Form 10-K for year ended December 31, 2005

Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ 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 ¨

Indicate by check mark if disclosure of delinquent filers in response to Item 405 of Regulation S-K 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. ¨

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):

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

The aggregate market value of the voting common equity held by nonaffiliates of the registrant computed by reference to the closing sale price of such stock, was approximately $1.0 million as of June 30, 2005, the last business day of the registrant’s most recently completed second fiscal quarter. The registrant has no non-voting common equity.

The number of shares of the registrant’s common stock, $.001 par value, outstanding as of March 31, 2006 was 4,562,847.

This Annual Report on Form 10-K contains “forward-looking statements.” These forward-looking statements include, but are not limited to, statements relating to our anticipated financial performance, business prospects, new developments, new strategies and similar matters, and/or statements preceded by, followed by or that include the words “believe,” “may,” “could,” “expect,” “anticipate,” “estimate,” “intend,” “plan,” “seek,” or similar expressions. We have based these forward-looking statements on our current expectations and projections about future events, based on the information currently available to us. These forward-looking statements are subject to risks, uncertainties and assumptions, including those described under Item 1A – Risk Factors of this Annual Report on Form 10-K that may affect the operations, performance, development and results of our business. You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date stated, or if no date is stated, as of the date of this Annual Report on Form 10-K. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or any other reason except as we may be required to do under applicable law. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this Annual Report on Form 10-K may not occur.

Interested readers can access our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, through the United States Securities and Exchange Commission’s website at http://www.sec.gov. These reports can be accessed free of charge.

We own or have rights to use all of the product names, brand names and trademarks that we use in conjunction with the sale of our products, including our I/OMagic^{^®}, Hi-Val^{^®} and Digital Research Technologies^{^®} brand names and related logos, and our “MediaStation,” “DataStation,” GigaBank^™, and EZ NetShare^™ product names. In addition, this report refers to other product names, trade names and trademarks that are the property of their respective owners.

For purposes of this Annual Report, unless the context indicates otherwise, references to “we,” “us,” “our,” “I/OMagic,” and the “Company” means or refers to I/OMagic Corporation.

We operate primarily in the data storage industry and, to a much lesser extent, we also sell digital entertainment and other products. We sell our products primarily in the United States and, to a much lesser extent, in Canada, together known as the North American retail marketplace. During 2005, sales generated within the United States accounted for approximately 98% of our net sales and sales generated within Canada accounted for approximately 2% of our net sales. For the years ended December 31, 2004 and 2003 sales generated within the United States accounted for approximately 98 % and 99%, respectively, of our net sales and sales generated within Canada accounted for approximately 2% and 1%, respectively, of our net sales.

Our product offerings predominantly consist of optical data storage products and portable magnetic data storage products. Our optical data storage products include recordable compact disc, or CD, drives and recordable digital video or versatile disc, or DVD, drives. Our CD and DVD drives are primarily for use with personal computers, or PCs. Although we have sold various media in the past, such as floppy disks and CDs, we do not currently sell media products. Our portable magnetic data storage products, which we call our GigaBank^™ products, consist of compact and portable universal serial bus, or USB, hard disk drives that plug into any standard USB port and that provide from 2.2 gigabytes, or 2,200 megabytes, to up to 120 gigabytes, or 120,000 megabytes, of storage capacity, depending on the user’s operating system and other factors. We have designed our GigaBank^™ products as cost-effective portable alternatives to flash media devices and standard hard disk drives. Our data storage products accounted for approximately 99% of our net sales for 2005. We also sell digital entertainment and other products, which accounted for only approximately 1% of our net sales for that period.

We sell our products through computer, consumer electronics and office supply superstores and other major North American retailers, including Best Buy, Best Buy Canada, Circuit City, CompUSA, Costco, Fred Meyer Stores, Micro Center, Office Depot, RadioShack, Staples and Target. We sell our products in over 8,000 retail locations throughout North America. Our retailers collectively operate retail locations throughout North America. We also have relationships with other retailers, catalog companies and Internet retailers such as Buy.com, Dell, PC Mall, Shop at Home and Tiger Direct, predominantly through distribution by Tech Data.

Our sales have historically been seasonal. The seasonality of our sales is in direct correlation to the seasonality experienced by our retailers and the seasonality of the consumer electronics industry. After adjusting for the addition of new retailers, our fourth quarter has historically generated the strongest sales, which correlates to well-established consumer buying patterns during the Thanksgiving through Christmas holiday season. Our first and third quarters have historically shown some strength from time to time based on post-holiday season sales in the first quarter and back-to-school sales in the third quarter. Our second quarter has historically been our weakest quarter for sales, again following well-established consumer buying patterns.

Our most significant retailers during the past few years have been Staples, Office Depot, CompUSA and Circuit City. Collectively, these four retailers accounted for 81% of our net sales during 2005, including 36%, 17%, 17% and 11% of our total net sales for that period to these four retailers, respectively.

We market our products primarily under one brand name. Our primary brand name is I/OMagic^{^®}. We also, from time to time, market products under our Hi-Val^{^®} and Digital Research Technologies^{^®} brand names. We sell our data storage products primarily under our I/OMagic^{^®} brand name, bundling various hardware devices with different software applications to meet different consumer needs.

We do not directly manufacture any of the products that we sell. We subcontract manufacture or source our products in Asia, predominantly in Taiwan and China, which allows us to offer products at highly competitive prices. Most of our subcontract manufacturers and suppliers have substantial product development resources and facilities, and are among the major component manufacturers and suppliers in their product categories, which we believe affords us substantial flexibility in offering new and enhanced products. Some of our largest subcontract manufacturers and suppliers are also our stockholders, including Behavior Tech Computer Corp. and its affiliated companies, or BTC, and Lung Hwa Electronics Co., Ltd. BTC and Lung Hwa Electronics also provide us with significant trade lines of credit. We believe that BTC is among the largest optical storage drive manufacturers in the world and Lung Hwa Electronics is a supplier of USB hard disk drives, including some of our GigaBank^™ products, as well as a major manufacturer of digital entertainment products. Certain of these subcontract manufacturers and suppliers provide us with significant benefits by allowing us to purchase products on terms more advantageous than we believe are generally available in our industry. These advantageous terms include generous trade lines of credit and extended payment terms which allows us to utilize more capital resources for other aspects of our business. See “Management,” and “Certain Relationships and Related Transactions.”

I/OMagic Corporation was incorporated under the laws of the State of Nevada in October 1992. We have one subsidiary, IOM Holdings, Inc., a Nevada corporation. Our principal executive offices are located in Irvine, California and our main telephone number is (949) 707-4800.

Storing, managing, protecting, retrieving and transferring data has become critical to individuals and businesses due to their increasing dependence on and participation in data-intensive activities. The data storage industry is growing in response to the needs of individuals and businesses to store, manage, protect, retrieve and transfer increasing amounts of data resulting from:

Traditional PC data generally includes document, e-mail, financial and historical, software program and other data. The data storage industry has grown significantly over the last two decades as the PC has become a virtually indispensable tool in the home and office, resulting in increasing amounts of traditional PC data. As a result of these and other developments, traditional PC data storage requirements have correspondingly increased.

Digital entertainment data generally includes music, photographic, movie and video game data. For nearly two decades, music has been offered on CDs as the prevailing standard. In the mid-to-late 1990s, the ability to copy CDs, and to download, remix, and copy or “burn” music to a personalized CD began to gain popularity and made the recordable CD drive, or “CD burner,” a desirable component of the PC. With the growth and acceptance of the Internet and the advent of on-line music availability, the demand for on-line music has increased and as a result, the demand for faster and easier data storage and retrieval has grown.

We believe that the increasing amount of traditional PC and digital entertainment data that is being generated and used is stimulating increased demand for products offering data storage, management, protection, retrieval and transfer. We also believe that those products that offer flexibility and high-capacity storage in a cost-effective, user-friendly manner are in highest demand.

We believe that the following factors, among others, are driving and will continue to drive growth in the data storage industry:

The following types of data storage media are the principal means through which traditional PC data as well as digital entertainment data can be stored, managed, protected, retrieved and transferred:

Each of the principal types of data storage media generally available to consumers has certain advantages and disadvantages. These include:

We believe that the challenges currently facing the data storage industry include:

We believe that trends in the data storage industry include the trend toward higher capacity optical storage media and related drives, including the trend away from CD-based media and devices and towards DVD-based media and devices.

Another trend in the data storage industry is the progression toward smaller, more portable hard disk drives such as our GigaBank^™ products. We expect that products with storage capacities of up to 20 gigabytes, or 20,000 megabytes, on a 1-inch hard disk drive, and up to one terabyte, or one million megabytes, on a 3.5 inch hard disk drive will be available in late 2006. It is not clear when we will be able to offer products with similar storage capacities.

Developing trends in the data storage industry include the early adoption of super-high-capacity optical data storage devices using technology such as Blu-ray DVD or High-definition DVD. Blu-ray DVD technology is expected to expand DVD capacity up to tenfold and is expected to allow, for the first time in a device widely available to consumers, the storage and retrieval of high definition videos and images for playback on high-definition DVD players and compatible televisions and monitors. A competing new technology also exists called High-definition DVD, or HD-DVD. The storage capacity of HD-DVD is limited to approximately 60% of a Blu-ray DVD. Proponents of HD-DVD technology contend, however, that it has less compatibility problems with existing DVD technology as compared to Blu-ray DVD technology and that data compression software reduces the importance of the greater storage capacity offered by Blu-ray DVD technology.

It is not yet clear whether Blu-ray DVD or HD-DVD will become the dominant technology, if they will coexist, or if a new technology will emerge. Nonetheless, we believe that the increased performance offered by these technologies will likely result in increased consumer demand for optical data storage devices. Furthermore, we believe that regardless of which technology becomes the dominant technology, we will be able to incorporate either technology into our product offerings in much the same way as we do today with the large number of format types ranging from recordable and rewritable CD-based products to DVD-based products.

We sell optical and magnetic data storage products in the North American retail marketplace. We believe that we possess a combination of core competencies that provide us with a competitive advantage, including the ability to successfully identify consumer needs and preferences, use our sales and distribution channels to sell new and enhanced products, efficiently bring to market newly developed products and enhanced products, efficiently manage our product supply chain, and use our brands and merchandising efforts to market and sell data storage products. In addition, we sell digital entertainment and other products in the North American retail marketplace.

Successfully executing our core competencies yields substantial benefits including the ability to:

We work closely with our retailers to promote our products, monitor consumer demands and preferences and stay at the forefront of the market for data storage products. We also work closely with our subcontract manufacturers and suppliers and benefit from their substantial research and development resources and economies of scale. As a result of working with our retailers, subcontract manufacturers and suppliers, we are able to rapidly bring new and enhanced data storage products to market in a cost-effective manner.

The market intelligence we gain through consultation with our retailers, subcontract manufacturers and suppliers enables us to deliver products that combine performance and functionality demanded by the marketplace. Obtaining these products through our subcontract manufacturers and suppliers, along with efficient management of our supply chain, allows us to offer these products at competitive prices.

We sell our products through computer, consumer electronics and office supply superstores and other retailers who collectively operate retail locations throughout North America. Our network of retailers enables us to offer products to consumers across North America, including nearly every major metropolitan market in the United States. Over the past three years, our largest retailers have included Best Buy, Circuit City, CompUSA, Staples, Office Depot and OfficeMax.

Historically, we focused on optical data storage products, such as CD and DVD drives. We continue to focus on optical data storage products but also focus on a line of portable magnetic data storage products, called our GigaBank^™ products, which are compact and portable universal serial bus, or USB, hard disk drives that plug into any standard USB port, to respond to the demands and preferences of the data storage marketplace. We believe that the market for data storage products, especially “after-market” devices that can be purchased separately from and easily used in conjunction with a standard PC, has shifted its demand largely to optical media and drives as well as to compact and portable hard disk drives. We believe that optical media and drives represent the optimal combination of high-capacity storage capability, cost-effectiveness and flexibility. Magnetic hard-disk and drive technology is the closest competitor to optical media in the contexts of storage capacity, cost-effectiveness and flexibility. However, while the storage capacity of any given hard disk is fixed, optical media has virtually unlimited storage capacity through the addition of low-cost CDs or DVDs. Moreover, optical media has far more flexibility than hard disk media, allowing users to store music, photos and movies utilizing a stand-alone recorder or a desktop or laptop PC and then play them back on standalone CD or DVD players. In addition, hard disk media is usually built into a PC, lacking effective portability and ease of physical transport of data. However, since late 2004, we have also focused on our GigaBank^™ products as a cost-effective portable alternative to flash media devices and standard hard disk drives.

We believe that our focus on optical data storage products and our GigaBank^™ products is also consistent with the proliferation of digital entertainment devices. Digital cameras, MP3 players and other digital entertainment devices are well-complemented by the use of optical media for data back-up and high-capacity storage purposes. Existing solid state media, while convenient in many respects, offers relatively low storage capacity and relatively poor cost effectiveness. Accordingly, optical media, with its high storage capacity, cost effectiveness and convenience, together with a related drive unit, is a complementary product for consumers who desire to store, manage, protect, retrieve and transfer digital data used in conjunction with their digital entertainment devices. In addition, for greater storage capacity and portability at cost-effective prices, we offer our GigaBank^™ products.

Our primary goal is to remain a leading provider of optical data storage products and to expand our market share of portable magnetic data storage products. Our business strategy to achieve this goal includes the following elements:

We have two primary data storage product categories: our optical data storage product category and our portable magnetic data storage product category. Our optical data storage products consist of a range CD and DVD drives that store traditional PC data as well as music, photos, movies, games and other multi-media. These products are designed principally for general data storage purposes. Our portable magnetic data storage products consist of a range of hard disk drives that we call our GigaBank^™ products.

Our optical data storage products are based on one or more of the following technology formats which allow the storage, management, protection, retrieval and transfer of data:

Many of the technologies identified in the table above are competing formats. We seek to deliver optical data storage products that enable the storage, management, protection, retrieval and transfer of data to and from all major formats to satisfy the needs of consumers regardless of their choice of format. Because certain formats ultimately may be rejected or disfavored by the marketplace, we do not base our products on a single format or on a small number of formats. We seek to offer products that are cross-compatible over numerous formats to offer the most comprehensive solution available to the broadest range of consumers.

We also offer optical data storage products that use double-layer DVD technology, which doubles DVD capacity to approximately 8.5 gigabytes, or 8,500 megabytes, depending on the user’s operating system and other factors. We plan to continue our efforts to enhance our optical data storage products by increasing performance and functionality as well as reducing the size of their drive units and enclosures to increase portability and ergonomics.

Our existing and planned portable magnetic data storage products currently include.

The growth in the availability of digital data, such as movie, photographic and music data has generated new data storage applications and created significant demand for portable data storage devices. The typical portable data storage device is compact, often small enough to fit in a pocket, consumes low power, is durable, re-writable and is versatile due to its ease of operation. In addition, most of these portable data storage devices do not require a separate power source other than through a standard USB port. USB portable storage devices, such as USB flash drives and compact USB hard disk drives, that compete with our CD- and DVD-based data storage products were introduced in late 2002 and sales of these devices have continued to represent an increased share of the market for data storage products.

Our GigaBank^™ products, which are compact and portable external hard disk drives with a built-in USB connector, are designed to provide cost-effective portable alternatives to flash media devices and standard hard disk drives. We believe that our GigaBank^™ line of products represents a substantial opportunity for sales growth. We also believe that sales of our GigaBank^™ products will, over the next twelve months, grow as a percentage of our net sales.

Our EZ NetShare^™ drives are designed for network data storage needs. We believe that over the last few years there has been a substantial increase in the number of households that have high-speed Internet connections. Our EZ NetShare^™ drives allow individuals to store documents, music, videos and pictures and share them with friends, family members and coworkers throughout a personal network. Our EZ NetShare^™ drives operate as network data storage devices as well as standalone USB compatible data storage drives. We believe that our EZ NetShare^™ products represent a substantial opportunity for sales growth. We also believe that sales of our EZ NetShare^™ drives will, over the next twelve months, grow as a percentage of our net sales.

We believe that the markets for digital entertainment and other consumer electronics and peripheral products are expanding. We intend to continue to monitor these markets and develop and sell digital entertainment and other consumer electronics and peripheral products as we are able to identify products that we believe we can sell competitively. Currently, our digital entertainment and other consumer electronics and peripheral products represent only a minor product category. These products accounted for only approximately 1% of our net sales during 2005 and approximately 1% of our net sales during 2004.

Our products are subject to limited warranties of up to one year in duration. These warranties cover only repair or replacement of the product. Our subcontract manufacturers and suppliers provide us with warranties of a duration at least as long as the warranties provided to consumers. The warranties provided by our subcontract manufacturers and suppliers cover repair or replacement of the product.

Our product offerings are primarily directed toward satisfying the demands of the North American retail marketplace for data storage products. We also sell digital entertainment and other products in the North American retail marketplace. We operate in industries that are subject to rapid technological change, product obsolescence and rapid changes in consumer demands and preferences. We attempt to anticipate and respond to these changes by focusing on the following primary objectives:

Our retailers, subcontract manufacturers and our suppliers play an important role in the enhancement of our existing products and the development of new products. We work closely with our retailers, subcontract manufacturers and our suppliers to identify existing market trends, predict future market trends and monitor the sales performance of our products.

Many of our retailers are among the largest computer, consumer electronics and office supply retailers in North America. Over the past three years, our retailers have included Best Buy, Circuit City, CompUSA, Office Depot, OfficeMax, RadioShack and Staples. Through their close contact with the marketplace for data storage products, our retailers are able to provide us with important information about consumer demands and preferences.

Many of our subcontract manufacturers and suppliers have substantial product development resources and facilities in Asia, and are among the major component manufacturers and suppliers in their product categories. Some of our largest subcontract manufacturers and suppliers are also our stockholders, including BTC and Lung Hwa Electronics. We believe that BTC is among the largest optical storage drive manufacturers in the world and Lung Hwa Electronics is a supplier of USB hard disk drives, including some of our GigaBank^™ products, as well as a major manufacturer of digital entertainment products. These subcontract manufacturers and suppliers expend substantial resources on research, development and design of new technologies and efficient manufacturing processes.

Our Irvine, California headquarters houses a product development team that coordinates and manages the subcontract logistics and product development efforts of our subcontract manufacturers and suppliers in Asia. At our Irvine facility, we also develop user manuals, product packaging and marketing literature as well as installation guides and supplemental materials, including software and hardware designed to permit user-friendly product installation.

We do not have a traditional research and development program. Instead, we work closely with our retailers, subcontract manufacturers and suppliers and conduct various other activities in connection with the enhancement of our existing products and the offering of new products. We have not, in any reporting period, made any material expenditures on research and development activities relating to the development of new products, services or techniques or the improvement of existing products, services or techniques. Our efforts are largely directed at the evaluation of new products and enhancements to existing products rather than the actual development of new products or product enhancements.

Our representatives meet frequently with our subcontract manufacturers, suppliers and our retailers to identify and discuss emerging trends and to address the sales performance of our products. We provide and receive product-related input to and from our subcontract manufacturers, suppliers and our retailers. Much of the input that we provide arises from our technical service department, which is responsible for assisting end-users in installing and successfully utilizing our products. Problems in the installation or utilization of our products are reported to management by our technical service department and

often provide the basis for existing product enhancements. New products are developed and offered by our subcontract manufacturers and suppliers, and offered by us and in turn by our retailers largely on the basis of market research and trends identified in the data storage, digital entertainment and computer peripheral industries. We also monitor industry trade publications and technical papers to understand emerging trends and new technologies and to plan for new product offerings.

We believe that these activities assist us in attempting to achieve our goal of being among the first-to-market with new and enhanced product offerings based on established technologies.

We do not directly manufacture any of the products that we sell. We subcontract manufacture or source our data storage, digital entertainment and other products. We believe that by outsourcing the manufacturing of our products to our subcontract manufacturers or sourcing them from our suppliers, we benefit from:

We believe that the relatively low overhead costs resulting from subcontract manufacturing or sourcing the products we offer for sale, the economies of scale of our subcontract manufacturers and suppliers, and the engineering and manufacturing resources of our subcontract manufacturers enable us to offer products combining high levels of performance, functionality and reliability at prices competitive with other leading products offered in the marketplace.

We utilize a subcontract logistics and product development consultant located in Taipei, Taiwan. Our consultant assists us in identifying new products, qualifying prospective manufacturing facilities and coordinating product purchases and shipments from some of our subcontract manufacturers and suppliers. The majority of our products are shipped directly by our subcontract manufacturers or suppliers to our packaging, storage and distribution facility in Irvine. These products are then packaged and shipped by us either directly to retail locations across North America or to a centralized distribution center. Product shipments are primarily made through major commercial carriers.

Our primary subcontract manufacturers and suppliers are among the major computer and electronic component manufacturers and suppliers in Asia who we believe have rigorous quality control and shipping guidelines. We regularly inspect and test product samples, periodically tour our subcontract manufacturing and supply facilities, monitor defective product returns and test defective products.

We primarily sell our products through retailers who collectively operate locations throughout North America. These include nationally-recognized computer, consumer electronics and office supply superstores. In addition, we sell our products through Internet retailers and mail order catalogs.

Our North American retailers include Best Buy, Best Buy Canada, Circuit City, CompUSA, Fred Meyer Stores, Micro Center, Office Depot, RadioShack, Staples, and Target. We also have relationships with other retailers and with catalog companies and Internet retailers such as Buy.com, Dell, PC Mall and Tiger Direct.

We cooperate with our retailers to promote our products and brand names. We participate in co-sponsored events with our retailers and industry trade shows such as CES^{^®} and RetailVision^{^®}. We participate in these events and trade shows in order to develop new relationships with potential retailers and maintain close relationships with our existing retailers. We also fund co-operative advertising campaigns, develop custom product features and promotions, provide direct personal contact with our sales representatives and develop and procure certain products as requested by our retailers. We cooperate with our retailers to use point-of-sale and mail-in rebate promotions to increase sales of our products. We also utilize sales circulars and our close working relationships with our significant retailers to obtain national exposure for our products and our brands. We believe that these marketing efforts help generate additional shelf-space for our products with our major retailers, promote retail traffic and sales of our products, and enhance our goodwill with these retailers.

We maintain a large database containing information regarding many end-users of our products. Through a targeted, direct marketing strategy, we intend to offer these end-users other products to establish repeat end-user customers, increase our product sales and promote brand loyalty. We currently sell and plan to continue to sell products, conduct special promotions, and offer downloads on our company websites to existing and potential end-user customers. Our websites are located at http://www.iomagic.com, http://www.dr-tech.com and http://www.hival.com.

We operate primarily in the highly-competitive data storage industry. We believe that our data storage products compete with other types of data storage devices such as internal, external and portable hard disk drives, magnetic tape drives, floppy disk drives and flash memory devices, as well as internal and external optical data storage products offered by other companies.

Companies that offer products similar to our optical data storage products include BenQ, Hewlett-Packard, Lite-On, Memorex, Philips Electronics, Samsung Electronics, Sony and TDK. We also indirectly compete against original equipment manufacturers such as Dell and Hewlett-Packard to the extent that they manufacture their own computer peripheral products or incorporate the functionalities offered by our products directly into PCs. Companies that offer products similar to our portable magnetic data storage products include Iomega, LaCie, PNY Technologies, Sony, Seagate Technology and Western Digital.

We believe that our ability to compete in the data storage industry depends on many factors, including the following:

elements of our ability to compete. Consumers continuously demand higher levels of performance and functionality in data storage products. We attempt to compete successfully by bringing products with higher levels of performance and functionality rapidly to market to satisfy changing consumer demands and preferences. We believe that the research and development efforts and economies of scale of our major subcontract manufacturers and suppliers enable us to rapidly introduce enhanced products and new products offering higher levels of performance and functionality. Our products are often among the first-to-market with new features and technology to be made widely available to consumers.

We currently rely on a combination of contractual rights, copyrights, trademarks and trade secrets to protect our proprietary rights. I/OMagic^{^®}, Hi-Val^{^®} and Digital Research Technologies^{^®} are our registered trademarks. We also sell products under various product names such as MediaStation, DataStation, GigaBank^™ and EZ NetShare^™. As we develop new products, we may file federal trademark applications covering the trademarks under which we sell those products. There can be no assurance that we will eventually secure a registered trademark covering these products. We currently do not have any issued or pending patents.

We own, license or have otherwise obtained the right to use certain technologies incorporated in our products. We may receive infringement claims from third parties relating to our products and technologies. In those cases, we intend to investigate the validity of the claims and, if we believe the claims have merit, to respond through licensing or other appropriate actions. To the extent claims relate to technology included in components purchased from third-party vendors for incorporation into our products, we would forward those claims to the appropriate vendor. If we or our product manufacturers are unable to license or otherwise provide any necessary technology on a cost-effective basis, we could be prohibited from marketing products containing that technology, incur substantial costs in redesigning products incorporating that technology, or incur substantial costs defending any legal action taken against us.

We have been, and may in the future be, notified of claims asserting that we may be infringing certain patents, trademarks and other intellectual property rights of third parties. We cannot predict the outcome of such claims and there can be no assurance that such claims will be resolved in our favor. An unfavorable resolution of such claims may have a material adverse effect on our business, prospects, financial condition and results of operations. The data storage industry, has been characterized by significant litigation relating to infringement of patents and other intellectual property rights. We have in the past been engaged in infringement litigation, both as plaintiff and defendant. There can be no assurance that future intellectual property claims will not result in litigation.

If infringement is established, we may be required to pay substantial damages or we may be enjoined from manufacturing and selling an infringing product. In addition, the costs of engaging in the prosecution or defense of intellectual property claims may be substantial regardless of the outcome.

A number of our agreements with our retailers provide that we will defend, indemnify and hold harmless our retailers from damages and costs that arise from product warranty claims or claims for injury or damage resulting from defects in our products. If such claims are asserted against us, our insurance coverage may not be adequate to cover the costs associated with our defense of those claims or any resulting liability we would incur if those claims are successful. A successful claim brought against us for product defects that is in excess of, or excluded from, our insurance coverage could have a material adverse affect on our business and results of operations.

Our products are designed by our subcontract manufacturers to comply with a significant number of regulations and industry standards, some of which are evolving as new technologies are deployed. We believe that we are currently in compliance with each applicable regulation and industry standard. In the United States, our products must comply with various regulations defined by the United States Federal Communications Commission, or FCC, and Underwriters Laboratories, or other nationally recognized test laboratories. We also must comply with numerous import/export regulations. The regulatory process in the United States can be time-consuming and can require the expenditure of substantial resources. We cannot assure you that the FCC will grant the requisite approvals for any of our products on a timely basis, or at all. The failure of our products to comply, or delays in compliance, with the various existing and evolving standards could negatively impact our ability to sell our products. United States regulations regarding the manufacture and sale of data communications devices are subject to future change. We cannot predict what impact, if any, such changes may have upon our business.

As of March 31, 2006, we had approximately 50 full-time employees. We have no collective bargaining agreements with our employees. We believe that our relationship with our employees is good.

An investment in our common stock involves a high degree of risk. In addition to the other information in this Annual Report and in our other filings with the Securities and Exchange Commission, including our subsequent reports on Forms 10-Q and 8-K, you should carefully consider the following risk factors before deciding to invest in shares of our common stock or to maintain or increase your investment in shares of our common stock. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also affect our business, financial condition and operating results. If any of the following risks, or any other risks not described below, actually occur, it is likely that our business, financial condition and operating results could be seriously harmed. As a result, the trading price of our common stock could decline, and you could lose part or all of your investment.

If we continue to sustain losses, we will be in violation of our financial covenant to GMAC Commercial Finance and we may be unable to borrow funds to purchase inventory, to sustain or expand our current sales volume and to fund our day-to-day operations.

Our credit facility with GMAC Commercial Finance has one covenant that requires us to have a fixed charge coverage ratio of 1.5 to 1.0 for the nine months ended December 31, 2005, for the twelve month period ending March 31, 2006 and for each twelve month period ending on the end of each calendar quarter thereafter. We have been in violation of this financial covenant in the past, including as of December 31, 2005, and may be in violation of this financial covenant in the future. If we are unable to attain the required financial covenant ratio in the future, then GMAC Commercial Finance may immediately terminate the line of credit and the unpaid principal balance and all accrued interest on the unpaid balance will then be immediately due and payable. If the loan were to be called and we were unable to obtain alternative financing, we would lack adequate funds to acquire inventory in amounts sufficient to sustain or expand our current sales volume. In addition, we would be unable to fund our day-to-day operations.

We have incurred significant losses in the past, and we may continue to incur significant losses in the future. If we continue to incur losses, we will experience negative cash flow which may hamper current operations and may prevent us from sustaining or expanding our business.

We have incurred net losses in each of the last six years. As of December 31, 2005, we had an accumulated deficit of approximately $24.9 million. During 2005, 2004, 2003, 2002, 2001 and 2000, we incurred net losses in the amounts of approximately $1.8 million, $8.1 million, $460,000, $8.8 million, $5.4 million and $6.2 million, respectively. Historically, we have relied upon cash from operations and financing activities to fund all of the cash requirements of our business. If our extended period of net losses continues, our negative cash flow will likewise and may hamper current operations and prevent us from sustaining or expanding our business. We cannot assure you that we will attain, sustain or increase profitability on a quarterly or annual basis in the future. If we do not achieve, sustain or increase profitability, our business will be adversely affected and our stock price may decline.

We have identified material weaknesses in our disclosure controls and procedures. Our business and stock price may be adversely affected if we do not remediate these material weaknesses or if we have other material weaknesses in our disclosure controls and procedures.

Following their evaluation of our disclosure controls and procedures, our Chief Executive Officer and Chief Financial Officer concluded that certain material weaknesses in our disclosure controls and procedures existed as of December 31, 2005. As a result of these material weaknesses, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were not effective at the reasonable assurance level as of December 31, 2005. The existence of one or more material weaknesses in our disclosure controls and procedures could result in errors in our financial statements and substantial costs and resources may be required to rectify these material weaknesses. If we are unable to produce reliable financial reports, investors could lose confidence in our reported financial information, the market price of our stock could decline significantly, we may be unable to obtain additional financing to operate and expand our business, and our business and financial condition could be harmed.

