Commission file number 000-28985

 

VOIP, INC.

(Exact name of registrant as specified in its charter)

Texas		75-2785941
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)
151 South Wymore Road, Suite 3000
Altamonte Springs, Florida		32714
(Address of principal executive offices)		(ZIP Code)

Issuer's telephone number, including area code: (407) 389-3232

Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $0.001.

Indicate by check mark if the registrant is a well-known seasoned issuer as defined in Rule 405 of the Securities Act.  YES o NO x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  YES o NO x

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

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

Large accelerated filer o   Accelerated filer o   Non-accelerated filer x

Indicate by check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Act).  YES o NO x

Issuer's revenues for its most recent fiscal year were $5,933,248.

At June 30, 2006, the last business day of the registrant's most recently completed second fiscal quarter, there were 3,525,456 shares of registrant's common stock outstanding (after adjustment for reverse stock split effective August 16, 2007), and the aggregate market value of such shares held by non-affiliates of the registrant (based upon the closing sale price of such shares on the Over-The-Counter Bulletin Board on June 30, 2006) was approximately $38,722,066. Shares of the registrant's common stock held by each executive officer and director and by each entity or person that, to the registrant's knowledge, owned 5% or more of the registrant's outstanding common stock as of June 30, 2006, have been excluded in that such persons may be deemed to be affiliates of the registrant. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

At March 28, 2007, the registrant had outstanding 4,930,486 (after adjustment for reverse stock split effective August 16, 2007) and no shares of par value $0.001 common stock and par value $0.001 preferred stock, respectively.

Company Symbol: VOIC

 

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TABLE OF CONTENTS

PART I			4
Item 1.	Business		4
Item 1A.	Risk Factors		9
Item 2.	Properties		18
Item 3.	Legal Proceedings		18
Item 4.	Submission of Matters to a Vote of Security Holders		19
PART II			20
Item 5.	Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities		20
Item 6.	Selected Financial Data		20
Item 7.	Management's Discussion and Analysis of Financial Condition and Results of Operations		21
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk		31
Item 8.	Financial Statements and Supplementary Data		32
Item 9.	Changes in and Disagreements With Accountants on Accounting and Financial Disclosure		32
Item 9A.	Controls and Procedures		32
Item 9B.	Other Information		34
PART III			34
Item 10.	Directors and Executive Officers of the Registrant		34
Item 11.	Executive Compensation		36
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters		42
Item 13.	Certain Relationships and Related Transactions		44
Item 14.	Principal Accounting Fees and Services		44
PART IV			45
Item 15.	Exhibits and Financial Statement Schedules		45

 

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Explanatory Note

VoIP, Inc. (the "Company") is filing this Amendment No. 1 to its Annual Report on Form 10-K for the year ended December 31, 2006 (the "2006 10-K"), which was originally filed on April 2, 2007.

As reported in the Company’s Form 8-K filed on July 3, 2007, on June 27, 2007 the Company sold substantially all of the tangible operating assets utilized by its Dallas, Texas, division, including assets related to its EasyTalk and Rocket VoIP products.  This Amendment is being filed to reclassify the Company’s financial position, results of operations, and cash flows related to this division since the date of its acquisition in October 2005 to reflect discontinued operations accounting treatment.

As reported in the Company’s Form 8-K filed on August 16, 2007, on that day the Company effected a reverse split of its outstanding common stock, at a ratio of 1-for-20 shares Accordingly, this amendment restates all share and per-share information to reflect this reverse stock split. Further, the reported common stock in the Company's consolidated balance sheets was reduced by a factor of twenty, with corresponding increases in additional paid-in capital.

This Amendment No. 1 amends primarily (i) Part II, Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations to reflect the reclassified consolidated financial statements for 2005 and 2006; and (ii) Part II, Item 8 - Financial Statements to provide the reclassified financial statements and notes thereto for 2005 and 2006. Other portions of the Company’s 2006 Form 10-K are amended herein as necessary to reflect the above treatments.

This Amendment does not reflect any other events occurring after the original filing of the Company’s 2006 10-K, and does not update or modify the disclosures therein in any way other than as required to reflect the amendments described above.

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VOIP, INC.

 

PART I

 

Item 1. Business

Caution Regarding Forward-Looking Statements

This annual report contains forward-looking statements relating to events anticipated to happen in the future. These forward-looking statements are based on the beliefs of our management, as well as assumptions made by and information currently available to our management. Forward-looking statements also may be included in other written and oral statements made or released by us. You can identify forward-looking statements by the fact that they do not relate strictly to historical or current facts. The words "believe," "anticipate," "intend," "expect," "estimate," "project," “may”, “could” and similar expressions are intended to identify forward-looking statements. Forward-looking statements describe our expectations today of what we believe is most likely to occur or may be reasonably achievable in the future, but they do not predict or assure any future occurrence and may turn out to be wrong. Forward-looking statements are subject to both known and unknown risks and uncertainties and can be affected by inaccurate assumptions we might make. Consequently, no forward-looking statement can be guaranteed. Actual future results may vary materially. We do not undertake any obligation to publicly update any forward-looking statements to reflect new information or future events or occurrences. These statements reflect our current views with respect to future events and are subject to risks and uncertainties about us, including, among other things:

 

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Our ability to market our services successfully to new customers;

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Our ability to retain a high percentage of our customers;

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The possibility of unforeseen capital expenditures and other upfront investments required to deploy new technologies or to effect new business initiatives;

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Our ability to raise capital;

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Network development and operations;

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Our expansion, including consumer acceptance of new price plans and bundled offerings;

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Additions or departures of key personnel;

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Competition, including the introduction of new products or services by our competitors;

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Existing and future laws or regulations affecting our business and our ability to comply with these laws or regulations;

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Our reliance on the systems and provisioning processes of regional Bell operating companies;

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Technological innovations;

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The outcome of legal and regulatory proceedings;

·

General economic and business conditions, both nationally and in the regions in which we operate; and

·

Other factors described in this document, including those described in more detail in PART I, Item 1A. “Risk Factors.”

 

DESCRIPTION OF BUSINESS

General Development

We were incorporated under the laws of the State of Texas on August 3, 1998, under our original name of Millennia Tea Masters. In February 2004 we exchanged 625,000 shares for the assets of two start-up telecommunication businesses, eGlobalphone, Inc. and VoIP Solutions, Inc. We changed our name to VoIP, Inc., in April 2004. We consummated the acquisitions of DTNet Technologies, a hardware supplier, and VoIP Americas, an interconnected Voice-over-Internet-Protocol (“VoIP”) related company, in June and September, respectively, of 2004. We decided to exit our former tea business in December 2004, and focus our efforts and resources in the VoIP telecommunications industry. In May 2005 we completed the acquisition of Caerus, Inc., a VoIP carrier and service provider, and in October 2005 we purchased substantially all of the VoIP-related assets of WQN, Inc. (“WQN”). In April 2006, we sold DTNet Technologies to a former officer of the Company. In October 2006 we terminated our Marketing and Distribution Agreement with Phone House, Inc., a wholesale prepaid telephone calling card business acquired in our WQN acquisition. On June 27, 2007 we sold substantially all of the tangible operating assets utilized by our Dallas, Texas, division that were acquired in our WQN acquisition.

 

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We are an emerging global provider of wholesale long-distance and local telephone services through our VoIP network (called the VoiceOne Network). VoIP is the real time transmission of voice communications in the form of digitized "packets" of information over the public Internet or our own private network, similar to the way in which e-mail and other data is transmitted. Our services allow customers to communicate at significantly reduced costs compared to traditional telephony networks, using our softswitches that connect calls over different phone lines entirely by software run on a computer system. We are a certified Competitive Local Exchange Carrier (“CLEC”) and InterExchange Carrier (“IXC”).

 

Since 2004 we have developed our business through strategic acquisitions, as noted in the second preceding paragraph. These acquisitions, and our subsequent VoIP-related technological enhancements, have provided us with important technology, intellectual capital and VoIP expertise, trade names, domain names, VoIP enhanced service applications, key business relationships and revenues. We own our network and technology, and provide a portfolio of advanced telecommunications technologies, enhanced service solutions, and broadband products to the VoIP industry. Our current and targeted customers include CLECs, IXCs, Internet Service Providers (“ISPs”), cable operators, and VoIP service providers in the United States and various countries around the world.

Our goal is to become the premier enabler for packet communication services for carriers (portal and ISP), service providers and cable operators seeking to offer value-added voice, data and enhanced services products using VoIP technology.

Business Segments

Our business was previously divided into three primary segments: (1) telecommunications, which consists of consumer and wholesale telecommunication services provided through our propriety VoIP network and technology; (2) wholesale sales of VoIP hardware and broadband components; and (3) the wholesaling of prepaid calling cards. We recently sold businesses comprising our hardware sales and prepaid calling card segments. Accordingly, separate financial statement information for the former segments is not provided.

Our Technology and Network

Our proprietary softswitch technology was developed in-house using protocol agnostic architecture, enabling virtually any network protocol, from legacy switches to the latest Multi-Protocol Label Switching (“MPLS”) standards, to communicate with our softswitches. Older, legacy technology uses hardware such as physical switches to route calls. Our technology approach enables us to integrate our network directly into the public switched telephone networks, with more limited capital expenditure costs.

Based on Microsoft .NET technology, we believe that integration to the enterprise desktop will drive market acceptance and use of our advanced services. Our network currently supports its own media gateways, softswitch controller, unified messaging systems, voicemail, media trans-coding and many other integral parts of a complete solution. Using our web interfaces, our customers also have the management tools needed for provisioning and maintenance of their services.

Our network operations center (“NOC”) located in Orlando, Florida, is a fully staffed, 24x7x365 operation. From the NOC we monitor all aspects of the technical environment, from our nationwide OC-12 backbone to network routers, SIP proxies and numerous routing gateways, soft switches and other aspects of our VoIP infrastructure. Fully redundant technologies are deployed in a scalable network environment that we believe will enable us to compete in the demanding IP telephony marketplace. Our network incorporates an advanced MPLS architecture which provides services to carriers and other service providers. Our network features direct interconnection facilities with multiple RBOCs, CLECs, IXCs, service providers, cable operators, wireless carriers and resellers.

 

Products and Services

Our telecommunications products and service offerings target VoIP wholesale customers, CLECs, IXCs, ISPs, cable operators and other providers of telephony services in the United States and various countries around the world.

Call Termination

We charge our wholesale customers minute-based fees to terminate calls on our network. We pay termination fees when it is necessary to route calls from our network to other networks for termination. Our revenues and profit margins on those revenues are a function of the number and duration of calls handled by our network and what we charge and pay to handle this traffic.

 

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U.S. call termination takes place either on our network or that of one of our network partners to which we route traffic. Our international termination product features direct routes and connections established to many international voice carriers worldwide. Carriers use complex least-cost-routing algorithms that direct traffic to the lowest cost carrier. We are attempting to establish a competitive cost structure through the efficiencies of our network design, the completion and implementation of our own least-cost routing algorithms, and through current and future partnerships with key off-net and niche providers. Revenues generated from these services for the year ended December 31, 2006, substantially all of which were derived from one customer, amounted to $5.7 million or 39% of our consolidated revenues during this period.

 

VoiceOne Carrier Direct

We are in the early stages of implementing our VoiceOne Carrier Direct program which we believe will enable us to develop a significant facilities-based, carrier customer base. We believe that carriers that want to offer VoIP services have essentially three options: create their own internal VoIP capabilities, acquire a VoIP carrier, or partner with a VoIP carrier. The first two of these options are typically expensive and time consuming, both initially and with respect to ongoing system maintenance. With respect to the third option, our VoiceOne Carrier Direct is a partner program for carriers that provides them with our technology to IP-enable their TDM networks. With this program the carriers receive our equipment and expertise, enabling them to rapidly enter the VoIP services market without making significant capital expenditures. Because our technology is protocol agnostic, by implementing the VoiceOne Carrier Direct program we believe our customers can avoid modifications to their TDM networks and the operability issues that can plague the interface of legacy systems with IP technology. We interface our customers' TDM systems to our VoIP network. We do not charge the carriers for equipment that includes softswitch technology, a media gateway, a service creation environment, a multi-protocol label switching network and access to our products and services. In return for our equipment and expertise, the facilities based carrier pays us fees to terminate calls on our network and for other services such as Hosted IP Centrex and local inbound. We anticipate that this strategy will be attractive to the carriers since it provides them with a new group of customers and revenue sources without requiring them to modify their legacy systems or expend capital. Once the carriers are part of our Carrier Direct Program, we can obtain revenues from calls the carriers terminate on our network, and can terminate calls on their network. Through December 31, 2006 we had not generated any significant revenues from our VoiceOne Carrier Direct program.

Click-to-Call

In November 2006 we introduced Click-to-Call, which involves initiating phone calls from computers without dialing. This technology is currently used as a sales lead generator in online ads. From a web site, users type in the desired service (flowers, pizza, etc.) along with their zip code. Once a service provider is located and selected, the user then enters their phone number, clicks “call” on the web site, and their phone will ring connecting them to the service provider. We receive minute-based revenue for each call carried on our network. Through December 31, 2006 we had not generated significant revenues from our Click-to-Call program.

 

Prepaid Calling Cards Segment

We previously sold prepaid calling cards that we purchased from other carriers to private distributors located in Southern California. Unlike our other communications products, the communication traffic arising from the use of these cards to place telephone calls was handled by carriers affiliated with vendors we purchased the cards from, and not by our network. In October 2006, we terminated our Marketing and Distribution Agreement with Phone House, Inc., effectively discontinuing this business segment, and its operations are accounted for as discontinued.

Hardware Sales Segment

Our hardware sales subsidiary, doing business as DTNet Technologies, operated a fulfillment center in Clearwater, Florida, from which we sold a variety of VoIP hardware and broadband components to broadband service providers. These products included cable modems, DSL modems, AV power line and home plug adapters, and multimedia terminal adapters. In April 2006, we sold DTNet Technologies to our former Chief Operating Officer, and its operations have since been accounted for as discontinued.

OUR STRATEGY

Our objective is to provide reliable, scalable, and competitively-priced worldwide VoIP communication services with unmatched quality. We plan to achieve this objective by delivering innovative technologies and services while balancing the needs of our customers with the needs of our business. We intend to bring high quality voice products and services at an affordable price to other communication providers, businesses and residential consumers to enhance the ways in which these customers communicate with the rest of the world. Recognizing that basic voice service is a commodity item that does not drive significant profits, we plan to provide basic services to customers that will lead into margin expansion as more advanced features are offered on our network, including initiating phone calls from computers without dialing (click-to-call technology), checking voicemail, faxes, and emails from a single computer in-box (unified messaging), providing audio and video teleconferencing, and offering VoIP services with leased lines.

Specific strategies to accomplish this objective include:

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Building our carrier/service provider customer base through aggressive marketing of our VoiceOne Carrier Direct program;

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Completing the expansion of our network (currently in process);

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Capitalizing on our technological expertise to introduce new products, services and features;

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Customizing our service offerings for the purpose of pursuing strategic partnerships with major customers and suppliers;

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Offering the best possible service and support to our customers;

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Developing additional distribution channels;

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Increasing our customer base by introducing cost-effective solutions to interconnect with our network; and

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Controlling operating expenses and capital expenditures.

Competition

We compete primarily in the market for enhanced IP communications services. This market is highly competitive and has numerous service providers. The market for enhanced Internet and IP communications services is new and rapidly evolving. We believe that the primary competitive factors determining success in the Internet and IP communications market are:

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Quality of service;

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Breadth and depth of service offerings;

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Ability to custom create innovative solutions;

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Ability to meet and anticipate customer needs through multiple service offerings and feature sets;

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Responsive customer care services; and

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Price.

Future competition could come from a variety of companies both in the Internet and telecommunications industries. These industries include major companies that have greater resources and larger customer bases than we have, and have been in operation for many years. In addition, some Internet service providers have begun to aggressively enhance their real time interactive communications, including instant messaging, PC-to-PC and PC-to-Phone services, and broadband phone services.

Some competitors may be able to bundle services and products that are not offered by us together with enhanced Internet and IP communications services, which could place us at a significant competitive disadvantage. Many of our competitors enjoy economies of scale that can result in lower cost structure for transmission and related costs, which could cause significant pricing pressures within the industry. At the same time, we see these potential competitors as potential customers, and have organized our various reseller and service provider products and services to meet the emergent needs of these companies.

Our primary competitors include:

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Carriers operating in the U.S. and abroad, including Level 3, Global Crossing, Cogent Communications Group, Inc., XO Holdings, Inc., US LEC Corporation, Pac-West Telecomm, Inc.; and

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Subscriber-based service provider competitors, including Vonage, Packet8, DeltaThree, SunRocket, Time Warner, Comcast, and Net2phone.

Human Resources

VoIP, Inc. currently employs 53 persons in the following capacities: 3 officers, 26 general and administrative employees, and 24 technology personnel. We consider our relations with our employees to be favorable. We have never had a work stoppage, and none of our employees is represented by collective bargaining agreements. We believe that our future success will depend in part on our ability to attract, integrate, retain and motivate highly qualified personnel, and upon the continued service of our senior management and key technical personnel. Our Chief Executive Officer and Chief Operating Officer are bound by employment agreements through September 2009. Competition for qualified personnel in our industry and geographical location is intense. We cannot assure you that we will be successful in attracting, integrating, retaining and motivating a sufficient number of qualified employees to conduct our business in the future.

