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<table style="margin-top: 0px; font: 10pt times new roman, times, serif; margin-bottom: 0px;" cellspacing="0" cellpadding="0">
<tr style="text-align: justify; vertical-align: top;">
<td style="text-align: left; width: 0.5in;"><b>1.</b></td>
<td style="text-align: justify;"><b>Basis of Presentation</b></td>
</tr>
</table>
<p style="margin: 0pt 0px; font: 10pt times new roman, times, serif;"> </p>
<p style="text-align: justify; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><i>Financial Statement Preparation</i></p>
<p style="margin: 0pt 0px; font: 10pt times new roman, times, serif;"> </p>
<p style="text-align: justify; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;">The unaudited condensed consolidated financial statements of deltathree, Inc. and its subsidiaries (collectively referred to in this Quarterly Report on Form 10-Q as the “Company”, “we”, “us”, or “our”), of which these notes are a part, have been prepared in accordance with generally accepted accounting principles for interim financial information and pursuant to the instructions of Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for annual financial statements. In the opinion of our management, all adjustments (consisting only of normal recurring accruals) considered necessary for a fair presentation of the financial information as of and for the periods presented have been included.</p>
<p style="margin: 0pt 0px; font: 10pt times new roman, times, serif;"> </p>
<p style="text-align: justify; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;">The results for the interim periods presented are not necessarily indicative of the results that may be expected for any future period. The unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes for the year ended December 31, 2011, included in our Annual Report on Form 10-K filed with the SEC on March 28, 2012,<font style="background-color: white;"> </font>our <font style="background-color: white;">Quarterly Report on Form 10-Q for the quarter ended March 31, 2012, filed with the SEC on May 14, 2012, </font>our <font style="background-color: white;">Quarterly Report on Form 10-Q for the quarter ended June 30, 2012, filed with the SEC on August 13, 2012, </font>and all of our other periodic filings, including Current Reports on Form 8-K, filed with the SEC after the end of our 2011 fiscal year and through the date of this Report.</p>
<p style="margin: 0pt 0px; font: 10pt times new roman, times, serif;"> </p>
<p style="text-align: justify; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><i>Going Concern </i></p>
<p style="margin: 0pt 0px; font: 10pt times new roman, times, serif;"> </p>
<p style="text-align: justify; background-color: white; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font style="background-color: white;">The Company has sustained significant operating losses in recent periods, which has resulted in a significant reduction in its cash reserves.  The Company and its subsidiaries have entered into four loan agreements with D4 Holdings, LLC, its majority stockholder, pursuant to which D4 Holdings has agreed to provide the Company with loans in the aggregate principal amount of $4,100,000.  The initial Loan and Security Agreement, or the “First Loan Agreement”, was entered into on March 1, 2010, and the Company has drawn the maximum principal amount available under the First Loan Agreement.  On August 10, 2010, the Company and its subsidiaries entered into the Second Loan and Security Agreement, or the “Second Loan Agreement”, with D4 Holdings with a maximum principal amount of $1,000,000, and the Company has drawn the maximum principal amount available under the Second Loan Agreement.  In connection with the Second Loan Agreement, the Company issued D4 Holdings a warrant to purchase up to 4,000,000 shares of the Company's common stock at an exercise price of $0.1312 per share. On March 2, 2011, the Company and its subsidiaries entered into the Third Loan and Security Agreement, or the “Third Loan Agreement”, with D4 Holdings, pursuant to which D4 Holdings agreed to provide the Company and its subsidiaries an additional line of credit in a principal amount of $1,600,000. Pursuant to the terms of the Convertible Promissory Note, or the “Convertible Note”, issued by the Company in connection with the Third Loan Agreement, D4 Holdings may elect to convert all or any portion of the outstanding principal amount under the Convertible Note into that number of shares of the Company’s common stock determined by dividing such principal amount by $0.08 (as may be adjusted under the terms of the Convertible Note). Simultaneous with the Company’s entering into the Third Loan Agreement, D4 Holdings and the Company entered into an amendment of the First Loan Agreement, pursuant to which (among other things) the maturity date for repayment of principal under the First Loan Agreement was extended from March 1, 2011, to March 1, 2012. The maturity date was subsequently extended by oral agreement of the parties to July 1, 2012, and then subsequently orally extended again to January 2, 2014, pending the parties finalizing and entering into a formal amendment. In connection with the Third Loan Agreement, the Company issued D4 Holdings a warrant to purchase up to 1,000,000 shares of the Company’s common stock at an exercise price of $0.096 per share. The Company has drawn the aggregate principal amount available under the Third Loan Agreement, the principal amount of which can be converted by D4 Holdings into an aggregate of 20,000,000 shares of the Company’s common stock. On September 12, 2011, the Company and its subsidiaries entered into the Fourth Loan and Security Agreement, or the “Fourth Loan Agreement”, with D4 Holdings, pursuant to which D4 Holdings agreed to provide the Company and its subsidiaries an additional line of credit in a principal amount of $300,000. As of September 30, 2012, the Company had drawn down the aggregate amount of $200,000 from D4 Holdings pursuant to notices of borrowing under the Fourth Loan Agreement.</font></p>
<p style="text-align: justify; background-color: white; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font style="background-color: white;"> </font></p>
<p style="text-align: justify; background-color: white; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;">As of September 30, 2012, the Company had negative working capital equal to approximately $5.9 million as well as negative stockholders’ equity equal to approximately $5.6 million. The Company believes it is probable that it will continue to experience losses and increased negative working capital and negative stockholders’ equity in the near future and may not be able to return to positive cash flow before it requires additional cash (in addition to any further amounts it may borrow from D4 Holdings under the Fourth Loan Agreement) in the near term. The Company may experience difficulties accessing the equity and debt markets and raising additional capital, and there can be no assurance that the Company will be able to raise such additional capital on favorable terms or at all.  If additional funds are raised through the issuance of equity securities, the Company’s existing stockholders will experience significant further dilution. Because of the Company’s significant losses to date and the Company’s limited tangible assets, the Company does not fit traditional credit lending criteria, which could make it difficult for the Company to obtain loans or to access the capital markets. If the Company issues additional equity or convertible debt securities to raise funds, the ownership percentage of the Company’s existing stockholders would be reduced and they may experience significant dilution. New investors may demand rights, preferences or privileges senior to those of existing holders of the Company’s common stock.</p>
<p style="text-align: justify; background-color: white; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"> </p>
<p style="text-align: justify; background-color: white; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;">Due to the limited availability of additional loan advances under the Fourth Loan Agreement, the Company believes that, unless it is able to increase revenues and generate additional cash flows, its current cash and cash equivalents will not satisfy its current projected cash requirements beyond the foreseeable future. As a result, there is substantial doubt about the Company’s ability to continue as a going concern.</p>
