converted to the Company’s common stock, through the date the conversion feature was recorded, as a dividend expense of $22 thousand.

The Company evaluated the terms and conditions of the warrants issued with the New Series A Preferred Stock under the guidance in ASC 815-40-25 and ASC 815-40-15 to determine whether the warrants should be accounted for as equity or a liability and thereafter adjusted to their respective estimated fair value at each reporting date.

Prior to the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the warrants issued with the New Series A Preferred Stock did not meet the criteria in ASC 815-40-25 and ASC 815-40-15 at issuance because the Company did not have control to ensure the sufficiency of its authorized shares of common stock. Therefore, the Company recorded the estimated value fair value of the warrants of $148 thousand as Warrant and Derivative Liability.  At December 31, 2008, and June 30, 2009, respectively, the estimated fair value of the warrants was revalued to $40 thousand and $40 thousand, respectively, with the related credit of $108 thousand and $0 thousand included in the Company’s statement of operations in financing expense for the year ended December 31, 2008, and the six months ended June 30, 2009, respectively. The Company determined the estimated fair value of the warrants on December 3 and 31, 2008 and June 30, 2009, and February 27 and June 30, 2009, by using the Black-Scholes Merton valuation model and the following assumptions: fair value of the Company’s common stock of $0.60, $0.33 and $0.36, and $0.51 and $0.36, respectively, per share; terms of 3, 2.92 and 2.42, and 3.0 and 2.67 years, respectively; risk free interest rates of 1.07%, 0.98% and 1.33%, and 1.4% and 1.46%, respectively; and volatility of 53.07%, 54.96% and 54.25%, and 53.63% and 52.58%, respectively.

Upon the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the warrants issued in relation to the New Series A Preferred Stock met the criteria in ASC 815-40-25 and ASC 815-40-15 to be accounted for as an equity instrument because the Company had control to ensure the sufficiency of its authorized shares of common stock. The Company reached this conclusion because the conversion price of the January 2008 and April 2008 Debentures that was subject to adjustment due to price-based anti-dilution provisions was modified to include a floor on the conversion price adjustment as a result of any subsequent equity sales, and therefore the Company was able to conclude that it has a sufficient authorized but unissued number of shares to settle all outstanding contracts requiring settlement in shares.  Due to the change in classification from liability to equity, the Company recorded a reclassification of the fair value as of June 30, 2009 to additional paid in capital of $40 thousand. As of September 30, 2009, the Company continues to conclude that the warrants issued with the New Series A Preferred Stock should be accounted for as equity.

Warrants Issued in Connection with Litigation Settlement

Effective December 5, 2008, the Company entered into a settlement agreement with Kaufman Bros., pursuant to which the Company issued to Kaufman Bros. a warrant to purchase 500,000 shares of the Company’s common stock at an exercise price of $0.75 per share, which warrant has a term of five years. See discussion infra Note 12.

The Company evaluated the terms and conditions of the warrants issued in the settlement under the guidance in ASC 815-40-25 and ASC 815-40-15 to determine whether the warrants should be accounted for as equity or a liability and thereafter adjusted to its respective estimated fair value at each reporting date.

Prior to the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the warrants issued in the settlement did not meet the criteria in ASC 815-40-25 and ASC 815-40-15 at issuance because the Company did not have control to ensure the sufficiency of its authorized shares of common stock and therefore, recorded the estimated value fair value of the warrants of $130 thousand as Warrant and Derivative Liability.  At December 31, 2008, and June 30, 2009, respectively, the estimated fair value of the warrants was revalued to $46 thousand and $47 thousand with the related (credit) debit of ($84) thousand and $1 thousand included in the Company’s statement of operations in settlement expense for the year ended December 31, 2008, and the six months ended June 30, 2009, respectively. The Company determined the estimated fair value of the warrants on December 5 and December 31, 2008, and June 30, 2009, by using the Black-Scholes Merton valuation model and the following assumptions: fair value of the Company’s common stock of $0.60, $0.33, and $0.36, respectively, per share; terms of 5 years, 4.92, and 4.42 years, respectively; risk free interest rates of 1.67%, 1.53%, and 2.28%, respectively; and volatility of 56.16%, 56.74%, and 54.68%, respectively.

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Upon the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the warrants issued in relation to the litigation settlement met the criteria in ASC 815-40-25 and ASC 815-40-15 to be accounted for as an equity instrument because the Company had control to ensure the sufficiency of its authorized shares of common stock. The Company reached this conclusion because the conversion price of the January 2008 and April 2008 Debentures that was subject to adjustment due to price-based anti-dilution provisions was modified to include a floor on the conversion price adjustment as a result of any subsequent equity sales, and therefore the Company was able to conclude that it has a sufficient authorized but unissued number of shares to settle all outstanding contracts requiring settlement in shares.  Due to the change in classification from liability to equity, the Company recorded a reclassification of the fair value as of June 30, 2009, to additional paid in capital of $47 thousand. As of September 30, 2009, the Company continues to conclude that the warrants issued with the litigation settlement should be accounted for as equity.

