Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Cautionary Note Regarding Forward-Looking Statements

This report contains "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Rule 175 promulgated thereunder, and Section 21E of the Securities Exchange Act of 1934, as amended, and Rule 3b-6 promulgated thereunder, that involve inherent risk and uncertainties. Any statements about our expectations, beliefs, plans, objectives, strategies or future events or performance constitute forward-looking statements. These statements are often, but not always, made through the use of words or phrases such as "anticipate," "estimate," "plan," "project," "continuing," "ongoing," "expect," "believe," "intend" and similar words or phrases. Accordingly, these statements involve estimates, assumptions and uncertainties that could cause actual results to differ materially from those expressed or implied therein. All forward-looking statements are qualified in their entirety by reference to the factors discussed in this report, including, among others, the following risk factors discussed more fully in Item 1A hereof:

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dependence on commercialization of our CodecSys technology;

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our need and ability to raise sufficient additional capital;

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our continued losses;

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restrictions contained in our outstanding convertible notes;

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general economic and market conditions;

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ineffective internal operational and financial control systems;

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rapid technological change;

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intense competitive factors;

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our ability to hire and retain specialized and key personnel;

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dependence on the sales efforts of others;

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dependence on significant customers;

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uncertainty of intellectual property protection;

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potential infringement on the intellectual property rights of others;

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factors affecting our common stock as a "penny stock;"

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extreme price fluctuations in our common stock;

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price decreases due to future sales of our common stock;

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future shareholder dilution; and

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absence of dividends.

Because the risk factors referred to above could cause actual results or outcomes to differ materially from those expressed or implied in any forward-looking statements made by us or on our behalf, you should not place undue reliance on any forward-looking statement. Further, any forward-looking statement speaks only as of the date on which it is made, and we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of future events or developments. New factors emerge from time to time, and it is not possible for us to predict which factors will arise. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.

Critical Accounting Policies

The preparation of financial statements in conformity with U.S. GAAP requires that we make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our assumptions and estimates, including those related to recognition of revenue, valuation of investments, valuation of inventory, valuation of intangible assets, valuation of derivatives, measurement of stock-based compensation expense and litigation. We base our estimates on historical experience and on various assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We discuss our critical accounting policies in Management's Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2007. Except for the critical accounting policy set forth below entitled "Valuation of Investments," there have been no other significant changes in our critical accounting policies or estimates since those reported in our Annual Report.

Valuation of Investments

As discussed in Note 6 to the unaudited condensed consolidated financial statements, we adopted the provisions of Statement 157 effective January 1, 2008. In valuing our investments we predominantly use market data or data derived from market sources. When market data is not available, such as when the investment is illiquid, we utilize a discounted cash flow analysis to arrive at the recorded fair value. This process involves incorporating our assumption about the anticipated term and the yield that a market participant would require to purchase the security in the marketplace. We utilized unobservable (Level 3) inputs in determining the fair value of our auction rate preferred securities, which totaled $2,605,674 at June 30, 2008.

Our auction rate preferred securities are classified as available-for-sale securities and reflected at fair value. In prior periods, due to the auction process which took place every 7-30 days for most securities, quoted market prices were readily available, which would qualify as Level 1 under Statement
157. However, due to events in credit markets during first quarter 2008, the auction events for most of these instruments failed, and, therefore, we have determined the estimated fair values of these securities utilizing a discounted cash flow analysis as of June 30, 2008. This analysis considers, among other items, the collateralization of the underlying securities, the expected future cash flows and the expectation of the next time the security is expected to have a successful auction. These securities were also compared, when possible, to other observable market data with similar characteristics to the securities held by us. Due to these events, we reclassified these instruments as Level 3 during first quarter 2008 and recorded a temporary unrealized decline in fair value of $560,187, with an offsetting entry to Accumulated other comprehensive loss at March 31, 2008. During the quarter ended June 30, 2008, we liquidated at par approximately 80% of our auction rate securities held at March 31, 2008 resulting in the temporary unrealized decline in fair value being adjusted to $194,326 at June 30, 2008. We currently believe that this temporary decline in fair value is due entirely to liquidity issues and not credit issues, because they are in AAA closed-end bond mutual funds that are over-collateralized by at least 200% and are backed by the underlying marketable securities. We believe we have sufficient cash and cash equivalents available at June 30, 2008 to allow us sufficient time for the securities to return to full value. We will re-evaluate each of these factors as market conditions change in subsequent periods.

