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 oNO 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 $14,676,948.

At June 30, 2006, the last business day of the registrant’s most recently completed second fiscal quarter, there were 70,509,102 shares of registrant’s common stock outstanding, 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 98,609,701 and no shares of par value $0.001 common stock and par value $0.001 preferred stock, respectively.

Company Symbol-VOII

 

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	TABLE OF CONTENTS
		Page  No.
PART I
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
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	30
Item 8.	Financial Statements and Supplementary Data	30
Item 9.	Changes in and Disagreements With Accountants on Accounting and Financial Disclosure	31
Item 9A.	Controls and Procedures	31
Item 9B.	Other Information	33
PART III
Item 10.	Directors, Executive Officers and Corporate Governance	33
Item 11.	Executive Compensation	35
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder
	Matters	41
Item 13.	Certain Relationships and Related Transactions	44
Item 14.	Principal Accounting Fees and Services	44
PART IV
Item 15.	Exhibits and Financial Statement Schedules	46

 

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VOIP, INC.

We have experienced significant changes in our top management.

 

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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 $21.2 million in goodwill and approximately $11.5 million in other intangible assets recorded in connection with our acquisitions. We recorded significant additional amounts of goodwill and intangible assets as a result of our acquisition in October 2005 of substantially all of the assets relating to the VoIP business of WQN, and 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 31, 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.

 

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 $20.0 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.

 

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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. Approximately 39% 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, and from the sales of retail VoIP services to consumers. 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.

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.

 

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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 rely on vendors to terminate calls. Vendor charges for these services vary by call route, and costs between vendors for the same routes vary. Because of the heavy volume of calls handled by our network, automation of the call routing to the “least-cost” vendor for each route is typically required to generate a positive gross margin. We are currently developing such automation, but we may not be successful in its implementation or further maintenance, which would adversely affect our financial performance.

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.

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.

Online credit card fraud can harm our business.

The sale of our products and services over the Internet exposes us to credit card fraud risks. Some of our products and services can be ordered or established (in the case of new accounts) over the Internet using a major credit card for payment. As is prevalent in retail telecommunications and Internet services industries, we are exposed to the risk that some of these credit card accounts are stolen or otherwise fraudulently obtained. In general, we are not able to recover fraudulent credit card charges from such accounts. In addition to the loss of revenue from such fraudulent credit card use, we also remain liable to third parties whose products or services are engaged by us (such as termination fees due telecommunications providers) in connection with the services which we provide. In addition, depending upon the level of credit card fraud we experience, we may become ineligible to accept the credit cards of certain issuers. We are currently authorized to accept American Express, Visa, MasterCard, and Discover. The loss of eligibility for acceptance of credit cards could significantly and adversely affect our business. We will attempt to manage fraud risks through our internal controls and our monitoring and blocking systems. If those efforts are not successful, fraud could cause our revenue to decline significantly and our business, financial condition and results of operations to be materially and adversely affected.

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.

 

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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 businesses 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;

·	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.

 

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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. We also compete against discount telecommunications services including prepaid calling cards, call-back services, dial-around or 10-10 calling and collect calling services. 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, 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.

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.

 

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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. We currently license third party technology for products acquired through the WQN acquisition.

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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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.

 

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.

 

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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 10,000,000 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 10,000,000 shares of our common stock each for Messrs. Cataldo and Lewis at an exercise price of $0.01 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 10,000,000 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.

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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.

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 3,000,000 common shares at $0.36 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 3,000,000 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 100,000 options and 100,000 warrants, subject to approval by our board of directors. The options and warrants will each be exercisable to purchase 100,000 shares of our common stock at $1.02 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 300,000 common shares. Mr. Post's employment agreement also provided for the award of options and warrants to purchase a total of 3,000,000 shares of the Company's common stock at $1.00 a share until May 2011. On December 12, 2006 these options and warrants were converted to warrants to purchase 3,000,000 of our common shares at $0.475 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.

 

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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
		Exercisable			Unexercisable			Price			Expiration 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			190,625			59,375		$	1.02			5/17/11
Chief Accounting Officer			62,500			38,500(9	)	$	1.12			6/3/10
Gary Post (3)			3,000,000			-		$	0.475			12/12/16
Former President, Chief Executive
Officer and Chairman (6)
Michael Adler (4)			500,000			-		$	1.56			10/18/10
Former Chairman and Chief			500,000			-		$	1.50			10/18/10
Executive Officer (7)
David Sasnett (5)			450,000					$	1.53			10/18/10
Former Chief Financial Officer (8)

(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 3,000,000 shares of the Company's common stock at $1.00 a share until May 2011. On December 12, 2006 these options and warrants were converted to warrants to purchase 3,000,000 of the Company's common shares at $0.475 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 59,375 and 38,500 options vest ratably until May 2009 and June 2008, respectively.

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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)			3,000,000		$	-			-		$	-
Chief Operating Officer;
Chief Technology Officer
Robert V. Staats			-		$	-			-		$	-
Chief Accounting Officer
Gary Post (3)			-		$	-			300,000		$	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)

 

(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 3,000,000 common shares at $0.36 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 3,000,000 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 300,000 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.

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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.

 

Name of Director		Stock Awards
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 300,000 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 $0.35 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.

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 on page 68 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.