Warrants Issued in Connection with Consulting Agreement

Effective March 2, 2009, the Company entered into a consulting agreement with Salzwedel Financial Communications, Inc., pursuant to which the Company issued a warrant to purchase 2,000,000 shares of the Company’s common stock at an exercise price of $0.01 per share, which warrant has a term of five years.

The Company evaluated the terms and conditions of the warrants issued in relation to the consulting agreement under the guidance in ASC 815-40-25 and ASC 815-40-15 to determine whether the warrants should be accounted for as equity or a liability and thereafter adjusted to its respective estimated fair value at each reporting date.

Prior to the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the warrant issued in relation to the consulting agreement did not meet the criteria in ASC 815-40-25 and ASC 815-40-15 at issuance because the Company did not have control to ensure the sufficiency of its authorized shares of common stock and therefore, recorded the estimated value fair value of the warrants of $1,001 thousand as Warrant and Derivative Liability.  At June 30, 2009, the estimated fair value of the warrants was revalued to $702 thousand with the related credit of $299 thousand included in the Company’s statement of operations in investor relations expense for the six months ended June 30, 2009. The Company determined the estimated fair value of the warrants on March 2 and June 30, 2009, by using the Black-Scholes Merton valuation model and the following assumptions: fair value of the Company’s common stock of $0.51 and $0.36, respectively, per share; terms of 5 years and 4.67 years, respectively; risk free interest rates of 1.86% and 2.39%, respectively; and volatility of 56.68% and 54.64%, respectively.

Upon the restructuring of the January 2008 and April 2008 Debentures on June 30, 2009, the Company concluded that the warrants issued in relation to the consulting agreement met the criteria in ASC 815-40-25 and ASC 815-40-15 to be accounted for as an equity instrument because the Company had control to ensure the sufficiency of its authorized shares of common stock. The Company reached this conclusion because the conversion price of the January 2008 and April 2008 Debentures that was subject to adjustment due to price-based anti-dilution provisions was modified to include a floor on the conversion price adjustment as a result of any subsequent equity sales, and therefore the Company was able to conclude that it has a sufficient authorized but unissued number of shares to settle all outstanding contracts requiring settlement in shares.  Due to the change in classification from liability to equity, the Company recorded a reclassification of the fair value as of June 30, 2009 to additional paid in capital of $702 thousand. As of September 30, 2009, the Company continues to conclude that the warrants issued with the consulting agreement should be accounted for as equity.

The following is a summary of the movement related to embedded derivatives and warrant liabilities during the nine months ended September 30, 2009 (in thousands):

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7. Notes Payable to Related Parties

The Company previously entered into a series of unsecured loan transactions with relatives of Daniel J.A. Kolke, its executive chairman, chief executive officer, acting chief financial officer, and chief technology officer.  On December 30, 2007, in connection with settlement of these loans, the Company entered into three unsecured promissory notes with an aggregate original principal amount of $816 thousand, each of which will become collateralized by certain presently unidentified assets of the Company if and when Daniel J.A. Kolke is no longer an employee of the Company nor a member of its board of directors.  Such security interest, if granted, would be subordinated to any and all bank debt or convertible corporate debt.  These three notes are outstanding and in default in an aggregate balance of $685 thousand as of September 30, 2009.  No demands for payment have been made as of the date of this report and the default has been waived through the nine months ended September 30, 2009.

During the quarter ended March 31, 2009, the Company issued an unsecured promissory note with one of its directors, in the principal amount of $100,000, with a maturity date of October 31, 2009, and an interest rate of ten percent per annum.  In connection with this promissory note, the Company also issued to that director warrants to purchase 133,333 shares of common stock of the Company with an exercise price of $0.75 per share and a term of three years.

8. Notes Payable

On March 19, 2009, the Company issued an unsecured note of $88 thousand for an accounts payable balance. The note bears interest of 11% and is due on April 1, 2010, with payment terms of $15 thousand on issuance of the note, and monthly payments of $6 thousand beginning May 1, 2009 with a final payment on March 20, 2010. Interest expense was $3 thousand for the nine months ended September 30, 2009.

9. Equity

Preferred Stock

During the nine months ended September 30, 2009, the Company sold 10,000 shares of its New Series A Preferred Stock at $0.75 per share, for an aggregate purchase price of $7.5 thousand, and warrants to purchase 10,000 shares of common stock of the Company, at an exercise price of $0.75 per share, and a three year term.

Common Stock

The Company has issued 24,826,360 shares of common stock from a total of 250,000,000 authorized shares with a par value of $0.01 per share.

On March 2, 2009, the Company entered into a consulting agreement with Salzwedel Financial Communications, Inc. to provide services to the Company for a period of one year.  Compensation payable under that agreement included 1,000,000 shares of the Company’s common stock and a warrant to purchase 2,000,000 shares of the Company’s common stock at a price of $0.01 per share, exercisable through March 14, 2014.

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In connection with the issuance of the 10% Senior Secured Debentures, the Company also issued 750,000 shares of common stock.  The Company determined the fair value of these shares of common stock on the date of issuance to be $191 thousand, and recorded a discount on the 10% Senior Secured Debentures that will be amortized as interest expense over the life of the debentures using the interest method.

10. Accounting for Share-Based Compensation

The following table summarizes stock option activity under the Company’s stock option plans (in thousands, except share and per share data):