We depend on a small number of retailers for the vast majority of our sales. A reduction in business from any of these retailers could cause a significant decline in our sales and profitability.

The vast majority of our sales are generated from a small number of retailers. During 2005, net sales to our four largest retailers, Staples, Office Depot, CompUSA and Circuit City represented approximately 36%, 17%, 17% and 11%, respectively, of our total net sales. During 2005, aggregate net sales to these four retailers represented approximately 81% of our total net sales. We expect that we will continue to depend upon a small number of retailers for a significant majority of our sales for the foreseeable future.

Our agreements with these retailers do not require them to purchase any specified number of products or dollar amount of sales or to make any purchases whatsoever. Therefore, we cannot assure you that, in any future period, our sales generated from these retailers, individually or in the aggregate, will equal or exceed historical levels. We also cannot assure you that, if sales to any of these retailers cease or decline, we will be able to replace these sales with sales to either existing or new retailers in a timely manner, or at all. A cessation or reduction of sales, or a decrease in the prices of products sold to one or more of these retailers has significantly reduced our net sales for one or more reporting periods in the past and could, in the future, cause a significant decline in our net sales and profitability.

Our lack of long-term purchase orders and commitments could lead to a rapid decline in our sales and profitability.

All of our significant retailers issue purchase orders solely in their own discretion, often only one to two weeks before the requested date of shipment. Our retailers are generally able to cancel orders or delay the delivery of products on short notice. In addition, our retailers may decide not to purchase products from us for any reason. Accordingly, we cannot assure you that any of our current retailers will continue to purchase our products in the future. As a result, our sales volume and profitability could decline rapidly with little or no warning whatsoever. For example, in 2004 we did not sell any of our products to OfficeMax which resulted in a 100% decrease in sales to OfficeMax in 2004 as compared to 2003. This significant decline in sales was one of the primary reasons for the 30% decline in net sales for 2004 as compared to 2003. This decline was primarily the result of disagreements with OfficeMax relating to amounts we believed we were owned and deductions claimed by OfficeMax for 2003 and, as a result, we discontinued sales to OfficeMax in January 2004.

We cannot rely on long-term purchase orders or commitments to protect us from the negative financial effects of a decline in demand for our products. The limited certainty of product orders can make it difficult for us to forecast our sales and allocate our resources in a manner consistent with our actual sales. Moreover, our expense levels are based in part on our expectations of future sales and, if our expectations regarding future sales are inaccurate, we may be unable to reduce costs in a timely manner to adjust for sales shortfalls. Furthermore, because we depend on a small number of retailers for the vast majority of our sales, the magnitude of the ramifications of these risks, is greater than if our sales were less concentrated within a small number of retailers. As a result of our lack of long-term purchase orders and purchase commitments we may experience a rapid decline in our sales and profitability.

One or more of our largest retailers may directly import or private label products that are identical or very similar to our products. This could cause a significant decline in our sales and profitability.

Optical data storage products and digital entertainment products are widely available from manufacturers and other suppliers around the world. Our largest retailers include Staples, Office Depot, CompUSA and Circuit City. Collectively, these four retailers accounted for 81% of our net sales in 2005. Each of these retailers has substantially greater resources than we do, and has the ability to directly import or private-label data storage and digital entertainment products from manufacturers and other suppliers around the world, including from some of our own subcontract manufacturers and suppliers. For example, Best Buy, which was our largest retailer in 2003, had a private label program and sold certain products that competed with some of our products. Sales to Best Buy in 2005 were only $61,000. Sales to Best Buy in 2004 totaled $5.0 million representing a decrease of 72.5% from $18.2 million in 2003. We believe that this decrease reflects, at least in part, Best Buy’s increased sales of private label products that compete with products that we sell. Our retailers may believe that higher profit margins can be achieved if they implement a direct import or private-label program, excluding us from the sales channel. Accordingly, one or more of our largest retailers may stop buying products from us in favor of a direct import or private-label program. As a consequence, our sales and profitability could decline significantly.

Historically, a substantial portion of our assets have been comprised of accounts receivable representing amounts owed by a small number of retailers. We expect this to continue in the future. If any of these retailers fails to timely pay us amounts owed, we could suffer a significant decline in cash flow and liquidity which, in turn, could cause us to be unable pay our liabilities and purchase an adequate amount of inventory to sustain or expand our current sales volume.

Our accounts receivable represented 50%, 53% and 46% of our total assets as of December 31, 2005, 2004 and 2003, respectively. As of December 31, 2005, 67% of our accounts receivable represented amounts owed by two retailers, each of which represented over 10% of the total amount of our accounts receivable. Similarly, as of December 31, 2004, 73% of our accounts receivable represented amounts owed by three retailers, each of which represented over 10% of the total amount of our accounts receivable. As a result of the substantial amount and concentration of our accounts receivable, if any of our major retailers fails to timely pay us amounts owed, we could suffer a significant decline in cash flow and liquidity which would negatively affect our ability to make payments under our line of credit with GMAC Commercial Finance and which, in turn, could adversely affect our ability to borrow funds to purchase inventory to sustain or expand our current sales volume. Accordingly, if any of our major retailers fails to timely pay us amounts owed, our sales and profitability may decline.

We rely heavily on our Chief Executive Officer, Tony Shahbaz. The loss of his services could adversely affect our ability to source products from our key suppliers and our ability to sell our products to our retailers.

Our success depends, to a significant extent, upon the continued services of Tony Shahbaz, who is our Chairman of the Board, President, Chief Executive Officer and Secretary. For example, Mr. Shahbaz has developed key personal relationships with our suppliers and retailers, including with our subcontract manufacturers. We greatly rely on these relationships in the conduct of our operations and the execution of our business strategies. Mr. Shahbaz and some of these subcontract manufacturers and suppliers have acquired interests in business entities that own shares of our common stock. Further, some of these manufacturers also directly hold shares of our common stock. See “Certain Relationships and Related Transactions.” The loss of Mr. Shahbaz could, therefore, result in the loss of our favorable relationships with one or more of our subcontract manufacturers or suppliers. Although we have entered into an employment agreement with Mr. Shahbaz, that agreement is of limited duration and is subject to early termination by Mr. Shahbaz under certain circumstances. In addition, we do not maintain “key person” life insurance covering Mr. Shahbaz or any other executive officer. The loss of Mr. Shahbaz could significantly delay or prevent the achievement of our business objectives. Consequently, the loss of Mr. Shahbaz could adversely affect our business, financial condition and results of operations.

The high concentration of our sales within the data storage industry could result in a significant reduction in net sales and negatively affect our earnings if demand for those products declines.

Sales of our data storage products accounted for approximately 99% of our net sales in each of 2005 and 2004. Except for our digital entertainment and other products, which accounted for only approximately 1% of our net sales in each of 2005 and in 2004, we have not diversified our product categories outside of the data storage industry. We expect data storage products to continue to account for the vast majority of our net sales for the foreseeable future. As a result, our net sales and profitability would be significantly and adversely impacted by a downturn in the demand for data storage products.

If we fail to accurately forecast the costs of our product rebate or other promotional programs, we may experience a significant decline in cash flow and our brand image may be adversely affected resulting in reduced sales and profitability.

We rely heavily on product rebates and other promotional programs to establish, maintain and increase sales of our products. If we fail to accurately forecast the costs of these programs, we may fail to allocate sufficient resources to these programs. For example, we may fail to have sufficient funds available to satisfy mail-in product rebates. If we are unable to satisfy our promotional obligations, such as providing cash rebates to consumers, our brand image and goodwill with consumers and retailers would be harmed, which may result in reduced sales and profitability. In addition, our failure to adequately forecast the costs of these programs may result in unexpected liabilities causing a significant decline in cash flow and capital resources with which to operate our business.

Our two principal subcontract manufacturers and suppliers provide us with significantly preferential trade credit terms. If either of these manufacturers does not continue to offer us substantially the same preferential credit terms, our sales and profitability would decline significantly.

Lung Hwa Electronics and Behavior Tech Computer Corp., our two principal subcontract manufacturers and suppliers, provide us with significantly preferential trade credit terms. These terms include extended payment terms, substantial trade lines of credit and other preferential buying arrangements. We believe that these terms are substantially better terms than we could likely obtain from other subcontract manufacturers or suppliers. In fact, we believe that our trade credit facility with Lung Hwa Electronics is likely unique and could not be replaced through a relationship with an unrelated third party. If either of these subcontract manufacturers and suppliers does not continue to offer us substantially the same preferential trade credit terms, our ability to finance inventory purchases would be harmed, resulting in significantly reduced sales and profitability. In addition, we would incur additional financing costs associated with shorter payment terms which would also cause our profitability to decline. See “Certain Relationships and Related Transactions.”

The data storage industry is extremely competitive. All of our significant competitors have greater financial and other resources than we do, and one or more of these competitors could use their greater resources to gain market share at our expense.

The data storage industry is extremely competitive. All of our significant competitors in the data storage industry, including BenQ, Hewlett-Packard, Lite-On, Memorex, Philips Electronics, Samsung Electronics, Sony and TDK have substantially greater production, financial, research and development, intellectual property, personnel and marketing resources than we do. As a result, each of these companies could compete more aggressively and sustain that competition over a longer period of time than we could. Our lack of resources relative to all of our significant competitors may cause us to fail to anticipate or respond adequately to technological developments and changing consumer demands and preferences, or may cause us to experience significant delays in obtaining or introducing new or enhanced products. These failures or delays could reduce our competitiveness and cause a decline in our market share and sales.

Data storage products are subject to rapid technological changes. If we fail to accurately anticipate and adapt to these changes, the products we sell will become obsolete, causing a decline in our sales and profitability.

Data storage products are subject to rapid technological changes which often cause product obsolescence. Companies within the data storage industry are continuously developing new products with heightened performance and functionality. This puts pricing pressure on existing products and constantly threatens to make them, or causes them to be, obsolete. Our typical product life cycle is extremely short and ranges from only three to twelve months, generating lower average selling prices as the cycle matures. If we fail to accurately anticipate the introduction of new technologies, we may possess significant amounts of obsolete inventory that can only be sold at substantially lower prices and profit margins than we anticipated. In addition, if we fail to accurately anticipate the introduction of new technologies, we may be unable to compete effectively due to our failure to offer products most demanded by the marketplace. If any of these failures occur, our sales, profit margins and profitability will be adversely affected.

If we fail to select high turnover products for our consignment sales channels, our financing costs may exceed targeted levels, we may be unable to fund additional purchases of inventory and we may be forced to reduce prices and accept lower margins to sell consigned products, which would cause our sales, profitability and financial resources to decline.

We retain most risks of ownership of products in our consignment sales channels. These products remain our inventory until their sale by our retailers. The turnover frequency of our inventory on consignment is critical to generating regular cash flow in amounts necessary to keep financing costs to targeted levels and to purchase additional inventory. If this inventory turnover is not sufficiently frequent, our financing costs may exceed targeted levels and we may be unable to generate regular cash flow in amounts necessary to purchase additional inventory to meet the demand for other products. In addition, as a result of our products’ short life-cycles, which generate lower average selling prices as the cycles mature, low inventory turnover levels may force us to reduce prices and accept lower margins to sell consigned products. As of December 31, 2005 and 2004, we carried and financed inventory valued at approximately $3.4 million and $2.9 million, respectively, in our consignment sales channels. Sales generated through consignment sales were approximately 33% and 32%, respectively, of our total net sales in 2005 and 2004. If we fail to select high turnover products for our consignment sales channels, our sales, profitability and financial resources may decline.

Our indemnification obligations to our retailers for product defects could require us to pay substantial damages, which could have a significant negative impact on our profitability and financial resources.

A number of our agreements with our retailers provide that we will defend, indemnify and hold them and their customers, harmless from damages and costs that arise from product warranty claims or from claims for injury or damage resulting from defects in our products. If such claims are asserted against us, our insurance coverage may not be adequate to cover the costs associated with our defense of those claims or the cost of any resulting liability we incur if those claims are successful. A successful claim brought against us for product defects that is in excess of, or excluded from, our insurance coverage could adversely affect our profitability and financial resources and could make it difficult or impossible for us to adequately fund our day-to-day operations.

If we are subjected to one or more intellectual property infringement claims, our sales, earnings and financial resources may be adversely affected.

Our products rely on intellectual property developed, owned or licensed by third parties. From time to time, intellectual property infringement claims have been asserted against us. We expect to continue to be subjected to such claims in the future. Intellectual property infringement claims may also be asserted against our retailers as a result of selling our products. As a consequence, our retailers could assert indemnification claims against us. If any third party is successful in asserting an infringement claim against us, we could be required to acquire licenses, which may not be available on commercially reasonable terms, if at all, to discontinue selling certain products to pay substantial monetary damages or to develop non-infringing technologies, none of which may be feasible. Both infringement and indemnification claims could be time-consuming and costly to defend or settle and would divert management’s attention and our resources away from our business. In addition, we may lack sufficient litigation defense resources, therefore any one of these developments could place substantial financial and administrative burdens on us and our sales and earnings may be adversely affected.

If we fail to successfully manage the expansion of our business, our sales may not increase commensurately with our investments, which would cause our profitability to decline.

We plan to offer new data storage and digital entertainment products in the future. In particular, we plan to offer additional DVD-based products and additional products in our line of GigaBank^™ products, as well as products with heightened performance and added functionality. We also plan to offer a next-generation DVD-based product, such as Blu-ray DVD or HD-DVD, depending on which of these competing formats we believe is most likely to prevail in the marketplace. These planned product offerings will require significant investments of capital and management’s close attention. In offering new digital entertainment products, our resources and personnel are likely to be strained because we have little experience in the digital entertainment industry. Our failure to successfully manage our planned product expansion could result in our sales not increasing commensurately with our investments, causing a decline in our profitability.

A significant product defect or product recall could materially and adversely affect our brand image, causing a decline in our sales, and could reduce or deplete our financial resources.

A significant product defect could materially harm our brand image and could force us to conduct a product recall. This could result in damage to our relationships with our retailers and loss of consumer loyalty. Because we are a small company, a product recall would be particularly harmful to us because we have limited financial and administrative resources to effectively manage a product recall and it would detract management’s attention from implementing our core business strategies. As a result, a significant product defect or product recall could materially and adversely affect our brand image, causing a decline in our sales, and could reduce our deplete our financial resources.

If our products are not among the first-to-market, or if consumers do not respond favorably to either our new or enhanced products, our sales and earnings will decline.

One of our core business strategies is to be among the first-to-market with new and enhanced products based on established technologies. We believe that our I/OMagic^{^®} brand is perceived by the retailers and end-users of our products as among the leaders in the data storage industry. We also believe that these retailers and end-users view products offered under our I/OMagic^{^®} brand as embodying newly established technologies or technological enhancements. For instance, in introducing new and enhanced optical data storage products and portable magnetic data storage devices such as our GigaBank^™ products, we seek to be among the first-to-market, offering heightened product performance such as faster data recordation and access speeds. If our products are not among the first-to-market, our competitors may gain market share at our expense, which would decrease our net sales and earnings.

As a consequence of this core strategy, we are exposed to consumer rejection of our new and enhanced products to a greater degree than if we offered products later in their industry life cycle. For example, our anticipated future sales are largely dependent on future consumer demand for DVD-based products displacing current consumer demand for CD-based products as well as increasing demand for portable magnetic data storage devices such as our GigaBank^™ products. Accordingly, future sales and any future profits from DVD-based products and our GigaBank^™ line of products are substantially dependent upon widespread consumer acceptance of DVD-based products and portable data storage devices. If this widespread consumer acceptance of DVD-based products and our GigaBank^™ products does not occur, or is delayed, our sales and earnings will be adversely affected.

A labor strike or congestion at a shipping port at which our products are shipped or received could prevent us from taking timely delivery of inventory, which could cause our sales and profitability to decline.

From time to time, shipping ports experience labor strikes, work stoppages or congestion which delay the delivery of imported products. The port of Long Beach, California, through which most of our products are imported from Asia, experienced a labor strike in September 2002 which lasted nearly two weeks. As a result, there was a significant disruption in our ability to deliver products to our retailers, which caused our sales to decline. Any future labor strike, work stoppage or congestion at a shipping port at which our products are shipped or received would prevent us from taking timely delivery of inventory and cause our sales to decline. In addition, many of our retailers impose penalties for both early and late product deliveries, which could result in significant additional costs to us. In the event of a similar labor strike or work stoppage in the future, or in the event of congestion, in order to meet our delivery obligations to our retailers and avoid penalties for missed delivery dates, we may be required to arrange for alternative means of product shipment, such as air freight, which could add significantly to our product costs. We would typically be unable to pass these extra costs along to either our retailers or to consumers. Also, because the average selling prices of our products decline, often rapidly, during their short product life cycle, delayed delivery of products could yield significantly less than expected sales and profits.

Failure to adequately protect our trademark rights could cause us to lose market share and cause our sales to decline.

We sell our products primarily under our I/OMagic^{^®} brand name and, from time to time, also sell products under our Hi-Val^{^®} and Digital Research Technologies^{^®} brand names. Each of these trademarks has been registered by us with the United States Patent & Trademark Office. We also sell products under various product names such as “MediaStation,” “DataStation,” GigaBank^™ and EZ NetShare^™. One of our key business strategies is to use our brand and product names to successfully compete in the data storage industry. We have expended significant resources promoting our brand and product names and we have registered trademarks for our three brand names. However, we cannot assure you that the registration of our brand name trademarks, or our other actions to protect our non-registered product names, will deter or prevent their unauthorized use by others. We also cannot assure you that other companies, including our competitors, will not use our product names. If other companies, including our competitors, use our brand or product names, consumer confusion could result, meaning that consumers may not recognize us as the source of our products. This would reduce the value of goodwill associated with these brand and product names. This consumer confusion and the resulting reduction in goodwill could cause us to lose market share and cause our sales to decline.

Consumer acceptance of alternative sales channels may increase. If we are unable to adapt to these alternative sales channels, sales of our products may decline.

We are accustomed to conducting business through traditional retail sales channels. Consumers purchase our products predominantly through a small number of retailers. For example, during 2005, five of our retailers accounted for 88% of our total net sales. Similarly, during 2004, five of our retailers accounted for 80% of our total net sales. We currently generate only a small number of direct sales of our products through our Internet websites. We believe that many of our target consumers are knowledgeable about technology and comfortable with the use of the Internet for product purchases. Consumers may increasingly prefer alternative sales channels, such as direct mail order or direct purchase from manufacturers. In addition, Internet commerce is becoming increasingly accepted by consumers as a convenient, secure and cost-effective method of purchasing data storage and digital entertainment products. The migration of consumer purchasing habits from traditional retailers to Internet retailers could have a significant impact on our ability to sell our products. We cannot assure you that we will be able to predict and respond to increasing consumer preference of alternative sales channels. If we are unable to adapt to alternative sales channels, sales of our products may decline.

Our operations are vulnerable because we have limited redundancy and backup systems.

Our internal order, inventory and product data management system is an electronic system through which our retailers place orders for our products and through which we manage product pricing, shipment, returns and other matters. This system’s continued and uninterrupted performance is critical to our day-to-day business operations. Despite our precautions, unanticipated interruptions in our computer and telecommunications systems have, in the past, caused problems or stoppages in this electronic system. These interruptions, and resulting problems, could occur in the future. We have extremely limited ability and personnel to process purchase orders and manage product pricing and other matters in any manner other than through this electronic system. Any interruption or delay in the operation of this electronic system could cause a significant decline in our sales and profitability.

Our stock price is highly volatile, which could result in substantial losses for investors purchasing shares of our common stock and in litigation against us.

The market price of our common stock has fluctuated significantly in the past and may continue to fluctuate significantly in the future. During the first three months of 2006, the high and low closing bid prices of a share of our common stock were $5.10 and $3.75, respectively. During 2005, the high and low closing bid prices of a share of our common stock were $6.75 and $0.70, respectively. During 2004, the high and low closing bid prices of a share of our common stock were $4.50 and $3.00, respectively. The market price of our common stock may continue to fluctuate in response to one or more of the following factors, many of which are beyond our control:

The price at which you purchase shares of our common stock may not be indicative of the price that will prevail in the trading market. You may be unable to sell your shares of common stock at or above your purchase price, which may result in substantial losses to you.

In the past, securities class action litigation has often been brought against a company following periods of stock price volatility. We may be the target of similar litigation in the future. Securities litigation could result in substantial costs and divert management’s attention and our resources from our business. Any of the risks described above could have an adverse effect on our business, financial condition and results of operations and therefore on the price of our common stock.

Our common stock has a small public float and shares of our common stock eligible for public sale could cause the market price of our stock to drop, even if our business is doing well.

As of March 31, 2006, there were approximately 4.6 million shares of our common stock outstanding. As a group, our executive officers, directors and 10% stockholders beneficially own approximately 3.6 million of these shares. Accordingly, our common stock has a public float of approximately 1.0 million shares held by a relatively small number of public investors. In addition, we have a registration statement on Form S-8 in effect covering 133,334 shares of common stock issuable upon exercise of options under our 2002 Stock Option Plan and a registration statement on Form S-8 in effect covering 400,000 shares of common stock issuable upon exercise of options under our 2003 Stock Option Plan. Currently, options covering 99,550 shares of common stock are outstanding under our 2002 Stock Option Plan and 325,000 options are outstanding under our 2003 Stock Option Plan. The shares of common stock issued upon exercise of these options will be freely tradable without restriction or further registration, except to the extent purchased by one of our affiliates.

We cannot predict the effect, if any, that future sales of shares of our common stock into the public market will have on the market price of our common stock. However, as a result of our small public float, sales of substantial amounts of common stock, including shares issued upon the exercise of stock options or warrants, or an anticipation that such sales could occur, may materially and adversely affect prevailing market prices for our common stock.

If the ownership of our common stock continues to be highly concentrated, it may prevent you and other stockholders from influencing significant corporate decisions and may result in conflicts of interest that could cause our stock price to decline.

As a group, our executive officers, directors, and 10% stockholders beneficially own or control approximately 76% of our outstanding shares of common stock (after giving effect to the exercise of all outstanding vested options exercisable within 60 days from March 31, 2006). As a result, our executive officers, directors, and 10% stockholders, acting as a group, have substantial control over the outcome of corporate actions requiring stockholder approval, including the election of directors, any merger, consolidation or sale of all or substantially all of our assets, or any other significant corporate transaction. Some of these controlling stockholders may have interests different than yours. For example, these stockholders may delay or prevent a change in control of I/OMagic, even one that would benefit our stockholders, or pursue strategies that are different from the wishes of other investors. The significant concentration of stock ownership may adversely affect the trading price of our common stock due to investors’ perception that conflicts of interest may exist or arise.

Our articles of incorporation, our bylaws and Nevada law each contain provisions that could discourage transactions resulting in a change in control of I/OMagic, which may negatively affect the market price of our common stock.

Our articles of incorporation and our bylaws contain provisions that may enable our board of directors to discourage, delay or prevent a change in the ownership of I/OMagic or in our management. In addition, these provisions could limit the price that investors would be willing to pay in the future for shares of our common stock. These provisions include the following:

In addition, we may be subject to the restrictions contained in Sections 78.378 through 78.3793 of the Nevada Revised Statutes which provide, subject to certain exceptions and conditions, that if a person acquires a “controlling interest,” which is equal to either one-fifth or more but less than one-third, one-third or more but less than a majority, or a majority or more of the voting power of a corporation, that person is an “interested stockholder” and may not vote that person’s shares. The effect of these restrictions may be to discourage, delay or prevent a change in control of I/OMagic.

We cannot assure you that an active market for our shares of common stock will develop or, if it does develop, will be maintained in the future. If an active market does not develop, you may not be able to readily sell your shares of our common stock.

On March 25, 1996, our common stock commenced trading on the OTC Bulletin Board. Since that time, there has been limited trading in our shares, at widely varying prices, and the trading to date has not created an active market for our shares. We cannot assure you that an active market for our shares will be established or maintained in the future. If an active market is not established or maintained, you may not be able to readily sell your shares of our common stock.

Because we are subject to “penny stock” rules, the level of trading activity in our common stock may be reduced. If the level of trading activity is reduced, you may not be able to readily sell your shares of our common stock.

Broker-dealer practices in connection with transactions in “penny stocks” are regulated by penny stock rules adopted by the Securities and Exchange Commission. Penny stocks are, generally, equity securities with a price of less than $5.00 per share that trade on the OTC Bulletin Board or the Pink Sheets. The penny stock rules require a broker-dealer, prior to a transaction

in a penny stock not otherwise exempt from the rules, to deliver a standardized risk disclosure document that provides information about penny stocks and the nature and level of risks in investing in the penny stock market. The broker-dealer also must provide the prospective investor with current bid and offer quotations for the penny stock and the amount of compensation to be paid to the broker-dealer and its salespeople in the transaction. Furthermore, if the broker-dealer is the sole market maker, the broker-dealer must disclose this fact and the broker-dealer’s presumed control over the market, and must provide each holder of penny stock with a monthly account statement showing the market value of each penny stock held in the customer’s account. In addition, broker-dealers who sell penny stocks to persons other than established customers and “accredited investors” must make a special written determination that the penny stock is a suitable investment for the prospective investor and receive the purchaser’s written agreement to the transaction. These requirements may have the effect of reducing the level of trading activity in a penny stock, such as our common stock, and investors in our common stock may find it difficult to sell their shares.

Our corporate headquarters is located in Irvine, California in a leased facility of approximately 55,000 square feet. This facility contains all of our operations, including sales, marketing, finance, administration, production, shipping and receiving. The lease term began on September 1, 2003 and expires on August 31, 2006, with an option to extend the lease for another three year term upon providing notice 60 days prior to expiration of the current lease term. Our monthly lease payments are $25,480, $26,244, and $27,032 during the first, second, and third years of the lease, respectively. Under the option to extend the lease, monthly lease payments would be determined according to the then prevailing market price for the first year, and an increase of 3% per annum for years two and three. We believe this facility is adequate for our anticipated business purposes for the foreseeable future. We have no other leased or owned real property.

On or about May 30, 2003, I/OMagic and IOM Holdings, Inc. filed a complaint for breach of contract and legal malpractice against Lawrence W. Horwitz, Gregory B. Beam, Horwitz & Beam, Inc., Lawrence M. Cron, Horwitz & Cron, Kevin J. Senn and Senn Palumbo Mealemans, LLP, our former attorneys and their respective law firms, in the Superior Court of the State of California for the County of Orange. The complaint sought damages of $15 million arising out of the defendants’ representation of I/OMagic and IOM Holdings, Inc. in an acquisition transaction and in a separate arbitration matter. On or about November 6, 2003, we filed our First Amended Complaint against all defendants. Defendants responded to our First Amended Complaint denying our allegations. Defendants Lawrence W. Horwitz and Lawrence M. Cron also filed a Cross-Complaint against us for attorneys’ fees in the approximate amount of $79,000. We denied the allegations in the Cross-Complaint. Trial began on February 6, 2006 and on March 10, 2006, the jury ruled in our favor against Lawrence W. Horwitz, Horwitz & Beam, Inc., Lawrence M. Cron, Horwitz & Cron and Senn Palumbo Mealemans, LLP, and awarded us $3.0 million in damages. We have not collected any of this amount and we believe that this award may be appealed by defendants. As of the date of this report, we are not aware of any appeal having been filed.

On May 6, 2005, OfficeMax North America, Inc., or plaintiff, filed a Complaint for Declaratory Judgment in the United States District Court of the Northern District of Ohio against I/OMagic. The complaint sought declaratory relief regarding whether plaintiff was still obligated to us under certain previous agreements between the parties. The complaint also sought plaintiff’s costs as well as reasonable attorneys’ fees. The complaint did not seek any monetary damages. The complaint arose out of our contention that plaintiff is still obligated to us under an agreement entered into in May 2001 and plaintiff’s contention that it has been released from such obligation. We filed a motion to dismiss, or in the alternative, a motion to stay the plaintiff’s action against us. On or about February 7, 2006, the Court granted the motion, and issued an Order and Judgment dismissing the OfficeMax action.

On May 20, 2005, we filed a complaint for breach of contract, breach of implied covenant of good faith and fair dealing, and common counts against OfficeMax North America, Inc., or defendant, in the Superior Court of the State of California for the County of Orange, Case No. 05CC06433. The complaint seeks damages of in excess of $22 million arising

out of the defendants’ breach of contract under an agreement entered into in May 2001. On or about June 20, 2005, OfficeMax removed the case against OfficeMax to the United States District Court for the Central District of California, Case No. SA CV05-0592 DOC(MLGx), or the California Case. On or about June 28, 2005, I/OMagic and OfficeMax jointly filed a stipulation in requesting that the United States District Court in California temporarily stay the California Case pending the outcome of the Motion in Ohio. On July 6, 2005, the United States District Court in California denied the parties joint stipulation request to temporarily stay the California Case and instead ordered that OfficeMax answer the complaint by August 1, 2005. On August 1, 2005, OfficeMax filed its Answer and Counter-Claim against us. The Counter-Claim against us alleges four causes of action against: breach of contract, unjust enrichment, quantum valebant and an action for declaratory relief. The Counter-Claim alleges, among other things, that we are liable to OfficeMax in the amount of no less than $138,000 under the terms of a vendor agreement executed between I/OMagic and OfficeMax in connection with the return of computer peripheral products to us for which OfficeMax allegedly has never been reimbursed. The Counter-Claim seeks, among other things, at least $138,000 from us, along with pre-judgment interest, attorneys’ fees and costs of suit. We filed a response denying all of the affirmative claims set forth in the Counter-Claim, denying any wrongdoing or liability, denying that OfficeMax is entitled to obtain any relief, and we plan to vigorously contest the Counter-Claim. As of the date of this report, discovery has commenced and a trial date in this action has been set for October 17, 2006. The outcome of this action is presently uncertain. However, we believe that all of our claims and defenses are meritorious.