 

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		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			644,350		$	1.11			13,355,650
Equity compensation plans not approved by shareholders			8,156,247			1.00			-
Total			8,800,597		$	1.01			13,355,650

 

The above table excludes the 10,000,000 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 98,609,701 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)			27,816,227			23.1	%
14911 Quorum Drive, Suite 140
Dallas, Texas 75240
Nicholas A. Iannuzzi, Jr.			307,355			*
Stuart Kosh (4)			2,968,750			3.0	%
Shawn Lewis (5,6)			7,035,857			7.0	%
Gary Post (7)			3,600,000			3.5	%
Robert Staats (8)			253,125			*
Anthony Cataldo (6)			0			*
All directors and executive officers as a			14,165,087			13.3	%
group (6 persons) (9)

 

* Less than one percent.

 

 

(1)	We have issued and outstanding 98,609,701 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 98,609,701 shares of common stock issued and outstanding as of March 15, 2007.

(3)

Consists of 5,787,429 shares of common stock and 22,028,798 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 $0.18 per share.

(4)	Consists of (a) 1,962,500 shares of common stock; (b) currently exercisable options to purchase 156,250 shares of common stock; and (c) warrants to purchase 850,000 shares of common stock.

(5)	Consists of 7,035,857 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 10,000,000 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 10,000,000 shares of our common stock each for Messrs. Cataldo and Lewis at an exercise price of $0.01 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 10,000,000 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 600,000 shares of common stock and warrants to purchase 3,000,000 shares of common stock.

(8)	Consists of warrants to purchase 150,000 shares of common stock and currently exercisable options to purchase 103,125 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).

Item 13. Certain Relationships and Related Transactions

In October 2005, we purchased all of the assets of WQN, Inc. (“WQN”). Mr. Adler, our former chairman and chief executive officer, was the Chief Executive Officer of WQN, and owned approximately 37% of WQN's outstanding common stock. In connection with the transaction, we purchased the assets for a purchase price consisting of (1) a note in the principal amount of $3,700,000 (the “Note”), (2) 1,250,000 shares of our restricted common stock and (3) a warrant to purchase 5,000,000 shares of our common stock at an exercise price of $ $0.001 per share (the “Warrant”). The Note accrues interest at the rate of 6% per annum. In addition, we issued WQN, Inc. an additional 500,000 shares of restricted common stock relating to the difference between the amount of accounts receivable transferred in the transaction and the accounts payable. The Note is convertible into common stock or preferred stock (at such time that a series of preferred stock is established). The Warrant was exercised for common stock. Pursuant to our asset purchase agreement with WQN, on March 16, 2007 our shareholders approved a class of preferred stock that could have been used to satisfy the conversion features of the Note. On March 16, 2007, WQN notified us that it was exercising its right to convert its note and related accrued interest into approximately 22,008,524 shares of our common stock.

 

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 we 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 our stock option plan, as determined by the board of directors. We 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 we 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 500,000 shares of the our common stock.

On November 8, 2006, Mr. Lewis, our Chief Operating Officer and Chief Technology Officer, was granted options to purchase 3,000,000 common shares at $0.36 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 3,000,000 common shares, and the $1,080,000 proceeds from this exercise were credited toward the settlement of his claims.

On March 29, 2007, we issued an unsecured promissory note in the principal amount of $300,000 (the “Note”) to Shawn M. Lewis, the Company’s Chief Operating Officer. The Note and related accrued interest at 10% per annum is payable upon demand. The cash proceeds to the Company were $252,000 net of related closing costs and expense reimbursements of $48,000, $30,000 of which was paid to Mr. Lewis. In the event of a default, in addition to all sums due and owing under the Note, we will also be required to pay the sum of $750,000 as liquidated damages.

Item 14. Principal Accountant Fees and Services

Audit Fees. Berkovits, Lago & Company, LLP provided services to us during the years ended December 31, 2006 and 2005 in the categories shown below.

		Fiscal Years Ending
		December 31,
		2006			2005
Audit Fees (1)		$	291,914		$	120,234
Audit-Related Fees (2)			124,398			-
Tax Fees (3)			55,000			-
All Other Fees (4)			-			-

 

(1)

Audit fees - These are fees billed for professional services performed by Berkovits, Lago & Company, LLP for the audit of our annual financial statements and review of financial statements included in our Form 10-Q filings, and services that are normally provided in connection with statutory regulatory filings or engagements.

 

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(2)	Audit-related fees - These are fees billed for assurance and related services performed by Berkovits, Lago & Company, LLP that are reasonably related to the performance of the audit or review of our financial statements. These include attestations that are not required by statute, and consulting on financial accounting/reporting standards.
(3)	Tax fees - These are fees billed for professional services performed by Berkovits, Lago & Company, LLP with respect to tax compliance, tax advice and tax planning. These include preparation of original and amended tax returns for the Company and its consolidated subsidiaries, refund claims, payment planning, tax audit assistance, and tax work stemming from “audit-related” items.

 

(4)	All other fees - Services that do not meet the above three category descriptions are not permissible work performed for us by Berkovits, Lago & Company, LLP.