<p style="text-align: justify; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font style="background-color: white;"> </font></p>
<p style="text-align: justify; background-color: white; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;">In addition, unless the Company is able to increase revenues and generate additional cash flows, based on currently projected cash flows the Company believes that it may be unable to pay future scheduled interest and/or principal payments under the various loan agreements with D4 Holdings as these obligations become due. In the event that were to occur, if D4 Holdings is not willing to waive compliance or otherwise modify the Company’s obligations such that the Company is able to avoid defaulting on such obligations, D4 Holdings could accelerate the maturity of the Company’s debts due to it. Further, because D4 Holdings has a lien on all of the Company’s assets to secure the Company’s obligations under the loan agreements, D4 Holdings could take actions under the loan agreements and seek to take possession of or sell the Company’s assets to satisfy the Company’s obligations thereunder. Any of these actions would likely have an immediate material adverse effect on the Company’s business, financial condition or results of operations.</p>
<p style="text-align: justify; background-color: white; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"> </p>
<p style="text-align: justify; background-color: white; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;">Due to the Company’s ongoing losses and reduction in cash, the Company initiated restructuring activities beginning in the second quarter of 2011 in an effort to cut operating costs significantly and better align the Company’s operations with its current business model.  In accordance with the restructuring, the Company instituted a reduction in force and decreased the number of full time employees from approximately 53 to 37, reduced the salaries of all remaining employees by five percent, and decreased non-material expenses as well as payments to be made to vendors and other third parties. As of September 30, 2012, the Company had 23 full time employees.</p>
<p style="text-align: justify; background-color: white; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"> </p>
<p style="text-align: justify; background-color: white; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;">In view of the Company’s current cash resources, nondiscretionary expenses, debt and near term debt service obligations, the Company may begin to explore all strategic alternatives available to it, including, but not limited to, a sale or merger of the Company, a sale of its assets, recapitalization, partnership, debt or equity financing, voluntary deregistration of its securities, financial reorganization, liquidation and/or ceasing operations. In the event that the Company requires but is unable to secure additional funding, the Company may determine that it is in its best interests to voluntarily seek relief under Chapter 11 of the U.S. Bankruptcy Code. Seeking relief under the U.S. Bankruptcy Code, even if the Company is able to emerge quickly from Chapter 11 protection, could have a material adverse effect on the relationships between the Company and its existing and potential customers, employees, and others. Further, if the Company was unable to implement a successful plan of reorganization, the Company might be forced to liquidate under Chapter 7 of the U.S. Bankruptcy Code. There can be no assurance that exploration of strategic alternatives will result in the Company pursuing any particular transaction or, if the Company pursues any such transaction, that it will be completed.</p>
<p style="text-align: justify; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><i> </i></p>
<p style="text-align: justify; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><i>Use of Estimates </i></p>
<p style="margin: 0pt 0px; font: 10pt times new roman, times, serif;"> </p>
<p style="text-align: justify; text-indent: 0.55in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"> Our consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States, which require management to make estimates and assumptions that affect the amounts reported and disclosed in the consolidated financial statements and the accompanying notes. Actual results could differ materially from these estimates.<font style="font-size: 10pt;"> </font></p>
<p style="text-align: justify; text-indent: 0.55in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"> </p>
<p style="margin: 0pt 0px; font: italic 10pt times new roman, times, serif;"><font style="font-weight: normal;">Concentration of Credit and Business Risks </font></p>
<p style="margin: 0pt 0px; font: italic 10pt times new roman, times, serif;"><font style="font-weight: normal;"> </font></p>
<p style="text-align: justify; background-color: white; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;">Financial instruments that potentially subject the Company to concentration of credit risk consist principally of cash and cash equivalents and trade accounts receivable. The Company performs ongoing credit evaluations of its customers and adjusts credit limits based upon payment history, age of the balance and the customer’s current credit worthiness, as determined by a review of the customer’s current credit information. The Company monitors collections and payments from its customers and maintains an allowance for doubtful accounts based upon historical experience and any specific customer collection issues that have been identified. A considerable amount of judgment is required in assessing the ultimate realization of these receivables. Customer receivables are generally unsecured.</p>
<p style="text-align: justify; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;">  </p>
<p style="text-align: justify; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;">Sales to material customers for each of the three months ended September 30, 2012 and 2011, and accounts receivable as of September 30, 2012, and December 31, 2011, were as follows:<b> </b></p>
<p style="text-align: justify; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><b> </b></p>
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<tr style="vertical-align: bottom;">
<td style="font-weight: bold;" nowrap="nowrap"> </td>
<td style="padding-bottom: 1pt; font-weight: bold;" nowrap="nowrap"> </td>
<td style="border-bottom: black 1pt solid; text-align: center; font-weight: bold;" colspan="7" nowrap="nowrap">Revenues</td>
<td style="padding-bottom: 1pt; font-weight: bold;" nowrap="nowrap"> </td>
<td style="border-bottom: black 1pt solid; text-align: center; font-weight: bold;" colspan="7" nowrap="nowrap">Accounts Receivable</td>
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<tr style="vertical-align: bottom;">
<td nowrap="nowrap"> </td>
<td style="padding-bottom: 1pt; color: black; font-weight: bold;" nowrap="nowrap"> </td>
<td style="border-bottom: black 1pt solid; text-align: center; color: black; font-weight: bold;" colspan="7" nowrap="nowrap">Three Months Ended September 30,</td>
<td style="padding-bottom: 1pt; color: black; font-weight: bold;" nowrap="nowrap"> </td>
<td style="border-bottom: black 1pt solid; text-align: center; color: black; font-weight: bold;" colspan="7" nowrap="nowrap">As of</td>
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<td style="color: black; font-weight: bold;" nowrap="nowrap">Customer</td>
<td style="padding-bottom: 1pt; color: black; font-weight: bold;" nowrap="nowrap"> </td>
<td style="border-bottom: black 1pt solid; text-align: center; color: black; font-weight: bold;" colspan="3" nowrap="nowrap">2012</td>
<td style="padding-bottom: 1pt; color: black; font-weight: bold;" nowrap="nowrap"> </td>
<td style="border-bottom: black 1pt solid; text-align: center; color: black; font-weight: bold;" colspan="3" nowrap="nowrap">2011</td>
<td style="padding-bottom: 1pt; color: black; font-weight: bold;" nowrap="nowrap"> </td>
<td style="border-bottom: black 1pt solid; text-align: center; color: black; font-weight: bold;" colspan="3" nowrap="nowrap">September 30, 2012</td>
<td style="padding-bottom: 1pt; color: black; font-weight: bold;" nowrap="nowrap"> </td>
<td style="border-bottom: black 1pt solid; text-align: center; color: black; font-weight: bold;" colspan="3" nowrap="nowrap">December 31, 2011</td>
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<td style="text-align: justify; padding-left: 9pt; width: 48%; color: black;" nowrap="nowrap">Reseller A</td>
<td style="width: 1%;"> </td>
<td style="text-align: left; width: 1%;"> </td>
<td style="text-align: right; width: 10%;">44</td>