Intellectual Property

We have developed several important intellectual property features. VoiceOne has developed and the network provides an E911 solution to comply with the FCC's recent order imposing E911 requirements on VoIP service providers. VoiceOne's 911 service is known as Enhanced E911. A key feature of the E911 service is that it can route emergency calls for the customer whose location is constant as well as the customer who often moves the location of his VoIP device. Customers can update their location information in real time, so that their 911 call will be delivered to the appropriate PSAP in the new location. To further support the FCC 911 mandate, we have applied for a patent for our 911 compliant VoIP Multimedia Terminal Adaptor.

 

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We have developed Pathfinder as a "cascading provisioning server" feature for deployment of zero-touch hardware deployment and is a new development that is exclusive to our platform. The system allows each device to auto-provision without any customer interaction even in situations where there are multiple levels of resellers to distribute the product to their customers (to any number of resale levels). This allows for installations without any customer service or technical support time spent in configuration issues.

REGULATION

We are currently both a value added service provider and a provider of interconnected Voice over Internet Protocol (“VoIP”) services as that term is defined under federal law. The integration and softswitch portions of our business are expected to remain unthreatened by traditional common carrier regulation in major nations in which we expect to do business. Our telecommunications service offerings may potentially experience regulatory pressures as the United States makes changes in its telecommunications law to encompass interconnected VoIP services. The imposition of government regulation on our business could adversely affect our operations by requiring additional expense to meet compliance requirements and subject us to additional fees and surcharges that are currently applicable to providers of legacy telecommunications services.

The FCC regulates interstate and international telecommunications services. The FCC imposes extensive regulations on common carriers such as ILECs that have some degree of market power. The FCC imposes less regulation on common carriers without market power, such as the Company. The FCC permits these non-dominant carriers to provide domestic interstate services (including long-distance and access services) without prior authorization; but it requires carriers to receive an authorization to construct and operate telecommunications facilities and to provide or resell telecommunications services between the United States and international points. Under the Telecommunications Act of 1996 (the "1996 Act"), any entity, including cable television companies and electric and gas utilities, may enter any telecommunications market, subject to reasonable state regulation of safety, quality and consumer protection. The 1996 Act opened the local services market by requiring ILECs to permit interconnection to their networks.

The FCC has to date treated Internet service providers (“ISPs”) as "enhanced service providers," exempt from federal and state regulations governing common carriers, including the obligation to pay access charges and contribute to the universal service fund. Nevertheless, regulations governing disclosure of confidential communications, copyright, excise tax and other requirements may apply to the provision of Internet access services.

FCC Regulation of Interconnected VoIP Services

There are a number of regulatory proceedings underway or being considered by federal and state authorities, including the FCC and state regulatory agencies, that could potentially impact providers of interconnected VoIP services like us. Currently, providers of interconnected VoIP services are largely unregulated in the United States particularly when compared to providers of traditional telecommunications services. On March 10, 2004, the FCC adopted a Notice of Proposed Rulemaking, which will address a variety of issues concerning the regulatory treatment of VoIP telephony. We cannot predict the outcome of this proceeding. Should the FCC adopt additional regulations that would be applicable to interconnected VoIP providers like us, our costs of doing business would likely increase and would make our services less competitive with traditional providers of telecommunications services.

In November 2004, the FCC ruled that the interconnected VoIP services of a particular company are jurisdictionally interstate and not subject to state certification, tariffing and most other state telecommunications regulations. The FCC ruling was upheld on appeal. We believe that our interconnected VoIP service is substantially similar to the one the FCC ruled on and that our service would also be considered interstate and free from state regulation.

 

In June 2006, the FCC determined that providers of interconnected VoIP services must contribute to the federal Universal Service Fund, or USF. For a period of at least two quarters beginning October 1, 2006, we will be required to contribute to the USF for its subscribers' retail revenues as well as through its underlying carriers' wholesale charges. The impact of this obligation is to either increase prices for our services to our customers or to reduce our profit margin. This could have a material adverse effect on our financial position, results of operations and cash flows. The FCC Order applying USF contributions to interconnected VoIP providers is currently under appeal, and the FCC continues to evaluate alternative methods for assessing USF charges, including imposing an assessment on telephone numbers. The outcome of these proceedings cannot be determined at this time.

On August 5, 2005, the FCC unanimously adopted an order requiring interconnected VoIP providers, like the Company, to comply with the Communications Assistance for Law Enforcement Act, or CALEA. CALEA requires covered providers to assist law enforcement agencies in conducting lawfully authorized electronic surveillance. Under the FCC Order, interconnected VoIP providers will be required to comply with CALEA obligations by May 14, 2007 and make certain filings prior to that date. Consistent with the relevant rules, we are working with a third-party solution provider to devise a CALEA solution. Our failure to achieve compliance with any future CALEA orders, rules, filings or standards, or any enforcement action initiated by the FCC or other agency, state or task force against us could have a material adverse effect on our financial position, results of operations or cash flows.

The effect of any future laws and regulations on our operations cannot be determined.

 

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State Regulation

The 1996 Act is intended to increase competition in the telecommunications industry, especially in the local exchange market. With respect to local services, ILECs are required to allow interconnection to their networks and to provide unbundled access to network facilities, as well as a number of other pro-competitive measures. Because the implementation of the 1996 Act is subject to numerous state rulemaking proceedings on these issues, it is currently difficult to predict how quickly full competition for local services will develop.

Local Regulation

Our network is subject to numerous local regulations such as building codes and licensing. Such regulations vary on a city-by-city, county- by-county and state-by-state basis.

 

Item 1A. Risk Factors

RISKS RELATED TO OUR COMPANY

 

We are not in compliance with the terms of our secured loan agreement, and the note holders may accelerate the amounts due at any time.

 

We are not in compliance with certain covenants of the agreement for our secured loan from a lending institution, now held by a group of institutional investors (and formerly held by Cedar Boulevard Lease Funding LLC). The loan balance currently amounts to approximately $1.9 million, and we have also not made scheduled principal and interest payments. In addition, the loan is now accruing interest at 17.5%, and is repayable through May 2007. Because the investors have a security interest in all of our assets, they may choose to accelerate the loan payments at any time, which would have a significant adverse impact on our financial condition, and could impair our ability to continue as a going concern.

We are not in compliance with the terms of our convertible notes issued in July and October 2005, in January and February of 2006, and in October 2006, and the note holders may accelerate the amounts due at any time.

 

The provisions of the convertible notes issued in July and October 2005, in January and February 2006, and in October 2006 provide that the failure to pay principal and interest timely and the failure to register the securities underlying the notes within the required time limit are events of default under the notes. We have not made scheduled payments of $217,506 under the 2005 notes and have not made scheduled payments of $1,286,079 under the 2006 notes. Also we have not registered all of these note shares and related warrant shares. The convertible note holders have not declared a default under the loan agreements. However, the amounts due under the notes could be accelerated and immediately due and payable, which would adversely affect our financial condition.

 

Because we failed to meet our obligations to file registration statements required under the various subscription agreements related to certain of our note, warrant and common stock financings timely, we are accruing liquidated damages for breach of contract until such time as the registration statements are filed and are declared effective.

 

Pursuant to the subscription agreements under which certain investors purchased notes, common stock and warrants in 2005 and 2006, we agreed to register the securities purchased for resale by those investors under the Securities Act of 1933, as amended, within a specified time. Because we failed to comply with these requirements, we currently owe liquidated damages of $2,200,631 plus 76,761 shares of common stock, and will continue to incur liquidated damages amounting to $278,432 per month until there are effective registration statements covering the notes and warrants. Because we are incurring substantial liquidated damages on a monthly basis, our failure to comply with the terms of the notes and warrants could continue to have an adverse effect on our financial position and our results of operations. We are currently contractually obligated to register approximately 13.5 million shares, warrants and options. There is no assurance that sufficient registration statements can be filed or declared effective by the SEC, in which case we would continue to be unable to satisfy our contractual obligations to register shares.

Our substantial debt could adversely affect our financial position, operations and ability to grow.

As of December 31, 2006, our total liabilities were approximately $32.9 million, most of which are classified as current. Our substantial indebtedness could have adverse consequences in the future. For example, it could:

 

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Require us to dedicate a substantial portion of our cash flow from operations to payments on our debt, which would reduce amounts available for working capital, capital expenditures, research and development, and other general corporate purposes;

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Limit our flexibility in planning for, or reacting to, changes in our business and the industries in which we operate;

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Increase our vulnerability to general adverse economic and industry conditions;

 

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Place us at a disadvantage compared to our competitors that may have less debt than we do;

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Make it more difficult for us to obtain additional financing that may be necessary in connection with our business;

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Make it more difficult for us to implement our business and growth strategies; and

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Cause us to have to pay higher interest rates on future borrowings.

 

We need immediate additional capital to continue our operations.

We have experienced significant changes in our top management.

On September 12, 2006, we underwent a reorganization of our executive management. Accordingly, Mr. Anthony J. Cataldo was appointed Chief Executive Officer and Chairman, replacing Mr. Gary Post, who himself replaced a former Chief Executive Officer on May 19, 2006. Mr. David Ahn, Vice President Corporate Planning, also left the Company effective September 12, 2006. On May 19, 2006, Mr. Robert V. Staats was appointed Chief Accounting Officer, and Mr. David Sasnett resigned as Chief Financial Officer. On July 28, 2006, Mr. Shawn M. Lewis was appointed Chief Operating Officer in addition to Chief Technology Officer. Although the board of directors believes that these management changes are in our best interests and that the new management will have a positive impact, significant personnel changes may have the effect of disrupting our day-to-day operations until such time as the new management is integrated and fully informed with respect to our business and operations.

 

We may incur goodwill and intangible asset impairment charges.

Our balance sheet at December 31, 2006 includes approximately $16.8 million in goodwill and approximately $9.2 million in other intangible assets recorded in connection with our acquisitions. We recorded a significant additional amount of goodwill and intangible assets as a result of our acquisition in May 2005 of Caerus and its subsidiaries.

In accordance with SFAS 142, we test the carrying value of our goodwill and our other intangible assets for impairment at least annually by comparing the fair values of these assets to their carrying values. During the year ended December 31, 2005 we recorded an impairment charge to our operating results of approximately $4.2 million relating to goodwill previously recorded for an acquisition. During the year ended December 31, 2006, we recorded an impairment charge to operating results of $839,101 as a result of selling our interest in our subsidiary, DTNet Technologies, in April 2006. These charges reduced the carrying value of the subsidiary to its estimated fair value. We may be required to record additional impairment charges for these assets in the future, which could materially adversely affect our financial condition and results of operations. If the traded market price of our common stock declines, a material goodwill impairment charge in the future is possible.

Our internal controls over financial reporting are not adequate, and our independent auditors may not be able to later certify as to their adequacy, which could have a significant and adverse effect on our business and reputation.

Section 404 of Sarbanes-Oxley and the rules and regulations of the Securities Exchange Commission (the “Commission”) associated with Sarbanes-Oxley, which we refer to as Section 404, require a reporting company to, among other things, annually review and disclose its internal controls over financial reporting, and evaluate and disclose changes in its internal controls over financial reporting quarterly. Under Section 404 a reporting company is required to document and evaluate such internal controls in order to allow its management to report on, and its independent auditors to attest to, these controls. We are required to comply with Section 404 not later than our fiscal year ending December 2007. We are currently evaluating our strategy to begin performing the system and process documentation, evaluation and testing required (and any necessary remediation) in an effort to comply with management certification and auditor attestation requirements of Section 404. As reported in Item 9A. Controls and Procedures beginning at page 32, we have concluded that our disclosure controls and procedures, and our financial reporting controls, are currently ineffective. Further, in the course of our ongoing evaluation, we may identify additional areas of our internal controls requiring improvement, and plan to design enhanced processes and controls to address issues that might be identified through this review. As a result, we expect to incur additional expenses and diversion of management's time. We cannot be certain as to the timing of completion of our documentation, evaluation, testing and remediation actions or the impact of the same on our operations, and may not be able to ensure that the process is effective or that the internal controls are or will be effective in a timely manner. If we are not able to implement the requirements of Section 404 in a timely manner or with adequate compliance, our independent auditors may not be able to certify as to the effectiveness of our internal control over financial reporting, and we may be subject to sanctions or investigation by regulatory authorities, such as the Commission. As a result, there could be an adverse reaction in the financial markets due to a loss of confidence in the reliability of our financial statements. In addition, we may be required to incur costs in improving our internal control system and the hiring of additional personnel. Any such actions could adversely affect our results of operations, cash flows and financial condition.

 

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We have a history of losses and negative cash flows from operations, and we anticipate such losses and negative cash flows will continue.

We have incurred significant losses since inception, and we anticipate continuing to incur significant losses for the foreseeable future. Our net loss for the fiscal years ended December 31, 2006 and 2005 was approximately $41.2 million and $28.3 million, respectively. Our net cash used for operating activities for these same periods was approximately $12.4 million and $17.6 million, respectively. As of December 31, 2006, our accumulated deficit was approximately $76.0 million. Our revenues may not grow or even continue at their current level. We will need to significantly increase our revenues and gross margins to become profitable. In order to increase our revenues, we need to attract and maintain customers to increase the fees we collect for our services. If our revenues do not increase as much as we expect, we may never be profitable. Even if our revenues increase, if we are unable to generate sufficiently profitable margins on these revenues, we may never be profitable. If we become profitable, we may not be able to sustain or increase profitability.

We have a limited operating history upon which you can evaluate us.

We have only a limited operating history upon which you can evaluate our business and prospects. We commenced operations of our current business in 2004, and the majority of our operations are comprised of businesses we acquired in 2005. You should consider our prospects in light of the risks, expenses and difficulties we may encounter as an early stage company in the new and rapidly evolving market for Internet protocol (IP) communications services. These risks include our ability:

 

·

To successfully integrate our recent acquisitions;

·

To increase acceptance of our VoIP communications services, thereby increasing the number of users of our IP telephony services;

·

To compete effectively; and

·

To develop new products and keep pace with developing technology.

 

In addition, because we expect an increasing percentage of our revenues to be derived from our IP communications services, our past operating results may not be indicative of our future results.

We may not be able to expand our revenue base and achieve profitability.

Our business strategy is to expand our revenue sources by providing IP communications services to several different customer groups. We can neither assure you that we will be able to accomplish this nor that this strategy will be profitable. Substantially all of our consolidated revenues for the year ended December 31, 2006 were derived from one customer, and our gross margins for these revenues were negative. Currently, our revenues are generated by providing termination services for other carriers and end users.. These services have not been profitable to date and may not be profitable in the future.

In the future, we intend to generate increased revenues from IP communications services from multiple sources, many of which are unproven. We expect that our revenues for the foreseeable future will be dependent on, among other factors:

 

·

Acceptance and use of IP telephony;

·

Growth in the number of our customers;

·

Expansion of service offerings;

·

Traffic levels on our network;

·

The effect of competition, regulatory environment, international long distance rates, and access and transmission costs on our prices; and

·

Continued improvement of our global network quality.

 

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We cannot assure you that a market for our services will develop. Our market is new and rapidly evolving. Our ability to sell our services may be inhibited by, among other factors, the reluctance of some end-users to switch from traditional communications carriers to IP communications carriers and by concerns with the quality of IP telephony and the adequacy of security in the exchange of information over the Internet, and the reluctance of our resellers and service providers to utilize outsourced solutions providers.

 

End-users in markets serviced by recently deregulated telecommunications providers are not familiar with obtaining services from competitors of these providers and may be reluctant to use new providers such as us. We will need to devote substantial resources to educate customers and end-users about the benefits of IP communications solutions in general and our services in particular. If enterprises and their customers do not accept our enhanced IP communications services as a means of sending and receiving communications, we will not be able to increase our number of paid users or successfully generate revenues in the future.

Potential fluctuations in our quarterly financial results may make it difficult for investors to predict our future performance.

Our quarterly operating results may fluctuate significantly in the future as a result of a variety of factors, many of which are outside our control.

Such factors also may create other risks affecting our long-term success, as discussed in the other risk factors. We believe that quarter-to-quarter comparisons of our historical operating results may not be a good indication of our future performance, nor would our operating results for any particular quarter be indicative of our future operating results.

Our network may not be able to accommodate our capacity needs.

We expect the volume of traffic we carry over our network to increase significantly as we expand our operations and service offerings. Our network may not be able to accommodate this additional volume. In order to ensure that we are able to handle additional traffic, we may have to enter into long-term agreements for leased capacity. To the extent that we overestimate our capacity needs, we may be obligated to pay for more transmission capacity than we actually use, resulting in costs without corresponding revenues. Conversely, if we underestimate our capacity needs, we may be required to obtain additional transmission capacity from more expensive sources. If we are unable to maintain sufficient capacity to meet the needs of our users, our reputation could be damaged and we could lose customers and revenues.

 

Additionally, our success depends on our ability to handle a large number of simultaneous calls. We expect that the volume of simultaneous calls will increase significantly as we expand our operations. If this occurs, additional stress will be placed upon the network hardware and software that manages our traffic. We cannot assure stockholders of our ability to efficiently manage a large number of simultaneous calls. If we are not able to maintain an appropriate level of operating performance, or if our service is disrupted, then we may develop a negative reputation, and our business, results of operations, and financial condition could be materially adversely affected.

