The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the condensed consolidated financial statements and related notes included elsewhere in this document. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed below. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed above in the section entitled "Risk Factors."

Overview

We are a leading provider of IP telecommunications solutions for enterprises. Our solution is comprised of our ShoreGear switches, ShorePhone IP phones and ShoreWare software applications. We were founded in September 1996 and shipped our first system in 1998. We have continued to develop and enhance our product line since that time. We currently offer a variety of models of our switches and IP phones.

We sell our products primarily through channel partners that market and sell our systems to enterprises across all industries, including to small, medium and large companies and public institutions. We believe our channel strategy allows us to reach a larger number of prospective enterprise customers more effectively than if we were to sell directly. Channel partners typically purchase our products directly from us. Our internal sales and marketing personnel support these channel partners in their selling efforts. In some circumstances, the enterprise customer will purchase products directly from us, but in these situations we typically compensate the channel partner for its sales efforts. At the request of the channel partner, we often ship our products directly to the enterprise customer.

Most channel partners generally perform installation and implementation services for the enterprises that use our systems. In most cases, our channel partners provide the post-contractual support to the enterprise customer by providing first-level support services and purchasing additional services from us under a post-contractual support contract. For channel partners without support capabilities or that do not desire to provide support, we offer support contracts to provide all of the support to enterprise customers.

We outsource the manufacturing of our products to contract manufacturers. Our outsourced manufacturing model allows us to scale our business without the significant capital investment and on-going expenses required to establish and maintain a manufacturing operation. Our phone and switch products are manufactured by two contract manufacturers located in San Jose, California and China. Our contract manufacturers provide us with a range of operational and manufacturing services, including component procurement, final testing and assembly of our products. We work closely with our contract manufacturers to manage the cost of components, since our total manufacturing costs are directly tied to component costs. We regularly provide forecasts to our contract manufacturers, and we order products from our contract manufacturers based on our projected sales levels well in advance of receiving actual orders from our enterprise customers. We seek to maintain sufficient levels of finished goods inventory to meet our forecasted product sales with limited levels of inventory to compensate for unanticipated shifts in sales volume and product mix.

Although we have historically sold our systems primarily to small and medium sized enterprises, we expanded our sales and marketing activities to increase our focus on larger enterprise customers. Accordingly, we have a major accounts program whereby our sales personnel assist our channel partners with sales to large enterprise accounts, and we coordinate with our channel partners to enable them to better serve large multi-site enterprises. To the extent we are successful in penetrating larger enterprise customers, we expect that the sales cycle for our products will increase, and that the demands on our sales and support infrastructure will also increase.

We are headquartered in Sunnyvale, California and the majority of our personnel work at this location. Sales and support personnel are located throughout the United States and, to a lesser extent, in the United Kingdom, Germany, Belgium, Spain, Hong Kong, Singapore and Australia. While we expanded our operations to Europe in 2005 and to the Asia Pacific region in 2006, most of our enterprise customers are located in the United States. Revenue from international sales has been less than 10% of our total revenue for three months ended September 30, 2008 and 2007, respectively. Although we intend to focus on increasing international sales, we expect that sales to enterprise customers in the United States will continue to comprise the significant majority of our sales.

We have experienced growth in the past year, with our total revenue growing to $35.9 million for the three months ended September 30, 2008 from $32.0 million in the same period of 2007. This growth in revenue has largely been driven by increased demand for IP telecommunications systems from new enterprise customers and increase in service and support revenue. However, our operating expenses have increased significantly to $24.9 million for the three months ended September 30, 2008 from $18.3 million in the same period of 2007. This growth in operating expenses has primarily been driven by our growth in headcount, to 380 employees at September 30, 2008, as compared with 295 employees at September 30, 2007. We expect to continue to add personnel in all functional areas.

Key Business Metrics

We monitor a number of key metrics to help forecast growth, establish budgets, measure the effectiveness of sales and marketing efforts and measure operational effectiveness.