<td style="text-align: left; width: 1%;">%</td>
<td style="width: 1%;"> </td>
<td style="text-align: left; width: 1%;"> </td>
<td style="text-align: right; width: 10%;">-</td>
<td style="text-align: left; width: 1%;"> </td>
<td style="width: 1%;"> </td>
<td style="text-align: left; width: 1%;"> </td>
<td style="text-align: right; width: 10%;">38</td>
<td style="text-align: left; width: 1%;">%</td>
<td style="width: 1%;"> </td>
<td style="text-align: left; width: 1%;"> </td>
<td style="text-align: right; width: 10%;">-</td>
<td style="text-align: left; width: 1%;"> </td>
</tr>
<tr style="background-color: white; vertical-align: bottom;">
<td style="text-align: justify; padding-left: 9pt;">Reseller B</td>
<td> </td>
<td style="text-align: left;"> </td>
<td style="text-align: right;">9</td>
<td style="text-align: left;">%</td>
<td> </td>
<td style="text-align: left;"> </td>
<td style="text-align: right;">35</td>
<td style="text-align: left;">%</td>
<td> </td>
<td style="text-align: left;"> </td>
<td style="text-align: right;">14</td>
<td style="text-align: left;">%</td>
<td> </td>
<td style="text-align: left;"> </td>
<td style="text-align: right;">19</td>
<td style="text-align: left;">%</td>
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<td style="text-align: justify; padding-left: 9pt;">Affiliate A</td>
<td> </td>
<td style="text-align: left;"> </td>
<td style="text-align: right;">10</td>
<td style="text-align: left;">%</td>
<td> </td>
<td style="text-align: left;"> </td>
<td style="text-align: right;">-</td>
<td style="text-align: left;"> </td>
<td> </td>
<td style="text-align: left;"> </td>
<td style="text-align: right;">-</td>
<td style="text-align: left;"> </td>
<td> </td>
<td style="text-align: left;"> </td>
<td style="text-align: right;">-</td>
<td style="text-align: left;"> </td>
</tr>
<tr style="background-color: white; vertical-align: bottom;">
<td style="text-align: justify; padding-left: 9pt;">Affiliate B</td>
<td> </td>
<td style="text-align: left;"> </td>
<td style="text-align: right;">7</td>
<td style="text-align: left;">%</td>
<td> </td>
<td style="text-align: left;"> </td>
<td style="text-align: right;">13</td>
<td style="text-align: left;">%</td>
<td> </td>
<td style="text-align: left;"> </td>
<td style="text-align: right;">-</td>
<td style="text-align: left;"> </td>
<td> </td>
<td style="text-align: left;"> </td>
<td style="text-align: right;">-</td>
<td style="text-align: left;"> </td>
</tr>
<tr style="background-color: #ccffcc; vertical-align: bottom;">
<td style="text-align: justify; padding-left: 9pt;">Service Provider A</td>
<td> </td>
<td style="text-align: left;"> </td>
<td style="text-align: right;">5</td>
<td style="text-align: left;">%</td>
<td> </td>
<td style="text-align: left;"> </td>
<td style="text-align: right;">11</td>
<td style="text-align: left;">%</td>
<td> </td>
<td style="text-align: left;"> </td>
<td style="text-align: right;">21</td>
<td style="text-align: left;">%</td>
<td> </td>
<td style="text-align: left;"> </td>
<td style="text-align: right;">38</td>
<td style="text-align: left;">%</td>
</tr>
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<p style="text-align: justify; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><i> </i></p>
<p style="text-align: left; margin-top: 0pt; font: 10pt times new roman, times, serif; margin-bottom: 0pt;"><i>Earnings per Common Share</i></p>
<p style="margin: 0pt 0px; font: 10pt times new roman, times, serif;"> </p>
<p style="text-align: justify; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;">Basic earnings per common share is computed by dividing net income by the weighted-average number of shares of common stock outstanding during the reporting period. Diluted earnings per common share is computed by dividing net income by the combination of dilutive common share equivalents, comprised of shares issuable under the Company’s stock option and stock incentive compensation plans, and the weighted-average number of shares of common stock outstanding during the reporting period.<b> </b>Dilutive common share equivalents include the dilutive effect of in-the-money shares, which is calculated based on the average share price for each period using the treasury stock method. Under the treasury stock method, the exercise price of a share, the amount of compensation cost, if any, for future service that the Company has not yet recognized, and the amount of estimated tax benefits that would be recorded in additional paid-in capital, if any, when the share is exercised are assumed to be used to repurchase shares in the current period.</p>
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<td style="text-align: left; width: 0.5in;"><b>2.</b></td>
<td style="text-align: justify;"><b>Stock-Based Compensation</b></td>
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<p style="margin: 0pt 0px; font: 10pt times new roman, times, serif;"> </p>
<p style="text-align: justify; text-indent: 19.8pt; margin: 0pt 0px; font: 10pt times new roman, times, serif;">Options</p>
<p style="margin: 0pt 0px; font: 10pt times new roman, times, serif;"> </p>
<p style="text-align: justify; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;">Stock-based compensation cost is measured at the grant date, based on the estimated fair value of the award, and is recognized as expense over the employee’s requisite service period in accordance with the provisions of  “Compensation – Stock Compensation” [ASC 718-10].</p>
<p style="margin: 0pt 0px; font: 10pt times new roman, times, serif;"> </p>
<p style="text-align: justify; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;">The Company has no awards with market or performance conditions.</p>
<p style="margin: 0pt 0px; font: 10pt times new roman, times, serif;"> </p>
<p style="text-align: justify; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;">The risk-free interest rate assumption is based upon observed interest rates appropriate for the terms of the Company’s employee stock options. The Company does not target a specific dividend yield for its dividends payments but is required to assume a dividend yield as an input to the Black–Scholes model. The dividend yield assumption is based on the Company’s history and expectation of future dividends payout and may be subject to substantial change in the future. The expected life of employee stock options represent the period the stock options are expected to remain outstanding. The Black-Scholes model assumes that an employee’s exercise behavior is a function of the option’s remaining contractual life and the extent to which the option is in-the-money (i.e., the average market price of the underlying stock during the period is above the strike price of the stock option).</p>
<p style="margin: 0pt 0px; font: 10pt times new roman, times, serif;"> </p>
<p style="text-align: justify; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;">Options to purchase 400,000 shares of the Company’s common stock were granted during the three months ended September 30, 2012.</p>
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<td style="text-align: left; width: 0.5in;"><font size="2" style="font-family:times new roman,times"><b>3.</b></font></td>
<td style="text-align: justify;"><font size="2" style="font-family:times new roman,times"><b>Commitments and Contingencies</b></font></td>
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<p style="margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times"> </font></p>
<p style="text-align: justify; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times"><i>Lease Commitments</i></font></p>
<p style="margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times"> </font></p>
<p style="text-align: justify; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times"><font style="color: black;">The Company leases its executive offices at </font><font style="background-color: white;">26 Avenue at Port Imperial, West New York, New Jersey, and storage and equipment space at 117 Central Avenue, Hackensack, New Jersey</font><font style="color: black;">.  </font><font style="background-color: white;">The Company leases each of these facilities on a month-to-month basis. The aggregate </font><font style="color: black;">rent expense, net, for the two locations for the three months ended September 30, 2012, was $3,150.</font></font></p>
<p style="text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times"> </font></p>