We may be unsuccessful selecting the most economical call routing.

 

We face a risk of failure of computer and communications systems used in our business.

Our business depends on the efficient and uninterrupted operation of our computer and communications systems as well as those that connect to our network. We maintain communications systems (also referred to as network access points) in facilities in Orlando, Atlanta, New York, Dallas, and Los Angeles. Our systems and those that connect to our network are subject to disruption from natural disasters or other sources such as power loss, communications failure, hardware or software malfunction, network failures, and other events both within and beyond our control. Any system interruptions that cause our services to be unavailable, including significant or lengthy telephone network failures or difficulties for users in communicating through our network or portal, could damage our reputation and result in a loss of users.

 

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Our computer systems and operations may be vulnerable to security breaches.

Our computer infrastructure is potentially vulnerable to physical or electronic computer viruses, break-ins and similar disruptive problems and security breaches that could cause interruptions, delays or loss of services to our users. We believe that the secure transmission of confidential information, such as credit card numbers, over the Internet is essential in maintaining user confidence in our services. We rely on licensed encryption and authentication technology to effect secure transmission of confidential information, including credit card numbers. It is possible that advances in computer capabilities, new technologies or other developments could result in a compromise or breach of the technology we use to protect user transaction data. A party that is able to circumvent our security systems could misappropriate proprietary information or cause interruptions in our operations. Security breaches also could damage our reputation and expose us to a risk of loss or litigation and possible liability. Although we have experienced no security breaches to date of which we are aware, we cannot guarantee you that our security measures will prevent security breaches.

We depend on highly qualified technical and managerial personnel.

Our future success also depends on our continuing ability to attract, retain and motivate highly qualified technical expertise and managerial personnel necessary to operate our businesses. We may need to give retention bonuses and stock incentives to certain employees to keep them, which can be costly to us. The loss of the services of members of our management team or other key personnel could harm our business. Our future success depends to a significant extent on the continued service of key management, client service, product development, sales and technical personnel. We do not maintain key person life insurance on any of our executive officers and do not intend to purchase any in the future. Although we generally enter into non-competition agreements with our key employees, our business could be harmed if one or more of our officers or key employees decided to join a competitor or otherwise compete with us.

We may be unable to attract, assimilate or retain highly qualified technical and managerial personnel in the future. Wages for managerial and technical employees are increasing and are expected to continue to increase in the future. We may have difficulty in hiring and retaining highly skilled employees with appropriate qualifications. If we were unable to attract and retain the technical and managerial personnel necessary to support and grow our businesses, our business would likely be materially and adversely affected.

International operations may expose us to additional and unpredictable risks.

We may enter international markets such as Eastern Europe, the Middle East, Latin America, Africa and Asia and may expand our existing operations outside the United States. International operations are subject to inherent risks, including:

 

·

Potentially weaker protection of intellectual property rights;

·

Political and economic instability;

·

Unexpected changes in regulations and tariffs;

·

Fluctuations in exchange rates;

·

Varying tax consequences; and

·

Uncertain market acceptance and difficulties in marketing efforts due to language and cultural differences.

 

Our entry into new lines of business, as well as potential future acquisitions, joint ventures or strategic transactions, entail numerous risks and uncertainties that could have an adverse effect on our business.

We may enter into new or different lines of business, as determined by management and our board of directors. Our acquisitions, as well as any future acquisitions or joint ventures, could result, and in some instances have resulted, in numerous risks and uncertainties including:

·

Potentially dilutive issuances of equity securities, which may be issued at the time of the transaction or in the future if certain performance or other criteria are met or not met, as the case may be. These securities may be freely tradable in the public market or subject to registration rights which could require us to publicly register a large amount of our common stock, which could have a material adverse effect on our stock price;

 

·

Diversion of management's attention and resources from our existing businesses;

·

Significant write-offs if we determine that the business acquisition does not fit or perform up to expectations;

·

The incurrence of debt and contingent liabilities or impairment charges related to goodwill and other long-lived assets;

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·

Difficulties in the assimilation of operations, personnel, technologies, products and information systems of the acquired companies;

·

Regulatory and tax risks relating to the new or acquired business;

·

The risks of entering geographic and business markets in which we have limited (or no) prior experience;

·

The risk that the acquired business will not perform as expected; and

·

Material decreases in short-term or long-term liquidity.

RISKS RELATED TO OUR INDUSTRY

Our future success depends on the growth in the use of Internet Protocol as a means of communications.

If the market for IP communications in general, and our services in particular, does not grow or does not grow at the rate we anticipate, we will not be able to increase our number of customers or generate the revenues we anticipate. To be successful, IP communication requires validation as an effective, quality means of communication and as a viable alternative to traditional telephone service. Demand and market acceptance for recently introduced services are subject to a high level of uncertainty. The Internet may not prove to be a viable alternative to traditional telephone service for reasons including:

·

Inconsistent quality or speed of service;

·

Traffic congestion;

·

Potentially inadequate development of the necessary infrastructure;

·

Lack of acceptable security technologies;

·

Lack of timely development and commercialization of performance improvements; and

·

Unavailability of cost-effective, high-speed access.

 

If Internet usage grows, the Internet infrastructure may not be able to support the demands placed on it by such growth, or its performance or reliability may decline. In addition, Web sites may from time to time experience interruptions in their service as a result of outages and other delays occurring throughout the Internet network infrastructure. If these outages or delays frequently occur in the future, Internet usage, as well as usage of our communications portal and our services, could be adversely affected.

Intense competition could reduce our market share and harm our financial performance.

Competition in the market for IP communications services is becoming increasingly intense, and such competition is expected to increase significantly in the future. The market for Internet and IP communications is new and rapidly evolving. We expect that competition from companies both in the Internet and telecommunications industries will increase in the future. Our competitors include both start-up IP telephony service providers and established traditional communications providers. Many of our existing competitors and potential competitors have broader portfolios of services; greater financial, management and operational resources; greater brand-name recognition; larger subscriber bases; and more experience than we have. In addition, many of our IP telephony competitors use the public Internet instead of a private network to transmit traffic. Operating and capital costs of these providers may be less than ours, potentially giving them a competitive advantage over us in terms of pricing. In addition, some Internet service providers have begun to aggressively enhance their real time interactive communications, focusing on instant messaging, PC-to-PC and PC-to-phone, and/or broadband phone services.

In addition, traditional carriers, cable companies and satellite television providers are bundling services and products not offered by us with Internet telephony services. While this provides us with the opportunity to offer these companies our products and services as a way for them to offer Internet telephony services, it also introduces the risk that they will introduce these services on their own utilizing other options while at the same time making it more difficult for us to compete against them with direct-to-consumer offerings of our own. If we are unable to provide competitive service offerings, we may lose existing users and be unable to attract additional users. In addition, many of our competitors, especially traditional carriers, enjoy economies of scale that result in a lower cost structure for transmission and related costs, and which cause significant pricing pressures within the industry. In order to remain competitive we intend to increase our efforts to promote our services, and we cannot be sure that we will be successful in doing this.

 

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In addition to these competitive factors, recent and pending deregulation in some of our markets may encourage new entrants. We cannot assure you that additional competitors will not enter markets that we plan to serve or that we will be able to compete effectively.

Decreasing telecommunications rates may diminish our revenues and profitability.

International and domestic telecommunications rates have decreased significantly over the last few years in most of the markets in which we operate, and we anticipate that rates will continue to be reduced in all of the markets in which we do business or expect to do business. Users who select our services to take advantage of the current pricing differential between traditional telecommunications rates and our rates may switch to traditional telecommunications carriers as such pricing differentials diminish or disappear, and we will be unable to use such pricing differentials to attract new customers in the future. In addition, our ability to market our carrier transmission services to telecommunications carriers depends upon the existence of spreads between the rates offered by us and the rates offered by traditional telecommunications carriers, as well as a spread between the retail and wholesale rates charged by the carriers from which we obtain wholesale service. Continued rate decreases will require us to lower our rates to remain competitive, could reduce our revenues, and reduce or possibly eliminate our gross profit from our carrier transmission services. If telecommunications rates continue to decline, we may lose users for our services.

We may not be able to keep pace with rapid technological changes in the communications industry.

Our industry is subject to rapid technological change. We cannot predict the effect of technological changes on our business. In addition, widely accepted standards have not yet developed for the technologies we use. We expect that new services and technologies will emerge in the market in which we compete. These new services and technologies may be superior to the services and technologies that we use, or these new services may render our services and technologies obsolete. To be successful, we must adapt to our rapidly changing market by continually improving and expanding the scope of services we offer and by developing new services and technologies to meet customer needs. Our success will depend, in part, on our ability to license leading technologies and respond to technological advances and emerging industry standards on a cost-effective and timely basis. We may need to spend significant amounts of capital to enhance and expand our services to keep pace with changing technologies.

Third parties might infringe upon our proprietary technology, and we could be deemed to have infringed upon others' proprietary technology.

We cannot assure you that the steps we have taken to protect our intellectual property rights will prevent misappropriation of our proprietary technology. To protect our rights to our intellectual property, we rely on a combination of trademark and trade secret protection, confidentiality agreements and other contractual arrangements with our employees, affiliates, strategic partners and others. We may be unable to detect the unauthorized use of, or take appropriate steps to enforce, our intellectual property rights. Effective copyright and trade secret protection may not be available in every country in which we offer or intend to offer our services. Failure to adequately protect our intellectual property could harm our brand, devalue our proprietary content and affect our ability to compete effectively. Further, defending our intellectual property rights could result in the expenditure of significant financial and managerial resources. In addition, given the growing level of VoIP-related patents and related patent litigation, we could be deemed to have infringed on the patent rights of others, which could also result in the expenditure of significant financial and managerial resources, and which, if we are unsuccessful in defending, could result in significant damage awards.

 

If we are not able to obtain necessary licenses of third-party technology at acceptable prices, or at all, some of our products may become obsolete.

From time to time, we may be required to license technology from third parties to develop new products or product enhancements. Third-party licenses may not be available or continue to be available to us on commercially reasonable terms. The inability to maintain or re-license any third-party licenses required in our current products, or to obtain any new third-party licenses to develop new products and product enhancements, could require us to obtain substitute technology of lower quality or performance standards or at greater cost, and delay or prevent us from making these products or enhancements, any of which could seriously harm the competitiveness of our products.

Government regulation and legal uncertainties relating to IP telephony could harm our business.

Historically, voice communications services have been provided by regulated telecommunications common carriers. We offer voice communications to the public for international and domestic calls using IP telephony. Based on specific regulatory classifications and recent regulatory decisions, we believe we qualify for certain exemptions from telecommunications common carrier regulation in many of our markets. However, the growth of IP telephony has led to close examination of its regulatory treatment in many jurisdictions, making the legal status of our services uncertain and subject to change as a result of future regulatory action, judicial decisions or legislation in any of the jurisdictions in which we operate. Established regulated telecommunications carriers have sought and may continue to seek regulatory actions to restrict the ability of companies such as ours to provide services or to increase the cost of providing such services. In addition, our services may be subject to regulation if regulators distinguish phone-to-phone telephony service using IP technologies over privately-managed networks such as our services from integrated PC-to-PC and PC-originated voice services over the Internet. Some regulators may decide to treat the former as regulated common carrier services and the latter as unregulated enhanced or information services. Application of new regulatory restrictions or requirements to us could increase our costs of doing business and prevent us from delivering our services through our current arrangements. In such event, we would consider a variety of alternative arrangements for providing our services, including obtaining appropriate regulatory authorizations for our local network partners or ourselves, changing our service arrangements for a particular country or limiting our service offerings. Such regulations could limit our service offerings, raise our costs and restrict our pricing flexibility, and potentially limit our ability to compete effectively. Further, regulations and laws which affect the growth of the Internet could hinder our ability to provide our services over the Internet.

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		Additional Common Stock Outstanding												Additional Reservation									Current			Minimim Total
		Upon Conversion/Exercise 1												Requirements 2									Obligations			Additional
		Convertible												Convertible									To Issue			Authorized
		Notes			Warrants			Options			Subtotal			Notes			Options			Subotal			Shares 3			Shares Required
May 2005 private placement			-			124,349			-			124,349			-			-			-			76,761			201,110
July and October 2005 convertible notes and warrants			135,707			185,678			-			321,385			636,539			-			636,539			500,834			1,458,758
January and February 2006 convertible notes and warrants			2,320,307			453,706			-			2,774,013			525,712			-			525,712			308,254			3,607,979
November 2005 financing agreement			-			111,250			-			111,250			-			-			-			236,806			348,056
WQN, Inc.			1,098,906			-			-			1,098,906			-			-			-			-			1,098,906
October 06 convertible notes and warrants			807,188			518,907			-			1,326,095			807,188			-			807,188			-			2,133,283
January 07 convertible notes			532,662			-			-			532,662			-						-			-			532,662
February 07 convertible notes			1,162,220			1,066,034			-			2,228,254			1,162,220						1,162,220			-			3,390,474
Nov/Dec 06 & Jan 07 bridge notes			-			121,095			-			121,095			-			-			-			200,000			321,095
2004 Stock Option Plan			-			-			-			-			-			200,000			200,000			-			200,000
2006 Stock Option Plan			-			-			-			-			-			500,000			500,000			-			500,000
Securities owned by consulting and other professional firms			-			217,467			15,283			232,750			-						-			108,500			341,250
Current and former officer and employee securities 4			-			311,250			78,125			389,375			-			-			-			1,171,761			1,561,136
Securities owned by or owed to shareholders			-			194,620			-			194,620			-			-			-			48,965			243,585
Totals			6,056,990			3,304,356			93,408			9,454,754			3,131,659			700,000			3,831,659			2,651,881			15,938,294

 

¹ These columns represent common shares issuable upon the hypothetical conversion of outstanding convertible debt, and the exercise of all outstanding warrants and options.

² These columns represent contractual requirements to reserve specified or computed numbers of common shares from our authorized capital, in addition to the conversion/exercise amounts referred to in footnote 1.

³ These are common shares that are contractually owing to various individuals or firms, and are expected to be issued after our authorized shares are increased. (See Note R to our December 31, 2006 consolidated financial statements for subsequent authorized common stock increase.)

⁴ In addition, our Chief Executive Officer and Chief Operating Officer may receive additional options sufficient to maintain their common share ownership at 5% and 8%, respectively.

 

 

To date we have not had a standing compensation, nominating or audit committee. Existing board of directors members participate in the selection of director nominees, with the general objective of achieving a balance of experience, knowledge, integrity and capability on the board. A nominating committee is not considered necessary due to the small size of the company and of our board.

We shortly plan to establish a compensation committee consisting of two or more independent directors. The compensation committee will operate pursuant to a written charter. We also shortly plan to establish an audit committee consisting of two or more independent directors, and at least one financial expert. The audit committee will operate pursuant to a written charter.

 

We do not presently have a policy with respect to attendance by the directors at the annual meetings of shareholders.

Section 16(a) Beneficial Ownership Reporting Compliance

 

Section 16(a) of the Exchange Act requires our directors, executive officers and holders of more than 10% of our common stock to file with the SEC reports of their ownership and changes in ownership of our securities. Officers, directors and greater than 10% shareholders are required by SEC regulations to furnish us with copies of all Section 16(a) reports they file. To our knowledge, based solely on a review of the copies of such reports and written representations that no other reports were required, we believe that all filing requirements applicable to our officers, directors and greater than 10% shareholders were satisfied during the years ended December 31, 2006 and 2005, except as noted below:

 

Seventeen (17) Forms 4 required under Section 16(a) were filed late by Mr. Steven Ivester, and Mr. Ivester noted in reports filed by him that he had realized certain “short swing profits,” all of which have been repaid to the Company. Two Forms 4 were filed late by Mr. Bill Burbank; one Form 4 was filed late by Mr. David Sasnett; and one Form 4 was filed late by Mr. John Todd. In addition, Forms 3 were filed late by each of Mr. Gary Post, Mr. David Ahn, Mr. Robert Staats, Mr. Bill Burbank, Mr. David Sasnett, and WQN, Inc.  Forms 4 for 2006 transactions were not filed, and the related Form 5 was filed late, by Mr. Shawn M. Lewis.

Code of Ethics

 

We shortly plan to adopt a Code of Business Conduct and Ethics, within the meaning of Item 406(b) of Regulation S-K, that applies to our directors, officers and employees, including our principal executive officer, principal financial officer and principal accounting officer. Upon adoption, a complete copy of the proposed Code of Ethics will be posted at our website at www.voipincorporated.com under “Investor Info.” Any amendments to, or waivers of, the Code of Ethics will be promptly disclosed on our website.

 

Item 11. Executive Compensation

Compensation Discussion and Analysis

The objectives of our compensation program are as follows:

 

·

Reward performance that drives substantial increases in shareholder value, as evidenced through both future operating profits and increased market price of our common shares; and

 

·

Attract, hire and retain well-qualified executives given our competitive industry, start-up nature, and risk profile.