Initial and repeat sales orders. Our goal is to attract a significant number of new enterprise customers and to encourage existing enterprise customers to purchase additional products and support. Many enterprise customers make an initial purchase and deploy additional sites at a later date, and also buy additional products and support as their businesses expand. As our installed enterprise customer base has grown we have experienced an increase in revenue attributable to existing enterprise customers, which currently represents a significant portion of our total revenue.

Deferred revenue. Nearly all system sales include the purchase of post-contractual support contracts with terms of up to five years, and the rate of renewal on these contracts have been high historically. We recognize support revenue on a ratable basis over the term of the support contract. Since we receive payment for support in advance of our recognizing the related revenue, we carry a deferred revenue balance on our consolidated balance sheet. This deferred revenue helps provide predictability to our future support and services revenue. Accordingly, the level of purchases of post-contractual support with our product sales is an important metric for us along with the renewal rates for these services. Our deferred revenue balance at September 30, 2008 was $20.5 million, consisting of $2.8 million of deferred product revenue and $17.7 million of deferred support and services revenues, of which $15.5 million is expected to be recognized within one year.

Gross profit. Our gross profit for products is primarily affected by our ability to reduce hardware costs faster than the decline in average overall system prices. We have been able to increase our product gross profit by reducing hardware costs through product redesign and volume discount pricing from our suppliers. We have also introduced new, lower cost hardware following these introductions, which has continued to improve our product gross profit. In general, product gross profit on our switches is greater than product gross profit on our IP phones. As the prices and costs of our hardware components have decreased over time, our software components, which have lower costs than our hardware components, have represented a greater percentage of our overall system sales. We consider our ability to monitor and manage these factors to be a key aspect of maintaining product gross profit and increasing our profitability.

Gross profit for support and services is significantly lower than gross profit for products, and is impacted primarily by personnel costs and labor related expenses. The primary goal of our support and services function is to ensure maximum customer satisfaction and our investments in support personnel and infrastructure are made with this goal in mind. We expect that as our installed enterprise customer base grows, we will be able to improve gross profit for support and services through economies of scale. However, the timing of additional investments in our support and services infrastructure could materially affect our cost of support and services revenue, both in absolute dollars and as a percentage of support and services revenue and total revenue, in any particular period.

Operating expense management. Our operating expenses are comprised primarily of compensation and benefits for our employees and, therefore, the increase in operating expenses has been primarily related to increases in our headcount. We intend to expand our workforce to support our anticipated growth, and therefore our ability to forecast and increase revenue is critical to managing our operating expenses and profitability.

Basis of Presentation

Revenue. We derive our revenue from sales of our IP telecommunications systems and related support and services. Our typical system includes a combination of IP phones, switches and software applications. Channel partners buy our products directly from us. Prices to a given channel partner for hardware and software products depend on that channel partner's volume and customer satisfaction metrics, as well as our own strategic considerations. In circumstances where we sell directly to the enterprise customer in transactions that have been assisted by channel partners, we report our revenue net of any associated payment to the channel partners that assisted in such sales. This results in recognized revenue from a direct sale approximating the revenue that would have been recognized from a sale of a comparable system through a channel partner.

Support and services revenue primarily consists of post-contractual support, and to a lesser extent revenue from training services, professional services and installations that we perform. Post-contractual support includes software updates which grant rights to unspecified software license upgrades and maintenance releases issued during the support period. Post-contractual support also includes both Internet- and phone-based technical support. Post-contractual support revenue is recognized ratably over the contractual service period.

Cost of revenue. Cost of product revenue consists primarily of hardware costs, royalties and license fees for third-party software included in our systems, salary and related overhead costs of operations personnel, freight, warranty costs and provision for excess inventory. The majority of these costs vary with the unit volumes of product sold. Cost of support and services revenue consists of salary and related costs of personnel engaged in support and services, and are substantially fixed in the near term.

Research and development expenses. Research and development expenses primarily include personnel costs, outside engineering costs, professional services, prototype costs, test equipment, software usage fees and facilities expenses. Research and development expenses are recognized when incurred. We are devoting substantial resources to the development of additional functionality for existing products and the development of new products and related software applications. We intend to continue to make investments in our research and development efforts because we believe they are essential to maintaining and improving our competitive position. Accordingly, we expect research and development expenses to continue to increase in absolute dollars.