<p style="text-align: justify; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times">Delta Three Israel Ltd., a wholly-owned subsidiary of the Company (the "Subsidiary"), leases an office that houses the Company’s research and development facilities in Jerusalem, Israel. The term of the lease is until June 30, 2015. Rent expense, net for the Subsidiary for the three months ended September 30, 2012, was $36,750.</font></p>
<p style="text-align: justify; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times"><i> </i></font></p>
<div style="text-align: justify; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times"><i>Legal Proceedings</i></font></div>
<p style="margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times"> </font></p>
<p style="text-align: justify; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times"><font style="background-color: white;">On July 5, 2011, the Company received a notice from the New York City Department of Finance, or the Department of Finance, which claimed that the Company had not paid commercial rent tax required under the New York City Administrative Code from June 1998 through May 2008 for the two offices that the Company had leased during that time. The notice stated that the Company is obligated to pay the outstanding tax amounts, as well as significant interest and penalties that were assessed on the unpaid amounts as well as for the failure to file the applicable tax returns.  The Company engaged outside counsel, which began discussions with the Department of Finance, and contested the assessment and simultaneously attempted to negotiate a significant reduction in the amounts to be paid. The Company’s appeal was rejected in July 2012 by an examiner in the Department of Finance, and the Company has subsequently engaged and begun discussions with a manager in the Department of Finance and submitted additional supporting materials. The final outcome of this assessment and our negotiations cannot be determined at this time. In the event that the Company is required to pay all or most of the amounts claimed by the Department of Finance this would have a material adverse effect on the Company’s financial condition. During 2011 t</font>he Company recorded $300,000 as a provision for commercial rent tax.</font></p>
<p style="text-align: justify; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times"> </font></p>
<p style="text-align: justify; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times">In addition, from time to time the Company is a party to legal proceedings, much of which is ordinary routine litigation incidental to the business, and is regularly required to expend time and resources in connection with such proceedings.  Accordingly, the Company, in consultation with its legal advisors, accrues amounts that management believes it is probable the Company will be required to expend in connection with all legal proceedings to which it is a party.</font></p>
<p style="margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times"> </font></p>
<p style="text-align: justify; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times"><i>Regulatory Taxes, Fees and Surcharges</i></font></p>
<p style="margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times"> </font></p>
<p style="text-align: justify; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times">Some state and local regulatory authorities believe they retain jurisdiction to regulate the provision of, and impose taxes, fees and surcharges on, intrastate Internet and VoIP telephony services, and have attempted to impose such taxes, fees and surcharges, such as a fee for providing E-911 service. Rulings by the state commissions on the regulatory considerations affecting Internet and IP telephony services could affect our operations and revenues, and we cannot predict whether state commissions will be permitted to regulate the services we offer in the future.</font></p>
<p style="text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times"> </font></p>
<p style="text-align: justify; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times">The Company paid approximately $245,000 of state and local taxes and other fees during the three months ended September 30, 2012. To the extent the Company increases the cost of services to our customers to recoup some of the costs of compliance this will have the effect of decreasing any price advantage the Company may have over traditional telecommunications companies.</font></p>
<p style="text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times"> </font></p>
<p style="text-align: justify; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font style="color: black;; font-family:times new roman,times" size="2">In addition, it is possible that the Company will be required to collect and remit taxes, fees and surcharges in other states and local jurisdictions where it has not done so, and which such authorities may take the position that it should have collected. If so, they may seek to collect those past taxes, fees and surcharges from the Company and impose fines, penalties or interest charges on the Company. The Company’s payment of these past taxes, fees and surcharges, as well as penalties and interest charges, could have a material adverse effect on the Company.</font></p>
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<td style="text-align: left; width: 0.5in;"><b>4.</b></td>
<td style="text-align: justify;"><b>Warrants and Convertible Note</b></td>
</tr>
</table>
<p style="text-align: justify; margin: 0pt 0px; font: 10pt times new roman, times, serif;"> </p>
<p style="text-align: justify; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font style="color: black;">As discussed above under “Basis of Presentation”, the Company issued to D4 Holdings a warrant in connection with the Second Loan Agreement and a warrant and the Convertible Note in connection with the Third Loan Agreement. </font>The Company evaluated the warrants in accordance with “Contracts in Entity's Own Equity” [ASC 815-40] and determined that the warrants should be classified as equity and should not be considered derivatives. The Company accounted for the Convertible Note in accordance with “Debt with Conversion and Other Options” [ASC 470-20], which requires the Company to recognize separately, at issuance, the embedded beneficial conversion feature of the Convertible Note as additional paid-in capital. The amount to be recognized is calculated as the difference between the effective conversion price of the convertible instrument and the fair value of the underlying shares on the issuance date. As a result, the Convertible Note was initially recorded as having no value, as the beneficial conversion feature exceeded the carrying value of the Convertible Note.</p>
<p style="text-align: justify; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><i>Going Concern </i></p>
<p style="margin: 0pt 0px; font: 10pt times new roman, times, serif;"> </p>
<p style="text-align: justify; background-color: white; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font style="background-color: white;">The Company has sustained significant operating losses in recent periods, which has resulted in a significant reduction in its cash reserves.  The Company and its subsidiaries have entered into four loan agreements with D4 Holdings, LLC, its majority stockholder, pursuant to which D4 Holdings has agreed to provide the Company with loans in the aggregate principal amount of $4,100,000.  The initial Loan and Security Agreement, or the “First Loan Agreement”, was entered into on March 1, 2010, and the Company has drawn the maximum principal amount available under the First Loan Agreement.  On August 10, 2010, the Company and its subsidiaries entered into the Second Loan and Security Agreement, or the “Second Loan Agreement”, with D4 Holdings with a maximum principal amount of $1,000,000, and the Company has drawn the maximum principal amount available under the Second Loan Agreement.  