Executive Overview

In March 2007, we commenced a private placement offering of our securities by selling shares of our common stock at a price of $1.50 per share. In the offering, the purchaser of each share received a warrant to acquire one share of common stock. The warrants have a three-year exercise period and are exercisable at an exercise price of $2.00 per share. In the fourth quarter of 2007, we completed the offering pursuant to which we raised $5,975,317 from the sale of 3,983,557 shares of our common stock.

On October 31, 2007, we entered into an exchange agreement with the holder of our unsecured convertible note in the principal amount of $1.0 million and related warrants. Pursuant to the exchange agreement, we cancelled the holder's warrants to acquire up to 2,000,000 shares of our common stock at $2.10 per share and other warrants to

acquire up to 2,000,000 additional shares of our common stock at $3.00 per share in exchange for the issuance of 650,000 shares of our common stock to the holder.

In the fourth quarter of 2007, the institutional fund holders of our outstanding senior secured convertible notes issued in 2005 completed conversion of substantially all of their convertible notes into shares of our common stock.
At December 31, 2007, only an immaterial amount of the senior secured convertible notes remained outstanding, and has since been converted.

On November 15, 2007, we entered into a two-year license agreement with IBM pursuant to which we will license our patented CodecSys technology for use by IBM in video encoders that IBM intends to manufacture and sell. The IBM video encoder is not completed in a commercially deployable form. The IBM agreement is our first significant license of the CodecSys technology for use in a commercial application. We believe this agreement may hold substantial revenue opportunities for our business. Although IBM has commenced marketing and sales activities with respect to products incorporating our CodecSys technology, no sales of products have been made, and we have not derived any material revenue from our CodecSys technology to date.

On December 24, 2007, we completed a $15.0 million private placement of securities with an institutional investor. Pursuant to the financing, we entered into various agreements with the investor, including (i) a securities purchase agreement pursuant to which we, in exchange for $15.0 million, issued and sold to the investor (A) 1,000,000 shares of our common stock, (B) a 6.25% senior secured convertible promissory note in the principal amount of $15.0 million which is convertible into shares of our common stock at a conversion price of $5.45 per share, and (C) a five-year warrant that is exercisable to purchase up to 1,875,000 shares of common stock at an exercise price of $5.00 per share; (ii) a registration rights agreement pursuant to which we agreed to provide certain registration rights with respect to the shares of common stock, the shares of common stock issuable upon conversion of the note, the shares of common stock issuable as interest shares under the note and shares of common stock issuable upon exercise of the warrant; and (iii) a security agreement granting a first priority security interest in all of our property and assets to secure the note.

Our revenues decreased by 18% for the six months ended June 30, 2008 compared to the six months ended June 30, 2007, and the net cash used for operations in the six months ended June 30, 2008 increased compared to the six months ended June 30, 2007 by 247%. Until cash from operations is sufficient to cover all corporate expenses, we will continue to deplete our available cash and increase our need for future equity and debt financing.

The conversion feature and the prepayment provision of the $15.0 million senior secured convertible note and the $1.0 million unsecured convertible note have been accounted for as embedded derivatives and valued on the respective transaction dates using a Black-Scholes pricing model. The warrants related to the convertible notes have been accounted for as derivatives and were valued on the respective transaction dates using a Black-Scholes pricing model as well.
At the end of each quarterly reporting date, the values of the embedded derivatives and the warrants are evaluated and adjusted to current market value.
The conversion features of the convertible notes and the warrants may be exercised at any time and, therefore, have been reported as current liabilities.
Prepayment provisions contained in the convertible notes limit our ability to prepay the notes in certain circumstances. For all periods since the issuance of the senior secured convertible note and the unsecured convertible note, the derivative values of the respective prepayment provisions have been nominal and have not had any offsetting effect on the valuation of the conversion features of the notes. For a description of the accounting treatment of the senior secured convertible note financing, see Note 5 of our notes to consolidated financial statements included elsewhere herein.