Sales and marketing expenses. Sales and marketing expenses primarily include personnel costs, sales commissions, travel, marketing promotional and lead generation programs, advertising, trade shows, professional services fees and facilities expenses. We plan to continue to invest in development of our distribution channel by increasing the number of our channel partners to enable us to expand into new geographies, including Europe, Asia Pacific and Latin America, and further increase our sales to large enterprises. In conjunction with channel growth, we plan to continue to invest in our training and support of channel partners to enable them to more effectively sell our products. We also plan to continue investing in our domestic and international marketing activities to help build brand awareness and create sales leads for our channel partners. We expect that sales and marketing expenses will increase in absolute dollars and remain our largest operating expense category.

General and administrative expenses. General and administrative expenses relate to our executive, finance, human resources, legal and information technology organizations. Expenses primarily include personnel costs, professional fees for legal, accounting, tax, compliance and information systems, travel, recruiting expense, software amortization costs, depreciation expense and facilities expenses. We expect that we will continue to incur significant additional accounting, legal and compliance costs, including costs to comply with Sarbanes-Oxley 404 as well as additional insurance, investor relations and other costs associated with being a public company. We also expect to continue to incur significant legal expenses related to our litigation with Mitel and securities lawsuits discussed elsewhere in this report.

Other income, net. Other income primarily consists of interest earned on cash balances.

Income tax provision. Income tax provision includes federal, state and foreign tax on our income. From inception through 2005, we accumulated substantial tax credit carryforwards. We reserved a significant amount of the deferred tax asset from the tax credits on our financial statements. For the three months ended September 30, 2008, the Company had a tax expense of $0.6 million on a book loss of $1.6 million. The tax expense primarily due to permanent differences related to stock-based compensation expenses and limitations on the utilization of California research and development credits. The effective tax rate for the three months ended September 30, 2007 was 24%.

Critical Accounting Policies and Estimates

We consider our accounting policies related to revenue recognition, allowance for doubtful accounts, stock-based compensation, inventory valuation and accounting for income tax to be critical accounting policies. A number of significant estimates, assumptions, and judgments are inherent in our determination of when to recognize revenue, how to allow for doubtful accounts, the calculation of stock-based compensation expense, and how we value inventory. We base our estimates and judgments on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results could differ materially from these estimates. Management believes there have been no significant changes during the three months ended September 30, 2008 to the items that we disclosed as our critical accounting policies and estimates in Management's Discussion and Analysis of Financial Condition and Results of Operations in our 2008 Annual Report on Form 10-K filed with the Securities and Exchange Commission. For a description of those accounting policies, please refer to our 2008 Annual Report on Form 10-K.

Results of Operations

The following table sets forth selected consolidated statements of operations
data as a percentage of total revenue for each of the periods indicated.



                                                        Three Months Ended
                                                           September 30,
                                                       2008            2007
      Revenue:
      Product                                              84 %            88 %
      Support and services                                 16 %            12 %

      Total revenue                                       100 %           100 %
      Cost of revenue:
      Product                                              28 %            29 %
      Support and services                                  8 %             7 %

      Total cost of revenue                                36 %            36 %

      Gross profit                                         64 %            64 %
      Operating expenses:
      Research and development                             22 %            19 %
      Sales and marketing                                  31 %            26 %
      General and administrative                           17 %            12 %

      Total operating expenses                             70 %            57 %

      Operating income (loss)                              (6 %)            7 %
      Other income, net                                     2 %             4 %

      Income (loss) before provision for income tax        (4 %)           11 %
      Provision for income taxes                           (2 %)           (3 %)

      Net income (loss)                                    (6 %)            8 %

Comparison of the three months ended September 30, 2008 and September 30, 2007

Revenue.