In addition, we are involved in certain legal proceedings and claims which arise in the normal course of business. Management does not believe that the outcome of these matters will have a material affect on our financial position or results of operations.

We held our 2005 annual meeting of stockholders on December 30, 2005. As of the close of business on November 17, 2005, the record date for the meeting, we had outstanding 4,531,572 shares of common stock. A total of 2,935,919 shares of common stock were represented in person or by proxy at the meeting and constituted a quorum. At the meeting, the following two proposals were presented and voted on:

(1) to elect the following five directors: Tony Shahbaz, William Ting, Steel Su, Daniel Hou and Daniel Yao.

(2) to ratify the selection of Singer Lewak Greenbaum & Goldstein LLP as our independent certified public accountants to audit our financial statements for the year ending December 31, 2005:

Item 5. Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Our common stock has been traded on the OTC Bulletin Board under the symbol “IOMG” since December 20, 2002. Prior to that, it traded on the OTC Bulletin Board under the symbol “IOMC” since March 25, 1996. The table below shows for each fiscal quarter indicated the high and low closing bid prices for shares of our common stock. This information has been obtained from the OTC Bulletin Board. The prices shown reflect inter-dealer prices, without retail mark-up, mark-down, or commission and may not necessarily represent actual transactions.

As of March 31, 2006, we had 4,562,847 shares of common stock outstanding held of record by approximately 70 stockholders. These holders of record include depositories that hold shares of stock for brokerage firms which, in turn, hold shares of stock for numerous beneficial owners.

We have not paid dividends on our common stock to date. Our line of credit with GMAC Commercial Finance prohibits the payment of cash dividends on our common stock. We currently intend to retain future earnings to fund the development and growth of our business and, therefore, do not anticipate paying cash dividends on our common stock within the foreseeable future. Any future payment of dividends on our common stock will be determined by our board of directors and will depend on our financial condition, results of operations, contractual obligations and other factors deemed relevant by our board of directors.

In July 2005, we issued options to purchase an aggregate of 130,000 shares of common stock under our 2003 Stock Option Plan at an exercise price of $2.75 per share to certain of our officers, directors and employees. The options expire on July 14, 2010.

In July 2005, we issued options to purchase an aggregate of 240,000 shares of common stock under our 2003 Stock Option Plan at an exercise price of $2.50 per share to certain of our officers, directors and employees. The options expire on July 14, 2010.

In July 2005, we issued warrants to purchase 50,000 shares of common stock at an exercise price of $3.00 per share to an investor relations firm in connection with services to be rendered. The warrants expire on January 8, 2007.

In July 2005, we issued warrants to purchase 50,000 shares of common stock at an exercise price of $4.00 per share to an investor relations firm in connection with services to be rendered. The warrants expire on January 8, 2007.

In July 2005, we issued warrants to purchase 50,000 shares of common stock at an exercise price of $5.00 per share to an investor relations firm in connection with services to be rendered. The warrants expire on January 8, 2007.

In November 2005, we issued warrants to purchase 15,000 shares of common stock at an exercise price of $8.00 per share to an investor relations firm in connection with services to be rendered. The warrants expire on November 14, 2006.

In November 2005, we issued warrants to purchase 15,000 shares of common stock at an exercise price of $10.00 per share to an investor relations firm in connection with services to be rendered. The warrants expire on November 14, 2006.

The issuances of our securities in the above-referenced transactions were effected in reliance upon the exemption from registration under Section 4(2) of the Securities Act of 1933, as amended, as transactions not involving a public offering. Exemption from the registration provisions of the Securities Act is claimed on the basis that such transactions did not involve any public offering and the purchasers were sophisticated with access to the kind of information registration would provide including our most recent Annual Report on Form 10-K and our most recent Quarterly Report on Form 10-Q.

The following financial information should be read in conjunction with the consolidated audited financial statements and the notes to those statements beginning on page F-1 of this report, and the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this report. The consolidated statements of operations data for the years ended December 31, 2005, 2004 and 2003 and the consolidated balance sheet data at December 31, 2005 and 2004 are derived from, and are qualified in their entirety by reference to, the consolidated audited financial statements beginning on page F-1 of this report. The consolidated statements of operations data with respect to the years ended December 31, 2002 and 2001 and the consolidated balance sheet data at December 31, 2003, 2002 and 2001 are derived from, and are qualified in their entirety by reference to, our audited financial statements not included in this report. The historical results that appear below are not necessarily indicative of results to be expected for any future periods.

No cash dividends on our common stock were declared during any of the periods presented above.

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with our consolidated audited financial statements and the related notes and the other financial information included elsewhere in this report. This discussion contains forward-looking statements regarding the data storage and digital entertainment industries and our expectations regarding our future performance, liquidity and capital resources. Our actual results could differ materially from those expressed in these forward-looking statements as a result of any number of factors, including those set forth under “Risk Factors” and under other captions contained elsewhere in this report.

We are a leading provider of optical data storage products and also sell a range of portable magnetic data storage products which we call our GigaBank^™ products. In addition, and to a much lesser extent, we sell digital entertainment and other products. Our data storage products collectively accounted for approximately 99% of our net sales in 2005 and our digital entertainment and other products collectively accounted for only approximately 1% of our net sales in 2005.

Our data storage products consist of a range of products that store traditional PC data as well as music, photos, movies, games and other multi-media content. These products are designed principally for general data storage purposes. Our digital entertainment products consist of a range of products that focus on digital music, photos and movies. These products are designed principally for entertainment purposes.

We sell our products through computer, consumer electronics and office supply superstores and other retailers in over 8,000 retail locations throughout North America. Our network of retailers enables us to offer products to consumers across North America, including every major metropolitan market in the United States. Over the last three years, our largest retailers have included Best Buy, Circuit City, CompUSA, Office Depot, OfficeMax and Staples. Our principle brand is I/OMagic^®, however, from time to time, we also sell products under our Hi-Val^® and Digital Research Technologies^® brand names.

Our net sales declined by $6.6 million, or approximately 15.0%, to $37.8 million in 2005 from $44.4 million in 2004. Our net loss decreased, however, by $6.3 million, or approximately 78.0%, to $1.8 million in 2005 from $8.1 million in 2004.

We believe that the decline in our net sales is predominantly due to the following factors:

We believe that the significant reduction in our net loss is predominantly due to the following factors:

due to impairment. In 2004, we recorded an impairment of our Hi-Val® and Digital Research Technologies® trademarks in the amount of $3.7 million after determining their value to be significantly impaired. Sales of Hi-Val®- and Digital Research Technologies®-branded products declined by $16.4 million, or 68.0%, to $7.6 million in 2004 from $24.8 million in 2003. In addition, we reduced our forecasts for sales of Hi-Val®- and Digital Research Technologies®-branded products in future years. We did not writedown the value of these trademarks in 2005 as we determined that there was no further impairment of these trademarks.

We believe that the decline in our net sales in 2005 as compared to 2004 resulted in part from the rapid and continued decline in sales of our CD-based products. We elected to de-emphasize CD-based products because we believe that they are included as a standard component in most new computer systems and because DVD-based products are backward-compatible with CDs. Predominantly based on market forces, but also partly as a result of our decision to de-emphasize CD-based products, our sales of CD-based products declined by approximately 74.0% to $2.8 million in 2005 from $10.8 million in 2004. Sales of our DVD-based products decreased by approximately 35.0% to $18.8 million in 2005 from $28.8 million in 2004. This resulted in an overall decline of sales of our recordable optical data storage products of $18.0 million in 2005 as compared to 2004.

In addition, an industry-wide decline in CD-based product sales occurred more rapidly than the industry-wide increase in sales of DVD-based data storage products. We believe that lower than expected demand for DVD-based products resulted in part from slower than anticipated growth in DVD-compatible applications and infrastructure. Also, the market for DVD-based products was extremely competitive during 2005 and was characterized by abundant product supplies. We believe that, based on industry forecasts that predicted significant sales growth of DVD-based data storage products, suppliers produced quantities of these products that were substantial and excessive relative to the ultimate demand for those products. As a result of these relatively substantial and excessive quantities, the market for DVD-based data storage products experienced intense competition and downward pricing pressures resulting in lower than expected overall dollar sales. The effects of these factors on sales of our DVD-based products were substantially similar in this regard to that of the data storage industry.

Two additional factors that we believe contributed to the decline in our sales in 2005 as compared to 2004 were very short product life-cycles and the imminent availability of double-layer recordable DVD drives, which can increase storage capacity to up to twice the capacity of single-layer recordable DVD drives. We believe that these factors led consumers to delay purchases in anticipation of products incorporating faster drive speeds, which allow users to more quickly store and access data, and new technologies. During 2005, DVD drives of increasing speeds were introduced into the marketplace in very rapid succession. However, during this time, we expected our DVD-based products to experience longer product life-cycles similar in duration to the life-cycles of our CD-based products. We believe that consumer perception of shorter product life-cycles led consumers to delay purchases in anticipation of succeeding products incorporating faster data storage and access speeds. In addition, we expected that double-layer recordable DVD drives would be available commencing in the fourth quarter of 2004; however, the market’s transition from single-layer to double-layer recordable DVD drives began earlier than expected in the third quarter of 2004, confirming what we believe were consumer expectations regarding the imminent availability of products incorporating double-layer recordable DVD technology. We began selling our double-layer recordable DVD drives at the end of the third quarter of 2004; however, sales of our double-layer recordable DVD drives have not been as robust as expected partially as a result of the lack of reasonably-priced DVD media.

USB portable data storage devices, such as USB flash drives and compact USB hard disk drives that compete with our CD- and DVD-based data storage products were introduced in late 2002 and sales of these devices, as well as Apple’s Ipod^® and other MP3 players, have continued to represent an increasing share of the market for data storage products. We believe that these portable data storage devices, which are an alternative to optical data storage products, have accordingly caused a decline in the relative market share of CD- and DVD-based optical data storage products and likewise caused a decline in our sales of CD- and DVD-based products in 2005. In the third quarter of 2004, we began selling our GigaBank^™ products, which are compact and portable hard disk drives with a built-in USB connector, to complement our optical data storage products.

Another factor contributing significantly to the decline in our net sales in 2005 as compared to 2004 was the continued and expanded operation of private label programs by Best Buy. Our sales to Best Buy declined in 2005 to $61,000, representing a decrease of nearly 100.0% from $5.0 million in 2004. We believe that this decrease reflects, at least in part, Best Buy’s increased sales of private label products that compete with products that we sell. Although we expect the lack of sales to Best Buy to continue in subsequent reporting periods as a result of continued private label programs, management intends to use its best efforts to regain Best Buy as one of our major retailers. Management has been in recent discussions with Best Buy regarding the sale of other products not currently sold to, or private-labeled by, Best Buy. However, there can be no assurance that we will be successful in selling any of these products, or any products at all, to Best Buy.

Another factor contributing significantly to the decline in our net sales during 2005 as compared to 2004 was the significant decrease in sales of our DVD-based products to Circuit City. Sales to Circuit City decreased $3.5 million, or approximately 45.0%, to $4.3 million in 2005 from $7.8 million in 2004.

Our business focus is predominantly on DVD-based optical data storage products. In addition to CD- and DVD-based optical data storage products, we also focus on and sell a line of GigaBank^™ products, which are compact and portable hard disk drives with a built-in USB connector. In 2005, we broadened our range of data storage products by expanding our GigaBank^™ product line and we anticipate that sales of these devices will continue to be a significant percentage of our total net sales over the next twelve months. For 2005, our GigaBank^™ products accounted for approximately 40.0% of our total net sales. For 2004, sales our GigaBank^™ products accounted for approximately 8.7% of our total net sales.

One of our core strategies is to be among the first-to-market with new and enhanced product offerings based on established technologies. We expect to apply this strategy, as we have done in the contexts of CD- and DVD-based technologies and for our GigaBank^™ products, to next-generation super-high capacity optical data storage devices using technology such as Blu-ray DVD or High-definition DVD. This strategy extends not only to new products, but also to enhancements of existing products. We believe that by employing this strategy, we will be able to maintain relatively high average selling prices and margins and avoid relying on the highly competitive market of last-generation and older devices.

Our business faces the significant risk that certain of our retailers will implement a private label or direct import program, or expand their existing programs, especially for higher margin products. Our retailers may believe that higher profit margins can be achieved if they implement a direct import or private label program, excluding us from the sales channel. For example, as noted above, our sales to Best Buy, who was our largest retailer during 2003 and 2002, declined in 2005 to only $61,000 from $5.0 million in 2004, representing a decrease of nearly 100.0%. We believe that this decrease reflects, at least in part, Best Buy’s increased sales of private label products that compete with products that we sell. One of our challenges will be to deliver products and provide services to our retailers in a manner and at a level that makes private label or direct importation of products less attractive to our retailers, while maintaining product margins at levels sufficient to allow for profitability that meets or exceeds our goals.

We focus on numerous factors in evaluating our operating performance and our financial condition. In particular, in evaluating our operating performance, we focus primarily on net sales, net product margins, net retailer margins, rebates and sales incentives, and inventory turnover as well as operating expenses and net income.

Net sales. Net sales is a key indicator of our operating performance. We closely monitor overall net sales, as well as net sales to individual retailers, and seek to increase net sales by expanding sales to additional retailers and expanding sales to existing retailers both by increasing sales of existing products and introducing new products. Management monitors net sales on a weekly basis, but also considers sales seasonality, promotional programs and product life-cycles in evaluating weekly sales performance. As net sales increase or decrease from period to period, it is critical for management to understand and react to the various causes of these fluctuations, such as successes or failures of particular products, promotional programs, product pricing, retailer decisions, seasonality and other causes. Where possible, management attempts to anticipate potential changes in net sales and seeks to prevent adverse changes and stimulate positive changes by addressing the expected causes of adverse and positive changes. We believe that our good working relationships with our retailers enable us to monitor closely consumer acceptance of particular products and promotional programs which in turn enable us to better anticipate changes in market conditions.

Net product margins. Net product margins, from product-to-product and across all of our products as a whole, is an important measurement of our operating performance. We monitor margins on a product-by-product basis to ascertain whether particular products are profitable or should be phased out as unprofitable products. In evaluating particular levels of product margins on a product-by-product basis, we focus on attaining a level of net product margin sufficient to contribute to normal operating expenses and to provide a profit. The level of acceptable net product margin for a particular product depends on our expected product sales mix. However, we occasionally sell products for certain strategic reasons to, for example, complete a product line or for promotional purposes, without a rigid focus on historical product margins or contribution to operating expenses or profitability.

Net retailer margins. We seek to manage profitability on a retailer level, not solely on a product level. Although we focus on net product margins on a product-by-product basis and across all of our products as a whole, our primary focus is on attaining and building profitability on a retailer-by-retailer level. For this reason, our mix of products is likely to differ among our various retailers. These differences result from a number of factors, including retailer-to-retailer differences, products offered for sale and promotional programs.

Rebates and sales incentives. Rebates and sales incentives offered to customers and retailers are an important aspect of our business and are instrumental in obtaining and maintaining market leadership through competitive pricing in generating sales on a regular basis as well as stimulating sales of slow moving products. We focus on rebates and sales incentives costs as a proportion of our total net sales to ensure that we meet our expectations of the costs of these programs and to understand how these programs contribute to our profitability or result in unexpected losses.

Inventory turnover. Our products’ life-cycles typically range from 3-12 months, generating lower average selling prices as the cycles mature. We attempt to keep our inventory levels at amounts adequate to meet our retailers’ needs while minimizing the danger of rapidly declining average selling prices and inventory financing costs. By focusing on inventory turnover levels, we seek to identify slow-moving products and take appropriate actions such as implementation of rebates and sales incentives to increase inventory turnover.

Our use of a consignment sales model with certain retailers results in increased amounts of inventory that we must carry and finance. Our use of a consignment sales model results in greater exposure to the danger of declining average selling prices, however our consignment sales model allows us to more quickly and efficiently implement promotional programs and pricing adjustments to sell off slow-moving inventory and prevent further price erosion.

Our targeted inventory turnover levels for our combined sales models is 6 to 8 weeks of inventory, which equates to an annual inventory turnover level of approximately 6.5 to 8.5. In 2005, our annualized inventory turnover level was 5.5 as compared to 7.2 in 2004, representing a period-to-period decrease of 24% primarily as a result of a 13% increase in inventory and a 15% decrease in net sales. For 2004, our inventory turnover level was 7.2 as compared to 6.6 for 2003, representing a period-to-period increase of 9% primarily as a result of a 37% decrease in inventory offset by a 30% decrease in net sales.

Operating expenses. We focus on operating expenses to keep these expenses within budgeted amounts in order to achieve or exceed our targeted profitability. We budget certain of our operating expenses in proportion to our projected net sales, including operating expenses relating to production, shipping, technical support, and inside and outside commissions and bonuses. However, most of our expenses relating to general and administrative costs, product design and sales personnel are essentially fixed over large sales ranges. Deviations that result in operating expenses in greater proportion than budgeted signal to management that it must ascertain the reasons for the unexpected increase and take appropriate action to bring operating expenses back into the budgeted proportion.

Net income. Net income is the ultimate goal of our business. By managing the above factors, among others, and monitoring our actual results of operations, our goal is to generate net income at levels that meet or exceed our targets.

In evaluating our financial condition, we focus primarily on cash on hand, available trade lines of credit, available bank line of credit, anticipated near-term cash receipts, and accounts receivable as compared to accounts payable. Cash on hand, together with our other sources of liquidity, is critical to funding our day-to-day operations. Funds available under our line of credit with GMAC Commercial Finance are also an important source of liquidity and a measure of our financial condition. We use our line of credit on a regular basis as a standard cash management procedure to purchase inventory and to fund our day-to-day operations without interruption during periods of slow collection of accounts receivable. Anticipated near-term cash receipts are also regarded as a short-term source of liquidity, but are not regarded as immediately available for use until receipt of funds actually occurs.

The proportion of our accounts receivable to our accounts payable and the expected maturity of these balance sheet items is an important measure of our financial condition. We attempt to manage our accounts receivable and accounts payable to focus on cash flows in order to generate cash sufficient to fund our day-to-day operations and satisfy our liabilities. Typically, we prefer that accounts receivable are matched in duration to, or collected earlier than, accounts payable. If accounts payable are either out of proportion to, or due far in advance of, the expected collection of accounts receivable, we will likely have to use our cash on hand or our line of credit to satisfy our accounts payable obligations, without relying on additional cash receipts, which will reduce our ability to purchase and sell inventory and may impact our ability, at least in the short-term, to fund other parts of our business.

We employ three primary sales models: a standard terms sales model, a consignment sales model and a special terms sales model. We generally use one of these three primary sales models, or some combination of these sales models, with each of our retailers.

Currently, the majority of our net sales are on a terms basis. Under our standard terms sales model, a retailer is obligated to pay us for products sold to it within a specified number of days from the date of sale of products to the retailer. Our standard terms are typically net 60 days. We typically collect payment from a retailer within 60 to 75 days following the sale of products to a retailer.

Consignment sales represented a growing percentage of our net sales from 2001 through 2003. However, during 2004, our consignment sales model accounted for 31% of our total net sales as compared to 37% of our total net sales in 2003, primarily as a result of consigning fewer products to Best Buy, which was our largest consignment retailer, which was partially offset by an increase in consigning more products to Staples. In 2005, our consignment sales model accounted for 33% of our total net sales as compared to 31% of our total net sales in 2004. Although consignment sales increased slightly as a percentage of our net sales in 2005, it is not clear whether consignment sales as a percentage of our total net sales will grow or decline in the future.

During 2002 and 2003, we increased the use of our consignment sales model based in part on the preferences of some of our retailers. Our retailers often prefer the benefits resulting from our consignment sales model over our standard terms sales model. These benefits include payment by a retailer only in the event of resale of a consigned product, resulting in less risk borne by the retailer of price erosion due to competition and technological obsolescence. Deferring payment until following the sale of a consigned product also enables a retailer to avoid having to finance the purchase of that product by using cash on hand or by borrowing funds and incurring borrowing costs. In addition, retailers also often operate under budgetary constraints on purchases of certain products or product categories. As a result of these budgetary constraints, the purchase by a retailer of certain products typically will cause reduced purchasing power for other products. Products consigned to a retailer ordinarily fall outside of these budgetary constraints and do not cause reduced purchasing power for other products. As a result of these benefits, we believe that we are able to sell more products by using our consignment sales model than by using only our standard terms sales model.

Managing an appropriate level of consignment sales is an important challenge. As noted above, the payment period for products sold on consignment is based on the day consigned products are resold by a retailer, and the payment period for products sold on a standard terms basis is based on the day the product is sold initially to the retailer, independent of the date of resale of the product. Accordingly, we generally prefer that higher-turnover inventory is sold on a consignment basis while lower-turnover inventory is sold on a traditional terms basis. Management focuses closely on consignment sales to manage our cash flow to maximize liquidity as well as net sales. Close attention is directed toward our inventory turnover levels to ensure that they are sufficiently frequent to maintain appropriate liquidity. Our consignment sales model enables us to have more pricing control over inventory sold through our retailers as compared to our standard terms sales model. If we identify a decline in inventory turnover levels for products in our consignment sales channels, we can implement price modifications more quickly and efficiently as compared to the implementation of sales incentives in connection with our standard terms sales model. This affords us more flexibility to take action to attain our targeted inventory turnover levels.

We retain most risks of ownership of products in our consignment sales channels. These products remain our inventory until their resale by our retailers. The turnover frequency of our inventory on consignment is critical to generating regular cash flow in amounts necessary to keep financing costs to targeted levels and to purchase additional inventory. If this inventory turnover is not sufficiently frequent, our financing costs may exceed targeted levels and we may be unable to generate regular cash flow in amounts necessary to purchase additional inventory to meet the demand for other products. In addition, as a result of our products’ short life-cycles, which generate lower average selling prices as the cycles mature, low inventory turnover levels may force us to reduce prices and accept lower margins to sell consigned products. If we fail to select high turnover products for our consignment sales channels, our sales, profitability and financial resources may decline.

We occasionally employ a special terms sales model. Under our special terms sales model, the payment terms for the purchase of our products are negotiated on a case-by-case basis and typically cover a specified quantity of a particular product. We ordinarily do not offer any rights of return or rebates for products sold under our special terms sales model. Our payment terms are ordinarily shorter under our special terms sales model than under our standard terms or consignment sales models and we typically require payment in advance, at the time of sale, or shortly following the sale of products to a retailer.

Historically, a limited number of retailers have accounted for a significant percentage of our net sales. During 2005, 2004 and 2003, our six largest retailers accounted for approximately 92%, 84% and 80%, respectively, of our total net sales. We expect that sales of our products to a limited number of retailers will continue to account for a majority of our sales in the foreseeable future. We do not have long-term purchase agreements with any of our retailers. If we were to lose any of our major retailers or experience any material reduction in orders from any of them, and were unable to replace our sales to those retailers, it could have a material adverse effect on our business and results of operations.

Our products have historically been affected by seasonal purchasing patterns. The seasonality of our sales is in direct correlation to the seasonality experienced by our retailers and the seasonality of the consumer electronics industry. After adjusting for the addition of new retailers, our fourth quarter has historically generated the strongest sales, which correlates to well-established consumer buying patterns during the Thanksgiving through Christmas holiday season. Our first and third quarters have historically shown some strength from time to time based on post-holiday season sales in the first quarter and back-to-school sales in the third quarter. Our second quarter has historically been our weakest quarter for sales, again following well-established consumer buying patterns. The impact of seasonality on our future results will be affected by our product mix, which will vary from quarter to quarter.

We face downward pricing pressures within our industry that arise from a number of factors. The products we sell are subject to rapid technological change and obsolescence. Companies within the data storage and digital entertainment and related industries are continuously developing new products with heightened performance and functionality. This puts downward pricing pressures on existing products and constantly threatens to make them, or causes them to be, obsolete. Our typical product life-cycle is extremely short and ranges from only three to twelve months, generating lower average selling prices as the cycle matures.

In addition, the data storage industry is extremely competitive. Numerous large competitors such as BenQ, Hewlett-Packard, Sony, TDK and other competitors such as Lite-On, Memorex, Philips Electronics and Samsung Electronics compete with us in the optical data storage industry. Numerous large competitors such as Iomega, LaCie, PNY Technologies, Sony, Seagate Technology and Western Digital offer products similar to our GigaBank^™ and EZ NetShare^™ products. Intense competition within our industry exerts downward pricing pressures on products that we offer. Also, one of our core strategies is to offer our products as affordable alternatives to higher-priced products offered by our larger competitors. The effective execution of this business strategy results in downward pricing pressure on products that we offer because our products must appeal to consumers partially based on their attractive prices relative to products offered by our large competitors. As a result, we are unable to rely as heavily on other non-price factors such as brand recognition and must consistently maintain lower prices.

Finally, the actions of our retailers often exert downward pricing pressures on products that we offer. Our retailers pressure us to offer products to them at attractive prices. In doing this, we do not believe that the overall goal of our retailers

is to increase their margins on these products. Instead, we believe that our retailers pressure us to offer products to them at attractive prices in order to increase sales volume and consumer traffic, as well as to compete more effectively with other retailers of similar products. Additional downward pricing pressure also results from the continuing threat that our retailers may begin to directly import or private-label products that are identical or very similar to our products. Our pricing decisions with regard to certain products are influenced by the ability of retailers to directly import or private-label identical or similar products. Therefore, we constantly seek to maintain prices that are highly attractive to our retailers and that offer less incentive to our retailers to commence or maintain direct import or private-label programs.

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of net sales and expenses for each period. The following represents a summary of our critical accounting policies, defined as those policies that we believe are the most important to the portrayal of our financial condition and results of operations and that require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effects of matters that are inherently uncertain.

We recognize revenue under three primary sales models: a standard terms sales model, a consignment sales model and a special terms sales model. We generally use one of these three primary sales models, or some combination of these sales models, with each of our retailers.

Under our standard terms sales model, a retailer is obligated to pay us for products sold to it within a specified number of days from the date that title to the products is transferred to the retailer. Our standard terms are typically net 60 days from the transfer of title to the products to a retailer. We typically collect payment from a retailer within 60 to 75 days from the transfer of title to the products to a retailer. Transfer of title occurs and risk of ownership passes to a retailer at the time of shipment or delivery, depending on the terms of our agreement with a particular retailer. The sale price of our products is substantially fixed or determinable at the date of sale based on purchase orders generated by a retailer and accepted by us. A retailer’s obligation to pay us for products sold to it under our standard terms sales model is not contingent upon the resale of those products. We recognize revenue for standard terms sales at the time title to products is transferred to a retailer.

Under our consignment sales model, a retailer is obligated to pay us for products sold to it within a specified number of days following our notification by the retailer of the resale of those products. Retailers notify us of their resale of consigned products by delivering weekly or monthly sell-through reports. A sell-through report discloses sales of products sold in the prior period covered by the report — that is, a weekly or monthly sell-through report covers sales of consigned products in the prior week or month, respectively. The period for payment to us by retailers relating to their resale of consigned products corresponding to these sell-through reports varies from retailer to retailer. For sell-through reports generated weekly, we typically collect payment from a retailer within 30 days of the receipt of those reports. For sell-through reports generated monthly, we typically collect payment from a retailer within 15 days of the receipt of those reports. At the time of a retailer’s resale of a product, title is transferred directly to the consumer. Risk of theft or damage of a product, however, passes to a retailer upon delivery of that product to the retailer. The sale price of our products is substantially fixed or determinable at the date of sale based on a product sell-through report generated by a retailer and delivered to us. Except in the case of theft or damage, a retailer’s obligation to pay us for products transferred under our consignment sales model is entirely contingent upon the resale of those products. Products held by a retailer under our consignment sales model are recorded as our inventory at offsite locations until their resale by the retailer. Because we retain title to products in our consignment sales channels until their resale by a retailer, revenue is not recognized until the time of resale. Accordingly, price modifications to inventory maintained in our consignment sales channels do not have an effect on the timing of revenue recognition. We recognize revenue for consignment sales in the period during which resale occurs.

Under our special terms sales model, the payment terms for the purchase of our products are negotiated on a case-by-case basis and typically cover a specified quantity of a particular product. The result of our negotiations is a special agreement with a retailer that defines how and when transfer of title occurs and risk of ownership shifts to the retailer. We ordinarily do not offer any rights of return or rebates for products sold under our special terms sales model. A retailer is obligated to pay us for products sold to it within a specified number of days from the date that title to the products is transferred to the retailer, or as otherwise agreed to by us. Our payment terms are ordinarily shorter under our special terms sales model than under our standard terms or consignment sales models and we typically require payment in advance, at the time of transfer of title to the products or shortly following the transfer of title to the products to a retailer. Transfer of title occurs and risk of ownership passes to a retailer at the time of shipment, delivery, receipt of payment or the date of invoice, depending on the terms of our agreement with the retailer. The sale price of our products is substantially fixed or determinable at the date of sale based on our agreement with a retailer. A retailer’s obligation to pay us for products sold to it under our special terms sales model is not contingent upon the resale of those products. We recognize revenue for special terms sales at the time title to products is transferred to a retailer.

From time to time, we enter into agreements with certain retailers regarding price decreases that are determined by us in our sole discretion. These agreements allow those retailers (subject to limitations) a credit equal to the difference between our current price and our new reduced price on units in the retailers’ inventories or in transit to the retailers on the date of the price decrease.

We record an estimate of sales incentives based on our actual sales incentive rates over a trailing twelve-month period, adjusted for any known variations, which are charged to operations and offset against gross sales at the time products are sold with a corresponding accrual for our estimated sales incentive liability. This accrual—our sales incentive reserve—is reduced by deductions on future payments taken by our retailers relating to actual sales incentives.