Results of Operations for the Six Months ended June 30, 2008 and June 30, 2007

Revenues

We generated $1,998,195 in revenue during the six months ended June 30, 2007.
During the same six-month period in 2007, we generated revenue of $2,362,850. The decrease in revenue of $ 364,655 was due primarily to (i) the Company completing installation services for one client in 2007 that was not repeated in 2008, which resulted in a decrease in installation related revenues of $269,534 and (ii) a decrease in satellite fees charged of $172,356 due to the expiration of a customer contract that was not renewed. However, the loss of revenues from installation services performed for the former customer of $668,771 and the loss of revenues from the expiration of the customer contract of $220,800 were offset by increased installation and satellite usage revenues from new and

existing customers. In addition, license fee revenue increased by $58,582, and other revenues increased by $65,282.

Sales revenues from our three largest customers accounted for approximately 50% and 65% of total revenues for the six months ended June 30, 2008 and 2007, respectively. Any material reduction in revenues generated from any one of our largest customers could harm our results of operations, financial condition and liquidity.

Cost of Revenues

Cost of revenues decreased by $ 290,305 to $2,105,305 for the six months ended June 30, 2008 from $2,395,610 for the six months ended June 30, 2007. The decrease was due primarily to decreased activity in installation of equipment for one customer, which resulted in a decrease of $ 239,550 in the costs related to such installations. In addition, the general operations department costs decreased by approximately $81,931, due primarily to the decrease in installation activity, and satellite distribution costs decreased by $58,077, which were offset by an increase in depreciation and amortization of approximately $89,253.

Expenses

General and administrative expenses for the six months ended June 30, 2008 were $2,988,741 compared to $2,879,192 for the six months ended June 30, 2007. The increase of $109,549 resulted from an increase in employee salary and related expenses of $166,717, increased travel expenses of $36,103, and an increase of $83,151 in bad debt expense. In 2007 technical development departmental expenses of $129,615 were classified as general and administrative expenses, but all of the technical development department expenses in 2008 are classified as research and development expenses. Research and development in process increased by $1,444,697 for the six months ended June 30, 2008 to $1,828,786 from $384,089 for the six months ended June 30, 2007 not including a one-time expense for impairment of license rights of $1,142,400 recorded in 2007. The increase resulted primarily from an increase of $838,572 in employee related expenses, an increase of $129,214 in professional services, and increase of $156,551 in software maintenance and patent related expenses, an increase in general operating expenses of $97,483 related to the increased number of employees and an increase of $65,851 in materials and supplies expense. Sales and marketing expenses increased $293,066 to $602,501 for the six months ending June 30, 2008 from $309,435 for the six months ending June 30, 2007. The increases reflect additional sales personnel hired to begin marketing of our CodecSys products and related overhead expenses.

Interest Expense

For the six months ended June 30, 2008, we incurred interest expense of $2,994,577 compared to interest expense for the six months ended June 30, 2007 of $1,126,839. The increase of $1,867,738 resulted primarily from the Company recording more non cash interest expense related to the accretion of note liability on our 6.25% senior secured convertible note and related amortization of debt offering costs, which was not outstanding in 2007 and on our unsecured convertible note. In addition, interest expense paid or accrued on the 6.25% senior secured convertible note is likewise greater due to the increased principal balance outstanding.

Net Loss

We realized a net loss for the six months ended June 30, 2008 of $ 3,397,937 compared with a net loss for the six months ended June 30, 2007 of $5,534,396. The decrease in the net loss of $2,136,459 is primarily due to, an increase in gain of $4,535,733 related to our derivative valuation calculation offset by (i) the increase of $1,867,738 in interest expense, (ii) an increase in operating expenses of $704,912 as explained above, and (iii) a $74,350 decrease in gross margin as a result of decreased sales activity.

Results of Operations for the Three Months ended June 30, 2008 and June 30, 2007

Revenues

The Company generated $810,803 in revenue during the three months ended June 30, 2008. During the same three-month period in 2007, the Company generated revenue of $763,784. The increase in revenue of $ 47,019 was due primarily to the Company performing sufficient installation and service work in the three months ended June 30, 2008, to offset a decrease in satellite fees resulting from the expiration of a long time satellite customer.