                                 Three months ended
                           September 30,     September 30,       Change
                               2008              2007            $      %
                                 (in thousands, except percentages)

The increase was primarily attributable to increased sales of our products and services. Product revenue was $30.0 million in the three months ended September 30, 2008, an increase of $1.9 million, or 7%, from $28.1 million in the same period of 2007. Support and services revenue was $5.9 million in the three months ended September 30, 2008, an increase of $2.0 million, or 52%, from $3.9 million in the same period of 2007, as a result of increased revenue associated with post-contractual support contracts accompanying new system sales, post-contractual support contract renewals and increased revenue from training and installation services.

Cost of revenue and gross profit.

                                     Three months ended
                              September 30,       September 30,         Change
                                  2008                2007              $      %
                                      (in thousands, except percentages)
           Cost of revenue   $        12,900     $        11,563     $ 1,337   12 %
           Gross profit      $        22,960     $        20,412     $ 2,548   12 %
           Gross profit                 64.0 %              63.8 %       n/a    0 %

Gross profit percent slightly increased in the three months ended September 30, 2008 compared to the same period of 2007. The increase was attributable to an increase in support and services gross profit from 44% in the three months ended September 30, 2007 to 50% in the same period of 2008. Support and services gross profit increased due to support and services revenue increasing by 52% and support and services cost increasing by 35%, compared to the same period in 2007. Compensation for support and services employees, the largest category of support and service costs, increased 49% in the three months ended September 30, 2008, as headcount increased from 40 employees at September 30, 2007 to 57 employees at September 30, 2008. Product gross profit percent was 67% in the three months ended September 30, 2008 and September 30, 2007, respectively.

Operating expenses.

                                           Three months ended
                                    September 30,      September 30,       Change
                                        2008               2007            $      %
                                          (in thousands, except percentages)
      Research and development     $         7,786    $         6,207   $ 1,579   25 %
      Sales and marketing          $        11,148    $         8,322   $ 2,826   34 %
      General and administrative   $         6,010    $         3,723   $ 2,287   61 %

Research and development. Compensation, including stock-based compensation, for research and development employees accounted for $1.3 million of the increase, primarily as a result of an increase in headcount to 128 employees at September 30, 2008, from 103 employees at September 30, 2007. Additionally, facility costs, travel and entertainment and depreciation accounted for $0.2 million, $0.1 million and $0.1 million, respectively, of the increase.

Sales and marketing. Compensation, including stock-based compensation for sales and marketing employees represented $1.8 million of the increase, primarily as a result of an increase in headcount, to 133 employees at September 30, 2008 from 101 employees at September 30, 2007. Additionally, advertisement and lead generation, trade shows, travel and entertainment, consulting and temporary labor costs, and marketing cooperative advertising accounted for $0.3 million, $0.3 million, $0.2 million, $0.2 million, and $0.2 million, respectively, of the increase.

General and administrative. Compensation for general and administrative employees, including stock-based compensation, accounted for $0.7 million of the increase, primarily as a result of an increase in headcount, to 41 employees at September 30, 2008 from 34 employees at September 30, 2007. Bad debt expenses, audit and tax services, office rent, legal expenses including litigation expenses, and depreciation accounted for $1.0 million, $0.2 million, $0.2 million, $0.1 million and $0.1 million, respectively, of the increase.

Other income, net.

                                     Three months ended
                              September 30,      September 30,        Change
                                  2008               2007           $         %
                                     (in thousands, except percentages)

The decrease is primarily attributable to decrease in interest income by $0.5 million due to a decline in overall interest rates in the three months ended September 30, 2008 as compared to the same period of 2007. Additionally, in the three months ended September 30, 2008 there was an increase in loss on foreign currency exchange translation of $0.2 million compared to same period of 2007 due to higher fluctuation in foreign currency exchange rates. We expect that foreign currency exchange rates may be volatile in the near term.

Provision for income taxes.

                                   Three months ended
                            September 30,      September 30,        Change
                                2008               2007           $         %
                                   (in thousands, except percentages)

Income tax provision. The income tax provision was $0.6 million in the three months ended September 30, 2008 which is a decrease of $0.2 million from $0.8 million in the same period of 2007, primarily due to lower taxable income in the three months ended September 30, 2008 compared to same of 2007.