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PART IV

Item 15. Exhibits and Financial Statement Schedules

(b) Exhibits

(3)		2.1		Stock Contribution Agreement dated May 25, 2004, between Registrant and Steven Ivester
(12)		2.2		Agreement and Plan of Merger with Caerus, Inc. dated as of May 31, 2005
(14)		2.3		Asset Purchase Agreement dated as of August 3, 2005, by and between VoIP, Inc. Acquisition Company and WQN, Inc.
(1)		3.1.1		Articles of Incorporation
(1)		3.1.2		Bylaws
(3)		3.2		Amendment to Articles of Incorporation dated April 13, 2004
(32)		3.3		Amended and Restated Bylaws of VoIP, Inc.
(3)		4.1		Specimen Stock Certificate
(28)		4.2.1		Form of Consulting Agreement with Irawan Onggara effective November 20, 2006
(28)		4.2.2		Form of Consulting Agreement with Piter Korompis effective November 20, 2006
(2)		10.1		Stock Purchase Agreement dated February 27, 2004, between Registrant and Steven Ivester
(3)		10.2		2004 Stock Option Plan
(4)		10.3		Stock Purchase Agreement dated June 25, 2004, among Registrant, DTNet Technologies and Marc Moore
(5)		10.4		Stock Purchase Agreement dated September 10, 2004, among Carlos Rivas, Albert Rodriguz, Registrant and Vox Consulting Group Inc.
(6)		10.5.1		Subscription Agreement dated November 11, 2004
(6)		10.5.2		Form of Class A Warrant
(6)		10.5.3		Form of Class B Warrant
(8)		10.6.1		Stock Purchase Warrant dated December 10, 2004, issued to Ivano Angelastri
(8)		10.6.2		Stock Purchase Warrant dated December 10, 2004, issued to Ebony Finance
(9)		10.7.1		Form of Incentive Stock Option Agreement
(9)		10.7.2		Form of Non-Qualified Stock Option Agreement
(10)		10.8		Net Exercise Agreement dated February 14, 2005, with John Todd
(11)		10.9		Asset Purchase Agreement dated February 23, 2005, among Creative Marketing Associates, Registrant, and eGlobalPhone

 

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(12)		10.10		Caerus, Inc. Merger Documents dated May 31, 2005:
(12)		10.10.1		Option Exchange Agreement
(12)		10.10.2		Registration Rights Agreement
(12)		10.10.3		Exchange Agreement
(12)		10.10.4		Registration Rights Agreement
(12)		10.10.5		Consent and Waiver Agreement
(12)		10.10.6		Guaranty
(12)		10.10.7		Security Agreement
(12)		10.10.8		Employment Agreement dated May 27, 2005, between Registrant and Shawn Lewis
(13)		10.11.1		Subscription Agreement dated July 5, 2005
(13)		10.11.2		Form of Class C Warrant
(13)		10.11.3		Form of Class D Warrant
(13)		10.11.4		Form of Convertible Note
(13)		10.11.5		Security Agreement
(13)		10.11.6		Security and Pledge Agreement
(13)		10.11.7		Guaranty
(14)		10.12		WQN, Inc. Documents dated August 3, 2005:
(14)		10.12.1		Warrant
(14)		10.12.2		Security Agreement between Registrant and WQN, Inc.
(14)		10.12.3		Consent, Waiver and Acknowledgement by and among Cedar Boulevard Lease Funding, Inc., Registrant, and certain Subsidiaries of Registrant
(14)		10.12.4		Third Amendment to Subordinated Loan and Security Agreement by and among Cedar Boulevard Lease Funding, Inc., Registrant, and certain Subsidiaries of Registrant
(14)		10.12.5		Security Agreement between Cedar Boulevard Lease Funding, Inc. and VoIP Acquisition Company
(14)		10.12.6		Guaranty between Cedar Boulevard Lease Funding, Inc. And VoIP Acquisition Company
(15)		10.13		Consulting Services Agreement dated October 18, 2005, between Registrant and Steven Ivester
(16)		10.14.1		Cross Country Capital Partners Amendment Subscription Agreement dated November 16, 2005
(16)		10.14.2		Cross Country Capital Partners Class C Warrant
(16)		10.14.3		Stock Purchase Agreement with Steven Ivester
(16)		10.14.4		Promissory Note to Steven Ivester

 

47

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(17)		10.15.1		Subscription Agreement for Secured Notes dated January 6, 2006
(17)		10.15.2		Subscription Agreement for Unsecured Notes dated January 6, 2006
(17)		10.15.3		Form of Class A Warrant
(17)		10.15.4		Form of Class B Warrant
(17)		10.15.5		Form of Secured Convertible Note
(17)		10.15.6		Form of Unsecured Convertible Note
(17)		10.15.7		Security Agreement
(17)		10.15.8		Security and Pledge Agreement
(17)		10.15.9		Guaranty Agreement
(18)		10.16.1		Subscription Agreement dated February 2, 2006
(18)		10.16.2		Form of Class A Warrant
(18)		10.16.3		Form of Class B Warrant
(18)		10.16.4		Form of Secured Convertible Note
(18)		10.16.5		Security Agreement
(18)		10.16.6		Security and Pledge Agreement
(18)		10.16.7		Guaranty Agreement
(19)		10.17		2006 Equity Incentive Plan
(20)		10.18		Stock Purchase Agreement dated as of April 19, 2006, by and between Registrant, VCG Technologies, Inc. d/b/a DTNet Technologies and William F. Burbank
(21)		10.19.1		Employment Agreement effective May 15, 2006, between Registrant and Mr. Gary Post
(21)		10.19.2		Employment Agreement effective May 17, 2006, between Registrant and Mr. Robert Staats
(21)		10.19.3		Employment Agreement effective May 15, 2006, between Registrant and Mr. David Ahn
(21)		10.19.4		Modification and Amendment Agreement dated May 22, 2006
(36)		10.20.1		Promissory Note dated September 13, 2006, issued to Bristol Investment Fund, Ltd., in the Principal Amount of $166,666
(36)		10.20.2		Promissory Note dated September 13, 2006, issued to Alpha Capital Anstalt in the Principal Amount of $333,334
(22)		10.21		Promissory Note dated September 29, 2006, issued to Whalehaven Capital Fund Limited in the Principal Amount of $387,800
(23)		10.22.1		Subscription Agreement dated October 17, 2006
(23)		10.22.2		Form of Class C Warrant