The Company realized $ 201,867 more revenue from installation services performed in the quarter ended June 30, 2008, than in the second quarter of 2007, but we realized $166,911 less revenue from satellite fees in the quarter ended June 30, 2008 than we did in the quarter ended June 30, 2007.

The Company's three largest customers' sales revenues accounted for approximately 62% and 67% of total revenues for the quarters ended June 30, 2008 and 2007, respectively. The three customers with the greatest revenues in 2007 were not the same three customers in 2008. Any material reduction in revenues generated from any one of its largest customers could harm the Company's results of operations, financial condition and liquidity unless we could replace the lost revenues with new customers.

Cost of Revenues

Costs of Revenues increased by $168,024 to $968,859 for the three months ended June 30, 2008, from $800,835 for the three months ended June 30, 2007. The increase was due primarily to increased activity in installation of equipment, which resulted in an increase in the costs related to such installation services for all the Company's customers of $160,263. There was not an increase in the cost of equipment relative to the sales price of the equipment, but the general operations department costs increased by approximately $51,388 due to the increase in installation activity. In addition, depreciation increased by $64,563 due to purchases of equipment and upgrades of our internal network primarily for our development activities. The cost increases were partially offset by a decrease of approximately $68,731 in satellite distribution costs.

Expenses

General and Administrative expenses for the three months ended June 30, 2008 were $1,454,560 compared to $1,304,508 for the three months ended June 30, 2007.
The increase of $150,052 resulted primarily from increases in expenses incurred for outside consultants of $167,389, in payroll and related expenses of $134,398, legal expenses of $65,061 and outside director fees of $62,750 offset by a decrease in expenses of $243,681 for options and warrants granted.
Research and development in process increased by $853,127 for the three months ended June 30, 2008 to $1,052,153 from $199,026 for the three months ended March 31, 2007. This increase resulted primarily from increased development staff and related expenses of increasing the development activity. Sales and marketing expenses increased $189,495 for the three months ended June 30, 2008 to $356,309 from $166,814 for the three months ended June 30, 2007. The increase was due primarily to increased payroll and related expenses resulting from hiring of additional personnel devoted to sales. Total operating expenses were only $80,109 greater for the three months ended June 30, 2008 when compared to total operating expenses for the three months ended June 30, 2007. However, expenses for impairment of license rights was recorded in the period ending June 30, 2007 that was not repeated in the period ending June 30, 2008, which accounted for total expenses in the two quarters being more nearly comparable.

Interest Expense

For the three months ended June 30, 2008, the Company incurred interest expense of $1,492,785 compared to interest expense for the three months ended June 30, 2007 of $353,008. The increase of $1,139,777 resulted primarily from the Company recording non cash interest expense of $1,245,909 related to note accretion of our 6.25% senior secured convertible note, which was not outstanding during the second quarter of 2007, partially offset by note accretion of our 6.0% senior secured convertible notes in 2007, which have since been converted and are no longer outstanding. The $1,492,785 interest expense recorded primarily consisted of $1,131,159 recorded to account for the accretion of note liability on our balance sheet, interest payable on all notes of $246,876 and amortization of debt offering costs of $114,750.

Net Loss

The Company realized net loss for the three months ending June 30, 2008 of $5,556,920 compared with a net loss for the three months ended June 30, 2007 of $1,219,799. The increase in net loss $4,337,121 was primarily the result of an increase in derivative valuation loss of $3,127,720, which resulted primarily from valuation of our 6.25% senior secured convertible note, which was issued in December of 2007, and the increase of $1,139,777 in interest expense.

Liquidity and Capital Resources

At June 30, 2008, we had cash of $ 9,296,764, total current assets of $11,536,156, and total current liabilities of $8,984,351 and total stockholders' equity of $2,859,024. Included in current liabilities is $7,942,300, which relates to the value of the embedded derivatives for the 6.25% senior secured convertible note and related warrants and the unsecured convertible note and warrants. Our current liabilities, without considering the derivative liability are $1,042,051.