In connection with the Second Loan Agreement, the Company issued D4 Holdings a warrant to purchase up to 4,000,000 shares of the Company's common stock at an exercise price of $0.1312 per share. On March 2, 2011, the Company and its subsidiaries entered into the Third Loan and Security Agreement, or the “Third Loan Agreement”, with D4 Holdings, pursuant to which D4 Holdings agreed to provide the Company and its subsidiaries an additional line of credit in a principal amount of $1,600,000. Pursuant to the terms of the Convertible Promissory Note, or the “Convertible Note”, issued by the Company in connection with the Third Loan Agreement, D4 Holdings may elect to convert all or any portion of the outstanding principal amount under the Convertible Note into that number of shares of the Company’s common stock determined by dividing such principal amount by $0.08 (as may be adjusted under the terms of the Convertible Note). Simultaneous with the Company’s entering into the Third Loan Agreement, D4 Holdings and the Company entered into an amendment of the First Loan Agreement, pursuant to which (among other things) the maturity date for repayment of principal under the First Loan Agreement was extended from March 1, 2011, to March 1, 2012. The maturity date was subsequently extended by oral agreement of the parties to July 1, 2012, and then subsequently orally extended again to January 2, 2014, pending the parties finalizing and entering into a formal amendment. In connection with the Third Loan Agreement, the Company issued D4 Holdings a warrant to purchase up to 1,000,000 shares of the Company’s common stock at an exercise price of $0.096 per share. The Company has drawn the aggregate principal amount available under the Third Loan Agreement, the principal amount of which can be converted by D4 Holdings into an aggregate of 20,000,000 shares of the Company’s common stock. On September 12, 2011, the Company and its subsidiaries entered into the Fourth Loan and Security Agreement, or the “Fourth Loan Agreement”, with D4 Holdings, pursuant to which D4 Holdings agreed to provide the Company and its subsidiaries an additional line of credit in a principal amount of $300,000. As of September 30, 2012, the Company had drawn down the aggregate amount of $200,000 from D4 Holdings pursuant to notices of borrowing under the Fourth Loan Agreement.</font></p>
<p style="text-align: justify; background-color: white; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font style="background-color: white;"> </font></p>
<p style="text-align: justify; background-color: white; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;">As of September 30, 2012, the Company had negative working capital equal to approximately $5.9 million as well as negative stockholders’ equity equal to approximately $5.6 million. The Company believes it is probable that it will continue to experience losses and increased negative working capital and negative stockholders’ equity in the near future and may not be able to return to positive cash flow before it requires additional cash (in addition to any further amounts it may borrow from D4 Holdings under the Fourth Loan Agreement) in the near term. The Company may experience difficulties accessing the equity and debt markets and raising additional capital, and there can be no assurance that the Company will be able to raise such additional capital on favorable terms or at all.  If additional funds are raised through the issuance of equity securities, the Company’s existing stockholders will experience significant further dilution. Because of the Company’s significant losses to date and the Company’s limited tangible assets, the Company does not fit traditional credit lending criteria, which could make it difficult for the Company to obtain loans or to access the capital markets. If the Company issues additional equity or convertible debt securities to raise funds, the ownership percentage of the Company’s existing stockholders would be reduced and they may experience significant dilution. New investors may demand rights, preferences or privileges senior to those of existing holders of the Company’s common stock.</p>
<p style="text-align: justify; background-color: white; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"> </p>
<p style="text-align: justify; background-color: white; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;">Due to the limited availability of additional loan advances under the Fourth Loan Agreement, the Company believes that, unless it is able to increase revenues and generate additional cash flows, its current cash and cash equivalents will not satisfy its current projected cash requirements beyond the foreseeable future. As a result, there is substantial doubt about the Company’s ability to continue as a going concern.</p>
<p style="text-align: justify; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font style="background-color: white;"> </font></p>
<p style="text-align: justify; background-color: white; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;">In addition, unless the Company is able to increase revenues and generate additional cash flows, based on currently projected cash flows the Company believes that it may be unable to pay future scheduled interest and/or principal payments under the various loan agreements with D4 Holdings as these obligations become due. In the event that were to occur, if D4 Holdings is not willing to waive compliance or otherwise modify the Company’s obligations such that the Company is able to avoid defaulting on such obligations, D4 Holdings could accelerate the maturity of the Company’s debts due to it. Further, because D4 Holdings has a lien on all of the Company’s assets to secure the Company’s obligations under the loan agreements, D4 Holdings could take actions under the loan agreements and seek to take possession of or sell the Company’s assets to satisfy the Company’s obligations thereunder. Any of these actions would likely have an immediate material adverse effect on the Company’s business, financial condition or results of operations.</p>
<p style="text-align: justify; background-color: white; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"> </p>
<p style="text-align: justify; background-color: white; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;">Due to the Company’s ongoing losses and reduction in cash, the Company initiated restructuring activities beginning in the second quarter of 2011 in an effort to cut operating costs significantly and better align the Company’s operations with its current business model.  In accordance with the restructuring, the Company instituted a reduction in force and decreased the number of full time employees from approximately 53 to 37, reduced the salaries of all remaining employees by five percent, and decreased non-material expenses as well as payments to be made to vendors and other third parties. As of September 30, 2012, the Company had 23 full time employees.</p>
<p style="text-align: justify; background-color: white; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"> </p>
<p style="text-align: justify; background-color: white; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;">In view of the Company’s current cash resources, nondiscretionary expenses, debt and near term debt service obligations, the Company may begin to explore all strategic alternatives available to it, including, but not limited to, a sale or merger of the Company, a sale of its assets, recapitalization, partnership, debt or equity financing, voluntary deregistration of its securities, financial reorganization, liquidation and/or ceasing operations. In the event that the Company requires but is unable to secure additional funding, the Company may determine that it is in its best interests to voluntarily seek relief under Chapter 11 of the U.S. Bankruptcy Code. Seeking relief under the U.S. Bankruptcy Code, even if the Company is able to emerge quickly from Chapter 11 protection, could have a material adverse effect on the relationships between the Company and its existing and potential customers, employees, and others. Further, if the Company was unable to implement a successful plan of reorganization, the Company might be forced to liquidate under Chapter 7 of the U.S. Bankruptcy Code. There can be no assurance that exploration of strategic alternatives will result in the Company pursuing any particular transaction or, if the Company pursues any such transaction, that it will be completed.</p>
<p style="text-align: justify; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times"><i>Use of Estimates </i></font></p>
<p style="margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times"> </font></p>
<p style="text-align: justify; text-indent: 0.55in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times"> Our consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States, which require management to make estimates and assumptions that affect the amounts reported and disclosed in the consolidated financial statements and the accompanying notes. Actual results could differ materially from these estimates.</font></p>
<p style="margin: 0pt 0px; font: italic 10pt times new roman, times, serif;"><font style="font-weight: normal;; font-family:times new roman,times" size="2">Concentration of Credit and Business Risks </font></p>