 

48

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(23)		10.22.3		Form of Secured Convertible Note
(24)		10.23		Compensation Agreement dated October 12, 2006, among Registrant and Marc Ross
(26)		10.24.1		Alpha et al 3(a)(10) Settlement dated September 15, 2006
(26)		10.24.2		Stonestreet et al 3(a)(10) Settlement dated September 18, 2006
(26)		10.24.3		Employment Agreement effective September 14, 2006, between Registrant and Mr. Anthony Cataldo
(26)		10.24.4		Second Amendment effective September 14, 2006 to Employment Agreement between Registrant and Mr. Shawn Lewis
(26)		10.24.5		Non-Qualified Stock Option Agreement dated November 8, 2006
(26)		10.24.6		Settlement Agreement and Release of Claims among Shawn Lewis and Registrant
(27)		10.25.1		Promissory Note dated November 27, 2006, issued to Whalehaven Capital Fund, Limited, in the Principal Amount of $133,333
(27)		10.25.2		Promissory Note dated November 27, 2006, issued to Alpha Capital Anstalt in the Principal Amount of $133,334
(27)		10.25.3		Promissory Note dated November 27, 2006, issued to Ellis International Ltd. in the Principal Amount of $100,000
(29)		10.26.1		Form of Stock Purchase Warrant dated December 7, 2006, with Cashless Exercise Provision
(29)		10.26.2		Form of Stock Purchase Warrant dated December 7, 2006, without Cashless Exercise Provision
(30)		10.27.1		Promissory Note dated December 15, 2006, issued to Whalehaven Capital Fund, Limited, in the Principal Amount of $83,333
(30)		10.27.2		Promissory Note dated December 15, 2006, issued to Alpha Capital Anstalt in the Principal Amount of $83,334
(30)		10.27.3		Promissory Note dated December 15, 2006, issued to Ellis International Ltd. in the Principal Amount of $83,333
(31)		10.28.1		Promissory Note dated January 4, 2007, issued to Whalehaven Capital Fund, Limited, in the Principal Amount of $83,333
(31)		10.28.2		Promissory Note dated January 4, 2007, issued to Alpha Capital Anstalt in the Principal Amount of $83,332
(31)		10.28.3		Promissory Note dated January 4, 2007, issued to Alpha Capital Anstalt in the Principal Amount of $83,335
(33)		10.29.1		Promissory Note dated January 18, 2007, issued to Alpha Capital Anstalt in the principal amount of $100,000
(33)		10.29.2		Promissory Note dated January 18, 2007, issued to Centurion Microcap L.P. in the principal amount of $100,000
(33)		10.29.3		Promissory Note dated January 18, 2007, issued to Ellis International Ltd. in the principal amount of $100,000

 

49

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(33)		10.29.4		Form of Promissory Notes issued to Bristol Investment Fund, Ltd., in the principal amount of $250,000 each
(33)		10.29.5		Form of Bridge Financing Letter Agreement with Bristol Investment Fund, Ltd.
(34)		10.30.1		Form of Assignment of Secured Subordinated Promissory Note dated June 1, 2004 (Assignment dated February 1, 2007)
(34)		10.30.2		Form of Addendum to Assignment of Secured Subordinated Promissory Note (Addendum dated February 1, 2007)
(35)		10.31.1		Form of Subscription Agreement dated February 16, 2007
(35)		10.31.2		Form of Convertible Note dated February 16, 2007
(35)		10.31.3		Form of Class D Common Stock Purchase Warrant dated February 16, 2007
(35)		10.31.4		Form of Cedar Reallocation and Assignment Agreement dated February 16, 2007
(35)		10.31.5		Form of Reallocation and Assignment Agreement dated February 16, 2007
(36)		10.32.1		$300,000 Subordinated Demand Promissory Note dated March 29, 2007
(7)		16.1		Resignation Letter from Tschopp, Whitcomb & Orr
(25)		21.1		Subsidiaries of the Registrant
(36)		31.1		Certification of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
(36)		31.2		Certification of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
(36)		32.1		Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
(36)		32.2		Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
(1)				Filed as exhibit to Registrant’s Form 10-SB filed January 19, 2000
(2)				Filed as exhibit to Form 8-K filed March 3, 2004
(3)				Filed as exhibit to Form 8-K filed June 9, 2004
(4)				Filed as exhibit to Form 8-K filed July 7, 2004
(5)				Filed as exhibit to Form 8-K filed September 16, 2004
(6)				Filed as exhibit to form 8-K filed November 17, 2004
(7)				Filed as exhibit to form 8-K filed November 18, 2004
(8)				Filed as exhibit to form 8-K filed December 15, 2004
(9)				Filed as exhibit to form S-8 filed January 26, 2005
(10)				Filed as exhibit to form 8-K filed February 16, 2005
(11)				Filed as exhibit to form 8-K filed March 1, 2005

 