As of June 30, 2008, we held approximately $2,800,000 of auction rate preferred securities, valued at $2,605,674 and classified as long term investments. Beginning in February 2008, many of these auction rate preferred securities became illiquid because their scheduled auctions failed to settle. During the second quarter 2008, $8,800,000 of the $11,600,000 auction rate preferred securities held at March 31, 2008 were liquidated at par, with the Company not sustaining any losses. However, we may have limited or no opportunities to liquidate the remaining auction rate investments and fully recover their stated value in the near term. An auction failure occurs when the parties wishing to sell securities at auction cannot. When an auction fails the affected securities begin to pay interest under their default interest rate terms. As a result of this illiquidity caused by the lack of an active market, these investments were classified as non-current. Although approximately 80% of our investments have been redeemed by the issuers, none of the issuers of the auction rate preferred securities still held by us have announced a definitive plan for redemption of the remainder of the securities in the near term. A temporary unrealized loss of $560,187 was recorded in the first quarter of 2008, which was decreased to $ 194,326 at June 30, 2008 to reflect the redemptions which occurred in the second quarter. We utilized a discounted cash flow analysis in determining the fair value of these securities, which used significant unobservable inputs at June 30, 2008.

We believe the impairment of these securities is temporary because they are backed by more than 200% collateral and approximately 80% have already been redeemed. All of our remaining auction rate preferred securities are currently rated AAA, the highest rating by a rating agency. We believe we will ultimately be able to liquidate these investments without significant loss through successful auctions or redemptions of securities by the issuers. However, it could take a long period of time to realize the investments' full value for a portion of the investments. Based on our expected operating cash flows, and our other sources of cash, we do not anticipate that the current illiquidity of $2,800,000 of these investments will adversely affect our operations.

We experienced negative cash flow used in operations during the six months ending June 30, 2008 of $4,404,341 compared to negative cash flow used in operations for the six months ended June 30, 2007 of $1,269,143. The negative cash flow was met by cash reserves. We expect to continue to experience negative operating cash flow as long as we continue our technology development program or until we begin to receive licensing revenue from licenses of our CodecSys technology or increase our sales by adding new customers.

On December 24, 2007, we entered into a securities purchase agreement described above in which we raised $15,000,000 (less $937,000 of prepaid interest and $1,377,000 of related costs including commissions). We intend to use the proceeds from this financing to support our CodecSys commercialization and development and for general working capital purposes. The senior secured convertible note is due December 21, 2010 and bears interest at 6.25% per annum.
Interest for the first year was prepaid at closing. Interest-only payments thereafter in the amount of $234,375 are due quarterly and commence in April 2009. Interest payments may be made through issuance of common stock in certain circumstances. The note is convertible into 2,752,294 shares of our common stock at a conversion price of $5.45 per share, convertible any time during the term of the note. We have granted a first priority security interest in all of our property and assets and of our subsidiaries to secure our obligations under the note and related transaction agreements.

In connection with the financing, the senior secured convertible note holder received warrants to acquire 1,875,000 shares of our common stock exercisable at $5.00 per share. The warrants are exercisable any time for a five-year period beginning on the date of grant. We also issued to the convertible note holder 1,000,000 shares of our common stock valued at $3,750,000 and incurred an additional $1,377,000 for commissions, finders fees and other transaction expenses, including the grant of a three-year warrant to purchase 112,500 shares of our common stock to a third party at an exercise price of $3.75 per share, valued at $252,000. A total of $1,377,000 was included in debt offering costs and is being amortized over the term of the note.

The $5.45 conversion price of the senior secured convertible note and the $5.00 exercise price of the warrants are subject to adjustment pursuant to standard anti-dilution rights. These rights include (i) equitable adjustments in the event we effect a stock split, dividend, combination, reclassification or similar transaction; (ii) "weighted average" price protection adjustments in the event we issue new shares of common stock or common stock equivalents in certain transactions at a price less than the then current market price of our common stock; and (iii) "full ratchet" price protection adjustments in the event we issue new shares of common stock or common stock equivalents in certain transactions at a price less than $5.45 per share.

The senior secured convertible note contains a prepayment provision allowing us to prepay, in certain limited circumstances, all or a portion of the note. The portion of the note subject to prepayment must be purchased at a price equal to the greater of (i) 135% of the amount to be purchased and (ii) the company option redemption price, as defined in the note. Even if we elect to prepay the note, the note holder may still convert any portion of the note being prepaid pursuant to the conversion feature thereof.

We also entered into a registration rights agreement with the holder of the . . .