At the end of each quarterly period, we analyze our existing sales incentive reserve and apply any necessary adjustments based upon actual or expected deviations in sales incentive rates from our applicable historical sales incentive rates. The amount of any necessary adjustment is based upon the amount of our remaining field inventory, which is calculated by reference to our actual field inventory last conducted, plus inventory-in-transit and less estimated product sell-through. The amount of our sales incentive liability for each product is equal to the amount of remaining field inventory for that product multiplied by the difference between our current price and our new reduced price to our retailers for that product. This data, together with all data relating to all sales incentives granted on products in the applicable period, is used to adjust our sales incentive reserve established for the applicable period.

In 2005, our sales incentives were $1.3 million, or 2.6% of gross sales, all of which was offset against gross sales, as compared to $2.5 million, or 4.2% of gross sales, in 2004, all of which was offset against gross sales. In 2003, our sales incentives were $2.9 million, or 3.5% of gross sales, all of which was offset against gross sales.

Market Development Fund and Cooperative Advertising Costs, Rebate Promotion Costs and Slotting Fees

Market development fund and cooperative advertising costs, rebate promotion costs and slotting fees are charged to operations and offset against gross sales in accordance with Emerging Issues Task Force Issue No. 01-9. Market development fund and cooperative advertising costs and rebate promotion costs are each promotional costs. Slotting fees are fees paid directly to retailers for allocation of shelf-space in retail locations. In 2005, our market development fund and cooperative advertising costs, rebate promotion costs and slotting fees were $7.0 million, or 13% of gross sales, all of which was offset against gross sales, as compared to market development fund and cooperative advertising costs, rebate promotion costs and slotting fees of $7.8 million, or 13% of gross sales, in 2004, all of which was offset against gross sales. In 2003, our market development fund and cooperative advertising costs, rebate promotion costs and slotting fees were $8.4 million, or 10% of gross sales, all of which was offset against gross sales. These costs and fees were approximately the same in 2005 and 2004 at 13% of our gross sales, and increased as a percentage of our net sales in 2004, increasing to 13% of our gross sales from 10% of our gross sales in 2003, primarily as a result of instituting sales incentives and marketing promotions in order to lower the quantity of single-layer recordable DVD recordable drives in our retail sales channels to enable a more rapid transition to sales of double-layer recordable DVD recordable drives and strong promotional activity for our double-layer DVD recordable drives during the 2004 year-end holidays.

Consideration generally given by us to a retailer is presumed to be a reduction of selling price, and therefore, a reduction of gross sales. However, if we receive an identifiable benefit that is sufficiently separable from our sales to that retailer, such that we could have paid an independent company to receive that benefit and we can reasonably estimate the fair value of that benefit, then the consideration is characterized as an expense. We estimate the fair value of the benefits we receive by tracking the advertising done by our retailers on our behalf and calculating the value of that advertising using a comparable rate for similar publications.

Our warehouse supervisor, production supervisor and production manager physically review our warehouse inventory for slow-moving and obsolete products. All products of a material amount are reviewed quarterly and all products of an immaterial amount are reviewed annually. We consider products that have not been sold within six months to be slow-moving. Products that are no longer compatible with current hardware or software are considered obsolete. The potential for re-sale of slow-moving and obsolete inventories is considered through market research, analysis of our retailers’ current needs, and assumptions about future demand and market conditions. The recorded cost of both slow-moving and obsolete inventories is then reduced to its estimated market value based on current market pricing for similar products. We utilize the Internet to provide indications of market value from competitors’ pricing, third party inventory liquidators and auction websites. The recorded costs of our slow-moving and obsolete products are reduced to current market prices when the recorded costs exceed those market prices. For 2005 we increased our inventory reserve and recorded a corresponding increase in cost of goods sold of approximately $841,000 for inventory for which recorded cost exceeded the current market price of this inventory on hand. For 2004 we increased our inventory reserve and recorded a corresponding increase in cost of goods sold of approximately $2.0 million for inventory for which recorded cost exceeded the current market price of this inventory on hand. For 2003, we increased our inventory reserve and recorded a corresponding increase in cost of goods sold of $125,000 for inventory for which recorded cost exceeded the current market price of this inventory on hand. All adjustments establish a new cost basis for inventory as we believe such reductions are permanent declines in the market price of our products. Generally, obsolete inventory is sold to companies that specialize in the liquidation of these items while we continue to market slow-moving inventories until they are sold or become obsolete. As obsolete or slow-moving inventory is sold, we reduce the reserve by proceeds from the sale of the products. During 2005, 2004, and 2003, we sold inventories previously reserved for and accordingly reduced the reserve by approximately $2.3 million, $1.1 million and $670,000, respectively. For 2005, 2004 and 2003, gains recorded as a result of sales of obsolete inventory above the reserved amount were not significant to our results of operations and accounted for less than 1% our total net sales. Although we have no specific statistical data on this matter, we believe that our practices are reasonable and consistent with those of our industry.

Our warehouse supervisor, production supervisor and production manager physically review our warehouse inventory for obsolete or damaged inventory-related items on a monthly basis. Inventory-related items (such as sleeves, manuals or broken products no longer under warranty from our subcontract manufacturers or suppliers) which are considered obsolete or damaged are reviewed by these personnel together with our Controller or Chief Financial Officer. At the discretion of our Controller or Chief Financial Officer, these items are physically disposed of and we make corresponding accounting adjustments resulting in inventory adjustments. In addition, on a monthly basis, our detail inventory report and our general ledger are reconciled by our Controller and any variances result in a corresponding inventory adjustment. Although we have no specific statistical data on this matter, we believe that our practices are reasonable and consistent with those of our industry.

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our retailers to make required payments. Our current retailers consist of either large national or regional retailers with good payment histories with us. Since we have not experienced any previous payment defaults with any of our current retailers, our allowance for doubtful accounts is minimal. We perform periodic credit evaluations of our retailers and maintain allowances for potential credit losses based on management’s evaluation of historical experience and current industry trends. If the financial condition of our retailers were to deteriorate, resulting in the impairment of their ability to make payments, additional allowances may be required. New retailers are evaluated through Dunn & Bradstreet before terms are established. Although we expect to collect all amounts due, actual collections may differ.

We have a limited 90-day to one year time period for product returns from end-users; however, our retailers generally have return policies that allow their customers to return products within only fourteen to thirty days after purchase. We allow our retailers to return damaged or defective products to us following a customary return merchandise authorization process. We have no informal return policies. We utilize actual historical return rates to determine our allowance for returns in each period. Gross sales is reduced by estimated returns and cost of sales is reduced by the estimated cost of those sales. We record a corresponding accrual for the estimated liability associated with the estimated returns. This estimated liability is based on the gross margin of the products corresponding to the estimated returns. This accrual is offset each period by actual product returns.

Our current estimated weighted average future product return rate is approximately 10.2%. As noted above, our return rate is based upon our past history of actual returns and we estimate amounts for product returns for a given period by applying this historical return rate and reducing actual gross sales for that period by a corresponding amount. Our historical return rate for a particular product is the life-to-date return rate of similar products. This life-to-date return rate is updated monthly. We also compare this life-to-date return rate to our trailing 18-month return rate to determine whether any material changes in our return rate have occurred that may not be reflected in the life-to-date return rate. We believe that using a trailing 18-month return rate takes two key factors into consideration, specifically, an 18-month return rate provides us with a sufficient period of time to establish recent historical trends in product returns for each product category, and provides us with a period of time that is short enough to account for recent technological shifts in our product offerings in each product category. If an unusual circumstance exists, such as a product category that has begun to show materially different actual return rates as compared to life-to-date return rates, we will make appropriate adjustments to our estimated return rates. Factors that could cause materially different actual return rates as compared to life-to-date return rates include product modifications that simplify installation, a new product line, within a product category, that needs time to better reflect its return performance and other factors.

Although we have no specific statistical data on this matter, we believe that our practices are reasonable and consistent with those of our industry.

Our warranty terms under our arrangements with our suppliers are that any product that is returned by a retailer or retail customer as defective can be returned by us to the supplier for full credit against the original purchase price. We incur only minimal shipping costs to our suppliers in connection with the satisfaction of our warranty obligations.

The tables presented below, which compare our results of operations from one period to another, present the results for each period, the change in those results from one period to another in both dollars and percentage change and the results for each period as a percentage of net sales. The columns present the following:

Net Sales. We believe that the $6.6 million decrease in net sales from $44.4 million in 2004 to $37.8 million in 2005 is primarily due to the following factors: the continued decline in sales of our CD-based products; slower than anticipated growth in sales of our DVD-based products; the continued operation of private label programs by Best Buy; and the decrease in sales of our DVD-based products to Circuit City. The decline in net sales caused by these factors was partially offset by a substantial increase in the sale of our GigaBank^™ products.

We believe that the decline in our net sales during 2005 as compared to 2004 resulted in part from the continued decline in sales of our CD-based products. Predominantly based on market forces, but also partly as a result of our decision to de-emphasize CD-based products, our sales of our CD-based products declined by 74.1% to $2.8 million in 2005 from $10.8 million in 2004.

In addition, we also believe that part of the significant decline in our net sales during 2005 as compared to 2004 resulted from the decline in sales of our DVD-based products. For 2005, sales of our DVD-based products decreased to $18.8 million, or by 34.7%, as compared to $28.8 million in sales for 2004. We experienced a 30.9% decrease in our average selling price of DVD-based products for 2005 as compared to 2004. We believe that this decrease is an industry-wide effect and that these lower average selling prices were primarily the result of a slower than anticipated growth in DVD-compatible applications and infrastructure, which resulted in lower demand for DVD-based products. We believe that, based on industry forecasts that predicted significant sales growth of DVD-based data storage products, suppliers produced quantities of these products that were substantial and excessive relative to the ultimate demand for those products. As a result of these substantial and excessive quantities, the market for DVD-based data storage products experienced intense competition and downward pricing pressures resulting in lower than expected overall dollar sales.

In addition to the other factors described above, we believe that USB portable data storage devices, which are an alternative to optical data storage products, have caused a decline in the relative market share of CD- and DVD-based optical data storage products and likewise caused a decline in our sales of CD- and DVD-based products in 2005. Our business focus in 2004 was predominantly on DVD-based optical data storage products. Our business focus in 2005 was predominantly on DVD-based optical data storage products and our line of GigaBank^™ products. We expect to broaden our range of data storage products by expanding our GigaBank^™ product line and we anticipate that sales of these devices will increase as a percentage of our total net sales over the next twelve months. In 2004, we began selling our GigaBank^™ products. Sales of our GigaBank^™ products increased 282.5% to $15.3 million in 2005 as compared to $4.0 million in 2004. Sales of our GigaBank^™ products represented 39.9% of our total net sales in 2005. Our net sales to some of our retailers, including CompUSA, Office Depot and Tech Data, have increased during 2005 as compared to 2004 due to their expanded offerings of our GigaBank™ line of products. Other retailers, however, including Circuit City, RadioShack and Micro Center, did not begin or expand sales of our GigaBank^™ products as rapidly as CompUSA, Office Depot and Tech Data and thus the general decline in sales of our DVD-based products to these retailers was not offset by sales of our GigaBank^™ products to these retailers. In addition, we experienced a slight decrease in sales to Staples in 2005 as compared to 2004.

Another factor contributing significantly to the decline in our net sales during 2005 as compared to 2004 was the continued and expanded operation of private label programs by Best Buy. We had only $61,000 in sales to Best Buy in 2005, representing a decrease of nearly 100.0% from $5.0 million in sales to Best Buy in 2004. We believe that this decrease reflects, at least in part, Best Buy’s increased sales of private label products that compete with products that we sell.

In addition, our sales to Circuit City decreased significantly by $3.5 million, or by 44.9%, to $4.3 million in 2005 from $7.8 million in 2004.

A change in our allowance for product returns also resulted in an adjustment of $468,000 causing a decrease in net sales in 2005 as compared to an adjustment of $1.1 million that resulted in an increase in net sales in 2004.

The overall $6.6 million decrease in net sales in 2005 was comprised of a $5.7 million decrease in net sales resulting from a decrease in the volume of products sold and a decrease of $1.3 million resulting from a change in our reserves for future returns on sales. This decrease was partially offset by a $262,000 increase from higher average product sales prices. We had a decrease of $8.0 million in net sales for 2005 for our CD-based products resulting from a decrease of $1.1 million due to lower average product sales prices and a decrease of $6.9 million resulting from a decrease in the volume of products sold. We had a decrease of $10.0 million in net sales for 2005 for our DVD-based products resulting from a decrease of $8.4 million due to lower average product sales prices and a decrease of $1.6 million due to a decrease in the volume of products sold. The $11.2 million increase in net sales of our GigaBank^™ products in 2005 resulted from an increase of $13.3 million due to an increase in the volume of products sold, which was partially offset by a decrease of $2.1 million in net sales due to lower average product sales prices.

Gross Profit. Gross profit increased to $4.3 million, or by 43.3%, in 2005 from $3.0 million in 2004. Net sales decreased $6.6 million, or by 14.9%, to $37.8 million in 2005 from $44.4 million in 2004. This decrease was offset by a decrease in cost of sales of $7.9 million to $33.5 million, or 88.7% of net sales in 2005, from $41.4 million, or 93.3% of net sales in 2004. The percentage decrease in net sales was not as large as the percentage decrease in cost of sales because of large decreases in sales incentives and slotting fees, which are dilutive factors to sales and contributed to net sales for 2005 as compared to 2004. For 2005, slotting fees were none as compared to $950,000 for 2004. For 2005, sales incentives declined by $1.2 million compared to 2004.

Our inventory reserve increased by $841,000 in 2005 as compared to $2.0 million in 2004 due to our adjustment of the value of our slow-moving and obsolete inventory. Most of our inventory over 2 years old was fully reserved for in 2004. As a result of the short life cycles of many of our products resulting from, in part, the effects of rapid technological change, we expect to experience additional slow-moving and obsolete inventory charges in the future. However, we cannot predict with any certainty the future level of these charges.

Selling, Marketing and Advertising Expenses. The decrease in selling, marketing and advertising expenses was primarily due to a decline in advertising expenses in the amount of $263,000 due to no advertising activities in 2005 and a decline in commissions in the amount of $73,000 as a result of reduced sales volume, which were partially offset by an increase in customer products evaluations expense of $60,000.

General and Administrative Expenses. The decrease in general and administrative expenses is primarily due to a reduction in payroll and related expenses in the amount of $380,000 as a result of fewer personnel, a reduction in bad debt expense in the amount of $148,000 and a reduction in financial relations expenses of $93,000 due to a reduction in outside financial consultants. These reductions were partially offset by an increase in bank charges in the amount of $52,000 as a result of higher fees by banks in order to obtain more rapid clearing of cash receipts.

Depreciation and Amortization Expenses. The decrease in depreciation and amortization expenses is primarily due to a reduction in trademarks amortization of $510,000 due to the writedown in the value of our Hi-Val® and Digital Research Technologies® trademarks at December 31, 2004 due to impairment. Depreciation for office equipment, computer hardware and software decreased $88,000 as a many fixed assets became fully depreciated during the year.

Impairment of Trademarks. We conducted a valuation on our Hi-Val® and Digital Research Technologies® trademarks for possible impairment as of December 31, 2005. Based upon this valuation, we determined that there had been no impairment in the value of the trademarks.

We conducted a valuation on our Hi-Val^® and Digital Research Technologies^® trademarks for possible impairment as of December 31, 2004. Based upon this valuation, we determined that there had been a significant impairment in the value of the trademarks due to lower sales of products under the Hi-Val^® and Digital Research Technologies^® brands in 2004 and lower sales forecasted by us for subsequent periods. Therefore, we recorded an impairment in the value of the trademarks of $3.7 million as of December 31, 2004. This impairment will result in a reduction of $509,796 in amortization expense to $68,940 from $578,736 in each of the next five years.

Other Income (Expense). Other income (expense) increased by $136,000 in 2005, as compared to 2004, primarily due to an increase in interest expense in the amount of $98,000 to $299,000 in 2005 as compared to $201,000 in 2004 as a result of higher rates of interest in 2005 on our credit facility due to increases in the prime rate of interest.

Net Sales. We believe that the significant decrease in the amount of $19.2 million in net sales from $63.6 million in 2003 to $44.4 million in 2004 is primarily due to the following factors: the continued decline in sales of our CD-based products; slower than anticipated growth in sales of our DVD-based products; and the continued operation of private label programs by Best Buy; and a significant decline in sales to OfficeMax. The decline in net sales caused by these factors was partially offset by a substantial increase in sales to Staples.

We believe that the significant decline in our net sales during 2004 as compared to 2003 resulted in part from the rapid and continued decline in sales of our CD-based products. Predominantly based on market forces, but also partly as a result of our decision to de-emphasize CD-based products, our sales of recordable CD-based products declined by 76.1% to $7.1 million in 2004 from $29.7 million in 2003. Sales of our recordable DVD-based products increased by 50.0% to $29.4 million in 2004 from $19.6 million in 2003. These results suggest that our sales of recordable CD-based products declined by $22.6 million in 2004 as compared to 2003, which decline was only partially offset by an increase in sales of our recordable DVD-based products by $9.8 million for the same periods, resulting in an overall decline of sales of our recordable optical data storage products of $12.8 million in 2004 as compared to 2003.

Also, an industry-wide decline in CD-based product sales occurred more rapidly than the industry-wide increase in sales of DVD-based data storage products. We believe that lower than expected demand for DVD-based products resulted in part from slower than anticipated growth in DVD-compatible applications and infrastructure. Also, the market for DVD-based products was extremely competitive during 2004 and was characterized by abundant product supplies. We believe that, based on industry forecasts that predicted significant sales growth of DVD-based data storage products, suppliers produced quantities of these products that were substantial and excessive relative to the ultimate demand for those products. As a result of these relatively substantial and excessive quantities, the market for DVD-based data storage products experienced intense competition and downward pricing pressures resulting in lower than expected overall dollar sales. The effects of these factors on sales of our DVD-based products were substantially similar in this regard to that of the data storage industry.

Two additional factors that we believe contributed to the decline in our sales in 2004 as compared to 2003 were very short product life-cycles and the imminent availability of double-layer recordable DVD drives, which can increase storage capacity to up to twice the capacity of single-layer recordable DVD drives. We believe that these factors led consumers to delay purchases in anticipation of products incorporating faster drive speeds, which allow users to more quickly store and access data, and new technologies.

We believe that USB portable data storage devices, which are an alternative to optical data storage products, have caused a decline in the relative market share of CD- and DVD-based optical data storage products and likewise caused a decline in our sales of CD- and DVD-based products in 2004. In the third quarter of 2004, we began selling our GigaBank^™ products, which are compact and portable hard disk drives with a built-in USB connector, and sales of these devices accounted for approximately 27.0% of our total net sales in the fourth quarter of 2004 and 8.7% of our total net sales for the year ended December 31, 2004 with only approximately three months of sales of these devices.

Another factor contributing significantly to the decline in our net sales during 2004 was the continued and expanded operation of private label programs by Best Buy. Our sales to Best Buy, who was our largest retailer during 2003 and 2002, declined in 2004 to $5.0 million, representing a decrease of 72.5% from $18.2 million in 2003. We believe that this decrease reflects, at least in part, Best Buy’s increased sales of private label products that compete with products that we sell.

Also contributing to the overall decline in net sales for 2004 was a $6.2 million, or 100%, decrease in sales to OfficeMax as compared to 2003. This decline was primarily the result of disagreements with OfficeMax relating to amounts we believed we were owned and deductions claimed by OfficeMax for 2003 and, as a result, we discontinued sales to OfficeMax in January 2004. We entered into a new vendor agreement with OfficeMax in November 2004 in anticipation of resuming sales. As of the date of this report, OfficeMax has paid us for our previously-disputed deductions and we have commenced shipping new orders to OfficeMax. However, we are currently in dispute with OfficeMax concerning certain marketing arrangements and related purchase commitments that we believe were made to us by OfficeMax. There can be no assurance that sales to OfficeMax will continue.

These decreases in sales to Best Buy and OfficeMax were partially offset by an increase in sales to Staples of $8.7 million, or 158%, for 2004 as compared to 2003.

In addition, we instituted additional sales incentives and marketing promotions in the third quarter of 2004 in order to lower the quantity of single-layer DVD recordable drives in our retail sales channels to enable a more rapid transition to sales of double-layer DVD recordable drives. Our sales incentives in 2004 were $2.5 million, or 4.2% of gross sales, as compared to $2.9 million, or 3.5% of gross sales, in 2003, all of which was offset against gross sales. Our market development fund and cooperative advertising costs, promotion costs and slotting fees in 2004 were $7.8 million, or 13.0% of gross sales, as compared to $8.4 million, or 10.4% of gross sales in 2003, all of which were offset against gross sales. We incurred additional promotion costs in the fourth quarter of 2004 relating to our double-layer DVD recordable drives.

Also, sales of certain de-emphasized products declined by $5.8 million to $2.8 million in 2004 from $8.6 million in 2003. A change in the allowance for product returns also resulted in an adjustment of $1.1 million causing an increase in sales in 2004 as compared to an adjustment of $1.4 million causing an increase in sales in 2003, resulting in a decrease of $313,000 in sales in 2004 as compared to 2003.

The significant decrease in net sales for 2004 was comprised of a decrease in net sales in the amount of $28.9 million resulting from a decrease in the volume of products sold and a decrease in the amount of $313,000 resulting from a change in our reserves for future returns on sales. These decreases were partially offset by an increase in net sales in the amount of $10.0 million resulting from higher average product sales prices. The decrease in the volume of products sold was consistent with reduced sales of our CD-based products, as noted above.

Gross Profit. The decrease in gross profit, both in dollar terms and as a percentage of net sales, is primarily due to a reduction in net sales in the amount of $19.2 million, or 30.2%, in 2004 as compared to 2003. Another factor contributing to our decrease in gross profit is an increase in the amount of $1.9 million in our slow-moving and obsolete inventory charges to $2.0 million in 2004 from $125,000 in 2003. In 2004, most inventory over 2-years old was fully reserved for and no material amounts of slow-moving or obsolete inventory were sold in 2004. We plan to take more aggressive measures in 2005 to sell remaining slow-moving or obsolete inventory. Due to the short life-cycle of many of our products resulting from, in part, the effects of technological change, we expect to experience additional slow-moving and obsolete inventory charges in the future. However, we cannot predict with any certainty the future level of these charges.

In addition, product costs as a percentage of net sales increased to 82.3% in 2004 from 79.6% in 2003. The increase in product costs primarily resulted from increases in sales incentives, market development fund and cooperative advertising costs, rebate promotion costs and slotting fees as a percentage of net sales to 23.3% in 2004 from 17.7% in 2003.

Selling, Marketing and Advertising Expenses. The decrease in selling, marketing and advertising expenses was primarily due to a decline in commissions in the amount of $180,000 as a result of reduced sales volume and a reduction in payroll and related expenses in the amount of $154,000 as a result of fewer personnel.

General and Administrative Expenses. The decrease in general and administrative expenses is primarily due to a reduction in bad debt expense in the amount of $1.3 million. Bad debt expense was $203,000 in 2004 as compared to $1.5 million in 2003. The decrease in general and administrative expenses is also due to a reduction in phone and utilities expenses in the amount of $118,000, a reduction in product design expenses in the amount of $83,000, a reduction in warehouse supplies in the amount of $77,000 and a reduction in outside assembly expenses in the amount of $65,000 resulting from lower sales volume in 2004 as compared to 2003. These reductions were partially offset by an increase in legal expenses in the amount of $430,000 as a result of increased legal fees relating to current litigation and as a result of an adjustment in 2003 for an over-accrual of legal expenses. Legal expenses were $395,000 in 2004 as compared to a credit in the amount of $35,000 in 2003.

Depreciation and Amortization Expenses. The decrease in depreciation and amortization expenses is primarily due to accelerated amortization in 2003 on our prior Santa Ana facility which was originally to be leased through 2010. At the beginning of 2003, we decided to move to a larger facility by the end of September 2003 and thus, we accelerated our amortization by $389,000 in 2003.

Impairment of Trademarks. We conducted a valuation on our Hi-Val^{^®} and Digital Research Technologies^{^®} trademarks for possible impairment as of December 31, 2004. Based upon this valuation, we determined that there had been a significant impairment in the value of the trademarks due to lower sales of products under the Hi-Val^{^®} and Digital Research Technologies^{^®}brands in 2004 and lower sales forecasted by us for subsequent periods. Therefore, we recorded an impairment in the value of the trademarks of $3.7 million as of December 31, 2004. This impairment will result in a reduction of $509,796 in amortization expense to $68,940 from $578,736 in each of the next five years.

Other Income (Expense). Other income (expense) decreased by $43,000 in 2004, as compared to 2003, primarily due to a decrease in interest expense in the amount of $47,000 to $201,000 in 2004 as compared to $248,000 in 2003 as a result of reduced borrowings under our credit facility.

Income Tax Expense (Benefit). Income taxes provision increased by $30,000 in 2004 to $3,000 as compared to a $27,000 benefit in 2003. In 2003, our income taxes represented primarily refunds we received.

Our principal sources of liquidity have been cash provided by operations and borrowings under our bank and trade credit facilities. Our principal uses of cash have been to finance working capital, capital expenditures and debt service requirements. We anticipate that these uses will continue to be our principal uses of cash in the future. As of December 31, 2005, we had working capital of $6.0 million, an accumulated deficit of $24.9 million, $4.1 million in cash and cash equivalents and $13.1 million in net accounts receivable. This compares with working capital of $7.5 million, an accumulated deficit of $23.1 million, $3.6 million in cash and cash equivalents and $14.6 million in net accounts receivable as of December 31, 2004.

For the year ended December 31, 2005, our cash increased $469,000, or by 13.0%, from $3.6 million to $4.1 million as compared to a decrease of $418,000, or by 10.5%, for the year ended December 31, 2004 from $4.0 million to $3.6 million.

Cash provided by our operating activities totaled $389,170 during the year ended December 31, 2005 as compared to cash used in our operating activities of $1.6 million during the year ended December 31, 2004. This increase of $1.9 million in cash provided by our operating activities primarily resulted from:

Cash provided by our investing activities totaled $982,000 during 2005 as compared to $1.1 million during 2004. Our investing activities in 2005 consisted of a reduction of $1.0 million in restricted cash related to our United National Bank loan offset by $31,000 for purchases of property and equipment.

Cash used in our financing activities totaled $871,000 during 2005 as compared to cash provided by our financing activities of $24,000 during 2004. We paid down $2.2 million of our $6.0 million United National Bank loan balance in early 2005 through funds generated by our operations. In March 2005, we paid the remaining balance of $3.8 million with our new line of credit through GMAC Commercial Finance. We borrowed $1.3 million more under our GMAC Commercial Finance line of credit, net of interim payments, to fund our operations.

On August 15, 2003, we entered into an asset-based business loan agreement with United National Bank. The agreement provided for a revolving loan of up to $6.0 million secured by substantially all of our assets and initially was to expire on September 1, 2004 and which, on numerous occasions in 2004 and 2005, was extended to its final expiration date on March 11, 2005. Advances of up to 65% of eligible accounts receivable bore interest at a floating interest rate equal to the prime rate of interest as reported in The Wall Street Journal plus 0.75%. The agreement also contained five restrictive financial covenants: our quick ratio had to be at least 1.0; our tangible net worth had to be no lower than $10.5 million; our debt to tangible net worth ratio could not exceed 2.0; our current ratio had to be no lower than 1.25 and we had to be profitable for the year ended December 31, 2004. As of December 31, 2004, we were in compliance with the quick and current ratio covenants. As of December 31, 2004, we were not in compliance with the tangible net worth, debt to tangible net worth ratio and profitability covenants. As a consequence, we were in default under our line of credit with United National Bank. On March 9, 2005, we replaced our asset-based line of credit with United National Bank with an asset-based line of credit with GMAC Commercial Finance.

Our asset-based line of credit with GMAC Commercial Finance expires on March 9, 2008 and allows us to borrow up to $10.0 million. The line of credit bears interest at a floating interest rate equal to the prime rate of interest plus 0.75%. This interest rate is adjustable upon each movement in the prime lending rate. If the prime lending rate increases, our interest rate expense will increase on an annualized basis by the amount of the increase multiplied by the principal amount outstanding under our credit facility. Our obligations under our loan agreement with GMAC Commercial Finance are secured by substantially all of our assets and guaranteed by our wholly-owned subsidiary, IOM Holdings, Inc. The loan agreement has one financial covenant which requires us to have a fixed charge coverage ratio of at least 1.2 to 1.0 for the three months ended June 30, 2005 and the six months ended September 30, 2005. The ratio becomes 1.5 to 1.0 for the nine months ended December 31, 2005, for the twelve month period ending March 31, 2006 and for each twelve month period ending on the end of each calendar quarter thereafter. We have been in violation of this financial covenant in the past and may be in violation of this financial covenant in the future. If we are unable to attain the financial covenant ratios, then GMAC Commercial Finance has the option to immediately terminate the line of credit and the unpaid principal balance and all accrued interest on the unpaid balance will then be immediately due and payable. If the loan were to be called and we were unable to obtain alternative financing, we would lack adequate funds to acquire inventory in amounts sufficient to sustain or expand our current sales operation. In addition, we would be unable to fund our day-to-day operations.

Our new credit facility was initially used to pay off our outstanding loan balance as of March 10, 2005 with United National Bank, which balance was approximately $3.8 million, and was also used to pay $25,000 of our closing fees in connection with securing the credit facility. As of December 31, 2005, we owed GMAC Commercial Finance approximately $5.1 million and had available to us approximately $279,000 of additional borrowings. As of that date, we were in breach of the financial covenant; however, we received a waiver of this breach from GMAC Commercial Finance on March 27, 2006.