50

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(12)				Filed as exhibit to form 8-K filed June 6, 2005
(13)				Filed as exhibit to Form 8-K filed July 11, 2005
(14)				Filed as exhibit to Form 8-K filed August 9, 2005
(15)				Filed as exhibit to Form 8-K filed October 24, 2005
(16)				Filed as exhibit to Form 8-K filed November 22, 2005
(17)				Filed as exhibit to Form 8-K filed January 12, 2006
(18)				Filed as exhibit to Form 8-K filed February 8, 2006
(19)				Filed as exhibit to Form 10-KSB filed April 17, 2006
(20)				Filed as exhibit to Form 8-K filed April 25, 2006
(21)				Filed as exhibit to Form 8-K filed May 25, 2006
(22)				Filed as exhibit to Form 8-K filed October 5, 2006
(23)				Filed as exhibit to Form 8-K filed October 20, 2006
(24)				Filed as exhibit to Form S-8 filed October 27, 2006
(25)				Filed as exhibit to Form 10-KSB/A filed October 27, 2006
(26)				Filed as exhibit to Form 10-Q filed November 17, 2006
(27)				Filed as exhibit to Form 8-K filed December 1, 2006
(28)				Filed as exhibit to Form S-8 filed December 1, 2006
(29)				Filed as exhibit to Form 8-K filed December 13, 2006
(30)				Filed as exhibit to Form 8-K filed December 21, 2006
(31)				Filed as exhibit to Form 8-K filed January 10, 2007
(32)				Filed as exhibit to Form 8-K filed January 29, 2007
(33)				Filed as exhibit to Form 8-K filed February 1, 2007
(34)				Filed as exhibit to Form 8-K filed February 2, 2007
(35)				Filed as exhibit to Form 8-K filed February 23, 2007
(36)				Filed herewith

 

51

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors

VoIP, Inc. and Subsidiaries 

Ft. Lauderdale, Florida

We have audited the accompanying consolidated balance sheets of VoIP, Inc. and Subsidiaries (“the Company”) as of December 31, 2006 and 2005, and the related consolidated statements of operations, shareholders’ equity, and cash flows for the years ended December 31, 2006, 2005 and 2004. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2006 and 2005, and the results of its operations and its cash flows for the years ended December 31, 2006, 2005 and 2004 in conformity with accounting principles generally accepted in the United States of America.

The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note C to the financial statements, the Company’s dependence on outside financing, lack of sufficient working capital, and recurring losses raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans are described in Note C to the financial statements. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

 

As described in Note E to the consolidated financial statements, the accompanying consolidated balance sheet and statement of changes in shareholders’ equity of VoIP, Inc. and Subsidiaries as of December 31, 2005 and for the year then ended have been restated to correct for misstatements in the December 31, 2005 financial statements previously filed.

/s/ Berkovits, Lago & Company, LLP

 

Fort Lauderdale, Florida 

March  23, 2007

 

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VoIP, Inc.

Consolidated Balance Sheets

 

		December 31
		2006			2005
ASSETS					(Restated)
Current assets:
Cash and cash equivalents		$	90,172		$	3,228,745
Accounts receivable, net of allowance for doubtful account
of $113,653 and $177,489, respectively			439,818			471,649
Due from related parties			31,227			161,530
Inventory			-			238,292
Prepaid expenses and deposits			716,021			935,320
Total current assets			1,277,238			5,035,536
Property and equipment, net			6,860,233			10,141,872
Goodwill and other intangible assets			32,687,822			36,044,271
Net assets of discontinued operations			-			1,767,475
Other assets			99,828			349,205
TOTAL ASSETS		$	40,925,121		$	53,338,359
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable		$	8,219,743		$	10,488,745
Accrued expenses			4,853,007			2,149,514
Loans payable			2,574,835			4,685,236
Convertible notes payable			9,576,592			3,399,798
Fair value liability for warrants			5,102,731			-
Nonregistration penalties and other stock-based payables			4,748,380			-
Accrued litigation charges			1,054,130			-
Notes and advances from investors			616,667			3,000,000
Due to related parties			-			1,572,894
Net liabilities from discontinued operations			354,398			-
Other current liabilities			557,153			931,004
Total current liabilities			37,657,636			26,227,191
Other liabilities			222,669			245,248
TOTAL LIABILITIES			37,880,305			26,472,439
Shareholders' equity:
Common stock - $0.001 par value;
100,000,000 shares authorized;
98,609,701 and 59,523,397 shares
issued and outstanding, respectively			98,610			59,523
Additional paid-in capital			78,942,818			61,606,497
Accumulated deficit			(75,996,612	)		(34,800,100	)
Total shareholders' equity			3,044,816			26,865,920
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY		$	40,925,121		$	53,338,359

 

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

 

53

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VoIP Inc.

Consolidated Statements of Operations

 

