10-Q 1 v062602_10q.htm Unassociated Document
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549 

FORM 10-Q


(Mark One)
 
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
   
For the quarterly period ended November 30, 2006
OR
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
   
 
For the transition period from ___________ to _______________
   
 
Commission File Number 0-22182
 
PATRIOT SCIENTIFIC CORPORATION
(Exact name of registrant as specified in its charter)

Delaware
(State or other jurisdiction of
incorporation or organization)
84-1070278
(I.R.S. Employer Identification No.)

6183 Paseo Del Norte, Suite 180, Carlsbad, California
(Address of principal executive offices)
92011
(Zip Code)

(Issuer’s telephone number): (760) 547-2700

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 whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer o
Accelerated filer o
Non-accelerated filer x
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
 
Yes o     No x
 
On January 12, 2007, 381,214,818 shares of common stock, par value $.00001 per share (the issuer’s only class of voting stock) were outstanding.
 

 
 
INDEX
 
 
 
Page 
PART I. FINANCIAL INFORMATION
 
ITEM 1. Financial Statements
 
Condensed Consolidated Balance Sheets as of November 30, 2006 (unaudited) and May 31, 2006
3
Unaudited Condensed Consolidated Statements of Operations for the three and six months ended November 30, 2006 and 2005
4
Unaudited Condensed Consolidated Statements of Cash Flows for the six months ended November 30, 2006 and 2005
5
Notes to Unaudited Condensed Consolidated Financial Statements
6-24
ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
25-33
ITEM 3. Quantitative and Qualitative Disclosures About Market Risk
33
ITEM 4. Controls and Procedures
33
 
PART II. OTHER INFORMATION
 
ITEM 1. Legal Proceedings
35-36
ITEM 1A. Risk Factors
36
ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds
38
ITEM 3. Defaults Upon Senior Securities
39
ITEM 4. Submission of Matters to a Vote of Security Holders
39
ITEM 5. Other Information
39
ITEM 6. Exhibits
39-46
   
SIGNATURES
 


 
2

 


Patriot Scientific Corporation
Condensed Consolidated Balance Sheets
 
   
November 30, 2006
 
May 31, 2006
 
ASSETS
 
(Unaudited)
     
           
Current Assets:
         
Cash and cash equivalents
 
$
11,718,031
 
$
3,984,240
 
Restricted cash and cash equivalents
   
101,578
   
100,320
 
Marketable securities and short term investments
   
3,652,830
   
3,518,879
 
Accounts receivable
   
7,438
   
4,113
 
Prepaid expenses and other current assets
   
234,497
   
407,418
 
               
Total current assets
   
15,714,374
   
8,014,970
 
               
Property and equipment, net
   
59,400
   
64,006
 
               
Other assets
   
8,190
   
8,190
 
               
Investment in affiliated company
   
7,598,638
   
3,952,914
 
               
Investment in debt securities
   
350,000
   
 
               
Patents and trademarks, net of accumulated amortization of $595,665 and $584,387
   
20,309
   
31,587
 
   
$
23,750,911
 
$
12,071,667
 
               
LIABILITIES AND STOCKHOLDERS’ EQUITY
             
               
Current liabilities:
             
Accounts payable
 
$
328,287
 
$
695,323
 
Accrued liabilities and other
   
131,254
   
154,730
 
Accrued contingency fee payable
   
6,354,063
   
394,063
 
Accrued income taxes payable
   
4,154,600
   
 
               
Total current liabilities
   
10,968,204
   
1,244,116
 
               
Total liabilities
   
10,968,204
   
1,244,116
 
               
Commitments and contingencies 
             
               
Stockholders’ equity:
             
Preferred stock, $0.00001 par value; 5,000,000 shares authorized:
none outstanding
   
   
 
Common stock, $0.00001 par value: 500,000,000 shares authorized:
389,197,145 shares issued and 384,322,318 shares outstanding and
366,199,765 shares issued and outstanding
   
3,892
   
3,661
 
Additional paid-in capital
   
71,423,026
   
69,551,981
 
Accumulated deficit
   
(54,619,816
)
 
(58,728,091
)
Common stock held in treasury, at cost - 4,874,827 shares and no shares
as of November 30, 2006 and May 31, 2006, respectively
   
(4,024,395
)
 
 
Total stockholders’ equity
   
12,782,707
   
10,827,551
 
               
   
$
23,750,911
 
$
12,071,667
 

See accompanying notes to unaudited condensed consolidated financial statements.

3


Patriot Scientific Corporation
Condensed Consolidated Statements of Operations
(Unaudited)

   
Three Months Ended
 
Six Months Ended
 
   
November 30,
2006
 
November 30,
2005
 
November 30,
2006
 
November 30,
2005
 
       
(As restated,
see Note 2)
     
(As restated,
see Note 2)
 
Revenues:
                 
Licenses and royalties
 
$
 
$
 
$
 
$
10,000,000
 
Other
   
18,500
   
10,202
   
44,875
   
20,272
 
     
18,500
   
10,202
   
44,875
   
10,020,272
 
                           
Operating expenses:
                         
Research and development
   
   
109,553
   
   
198,260
 
Selling, general and administrative
   
1,736,422
   
657,338
   
4,468,946
   
1,819,734
 
Settlement and license expense
   
6,300,000
   
   
6,300,000
   
1,918,054
 
Total operating expenses
   
8,036,422
   
766,891
   
10,768,946
   
3,936,048
 
Operating income (loss)
   