On June 6, 2005, we entered into a new trade credit facility with Lung Hwa Electronics that replaced our previous $10.0 million trade credit facility. Under the terms of the new facility, Lung Hwa Electronics has agreed to purchase and manufacture inventory on our behalf. We can purchase an aggregate of up to $15.0 million of inventory manufactured by Lung Hwa Electronics or manufactured by third parties, in which case we use Lung Hwa Electronics as an international purchasing office. For inventory manufactured by third parties and purchased through Lung Hwa Electronics, the payment terms are 120 days following the date of invoice by Lung Hwa Electronics. Lung Hwa Electronics charges us a 5% handling fee on a supplier’s unit price. A 2% discount of the handling fee is applied if we reach an average running monthly purchasing volume of $750,000. Returns made by us, which are agreed to by a supplier, result in a credit to us for the handling charge. For inventory manufactured by Lung Hwa Electronics, the payment terms are 90 days following the date of invoice by Lung Hwa Electronics. We are to pay Lung Hwa Electronics, within one week of the purchase order, 10% of the purchase price on any purchase orders issued to Lung Hwa Electronics as a down-payment for the order. The trade credit facility has an initial term of one year after which the facility will continue indefinitely if not terminated at the end of the initial term. At the end of the initial term and at any time thereafter, either party has the right to terminate the facility upon 30 days’ prior written notice to the other party. The agreement containing the terms of the new trade credit facility was amended and restated on July 21, 2005 to provide that the new facility would be retroactive to April 29, 2005. As of December 31, 2005, we owed Lung Hwa Electronics $4.5 million in trade payables.

In February 2003, we entered into a Warehouse Services and Bailment Agreement with Behavior Tech Computer (USA) Corp., or BTC USA. Under the terms of the agreement, BTC USA has agreed to supply and store at our warehouse up to $10.0 million of inventory on a consignment basis. We are responsible for insuring the consigned inventory, storing the consigned inventory for no charge, and furnishing BTC USA with weekly statements indicating all products received and sold and the current level of consigned inventory. The agreement also provides us with a trade line of credit of up to $10.0 million with payment terms of net 60 days, without interest. The agreement may be terminated by either party upon 60 days’ prior written notice to the other party. As of December 31, 2005, we owed BTC USA $3.8 million under this arrangement. BTC USA is a subsidiary of Behavior Tech Computer Corp., one of our significant stockholders. Mr. Steel Su, a director of I/OMagic, is the Chief Executive Officer of Behavior Tech Computer Corp. See “Certain Relationships and Related Transactions.”

Lung Hwa Electronics and BTC USA provide us with significantly preferential trade credit terms. These terms include extended payment terms, substantial trade lines of credit and other preferential buying arrangements. We believe that these terms are substantially better terms than we could likely obtain from other subcontract manufacturers or suppliers. In fact, we believe that our trade credit facility with Lung Hwa Electronics is likely unique and could not be replaced through a relationship with an unrelated third party. If either of Lung Hwa Electronics or BTC USA does not continue to offer us substantially the same preferential trade credit terms, our ability to finance inventory purchases would be harmed, resulting in significantly reduced sales and profitability. In addition, we would incur additional financing costs associated with shorter payment terms which would also cause our profitability to decline. See “Certain Relationships and Related Transactions.”

Our net loss decreased by approximately 77% to $1.8 million in 2005 from $8.1 million in 2004. If our net losses continue or increase, we could experience significant shortages of liquidity and our ability to purchase inventory and to operate our business may be significantly impaired, which could lead to further declines in our operating performance and financial condition.

If, like Best Buy, any other of our major retailers, or a significant number of our smaller retailers, implement or expand private label programs covering products that compete with our products, our net sales will likely continue to decline

and our net losses are likely to increase, which in turn could have a material and adverse impact on our liquidity, financial condition and capital resources. Our sales to Best Buy have discontinued as a result of continued private label programs; however, management intends to use its best efforts to insure that we again engage Best Buy as one of our major retailers. We cannot assure you that Best Buy will again become one of our major retailers or that we will successfully sell any products through Best Buy.

Despite the decline in our results of operations in 2005, we believe that current and future available capital resources, revenues generated from operations, and other existing sources of liquidity, including our trade credit facilities with Lung Hwa Electronics and BTC USA and our credit facility with GMAC Commercial Finance will be sufficient to fund our anticipated working capital and capital expenditure requirements at least for the next twelve months. If, however, our capital requirements or cash flow vary materially from our current projections or if unforeseen circumstances occur, we may require additional financing. Our failure to raise capital, if needed, could restrict our growth, limit our development of new products or hinder our ability to compete.

Our backlog at December 31, 2005 and 2004 was $3.7 million. Based on historical trends, we anticipate that our December 31, 2005 backlog may be reduced by approximately 11%, or approximately $400,000, to a net amount of $3.3 million as a result of returns and reclassification of certain expenses as reductions to net sales. Our backlog may not be indicative of our actual sales beyond a rotating six-week cycle. The amount of backlog orders represents revenue that we anticipate recognizing in the future, as evidenced by purchase orders and other purchase commitments received from retailers. The shipment of these orders for non-consigned retailers or the sell-through of our products by consigned retailers causes recognition of the purchase commitments as revenue. However, there can be no assurance that we will be successful in fulfilling such orders and commitments in a timely manner, that retailers will not cancel purchase orders, or that we will ultimately recognize as revenue the amounts reflected as backlog based upon industry trends, historical sales information, returns and sales incentives.

The following table outlines payments due under our significant contractual obligations over the next five years, exclusive of interest:

The above table outlines our obligations as of December 31, 2005 and does not reflect the changes in our obligations that occurred after that date.

In March 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets,” which provides an approach to simplify efforts to obtain hedge-like (offset) accounting. This Statement amends FASB SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”, with respect to the accounting for separately recognized servicing assets and servicing liabilities. The Statement (1) requires an entity to recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in certain situations; (2) requires that a separately recognized servicing asset or servicing liability be initially measured at fair value, if practicable; (3) permits an entity to choose either the amortization method or the fair value method for subsequent measurement for each class of separately recognized servicing assets or servicing liabilities; (4) permits at initial adoption a one-time reclassification of available-for-sale securities to trading securities by an entity with recognized servicing rights, provided the securities reclassified offset the entity’s exposure to changes in the fair value of the servicing assets or liabilities; and (5) requires separate presentation of servicing assets and servicing liabilities subsequently measured at fair value in the balance sheet and additional disclosures for all separately recognized servicing assets and

servicing liabilities. SFAS No. 156 is effective for all separately recognized servicing assets and liabilities as of the beginning of an entity’s fiscal year that begins after September 15, 2006, with earlier adoption permitted in certain circumstances. The Statement also describes the manner in which it should be initially applied. We do not believe that SFAS No. 156 will have a material impact on our financial position, results of operations or cash flows.

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments”, which amends SFAS No. 133, “Accounting for Derivatives Instruments and Hedging Activities” and SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities.” SFAS No. 155 amends SFAS No. 133 to narrow the scope exception for interest-only and principal-only strips on debt instruments to include only such strips representing rights to receive a specified portion of the contractual interest or principle cash flows. SFAS No. 155 also amends SFAS No. 140 to allow qualifying special-purpose entities to hold a passive derivative financial instrument pertaining to beneficial interests that itself is a derivative instrument. We are currently evaluating the impact of this new standard but we believe that the new standard will not have a material impact on our financial position, results of operations, or cash flows.

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections,” an amendment to Accounting Principles Bulletin Opinion No. 20, “Accounting Changes,” and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements.” Though SFAS No. 154 carries forward the guidance in APB No. 20 and SFAS No. 3 with respect to accounting for changes in estimates, changes in reporting entity, and the correction of errors, SFAS No. 154 establishes new standards on accounting for changes in accounting principles, whereby all such changes must be accounted for by retrospective application to the financial statements of prior periods unless it is impracticable to do so. SFAS No. 154 is effective for accounting changes and error corrections made in fiscal years beginning after December 15, 2005, with early adoption permitted for changes and corrections made in years beginning after May 2005. We will implement SFAS No. 154 in our fiscal year beginning January 1, 2006. We are currently evaluating the impact of this new standard but we believe that it will not have a material impact on our financial position, results of operations, or cash flows.

In December 2004, the FASB issued SFAS No. 123(R), “Share-Based Payment”. SFAS 123(R) amends SFAS No. 123, “Accounting for Stock-Based Compensation”, and APB Opinion No. 25, “Accounting for Stock Issued to Employees”. SFAS No. 123(R) requires that the cost of share-based payment transactions (including those with employees and non-employees) be recognized in the financial statements. SFAS No. 123(R) applies to all share-based payment transactions in which an entity acquires goods or services by issuing (or offering to issue) its shares, share options, or other equity instruments (except for those held by an ESOP) or by incurring liabilities (1) in amounts based (even in part) on the price of the company’s shares or other equity instruments, or (2) that require (or may require) settlement by the issuance of a company’s shares or other equity instruments. This statement is effective (1) for public companies qualifying as SEC small business issuers, as of the first interim period or fiscal year beginning after December 15, 2005, or (2) for all other public companies, as of the first interim period or fiscal year beginning after June 15, 2005, or (3) for all nonpublic entities, as of the first fiscal year beginning after December 15, 2005. On April 14, 2005, the Securities and Exchange Commission amended the compliance dates to allow companies to implement SFAS No. 123(R) at the beginning of their next fiscal year, instead of the next reporting period, that begins after June 15, 2005, or December 15, 2005 for small business issuers. Management is currently assessing the impact of this statement on its financial position and results of operations.

In December 2004, the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets,” an amendment to Opinion No. 29, “Accounting for Nonmonetary Transactions”. SFAS No. 153 eliminates certain differences in the guidance in Opinion No. 29 as compared to the guidance contained in standards issued by the International Accounting Standards Board. The amendment to Opinion No. 29 eliminates the fair value exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. Such an exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. SFAS No. 153 is effective for nonmonetary asset exchanges occurring in periods beginning after June 15, 2005. Earlier application is permitted for nonmonetary asset exchanges occurring in periods beginning after December 16, 2004. This statement is not applicable to us.

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs”. SFAS No. 151 amends the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) under the guidance in ARB No. 43, Chapter 4, “Inventory Pricing”. Paragraph 5 of ARB No. 43, Chapter 4, previously stated that “. . . under some circumstances, items such as idle facility expense, excessive spoilage, double freight, and rehandling costs may be so abnormal as to require treatment as current period charges. . . .” This statement requires that those items be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal.” In addition, this statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. This statement is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. This statement is not applicable to us.

Our operations were not subject to commodity price risk during 2005. Our sales to a foreign country (Canada) were approximately 2.1% of our total sales, and thus we experienced negligible foreign currency exchange rate risk. We do not hedge against this risk.

On March 9, 2005, we replaced our asset-based line of credit with United National Bank with an asset-based line of credit with GMAC Commercial Finance. The new line of credit is for an amount of up to $10.0 million. The new line of credit provides for an interest rate equal to the prime lending rate plus 0.75%. This interest rate is adjustable upon each movement in the prime lending rate. If the prime lending rate increases, our interest rate expense will increase on an annualized basis by the amount of the increase multiplied by the principal amount outstanding under our credit facility.

Reference is made to the financial statements included in this report, which begin at Page F-1.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

We conducted an evaluation, with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, or the Exchange Act, as of December 31, 2005, to ensure that information required to be disclosed by us in the reports filed or submitted by us under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities Exchange Commission’s rules and forms, including to ensure that information required to be disclosed by us in the reports filed or submitted by us under the Exchange Act is accumulated and communicated to our management, including our principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that as of December 31, 2005, our disclosure controls and procedures were not effective at the reasonable assurance level due to the material weaknesses described below.

A material weakness is a control deficiency (within the meaning of the Public Company Accounting Oversight Board (PCAOB) Auditing Standard No. 2) or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. Management has identified the following two material weaknesses which have caused management to conclude that, as of December 31, 2005, our disclosure controls and procedures were not effective at the reasonable assurance level:

1. As a result of our restatement of prior periods’ financial statements as of and for the years ended December 31, 2003 and 2002 and for each of the quarterly periods in the years ended December 31, 2003 and 2002, and through the nine months ended September 30, 2004, we were unable to meet our requirements to timely file our Form 10-K for the year ended December 31, 2004 and our Form 10-Q for the quarter ended March 31, 2005. Although we were able to timely file our Forms 10-Q for the quarters ended June 30, 2005 and September 30, 2005, and our Form 10-K for the year ended December 31, 2005, management evaluated, in the first quarter of 2006 and as of December 31, 2005, the impact of our inability to timely file periodic reports with the Securities and Exchange Commission on our assessment of our disclosure controls and procedures and has concluded, in the first quarter of 2006 and as of December 31, 2005, that the control deficiency that resulted in the inability to timely make these filings represented a material weakness.

2. We did not maintain a sufficient complement of finance and accounting personnel to handle the matters necessary to timely file our Form 10-K for the year ended December 31, 2004 and our Form 10-Q for the quarter ended March 31, 2005. Although we were able to timely file our Forms 10-Q for the quarters ended June 30, 2005 and September 30, 2005,

and our Form 10-K for the year ended December 31, 2005, management evaluated the impact of our lack of sufficient finance and accounting personnel on our assessment of our disclosure controls and procedures and has concluded, in the first quarter of 2006 and as of December 31, 2005, that the control deficiency that resulted in our lack of sufficient personnel represented a material weakness.

To remediate the material weaknesses in our disclosure controls and procedures identified above, we have done the following, in the periods specified below, which correspond to the two material weaknesses identified above:

1. In connection with making the changes discussed above to our disclosure controls and procedures, in addition to working with our independent auditors, in the fourth quarter of 2004, we retained a third-party consultant, who is an experienced partner of a registered public accounting firm specializing in public company financial reporting, to advise us and our Audit Committee regarding our financial reporting processes. We also engaged, in the fourth quarter of 2004, another third-party accounting firm, other than our independent auditors, to assist us with our financial reporting processes. These third-parties have assisted us in altering our financial reporting processes, which we expect will better enable us to timely file our periodic reports. In the third quarter of 2005, we further improved our ability to timely make required filings by implementing additional automated reporting procedures with respect to product returns and sales incentives through enhancements to our MIS financial reporting system that expedite our internal reporting processes and our periodic reviews by our independent auditors. In addition, we allocated and continue to allocate part of the time of certain company personnel with accounting experience to assist us in generating reports and schedules necessary to timely file our periodic reports. Prior to this time, these personnel focused their time on other matters. We also intend, in 2006, to continue to implement enhancements to our financial reporting processes, including increased training of our finance and accounting staff regarding financial reporting requirements and the evaluation and further implementation of automated procedures within our MIS financial reporting system.

Management expects that the remediation described in item 1 immediately above will remediate the corresponding material weakness also described above by June 30, 2006. Management estimates that we have paid the third-party consultant approximately $37,000 in connection with his services and estimates that we have paid the third-party accounting firm approximately $63,000 in connection with its services. Management is unable to estimate our capital or other expenditures associated with the allocation of time of certain company personnel to assist us in generating reports and schedules necessary to timely file our periodic reports, our enhancements to our MIS financial reporting system or our additional capital or other expenditures related to higher fees paid to our independent auditors in connection with their review of this remediation.

2. Management believes that the procedures we implemented in connection with the restatement of our financial statements, and the circumstances surrounding the restatement, have led to a greater depth of understanding by management of revenue recognition principles. Management also believes that these procedures, and the circumstances surrounding the restatement, have led to improved and expedited financial reporting processes as a result of more detailed and accurate recording of sales incentives and product returns as they relate to revenue recognition. In addition, management believes that these procedures, and the circumstances surrounding the restatement, have led to improved and expedited financial reporting processes as a result of more detailed and accurate recording of charges to our inventory reserve. Management further believes that the involvement of the third-party consultant and the third-party accounting firm, as discussed above, has led to improved procedures and controls with respect to these matters. In addition, as noted above, we allocated and continue to allocate part of the time of certain company personnel with accounting experience to assist us in generating reports and schedules necessary to timely file our periodic reports and we believe that this has assisted us, and will continue to assist us, in timely filing our periodic reports.

Management expects that the remediation described in item 2 immediately above will remediate the corresponding material weakness also described above by June 30, 2006. As noted above, management estimates that we have paid the third-party consultant approximately $37,000 in connection with his services and estimates that we have paid the third-party accounting firm approximately $63,000 in connection with its services. Management is unable to estimate our capital or other expenditures associated with the allocation of time of certain company personnel to assist us in generating reports and schedules necessary to timely file our periodic reports or our additional capital or other expenditures related to higher fees paid to our independent auditors in connection with their review of this remediation.

There were no changes during our most recently completed fiscal quarter that have materially affected or are reasonably likely to materially affect, our internal control over financial reporting, as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act.

The names, ages and positions held by our directors and executive officers as of March 31, 2006 and their business experience are as follows:

Tony Shahbaz is a founder of I/OMagic and has served as our Chairman of the Board, President, Chief Executive Officer, Secretary and as a director since September 1993, and as our Chief Financial Officer from September 1993 to October 2002. Prior to founding I/OMagic, Mr. Shahbaz was employed by Western Digital Corporation from September 1986 to March 1993. During his tenure at Western Digital Corporation, Mr. Shahbaz held several positions including Vice President of Worldwide Sales for its Western Digital Paradise division, and Regional Director of Asia Pacific Sales and Marketing Operations.

Steve Gillings has served as our Chief Financial Officer since October 2002. Prior to assuming this position, Mr. Gillings served as our Vice President of Finance from October 2000 to October 2002 and as our Controller from November 1997 to October 2000. Mr. Gillings received a B.S. degree in Accounting from the University of California at Berkeley in 1971 and an M.B.A. degree in Finance from California State University Fullerton in 1992.

Steel Su has served as a director of I/OMagic since September 2000 and is a founder of Behavior Tech Computer Corp., one of our principal subcontract manufacturers and stockholders and has served as its Chairman since 1980. Mr. Su has served and continues to serve as a director or chairman of the following affiliates of Behavior Tech Computer Corp.: Behavior Design Corporation (chairman), Behavior Tech Computer (USA) Corp. (chairman), Behavior Tech Computer Affiliates, N.V. (chairman) and BTC Korea Co., Ltd. (director). Mr. Su has served as chairman of Gennet Technology Corp., Emprex Technologies Corp., Maritek Inc. and MaxD Technology Inc. since 1992, 1998, 1999 and 2000, respectively. Mr. Su has also served as a director of Aurora Systems Corp. and Wearnes Peripherals International (PTE) Limited since 1998 and 2000, respectively. Mr. Su received a B.S. degree in Electronic Engineering from Ching Yuan Christian University, Taiwan in 1974 and an M.B.A. degree from National Taiwan University in 2001.

Daniel Hou has served as a director of I/OMagic since January 1998. Since 1986, Mr. Hou has served as the President of Hou Electronics, Inc., a computer peripheral supplier that he founded and that is one of our stockholders. Mr. Hou is a member and past President of the Southern California Chinese Computer Association and is an active member of the American Chemistry Society. Mr. Hou received a B.A. degree in Chemistry from National Chung-Hsing University, Taiwan in 1973 and a Masters degree in Material Science from the University of Utah in 1978.

Daniel Yao has served as a director of I/OMagic since February 2001 and has been a Chief Strategy Officer for Ritek Corporation, an affiliate of Citrine Group Limited, one of our stockholders, since July 2000. Prior to joining Ritek, Mr. Yao served as the Senior Investment Consultant for Core Pacific Securities Capital from July 1998 to July 2000. Prior to that, Mr. Yao was an Executive Vice President for ABN Amro Bank in Taiwan from July 1996 to July 1998. Mr. Yao received a B.A. degree in Business Management from National Taiwan University in 1978 and an M.B.A. degree from the University of Rochester in New York in 1984.

Dr. William Ting has served as a director of I/OMagic since December 2005. Dr. Ting is currently Chairman of the Global Advisory Committee for Redwood Securities. Prior to that, Dr. Ting was founder, Chairman and CEO of US-Sino Gateway from 2002 to 2005. Prior to that, Dr. Ting was CEO of Adminisoft in 2001, President and CEO of DataQuad in

2000, President and CEO of BMDP Statistical Software from 1991 to 1992, and Corporate Director of Financial Planning and Corporate Vice President of Information Technology of Geneva Companies from 1989 to 1991. Dr. Ting served as Director of Strategic Planning at Northrop EMD from 1986 to 1989. Dr. Ting served as Manager of Market Research, Manager of International Offset and Director of Planning at General Dynamics units from 1982 To 1986. Dr. Ting was an assistant professor of political science at the University of Michigan from 1978 to 1982. Dr. Ting received a B.A. degree in Political Science from Illinois State University in 1970, an M.A. in Political Science from Illinois State University in 1972 and a Ph.D. in Political Science from the University of Washington in 1976.

Our directors are elected annually and hold office until the next annual meeting of stockholders, until their respective successors are elected and qualified or until their earlier death, resignation or removal.

Section 16(a) of the Securities Exchange Act of 1934, as amended, requires our executive officers, directors and persons who beneficially own more than 10% of a registered class of our equity securities (“reporting persons”) to file initial reports of ownership and reports of changes in ownership of our common stock and other equity securities with the Securities and Exchange Commission. The reporting persons are required by the Securities and Exchange Commission regulations to furnish us with copies of all reports that they file.

Based solely upon a review of copies of the reports furnished to us during our fiscal year ended December 31, 2005 and thereafter, or any written representations received by us from reporting persons that no other reports were required, we believe that all Section 16(a) filing requirements applicable to our reporting persons during 2005 were complied with, except as described below.

The following individuals did not timely file the following numbers of Forms 4 to report the following numbers of transactions: Tony Shahbaz — 1 report, 1 transaction; Steel Su — 1 report, 1 transaction; Daniel Yao — 1 report, 1 transaction; Daniel Hou — 1 report, 1 transaction; and Steve Gillings — 1 report, 1 transaction.

Our board of directors has adopted a Code of Business Conduct and Ethics that applies to all of our directors, officers and employees and an additional Code of Business Ethics that applies to our Chief Executive Officer and senior financial officers.

We intend to satisfy the disclosure requirement under Item 10 of Form 8-K relating to amendments to or waivers from provision of these codes that relate to one or more of the items set forth in Item 406(b) of Regulation S-K, by describing on our Internet website, within five business days following the date of a waiver or a substantive amendment, the date of the waiver or amendment, the nature of the waiver or amendment, and the name of the person to whom the waiver was granted.

Information on our Internet website is not, and shall not be deemed to be, a part of this prospectus or incorporated into any other filings we make with the SEC.

The following table provides information concerning the annual and long-term compensation for the years ended December 31, 2005, 2004 and 2003 earned for services in all capacities as an employee by our Chief Executive Officer and each of our other executive officers who received an annual salary and bonus of more than $100,000 for services rendered to us during 2005:

The following table provides information regarding options granted in the year ended December 31, 2005 to the executive officers named in the summary compensation table. We did not grant any stock appreciation rights during 2005. This information includes hypothetical potential gains from stock options granted in 2005. These hypothetical gains are based entirely on assumed compounded annual growth rates of 5% and 10% in the value of our common stock price over the five-year life of the stock options granted in 2005. These assumed rates of growth were selected by the Commission for illustrative purposes only and are not intended to predict future stock prices, which will depend upon market conditions and our future performance and prospects.

The following table provides information regarding the value of unexercised options held by the named executive officers as of December 31, 2005. None of the named executives officers acquired shares through the exercise of options during 2005.

Employment Contracts and Termination of Employment and Change-in-Control Arrangements

On October 15, 2002, we entered into an employment agreement with Tony Shahbaz. Under the terms of the employment agreement, which were retroactively effective as of January 1, 2002, Mr. Shahbaz serves as our President and Chief Executive Officer and is entitled to receive an initial annual salary of $198,500 and is eligible to receive quarterly bonuses equal to 7% of our quarterly net income. Mr. Shahbaz is also entitled to a monthly car allowance equal to $1,200.

The employment agreement terminates on October 15, 2007; however, it is subject to automatic renewal. Under the terms of the employment agreement, if Mr. Shahbaz is terminated for cause, he is entitled to receive four times his annual salary and any and all warrants and options granted to him shall be extended an additional seven years from date of termination and upon termination without cause, he is entitled to receive his remaining salary amount for the remaining outstanding term of the agreement. Mr. Shahbaz’s employment agreement further provides that the agreement shall not be terminated without the prior written consent of Mr. Shahbaz in the event of a merger, transfer of assets, or dissolution of I/OMagic, and that the rights, benefits, and obligations under the agreement shall be assigned to the surviving or resulting corporation or the transferee of our assets.

Our board of directors currently has an Audit Committee, a Compensation Committee and a Nominating Committee.

The Audit Committee selects our independent auditors, reviews the results and scope of the audit and other services provided by our independent auditors and reviews our financial statements for each interim period and for our year end. This committee consisted solely of Messrs. Hou and Yao from November 2002 until December 2005 when Dr. Ting was added as the third member of our Audit Committee. Our board of directors has determined that Mr. Yao and Dr. Ting are Audit Committee financial experts. Our board of directors has also determined that Messrs. Hou and Yao and Dr. Ting are “independent” as defined in NASD Marketplace Rule 4200(a)(15). We currently satisfy the requirements of Nasdaq that we have an audit committee comprised of at least three independent directors.

The Compensation Committee is responsible for establishing and administering our policies involving the compensation of all of our executive officers and establishing and recommending to our board of directors the terms and conditions of all employee and consultant compensation and benefit plans. This committee consisted solely of Messrs. Hou and Yao from April 2004 until December 2005 when Dr. Ting was added as the third member of our Compensation Committee.

The Nominating Committee selects nominees for the board of directors. This committee consisted solely of Messrs. Hou and Yao from April 2004 until December 2005 when Dr. Ting was added as the third member of our Nominating Committee. The Nominating Committee utilizes a variety of methods for identifying and evaluating nominees for director, including candidates that may be referred by stockholders. Stockholders that desire to recommend candidates for evaluation may do so by contacting I/OMagic in writing, identifying the potential candidate and providing background information. Candidates may also come to the attention of the Nominating Committee through current board members, professional search firms and other persons. In evaluating potential candidates, the Nominating Committee will take into account a number of factors, including, among others, the following:

None of our executive officers served on the compensation committee of another entity or on any other committee of the board of directors of another entity performing similar functions during 2005. During 2003 and until April 2004, Mr. Shahbaz, our Chief Executive Officer, President and Secretary, was a member of the Compensation Committee. While a member of that committee, Mr. Shahbaz did not make any salary recommendations to our Compensation Committee or our board of directors regarding salary increases for key executives.

Except as follows, our directors do not receive any compensation for their services. Dr. Ting is to be compensated at the rate of $1,500 per meeting of our board of directors or its committees attended by Dr. Ting. In addition, each director is entitled to reimbursement of his reasonable expenses incurred in attending board of directors’ meetings.

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

As of March 31, 2006, a total of 4,562,847 shares of our common stock were outstanding. The following table sets forth information as of that date regarding the beneficial ownership of our common stock by:

Beneficial ownership is determined in accordance with the rules of the Securities and Exchange Commission and generally includes voting or investment power with respect to securities. Except as indicated in the footnotes to the table, we believe each security holder possesses sole voting and investment power with respect to all of the shares of common stock owned by such security holder, subject to community property laws where applicable. In computing the number of shares beneficially owned by a security holder and the percentage ownership of that security holder, shares of common stock subject to options, warrants or preferred stock held by that person that are currently exercisable or convertible or are exercisable or convertible into shares of common stock within 60 days after the date of the table are deemed outstanding. Those shares, however, are not deemed outstanding for the purpose of computing the percentage ownership of any other person or group.

The following table provides information about our common stock that may be issued upon the exercise of options, warrants, and rights under all of our existing equity compensation plans as of December 31, 2005.

In January 2003, we entered into a trade credit facility with Lung Hwa Electronics, one of our stockholders, subcontract manufacturers and suppliers. Under the terms of the facility, Lung Hwa Electronics agreed to purchase inventory on our behalf. We could purchase up to $10.0 million of this inventory from Lung Hwa Electronics, with payment terms of 120 days following the date of invoice. Lung Hwa Electronics charged us a 5% handling fee on a supplier’s unit price. A 2% discount of the handling fee, so that the net handling fee was 3%, was applied if we reached an average running monthly purchasing volume of $750,000. Returns made by us, which were agreed to by a supplier, resulted in a credit to us for the handling charge. As security for the trade credit facility, we paid Lung Hwa Electronics a $1.5 million security deposit during 2003. As of December 31, 2004, $1.5 million of this deposit had been applied against outstanding trade payables as allowed under the trade credit facility agreement. This trade credit facility was for an indefinite term, however, either party had the right to terminate the facility upon 30 days’ written notice to the other party. In connection with the entry into the new trade credit facility with Lung Hwa Electronics described below, we entered into a Termination Agreement effective June 6, 2005 that terminated our $10.0 million trade credit facility with Lung Hwa Electronics.

As of December 31, 2005, we owed Lung Hwa Electronics $4.5 million in trade payables. As of December 31, 2004, we owed Lung Hwa Electronics $0 million in trade payables. During 2005, we purchased $7.9 million of inventory from Lung Hwa Electronics. During 2004, we purchased $2.5 million of inventory from Lung Hwa Electronics. During 2003, we purchased $12.7 million of inventory from Lung Hwa Electronics.

We believe that many of the terms available to us under our trade credit facility with Lung Hwa Electronics are advantageous as compared to terms available from unrelated third parties. For example, Lung Hwa Electronics extends us 120 day payment terms. We believe that the best payment terms that we could likely obtain from unrelated third parties would be 60-day payment terms; however, payment in advance or within 30 days is more customary. Also, Lung Hwa Electronics charges us a 5% handling fee on a supplier’s unit price, but applies a 2% discount of the handling fee, so that the net handling fee is 3%, if we reach an average running monthly purchasing volume of $750,000. In addition, under our trade credit facility with Lung Hwa Electronics, the level of security provided by us to Lung Hwa Electronics was initially $1.5 million, and is currently only 10% of each product order, for a $15.0 million trade credit facility. We believe that the payment terms, handling fee and the level of security required are all substantially better terms that we could obtain from unrelated third parties. In fact, we believe that our trade credit facility is likely unique and could not be replaced through a relationship with an unrelated third party.