		Year Ended December 31
		2006			2005			2004
Revenues		$	14,676,948		$	8,945,868		$	1,020,285
Cost of sales			14,685,010			10,245,516			754,598
Gross profit (loss)			(8,062	)		(1,299,648	)		265,687
Operating expenses
Compensation and related expenses			13,184,377			7,328,685			3,800,336
Commissions and fees to third parties			2,573,386			4,823,786			400,787
Professional, legal and consulting expenses			6,852,584			1,858,088			430,432
Depreciation and amortization			5,168,467			3,111,042			70,988
General and administrative expenses			3,236,871			3,941,440			871,032
Total operating expenses			31,015,685			21,063,041			5,573,575
Loss from continuing operations before income taxes			(31,023,747	)		(22,362,689	)		(5,307,888	)
Other (income) expenses:
Interest expense			7,715,400			1,638,489			-
Financing penalties and expenses			6,375,342			-			-
Gain on sale of fixed assets			-			(206,184	)		-
Decrease in fair value liability for warrants			(7,226,430	)		-			-
Litigation charges			1,068,500			-			-
Other			260,000			-			-
Total other expenses			8,192,812			1,432,305			-
Loss before income taxes and results of
discontinued operations			(39,216,559	)		(23,794,994	)		(5,307,888	)
Provision for income taxes			-			-			-
Net loss before discontinued operations			(39,216,559	)		(23,794,994	)		(5,307,888	)
Loss from discontinued operations,
net of income taxes			(1,979,953	)		(4,518,339	)		(554,232	)
Net loss		$	(41,196,512	)	$	(28,313,333	)	$	(5,862,120	)
Basic and diluted loss per share:
Loss before discontinued operations		$	(0.52	)	$	(0.62	)	$	(0.36	)
Loss from discontinued operations,
net of income taxes			(0.03	)		(0.12	)		(0.04	)
Net loss per share		$	(0.55	)	$	(0.74	)	$	(0.40	)
Weighted average number of shares outstanding			75,329,007			38,458,871			14,597,312

 

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

 

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VoIP, Inc.

Consolidated Statements of Cash Flows

		Year Ended December 31
		2006			2005			2004
CASH FLOWS FROM OPERATING ACTIVITIES
Continuing operations:
Net loss		$	(39,216,559	)	$	(23,794,994	)	$	(5,307,888	)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation and amortization			5,168,467			3,140,401			82,832
Common shares issued for services			2,713,405			3,380,474			599,166
Common shares issued for nonregistration penalty settlements			1,125,000			-			-
Options and warrants issued for services and compensation			10,014,613			2,181,350			3,320,763
Amortization of debt discounts			6,266,190			416,175			-
Decrease in fair value liability for warrants			(7,226,431	)		-			-
Noncash nonregistration penalties			5,130,219			-			-
Noncash litigation charges			663,713			-			-
Changes in operating assets and liabilities:
Accounts receivable			31,831			861,934			202,731
Due from related parties			130,303			(161,530	)		-
Inventory			238,292			495,241			171,800
Prepaid expenses and deposits			219,298			(583,783	)		54,531
Accounts payable and accrued expenses			2,768,766			(4,474,899	)		(1,113,607	)
Other current liabilities			(393,851	)		870,948			(378,670	)
Net cash used in continuing operating activities			(12,366,745	)		(17,668,683	)		(2,368,342	)
Discontinued operations:
Loss from discontinued operations			(1,979,953	)		(4,518,339	)		(554,232	)
Goodwill impairment charge			839,101			4,173,452			-
Provision for assets & liabilties of discontinued operations			1,136,122			412,420			(408,000	)
Net cash provided by (used in) discontinued operating activities			(4,730	)		67,533			(962,232	)
Net cash used in operating activities			(12,371,475	)		(17,601,150	)		(3,330,574	)
CASH FLOWS FROM INVESTING ACTIVITIES
Continuing operations:
Purchase of property and equipment			(18,522	)		(2,582,827	)		(127,541	)
Acquisition of Caerus and WQN (Note J)			-			(1,290,727	)		-
Cash from acquisitions			-			-			104,872
(Purchase) or disposition of other assets			249,377			267,940			(71,100	)
Net cash provided by (used in) continuing investing activities			230,855			(3,605,614	)		(93,769	)
Discontinued operations:
Net assets - DTNet and Phone House (Note P)			(237,350	)		(1,303,738	)		573,363
Net cash provided by (used in) discontinued investing activities			(237,350	)		(1,303,738	)		573,363
Net cash provided by (used in) investing activities			(6,494	)		(4,909,352	)		479,594
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from issuance of notes payable and advances			13,337,094			10,656,104			360,000
Proceeds from common stock issuances			3,689,726			11,719,614			3,628,618
Issuance of stock for note conversions			-			2,465,286			-
Repayment of notes payable and advances			(7,787,424	)		(242,894	)		-
Net cash provided by financing activities			9,239,396			24,598,110			3,988,618
Net increase (decrease) in cash			(3,138,573	)		2,087,608			1,137,638
Cash and cash equivalents at beginning of year			3,228,745			1,141,137			3,499
Cash and cash equivalents at end of year		$	90,172		$	3,228,745		$	1,141,137

 

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

 

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VoIP, Inc.

Consolidated S tatements of Changes in S hareholders' Equity

Years Ended December 31, 2006, 2005 and 2004

 