<p style="margin: 0pt 0px; font: italic 10pt times new roman, times, serif;"><font style="font-weight: normal;; font-family:times new roman,times" size="2"> </font></p>
<p style="text-align: justify; background-color: white; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times">Financial instruments that potentially subject the Company to concentration of credit risk consist principally of cash and cash equivalents and trade accounts receivable. The Company performs ongoing credit evaluations of its customers and adjusts credit limits based upon payment history, age of the balance and the customer’s current credit worthiness, as determined by a review of the customer’s current credit information. The Company monitors collections and payments from its customers and maintains an allowance for doubtful accounts based upon historical experience and any specific customer collection issues that have been identified. A considerable amount of judgment is required in assessing the ultimate realization of these receivables. Customer receivables are generally unsecured.</font></p>
<p style="text-align: justify; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times"> </font></p>
<p style="text-align: justify; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times">Sales to material customers for each of the three months ended September 30, 2012 and 2011, and accounts receivable as of September 30, 2012, and December 31, 2011, were as follows:<b> </b></font></p>
<p style="text-align: justify; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times"><b> </b></font></p>
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<td style="font-weight: bold;" nowrap="nowrap"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="padding-bottom: 1pt; font-weight: bold;" nowrap="nowrap"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="border-bottom: black 1pt solid; text-align: center; font-weight: bold;" colspan="7" nowrap="nowrap"><font size="2" style="font-family:times new roman,times">Revenues</font></td>
<td style="padding-bottom: 1pt; font-weight: bold;" nowrap="nowrap"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="border-bottom: black 1pt solid; text-align: center; font-weight: bold;" colspan="7" nowrap="nowrap"><font size="2" style="font-family:times new roman,times">Accounts Receivable</font></td>
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<td nowrap="nowrap"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="padding-bottom: 1pt; color: black; font-weight: bold;" nowrap="nowrap"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="border-bottom: black 1pt solid; text-align: center; color: black; font-weight: bold;" colspan="7" nowrap="nowrap"><font size="2" style="font-family:times new roman,times">Three Months Ended September 30,</font></td>
<td style="padding-bottom: 1pt; color: black; font-weight: bold;" nowrap="nowrap"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="border-bottom: black 1pt solid; text-align: center; color: black; font-weight: bold;" colspan="7" nowrap="nowrap"><font size="2" style="font-family:times new roman,times">As of</font></td>
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<td style="color: black; font-weight: bold;" nowrap="nowrap"><font size="2" style="font-family:times new roman,times">Customer</font></td>
<td style="padding-bottom: 1pt; color: black; font-weight: bold;" nowrap="nowrap"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="border-bottom: black 1pt solid; text-align: center; color: black; font-weight: bold;" colspan="3" nowrap="nowrap"><font size="2" style="font-family:times new roman,times">2012</font></td>
<td style="padding-bottom: 1pt; color: black; font-weight: bold;" nowrap="nowrap"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="border-bottom: black 1pt solid; text-align: center; color: black; font-weight: bold;" colspan="3" nowrap="nowrap"><font size="2" style="font-family:times new roman,times">2011</font></td>
<td style="padding-bottom: 1pt; color: black; font-weight: bold;" nowrap="nowrap"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="border-bottom: black 1pt solid; text-align: center; color: black; font-weight: bold;" colspan="3" nowrap="nowrap"><font size="2" style="font-family:times new roman,times">September 30, 2012</font></td>
<td style="padding-bottom: 1pt; color: black; font-weight: bold;" nowrap="nowrap"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="border-bottom: black 1pt solid; text-align: center; color: black; font-weight: bold;" colspan="3" nowrap="nowrap"><font size="2" style="font-family:times new roman,times">December 31, 2011</font></td>
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<td style="text-align: justify; padding-left: 9pt; width: 48%; color: black;" nowrap="nowrap"><font size="2" style="font-family:times new roman,times">Reseller A</font></td>
<td style="width: 1%;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left; width: 1%;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right; width: 10%;"><font size="2" style="font-family:times new roman,times">44</font></td>
<td style="text-align: left; width: 1%;"><font size="2" style="font-family:times new roman,times">%</font></td>
<td style="width: 1%;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left; width: 1%;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right; width: 10%;"><font size="2" style="font-family:times new roman,times">-</font></td>
<td style="text-align: left; width: 1%;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="width: 1%;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left; width: 1%;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;
width: 10%;"><font size="2" style="font-family:times new roman,times">38</font></td>
<td style="text-align: left; width: 1%;"><font size="2" style="font-family:times new roman,times">%</font></td>
<td style="width: 1%;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left; width: 1%;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right; width: 10%;"><font size="2" style="font-family:times new roman,times">-</font></td>
<td style="text-align: left; width: 1%;"><font size="2" style="font-family:times new roman,times"> </font></td>
</tr>
<tr style="background-color: white; vertical-align: bottom;">
<td style="text-align: justify; padding-left: 9pt;"><font size="2" style="font-family:times new roman,times">Reseller B</font></td>
<td><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">9</font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times">%</font></td>
<td><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">35</font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times">%</font></td>
<td><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">14</font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times">%</font></td>
<td><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">19</font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times">%</font></td>
</tr>
<tr style="background-color: #ccffcc; vertical-align: bottom;">
<td style="text-align: justify; padding-left: 9pt;"><font size="2" style="font-family:times new roman,times">Affiliate A</font></td>
<td><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">10</font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times">%</font></td>
<td><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">-</font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">-</font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">-</font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
</tr>
<tr style="background-color: white; vertical-align: bottom;">
<td style="text-align: justify; padding-left: 9pt;"><font size="2" style="font-family:times new roman,times">Affiliate B</font></td>
<td><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">7</font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times">%</font></td>
<td><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">13</font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times">%</font></td>
<td><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">-</font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">-</font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
</tr>
<tr style="background-color: #ccffcc; vertical-align: bottom;">
<td style="text-align: justify; padding-left: 9pt;"><font size="2" style="font-family:times new roman,times">Service Provider A</font></td>
<td><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">5</font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times">%</font></td>