Our relationship and our trade credit facility with Lung Hwa Electronics enables us to acquire products from manufacturers who we believe are some of the largest electronics manufacturers in the world. We buy products through Lung Hwa Electronics by using Lung Hwa Electronics’ size and purchasing power as a source of credit strength. If we were to acquire these products directly from the manufacturers, we would likely be required to send payment in advance of shipment of those products. Due to our relatively small size, we would likely be unable to qualify for extended payment terms of even 30 days. Accordingly, we believe that our relationship and trade credit facility with Lung Hwa Electronics is likely unique, could not be replaced through a relationship with an unrelated third party and is important in enabling us to secure certain products that we sell.

In February 2003, we entered into a Warehouse Services and Bailment Agreement with BTC USA, an affiliate of several of our stockholders, namely BTC, BTC Korea Co., Ltd., Behavior Tech Computer (BVI) Corp. and BTC Taiwan, as well as an affiliate of one of our principal subcontract manufacturers, namely Behavior Tech Computer Corp. Under the terms of the agreement, BTC USA has agreed to supply and store at our warehouse up to $10.0 million of inventory on a consignment basis. We are responsible for insuring the consigned inventory, storing the consigned inventory for no charge; and furnishing BTC USA with weekly statements indicating all products received and sold and the current level of consigned inventory. The agreement also provides us with a trade line of credit of up to $10.0 million with payment terms of net 60 days, without interest. The agreement may be terminated by either party upon 60 days’ prior written notice to the other party. As of December 31, 2005, we owed BTC USA $3.8 million under this arrangement. As of December 31, 2004, we owed BTC USA $7.3 million under this arrangement. During 2005, we purchased $16.6 million of inventory from BTC USA. During 2004, we purchased $19.2 million of inventory from BTC USA. During 2003 we purchased $20.1 million of inventory from BTC USA. Steel Su, a director of I/OMagic, is the Chief Executive Officer of BTC. BTC USA, its affiliates and Mr. Su also have beneficial ownership in or are otherwise affiliated with the following affiliates of BTC and BTC USA: BTC Korea Co., Ltd., Behavior Tech Computer (BVI) Corp., BTC Taiwan, Susha, LLC, a Nevada limited liability company, and Susha, LLC, a California limited liability company, each of which is also a stockholder of our company. Mr. Shahbaz, our Chief Executive Officer, President, Secretary and a Director, also has beneficial ownership in, and sole voting control of, Susha, LLC, a Nevada limited liability company, and Susha, LLC, a California limited liability company. See “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.”

We believe that many of the terms available to us under our Warehouse Services and Bailment Agreement with BTC USA are advantageous as compared to terms available from unrelated third parties. For example, this Agreement allows us to store up to $10.0 million of consigned inventory at our warehouse, without obligation to pay BTC USA for the inventory until 60 days after we take title to the inventory. We believe that it is unlikely that unrelated third parties would permit this consignment arrangement and that we would instead be subject to standard payment terms, the best of which would likely be 60-day payment terms; however, either payment in advance or within 30 days is more customary. Our $10.0 million line of credit with 60 days payment terms without interest may also permit terms better than we could obtain from unrelated third parties. The best payment terms under a line of credit with a unrelated third party subcontract manufacturer or supplier would likely be 60 day payment terms; however, payment in advance or within 30 days is more customary.

Our relationships with Lung Hwa Electronics and BTC USA provide us with numerous advantages. We believe that both entities are significant suppliers within their industries and have substantial manufacturing and product development capabilities and resources. The advantageous terms we are able to obtain from them allow us to utilize more capital resources for other aspects of our business and to remain competitive with larger, more established companies. In addition, we are better able to manage our cash flow as a result of our significant trade line of credit with Lung Hwa Electronics and our consignment arrangement with BTC USA. We believe that these advantageous terms contribute positively to our results of operations.

In the past, equity investments by Lung Hwa Electronics and BTC USA, or its affiliates, have enabled us to obtain inventory with little or no cash expenditures, which we believe has helped us establish, maintain and grow our business. We believe that our relationships with these related parties has in the past benefited our business and contributed positively to our historical results of operations.

We leased our previous facility, located in Santa Ana, California, from January 2001 through September 2003 from Alex Properties, an entity owned through late March 2003 by Mr. Shahbaz, our Chief Executive Officer, President, Secretary and Director, and Mr. Su, a director and beneficial owner of I/OMagic. In late March 2003, the ownership of Alex Properties was transferred to Mark Vakili as part of the settlement of a lawsuit. See “Business — Legal Proceedings” elsewhere in this report. In 2003, we paid $86,000 to Alex Properties for rent while it was owned by Mr. Shahbaz and Mr. Su.

In March 2004, we granted to our directors and officers options to purchase an aggregate of 97,000 shares of our common stock. Of this amount, Tony Shahbaz, our President, CEO and Secretary, and one of our directors, received options to purchase 59,000 shares of our common stock at an exercise price of $3.85 per share; Steel Su, one of our directors, received options to purchase 3,000 shares of our common stock at an exercise price of $3.85 per share; Daniel Hou, one of our directors, received options to purchase 3,000 shares of our common stock at an exercise price of $3.50 per share; Daniel Yao, one of our directors, received options to purchase 3,000 shares of our common stock at an exercise price of $3.50 per share; Steve Gillings, our Chief Financial Officer, received options to purchase 13,000 shares of our common stock at an exercise price of $3.50 per share; Tony Andrews, who at the time of grant was one of our directors, but who has since resigned, received options to purchase 13,000 shares of our common stock at an exercise price of $3.50 per share; and Young-Hyun Shin, who at the time of grant was one of our directors, but who was not reelected, received options to purchase 3,000 shares of our common stock at an exercise price of $3.50 per share. These options vested immediately as to 40% of the underlying shares with the balance vesting in equal installments in each of the 36 months following the date of grant. The options held by Messrs. Shahbaz and Su expire 5-years following the date of grant and the options held by other directors and officers, other than Messrs. Andrews and Shin, expire 10-years following the date of grant. Of the options held by Mr. Andrews, a portion was exercised and Mr. Andrews received 1,900 shares of our common stock, and the balance of options to purchase 11,100 shares of our common stock were terminated following Mr. Andrews’ cessation as a member of our board of directors. The options held by Mr. Shin terminated following his cessation as a member of our board of directors.

In July 2005, we granted to our directors and officers options to purchase an aggregate of 255,000 shares of our common stock. Of this amount, Mr. Shahbaz received options to purchase 105,000 shares of our common stock at an exercise price of $2.75 per share; Mr. Su received options to purchase 25,000 shares of our common stock at an exercise price of $2.75 per share; Mr. Hou received options to purchase 30,000 shares of our common stock at an exercise price of $2.50 per share; Mr. Yao received options to purchase 30,000 shares of our common stock at an exercise price of $2.50 per share; and Mr. Gillings received options to purchase 65,000 shares of our common stock at an exercise price of $2.50 per share. These options vested immediately as to 50% of the underlying shares with the balance vesting in equal installments in each of the 48 months following the date of grant. The options expire 5-years following the date of grant.

In December 2005, we paid to William Ting, one of our directors, $350 for his time spent with our management on strategic financial and product review and analysis.

We are a party to an employment agreement with Mr. Shahbaz. See “Management — Employment Contracts and Termination of Employment and Change-in-Control Arrangements.”

The following table sets forth the aggregate fees billed to us by Singer Lewak Greenbaum & Goldstein LLP for professional services rendered for the years ended December 31, 2005 and 2004:

Audit Fees. Consists of fees billed for professional services rendered for the audit of I/OMagic’s consolidated financial statements and review of the interim consolidated financial statements included in quarterly reports and services that are normally provided by Singer Lewak Greenbaum & Goldstein LLP in connection with statutory and regulatory filings or engagements.

Audit-Related Fees. Consists of fees billed for professional services for consents relating to I/OMagic’s registration statement, and amendments thereto, on Form S-1.

Tax Fees. Consists of fees billed for professional services for tax compliance, tax advice and tax planning. These services include assistance regarding federal, state and international tax compliance, tax audit defense, customs and duties, mergers and acquisitions, and international tax planning.

Our audit committee pre-approves all services provided by Singer Lewak Greenbaum & Goldstein LLP.

Reference is made to the financial statements and financial statement schedule listed on and attached following the Index to Consolidated Financial Statements and Supplemental Information contained on page F-1 of this report.

Reference is made to the exhibits listed on the Index to Exhibits that follows the financial statements and financial statement schedule.

We have audited the accompanying consolidated balance sheets of I/OMagic Corporation and subsidiaries (collectively, the “Company”) as of December 31, 2005 and 2004, and the related consolidated statements of operations, retained earnings and cash flows for each of the three years in the period ended December 31, 2005. 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 audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes 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 provided a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of I/OMagic Corporation and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America.

The Company did not have any non-cash transactions during the years ended December 31, 2005, 2004 and 2003.

I/OMagic Corporation (“I/OMagic”), a Nevada corporation, and its subsidiary IOM Holdings, Inc. (collectively, the “Company”) develops, manufactures through subcontractors or obtains from suppliers, markets, and distributes data storage and digital entertainment products for the consumer electronics market. The Company sells its products in the United States and Canada to distributors and retailers. On July 6, 2004 the Company completed the merger of its wholly owned subsidiary, I/OMagic Corporation, a California corporation, with and into the Company.

The consolidated financial statements include the accounts of I/OMagic and its subsidiary, IOM Holdings, Inc. All material intercompany accounts and transactions have been eliminated.

The Company recognizes revenue in accordance with Staff Accounting Bulletin (“SAB”) 101, “Revenue Recognition”, updated by SAB’s 103 and 104, “Update of Codification of Staff Accounting Bulletins.” Under SAB 104, revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the seller’s price to the buyer is fixed or determinable, and collectibility is reasonably assured. The Company applies the specific provisions of Statement of Financial Accounting Standards (“SFAS”) No. 48, “Revenue Recognition when Right of Return Exists.” Under SFAS No. 48, product revenue is recorded at the transfer of title to the products to a retailer, net of estimated allowances and returns and sales incentives. Transfer of title occurs and risk of ownership passes to a retailer at the time of shipment or delivery, depending on the terms of the Company’s agreement with a particular retailer. The criteria for revenue recognition in SFAS No. 48 are satisfied as follows: the sales price is substantially fixed or determinable at the date of sale; there is an obligation by the retailer to pay the Company which is not contingent upon resale of the product by the retailer and which does not change if the product is stolen or damaged while in the retailer’s possession; the retailer has separate economic substance (is an independent third party unaffiliated with the Company); the Company does not have significant obligations to the retailer for future performance at the time of sale to directly bring about the sale of the product by the retailer; and, the amount of future returns can be reasonably estimated (based upon the Company’s prior periods’ actual returns). For transactions not satisfying the conditions for revenue recognition under SFAS No. 48, product revenue is deferred until the conditions are met, net of an estimate for cost of sales. Consignment sales are recognized when the Company’s retailers sell its products to retail customers, at which point the retailers incur an obligation to pay the Company.

In accordance with EITF 01-9, “Accounting for Consideration Given by a Vendor to a Customer including a Reseller of the Vendor’s Products,” the Company reduces its product revenue for marketing promotions, Market Development Fund and Cooperative Advertising costs.

The Company recognizes revenue under three primary sales models: a standard terms sales model, a consignment sales model and a special terms sales model. The Company generally uses one of these three primary sales models, or some combination of these sales models, with each of its retailers. Under each of these sales models the Company’s payment terms are explicitly stated and agreed to by the Company and the retailer before goods are shipped, thereby making our fee fixed or determinable before revenue is recognized.

Under the Company’s standard terms sales model, a retailer is obligated to pay the Company for products sold to it within a specified number of days from the date that title to the products is transferred to the retailer. The Company’s standard terms are typically net 60 days from the transfer of title to the products to a retailer. The Company typically collects payment from a retailer within 60 to 75 days from the transfer of title to the products to a retailer. Transfer of title occurs and risk of ownership passes to a retailer at the time of shipment or delivery, depending on the terms of the Company’s agreement with a particular retailer. The sale price of the Company’s products is substantially fixed or determinable at the date of sale based on purchase orders generated by a retailer and accepted by the Company. A retailer’s obligation to pay the Company for products sold to it under the Company’s standard terms sales model is not contingent upon the resale of those products. The Company recognizes revenue for standard terms sales at the time title to products is transferred to a retailer, net of an estimate for sales incentives, rebates and returns.

Under the Company’s consignment sales model, a retailer is obligated to pay the Company for products sold to it within a specified number of days following notification to the Company by the retailer of the resale of those products. Retailers notify the Company of their resale of consigned products by delivering weekly or monthly sell-through reports. A sell-through report discloses sales of products sold in the prior period covered by the report — that is, a weekly or monthly sell-through report covers sales of consigned products in the prior week or month, respectively. The period for payment to the Company by retailers relating to their resale of consigned products corresponding to these sell-through reports varies from retailer to retailer. For sell-through reports generated weekly, the Company typically collects payment from a retailer within 30 days of the receipt of those reports. For sell-through reports generated monthly, the Company typically collects payment from a retailer within 15 days of the receipt of those reports. At the time of a retailer’s resale of a product, title is transferred directly to the consumer. Risk of theft or damage of a product, however, passes to a retailer upon delivery of that product to the retailer. The sale price of the Company’s products is substantially fixed or determinable at the date of sale based on a product sell-through report generated by a retailer and delivered to the Company. Except in the case of theft or damage, a retailer’s obligation to pay the Company for products transferred under the Company’s consignment sales model is entirely contingent upon the resale of those products. Products held by a retailer under the Company’s consignment sales model are recorded as the Company’s inventory at offsite locations until their resale by the retailer. Because the Company retains title to products in its consignment sales channels until their resale by a retailer, revenue is not recognized until the time of resale. Accordingly, price modifications to inventory maintained in the Company’s consignment sales channels do not have an effect on the timing of revenue recognition. The Company recognizes revenue for consignment sales in the period during which resale occurs.

Under the Company’s special terms sales model, the payment terms for the purchase of the Company’s products are negotiated on a case-by-case basis and typically cover a specified quantity of a particular product. The result of the Company’s negotiations is a special agreement with a retailer that defines how and when transfer of title occurs and risk of ownership shifts to the retailer.

The Company ordinarily does not offer any rights of return or rebates for products sold under its special terms sales model. A retailer is obligated to pay the Company for products sold to it within a specified number of days from the date that title to the products is transferred to the retailer, or as otherwise agreed to by the Company. The Company’s payment terms are ordinarily shorter under its special terms sales model than under its standard terms or consignment sales models and the Company typically requires payment in advance, at the time of transfer of title to the products or shortly following the transfer of title to the products to a retailer. However, under its special terms sales model, the Company often requires payment in advance or at the time of transfer of title to the products to a retailer. Transfer of title occurs and risk of ownership passes to a retailer at the time of shipment, delivery, receipt of payment or the date of invoice, depending on the terms of the Company’s agreement with the retailer. The sale price of the Company’s products is substantially fixed or determinable at the date of sale based on the Company’s agreement with a retailer. A retailer’s obligation to pay the Company for products sold to it under the Company’s special terms sales model is not contingent upon the resale of those products. The Company recognizes revenue for special terms sales at the time title to products is transferred to a retailer.

The Company utilizes SFAS No. 130, “Reporting Comprehensive Income.” This statement establishes standards for reporting comprehensive income and its components in a financial statement. Comprehensive income as defined includes all changes in equity (net assets) during a period from non-owner sources. Examples of items to be included in comprehensive income, which are excluded from net income, include foreign currency translation adjustments and unrealized gains and losses on available-for-sale securities. For the years ended December 31, 2005, 2004, and 2003, comprehensive income is not presented in the Company’s financial statements since the Company did not have any of the items of comprehensive income in any period presented.

Gains and losses from foreign currency transactions, such as those resulting from the settlement of foreign receivables, are included in the consolidated statement of operations.

For purposes of the statements of cash flows, the Company considers all highly liquid investments purchased with original maturities of three months or less to be cash equivalents.

Cash of $30,864 at December 31, 2005 was restricted to pay down any outstanding balance on the Company’s line of credit with GMAC Commercial Finance LLC (“GMAC”). Cash of $1,044,339 at December 31, 2004 was restricted to pay down any outstanding balance on the Company’s line of credit with United National Bank.

Inventory is stated at the lower of cost, using the weighted-average method, which approximates the first-in, first-out method, or market.

The Company’s products are subject to limited warranties ranging in duration of up to one year. These warranties cover only repair or replacement of the product. The Company’s subcontract manufacturers and suppliers provide the Company with warranties of a duration at least as long as the warranties provided by the Company to consumers. The warranties provided by the Company’s subcontract manufacturers and suppliers cover repair or replacement of the product. The Company has a specific right of offset against its subcontract manufacturers and suppliers for defective products, therefore the amount of the Company’s warranty claims is not material.

Property and equipment are recorded at cost, less accumulated depreciation and amortization. Depreciation and amortization are provided using the straight-line method over estimated useful lives as follows:

Expenditures for major renewals and betterments that extend the useful lives of property and equipment are capitalized. Expenditures for maintenance and repairs are charged to expense as incurred. Depreciation expense on assets acquired under capital leases is included with depreciation expense on owned assets.

The Hi-Val^® and Digital Research Technologies^® trademarks acquired in April 2000 were originally being amortized over a 5-year period. A valuation in early 2002 established that the trademarks had an additional 10-year life. Therefore, effective with the second quarter 2002, the Company extended the amortization period by ten years. The Company continually evaluates whether events or circumstances have occurred that indicate the remaining estimated value of the trademarks may not be recoverable.

In accordance with SFAS No. 142, “Goodwill and other Intangible Assets,” the Company conducted its required valuation on the trademarks for possible impairment as of December 31, 2004. Based upon this valuation, the Company determined that there had been a significant impairment in the value of the trademarks due to lower sales of products under the Hi-Val^® and Digital Research Technologies^® brands in 2004 and lower sales forecasted by the Company for subsequent periods. Therefore, the Company wrote down the value of the trademarks by $3,696,099 as of December 31, 2004. This writedown will result in a reduction of $509,808 in amortization expense to $68,928 from $578,736 in each of the following five years.

The Company adopted SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” SFAS No. 144 requires impairment losses to be recorded on long-lived assets used in operations when indicators of impairment are present and the undiscounted cash flows estimated to be generated by those assets are less than the assets’ carrying amount. Management determined that there was no impairment of long-lived assets during the years ended December 31, 2005, 2004, and 2003 other than the impairment of the Company’s Hi-Val^® and Digital Research Technologies^® trademarks during the year ended December 31, 2004.

For certain of the Company’s financial instruments, including cash and cash equivalents, accounts receivable, prepaid expenses and other current assets, line of credit, accounts payable and accrued expenses, accounts payable—related parties, reserve for customer returns and allowances, and settlement payable, the carrying amounts approximate fair value due to their short maturities.

SFAS No. 123, “Accounting for Stock-Based Compensation” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure,” establishes and encourages the use of the fair value based method of accounting for stock-based compensation arrangements under which compensation cost is determined using the fair value of stock-based compensation determined as of the date of grant and is recognized over the periods in which the related services are rendered. The statement also permits companies to elect to continue using the current intrinsic value accounting method specified in Accounting Principles Bulletin (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” to account for stock-based compensation issued to employees. The Company has elected to use the intrinsic value based method and has disclosed the pro forma effect of using the fair value based method to account for its stock-based compensation. For stock-based compensation issued to non-employees, the Company uses the fair value method of accounting under the provisions of SFAS No. 123.

Pro forma information regarding net loss and loss per share is required by SFAS No. 123 and has been determined as if the Company had accounted for its employee stock options under the fair value method of SFAS No. 123. For the year ended December 31, 2005 options to purchase up to 370,000 shares of common stock of the Company were granted. For the year ended December 31, 2004 options to purchase up to 126,375 shares of common stock of the Company were granted. For the year ended December 31, 2003 no options were granted.

For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options’ vesting period. Adjustments are made for options forfeited prior to vesting. The effect on net loss and basic and diluted loss per share had compensation costs for the Company’s stock option plans been determined based on a fair value at the date of grant consistent with the provisions of SFAS No. 123 for the years ended December 31, 2005, 2004, and 2003 is as follows:

The Company expenses advertising costs as incurred. For the years ended December 31, 2005, 2004, and 2003, advertising costs were $0, $262,584 and $160,000, respectively.

Deferred income taxes are recognized for the tax consequences in future years of differences between the tax basis of assets and liabilities and their financial reporting amounts at each period end, based on enacted tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized. The provision for income taxes represents the tax payable for the period, if any, and the change during the period in deferred tax assets and liabilities.

The Company calculates loss per share in accordance with SFAS No. 128, “Earnings Per Share.” Basic loss per share is computed by dividing the net loss available to common stockholders by the weighted-average number of common shares outstanding. Diluted loss per share is computed similar to basic loss per share, except that the denominator is increased to include the number of additional common shares that would have been outstanding if the potential common shares had been issued and if the additional common shares were dilutive.

The following potential common shares have been excluded from the computations of diluted net loss per share for the years ended December 31, 2005, 2004, and 2003 because the effect would have been anti-dilutive.

The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

From time to time, the Company enters into agreements with certain retailers regarding price decreases that are determined by the Company in its sole discretion. These agreements allow those retailers (subject to limitations) a credit equal to the difference between the Company’s current price and its new reduced price on units in the retailers’ inventories or in transit to the retailers on the date of the price decrease.

The Company records an estimate of sales incentives based on its actual sales incentive rates over a trailing twelve-month period, adjusted for any known variations, which are charged to operations and offset against gross sales at the time products are sold. The Company also records a corresponding accrual for its estimated sales incentive liability. This accrual—the Company’s sales incentive reserve—is reduced by deductions on future payments taken by the Company’s retailers relating to actual sales incentives.

At the end of each quarterly period, the Company analyzes its existing sales incentive reserve and applies any necessary adjustments based upon actual or expected deviations in sales incentive rates from the Company’s applicable historical sales incentive rates. The amount of any necessary adjustment is based upon the amount of the Company’s remaining field inventory, which is calculated by reference to the Company’s actual field inventory last conducted, plus inventory-in-transit and less estimated product sell-through. The amount of the Company’s sales incentive liability for each product is equal to the amount of remaining field inventory for that product multiplied by the difference between the Company’s current price and its new reduced price to its retailers for that product. This data, together with all data relating to all sales incentives granted on products in the applicable period, is used to adjust the Company’s sales incentive reserve established for the applicable period.

In 2005, the Company’s sales incentives were $1.3 million, or 2.5% of gross sales, all of which was offset against gross sales, as compared to $2.5 million, or 4.2% of gross sales, in 2004, all of which was offset against gross sales. In 2003, the Company’s sales incentives were $2.9 million, or 3.5% of gross sales, all of which was offset against gross sales.

The Company periodically offers rebate promotions to retailers which are provided to their end-user customers. During the period of the rebate promotion, the Company reduces sales by the estimated amount of the rebate promotion with a corresponding accrual for the estimated liability. Estimates for rebate promotions are based on a number of variable factors that depend on the specific program or product. These variables include the length of the rebate promotion, the estimated sales during the promotion, and the anticipated redemption rate of the program based on historical experience.

The Company has agreements with certain retailers in which the retailer is allowed to use a set percentage of its purchases of the Company’s products for various marketing purposes. The purpose of these agreements is to encourage advertising and promotional events to promote the sale of the Company’s products. Each period the Company reduces sales by the estimated amounts to be deducted by the retailers on future payments with a corresponding increase in the accrual for the estimated liability.

The Company has a limited 90-day to one year time period for product returns from end-users; however, its retailers generally have return policies that allow their customers to return products within only fourteen to thirty days after purchase. The Company allows its retailers to return damaged or defective products to it following a customary return merchandise authorization process. The Company has no informal return policies. The Company utilizes actual historical return rates to determine its allowance for returns in each period. Gross sales is reduced by estimated returns and cost of sales is reduced by the estimated cost of those sales. The Company records a corresponding accrual for the estimated liability associated with the estimated returns. This estimated liability is based on the gross margin of the products corresponding to the estimated returns. This accrual is offset each period by actual product returns.

As noted above, the Company’s return rate is based upon its past history of actual returns and the Company estimates amounts for product returns for a given period by applying this historical return rate and reducing actual gross sales for that period by a corresponding amount. The Company’s historical return rate for a particular product is the life-to-date return rate of similar products. This life-to-date return rate is updated monthly. The Company also compares this life-to-date return rate to its trailing 18-month return rate to determine whether any material changes in the Company’s return rate have occurred that may not be reflected in the life-to-date return rate. The Company believes that using a trailing 18-month return rate takes two key factors into consideration, specifically, an 18-month return rate provides the Company with a sufficient period of time to establish recent historical trends in product returns for each product category, and provides it with a period of time that is short enough to account for recent technological shifts in the Company’s product offerings in each product category. If an unusual circumstance exists, such as a product category that has begun to show materially different actual return rates as compared to life-to-date return rates, the Company will make appropriate adjustments to its estimated return rates. Factors that could cause materially different actual return rates as compared to life-to-date return rates include product modifications that simplify installation; a new product line, within a product category, that needs time to better reflect its return performance; and other factors. For the years ended December 31, 2005, 2004, and 2003, the Company had reserves for product returns totaling $178,055, $270,706 and $364,989, respectively, which reflect the estimated gross margin effect for future returns.

The Company’s warranty terms under its arrangements with its suppliers are that any product that is returned by a retailer or retail customer as defective can be returned by the Company to the supplier for full credit against the original purchase price. The Company incurs only minimal shipping costs to its suppliers in connection with the satisfaction of its warranty obligations.

The Company’s warehouse supervisor, production supervisor and production manager physically review the Company’s warehouse inventory for slow moving and obsolete products. All products of a material amount are reviewed quarterly and all products of an immaterial amount are reviewed annually. The Company considers products that have not been sold within six months to be slow moving. Product that is no longer compatible with current hardware or software is considered obsolete. The potential for re-sale of slow moving and obsolete inventories is considered through market research, analysis of the Company’s retailers’ current needs, and assumptions about future demand and market conditions. The recorded cost of both slow-moving and obsolete inventories is then reduced to its estimated market value based on current market pricing for similar products. The Company utilizes the Internet to provide indications of market value from competitors’ pricing, third party inventory liquidators and auction websites. The recorded costs of the Company’s slow moving and obsolete products are reduced to current market prices when the recorded costs exceed such market prices. All adjustments establish a new cost basis for inventory as the Company believes such reductions are permanent declines in the market price of its products. Generally, obsolete inventory is sold to companies that specialize in the liquidation of such items while the Company continues to market slow-moving inventories until they are sold or become obsolete. As obsolete or slow moving inventory is sold, the Company reduces the reserve by proceeds from the sale of the products.

The Company’s warehouse supervisor, production supervisor and production manager physically review the Company’s warehouse inventory for obsolete or damaged inventory-related items on a monthly basis. Inventory-related items (such as sleeves, manuals or broken products no longer under warranty from the Company’s subcontract manufacturers and suppliers) which are considered obsolete or damaged are reviewed by these personnel together with the Company’s Controller or Chief Financial Officer. At the discretion of the Company’s Controller or Chief Financial Officer, these items are physically disposed of and the Company makes corresponding accounting adjustments resulting in inventory adjustments. In addition, on a monthly basis, the Company’s detail inventory report and its general ledger are reconciled by the Company’s Controller and any variances result in a corresponding inventory adjustment.

The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability of its retailers to make required payments. If the financial condition of the Company’s retailers were to deteriorate, resulting in the impairment of their ability to make payments, additional allowances may be required. Since the Company’s current retailers are national retailers with a good payment history with the Company, its allowance for doubtful accounts is minimal.

The Company performs periodic credit evaluations of its retailers and maintains allowances for potential credit losses based on management’s evaluation of historical experience and current industry trends. Although the Company expects to collect amounts due, actual collections may differ.

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments”, which amends SFAS No. 133, “Accounting for Derivatives Instruments and Hedging Activities” and SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities.” SFAS No. 155 amends SFAS No. 133 to narrow the scope exception for interest-only and principal-only strips on debt instruments to include only such strips representing rights to receive a specified portion of the contractual interest or principle cash flows. SFAS No. 155 also amends SFAS No. 140 to allow qualifying special-purpose entities to hold a passive derivative financial instrument pertaining to beneficial interests that itself is a derivative instrument. The Company is currently evaluating the impact of this new standard but the Company believes that this new standard will not have a material impact on its financial position, results of operations, or cash flows.

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections,” an amendment to Accounting Principles Bulletin Opinion No. 20, “Accounting Changes,” and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements.” Though SFAS No. 154 carries forward the guidance in APB No. 20 and SFAS No. 3 with respect to accounting for changes in estimates, changes in reporting entity, and the correction of errors, SFAS No. 154 establishes new standards on accounting for changes in accounting principles, whereby all such changes must be accounted for by retrospective application to the financial statements of prior periods unless it is impracticable to do so. SFAS No. 154 is effective for accounting changes and error corrections made in fiscal years beginning after December 15, 2005, with early adoption permitted for changes and corrections made in years beginning after May 2005. The Company will implement SFAS No. 154 in its fiscal year beginning January 1, 2006. The Company is currently evaluating the impact of this new standard but the Company believes that it will not have a material impact on the Company’s financial position, results of operations, or cash flows.