		Common Stock Shares			Common Stock Amount			Additional Paid- in Capital			Accumulated Deficit			Total
Balance as of December 31, 2003			1,730,939		$	1,731		$	731,208		$	(624,647	)	$	108,292
Common stock issued			12,500,000			12,500			-			-			12,500
Common stock issued to investors for cash received			5,520,566			5,521			3,610,598			-			3,616,119
Common stock issued for services			907,477			907			493,259			-			494,166
Common Stock issued for acquisition of DTNet Tech.			2,500,000			2,500			4,747,500			-			4,750,000
Common Stock issued for acquisition of Voip Americas			1,000,000			1,000			1,099,000			-			1,100,000
Warrants issued to two comp any officers			-			-			3,320,763			-			3,320,763
Warrants issued for intellectual property			100,000			100			105,000			-			105,100
Loss for the y ear			-			-			-			(5,862,120	)		(5,862,120	)
Balance December 31, 2004			24,258,982			24,259			14,107,328			(6,486,767	)		7,644,820
Common Stock issued for services			2,994,592			2,995			3,377,479			-			3,380,474
Common stock issued to investors for cash received			6,740,038			6,740			8,022,598			-			8,029,338
Common stock issued for cash received, pursuant to
exercise of warrants			3,292,778			3,293			3,919,360			-			3,922,653
Common stock issued for debt conversions			4,054,536			4,054			2,461,232			-			2,465,286
Common Stock issued for acquisition of Caerus, Inc. (restated)			16,932,471			16,932			17,598,068			-			17,615,000
Options issued for acquisition of Caerus, Inc.			-			-			355,000			-			355,000
Common Stock issued for acquisition of WQN			1,250,000			1,250			1,298,250			-			1,299,500
Value of warrants issued for acquisition of WQN			-			-			5,200,000			-			5,200,000
Value of warrants and conversion features of debt issue			-			-			3,085,832			-			3,085,832
Stock compensation - amortization			-			-			242,101						242,101
Option and warrant compensation - amortization			-			-			1,939,249			-			1,939,249
Loss for the y ear			-			-			-			(28,313,333	)		(28,313,333	)
Balance December 31, 2005 (restated)			59,523,397			59,523			61,606,497			(34,800,100	)		26,865,920
Common Stock issued for services			4,658,595			4,659			3,272,337						3,276,996
Common stock issued for cash received, pursuant to
exercise of warrants			8,826,609			8,826			2,339,725						2,348,551
Common stock issued for debt conversions			16,230,505			16,230			1,811,728						1,827,958
Common stock issued for nonregistration and
other penalties, and interest			8,584,278			8,585			3,320,657						3,329,242
Common stock issued for acquisition of Caerus, Inc.			666,667			667			259,333						260,000
Common stock issued for cash received, pursuant to			319,650			320			330,753						331,073
exercise of options
Common stock acquired, DTNet sale			(200,000	)		(200	)		(383,800	)					(384,000	)
Value of warrants and conversion features of debt issued									5,168,168						5,168,168
Stock compensation - amortization									296,875						296,875
Option and warrant compensation - amortization									6,326,829						6,326,829
Value of warrants reclassified to liabilities									(5,406,284	)					(5,406,284	)
Loss for the year												(41,196,512	)		(41,196,512	)
Balance December 31, 2006			98,609,701		$	98,610		$	78,942,818		$	(75,996,612	)	$	3,044,816

 

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

 

56

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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 12,500,000 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 (“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.

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 and the termination of its Marketing and Distribution Agreement with Phone House, Inc., both 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. As of December 31, 2006 and 2005 the balance of the allowance for uncollectible accounts amounted to $133,653 and $177,489, respectively.

 

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 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 are 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 statements 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 are charged to operating expenses based on the fair value of the stock at the date the stock rights are granted.

 

Restatement

The Company’s consolidated balance sheet at December 31, 2005 was restated to reduce both goodwill and stockholders’ equity by $2,360,000, which represented contingent consideration (escrowed common shares - see Note J) related to the Caerus acquisition. According to Statement of Financial Accounting Standards No. 141 (“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.

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.

 

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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 do not expect the adoption of this Statement to have a material impact on its financial statements.

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 2,242,500 shares of its common stock for $0.80 per share, and warrants to purchase 2,207,751 common shares at prices from $1.60 to $2.23 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 1,482,500 shares and 226,500 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 1,375,000 shares of its common stock for $0.80 per share, and warrants to purchase 2,225,000 common shares at prices ranging from $1.37 to $1.60 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 $0.18 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 5,850,000 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.

 

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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.

 

The Company's authorized common stock consisted of 100,000,000 common shares at December 31, 2006, of which 98,609,701 common shares were issued and outstanding, and approximately 141 million additional shares were contingently issuable upon the exercise of stock options and warrants, or conversion of convertible securities. An additional 24 million 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 192 million 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		$	8,766,749		$	9,381,372
Furniture & Fixtures			91,647			171,705
Software			666,842			1,667,864
Vehicles			15,269			15,269
Leasehold improvements			105,075			248,952
Total			9,645,582			11,485,162
Less accumulated depreciation			(2,785,349	)		(1,343,290	)
Total		$	6,860,233		$	10,141,872

 

Depreciation expense for the years ended December 31, 2006, 2005 and 2004 amounted to $1,844,020, $1,208,331, 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 $21.2 million in goodwill and approximately $11.5 million in other intangible assets recorded in connection with its acquisition in October 2005 of substantially all of the assets relating to the VoIP business of WQN, and 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					$	21,228,339		$	20,946,341
Other intangible assets:
			Useful Life (Years)
Technology			4.0		$	6,000,000		$	6,000,000
Customer relationships			5.0 - 6.0			8,325,000			8,325,000
Trade names			9.0			1,700,000			1,700,000
Non-compete agreement			1.0			500,000			500,000
Other intangible assets			Indefinite			200,000			200,000
Subtotal						16,725,000			16,725,000
Accumulated amortization						(5,265,517	)		(1,627,070	)
Other intangible assets, net						11,459,483			15,097,930
Total goodwill and other intangible assets					$	32,687,822		$	36,044,271

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 $3,324,447, $1,627,070 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.

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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:

		Convertible Notes Payable						Fair Value Liability for Warrants
		2006			2005			2006			2005
Payable to WQN, Inc. (1)		$	3,700,000		$	3,700,000		$	-		$	-
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			15,447,520			5,196,804			5,102,731			-
Less discounts			(5,870,928	)		(1,797,006	)		-			-
Total		$	9,576,592		$	3,399,798		$	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. While WQN has not declared the note in default, the full amount of the note at December 31, 2006, has been classified as current.