 

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The compensation level of our Chief Executive Officer (“CEO”) and our Chief Operating Officer (“COO”) in general is higher than other Company executives, and reflects the CEO's and COO's unique position and incentive to positively affect our future operating performance and shareholder value. Our CEO's and COO's compensation is heavily weighted toward equity compensation, primarily through stock options and grants, to provide a relatively strong personal economic incentive for these executives to increase the market price of our common shares. Specific salary and bonus levels, as well as the amount and timing of equity incentive grants, are determined informally and judgmentally, on an individual-case basis, taking into consideration each executive's unique talents and experience as they relate to our needs. Specific Company performance measures as they may relate to the timing and amount of executive compensation have not yet been developed. Executive compensation is primarily paid or granted pursuant to each executive's formal compensation agreement, but relatively small discretionary cash compensation is awarded at times on an individual-case basis. Compensation adjustments are made occasionally based on changes in an executive's level of responsibility or on changed local and specific executive employment market conditions.

Our current employment agreements with our CEO, COO and Chief Accounting Officer (“CAO”) contain provisions for lump sum payments in the event their employment is involuntarily terminated without defined cause. In addition, our CEO's employment agreement contains a provision for a lump sum payment in the event his employment is voluntarily terminated for good cause, as defined. For our CEO and COO, these lump sum payments would equal any earned but unpaid salary and bonus, unearned and unpaid bonus to the end of the contract term, plus the greater of unearned and unpaid salary to the end on the contract term or six months of salary. For our CAO, this lump sum payment would equal $75,000.

While our executives are involved in negotiating their own employment agreements, such agreements are approved by our board of directors.

On September 14, 2006, we entered into employment agreements with Anthony J. Cataldo, our Chairman and Chief Executive Officer, and Shawn Lewis, our Chief Operating and Technology Officer. These agreements provided for, among other things, the award of 500,000 stock options each to Messrs. Cataldo and Lewis upon sufficient underlying shares of common stock being authorized and available. The options were to be exercisable to purchase 500,000 shares of our common stock each for Messrs. Cataldo and Lewis at an exercise price of $0.20 per share for a period of five (5) years. The options were to contain a cashless exercise provision and cost free piggyback registration rights with respect to the common stock underlying the options. Messrs. Cataldo and Lewis were also to receive sufficient additional options under the same terms to assure that they have the right to exercise options to maintain a minimum of 5% and 8% beneficial ownership, respectively, of our issued and outstanding common stock.

A number of our current financing agreements contain “favored nations” provisions that require convertible debt conversion prices and stock warrant exercise prices to be repriced (reduced) in the event that, among other things, options are granted at exercise prices less than our quoted common stock market price at grant date. However, these favored nations repricing provisions are not triggered upon issuing employee stock grants. Accordingly, in lieu of the stock options to be granted to Messrs. Cataldo and Lewis, the board of directors on January 24, 2007 resolved to issue stock grants for 500,000 common shares each, subject to sufficient increased shares of common stock being authorized and available for issuance, which will require shareholder approval. The stock grants are to have the same 5% and 8% anti-dilution provisions and piggyback registration rights as the options were to have. On March 16, 2007, our shareholders approved an authorized common share increase sufficient to issue these shares.

Compensation Committee Report

The board of directors has reviewed and discussed the Compensation Discussion and Analysis with management, and based on this discussion the following board members, representing all current board members, recommended that this Compensation Discussion and Analysis be included in this annual report on Form 10-K:

Anthony Cataldo;

Gary Post;

Stuart Kosh; and

Nicholas A. Iannuzzi, Jr.

The following table sets forth information with respect to the compensation for the year ended December 31, 2006 of our principal executive officers and principal financial officers during 2006, and each person who served as an executive officer of our Company as of December 31, 2006.

 

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Summary Compensation Table

 

Name and											Stock			Option			All Other
Principal Position		Year			Salary			Bonus			Awards			Awards (1)			Compensation			Total
Anthony Cataldo (2)			2006		$	83,333		$	23,750		$	-		$	-		$	6,000		$	113,083
Chairman and Chief Executive Officer
(Principal Executive Officer)
Shawn M. Lewis (3)			2006			214,584			64,808			1,080,000			-			35,429			1,394,821
Chief Operating Officer;
Chief Technology Officer
Robert V. Staats (4)			2006			132,597			5,692			-			133,000			-			271,289
Chief Accounting Officer
(Principal Financial Officer)
Gary Post (5)			2006			72,668			-			300,000			930,000			241,672			1,544,340
Former President, Chief Executive
Officer and Chairman (6)
Michael Adler			2006			60,923			-			-			-			-			60,923
Former Chairman and Chief
Executive Officer (7)
David Sasnett			2006			54,375			-			-			-			-			54,375
Former Chief Financial Officer (8)

 

(1)	Includes awards of stock warrants where applicable. Values are computed in accordance with Statement of Financial Accounting Standards number 123R.

(2)

Mr. Cataldo's 2006 salary and bonus represent the contractual monthly amounts ($20,833 and $5,000, respectively) earned since September 2006, plus a discretionary bonus of $3,750. All Other Compensation represents Mr. Cataldo's monthly vehicle allowance since September 2006. Mr. Cataldo's employment agreement is effective through September 2009, and will thereafter automatically renew for successive one-year periods unless either party provides a 90-day notice of termination. See Compensation Discussion and Analysis for a description of certain stock options and stock grants pertaining to Mr. Cataldo. Since those stock options were not granted, they are not reflected in the Summary Compensation Table.

(3)

Mr. Lewis' 2006 salary and bonus represent his contractual monthly amounts earned (which have been $20,833 and $5,000, respectively, since September 2006), plus a discretionary bonus of $4,808. On November 8, 2006, Mr. Lewis was granted options to purchase 150,000 common shares at $7.20 per share (closing market price at the grant date). On November 9, 2006, we settled Mr. Lewis' claims against us for alleged breaches of his employment agreement, and for nonregistration of our common shares he holds pursuant to the Caerus merger agreement dated May 31, 2005, for $1,080,000. Also on November 9, 2006, Mr. Lewis exercised his options to purchase 150,000 common shares, and the $1,080,000 proceeds were credited toward the settlement of his claims. All Other Compensation represents Mr. Lewis' $1,500 monthly vehicle allowance since July 2006, plus discretionary expense reimbursement treated as compensation. Mr. Lewis' employment agreement is effective through September 2009. See Compensation Discussion and Analysis for a description of certain stock options and stock grants pertaining to Mr. Lewis. Since those stock options were not granted, they are not reflected in the Summary Compensation Table.

 

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(4)

Mr. Staats' 2006 salary ($11,667 per month at December 31, 2006, increasing to $12,917 in January 2007) represents his contractual monthly amounts earned. His bonus amount was discretionary. Mr. Staats' employment agreement also provides for the award of 5,000 options and 5,000 warrants, subject to approval by our board of directors. The options and warrants will each be exercisable to purchase 5,000 shares of our common stock at $20.40 a share until May 2011, and were valued at a combined $133,000 in May 2006. Mr. Staats' employment agreement is effective through May 2009, and will thereafter automatically renew for successive one-year periods unless terminated at least 90 days prior to the expiration of each current existing twelve-month period. Mr. Staats may terminate his employment agreement upon 30 days' prior notice.

(5)

Mr. Post's 2006 salary represents his contractual monthly amount earned from May to September 2006. Subject to approval by our board of directors, Mr. Post's employment agreement provides for the issuance of 15,000 common shares. Mr. Post's employment agreement also provided for the award of options and warrants to purchase a total of 150,000 shares of the Company's common stock at $20.00 a share until May 2011. On December 12, 2006 these options and warrants were converted to warrants to purchase 150,000 of our common shares at $9.50 per share, exercisable until December 2016. These new warrants were valued at $930,000. Mr. Post's employment agreement also provides for certain post-employment compensation totaling approximately $241,672, listed under All Other Compensation.

(6)	Mr. Post resigned his position as President, Chief Executive Officer and Chairman in September, 2006.

(7)	Mr. Adler resigned his position as Chairman and Chief Executive Officer in May, 2006.

(8)	Mr. Sasnett resigned his position as Chief Financial Officer in May, 2006.

Outstanding Equity Awards at Fiscal Year-End

 

The following table sets forth information with respect to grants of options to purchase our common stock to the named executive officers as of December 31, 2006.

		Option and Warrant Awards
		Number of Securities Underlying Unexercised Options and Warrants						Option or Warrant Exercise			Option or Warrant Expiration
		Exercisable			Unexercisable			Price			Date
Name and
Principal Position
Anthony Cataldo (1)			-			-		$	-
Chairman and Chief Executive Officer			-			-		$	-
(Principal Executive Officer)
Shawn M. Lewis (2)			-			-		$	-
Chief Operating Officer;			-			-		$	-
Chief Technology Officer
Robert V. Staats			9,532			2,969		$	20.40			5/17/11
Chief Accounting Officer			3,125			1,925 (9	)	$	22.40			6/3/10
Gary Post (3)			150,000			-		$	9.50			12/12/16
Former President, Chief Executive
Officer and Chairman (6)
Michael Adler (4)			25,000			-		$	31.20			10/18/10
Former Chairman and Chief			25,000			-		$	30.00			10/18/10
Executive Officer (7)
David Sasnett (5)			22,500					$	30.60			10/18/10
Former Chief Financial Officer (8)

 

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(1)	See Compensation Discussion and Analysis for a description of certain stock options and stock grants pertaining to Mr. Cataldo. Since those stock options were not granted, they are not reflected in the Outstanding Equity Awards at Fiscal Year-End table.

(2)	See Compensation Discussion and Analysis for a description of certain stock options and stock grants pertaining to Mr. Lewis. Since those stock options were not granted, they are not reflected in the Outstanding Equity Awards at Fiscal Year-End table.

(3)

Mr. Post's employment agreement provided for the award of options and warrants to purchase a total of 150,000 shares of the Company's common stock at $20.00 a share until May 2011. On December 12, 2006 these options and warrants were converted to warrants to purchase 150,000 of the Company's common shares at $9.50 per share, exercisable until December 2016.

(4)	Mr. Adler's options and warrants were issued in 2005 in conjunction with his employment agreement.

(5)	Mr. Sasnett's's warrants were issued in 2005 in conjunction with his employment agreement.

(6)	Mr. Post resigned his position as President, Chief Executive Officer and Chairman in September, 2006.

(7)	Mr. Adler resigned his position as Chairman and Chief Executive Officer in May, 2006.

(8)	Mr. Sasnett resigned his position as Chief Financial Officer in May, 2006.

(9)	Mr. Staats' remaining 2,969 and 1,925 options vest ratably until May 2009 and June 2008, respectively.

 

Option Exercises and Stock Vested
		Option Awards (1)						Stock Awards
		Number of Shares Acquired on Exercise			Value Realized on Exercise			Number of Shares Acquired on Vesting			Value Realized on Vesting
Name and
Principal Position
Anthony Cataldo			-		$	-			-		$	-
Chairman and Chief Executive Officer
(Principal Executive Officer)
Shawn M. Lewis (2)			150,000		$	-			-		$	-
Chief Operating Officer;
Chief Technology Officer
Robert V. Staats			-		$	-			-		$	-
Chief Accounting Officer
Gary Post (3)			-		$	-			15,000		$	300,000
Former President, Chief Executive
Officer and Chairman (4)
Michael Adler			-		$	-			-		$	-
Former Chairman and Chief
Executive Officer (5)
David Sasnett			-		$	-			-		$	-
Former Chief Financial Officer (6)

 

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(1)	Includes awards of stock warrants, where applicable. Values are computed in accordance with Statement of Financial Accounting Standards No. 123R.

(2)

On November 8, 2006, Mr. Lewis was granted options to purchase 150,000 common shares at $7.20 per share (closing market price at the grant date). On November 9, 2006, we settled Mr. Lewis' claims against us for alleged breaches of his employment agreement, and for nonregistration of our common shares he holds pursuant to the Caerus merger agreement dated May 31, 2005, for $1,080,000. Also on November 9, 2006, Mr. Lewis exercised his options to purchase 150,000 common shares, and the $1,080,000 proceeds were credited toward the settlement of his claims.

(3)	Subject to approval by our board of directors, Mr. Post's employment agreement provides for the issuance of 15,000 common shares.

(4)	Mr. Post resigned his position as President, Chief Executive Officer and Chairman in September, 2006.

(5)	Mr. Adler resigned his position as Chairman and Chief Executive Officer in May, 2006.

(6)	Mr. Sasnett resigned his position as Chief Financial Officer in May, 2006.

 

Director Compensation
The following table sets forth with respect to the named director, compensation information inclusive of equity awards and payments made in the year ended December 31, 2006.

 

		Stock Awards
Name of Director
Anthony Cataldo		$	-
Gary Post (1)		$	105,000
Stuart Kosh (1)		$	105,000
Nicholas A. Iannuzzi, Jr. (1)		$	-

 

(1)

On December 12, 2006 non-employee directors were each awarded 15,000 of our common shares, subject to sufficient authorized shares being approved by shareholders, as annual board member compensation. The fair value of the stock awards was based on the our closing common stock price of $7.00 per share on the grant date. Nicholas A. Iannuzzi was elected to our board of directors on March 16, 2007.

 

Potential Payments upon Termination or Change in Control

Our current employment agreements with our CEO, COO and CAO contain provisions for lump sum payments in the event their employment is involuntarily terminated without defined cause. In addition, our CEO's employment agreement contains a provision for a lump sum payment in the event his employment is voluntarily terminated for good cause, as defined. For our CEO and COO, these lump sum payments would equal any earned but unpaid salary and bonus, unearned and unpaid bonus to the end of their contract terms (September 2009), plus the greater of unearned and unpaid salary to the end on their contract terms or six months of salary. As of December 31, 2006, this would have equated to a lump sum payment of approximately $840,000 each for our CEO and COO, respectively. For our CAO, this lump sum payment would equal $75,000.

In May 2006 we entered into an employment agreement with Gary Post who became our President, Chief Executive Officer and Chairman and served in this capacity until September 2006. During his employment with us, Mr. Post served under an employment agreement. The employment agreement was for a term of three years (unless terminated earlier pursuant to its terms) and provided for a salary of $16,667 per month through December 31, 2006, increasing to $18,000 per month on January 1, 2007. Mr. Post's employment agreement also provides for the future payment of certain post-employment compensation totaling approximately $241,672 as of December 31, 2006.

Compensation Committee Interlocks and Insider Participation

To date we have not had a standing compensation committee. Mr. Anthony Cataldo, our Chief Executive Officer, Mr. Shawn Lewis, our Chief Operating Officer and Chief Technical Officer, and Mr. Gary Post, our former Chief Executive officer, participated in deliberations with our board of directors concerning executive officer compensation during the year ended December 31, 2006.

 

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Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

Equity Compensation Plan Information

See Note L to our consolidated financial statements for a description of our 2004 Employee Stock Option Plan (the “2004 Plan”) and our 2006 Equity Incentive Plan (the “2006 Plan”). The following table provides information as of December 31, 2006 regarding compensation plans under which our equity securities are authorized for issuance.

		Number of securities to be issued upon exercise of outstanding options, warrants and rights (a)			Weighted-average exercise price of outstanding options, warrants and rights (b)			Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a)) (c)
Equity compensation plans approved by shareholders			32,218		$	22.20			667,782
Equity compensation plans not approved by shareholders			407,813			20.00			-
Total			440,031		$	20.20			667,782

 

The above table excludes the 500,000 common shares that were granted to each of Messrs. Cataldo and Lewis by the board of directors on January 24, 2007, as more fully described in the Compensation Discussion and Analysis above.

Beneficial Ownership

The following table sets forth information as of March 15, 2007, except as otherwise noted, with respect to the beneficial ownership of our common stock and is based on 4,930,486 shares of common stock issued and outstanding as of March 15, 2007:

·	Each person known by us to own beneficially more than five percent of our outstanding common stock;

·	Each of our directors and prospective directors;

·	Our Chief Executive Officer and each person who serves as an executive officer of the Company; and

·	All our executive officers and directors as a group.

The number of shares beneficially owned by each shareholder is determined under rules promulgated by the SEC. The information is not necessarily indicative of beneficial ownership for any other purpose. Under these rules, beneficial ownership includes any shares as to which the individual has sole or shared voting power or investment power and any shares as to which the individual has the right to acquire beneficial ownership within 60 days, except as otherwise noted, through the exercise or conversion of any stock option, warrant, preferred stock or other right. The inclusion in the following table of those shares, however, does not constitute an admission that the named shareholder is a direct or indirect beneficial owner of those shares. Unless otherwise indicated, to our knowledge based upon information produced by the persons and entities named in the table, each person or entity named in the table has sole voting power and investment power, or shares voting and/or investment power with his or her spouse, with respect to all shares of capital stock listed as owned by that person or entity.

The address for each of our officers and directors is c/o VoIP, Inc., 151 South Wymore Road, Suite 3000, Altamonte Springs, Florida 32714.

 

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Name of Beneficial Owner		Shares of Common Stock Beneficially Owned (1)		Ownership of Common Stock (1,2)
WQN, Inc. (3)		1,390,812		23.1%
14911 Quorum Drive, Suite 140
Dallas, Texas 75240
Nicholas A. Iannuzzi, Jr.		15,368		*
Stuart Kosh (4)		148,438		3.0%
Shawn Lewis (5,6)		351,793		7.0%
Gary Post (7)		180,000		3.5%
Robert Staats (8)		12,657		*
Anthony Cataldo (6)		0		*
All directors and executive officers as a group (6 persons) (9)		708,256		13.3%

 

* Less than one percent.

(1)	We have issued and outstanding 4,930,486 shares of common stock; and a total of 400,000,000 shares are authorized. Additional issuances of common stock resulting from the exercise of options and/or warrants and/or the conversion of debt are subject to the authorized limit.