In December 2004, the FASB issued SFAS No. 123(R), “Share-Based Payment”. SFAS 123(R) amends SFAS No. 123, “Accounting for Stock-Based Compensation”, and APB Opinion No. 25, “Accounting for Stock Issued to Employees”. SFAS No. 123(R) requires that the cost of share-based payment transactions (including those with employees and non-employees) be recognized in the financial statements. SFAS No. 123(R) applies to all share-based payment transactions in which an entity acquires goods or services by issuing (or offering to issue) its shares, share options, or other equity instruments (except for those held by an ESOP) or by incurring liabilities (1) in amounts based (even in part) on the price of the company’s shares or other equity instruments, or (2) that require (or may require) settlement by the issuance of a company’s shares or other equity instruments. This statement is effective (1) for public companies qualifying as SEC small business issuers, as of the first interim period or fiscal year beginning after December 15, 2005, or (2) for all other public companies, as of the first interim period or fiscal year beginning after June 15, 2005, or (3) for all nonpublic entities, as of the first fiscal year beginning after December 15, 2005. On April 14, 2005, the Securities and Exchange Commission amended the compliance dates to allow companies to implement Statement No. 123R at the beginning of their next fiscal year, instead of the next reporting period, that begins after June 15, 2005, or December 15, 2005 for small business issuers. Management is currently assessing the impact of this statement on its financial position and results of operations.

The data storage and digital entertainment industries are characterized by rapid technological advancement and change. Should demand for the Company’s products prove to be significantly less than anticipated, the ultimate realizable value of such products could be substantially less than the amounts reflected in the accompanying balance sheets.

Reliance on Independent and Related Party Manufacturers/Subcontractors/Suppliers

The Company does not maintain its own manufacturing or production facilities and does not intend to do so in the foreseeable future. The Company anticipates that its products will be manufactured, and independent companies, some of which are stockholders of the Company, will supply its raw materials and components. Many of these independent and related party manufacturers/subcontractors/suppliers may manufacture and supply products for the Company’s existing and potential competitors. As is customary in the manufacturing industry, the Company does not have any material ongoing licensing or other supply agreements with its manufacturers and suppliers. Typically, the purchase order is the Company’s “agreement” with the manufacturer or supplier. Therefore, any of these companies could terminate their relationships with the Company at any time. In the event the Company was to have difficulties with its present manufacturers and suppliers, the Company could experience delays in supplying products to its retailers.

The Company’s success will depend to a significant extent upon the ability to develop and maintain a multi-channel distribution system with retail distributors to sell the Company’s products in the marketplace. There cannot be any assurance that the Company will be successful in obtaining and retaining the retail distributors it requires to continue to grow and expand its marketing and sales efforts.

The Company maintains its cash and cash equivalent balances in several banks located in Southern California and a financial institution that from time to time exceed amounts insured by the Federal Deposit Insurance Corporation up to $100,000 per bank and by the Securities Investor Protection Corporation up to $500,000 per financial institution. As of December 31, 2005 and 2004, balances totaling $3,885,426 and $4,404,578, respectively, were uninsured. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant credit risk on cash.

During the year ended December 31, 2005, the Company had net sales to four major retailers that represented 36%, 17%, 17% and 11% of net sales. As of December 31, 2005, accounts receivable from these four retailers were 43%, 8%, 24% and 7% of accounts receivable, respectively.

During the year ended December 31, 2004, the Company had net sales to five major retailers that represented 32%, 17%, 11%, 10% and 10% of net sales. As of December 31, 2004, accounts receivable from these five retailers were 57%, 6%, 0%, 3% and 16% of accounts receivable, respectively.

During the year ended December 31, 2003, the Company had net sales to five major retailers that represented 29%, 14%, 10%, 10% and 10% of net sales. As of December 31, 2003, accounts receivable from these five retailers were 13%, 4%, 8%, 7% and 17% of accounts receivable, respectively.

During the year ended December 31, 2005, the Company purchased inventory from two related party vendors that represented 52% and 25% of purchases. As of December 31, 2005, these two vendors represented 54% and 46% of accounts payable – related parties.

During the year ended December 31, 2004, the Company purchased inventory from one related party vendor that represented 55% of purchases. In addition, the Company purchased inventory from a second vendor that represented 13% of purchases. As of December 31, 2004, the related party vendor represented 100% of accounts payable – related parties. As of December 31, 2004, the other vendor represented 19% of other accounts payable.

During the year ended December 31, 2003, the Company purchased inventory from two related party vendors that represented 45% and 26% of purchases. In addition, the Company purchased inventory from a third vendor that represented 13% of purchases. As of December 31, 2003, the two related party vendors represented 80% and 20% of accounts payable – related parties. As of December 31, 2003, the other vendor represented 36% of other accounts payable.

Consigned inventory is located at the stores and distribution centers of certain retailers with which the Company has consignment agreements. The inventory is owned by the Company until sold by the retailers.

Property and equipment as of December 31, 2005 and 2004 consisted of the following:

For the years ended December 31, 2005, 2004, and 2003, depreciation and amortization expense was $166,907, $254,808 and $689,341, respectively. Included in depreciation and amortization expense for the year ended December 31, 2003 is $389,000 related to the accelerated amortization of the leasehold improvements at the Company’s prior Santa Ana facility. At the beginning of 2003, the Company decided to move to a larger facility by the end of September 2003 and therefore amortized the remaining leasehold improvements balance at December 31, 2002 through September 2003.

For the years ended December 31, 2005, 2004, and 2003, amortization expense was $68,928, $578,736 and $578,736, respectively. In accordance with SFAS No. 142, the Company performed its required valuation on its Hi-Val^{^®} and Digital Research Technologies^{^®} trademarks for possible impairment as of December 31, 2004. Based upon this valuation, the Company determined that there had been a significant impairment in the value of the trademarks due to lower sales of products under the Hi-Val^{^®} and Digital Research Technologies^{^®}brands in 2004 and lower sales forecasted by the Company for subsequent periods. Therefore, the Company recorded an impairment of the value of the trademarks of $3,696,099 as of December 31, 2004. This impairment will result in a reduction of $509,808 in amortization expense to $68,928 from $578,736 in each of the next five years. No further impairment was determined as of December 31, 2005.

Accounts payable and accrued expenses as of December 31, 2005 and 2004 consisted of the following:

On January 1, 2002, the Company obtained a $9.0 million asset-based line of credit (with a sub-limit of $8.0 million) with ChinaTrust Bank (USA) that was to expire December 15, 2003. The credit facility contained a number of restrictive financial covenants. On each of December 31, 2002, March 31, 2003, and June 30, 2003, the Company was not in compliance with certain of those financial covenants. However, the Company subsequently obtained waivers of these violations from the lender. The waiver relating to the December 31, 2002 covenant violation also modified the original expiration date of December 15, 2003 to October 15, 2003. Subsequently, the Company replaced this line of credit with a line of credit from United National Bank.

On August 15, 2003, the Company entered into an agreement for an asset-based line of credit with United National Bank, effective August 18, 2003. The line allows the Company to borrow up to a maximum of $6.0 million. The line of credit expires September 1, 2004 and is secured by a UCC filing on substantially all of the Company’s assets. Advances on the line bear interest at the floating commercial loan rate equal to the prime rate as reported in The Wall Street Journal plus 0.75%. As of December 31, 2004, the interest rate was 6.00%. The agreement also calls for the Company to be in compliance with certain financial covenants. As of December 31, 2004, the Company was in compliance with all financial covenants except the financial covenant that the Company’s tangible net worth be at least $10.5 million and the financial covenant that the Company make at least $1 in the year 2004.

The new line of credit was initially used to pay off the outstanding balance with ChinaTrust Bank (USA) as of September 2, 2003, which was $3,379,827. The outstanding balance with United National Bank as of December 31, 2004 was $5,962,891.

On March 9, 2005, the Company entered into a Loan and Security Agreement for an asset-based line of credit with GMAC Commercial Finance LLC (“GMAC”). The line of credit allows the Company to borrow up to a maximum of $10.0 million. The line of credit expires on March 9, 2008 and is secured by substantially all of the Company’s assets. The line of credit allows for a sublimit of $2.0 million for outstanding letters of credit. Advances on the line of credit bear interest at the floating commercial loan rate initially equal to the prime rate plus 0.75%. The prime rate as of December 31, 2005 was 7.25%. The Company also has the option to use the LIBOR rate plus an initial amount of 3.50%.

These rates are applicable if the average amount available for borrowing for the prior six month period is between $1.0 million and $3.5 million. If the average amount available for borrowing is less than $1.0 million, then the rates applicable to all amounts borrowed increase by 0.25%. If the average amount available for borrowing is greater than $3.5 million, then the rates applicable to all amounts borrowed decrease by 0.25%. For the unused portion of the line, the Company is to pay on a monthly basis, an unused line fee in the amount of 0.25% of the average unused portion of the line for the preceding month.

The Loan Agreement contains one financial covenant—that the Company maintain at the end of each measurement period through and including September 30, 2005, a fixed charge coverage ratio (the ratio of (a) EBITDA Minus internally funded Capital Expenditures to (b) the sum of any scheduled Principal and interest payments on all funded debt and income taxes paid or Payable) of at least 1.2 to 1.0 and a fixed charge coverage ratio of at least 1.5 to 1.0 for all measurement periods thereafter. A measurement period is defined in the Loan Agreement as the three month period ending March 31, 2005, the six month period ending June 30, 2005, the nine month period ending September 30, 2005, the 12 month period ending December 31, 2005, and thereafter the twelve month period ending on March 31, June 30, September 30, and December 31 of each year during the term of the credit facility. As of March 31, 2005, the Company was in breach of the financial covenant.

On May 23, 2005, the Company entered into a Letter Agreement (“Letter Agreement”) with GMAC with respect to a certain financial covenant under the Loan Agreement with GMAC dated March 9, 2005. The Letter Agreement amended The Loan Agreement to exclude the required fixed coverage ratio for the Measurement period ending March 31, 2005. The Letter Agreement amended the financial covenant to provide that the Company maintain a fixed charge coverage ratio of at least 1.0 to 1.0 for the months of April 2005 and May 2005, a fixed coverage ratio of at least 1.2 to 1.0 for the three months ended June 30, 2005 and the six months ended September 30, 2005, and a fixed charge coverage ratio of at least 1.5 to 1.0 for the nine months ended December 31, 2005 and for each twelve month period thereafter ending on March 31, June 30, September 30 and December 31 during the term of the credit facility. As a result of this Letter Agreement, the Company was no longer in breach of the financial covenant.

On June 30, 2005, the Company entered into a First Amendment to Loan and Security Agreement (“First Amendment”) with GMAC with respect to the foregoing financial covenant. The First Amendment amended the Letter Agreement to exclude the required fixed charge coverage ratio for the measurement periods ending April 30, 2005 and May 31, 2005. The fixed charge coverage ratio as it applies to future measurement periods remains the same. The Company was in compliance with this covenant for the nine months ended September 30, 2005.

The obligations of the Company under the Loan Agreement are secured by substantially all of the Company’s assets and guaranteed by the Company’s wholly-owned subsidiary, IOM Holdings, Inc. (the “Subsidiary”). The obligations of the Company and the guarantee obligations of its Subsidiary are secured pursuant to a Pledge and Security Agreement executed by the Company, a Collateral Assignment Agreement executed by the Company, a Guaranty Agreement executed by its Subsidiary, a General Security Agreement executed by its Subsidiary, an Intellectual Property Security Agreement and Collateral Assignment executed by the Company, and an Intellectual Property Security Agreement and Collateral Assignment executed by its Subsidiary (collectively, the “Security Agreements”).

The new credit facility was initially used to pay off the Company’s outstanding balance with United National Bank as of March 10, 2005, which balance was $3,809,320, and was also used to pay $25,000 of the Company’s closing fees for the GMAC line of credit. The line of credit will be used for general operations.

The outstanding balance with GMAC as of December 31, 2005 was $5,053,582. The amount available to the Company for borrowing as of December 31, 2005 was $279,318. As of December 31, 2005, the Company was in breach of the financial covenant; however, the Company received a waiver of this breach from GMAC Commercial Finance on March 27, 2006.

In connection with a 1997 Strategic Alliance Agreement, the Company has available a trade line of credit with a related party for purchases up to $2.0 million. Purchases are non-interest bearing and are due 75 days from the date of receipt. The credit agreement can be terminated or changed at any time. As of December 31, 2003, there was $0 in trade payables outstanding under this arrangement. This trade line of credit was terminated on March 31, 2004.

Pursuant to an oral agreement, the Company also had available an additional trade line of credit with a related party that provided a trade credit facility of up to $3.0 million carrying net 60 day terms, as defined. As of December 31, 2003, there was $0 in trade payables outstanding under this arrangement. This trade line of credit was terminated on March 31, 2004.

In January 2003, the Company entered into a trade credit facility with a related party, whereby the related party agreed to purchase inventory on behalf of the Company. The agreement allowed the Company to purchase up to $10.0 million, with payment terms of 120 days following the date of invoice. The third party was to charge the Company a 5% handling fee on the supplier’s unit price. A 2% discount to the handling fee applied if the Company reached an average running monthly purchasing volume of $750,000. Returns made by the Company, which were agreed by the supplier, resulted in a credit to the Company for the handling charge. As security for the trade credit facility, the Company paid the related party a security deposit of $1.5 million, of which $750,000 could be applied against outstanding accounts payables to the related party after six months. As of December 31, 2004, $1.5 million had been applied against outstanding accounts payables to the related party. The agreement was for 12 months. At the end of the 12-month period, either party was entitled to terminate the agreement upon 30 days’ written notice. Otherwise, the agreement would remain continuously valid without requiring a newly signed agreement. Both parties had the right to terminate the agreement one year following the inception date by giving the other party 30 days written notice of termination. During 2004, the Company purchased $2.5 million of inventory under this arrangement. As of December 31, 2004, there were $0 in trade payables under this arrangement. This trade line of credit was terminated on June 6, 2005 and a new trade facility was entered into. The agreement containing the terms of the new trade credit facility was amended and restated on July 21, 2005 to provide that the new facility would be retroactive to April 29, 2005.

Under the terms of the new facility, the related party has agreed to purchase and manufacture inventory on behalf of the Company. The Company can purchase up to $15.0 million of inventory either (i) through the related party as an international purchasing office, or (ii) manufactured by the related party. For inventory purchased through the related party, the payment terms are 120 days following the date of invoice by the related party and the related party charges the Company a 5% handling fee on a supplier’s unit price. A 2% discount of the handling fee is applied if the Company reaches an average running monthly purchasing volume of $750,000. Returns made by the Company, which are agreed to by a supplier, result in a credit to the Company for the handling charge. For inventory manufactured by LHE, the payment terms are 90 days following the date of the invoice by the related party. The Company is to pay the related party 10% of the purchase price on any purchase orders issued to the related party, as a down-payment for the order, within one week of the purchase order. The Agreement has an initial term of one year after which the Agreement will continue indefinitely if not terminated at the end of the initial term. At the end of the initial term and at any time thereafter, either party has the right to terminate the facility upon 30 days’ prior written notice to the other party. During 2005, the Company purchased $7.9 million of inventory under this arrangement. As of December 31, 2005, there were $4,465,267 in trade payables under this arrangement.

In February 2003, the Company entered into an agreement with a related party, whereby the related party agreed to supply and store at the Company’s warehouse up to $10.0 million of inventory on a consignment basis. Under the agreement, the Company will insure the consignment inventory, store the consignment inventory for no charge, and furnish the related party with weekly statements indicating all products received and sold and the current consignment inventory level. The agreement may be terminated by either party with 60 days written notice. In addition, this agreement provides for a trade line of credit of up to $10.0 million with payment terms of net 60 days, non-interest bearing. During 2005 and 2004 the Company purchased $16.6 million and $19.2 million of inventory, respectively, under this arrangement. As of December 31, 2005 and December 31, 2004, there were $3,756,811 and $7,346,596, respectively, in trade payables outstanding under this arrangement.

The Company leases its facilities and certain equipment under non-cancelable, operating lease agreements, expiring through December 2008.

The Company previously leased its facilities from a related party that was, through March 2003, under the control of an officer of the Company. In March 2003, in connection with the settlement of a litigation matter with this related party, an officer of the Company relinquished control, to that related party, of the entity that owned the warehouse and office space that was being leased by the Company. Under the terms of the settlement agreement, the lease dated April 1, 2000, as amended on June 1, 2000 and which originally expired in March 2010, was terminated and replaced with a new lease. The new lease required monthly payments of $28,687 and expired on September 30, 2003. The Company moved to its current facilities in September 2003.

Future minimum lease payments under these non-cancelable operating lease obligations at December 31, 2005 are as follows:

Rent expense was $378,674, $366,574 and $420,425 for the years ended December 31, 2005, 2004 and 2003, respectively, and is included in general and administrative expenses in the accompanying statements of income.

Periodically, the Company enters into various agreements for services including, but not limited to, public relations, financial consulting, and manufacturing consulting. The agreements generally are ongoing until such time they are terminated, as defined. Compensation for services is paid either on a fixed monthly rate or based on a percentage, as specified, and may be payable in shares of the Company’s common stock. During the years ended December 31, 2005, 2004, and 2003, the Company incurred expenses of $276,388, $364,588 and $333,982, respectively, in connection with such arrangements. These expenses are included in general and administrative expenses in the accompanying statements of operations.

The Company entered into an employment agreement with one of its officers on October 15, 2002, which expires on October 15, 2007. The agreement, which is effective as of January 1, 2002, calls for an initial salary of $198,500, and provides for certain expense allowances. In addition, the agreement provides for a quarterly bonus equal to 7% of the Company’s quarterly net income. For the years ended December 31, 2005, 2004, and 2003, bonuses totaling $15,888, $60,702, and $28,259, respectively, were paid under the terms of this agreement. As of December 31, 2005 and 2004, the accrued bonuses were $0 and $0, respectively.

In connection with certain retail agreements, the Company has agreed to pay for certain marketing development and advertising on an ongoing basis. Marketing development and advertising costs are generally agreed upon at the time of the event. The Company also records a liability for co-op marketing based on management’s evaluation of historical experience and current industry and Company trends.

In May 2001, the Company entered into an agreement to pay certain market development and advertising funds. The agreement provided that the Company was to pay $6.0 million in marketing expenses to a retailer in connection with the retailer’s providing $60 million per year in net revenue for a two-year period. These marketing expenses were in addition to previously agreed upon marketing development funds. In June 2001, the Company began recognizing revenue from the retailer. In the two-year period from June 2001 through May 2003, the Company received $51.4 million in net revenue from the retailer. The net revenue the Company received from June 2001 through November 2002 had been offset by the proportional allocation of the $6.0 million in marketing expenses in relation to the revenue of each period. From June 2001 through December 2001, the Company recorded $3.9 million of the market development and advertising funds. From January 2002 through November 2002, the Company recorded $2.1 million of the market development and advertising funds. The Company also expensed $4.9 million in marketing promotions above the $6.0 million allocation in the two-year period from June 2001 through May 2003. The market development and advertising funds were primarily to be used by the retailer to launch the Company’s products through sales promotions, printed media and weekly sales circulars distributed by the retailer. The last revenues received from the retailer under this agreement were in April 2003.

For the years ended December 31, 2005, 2004, and 2003, the Company incurred $1,804,702, $1,701,178 and $2,893,200, respectively, related to its retail agreements with its retailers. These amounts are netted against revenue in the accompanying statements of operations.

On August 2, 2001, Mark and Mitra Vakili filed a complaint in the Superior Court of the State of California for the County of Orange against Tony Shahbaz, our Chairman, President, Chief Executive Officer and Secretary. This complaint was later amended to add Alex Properties and Hi-Val, Inc. as plaintiffs, and I/OMagic, IOM Holdings, Inc., Steel Su, a director of I/OMagic, and Meilin Hsu, an officer of Behavior Tech. Computer Corp., as defendants. The final amended complaint alleged causes of action based upon breach of contract, fraud, breach of fiduciary duty and negligent misrepresentation and sought monetary damages and rescission. As a result of successful motions for summary judgment, I/OMagic, Mr. Su and Ms. Hsu were dismissed as defendants. On February 18, 2003, a jury verdict adverse to the remaining defendants was rendered, and on or about March 28, 2003, all parties to the action entered into a Settlement Agreement and Release which settled this action prior to the entry of a final judgment. As part of the Settlement Agreement and Release, Mr. Shahbaz and Mr. Su relinquished their interests in Alex Properties and the Vakilis relinquished 66,667 shares of the Company’s common stock, of which 13,333 shares were transferred to a third party designated by the Vakilis. In addition, the Company agreed to make payments totaling $4.0 million in cash and entered into a new written lease agreement with Alex Properties relating to the real property in Santa Ana, California, which the Company physically occupied. On September 30, 2003, pursuant to the terms of the lease agreement, the Company vacated this real property. During the latter part of 2003 and continuing into the first quarter of 2004, Mark and Mitra Vakili and Alex Properties alleged that the Company had improperly caused damage to the Santa Ana facility. On or about February 15, 2004, all parties to the original Settlement Agreement and Release executed a First Amendment to Settlement Agreement and Release, releasing all defendants from all of these new claims conditioned upon the making of the final $1.0 million payment under the Settlement Agreement and Release by February 17, 2004, rather than on the original due date of March 15, 2004. The Company made this payment, and a dismissal of the case was filed with the court on March 8, 2004.

On or about May 30, 2003, I/OMagic and IOM Holdings, Inc. filed a complaint for breach of contract and legal malpractice against Lawrence W. Horwitz, Gregory B. Beam, Horwitz & Beam, Inc., Lawrence M. Cron, Horwitz & Cron, Kevin J. Senn and Senn Palumbo Mealemans, LLP, the Company’s former attorneys and their respective law firms, in the Superior Court of the State of California for the County of Orange. The complaint sought damages of $15.0 million arising out of the defendants’ representation of I/OMagic and IOM Holdings, Inc. in an acquisition transaction and in a separate arbitration matter. On or about November 6, 2003, the Company filed its First Amended Complaint against all defendants. Defendants responded to the Company’s First Amended Complaint denying the Company’s allegations. Defendants Lawrence W. Horwitz and Lawrence M. Cron also filed a Cross-Complaint against the Company for attorneys’ fees in the approximate amount of $79,000. The Company denied the allegations in the Cross-Complaint. Trial began on February 6, 2006 and on March 10, 2006, the jury ruled in the Company’s favor against Lawrence W. Horwitz, Horwitz & Beam, Inc., Lawrence M. Cron, Horwitz & Cron and Senn Palumbo Mealemans, LLP, and awarded the Company $3.0 million in damages. The Company has not collected any of this amount and the Company believes that this award may be appealed by defendants. The Company is not presently aware of any appeal having been filed.

On March 15, 2004, Magnequench International, Inc., or plaintiff, filed an Amended Complaint for Patent Infringement in the United States District Court of the District of Delaware (Civil Action No. 04-135 (GMS)) against, among others, the Company, Sony Corp., Acer Inc., Asustek Computer, Inc., Iomega Corporation, LG Electronics, Inc., Lite-On Technology Corporation and Memorex Products, Inc., or defendants. The complaint seeks to permanently enjoin defendants from, among other things, selling products that allegedly infringe one or more claims of plaintiff’s patents. The complaint also seeks damages of an unspecified amount, and treble damages based on defendants’ alleged willful infringement. In addition, the complaint seeks reimbursement of plaintiff’s costs as well as reasonable attorney’s fees, and a recall of all existing products of defendants that infringe one or more claims of plaintiff’s patents that are within the control of defendants or their wholesalers and retailers. Finally, the complaint seeks destruction (or reconfiguration to non-infringing embodiments) of all existing products in the possession of defendants that infringe one or more claims of plaintiff’s patents. The Company has filed a response denying plaintiff’s claims and asserting defenses to plaintiff’s causes of action alleged in the complaint.

On March 9, 2005, the Company entered into a Settlement Agreement with Magnequench International, Inc., releasing all claims against the Company in exchange for certain information and covenants by the Company, including disclosure of identities of certain of its suppliers of alleged infringing products, a covenant to provide sample products for testing purposes and a covenant to not source products from suppliers of alleged infringing products, provided that, among other limitations, another supplier makes those products available to the Company in sufficient quantities. A dismissal of the case was filed with the court on April 15, 2005.

On May 6, 2005, OfficeMax North America, Inc., or plaintiff, filed a Complaint for Declaratory Judgment in the United States District Court of the Northern District of Ohio against the Company. The complaint sought declaratory relief regarding whether plaintiff was still obligated to the Company under certain previous agreements between the parties. The complaint also sought plaintiff’s costs as well as reasonable attorneys’ fees. The complaint did not seek any monetary damages against the Company. The complaint arose out of the Company’s contention that plaintiff was still obligated to the Company under an agreement entered into in May 2001 and plaintiff’s contention that it had been released from such obligation. The Company filed a motion to dismiss, or in the alternative, a motion to stay the plaintiff’s action against the Company. On or about February 7, 2006, the Court granted the motion, and issued an Order and Judgment dismissing the OfficeMax action.

On May 20, 2005, the Company filed a complaint for breach of contract, breach of implied covenant of good faith and fair dealing, and common counts against OfficeMax North America, Inc., or defendant, in the Superior Court of the State of California for the County of Orange, Case No. 05CC06433. The complaint seeks damages of in excess of $22 million arising out of the defendants’ breach of contract under an agreement entered into in May 2001. On or about June 20, 2005, OfficeMax removed the case against OfficeMax to the United States District Court for the Central District of California, Case No. SA CV05-0592 DOC(MLGx) (the “California Case”). On or about June 28, 2005, the Company and OfficeMax jointly filed a stipulation in requesting that the United States District Court in California temporarily stay the California Case pending the outcome of the Motion in Ohio. On July 6, 2005, the United States District Court in California denied the parties joint stipulation request to temporarily stay the California Case and instead ordered that OfficeMax answer the complaint by August 1, 2005. On August 1, 2005, OfficeMax filed its Answer and Counter-Claim against the Company. The Counter-Claim against the Company alleges four causes of action against the Company: breach of contract, unjust enrichment, quantum valebant, and an action for declaratory relief. The Counter-Claim alleges, among other things, that the Company is liable to OfficeMax in the amount of no less than $138,000 under the terms of a vendor agreement executed between the Company and OfficeMax in connection with the return of computer peripheral products to the Company for which OfficeMax allegedly has never been reimbursed. The Counter-Claim seeks, among other things, at least $138,000 from the Company, along with pre-judgment interest, attorneys’ fees and costs of suit. The Company filed a response denying all of the affirmative claims set forth in the Counter-Claim, denying any wrongdoing or liability, denying that OfficeMax is entitled to obtain any relief, and plans to vigorously contest the Counter-Claim. As of the date of this report, discovery has commenced and a trial date in this action has been set for October 17, 2006. The outcome of this action is presently uncertain. However, the Company believes that all of its claims and defenses are meritorious.

In addition, the Company is involved in certain legal proceedings and claims which arise in the normal course of business. Management does not believe that the outcome of these matters will have a material affect on the Company’s financial position or results of operations.

During December 2000, the Company amended its Articles of Incorporation to authorize 10,000,000 shares of preferred stock, of which 1,000,000 shares are designated as Series A preferred stock. Preferred stockholders of the Series A preferred stock do not have voting powers and are entitled to receive dividends on an equal basis with the holders of common stock of the Company.

In addition, the Company designated 1,000,000 shares as Series B preferred stock. The Series B stockholder has the same rights as the Series A holders, except the Company will be obligated to redeem any issued shares which have been outstanding for two years.

During the year ended December 31, 2005, the Company issued an aggregate of 1,900 shares of common stock in connection with the exercise of employee stock options issued March 9, 2004 for cash of $6,650 or at a per share price of $3.50.

On February 12, 2002, the Company announced the approval by the Board of Directors of the Company to redeem its own stock in open market transactions of up to $500,000. During the year ended December 31, 2002, the Company purchased 4,226 shares of common stock for $42,330 on the open market. During the year ended December 31, 2003, the Company purchased 9,267 shares of common stock for $83,684 on the open market. It is the Company’s intention to cancel these shares.

During the years ended December 31, 2001 and 2000, the Company issued warrants to purchase 8,000 and 2,667 shares, respectively, of restricted common stock to the Company’s prior law firm and a consultant, respectively. The warrants were exercisable at prices ranging from $4.50 to $30.00 (fair market value or higher) per share for one year. Management of the Company determined that no additional amounts would have been paid to such law firm for services as invoiced services were paid in cash. Accordingly, the Company did not record legal or consulting expense. During the years ended December 31, 2001 and 2000, 0 and 2,667 warrants, respectively, were exercised. As of December 31, 2003, none of the remaining warrants were exercised, and such warrants expired.

During the year ended December 31, 2003, the Company issued warrants to purchase 20,004 shares of common stock to an investor relations firm. The warrants were exercisable at $9.78 per share and vested over six months from grant date. These warrants expired in July 2004.

During the year ended December 31, 2003, the Company issued warrants to purchase 20,004 shares of common stock to a financial advisory firm. The warrants are exercisable at $9.78 per share and vest over six months from grant date. These warrants expire in July 2004. The value of the warrants was not material.

During the year ended December 31, 2004, the Company issued warrants to purchase 20,000 shares of common stock to a financial advisory firm, 10,000 of which are exercisable at $4.00 per share and 10,000 of which are exercisable at $6.00 per share. These warrants vested immediately. None of the warrants were exercised, and such warrants expired in September 2005.

During the year ended December 31, 2005, the Company issued warrants to purchase 150,000 shares of common stock to a financial advisory firm, 50,000 of which are exercisable at $3.00 per share, 50,000 of which are exercisable at $4.00 per share and 50,000 of which are exercisable at $5.00 per share. These warrants vested immediately. None of the warrants have been exercised, and such warrants expire in January 2007.

During the year ended December 31, 2005, the Company issued warrants to purchase 30,000 shares of common stock to a financial advisory firm, 15,000 of which are exercisable at $8.00 per share and 15,000 of which are exercisable at $10.00 per share. These warrants vested immediately. None of the warrants have been exercised, and such warrants expire in November 2006.

The total number of shares of the Company’s common stock authorized for issuance under the 2002 Plan and the 2003 Plan are 133,334, and 400,000, respectively.