(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 $0.80 per share. These investors also received five-year warrants to purchase 964,322 shares of the Company's common stock for $1.37612 per share, five-year warrants to purchase 964,322 shares of the Company's common stock for $1.6503 per share, and one-year warrants to purchase 1,928,644 shares of the Company's common stock for $1.60 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 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 $0.80 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 $0.78 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 $0.80. 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 $0.26 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 $0.18 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 $1.318 per share. These investors also received five-year warrants to purchase 4,537,052 shares of the Company's common stock for $1.45889 per share, and one-year warrants to purchase 4,537,052 shares of the Company's common stock for $1.5915 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 $1.318 per share or 85% of the weighted average price of the stock on the OTCBB, but not less than $1.00 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 $1.00 per share or 85% of the weighted average price of the stock on the OTCBB, but not less than $0.80 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 $0.26 per share, and the outstanding warrants were re-priced to $0.475 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 $0.18 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 166,368 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 20,917,153 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 $0.26; 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 $0.475; and 5)  certain investors agreed to surrender their claims associated with warrants issued in May 2006 in exchange for 2,500,000 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.

(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 10,378,125 shares of the Company's common stock at an exercise price of $0.407 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 $0.28 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 $0.18 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.

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(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 $0.78 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 $0.78 per share. The effect was to increase the number of fully diluted shares of common stock at the time to approximately 129 million, relative to the Company's then-authorized 100 million common shares. The Company's total warrants then outstanding were approximately 28 million. 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 and 2005, nonregistration penalties and other stock-based payables consisted of the following:

		2006			2005
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			347,419			-
Common stock payable for other services rendered			439,200			-
Total		$	4,730,454		$	-

 

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 3,000,000 shares of common stock. Since the Company had insufficient authorized common shares at December 31, 2006, only 964,782 shares were issued, and the balance of 2,035,218 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).

 

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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 14,400,000 of the Company's common shares (excluding 2,000,000 escrowed common shares, 666,667 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), 1,250,000 shares of the Company's common stock, and 5,000,000 warrants to purchase the Company's common stock at $0.001 per share.

Condensed balance sheets of the Caerus and WQN acquisitions, reflecting the net fair value amounts assigned to each major asset and liability, as of their respective acquisition dates are as follows:

		Caerus, Inc.			WQN, Inc.
		(Restated)
Current assets		$	617,000		$	3,775,000
Property and equipment, net			7,869,000			508,000
Other assets			131,000			463,000
Accounts payable and other current liabilities			(14,674,000	)		(2,031,000	)
Note payable			(4,832,000	)		-
Net liabilities assumed			(10,889,000	)		2,715,000
Goodwill			15,418,000			4,120,000
Intangible assets - other			13,800,000			2,925,000
Intangible assets			29,218,000			7,045,000
Net fair value assets acquired		$	18,329,000		$	9,760,000

 

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.

 

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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.

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 500,000 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.

 

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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 475,000 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 4,000,000 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 10,000,000 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:

		Number			Exercise Price Range			Wtd. Avg. Exercise Price
Options outstanding at December 31, 2005			3,746,562			$0.85 - $1.56		$	1.21
Options returned to the plan due
to employee terminations			(2,782,562	)		$0.85 - 1.56		$	1.29
Options granted			3,000,000			$0.36		$	0.36
Options exercised			(3,319,650	)		$0.36 - $1.56		$	0.43
Options outstanding at December 31, 2006			644,350			$0.85 - $1.56		$	1.11

 

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 10,000,000 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 10,000,000 shares of the Company's common stock each for Messrs. Cataldo and Lewis at an exercise price of $0.01 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 10,000,000 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 3,000,000 shares of the Company's common stock at $0.36 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 3,000,000 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.

 

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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 644,350 shares of common stock, at exercise prices ranging from $0.85 to $1.56 per share, and at a weighted average exercise price of $1.11 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 8,826,609, 4,400,000 and 0 shares, respectively, of common stock in exchange for these warrants. As of December 31, 2006, the Company had outstanding 15,780,776 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 $0.26 to $2.60 per share, and at a weighted average exercise price of $1.09 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:

 

Year ending December 31,
2007		$	268,556
2008			98,386
2009			43,736
2010			-
Total		$	410,678

 

Rent expense for these leases for the years ended December 31, 2006, 2005, and 2004 was $233,355, $144,833 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

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 200,000 shares of the Company's common stock held by the Purchaser; and (2) the return for cancellation of 200,000 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.

 

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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.

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

 

		2006			2005			2004
Revenues		$	14,308,466		$	6,561,277		$	807,908
Cost of sales			13,968,554			6,086,147			617,547
Gross profit			339,912			475,130			190,361
Compensation and benefits			358,189			402,110			-
Asset impairment charges			1,775,223			4,173,452			-
Other operating expenses			186,453			417,907			744,593
Net loss		$	(1,979,953	)	$	(4,518,339	)	$	(554,232	)

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		$	6,259,445		$	7,025,848		$	2,040,000
Deferred benefit (expense)			2,334,449			(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			-			-			-

 

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

 

Net operating loss carryforwards		$	14,703,783
Excess tax over book depreciation expense			(634,033	)
Excess book over tax amortization of debt discounts			2,130,505
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.

 

NOTE R - SUBSEQUENT EVENTS

Cedar Note Assignment and Restructure