(2)	Based upon 4,930,486 shares of common stock issued and outstanding as of March 15, 2007.

(3)

Consists of 289,372 shares of common stock and 1,101,440 shares issuable upon conversion of a convertible promissory note. Conversion shares were calculated by dividing (i) the sum of the note principal of $3,700,000 and interest at 6% from 1/3/06 through 3/15/07 by (ii) effective conversion price of $3.60 per share.

(4)	Consists of (a) 98,125 shares of common stock; (b) currently exercisable options to purchase 7,813 shares of common stock; and (c) warrants to purchase 42,500 shares of common stock.

(5)	Consists of 351,793 shares of common stock.

(6)

As previously disclosed, on September 14, 2006, we entered into employment agreements with Anthony J. Cataldo, our Chairman and Chief Executive Officer, and Shawn Lewis, our Chief Operating and Technology Officer. These agreements provided for, among other things, the award of 500,000 stock options each to Messrs. Cataldo and Lewis upon sufficient underlying shares of common stock being authorized and available. The options were to be exercisable to purchase 500,000 shares of our common stock each for Messrs. Cataldo and Lewis at an exercise price of $0.20 per share for a period of five (5) years. The options were to contain a cashless exercise provision and cost free piggyback registration rights with respect to the common stock underlying the options. Messrs. Cataldo and Lewis were also to receive sufficient additional options under the same terms to assure that they have the right to exercise options to maintain a minimum of 5% and 8% beneficial ownership, respectively, of our issued and outstanding common stock.   A number of our current financing agreements contain “favored nations” provisions that require convertible debt conversion prices and stock warrant exercise prices to be repriced (reduced) in the event that, among other things, options are granted at exercise prices less than our quoted common stock market price at grant date. However, these favored nations repricing provisions are not triggered upon issuing employee stock grants. Accordingly, in lieu of the stock options to be granted to Messrs. Cataldo and Lewis, the board of directors on January 24, 2007 resolved to issue stock grants for 500,000 common shares each, subject to sufficient increased shares of common stock being authorized and available for issuance, which will require shareholder approval. The stock grants are to have the same 5% and 8% anti-dilution provisions and piggyback registration rights as the options were to have.   Accordingly, these shares are not included with the shares, if any, reported as beneficially owned herein.

 

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(7)	Consists of 30,000 shares of common stock and warrants to purchase 150,000 shares of common stock.

(8)	Consists of warrants to purchase 7,500 shares of common stock and currently exercisable options to purchase 5,157 shares of common stock.

(9)	Represents the combined beneficial ownership as of March 15, 2007, of the executives and the Company's four directors (a total of six persons).

Notes to Consolidated Financial Statements

NOTE A - ORGANIZATION AND DESCRIPTION OF BUSINESS

VoIP, Inc. (the "Company") was incorporated on August 3, 1998 under its original name of Millennia Tea Masters under the laws of the State of Texas. In February 2004, the Company exchanged 625,000 shares for the common stock of two start-up telecommunication businesses, eGlobalphone, Inc. and VoIP Solutions, Inc. The Company changed its name to VoIP, Inc. in April 2004 and acquired VCG Technologies, Inc. d/b/a DTNet Technologies (“DTNet Technologies”), a hardware supplier, and VoIP Americas, Inc. (“VoIP Americas”), in June and September, respectively, of 2004. The Company decided to exit its former tea business in December 2004 and focus its efforts and resources in the Voice over Internet Protocol (“VoIP”) telecommunications industry. In May 2005 the Company acquired Caerus, Inc. (“Caerus”), a VoIP carrier and service provider. In October 2005 the Company purchased substantially all of the VoIP assets of WQN Inc.'s (a Delaware corporation) (“WQN”) business. In April 2006 the Company sold DTNet Technologies to a former officer of the Company. In October 2006 the Company terminated its Marketing and Distribution Agreement with Phone House, Inc., a wholesale prepaid telephone calling card business acquired in its WQN acquisition. In June 2007 the Company sold substantially all of the tangible operating assets utilized by its Dallas, Texas division.

The Company is an emerging global provider of advanced communications services utilizing VoIP technology. VoIP telephony is the real time transmission of voice communications in the form of digitized "packets" of information over the Internet or a private network, similar to the way in which e-mail and other data is transmitted. VoIP services are expected to allow consumers and businesses to communicate in the future at dramatically reduced costs compared to traditional telephony networks.

The Company owns its network and its technology and offers the ability to provide complete product and service solutions, including wholesale carrier services for call routing and termination, outsourced customer service and hardware fulfillment. The Company is a certified Competitive Local Exchange Carrier (“CLEC”) and Interexchange Carrier (“IXC”). The Company offers a portfolio of advanced telecommunications technologies, enhanced service solutions, and broadband products. Current and targeted customers include regional bell operating companies (“RBOCs”), CLECs, IXCs, wireless carriers, resellers, Internet service providers, cable multiple system operators and other providers of telephony services.

NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation

 

The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries, Caerus, Inc., eGlobalphone, Inc., VoIP Solutions, Inc., and VoIP Americas, Inc. from their respective dates of acquisition. All significant intercompany balances and transactions have been eliminated in consolidation.

Discontinued Operations

The Company's operations formerly consisted of three segments: Telecommunication Services, Hardware Sales and Calling Card Sales. However, with the Company's sale of DTNet Technologies, the termination of its Marketing and Distribution Agreement with Phone House, Inc., and the sale of substantially all of the tangible operating assets utilized by its Dallas, Texas division, all referred to above, these former segments are being accounted for as discontinued operations, as discussed more fully in Note P, and prior period financial statements have been appropriately reclassified. Also as a result of these discontinued operations, the Company's operations currently consist of one segment, Telecommunication Services. Therefore, separate segmented financial results are not presented.

Use of Estimates

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

 

Cash and Cash Equivalents

 

For purposes of reporting cash flows, the Company considers all cash on hand, in banks, including amounts in book overdraft positions, certificates of deposit and other highly liquid debt instruments with a maturity of three months or less at the date of purchase, to be cash and cash equivalents. Cash overdraft positions may occur from time to time due to the timing of making bank deposits and releasing checks, in accordance with the Company's cash management policies.

 

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Accounts Receivable

 

Accounts receivable are stated at the amount management expects to collect from outstanding balances. Management provides for probable uncollectible amounts based on its assessment of the current status of the individual receivables and after using reasonable collection efforts.

Inventory

 

Inventory consists of finished goods and is valued at the lower of cost or market using the first-in, first-out method.

 

Convertible Debt

 

Convertible debt with beneficial conversion features, whereby the conversion feature is “in the money,” are accounted for in accordance with guidance supplied by Emerging Issues Task Force (“EITF”) No. 98-5 "Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios" and EITF No. 00-27 "Application of Issue 98-5 to Certain Convertible Instruments." The relative fair value of the warrants and the beneficial conversion feature has been recorded as a discount against the debt and is amortized over the term of the debt.

 

Fair Value Liability for Warrants

As a result of the Company's 2006 financing agreements, the number of common shares issuable upon the exercise of outstanding warrant agreements, when combined with existing outstanding common shares and shares issuable upon the conversion of applicable notes payable, exceeded the Company's authorized common shares. Therefore, as required by Emerging Issues Task Force Issue No. 00-19 (“EITF 00-19”), asset or liability classification of the warrants is required (as opposed to permanent equity classification) for the excess warrant shares.  From January to May 2006, only a portion of the Company's warrants were subject to liability classification. However, beginning May 2006, all of the Company's warrants were classified as a liability on its consolidated balance sheet, and their values were marked-to-market at December 31, 2006. Until the Company has sufficient authorized common shares to satisfy these warrant obligations, it will be subject to future noncash mark-to-market income or expense to the extent that the estimated market value of these warrants changes in the future, which is in turn primarily dependent upon the Company's common stock market price per share. See Note R for subsequent authorization of common shares, sufficient to satisfy these warrant obligations.

Income Taxes

 

The Company follows Statement of Financial Accounting Standards No. 109 “Accounting for Income Taxes” (“SFAS No. 109”). Under the asset and liability method of SFAS No. 109, deferred tax assets and liabilities are recognized for the future tax consequences attributed to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax base. 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. Under SFAS No. 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in the results of operations in the period that includes the enactment date. If it is more likely than not that some portion of a deferred tax asset will not be realized, a valuation allowance is recognized

 

Earnings (Loss) Per Share

Basic earnings (loss) per share is computed by dividing the net income (loss) for the year by the weighted-average number of shares of common stock outstanding. The calculation of fully diluted earnings per share assumes the dilutive effect of all potential outstanding common shares attributable to outstanding options, warrants, and convertible notes. Potential outstanding shares are not included in the computation of fully diluted loss per share as their effect is anti-dilutive.

 

Fair Value of Financial Instruments

 

The carrying amount of cash, accounts receivable, accounts payable and notes payable, as applicable, approximates fair value due to the short term nature of these items and/or the current interest rates payable in relation to current market conditions.

 

Revenue Recognition

 

Revenues are primarily derived from fees charged to terminate voice services over the Company's network and from monthly recurring charges associated with Internet and telecommunication services.

 

Variable revenue is earned based on the number of minutes during a call and is recognized upon completion of a call. Revenue for each customer is calculated from information received through the Company's network switches. The Company tracks the information received from the switch and analyzes the call detail records and applies the respective revenue rate for each call. Fixed revenue is earned from monthly recurring services provided to customers that are fixed and recurring in nature, and are connected for a specified period of time. Revenue recognition commences after the provisioning, testing, and acceptance of the service by the customer. Revenues are recognized as the services are provided and continue until the expiration of the contract or until cancellation of the service by the customer.

 

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Property and Equipment

 

Property and equipment are stated at cost. Depreciation is provided over the estimated useful lives of the related assets using the straight line method. The useful life of assets ranges from three to five years. The leasehold improvements are amortized over the life of the related leases. The Company reviews the recoverability of its property and equipment when events or changes in circumstances occur that indicate that the carrying value of the asset group may not be recoverable.

 

Business Combinations

The Company accounts for business combinations in accordance with Statement of Financial Accounting Standard No. 141, “Business Combinations” (SFAS No. 141). SFAS No. 141 requires that the purchase method of accounting be used for all business combinations. SFAS No. 141 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead be tested for impairment at least annually by comparing carrying value to the respective fair value in accordance with the provisions of Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (SFAS No. 142). This pronouncement also requires that the intangible assets with estimated useful lives be amortized over their respective estimated useful lives.

Goodwill and Other Intangible Assets

 

In accordance with Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets," the Company tests its goodwill and intangible assets for impairment at least annually by comparing the fair values of these assets to their carrying values, and the Company may be required to record impairment charges for these assets if in the future their carrying values exceed their fair values. During the years ended December 31, 2006 and 2005, the Company recognized impairment expense of $839,101 and $4,173,452, respectively, related to goodwill recorded for its former hardware sales business segment, and included in its reported loss from discontinued operations. If in the future the remaining carrying value of our goodwill exceeds its fair market value, the Company will be required to record an additional impairment charge in its statement of operations. Such an impairment charge could have a significant adverse impact on both our operating results and financial condition. If the traded market price of our common stock declines, a material goodwill impairment charge in the future is possible.

 

Stock Based Compensation

 

The Company applies the fair value method of Statement of Financial Accounting Standards No. 123R, "Accounting for Stock Based Compensation" (SFAS No. 123R) in accounting for its stock options. This standard states that compensation cost is measured at the grant date based on the value of the award and is recognized over the service period, which is usually the vesting period. The fair value for each option granted is estimated on the date of the grant using the Black-Scholes option pricing model. The fair value of all vested options granted has been charged to salaries, wages, and benefits in accordance with SFAS No. 123. Common stock granted to employees, directors and consultants is charged to operating expense based on the fair value of the stock at the date the stock rights are granted.

Reclassifications

 

Certain reclassifications have been made to the 2005 and 2004 financial statements to conform to the 2006 presentation, including reclassifications pertaining to discontinued operations as described in Note P.

 

Recent Accounting Pronouncements

 

In September 2006, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements.” SFAS No. 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, and also establishes a framework for measuring fair value. The provisions of this Statement are effective for fiscal years beginning after November 15, 2007. The Company does not expect the adoption of this Statement to have a material impact on its financial statements.

 

In February 2007, the Financial Accounting Standards Board issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” which amends SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” SFAS No. 159 permits companies to choose to measure many financial instruments at fair value, and could apply to the Company's potential future convertible debt and stock warrant agreements. The provisions of this Statement are effective for fiscal years beginning after November 15, 2007. The Company does not plan to elect fair value accounting under SAFS No. 159; therefore the Company does not expect the adoption of this Statement to have a material impact on its financial statements.

 

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NOTE C - LIQUIDITY, CAPITAL RESOURCES, AND GOING CONCERN

This Note C should be reviewed in conjunction with Notes F, G, H, I and R to the Company's consolidated financial statements.

The accompanying consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America, which contemplates continuation of the Company as a going concern. The Company has incurred operating losses and negative cash flows from operations since inception of its current business in 2004, has been dependent on issuances of debt and equity instruments to fund its operations and capital expenditures, and is in violation of most of its financing covenants. The Company's independent auditors have added an explanatory paragraph to their opinion on the Company's consolidated financial statements for the year ended December 31, 2006, based on substantial doubt about the Company's ability to continue as a going concern.

At December 31, 2006, the Company's contractual obligations for debt, leases and capital expenditures totaled approximately $25.3 million. Included in this amount is approximately $2.4 million due on a loan from a lending institution. The Company was not in compliance with certain covenants under the loan agreement for this debt. However, the lender has not declared this loan in default. (See Note R, for a description of the subsequent assignment and restructure of this debt.)

See Notes G and R for a description of the Company's convertible notes issued in July and October 2005 (“2005 Notes”), January and February 2006 (“Early 2006 Notes”), October 2006 (“Late 2006 Notes”), and February 2007 (“2007 Notes”). As explained below and in Notes G and R, the subscription agreements for these notes contain provisions that could impact the Company's future capital raising efforts and its capital structure:

·

The Company is required to file registration statements to register amounts ranging up to 200% of the shares issuable upon conversion of these notes, and all of the shares issuable upon exercise of the warrants issued in connection with these notes. Certain registration statements were filed, but have since become either ineffective or withdrawn. Until sufficient registration statements are declared effective by the Securities and Exchange Commission (the “SEC”), the Company is liable for liquidated damages totaling $1,058,858 through December 31, 2006, and will continue to incur additional liquidated damages of $228,432 per month until the required shares and warrants are registered.

·

Unless consent is obtained from the note holders, the Company may not file any new registration statements or amend any existing registrations until the sooner of (a) 60 to 365 days following the effective date of the notes registration statement or (b) all the notes have been converted into shares of the Company's common stock and such shares of common stock and the shares of common stock issuable upon exercise of the warrants have been sold by the note holders.

·	Since October 2005, the Company has been in violation of certain requirements of the 2005 Notes, the Early 2006 Notes, and the Late 2006 Notes. While the investors have not declared these notes currently in default, the full amount of the notes at December 31, 2006 has been classified as current.

In connection with a private placement memorandum dated May 20, 2005, the Company issued 112,125 shares of its common stock for $16.00 per share, and warrants to purchase 110,388 common shares at prices from $32.00 to $44.60 per share. At December 31, 2006, the fair value of these outstanding warrants was $58,510, which was recorded as a liability on the Company's consolidated balance sheet. As required by the subscription agreements, a portion of the shares was registered with the SEC in October 2005, but that registration became ineffective in July 2006. Non-registration liquidated damages accrued until September 2006, when all related shares and warrants became tradable under Rule 144, and, in accordance with the terms of the subscription agreements, accrual of liquidated damages ceased. At December 31, 2006, liquidated damages totaled 74,125 shares and 11,325 warrants owing, recognized as a $1,342,299 current liability on the Company's balance sheet.

In connection with a subscription agreement dated August 26, 2005 and amended on November 16, 2005, the Company issued 68,750 shares of its common stock for $16.00 per share, and warrants to purchase 111,250 common shares at prices ranging from $27.40 to $32.00 per share. The investor also received “favored nations” rights such that for future securities offerings by the Company at a price per share less than the per share purchase price or warrant exercise prices, the investor's effective per share purchase price and warrant exercise price would be adjusted to the lower offering price. As a result of this favored nations provision and the February 2007 financing agreements described in Note R, the subscription agreement's per share purchase price and the warrants' exercise prices were effectively reduced to $3.60 per share. At December 31, 2006, the fair value of these outstanding warrants was $400,500, which was recorded as a liability on the Company's consolidated balance sheet. The Company also agreed to register a total of 292,500 common shares and warrants related to this agreement by January 17, 2006. Until a registration statement is declared effective by the SEC, the Company is liable for liquidated damages totaling $600,000 through December 31, 2006, and will continue to incur additional liquidated damages of $50,000 per month until the required shares and warrants are registered.

The Company will need to continue to raise additional debt or equity capital to provide the funds necessary to restructure or repay its $2.4 million loan, meet its other contractual commitments, and continue its operations. The Company is actively seeking to raise this additional capital but may not be successful in obtaining the imminently-required debt or equity financing. The accompanying financial statements do not include any adjustments relating to the recoverability and classification of asset amounts or the amounts and classification of liabilities that might be necessary should the Company be unable to continue as a going concern.