<td><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">11</font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times">%</font></td>
<td><font size="2" style="font-family:times new
roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">21</font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times">%</font></td>
<td><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">38</font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times">%</font></td>
</tr>
</table>
<p style="text-align: left; margin-top: 0pt; font: 10pt times new roman, times, serif; margin-bottom: 0pt;"><font size="2" style="font-family:times new roman,times"><i>Earnings per Common Share</i></font></p>
<p style="margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times"> </font></p>
<p style="text-align: justify; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times">Basic earnings per common share is computed by dividing net income by the weighted-average number of shares of common stock outstanding during the reporting period. Diluted earnings per common share is computed by dividing net income by the combination of dilutive common share equivalents, comprised of shares issuable under the Company’s stock option and stock incentive compensation plans, and the weighted-average number of shares of common stock outstanding during the reporting period.<b> </b>Dilutive common share equivalents include the dilutive effect of in-the-money shares, which is calculated based on the average share price for each period using the treasury stock method. Under the treasury stock method, the exercise price of a share, the amount of compensation cost, if any, for future service that the Company has not yet recognized, and the amount of estimated tax benefits that would be recorded in additional paid-in capital, if any, when the share is exercised are assumed to be used to repurchase shares in the current period.</font></p>
<p style="text-align: justify; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times">Sales to material customers for each of the three months ended September 30, 2012 and 2011, and accounts receivable as of September 30, 2012, and December 31, 2011, were as follows:<b> </b></font></p>
<p style="text-align: justify; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times"><b> </b></font></p>
<table style="width: 100%; border-collapse: collapse; font: 10pt times new roman, times, serif;" cellspacing="0" cellpadding="0">
<tr style="vertical-align: bottom;">
<td style="font-weight: bold;" nowrap="nowrap"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="padding-bottom: 1pt; font-weight: bold;" nowrap="nowrap"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="border-bottom: black 1pt solid; text-align: center; font-weight: bold;" colspan="7" nowrap="nowrap"><font size="2" style="font-family:times new roman,times">Revenues</font></td>
<td style="padding-bottom: 1pt; font-weight: bold;" nowrap="nowrap"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="border-bottom: black 1pt solid; text-align: center; font-weight: bold;" colspan="7" nowrap="nowrap"><font size="2" style="font-family:times new roman,times">Accounts Receivable</font></td>
</tr>
<tr style="vertical-align: bottom;">
<td nowrap="nowrap"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="padding-bottom: 1pt; color: black; font-weight: bold;" nowrap="nowrap"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="border-bottom: black 1pt solid; text-align: center; color: black; font-weight: bold;" colspan="7" nowrap="nowrap"><font size="2" style="font-family:times new roman,times">Three Months Ended September 30,</font></td>
<td style="padding-bottom: 1pt; color: black; font-weight: bold;" nowrap="nowrap"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="border-bottom: black 1pt solid; text-align: center; color: black; font-weight: bold;" colspan="7" nowrap="nowrap"><font size="2" style="font-family:times new roman,times">As of</font></td>
</tr>
<tr style="vertical-align: bottom;">
<td style="color: black; font-weight: bold;" nowrap="nowrap"><font size="2" style="font-family:times new roman,times">Customer</font></td>
<td style="padding-bottom: 1pt; color: black; font-weight: bold;" nowrap="nowrap"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="border-bottom: black 1pt solid; text-align: center; color: black; font-weight: bold;" colspan="3" nowrap="nowrap"><font size="2" style="font-family:times new roman,times">2012</font></td>
<td style="padding-bottom: 1pt; color: black; font-weight: bold;" nowrap="nowrap"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="border-bottom: black 1pt solid; text-align: center; color: black; font-weight: bold;" colspan="3" nowrap="nowrap"><font size="2" style="font-family:times new roman,times">2011</font></td>
<td style="padding-bottom: 1pt; color: black; font-weight: bold;" nowrap="nowrap"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="border-bottom: black 1pt solid; text-align: center; color: black; font-weight: bold;" colspan="3" nowrap="nowrap"><font size="2" style="font-family:times new roman,times">September 30, 2012</font></td>
<td style="padding-bottom: 1pt; color: black; font-weight: bold;" nowrap="nowrap"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="border-bottom: black 1pt solid; text-align: center; color: black; font-weight: bold;" colspan="3" nowrap="nowrap"><font size="2" style="font-family:times new roman,times">December 31, 2011</font></td>
</tr>
<tr style="background-color: #ccffcc; vertical-align: bottom;">
<td style="text-align: justify; padding-left: 9pt; width: 48%; color: black;" nowrap="nowrap"><font size="2" style="font-family:times new roman,times">Reseller A</font></td>
<td style="width: 1%;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left; width: 1%;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right; width: 10%;"><font size="2" style="font-family:times new roman,times">44</font></td>
<td style="text-align: left; width: 1%;"><font size="2" style="font-family:times new roman,times">%</font></td>
<td style="width: 1%;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left; width: 1%;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right; width: 10%;"><font size="2" style="font-family:times new roman,times">-</font></td>
<td style="text-align: left; width: 1%;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="width: 1%;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left; width: 1%;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right; width: 10%;"><font size="2" style="font-family:times new roman,times">38</font></td>
<td style="text-align: left; width: 1%;"><font size="2" style="font-family:times new roman,times">%</font></td>
<td style="width: 1%;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left; width: 1%;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right; width: 10%;"><font size="2" style="font-family:times new roman,times">-</font></td>
<td style="text-align: left; width: 1%;"><font size="2" style="font-family:times new roman,times"> </font></td>
</tr>
<tr style="background-color: white; vertical-align: bottom;">
<td style="text-align: justify; padding-left: 9pt;"><font size="2" style="font-family:times new roman,times">Reseller B</font></td>
<td><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">9</font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times">%</font></td>
<td><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">35</font></td>
<td style="text-align: left;"><font size="2"
style="font-family:times new roman,times">%</font></td>
<td><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">14</font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times">%</font></td>
<td><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">19</font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times">%</font></td>
</tr>
<tr style="background-color: #ccffcc; vertical-align: bottom;">
<td style="text-align: justify; padding-left: 9pt;"><font size="2" style="font-family:times new roman,times">Affiliate A</font></td>
<td><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">10</font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times">%</font></td>
<td><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">-</font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">-</font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">-</font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
</tr>
<tr style="background-color: white; vertical-align: bottom;">
<td style="text-align: justify; padding-left: 9pt;"><font size="2" style="font-family:times new roman,times">Affiliate B</font></td>