Under the 2002 Plan and the 2003 Plan (collectively, the “Company Plans”) options granted may be either “incentive stock options,” within the meaning of Section 422 of the Internal Revenue Code, or “nonqualified options.” Incentive options granted under the Company Plans must have an exercise price of not less than the fair market value of a share of common stock on the date of grant unless the optionee owns more than 10% of the total voting securities of the Company. In this case, the exercise price will not be less than 110% of the fair market value of a share of common stock on the date of grant. Incentive stock options may not be granted to an optionee under any of the Company Plans if the aggregate fair market value, as determined on the date of grant, of the stock with respect to which incentive stock options are exercisable by such optionee in any calendar year under the Company Plans, exceeds $100,000. Nonqualified options granted under the Company Plans must have an exercise price of not less than the fair market value of a share of common stock on the date of grant. Nonqualified options granted under the Company Plans must have an exercise price of not less than 85% of the fair market value of a share of common stock on the date of grant.

Under the Company Plans, options may be exercised during a period of time fixed by the committee administering the Company Plans (which could include the entire Board of Directors). Options granted under the Company Plans must vest at a rate not less than 20% per year over a consecutive five-year period. No option granted under any of the Company Plans may be exercised more than 10 years after the date of grant. Incentive stock options granted to an optionee who owns more than 10% of the voting securities of the Company may not be exercised more than five years after the date of grant.

In January 2000, the Company granted an aggregate of 134,167 stock options (the “2000 Options”) under the Company’s 1997 Incentive and Non-Statutory Stock Option Plan (the “1997 Plan”) and the 1998 Incentive and Non-Statutory Stock Option Plan (the “1998 Plan”). On March 21, 2000, the Company’s board of directors approved, upon advice of prior legal counsel, the extension of the termination date for each of the 1997 Plan and 1998 Plan to December 31, 2000 in order to cover the grant of the 2000 Options that were intended to be made on January 2000. The original termination date for the 1997 Plan and 1998 Plan was December 31, 1997 and December 31, 1998, respectively. Note 14 to the Company’s consolidated financial statements dated December 31, 2003, contained in the Company’s annual report on Form 10-K filed with the Securities and Exchange Commission on April 14, 2004, reflected the grant of the 2000 Options.

On June 27, 2004, the Company was advised by its current legal counsel that the Company did not have the authority to grant the 2000 Options under the 1997 Plan and 1998 Plan because the board of directors did not have the authority to extend the termination date of either the 1997 Plan or the 1998 Plan after the date each of these plans had expired pursuant to their original terms. The 1997 Plan and the 1998 Plan terminated pursuant to their own terms on December 31, 1997 and December 31, 1998, respectively. As a result, the 2000 Options were never granted by the Company and have never been outstanding. The information in this Note 14 reflects the foregoing.

The following summarizes options and warrants granted and outstanding as of December 31, 2005, 2004, 2003 and 2002:

The following table is a summary of the stock options and warrants as of December 31, 2005:

The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.

The components of the income tax provision (benefit) for the years ended December 31, 2005, 2004, and 2003 were as follows:

Income tax expense (benefit) for the years ended December 31, 2005, 2004, and 2003 differed from the amounts computed applying the federal statutory rate of 34% to pre-tax income as a result of:

Significant components of the Company’s deferred tax assets and liabilities for federal income taxes at December 31, 2005 and 2004 consisted of the following:

As of December 31, 2005 and 2004, the valuation allowance for deferred tax assets, totaled approximately $13,078,901 and $12,098,999, respectively. For the years ended December 31, 2005, 2004, and 2003, the net change in the valuation allowance was $979,902 (increase), $3,199,890 (increase) and $179,295 (increase), respectively.

As of December 31, 2005, the Company had net operating loss carryforwards for federal and state income tax purposes of approximately $26,612,000 and $17,358,000, respectively, that expire through 2025 and 2015, respectively. The utilization of net operating loss carryforwards may be limited under the provisions of Internal Revenue Code Section 382 and similar state provisions due to the change in ownership.

During the years ended December 31, 2005, 2004, and 2003, the Company made purchases from related parties totaling $24,510,810, $21,725,485 and $32,864,145, respectively.

Until March 28, 2003, the Company leased its warehouse and office space from a related party under the control of an officer of the Company. During the year ended December 31, 2003, the Company made rental payments totaling $86,018 to this related party.

The following tables are summaries of the unaudited quarterly financial information for the years ended December 31, 2005 and 2004.

Our audits of the consolidated financial statements referred to in our report dated February 24, 2006 (included elsewhere in this Annual Report on Form 10-K) also included the financial statement schedules of I/OMagic Corporation, listed in Item 15(a) of this Form 10-K. This schedule is the responsibility of I/OMagic Corporation’s management. Our responsibility is to express an opinion based on our audits of the consolidated financial statements.

In our opinion, the financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on this 31^st day of March, 2006.

I/OMAGIC CORPORATION

/s/ TONY SHAHBAZ

Tony Shahbaz

Chief Executive Officer, President and Secretary

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


Nevada		33-0773180
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

4 Marconi, Irvine, CA		92618
(Address of principal executive offices)		(Zip Code)


		Page
PART I
Item 1.	Business	2

Item 1A.	Risk Factors	15

Item 1B.	Unresolved Staff Comments	23

Item 2.	Properties	23

Item 3.	Legal Proceedings	23

Item 4.	Submission of Matters to a Vote of Security Holders	24

PART II

Item 5.	Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	25

Item 6.	Selected Financial Data	27

Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	28

Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	47

Item 8.	Financial Statements and Supplementary Data	47

Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	47

Item 9A.	Controls and Procedures	47

Item 9B.	Other Information	49

PART III

Item 10.	Directors and Executive Officers of the Registrant	50

Item 11.	Executive Compensation	51

Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	54

Item 13.	Certain Relationships and Related Transactions	55

Item 14.	Principal Accountant Fees and Services	58

PART IV

Item 15.	Exhibits, Financial Statement Schedules	58

Index to Consolidated Financial Statements and Supplemental Information		F-1

Index To Exhibits

Signatures

Exhibits Attached to This Report


Technology	Meaning	Data Storage and Retrieval Capability⁽¹⁾
CD-ROM	Compact Disc-Read Only Memory	Retrieval only

CD-R	Compact Disc-Recordable	Retrieval and single-session storage

CD-RW	Compact Disc-Rewritable	Retrieval and multi-session storage

DVD-ROM	Digital Video Disc-Read Only Memory	Retrieval only

DVD-R or DVD+R	Digital Video Disc-Recordable	Retrieval and single-session storage

DVD-RW or DVD+RW	Digital Video Disc-Rewritable	Retrieval and multi-session storage and backward compatibility with CDs

DVD-RAM	Digital Video Disc-Random Access Memory	Retrieval and multi-session storage

DVD+/-RW+/-R	Dual Format Digital Video Disc-Rewritable and Recordable	Retrieval and multi-session storage and backward compatibility with CDs and DVD-Rs

CD-RW+DVD	Compact Disc-Rewritable DVD	Retrieval and multi-session storage and backward compatibility with CDs and DVD-ROMs


	Price Range
	Low		High
2004:
First Quarter (January 1 – March 31)	$	3.00	$	4.20
Second Quarter (April 1 – June 30)		3.45		4.50
Third Quarter (July 1 – September 30)		3.50		4.45
Fourth Quarter (October 1 – December 31)		3.00		3.60

2005:
First Quarter	$	1.74	$	3.25
Second Quarter		0.70		1.80
Third Quarter		0.85		6.75
Fourth Quarter		4.15		5.85


	2005			2004			2003			2002			2001
Consolidated Statements of Operations Data:
Net sales	$	37,813,633		$	44,396,551		$	63,587,454		$	80,952,712		$	68,112,311
Cost of sales		33,523,147			41,418,750			54,643,371			73,564,456			61,951,641

Gross profit		4,290,486			2,977,801			8,944,083			7,388,256			6,160,670
Operating expenses		5,778,112			10,881,017			9,236,912			10,022,445			10,180,839

Loss from operations		(1,487,626	)		(7,903,216	)		(292,829	)		(2,634,189	)		(4,020,169	)
Total other expense		(287,345	)		(151,116	)		(194,337	)		(5,525,033	)		(376,431	)

Loss from operations before income taxes		(1,774,971	)		(8,054,332	)		(487,166	)		(8,159,222	)		(4,396,600	)
Income tax (benefit) expense		2,400			2,532			(27,148	)		685,372			981,266

Net loss	$	(1,777,371	)	$	(8,056,864	)	$	(460,018	)	$	(8,844,594	)	$	(5,377,866	)

Basic loss per share	$	(0.39	)	$	(1.78	)	$	(0.10	)	$	(1.95	)	$	(1.19	)

Diluted loss per share	$	(0.39	)	$	(1.78	)	$	(0.10	)	$	(1.95	)	$	(1.19	)

Weighted-average shares outstanding, basic		4,530,380			4,529,672			4,529,672			4,528,894			4,528,341

Weighted-average shares outstanding, diluted		4,530,380			4,529,672			4,529,672			4,528,894			4,528,341

Consolidated Balance Sheet Data:
Cash and cash equivalents		4,086,541		$	3,587,807		$	4,005,705		$	5,138,111		$	4,423,623
Working capital		5,992,653			7,527,474			11,051,270			11,524,146			19,272,671
Total assets		26,277,300			27,466,743			40,112,792			41,757,969			54,925,501
Stockholders’ equity		6,622,562			8,361,967			16,418,832			16,962,536			17,848,830
Redeemable convertible preferred stock	$	—		$	—		$	—		$	—		$	9,000,000


	Year Ended December 31,						Dollar Variance			Percentage Variance		Results as a Percentage of Net Sales for the Year Ended December 31,
	2005			2004			Favorable (Unfavorable)			Favorable (Unfavorable)		2005		2004
	(in thousands)
Net sales	$	37,773		$	44,397		$	(6,624	)	(14.9	)%	100.0	%	100.0	%
Cost of sales		33,523			41,419			7,896		19.1		88.7		93.3

Gross profit		4,250			2,978			1,272		42.7		11.3		6.7
Selling, marketing and advertising expenses		776			1,008			232		23.0		2.1		2.3
General and administrative expenses		4,767			5,343			576		10.8		12.6		12.0
Depreciation and amortization		236			834			598		71.7		0.6		1.9
Impairment of trademarks		—			3,696			3,696		100.0		—		8.3

Operating income (loss)		(1,529	)		(7,903	)		6,374		80.7		(4.0	)	(17.8	)
Net interest expense		(299	)		(201	)		(98	)	(48.8	)	(0.8	)	(0.4	)
Other income		12			50			(38	)	(76.0	)	—		0.1

Loss from operations before provision for income taxes		(1,816	)		(8,054	)		6,238		77.5		(4.8	)	(18.1	)
Income tax provision (benefit)		2			3			1		33.3		—		—

Net loss	$	(1,818	)	$	(8,057	)	$	6,239		77.4	%	(4.8	)%	(18.1	)%


	Payments Due by Period
Contractual Obligations At December 31, 2005	Total		Less than 1 Year		1-3 Years		4-5 Years		After 5 Years
Long Term Debt	$	—	$	—	$	—	$	—	$	—
Capital Lease Obligations		—		—		—		—		—
Operating Leases		239,326		227,686		11,640		—		—
Unconditional Purchase Obligations		—		—		—		—		—

Total Contractual Cash Obligations	$	239,326	$	227,686	$	11,640	$	—	$	—


Name	Age	Titles
Tony Shahbaz	43	Chairman of the Board, President, Chief Executive Officer, Secretary, Director

Steve Gillings	56	Chief Financial Officer

Steel Su	54	Director

Daniel Hou⁽¹⁾	56	Director

Daniel Yao⁽¹⁾	49	Director

Dr. William Ting ⁽¹⁾	58	Director


		Annual Compensation
Name and Principal Position	Year	Salary		Bonus
Tony Shahbaz	2005	$	198,500	$	15,888
Chairman, President, Chief	2004	$	198,500	$	60,702
Executive Officer and Secretary	2003	$	198,500	$	28,259

Steve Gillings	2005	$	95,000	$	2,500
Chief Financial Officer	2004	$	95,000	$	2,500
	2003	$	95,000	$	5,000


Named Officer	Grant Date	Number of Securities Underlying Options Granted(1)	Percentage of Total Options Granted to Employees in Fiscal Year(2)		Exercise Price Per Share		Expiration Date	Potential Realizable Value at Assumed Rates of Stock Price Appreciation for Option Term(3)
Named Officer	Grant Date	Number of Securities Underlying Options Granted(1)			Exercise Price Per Share		Expiration Date	5%		10%
Tony Shahbaz	7/14/2005	105,000	36.8	%	$	2.75	7/14/2010	$	46,200	$	134,400
Steve Gillings	7/14/2005	65,000	22.8	%	$	2.50	7/14/2010	$	44,850	$	99,450


Name	Number of Securities Underlying Unexercised Options at December 31, 2005		Value ($) of Unexercised In-The-Money Options at December 31, 2005 (1)
Name	Exercisable	Unexercisable	Exercisable		Unexercisable
Tony Shahbaz	103,202	60,798	$	197,929	$	130,772
Steve Gillings	45,853	32,147	$	111,543	$	82,157


Name and Address of Beneficial Owner⁽¹⁾	Title of Class	Amount and Nature of Beneficial Ownership of Class		Percent of Class
Tony Shahbaz	Common	2,471,253	⁽²⁾	52.8	%
Steel Su	Common	591,115	⁽³⁾	12.9	%
Sung Ki Kim	Common	375,529	⁽⁴⁾	8.2	%
Daniel Yao	Common	361,493	⁽⁵⁾	7.9	%
Daniel Hou	Common	154,011	⁽⁶⁾	3.4	%
Steve Gillings	Common	50,322	⁽⁷⁾	1.1	%
William Ting	Common	—		—
All directors and executive officers as a group (6 persons)	Common	3,628,194	⁽⁸⁾	75.8	%


Plan Category	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 security holders	478,550	$	2.84	54,784
Equity compensation plans not approved by security holders	—	$	—	—
Warrants issued for services	180,000	$	4.83	—

Total	658,550	$	3.38	54,784


Fee Category	2005		2004
Audit Fees	$	287,000	$	171,000
Audit-Related Fees		136,000		349,000
Tax Fees		5,000		10,000
All Other Fees		—		—

Total	$	428,000	$	530,000


		Page

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM		F-2

CONSOLIDATED FINANCIAL STATEMENTS

Consolidated Balance Sheets		F-3

Consolidated Statements of Operations		F-4

Consolidated Statements of Stockholders’ Equity		F-5

Consolidated Statements of Cash Flows		F-6

Notes to Consolidated Financial Statements		F-8

SUPPLEMENTAL INFORMATION

Report of Independent Registered Public Accounting Firm on Financial Statement Schedule		F-33

Valuation and Qualifying Accounts—Schedule II		F-34


	December 31,
	2005		2004
Current assets
Cash and cash equivalents	$	4,056,541	$	3,587,807
Restricted cash		30,864		1,044,339
Accounts receivable, net of allowance for doubtful accounts of $3,145 and $24,946		13,091,546		14,598,422
Inventory, net of allowance for obsolete inventory of $29,690 and $6,146,766		6,917,878		6,146,766
Inventory in transit		66,478		513,672
Prepaid expenses and other current assets		1,484,084		741,244

Total current assets		25,647,391		26,632,250
Property and equipment, net		172,005		307,661
Trademarks, net of accumulated amortization of $5,518,708 and 5,449,780		430,872		499,800
Other assets		27,032		27,032

Total assets	$	26,277,300	$	27,466,743


	Years Ended December 31,
	2005			2004			2003
Net sales	$	37,772,754		$	44,396,551		$	63,587,454
Cost of sales		33,523,147			41,418,750			54,643,371

Gross profit		4,249,607			2,977,801			8,944,083

Operating expenses
Selling, marketing, and advertising		776,001			1,008,248			1,507,222
General and administrative		4,766,276			5,343,125			6,461,613
Depreciation and amortization		235,835			833,545			1,268,077
Impairment of trademarks		—			3,696,099			—

Total operating expenses		5,778,112			10,881,017			9,236,912

Loss from operations		(1,528,505	)		(7,903,216	)		(292,829	)

Other income (expense)
Interest income		695			430			378
Interest expense		(299,592	)		(201,310	)		(248,754	)
Currency transaction gain		11,552			49,764			55,693
Loss on disposal of property and equipment		—			—			(61	)
Other expense		—			—			(1,593	)

Total other expense		(287,345	)		(151,116	)		(194,337	)

Loss before provision for (benefit from) income taxes		(1,815,850	)		(8,054,332	)		(487,166	)
Provision for (benefit from) income taxes		2,400			2,532			(27,148	)

Net loss	$	(1,818,250	)	$	(8,056,864	)	$	(460,018	)

Basic and diluted loss per share	$	(0.40	)	$	(1.78	)	$	(0.10	)

Basic and diluted weighted-average shares outstanding		4,530,380			4,529,672			4,529,672


	Preferred Stock
	Series A					Series B
	Shares	Amount		Additional Paid-In Capital		Shares	Amount		Additional Paid-In Capital		Common Stock			Additional Paid-In Capital		Treasury Stock			Accumulated Deficit			Total
	Shares	Amount		Additional Paid-In Capital		Shares	Amount		Additional Paid-In Capital		Shares	Amount		Additional Paid-In Capital		Treasury Stock			Accumulated Deficit			Total
Balance, December 31, 2002	—	$	—	$	—	—	$	—	$	—	4,529,672	$	4,530	$	31,557,988	$	(42,330	)	$	(14,557,655	)	$	16,962,533

Purchase of treasury stock	—		—		—	—		—		—	—		—		—		(83,684	)		—			(83,684	)
Net loss	—		—		—	—		—		—	—		—		—		—			(460,018	)		(460,018	)

Balance, December 31, 2003	—		—		—	—		—		—	4,529,672		4,530		31,557,988		(126,014	)		(15,017,673	)		16,418,831

Net loss	—		—		—	—		—		—	—		—		—		—			(8,056,864	)		(8,056,864	)

Balance, December 31, 2004	—		—		—	—		—		—	4,529,672		4,530		31,557,988		(126,014	)		(23,074,537	)		8,361,967

Exercise of Stock Options	—		—		—	—		—		—	1,900		2		6,648		—			—			6,650

Warrants for Services Rendered	—		—		—	—		—		—	—		—		31,316		—			—			31,316

Net Loss	—		—		—	—		—		—	—		—		—		—			(1,818,250	)		(1,818,250	)

Balance, December 31, 2005	—	$	—	$	—	—	$	—	$	—	4,531,572	$	4,532	$	31,595,952	$	(126,014	)	$	(24,892,787	)	$	6,581,683


	Year Ended December 31,
	2005			2004			2003
Cash flows from operating activities
Net loss	$	(1,818,250	)	$	(8,056,864	)	$	(460,018	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities
Depreciation and amortization		166,907			254,809			689,341
(Gain) loss on disposal of property and equipment		—			—			61
Amortization of trademarks		68,928			578,736			578,736
Impairment of trademarks		—			3,696,099			—
Allowance for doubtful accounts		52,604			200,000			1,478,089
Reserves for product returns and sales incentives		(79,282	)		(238,688	)		282,176
Reserves for obsolete inventory		841,000			2,046,217			125,000
Warrants issued for services rendered		31,316			—			—
(Increase) decrease in
Accounts receivable		1,454,272			3,641,471			(862,783	)
Inventory		(1,165,007	)		1,000,052			(916,430	)
Prepaid expenses and other current assets		(742,839	)		(333,984	)		(378,304	)
Other assets		—			25,952			(27,032	)
Increase (decrease) in
Accounts payable and accrued expenses		703,949			(351,160	)		(1,712,369	)
Accounts payable—related parties		875,482			(3,023,523	)		7,762,841
Settlement payable		—			(1,000,000	)		(3,000,000	)

Net cash provided by (used in) operating activities		389,170			(1,560,883	)		3,559,308

Cash flows from investing activities
Proceeds from disposal of property and equipment		—			—			500
Restricted cash		1,013,475			1,141,325			(3,632	)
Purchase of property and equipment		(31,252	)		(22,526	)		(170,776	)

Net cash provided by (used in) investing activities		982,223			1,118,799			(173,908	)

Cash flows from financing activities
Net borrowings (payments) on line of credit		(909,309	)		24,186			(4,434,122	)
Purchase of treasury stock		—			—			(83,684	)
Proceeds from exercise of options		6,650			—			—

Net cash provided by (used in) financing activities		(902,659	)		24,186			(4,517,806	)

Net increase (decrease) in cash and cash equivalents		468,734			(417,898	)		(1,132,406	)
Cash and cash equivalents, beginning of period		3,587,807			4,005,705			5,138,111

Cash and cash equivalents, end of period	$	4,056,541		$	3,587,807		$	4,005,705

Supplemental disclosures of cash flow information
Interest paid	$	296,928		$	192,488		$	229,379

Income taxes paid (refunded)	$	2,400		$	2,532		$	(3,083	)


Computer equipment and software		5 years
Warehouse equipment		7 years
Office furniture and equipment		5 to 7 years
Equipment under capital leases		5 years
Vehicles		5 years
Leasehold improvements		Estimated useful life or lease term whichever is shorter


	2005			2004
Component parts	$	2,491,594		$	2,123,173
Finished goods—warehouse		1,101,355			2,614,202
Finished goods—consigned		3,421,097			2,872,605
Reserves for obsolete and slow moving inventory		(29,690	)		(1,463,214	)

Total	$	6,984,356		$	6,146,766


	2005		2004
Trademarks	$	5,949,580	$	9,645,679
Less writedown		—		3,696,099
Less accumulated amortization		5,518,708		5,449,780

Total	$	430,872	$	499,800


	2005		2004
Accounts payable	$	1,477,459	$	1,282,082
Accrued rebates and marketing		3,848,545		3,231,655
Accrued compensation and related benefits		187,771		158,896
Other		411,893		549,086

Total	$	5,925,668	$	5,221,719


Year Ending December 31,
2006	$	227,686
2007		5,820
2008		5,820

Total	$	239,326


	Number of Shares				Total		Weighted- Average Exercise Price
	Employee		Non- Employee		Total		Weighted- Average Exercise Price
Outstanding, December 31, 2002	20,000		—		20,000		$	16.95
Granted	—		40,008		40,008		$	8.49
Expired, cancelled	(20,000	)	—		(20,000	)	$	16.95

Outstanding, December 31, 2003	—		40,008		40,008		$	8.49
Granted	126,375		20,000		146,375		$	3.85
Expired, cancelled	(375	)	(40,008	)	(40,383	)	$	8.44

Outstanding, December 31, 2004	126,000		20,000		146,000		$	3.85
Granted	370,000		180,000		550,000		$	3.32
Exercised	(1,900	)	—		(1,900	)	$	3.50
Expired, cancelled	(15,550	)	(20,000	)	(35,550	)	$	4.34

Outstanding, December 31, 2005	478,550		180,000		658,550		$	3.38

Exercisable, December 31, 2005	287,491		180,000		467,491		$	3.65


Range of Exercise Prices	Stock Options and Warrants Outstanding	Stock Options and Warrants Exercisable	Weighted- Average Remaining Contractual Life	Weighted- Average Exercise Price of Options and Warrants Outstanding		Weighted- Average Exercise Price of Options and Warrants Exercisable
$ 2.50–3.85	548,550	337,491	5.01 years	$	2.86	$	2.92
$ 4.00–6.00	100,000	100,000	1.08 years	$	4.50	$	4.50
$ 7.00–8.00	15,000	15,000	0.92 years	$	8.00	$	8.00
$ 9.00–10.00	15,000	15,000	0.92 years	$	10.00	$	10.00

	658,550	467,491	4.22 years	$	3.38	$	3.65


	2005			2004
Deferred tax assets
Net operating loss carryforward	$	10,853,808		$	9,093,879
Allowance for doubtful accounts		1,347			10,687
Allowances for product returns		76,279			115,970
Allowances for sales incentives		135,475			129,747
Accrued compensation		65,599			68,789
Amortization of trademarks		2,363,610			2,609,562
Inventory		312,271			738,002
Other		17,107			14,836
Valuation allowance		(13,078,901	)		(12,098,999	)

Total deferred tax assets		746,595			682,473

Deferred tax liabilities
State tax		(740,455	)		(676,333	)
Other		(6,140	)		(6,140	)

Total deferred tax liabilities		(746,595	)		(682,473	)

Net deferred tax assets/liabilities	$	—		$	—


Year Ended December 31, 2005	First Quarter			Second Quarter			Third Quarter			Fourth Quarter			Total Year
	(In thousands, except per share data)
Net sales	$	9,037		$	9,558		$	8,423		$	10,755		$	37,773
Gross profit		582			1,517			1,350			800			4,249
Operating expenses		1,670			1,227			1,485			1,396			4,778
Operating income (loss)		(1,088	)		291			(136	)		(596	)		(1,529	)
Other expense		(69	)		(62	)		(76	)		(80	)		(287	)
Pre-tax income (loss)		(1,157	)		229			(212	)		(676	)		(1,816	)
Income tax provision		—			2			—			—			2
Net income (loss)	$	(1,157	)	$	227		$	(212	)	$	(676	)	$	(1,818	)
Net income (loss) per common share diluted	$	(0.26	)	$	0.05		$	(0.05	)	$	(0.14	)	$	(0.40	)

Year Ended December 31, 2004	First Quarter			Second Quarter			Third Quarter			Fourth Quarter			Total Year
	(In thousands, except per share data)
Net sales	$	15,474		$	7,490		$	9,947		$	11,486		$	44,397
Gross profit (loss)		2,256			438			555			(271	)		2,978
Operating expenses		2,056			1,834			1,698			5,293			10,881
Operating income (loss)		200			(1,396	)		(1,143	)		(5,564	)		(7,903	)
Other expense		(52	)		(52	)		(26	)		(21	)		(151	)
Pre-tax income (loss)		148			(1,448	)		(1,169	)		(5,585	)		(8,054	)
Income tax provision (benefit)		3			(1	)		—			1			3
Net income (loss)	$	145		$	(1,447	)	$	(1,169	)	$	(5,586	)	$	(8,057	)
Net income (loss) per common share diluted	$	0.03		$	(0.32	)	$	(0.26	)	$	(1.23	)	$	(1.78	)


Exhibit Number		Description
3.1		Amended and Restated Articles of Incorporation of I/OMagic Corporation filed with the Secretary of State of Nevada on December 6, 2002 (7)

3.2		Amended and Restated Bylaws of I/OMagic Corporation dated July 25, 2002 (1)

10.1		Employment Agreement dated October 15, 2002 between I/OMagic Corporation and Tony Shahbaz (#) (2)

10.2		I/OMagic Corporation 2002 Stock Option Plan (#) (3)

10.3		Warehouse Services and Bailment Agreement dated February 3, 2003 between I/OMagic Corporation and Behavior Tech Computer (USA) Corp. (4)

10.4		I/OMagic Corporation 2003 Stock Option Plan (#) (6)

10.5		Standard Industrial/Commercial Single-Tenant Lease-Net dated July 1, 2003 between Laro Properties, L.P. and I/OMagic Corporation (5)

10.6		Form of Indemnification Agreement (8)

10.7		Trademark License Agreement dated July 24, 2004 by and between IOM Holdings, Inc. and I/OMagic Corporation (8)

10.8		Loan and Security Agreement entered into between I/OMagic Corporation and GMAC Commercial Finance LLC, dated March 9, 2005 (9)

10.9		Pledge and Security Agreement executed by I/OMagic Corporation, dated March 9, 2005 (9)

10.10		Collateral Assignment Agreement executed by I/OMagic Corporation, dated March 9, 2005 (9)

10.11		Guaranty Agreement entered into between IOM Holdings, Inc., and GMAC Commercial Finance LLC dated March 9, 2005 (9)

10.12		General Security Agreement entered into between IOM Holdings, Inc. and GMAC Commercial Finance LLC, dated March 9, 2005 (9)

10.13		Intellectual Property Security Agreement and Collateral Assignment entered into between I/OMagic Corporation and GMAC Commercial Finance LLC, dated March 9, 2005 (9)

10.14		Intellectual Property Security Agreement and Collateral Assignment entered into between IOM Holdings, Inc. and GMAC Commercial Finance LLC, dated March 9, 2005 (9)

10.15		Letter Agreement between GMAC Commercial Finance LLC and I/OMagic Corporation dated May 23, 2005 (10)

10.16		First Amendment to Loan and Security Agreement between GMAC Commercial Finance LLC and I/OMagic Corporation dated June 30, 2005 (11)

10.17		Amended and Restated Agreement between Lung Hwa Electronics Co. Ltd., and I/OMagic Corporation, dated July 21, 2005 (12)

14.1		I/OMagic Corporation Code of Business Conduct and Ethics dated March 15, 2004 (7)

14.2		I/OMagic Corporation Code of Business Ethics for CEO and Senior Financial Officers dated March 15, 2004 (7)

14.3		Charter of the Audit Committee of the Board of Directors of I/OMagic Corporation dated March 15, 2004 (7)

21.1		Subsidiaries of the Registrant (8)

23.1		Consent of Independent Registered Public Accounting Firm*

31		Certifications Required by Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002*

32		Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S. C. Section 350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002*


Signature	Title	Date
/s/ TONY SHAHBAZ Tony Shahbaz	Chief Executive Officer, President and Secretary (Principal Executive Officer)	March 31, 2006

/s/ STEVE GILLINGS Steve Gillings	Chief Financial Officer (Principal Accounting and Financial Officer)	March 31, 2006

Daniel Hou	Director	March 31, 2006

/s/ DANIEL YAO Daniel Yao	Director	March 31, 2006

/s/ STEEL SU Steel Su	Director	March 31, 2006

/s/ WILLIAM TING William Ting	Director	March 31, 2006


Exhibit Number		Description
23.1		Consent of Independent Registered Public Accounting Firm

31		Certifications Required by Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32		Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002


Date: March 31, 2006	By:	/s/ TONY SHAHBAZ
		Tony Shahbaz
		Chief Executive Officer
		(principal executive officer)

Date: March 31, 2006	By:	/s/ STEVE GILLINGS
		Steve Gillings
		Chief Financial Officer
		(principal financial officer)