 

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The Company's authorized common stock consisted of 100,000,000 common shares at December 31, 2006, of which 4,930,486 common shares (98,609,701 common shares pre-split) were issued and outstanding, and approximately 7.05 million (141 million pre-split) additional shares were contingently issuable upon the exercise of stock options and warrants, or conversion of convertible securities. An additional 1.2 million (24 million pre-split) common shares were required to be reserved under the Company's various existing financing agreements. As of December 31, 2006 the Company was also contractually obligated to register approximately 9.6 million (192 million pre-split) shares, warrants and options. (See Note R for a subsequent increase in the Company's authorized common stock to 400,000,000 shares, and the authorization of a new class of preferred stock.) There is no assurance that sufficient registration statements can be filed or declared effective by the SEC, or that sufficient additional common stock authorizations can be approved by shareholders, in which case the Company would continue to be unable to satisfy its contractual obligations to register shares, and would be unable to satisfy the contractual obligations it has undertaken to reserve shares of common stock.

NOTE D - PROPERTY AND EQUIPMENT, NET

 

At December 31, 2006 and 2005, property and equipment consisted of the following:

 

		2006			2005
Equipment		$	8,370,278		$	8,869,410
Furniture & Fixtures			85,397			160,553
Software			666,842			1,667,864
Vehicles			15,269			15,269
Leasehold improvements			95,415			238,857
Total			9,233,201			10,951,953
Less accumulated depreciation			(2,628,916	)		(1,264,483	)
Total		$	6,604,285		$	9,687,470

 

Depreciation expense for the years ended December 31, 2006, 2005 and 2004 amounted to $1,788,871, $1,129,525, and $82,832, respectively.

The amount of equipment held under capital leases, included above and net of accumulated amortization, was $244,656 and $259,946 at December 31, 2006 and 2005, respectively.

NOTE E - GOODWILL AND OTHER INTANGIBLE ASSETS

In accordance with Statement of Financial Accounting Standards No. 142 (“SFAS No. 142”), the Company performs an evaluation of the fair values of its operating segments annually, and more frequently if an event occurs or circumstances change that may indicate that the fair value of a reporting unit is less than its carrying amount. As described in Note P, on April 19, 2006, the Company completed the sale of its interest in its subsidiary DTNet Technologies. DTNet Technologies' operations were the primary component of the Company's hardware sales business segment, and the Company recorded a goodwill impairment charge of $839,101 in its March 31, 2006 statement of operations to reduce the carrying value of this subsidiary to its estimated fair value. The remaining $198,000 balance of goodwill for this segment was a component of net assets sold.

The Company's balance sheet at December 31, 2006 includes approximately $16.8 million in goodwill and approximately $9.2 million in other intangible assets recorded in connection with its acquisition in May 2005 of Caerus and its subsidiaries.

In accordance with SFAS 142, management tests the carrying value of its goodwill and other intangible assets for impairment at least annually by comparing the fair values of these assets to their carrying values. During the year ended December 31, 2005 the Company recorded an impairment charge to its operating results of approximately $4.2 million relating to goodwill previously recorded for an acquisition. During the year ended December 31, 2006, the Company recorded an impairment charge to operating results of $839,101 as a result of selling the Company's interest in its subsidiary, DTNet Technologies in April 2006. These charges reduced the carrying value of the subsidiary to its estimated fair value. The Company may be required to record additional impairment charges for these assets in the future, which could materially adversely affect its financial condition and results of operations. If the traded market price of the Company's common stock declines, or its future revenue does not increase coincident with amounts previously projected and utilized to determine the fair value of the Company's goodwill and other intangible assets, a material goodwill impairment charge in the future is possible.

 

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As of December 31, 2006 and 2005 goodwill and other intangible assets consisted of the following:

 

					2006			2005
								(Restated)
Goodwill					$	16,826,301		$	16,826,301
Other intangible assets:
			Useful Life (Years)
Technology			4.0		$	6,000,000		$	6,000,000
Customer relationships			6.0			5,800,000			5,800,000
Trade names			9.0			1,300,000			1,300,000
Non-compete agreement			1.0			500,000			500,000
Other intangible assets			Indefinite			200,000			200,000
Subtotal						13,800,000			13,800,000
Accumulated amortization						(4,634,267	)		(1,500,820	)
Other intangible assets, net						9,165,733			12,299,180
Total goodwill and other intangible assets					$	25,992,034		$	29,125,481

The December 31, 2005 goodwill amount excludes $1,037,101 related to the Company's former hardware sales segment, which was reclassified to net assets of discontinued operations. Amortization expense for the years ended December 31, 2006, 2005 and 2004 amounted to $2,819,447, $1,500,820 and $0, respectively.

 

The December 31, 2005 goodwill amount was also restated to reflect a reduction of $2,360,000 which represented contingent consideration (escrowed common shares - see Note J) related to the Caerus acquisition. According to SFAS No. 141, such contingent consideration should not have been included in the Caerus purchase price determination. The Company's consolidated statements of operations and cash flows for the year ended December 31, 2005 were not affected.

NOTE F - LOANS PAYABLE

At December 31, 2006 and 2005, loans payable consisted of the following:

		2006			2005
Note payable to a lending institution		$	2,381,085		$	4,685,236
Other notes payable			193,750			-
Total loans payable		$	2,574,835		$	4,685,236

The note payable to a lending institution bears interest at 17.5%, and is repayable through May 2007. Interest expensed and paid under this debt facility during the years ended December 31, 2006, 2005 and 2004 was $443,805, $399,551, and $0, respectively. The loan agreement contains customary covenants and restrictions and provides the lender the right to a perfected, first-priority security interest in all of the Company's assets. The Company was in violation of certain requirements of this debt facility at December 31, 2006, and has not made scheduled principal and interest payments. However, the lender has currently not declared this loan in default. As a result, the full amount of the loan at December 31, 2006 has been classified as current. (See Note R for subsequent reassignment and restructure of this loan.)

The other notes payable at December 31, 2006 was classified as common stock and additional paid-in capital at December 31, 2005, because related notes payable were converted to common stock in 2005. According to the terms of a November 2006 settlement agreement between the Company and the convertible note holders, the note holders returned the common stock to the Company, and the convertible debt was reclassified to loans payable.

NOTE G - CONVERTIBLE NOTES AND WARRANTS PAYABLE

At December 31, 2006 and 2005, convertible notes payable, and the fair value liability for related warrants consisted of the following:

 

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		Convertible Notes Payable						Fair Value Liability for Warrants
		2006			2005			2006			2005
Payable to WQN, Inc. (1)		$	-		$	-		$	-		$	-
Payable to accredited investors:
July & October 2005 (2)			488,543			1,496,804			441,313			-
January & February 2006 (3)			8,353,102			-			980,409			-
October 2006 (4)			2,905,875			-			1,971,844			-
May 2005 private placement (5)			-			-			58,510			-
August 2005 subscription agreement (5)			-			-			400,500			-
Other - see Note M			-			-			1,250,155			-
Subtotal			11,747,520			1,496,804			5,102,731			-
Less discounts			(5,845,303	)		(1,313,006	)		-			-
Total		$	5,902,217		$	183,798		$	5,102,731		$	-

(1)

In October 2005, the Company acquired substantially all of the operating assets and liabilities of WQN, Inc. for a total purchase price of $9.8 million. The acquisition was funded in part with the issuance of a convertible note in the principal amount of $3.7 million. A debt discount was established to reflect an effective interest rate of 20%, bringing the original net note payable value to $3,216,000. The note is secured by a subordinated lien on the Company's assets. The principal balance of the note was $3,700,000 at December 31, 2006. The note, bearing a nominal interest rate of 6%, became payable beginning February 2006 over 12 months in cash or, at the option of the Company, in Series A preferred stock (subsequently authorized - see Note R) at $10.00 per share or in common stock at an original $1.06 per share. WQN received “favored nations” rights such that for future securities offerings by the Company at a price per share less than this conversion price, this common stock conversion price would be adjusted to the lower offering price. As a result of this favored nations provision and the February 2007 financing agreements described in Note R, the note's common stock conversion rate was effectively reduced to $0.18 per share. At December 31, 2006, the Company had not made scheduled principal payments of $3,391,667. WQN has agreed to subordinate its repayment claim to the convertible note holders described in paragraphs (2) through (4) below. Also as a result of the October 2005 acquisition, WQN, Inc. received five-year warrants to purchase 5,000,000 shares of the Company's common stock for $0.001 per share. WQN exercised the warrants on January 5, 2006 for 4,996,429 shares of the Company's common stock. All WQN convertible shares and warrant shares have piggyback registration rights on any registration statement filed by the Company between October 2005 and October 2007. At December 31, 2006, the Company was in violation of certain requirements of this note. Due to the sale of substantially all of the tangible operating assets utilized by our Dallas, Texas division, this convertible note was classified with discontinued operations in our consolidated financial statements for all periods presented.

2)

In July and October 2005 the Company issued and sold $3,085,832 in principal amount of convertible notes to institutional investors at a discount, receiving net proceeds of $2,520,320. These notes are immediately convertible at the option of the note holders into shares of the Company's common stock, at an original conversion rate of $16.00 per share. These investors also received five-year warrants to purchase 48,217 shares of the Company's common stock for $27.52 per share, five-year warrants to purchase 48,217 shares of the Company's common stock for $33.01 per share, and one-year warrants to purchase 96,433 shares of the Company's common stock for $32.00 per share. The investors also received “favored nations” rights such that for future securities offerings by the Company at a price per share less than the above conversion rate or warrant exercise prices, the investors' conversion rate and warrant exercise price would be adjusted to the lower offering price. These notes are secured by a subordinated lien on the Company's assets, and the notes bear interest at an effective rate of approximately 20%. The principal balance of these notes was $488,543 and $1,496,804 at December 31, 2006 and 2005, respectively. Half of these notes became payable beginning in October 2005 and the other half beginning in January 2006 (three months following their respective issuances) over two years in cash or, at the option of the Company, in registered common stock at the lesser of $16.00 per share or 85% of the weighted average price of the stock on the OTC Bulletin Board (the “OTCBB”). In May 2006, the Company repriced these warrants to $15.60 per share, at which time these warrants were exercised, resulting in net proceeds to the Company of $2,740,120. The Company then issued warrants to the investors to purchase a like number of shares for $16.00. As a result of the favored nations provision discussed above and the Section 3(a)(10) agreement described below, the notes' conversion rate (retroactive to the original note principal balances) and the exercise price of outstanding warrants were effectively reduced to $5.20 per share. As a result of the February 2007 financing agreements described in Note R, the notes' conversion rate (retroactive to the original note principal balances) and the exercise price of outstanding warrants were further reduced to $3.60 per share. At December 31, 2006, the fair value of these outstanding warrants was $441,313, which was recorded as a liability on the Company's consolidated balance sheet. (See the last paragraph of this Note G below for additional background.) At December 31, 2006, the Company had not made scheduled principal payments of $118,930 on these notes. Beginning October 2005, the Company was in violation of the registration requirements contained in the October 2005 subscription agreements, and beginning July 2006 the Company was in violation of the registration requirements contained in the July 2005 subscription agreements. As a result, the Company owed related liquidated damages of $343,034 at December 31, 2006, and will incur additional damages of $40,494 per month until a registration statement related to the shares and warrants is declared effective by the SEC. While the investors have not declared the notes currently in default, the full amount of the notes at December 31, 2006 has been classified as current.

 

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(3)

In January and February 2006, the Company issued and sold $11,959,666 in principal amount of convertible notes to institutional investors at a discount, receiving net proceeds of $9,816,662. These notes are immediately convertible at the option of the note holders into shares of the Company's common stock at an original conversion rate of $26.36 per share. These investors also received five-year warrants to purchase 226,853 shares of the Company's common stock for $29.18 per share, and one-year warrants to purchase 226,853 shares of the Company's common stock for $31.83 per share. The investors also received “favored nations” rights such that for future securities offerings by the Company at a price per share less than the above conversion rate or warrant exercise prices, the investor's conversion rate and warrant exercise price would be adjusted to the lower offering price. Of the total initial principal, $8,318,284 of the notes are secured by a subordinated lien on the Company's assets. The principal balance of the notes was $8,353,101 at December 31, 2006, and all the notes bear interest at an effective rate of approximately 20%. The unsecured portion of these notes became payable beginning in July 2006 over two years in cash or, at the option of the Company, in registered common stock at the lesser of $26.36 per share or 85% of the weighted average price of the stock on the OTCBB, but not less than $20.00 per share. As a result of a May 2006 warrant restructure, the secured portion of these notes became payable beginning in August 2006 over two years in cash or, at the option of the Company, in registered common stock at the lesser of $20.00 per share or 85% of the weighted average price of the stock on the OTCBB, but not less than $16.00 per share. As a result of the favored nations provision discussed above and the Section 3(a)(10) agreement described below, the notes' conversion rate (retroactive to the original note principal balances) was effectively reduced to $5.20 per share, and the outstanding warrants were re-priced to $9.50 per share. As a result of the February 2007 financing agreements described in Note R, the notes' conversion rate (retroactive to the original note principal balances) and the exercise price of outstanding warrants were further reduced to $3.60 per share. At December 31, 2006, the fair value of these outstanding warrants was $980,409, which was recorded as a liability on the Company's consolidated balance sheet. (See the last paragraph of this Note G below for additional background.) At December 31, 2006, the Company had not made scheduled principal payments of $1,083,782 on these notes. Beginning April 2006, the Company was in violation of the registration requirements of the secured notes, and beginning May 2006, the Company was in violation of the registration requirements of the unsecured notes. In May 2006, the Company issued an aggregate of 8,319 shares to the secured investors in satisfaction of then-existing secured non-registration liquidated damages. The Company owed additional liquidated damages of $694,514 at December 31, 2006, and will incur additional damages of $129,014 per month until a registration statement related to the shares and warrants is declared effective by the SEC. While the investors have not declared the notes currently in default, the full amount of the notes at December 31, 2006 has been classified as current.

In September 2006 certain of the July and October 2005 and the January and February 2006 convertible note holders filed actions against the Company claiming a breach of contract related to the notes. In settlement of these actions, the parties entered into settlement agreements pursuant to which, among other things: 1) interest and liquidated damages due under the notes were set at $242,149 and $415,353, respectively; 2) the note holders exchanged the interest and liquidated damages due, along with $3,899,803 in principal, and a discount of $881,155, for 1,045,858 shares of the Company's common stock through the issuance of freely trading securities issued pursuant to Section 3(a)(10) of the Securities Act; 3) the conversion rate for the remaining principal balance due under the notes was reset to $5.20; 4) the exercise price of the outstanding warrants purchased by the note holders in connection with the January and February 2006 notes was reduced to $9.50; and 5)  certain investors agreed to surrender their claims associated with warrants issued in May 2006 in exchange for 125,000 shares of the Company's common stock through the issuance of freely trading securities issued pursuant to Section 3(a)(10) of the Securities Act.

 

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(4)

On October 17, 2006, the Company issued and sold $2,905,875 in secured convertible notes to twelve institutional investors, for a net purchase price of $2,324,700 (after a 20% original issue discount) in a private placement. Proceeds of approximately $1,436,900 (before closing costs of $308,748) were paid in cash to the Company at closing, and $887,800 of the proceeds were used to repay three outstanding promissory notes held by three of the investors in the private placement. The investors also received five-year warrants to purchase a total of 518,907 shares of the Company's common stock at an exercise price of $8.14 per share. The principal balance of the notes was $2,905,875 at December 31, 2006. These convertible notes are secured by a subordinated lien on the Company's assets, are not interest bearing, and are due on December 31, 2007. The note holders may at their election convert all or part of the Convertible Notes into shares of the Company's common stock at an original conversion rate of $5.60 per share. The investors also received “favored nations” rights such that for future securities offerings by the Company at a price per share less than the above conversion rate or warrant exercise prices, the investor's conversion rate and warrant exercise price would be adjusted to the lower offering price. As a result of the favored nations provision discussed above and the February 2007 financing agreements described in Note R, the notes' conversion rate (retroactive to the original note principal balances) and the exercise price of outstanding warrants were reduced to $3.60 per share. At December 31, 2006, the fair value of these outstanding warrants was $1,971,844, which was recorded as a liability on the Company's consolidated balance sheet. (See the last paragraph of this Note G below for additional background.) Pursuant to the subscription agreement, the Company was to obtain shareholder approval to increase its authorized shares of common stock to 400,000,000 shares and file an amendment to its articles of incorporation by December 20, 2006. Failing this, the holders of the convertible notes are entitled to liquidated damages that will accrue at the rate of two percent of the amount of the purchase price of the outstanding convertible notes per month during such default. The Company has also agreed to file registration statements covering the resale of 130% of the shares of common stock that may be issuable upon conversion of the convertible notes, and 100% of the shares of common stock issuable upon the exercise of the warrants. The first such registration statement was to be filed on or before January 2, 2007 and declared effective by March 31, 2007. Because the Company is in violation of these authorized share and registration requirements, liquidated damages have been accruing at the rate of $58,925 per month since December 20, 2006. (See Note R for subsequent authorized common stock increase.) While the investors have not declared the notes currently in default, the full amount of the notes at December 31, 2006 has been classified as current.

(5)

See Note C for a discussion of the May 2005 private placement and the August 2005 subscription agreement.