<td><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">7</font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times">%</font></td>
<td><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">13</font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times">%</font></td>
<td><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">-</font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">-</font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
</tr>
<tr style="background-color: #ccffcc; vertical-align: bottom;">
<td style="text-align: justify; padding-left: 9pt;"><font size="2" style="font-family:times new roman,times">Service Provider A</font></td>
<td><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">5</font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times">%</font></td>
<td><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">11</font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times">%</font></td>
<td><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">21</font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times">%</font></td>
<td><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times"> </font></td>
<td style="text-align: right;"><font size="2" style="font-family:times new roman,times">38</font></td>
<td style="text-align: left;"><font size="2" style="font-family:times new roman,times">%</font></td>
</tr>
</table>
0.00
0.35
0.00
0.13
0.11
0.44
0.09
0.10
0.07
0.05
0.00
0.19
0.00
0.00
0.38
0.38
0.14
0.00
0.00
0.21
1000000
4100000
300000
1600000
4000000
1000000
0.1312
0.096
0.08
2012-07-01
20000000
200000
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<p style="text-align: justify; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times"><i>Financial Statement Preparation</i></font></p>
<p style="margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times"> </font></p>
<p style="text-align: justify; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times">The unaudited condensed consolidated financial statements of deltathree, Inc. and its subsidiaries (collectively referred to in this Quarterly Report on Form 10-Q as the “Company”, “we”, “us”, or “our”), of which these notes are a part, have been prepared in accordance with generally accepted accounting principles for interim financial information and pursuant to the instructions of Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for annual financial statements. In the opinion of our management, all adjustments (consisting only of normal recurring accruals) considered necessary for a fair presentation of the financial information as of and for the periods presented have been included.</font></p>
<p style="margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times"> </font></p>
<p style="text-align: justify; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"><font size="2" style="font-family:times new roman,times">The results for the interim periods presented are not necessarily indicative of the results that may be expected for any future period. The unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes for the year ended December 31, 2011, included in our Annual Report on Form 10-K filed with the SEC on March 28, 2012,<font style="background-color: white;"> </font>our <font style="background-color: white;">Quarterly Report on Form 10-Q for the quarter ended March 31, 2012, filed with the SEC on May 14, 2012, </font>our <font style="background-color: white;">Quarterly Report on Form 10-Q for the quarter ended June 30, 2012, filed with the SEC on August 13, 2012, </font>and all of our other periodic filings, including Current Reports on Form 8-K, filed with the SEC after the end of our 2011 fiscal year and through the date of this Report.</font></p>
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<table style="margin-top: 0px; font: 10pt times new roman, times, serif; margin-bottom: 0px;" cellspacing="0" cellpadding="0">
<tr style="text-align: justify; vertical-align: top;">
<td style="text-align: left; width: 0.5in;"><b>5.</b></td>
<td style="text-align: justify;"><b>Subsequent Event</b>s</td>
</tr>
</table>
<p style="text-align: justify; text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"> </p>
<p style="text-align: justify; text-indent: 0px; margin: 0pt 0px; font: 10pt times new roman, times, serif;"></p>
<p style="text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;">On November 13, 2012, each of the Company, the Subsidiary and DME Solutions, Inc. entered into the Third Amendment to Loan and Security Agreements, or the "Third Amendment", and the Amendment to Warrant Agreements, or the "Warrants Amendment", with D4 Holdings. Pursuant to the Third Amendment and the Warrants Amendment,</p>
<p style="margin: 0pt 0px; font: 10pt times new roman, times, serif;"> </p>
<table style="margin-top: 0pt; width: 100%; font: 10pt times new roman, times, serif; margin-bottom: 0pt;" cellspacing="0" cellpadding="0">
<tr style="vertical-align: top;">
<td style="width: 0.25in;"></td>
<td style="width: 0.25in;"><font style="font-family: symbol;">·</font></td>
<td>the maturity date for repayment of principal and interest under the First Loan Agreement was extended to January 2, 2014;</td>
</tr>
</table>
<p style="text-indent: 1.5pt; margin: 0pt 0px; font: 10pt times new roman, times, serif;"> </p>
<table style="margin-top: 0pt; width: 100%; font: 10pt times new roman, times, serif; margin-bottom: 0pt;" cellspacing="0" cellpadding="0">
<tr style="vertical-align: top;">
<td style="width: 0.25in;"></td>
<td style="width: 0.25in;"><font style="font-family: symbol;">·</font></td>
<td>the maturity date for repayment of principal and interest under the Second Loan Agreement was extended to January 2, 2015;</td>
</tr>
</table>
<p style="text-indent: 1.5pt; margin: 0pt 0px; font: 10pt times new roman, times, serif;"> </p>
<table style="margin-top: 0pt; width: 100%; font: 10pt times new roman, times, serif; margin-bottom: 0pt;" cellspacing="0" cellpadding="0">
<tr style="vertical-align: top;">
<td style="width: 0.25in;"></td>
<td style="width: 0.25in;"><font style="font-family: symbol;">·</font></td>
<td>the maturity date for repayment of principal and interest under each of the Third and Fourth Loan Agreements was extended to January 2, 2016; and</td>
</tr>
</table>
<p style="text-indent: 1.5pt; margin: 0pt 0px; font: 10pt times new roman, times, serif;"> </p>
<table style="margin-top: 0pt; width: 100%; font: 10pt times new roman, times, serif; margin-bottom: 0pt;" cellspacing="0" cellpadding="0">
<tr style="vertical-align: top;">
<td style="width: 0.25in;"></td>
<td style="width: 0.25in;"><font style="font-family: symbol;">·</font></td>
<td>the exercise price under each of the Warrant Agreements entered into by the Company and D4 Holdings as of February 12, 2009, August 10, 2010, and March 2, 2011 was amended to $0.02 per share.</td>
</tr>
</table>
<p style="margin: 0pt 0px; font: 10pt times new roman, times, serif;"> </p>
<p style="text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;">In connection with the extension of the maturity dates under the Third Amendment, the Company issued to D4 Holdings a Warrant, or together with the Third Amendment and the Warrants Amendment, the "Transaction Documents", exercisable for ten years, to purchase up to 10,000,000 shares of common stock of the Company at an exercise price of $0.02 per share.</p>
<p style="text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;"> </p>
<p style="text-indent: 0.5in; margin: 0pt 0px; font: 10pt times new roman, times, serif;">The Company is majority-owned by D4 Holdings. The ultimate ownership of D4 Holdings includes owners of ACN, Inc. Each of Robert Stevanovski, Anthony Cassara and David Stevanovski, members of the Company’s Board of Directors, is a principal of D4 Holdings. As a result, each of these individuals and may be deemed to have a direct or indirect interest in the transactions contemplated by the Transaction Documents. In accordance with the Company’s Audit Committee Charter, the Transaction Documents and the transactions contemplated thereby were approved by the Audit Committee, which includes those directors who are not affiliated with D4 Holdings.</p>
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2012-11-13
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2014-01-02
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0001086740dddc:ThirdAndFourthloanAgreementMember2012-10-012012-11-13
2015-01-02
2016-01-02
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0001086740dddc:TransactionDocumentsMember2012-10-012012-11-13
0.02
P10Y
10000000
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