No interest was paid on any of the convertible notes described above during the years ended December 31, 2006, 2005 and 2004, except as described in the Section 3(a)(10) agreement above affecting the interest owed to the July/October 2005 and January/February 2006 convertible note holders.

The Company had insufficient authorized common shares to satisfy the warrant obligations associated with the convertible notes issued in January and February 2006 on the dates the warrants were issued. Therefore, in accordance with Emerging Issues Task Force Issue 00-19 (“EITF 00-19”), the $3,526,077 initial value of these warrants at their issuance dates was recorded as a debt discount and a warrant liability on the Company's consolidated balance sheet. In addition, $770,314 of the proceeds received from the May 2006 warrant repricing and exercise discussed in the sixth preceding paragraph above were allocated to these warrants, and recorded as a warrant liability on the Company's balance sheet. Also, the May 2006 warrant repricing to $15.60 per share triggering contractual “favored nations” price ratchets on a number of our existing convertible debt and warrant agreements, reducing their effective conversion and exercise prices to $15.60 per share. The effect was to increase the number of fully diluted shares of common stock at the time to approximately 6.45 million (129 million pre-split), relative to the Company's then-authorized 100 million common shares. The Company's total warrants then outstanding were approximately 1.4 million (28 million pre-split). Per EITF 00-19, the Company classified all remaining warrants as a liability, transferring $5,406,284 from additional paid-in capital to fair value liability for warrants on its consolidated balance sheet. The warrant liabilities have since been marked-to-market, resulting in a $5,102,731 liability at December 31, 2006, and a corresponding credit to earnings for the year ended December 31, 2006 of $7,226,430, respectively.

NOTE H - NONREGISTRATION PENALTIES AND OTHER STOCK-BASED PAYABLES

At December 31, 2006, nonregistration penalties and other stock-based payables consisted of the following (none existed at December 31, 2005):

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		2006
Nonregistration penalties payable:
In cash		$	1,658,858
In common stock and warrants			1,342,299
Common stock payable to officer			732,678
Common stock payable to directors			210,000
Common stock payable to investors			365,345
Common stock payable for other services rendered			439,200
Total		$	4,748,380

As discussed in Note G - Convertible Notes and Warrants Payable, the Company is in violation of the registration requirements of a number of its existing financing agreements. As such, liquidated damages payable in a combination of stock and cash amounted to $3,001,157 as of December 31, 2006.

As discussed in Note L, the Company's Chief Operating Officer exercised options to purchase 150,000 shares of common stock. Since the Company had insufficient authorized common shares at December 31, 2006, only 48,239 shares were issued, and the balance of 101,761 shares (valued at $732,678) will be issued upon authorization of sufficient common shares. Common stock payable to directors, investors and others for services rendered will be issued upon authorization of sufficient common shares. (See Note R for subsequent shareholder approval of increased common shares.)

NOTE I - NOTES AND ADVANCES FROM INVESTORS

Notes and advances from investors of $616,667 and $3,000,000 at December 31, 2006 and 2005, respectively, represent funds loaned to or deposited with the Company in anticipation of the issuance of future notes payable. The $616,667 at December 31, 2006 represents funds advanced to the Company in November and December 2006, in anticipation of the issuance of convertible notes payable, which were issued in February 2007 (see Note R). The $3,000,000 at December 31, 2005 represents funds deposited with the Company in anticipation of the issuance of convertible notes payable, which were issued in January 2006 (see Note G).

These notes and advances are unsecured. The $616,667 notes at December 31, 2006 bore interest at 18%. The $3,000,000 advance at December 31, 2005 was not interest bearing.

NOTE J - ACQUISITIONS

On May 31, 2005, the Company acquired 100% of Caerus and its wholly owned subsidiaries Volo Communications, Inc. (“Volo”), Caerus Networks, Inc., and Caerus Billing, Inc. in exchange for approximately 720,000 of the Company's common shares (excluding 100,000 escrowed common shares, 33,333 of which were issued in November 2006).

The goodwill, intangible assets and property recorded for the acquisition of Caerus represent the fair market value of liabilities as of the date of acquisition, plus approximately $15.9 million, which represents the value of the Company's common stock and options issued pursuant to the acquisition.

On October 5, 2005, the Company acquired substantially all of the operating assets and liabilities of WQN, for a total purchase price of $9.8 million. The acquisition was financed with the issuance of $3.7 million of convertible debt ($3.2 million net of discount), 62,500 shares of the Company's common stock, and warrants to purchase 250,000 shares of the Company's common stock at $0.001 per share. Since the tangible assets related to this acquisition were sold in June 2007, this business is being classified as discontinued operations for all financial statements presented.

The condensed balance sheet of the Caerus acquisition, reflecting the net fair value amounts assigned to each major asset and liability, as of its acquisition date is as follows:

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		Caerus, Inc.
Current assets		$	617,000
Property and equipment, net			7,869,000
Other assets			131,000
Accounts payable and other current liabilities			(14,674,000	)
Note payable			(4,832,000	)
Net liabilities assumed			(10,889,000	)
Goodwill			15,418,000
Intangible assets - other			13,800,000
Intangible assets			29,218,000
Net fair value assets acquired		$	18,329,000

 

The goodwill amount for Caerus, Inc. was restated to reflect a reduction of $2,360,000, which represented contingent consideration (escrowed common shares - see Note J) related to the Caerus acquisition.

NOTE K - LITIGATION

MCI

On April 8, 2005, the Company's subsidiary, Volo Communications, filed suit against MCI WorldCom Network Services, Inc. d/b/a UUNET ("MCI WorldCom"). Volo alleges that MCI WorldCom engaged in a pattern and practice of over-billing Volo for the telecommunications services it provided pursuant to the parties' Services Agreement, and that MCI WorldCom refused to negotiate such overcharges in good faith. Volo also seeks damages arising out of MCI WorldCom's fraudulent practice of submitting false bills by, among other things, re-routing long distance calls over local trunks to avoid access charges, and then billing Volo for access charges that were never incurred.

On April 4, 2005, MCI WorldCom declared Volo in default of its obligations under the Services Agreement, claiming that Volo owes a past due amount of $8,365,980, and threatening to terminate all services to Volo within five days. By this action Volo alleges claims for (1) breach of contract; (2) fraud in the inducement; (3) primary estoppel; and (4) deceptive and unfair trade practices. Volo also seeks a declaratory judgment that (1) MCI WorldCom is in breach of the Services Agreement; (2) $8,365,980 billed by MCI WorldCom is not "due and payable" under that agreement; and (3) MCI WorldCom's default letter to Volo is in violation of the Services Agreement. Volo seeks direct, indirect and punitive damages in an amount to be determined at trial.

  

On May 26, 2005, MCI WorldCom filed an Answer, Affirmative Defenses, Counterclaim and Third-Party Complaint naming Caerus as a third-party defendant. MCI WorldCom asserts a breach of contract claim against Volo, a breach of guarantee claim against Caerus, and a claim for unjust enrichment against both parties, seeking an amount to be determined at trial. On July 11, 2005, Volo and Caerus answered the counterclaim and third-party complaint, and filed a third-party counterclaim against MCI WorldCom for declaratory judgment, fraud in the inducement, and breach of implied duty of good faith and fair dealing. Volo and Caerus seek direct, indirect and punitive damages in an amount to be determined at trial.

Extensive discovery took place throughout 2006, with multiple depositions taking place, written discovery requests being exchanged, and extensive document productions being held.

On December 20, 2006, the Court granted MCI WorldCom summary judgment dismissing Caerus' claim for slander of credit. On January 7, 2007, the Court issued a scheduling order setting a trial date for June 18, 2007, with several interim deadlines. On February 28, 2007, the Court denied MCI WorldCom's motion for summary judgment of dismissal of the claims of Volo and Caerus for declaratory relief, denied Caerus' motion for clarification or reargument of the dismissal of the slander of credit claim and denied Volo's and Caerus' motions in the alternative to amend their complaints.

 

On January 2, 2007, an Amended Case Management and Scheduling Order was entered which imposed a May 18, 2007 discovery cutoff; a June 5, 2007 pre-trial conference; and a June 18, 2007 time-certain trial. On January 11, 2007, MCI WorldCom and Volo/Caerus participated in a Court-ordered mediation conference. The parties engaged in further settlement discussions in February and March 2007, which ultimately led to an agreement to terms to settle the litigation and the signing of a mutually acceptable settlement term sheet on March 27, 2007. The term sheet contains a due diligence provision that, upon completion under certain circumstances, permits MCI WorldCom to decide whether or not to proceed with the settlement. The parties' contemplate finalizing and executing mutually acceptable settlement documents reflecting the confidential settlement term sheet before the case is be dismissed.

 

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In the event the parties withdraw from the settlement, the Company is currently unable to assess the likelihood of a favorable or unfavorable outcome. In that event, it is not clear whether or not the Court will hold the parties to the previously-ordered June 2007 trial.

Netrake Corporation

The Company and its subsidiaries Caerus and Volo were involved in disputes with Netrake Corporation ("Netrake") arising from an equipment purchase contract under which Volo agreed to purchase approximately $2.0 million of Netrake's telephonic equipment and software. Through mediation, these disputes were settled July 27, 2006, primarily requiring Volo to return equipment purchased in connection with the contract and to make an immaterial monetary payment to Netrake. In conjunction with this settlement, the Company recognized a $408,343 litigation gain during the year ended December 31, 2006, primarily related to the excess of accounts payable over the net book value of the equipment returned.

Cross Country Capital Partners, L.P.

On or about September 25, 2006, Cross Country Capital Partners, L.P. (“Cross Country”) filed suit against the Company in the District Court, 116 ^th Judicial Circuit, Dallas County, Texas. Cross Country asserts a claim for breach of contract in connection with a securities purchase agreement entered into with the Company. Cross Country also seeks specific performance of the securities purchase agreement at issue. Cross Country seeks unspecified damages and attorneys' fees, which fees are provided for in the securities purchase agreement and under Texas law. On or about December 14, 2006, the Company filed its Answer denying any wrongdoing and asserting numerous affirmative defenses. The Company intends to vigorously defend this matter but is unable to assess the outcome of this litigation or its impact on the Company's financial condition and results of operations.

Other

The Company and Mr. Ivester, a shareholder and former Chief Executive Officer of the Company, entered into a 3-year consulting agreement on October 18, 2005, which the Company terminated in October 2006. Pursuant to the consulting agreement, Mr. Ivester provided general business strategy, financing and product development advice. Mr. Ivester received $200,000 per year for his services under the consulting agreement, as well as a $2,500 per month vehicle allowance. Mr. Ivester was eligible to receive bonuses and participate in the Company's stock option plan, as determined by the board of directors. The Company also owed Mr. Ivester $305,212 as of December 31, 2006 under a demand note payable bearing interest at 3.75%. On March 16, 2007, the Company agreed to settle all of Mr. Ivester's claims under his consulting agreement and his demand note payable, in return for cash payments totaling $75,000, and the issuance of 25,000 shares of the Company's common stock. In conjunction with this settlement, the Company recognized a $85,212 litigation gain during the year ended December 31, 2006, primarily related to the excess of the demand note payable over the fair value of the cash and stock settlement.

 

In February 2006, the Company settled claims against it pertaining to the exchange of its common shares for Caerus shares pursuant to the Caerus merger agreement dated May 31, 2005. The settlement required a cash payment of $710,000, which was recognized as a litigation charge during the year ended December 31, 2006.

In March 2007, the Company settled claims against it brought by a former employee and two investors, requiring cash payments totaling $132,000, and the issuance of 23,750 shares of the Company's common stock. In conjunction with this settlement, the Company recognized a $290,750 litigation charge during the year ended December 31, 2006.

The Company is currently a defendant in other lawsuits and disputes arising in the ordinary course of business, and has accrued related litigation charges totaling $561,305 for the year ended December 31, 2006. The Company believes that resolution of all known contingencies is uncertain, and there can be no assurance that future costs related to such litigation would not exceed the amounts accrued in its consolidated financial statements, which may in turn materially adversely affect the Company's financial position or results of operations.

NOTE L - STOCK BASED COMPENSATION

A total of 200,000 shares of common stock have been reserved for issuance under the Company's 2004 Employee Stock Option Plan (the “2004 Plan”). In addition, on March 16, 2007 the Company obtained shareholder approval of the Company's 2006 Equity Incentive Plan (the “2006 Plan”). The 2006 Plan provides that key employees, consultants and non-employee directors of the Company or an affiliate may be granted: (1) options to acquire up to 500,000 shares of the Company's common stock; (2) shares of restricted common stock; (3) stock appreciation rights; (4) performance-based awards; (5) “Dividend Equivalents”; and (6) other stock-based awards. The activity in the 2004 plan (no activity in the 2006 Plan) for the year ended December 31, 2006 is as follows:

 

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		Number			Exercise Price Range			Wtd. Avg. Exercise Price
Options outstanding at December 31, 2005			187,329		$17.00 - $31.20			$	24.20
Options returned to the plan due to employee terminations			(139,129	)	$17.00 - $31.20			$	25.80
Options granted			150,000		$7.20			$	7.20
Options exercised			(165,983	)	$7.20 - $31.20			$	8.51
Options outstanding at December 31, 2006			32,217		$17.00 - $31.20			$	22.20

In September 2006, the Company entered into employment agreements with its Chief Executive Officer (“CEO”) and Chief Operating Officer (“COO”). These agreements provided for, among other things, the award of 500,000 stock options each, upon sufficient underlying shares of common stock being authorized and available, and subject to the board of directors' approval. The options were to be exercisable to purchase 500,000 shares of the Company's common stock each for Messrs. Cataldo and Lewis at an exercise price of $0.20 per share for a period of five (5) years. The options were to contain a cashless exercise provision and cost free piggyback registration rights with respect to the common stock underlying the options. Messrs. Cataldo and Lewis were also to receive sufficient additional options under the same terms to assure that they have the right to exercise options to maintain a minimum of 5% and 8% beneficial ownership, respectively, of the Company's issued and outstanding common stock. In lieu of these stock options, the board of directors on January 24, 2007 resolved to issue stock grants for 500,000 common shares each, subject to sufficient increased shares of common stock being authorized and available for issuance, which in turn is subject to shareholder approval. The stock grants are to have the same 5% and 8% anti-dilution provisions and piggyback registration rights as the options were to have. (See Note R for subsequent authorization of sufficient increased common stock.)

On November 8, the Company's COO was granted options to purchase 150,000 shares of the Company's common stock at $7.20 per share (closing market price on November 6, 2006) under the Company's 2004 Stock Option Plan. On November 9, 2006, the Company settled claims the COO had against the Company for alleged breaches of his employment agreement, and for nonregistration of the Company's common shares he holds pursuant to the Caerus merger agreement dated May 31, 2005, for $1,080,000. Also on November 9, 2006, the COO exercised his options to purchase 150,000 common shares, and the proceeds were credited toward the settlement of his claims. The $1,080,000 settlement expense has been recognized in the Company's results of operations as compensation expense for the year ended December 31, 2006.

Separate from the CEO and COO options noted in the preceding paragraphs, at December 31, 2006 the Company had outstanding commitments to issue stock options under either the 2004 Plan or the 2006 Plan to purchase 32,217 shares of common stock, at exercise prices ranging from $17.00 to $31.20 per share, and at a weighted average exercise price of $22.20 per share.

The Company recorded compensation expense of $7,913,904, $894,333 and $1,103,309 for the years ended December 31, 2006, 2005, and 2004, respectively, in connection with options, warrants and stock granted to employees. As of December 31, 2006, approximately $8,361,649 in total compensation cost related options, warrants and stock grants remains to be expensed in future periods.

The value of options and warrants was estimated using the Black-Scholes pricing model. The Black-Scholes pricing calculations were made using volatilities at either one-year or three-year, monthly or weekly, trailing measures, as appropriate, and risk-free rates as determined by the nearest maturity Treasury yield as of respective valuation dates.

NOTE M - WARRANTS

Through December 31, 2006 the Company has issued to employees, institutional investors, and financial services firms warrants to purchase the Company's common stock. During the years ended December 31, 2006, 2005, and 2004, the Company issued 441,331, 220,000, and 0 shares, respectively, of common stock in exchange for these warrants. As of December 31, 2006, the Company had outstanding 789,039 warrants, excluding those warrants issued in conjunction with convertible debt and common stock issuances discussed in Notes C and G, to purchase its common stock exercise prices ranging from $5.20 to $52.00 per share, and at a weighted average exercise price of $21.80 per share. At December 31, 2006, the fair value of these outstanding warrants was $1,250,155, which was recorded as a liability on the Company's consolidated balance sheet.

NOTE N - COMMITMENTS

The Company is obligated under non-cancelable operating leases for its office facilities, and apartments used for business purposes by its employees. Future minimum lease payments under the Company's non-cancelable operating leases as of December 31, 2006 are as follows:

 

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Year ending December 31,
2007		$	208,159
2008			34,865
2009			-
2010			-
Total		$	243,024

Rent expense for these leases for the years ended December 31, 2006, 2005, and 2004 was $185,125, $129,755, and $41,957, respectively .

NOTE O - RELATED PARTY TRANSACTIONS

As of December 31, 2006 and 2005, the amount due from related parties of $31,227 and $161,530, respectively, consisted of an account receivable from Shawn M. Lewis, the Company's Chief Operating Officer, and from WQN, a shareholder of the Company.

In December 2004 the Company issued a $560,000 note payable to a shareholder, bearing interest at 3.75%, with an original maturity date of December 2005. In January 2005 the Company issued another note payable for $1,040,000 to the same shareholder under similar terms. At December 31, 2006 and 2005, the outstanding balance of these notes was $0 and $1,572,894, respectively. The December 31, 2006 amount reflects the March 2007 settlement discussed in Note K.

Interest paid under these notes was $12,208, $50,613, and $0 during the years ended December 31, 2006, 2005, and 2004, respectively.

NOTE P - DISCONTINUED OPERATIONS AND FINANCIAL STATEMENT RECLASSIFICATIONS

On April 19, 2006, the Company sold its wholly-owned subsidiary, DTNet Technologies, to the Company's former Chief Operating Officer (the “Purchaser”) pursuant to a stock purchase agreement. The consideration for the sale consisted primarily of (1) the return for cancellation of warrants to purchase 10,000 shares of the Company's common stock held by the Purchaser; and (2) the return for cancellation of 10,000 shares of the Company's common stock held by the Purchaser. Because DTNet Technologies' operations were the primary component of the Company's former hardware sales business segment, the Company recorded an impairment charge of $839,101 in its statement of operations for the year ended December 31, 2006. The remaining $198,000 of goodwill for this former segment approximated the excess of the sales proceeds received over DTNet Technologies' carrying value (excluding goodwill) and was written off in conjunction with the sale of DTNet Technologies.

Effective October 12, 2006, the Company terminated its Marketing and Distribution Agreement with Phone House, Inc. dated September 1, 2004 and amended February 16, 2006, effectively discontinuing this business segment. The Agreement called for the wholesale distribution, marketing and selling of prepaid telephone calling cards by Phone House, Inc., under license from the Company. The Company recognized a related impairment loss of $936,122 for the year ended December 31, 2006, primarily related to inventory and accounts receivable write-offs, and has filed suit in Los Angeles County against the primary Phone House, Inc. employee to recover same.

Effective June 27, 2007, the Company entered into an Asset Purchase Agreement (the "Purchase Agreement") with WQN, Inc., a Texas corporation (the “Purchaser”), pursuant to which the Company sold substantially all of the tangible operating assets utilized by its Dallas, Texas subsidiary, VoIP Solutions, Inc. (the "Assets"), to the Purchaser.  The Company’s patents were not sold. Pursuant to the Purchase Agreement, the Purchaser acquired the Assets for a purchase price consisting of (1) a cash payment of $400,000; (2) 4% of the defined monthly revenues related to the Assets in excess of $200,000 during the first year following execution of the Purchase Agreement; (3) 3% of the defined monthly revenues related to the Assets in excess of $150,000 during the second year following execution of the Purchase Agreement; and (4) 2% of the defined monthly revenues related to the Assets in excess of $100,000 during the third year following execution of the Purchase Agreement.

The following summarizes the combined operating results of DTNet Technologies, the calling card business of Phone House, Inc., and the Dallas, Texas assets of VoIP Solutions, Inc., for the years ended December 31, 2006, 2005 and 2004 (through the respective dates of sale or termination), and their respective financial position as of December 31, 2006 and 2005, classified as discontinued operations for all periods presented.

 

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Statement of Operations		Year ended December 31,
		2006			2005			2004
Revenues		$	23,052,166		$	9,186,030		$	807,908
Cost of sales			20,028,689			8,497,539			617,547
Gross profit			3,023,477			688,491			190,361
Compensation and benefits			957,236			582,919			-
Asset impairment charges			1,775,223			4,173,452			-
Other operating expenses			1,753,694			938,753			744,593
Interest expense			501,075			160,800
Net loss		$	(1,963,751	)	$	(5,167,433	)	$	(554,232	)

		December 31,
Balance Sheet		2006			2005
Current assets		$	406,315		$	2,159,925
Property and equipment, net			255,948			468,037
Goodwill and other intangible assets			6,695,788			7,955,891
Other assets			5,282			106,347
Total assets			7,363,332			10,690,200
Less current liabilities			4,996,325			4,814,947
Net assets of discontinued operations		$	2,367,007		$	5,875,253

As a result of the June 27, 2007 sale of substantially all of the tangible operating assets utilized by the Company’s Dallas, Texas division, we have reclassified our financial position, results of operations, and cash flows related to this division since the date of its acquisition in October 2005 to reflect discontinued operations accounting treatment. The following tables set forth the impact of this reclassification on certain amounts previously reported in our consolidated financial statements as of and for the years ended December 31, 2006 and 2005.

		Year Ended
		December 31, 2006						December 31, 2005
		Previously						Previously
Statement of Operations Data		Reported			Reclassified			Reported			Reclassified
Revenues		$	14,676,948		$	5,933,248		$	8,945,868		$	6,321,115
Cost of sales			14,685,010			8,624,876			10,245,516			7,834,124
Gross profit (loss)			(8,062	)		(2,691,628	)		(1,299,648	)		(1,513,009	)
Operating expenses			31,015,685			28,849,396			21,063,041			20,361,386
Other expenses			8,192,812			7,691,737			1,432,305			1,271,505
Net loss before discontinued operations			(39,216,559	)		(39,232,761	)		(23,794,994	)		(23,145,900	)
Loss from discontinued operations			(1,979,953	)		(1,963,751	)		(4,518,339	)		(5,167,433	)
Net loss		$	(41,196,512	)	$	(41,196,512	)	$	(28,313,333	)	$	(28,313,333	)

 

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		December 31, 2006						December 31, 2005
		Previously						Previously
Balance Sheet Data		Reported			Reclassified			Reported			Reclassified
Current assets		$	1,277,238		$	871,091		$	5,035,536		$	4,284,006
Property and equipment, net			6,860,233			6,604,285			10,141,872			9,687,470
Goodwill and other intangible assets			32,687,822			25,992,034			36,044,271			29,125,481
Net assets of discontinued operations			-			2,367,007			1,767,475			5,875,253
Other assets			99,828			94,546			349,205			242,858
Total assets		$	40,925,121		$	35,928,963		$	53,338,359		$	49,215,068
Current liabilities		$	37,657,636		$	32,661,478		$	26,227,191		$	22,103,900
Other liabilities			222,669			222,669			245,248			245,248
Total shareholders' equity			3,044,816			3,044,816			26,865,920			26,865,920
Total liabilities and shareholders' equity		$	40,925,121		$	35,928,963		$	53,338,359		$	49,215,068

NOTE Q - INCOME TAXES

The components of the Company's consolidated income tax provision are as follows:

		Year ended December 31,
		2006			2005			2004
Current benefit		$	6,415,293		$	7,025,848		$	2,040,000
Deferred benefit (expense)			2,178,602			(304,845	)		-
Subtotal			8,593,894			6,721,003			2,040,000
Less valuation allowances			(8,593,894	)		(6,721,003	)		(2,040,000	)
Net		$	-		$	-		$	-

The reconciliation of the income tax provision at the statutory rate to the reported income tax expense is as follows:

		Year ended December 31,
		2006			2005			2004
Computed at statutory rate			34	%		34	%		34	%
Options, warrants and stock-related expenses			-16	%		-4	%		-
Change in fair value liability for warrants			6	%		-			-
Goodwill impairments and intangible asset amortization			-3	%		-6	%		-
Valuation allowance			-21	%		-24	%		-34	%
Total			-			-			-

At December 31, 2006, the Company's net deferred tax assets consisted of the following:

Net operating loss carryforwards		$	14,859,630
Excess tax over book depreciation expense			(634,033	)
Excess book over tax amortization of debt discounts			1,974,657
Discontinued operations impairment charge			318,281
Noncash litigation charges			225,662
Subtotal			16,744,198
Less valuation allowances			(16,744,198	)
Total		$	-

The Company's net operating loss carryforwards for federal income tax purposes were approximately $43,200,000 as of December 31, 2006. These carryforwards expire in 2018 ($4,200,000), 2019 ($20,600,000), and 2020 ($18,400,000), respectively.

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NOTE R - SUBSEQUENT EVENTS

Cedar Note Assignment and Restructure

The Company as of December 31, 2006 owed the sum of $2.4 million to Cedar Boulevard Lease Funding LLC (“Cedar”) pursuant to a subordinated loan and security agreement (the “Loan Agreement”). As previously disclosed, the Company failed to make a payment due December 1, 2006 under the Loan Agreement and was declared in default by the lender as of December 15, 2006 and was provided until December 20, 2006 to cure the default. Subsequently, the lender extended the time to cure the default until January 3, 2007. The lender's default notice to the Company had demanded the entire principal amount of the loan plus unpaid interest, approximately $2.4 million as of that date. On January 3, 2007 the Company received a default notice pursuant to the Loan Agreement. On January 10, 2007 Cedar agreed to waive the prior default based upon the Company agreeing to make accelerated payments through May 2007, and to maintain the loan's interest rate at 17.5% per annum for the remainder of the loan's amended term.  Under the Loan Agreement, Cedar was granted a security interest in all of the Company's assets.

On February 1, 2007 Cedar assigned its rights under the Loan Agreement, including the note payable (the “Note”) with a current principal balance of $1,917,581 and the related security interest, to a group of institutional investors (the “Investors”). In conjunction with the assignment, the Company paid a fee of $200,000 to Cedar. Also following the assignment, the Note's terms were amended to allow conversion of any unpaid principal balance into the Company's restricted common stock at $5.20 per share, subject to sufficient increased authorized common shares being approved by the Company's shareholders. The Company is also not required to register these shares. The Note was also amended to include “favored nations” rights such that for future securities offerings by the Company at a price per share less than this $5.20 per share, the Note's conversion rate would be adjusted to the lower offering price. In conjunction with the Company's financing discussed below, on February 16, 2006 the Note's common stock conversion rate was reduced to $3.60 per share. 

Convertible Note and Warrant Financing

On February 16, 2007, VoIP, Inc. (the “Company”) issued and sold $3,462,719 in secured convertible notes (the “Convertible Notes”) to a group of institutional investors, for a net purchase price of $2,770,175 (after a 20% original issue discount) in a private placement. $900,000 of the proceeds (before closing costs of $67,512) were paid in cash to the Company at closing, and $1,870,175 of the proceeds were used to repay fourteen outstanding promissory notes (including related accrued interest and a 10% premium on the promissory notes' total principal of $1,666,667) held by five of the investors in the private placement. The investors also received five-year warrants to purchase a total of 961,867 shares of the Company's common stock at an effective exercise price of $3.60 per share.

The Convertible Notes are secured by a subordinated lien on the Company's assets, are not interest bearing, and are due on February 16, 2008. The note holders may at their election convert all or part of the Convertible Notes into shares of the Company's common stock at the conversion rate of $3.60 per share, subject to adjustment as provided in the notes. The investors also received “favored nations” rights such that for future securities offerings by the Company at a price per share less than the above conversion rate or warrant exercise price, the investors' conversion rate and warrant exercise price would be adjusted to the lower offering price.

Pursuant to the related subscription agreement, two of the investors are to receive due diligence fees totaling $346,272, in the form of convertible notes (“Due Diligence Notes”) having the same terms and conversion features as the Convertible Notes. Also pursuant to the Subscription Agreement, the Company agreed to issue a total of 200,000 common shares to the former holders of the above-referenced promissory notes, in lieu of and in payment for accrued damages associated with these promissory notes. Said common share issuance is required no later than April 15, 2007.

 

Also pursuant to the Subscription Agreement, the Company must obtain the authorization and reservation of its common stock on behalf of the investors of not less than 200% of the common shares issuable upon the conversion of the Convertible Notes and Due Diligence Notes, and 100% of the common shares issuable upon the exercise of the warrants by April 15, 2007. Failing this authorization and reservation, the holders of the Convertible Notes and Due Diligence Notes will be entitled to liquidated damages that will accrue at the rate of two percent of the amount of the purchase price of the outstanding Convertible Notes and Due Diligence Notes for each thirty days or pro rata portion thereof during such default.

Shareholders Meeting

At the annual shareholders meeting held on March 16, 2007, the following actions were approved:

 

1.	The 2006 VoIP, Inc. 2006 Equity Incentive Plan was approved.

2.	25,000,000 shares of preferred stock were authorized.

3.	The authorized shares of the Company's common stock were increased from 100,000,000 to 400,000,000 shares.

 

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At a special shareholders meeting held on August 16, 2007, shareholders approved the reverse stock split of the Company's outstanding common stock, at a ratio of 1-for-20 shares. In addition, the Company's stock symbol was changed to VOIC and continues to trade on the OTC Bulletin Board. Under the terms of the reverse split, for every twenty shares of issued and outstanding common stock, a shareholder received one share of common stock. Accordingly, all share and per-share information in these consolidated financial statements and related footnotes have been adjusted to retroactively reflect this reverse stock split. Further, the previously reported common stock in the Company's consolidated balance sheets was reduced by a factor of twenty, with corresponding increases in additional paid-in capital.

WQN, Inc. Convertible Note

On March 16, 2007, WQN notified the Company that it is exercising its right to convert its note and related accrued interest into approximately 1,100,427 shares of the Company's common stock.

 

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VOIP, INC. AND SUBSIDIARIES

UNAUDITED PRO FORMA CONDENSED COMBINED FINANCIAL STATEMENTS

The Following unaudited pro forma condensed combined financial statements are derived from and should be read in conjunction with the historical consolidated financial statements and related notes of VOIP, INC. ("VOIP" or the "Company"), and CAERUS, INC. ("CAERUS").

On June 1, 2005, the Company, and Caerus announced the closing of the merger of Volo Acquisition Corp., a wholly-owned subsidiary of the Company with and into Caerus, with Caerus as the surviving corporation (the "Merger"). The Merger was completed pursuant to an Agreement and Plan of Merger (the "Merger Agreement'), executed on May 31, 2005.

The unaudited pro forma condensed combined statements of operation for the year ended December 31, 2005 assumes that the merger of Caerus and the Company were consummated at the beginning of the respective periods.

The unaudited pro forma condensed combined statements of operations has been prepared based on currently available information and assumptions that are deemed appropriate by the Company's management. The pro forma information is for informational purposes only and is not intended to be indicative of the actual consolidated results that would have been reported had the transactions occurred on the dates indicated, nor does the information represent a forecast of the consolidated financial position at any future date or the combined financial results of the Company and Caerus for any future period.

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VoIP, Inc

Pro Forma Condensed Combined Statement of Operations (Unaudited)

Year Ended December 31, 2005

		VoIP, Inc			Caerus, Inc			Adjustments			Consolidated
Revenues		$	4,273,028			11,312,596		$	-		$	15,585,624
Cost of sales			3,908,523			14,814,908			-			18,723,431
Gross profit			364,505			(3,502,312	)		-			(3,137,807	)
Operating expenses			15,198,094			8,583,676			3,095,691			26,877,461
Loss from continuing operations before income taxes			(14,833,589	)		(12,085,988	)		(3,095,691	)		(30,015,268	)
Gain on sale of fixed assets			(206,184	)								(206,184	)
Interest expense			1,238,938			786,389			-			2,025,327
Loss before income taxes and results of discontinued operations			(15,866,343	)		(12,872,377	)		(3,095,691	)		(31,834,411	)
Provision for income taxes			-			-			-			-
Net loss before discontinued operations			(15,866,343	)		(12,872,377	)		(3,095,691	)		(31,834,411	)
Loss from discontinued operations, net of income taxes			(4,518,339	)		-			-			(4,518,339	)
Net Loss		$	(20,384,682	)	$	(12,872,377	)	$	(3,095,691	)	$	(36,352,750	)
Basic and diluted loss per share:
Loss before discontinued operations											$	(16.56	)
Loss from discontinued operations, net of income taxes												(2.35	)
Net Loss											$	(18.90	)
Weighted average number of shares outstanding												1,922,944

 

The accompanying notes are an integral part of this pro forma condensed combined statement of operations.

 

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VOIP, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED PRO FORMA CONDENSED COMBINED

FINANCIAL STATEMENTS

(1) VoIP, INC. Basis of Presentation

Historical financial information for VoIP, Inc. for the year ended December 31, 2005 has been derived from VoIP, Inc.'s historical statements.

(2) Caerus, Inc. Basis of Presentation

Historical financial information for Caerus, Inc. for the year ended December 31, 2005 has been derived from Caerus, Inc.'s historical statements.

(3) VoIP, Inc. and Caerus, Inc. Merger

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Altamonte Springs, State of Florida, on October 11, 2007.

 

	VOIP, INC.
	By:	/s/ Anthony J. Cataldo
		Anthony J. Cataldo
		Chief Executive Officer
Date:		October 11, 2007

 

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

 

	By:	/s/ Anthony J. Cataldo
		Anthony J. Cataldo
		Chief Executive Officer and Chairman
Date:		October 11, 2007

 

 

	By:	/s/ Shawn Lewis
		Shawn M. Lewis
		Chief Operating Officer
Date:		October 11, 2007

 

 

	By:	/s/ Robert Staats
		Robert V. Staats
		Chief Accounting Officer
Date:		October 11, 2007

 

 

	By:	/s/ Gary Post
		Gary Post
		Director
Date:		October 11, 2007

 

 

	By:	/s/ Stuart Kosh
		Stuart Kosh
		Director
Date:		October 11, 2007

 

89

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	By:	/s/ Sade Panahi
		Sade Panahi
		Director
Date:		October 11, 2007

 

90

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