(8,017,922
)
 
(756,689
)
 
(10,724,071
)
 
6,084,224
 
                           
Other income (expense):
                         
Unrealized loss on marketable securities
   
   
(1,137
)
 
   
(1,137
)
Interest and other income
   
181,131
   
59,758
   
307,898
   
93,648
 
Loss on sale of assets
   
   
   
(543
)
 
 
Interest expense
   
   
(111,030
)
 
   
(313,514
)
Change in fair value of warrant and derivative liabilities
   
   
1,181,356
   
   
2,261,155
 
Equity in earnings (loss) of affiliated company
   
6,674,793
   
(472,596
)
 
18,744,991
   
(720,165
)
Total other income, net
   
6,855,924
   
656,351
   
19,052,346
   
1,319,987
 
                           
Income (loss) before income taxes
   
(1,161,998
)
 
(100,338
)
 
8,328,275
   
7,404,211
 
                           
Provision for income taxes
   
720,000
   
   
4,220,000
   
 
                           
Net Income (loss)
 
$
(1,881,998
)
$
(100,338
)
$
4,108,275
 
$
7,404,211
 
                           
Basic income (loss) per common share
 
$
 
$
 
$
0.01
 
$
0.02
 
                           
Diluted income (loss) per common share
 
$
 
$
 
$
0.01
 
$
0.02
 
                           
Weighted average number of common shares outstanding-basic
   
378,817,682
   
303,431,364
   
373,800,101
   
297,350,377
 
                           
Weighted average number of common shares outstanding-diluted
   
378,817,682
   
303,431,364
   
419,862,437
   
370,675,410
 

See accompanying notes to unaudited condensed consolidated financial statements.
4


Patriot Scientific Corporation
Condensed Consolidated Statements of Cash Flows
(Unaudited)
   
Six months ended 
 
   
November 30,
2006
 
November 30,
2005
 
       
(As restated,
see Note 2)
 
Operating activities:
         
Net income
 
$
4,108,275
 
$
7,404,211
 
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
             
Amortization and depreciation
   
21,288
   
29,240
 
Non-cash interest expense related to convertible debentures, notes payable and warrants
   
   
280,801
 
Expense related to extension of expiration date of stock options
   
324
   
125,000
 
Net gain related to warrant re-pricing, reconveyance and issuance
   
   
(538,208
)
Non cash compensation relating to issuance and vesting of
stock options and vesting of warrants
   
1,773,102
   
 
Accrued interest income added to investments
   
(1,258
)
 
(21,022
)
Equity in (earnings) loss of affiliated company
   
(18,744,991
)
 
720,165
 
Unrealized loss on marketable securities
   
   
1,137
 
Loss on disposal of fixed assets
   
543
   
 
Issuance of stock
   
   
81,250
 
Change in fair value of warrant and derivative liabilities
   
   
(2,261,155
)
Changes in operating assets and liabilities:
             
Accounts receivable
   
(3,325
)
 
(2,625
)
Prepaid and other assets
   
172,921
   
(97,537
)
Licenses receivable
   
   
1,500,000
 
Accounts payable and accrued expenses
   
(390,512
)
 
(181,462
)
Accrued contested fee payable
   
5,960,000
   
 
Income tax payable
   
4,154,600
   
 
Net cash provided by (used in) operating activities
   
(2,949,033
)
 
7,039,795
 
               
Investing activities:
             
Purchases of marketable securities
   
(4,158,346
)
 
 
Proceeds from sales of marketable securities
   
4,024,395
   
100,000
 
Purchases of property and equipment
   
(5,947
)
 
(16,040
)
Investment in affiliated company
   
   
(2,000,000
)
Investment in debt securities
   
(350,000
)
 
 
Distributions from affiliated company
   
15,099,267
   
 
Net cash provided by (used in) investing activities
   
14,609,369
   
(1,916,040
)
               
Financing activities:
             
Payments on capital lease obligations
   
   
(2,306
)
Proceeds from exercise of common stock warrants and options
   
97,850
   
206,437
 
Repurchase of common stock for treasury
   
(4,024,395
)
 
 
Net cash provided by (used in) financing activities
   
(3,926,545
)
 
204,131
 
               
Net increase in cash and cash equivalents
   
7,733,791
   
5,327,886
 
Cash and cash equivalents, beginning of period
   
3,984,240
   
591,426
 
Cash and cash equivalents, end of period
 
$
11,718,031
 
$
5,919,312
 
               
Supplemental Disclosure of Cash Flow Information:
             
Cash payments for interest
 
$
 
$
2,637
 
Cash payments for income taxes
 
$
65,400
 
$
 
               
Supplemental Disclosure of Non-Cash Investing and Financing Activities:
             
Convertible debentures, notes payable and accrued interest exchanged
for common stock
 
$
 
$
138,540
 
Reclassification of derivative liabilities associated with debt conversions
and warrant exercises
 
$
 
$
1,690,705
 
Cashless exercise of warrants
 
$
225
 
$
116
 

See accompanying notes to unaudited condensed consolidated financial statements
 
5

Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated Financial Statements
 
1. Basis of Presentation and Summary of Significant Accounting Policies

The unaudited condensed consolidated financial statements of Patriot Scientific Corporation (the “Company”, “we”, “us” or “our”) presented herein have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) for quarterly reports on Form 10-Q and do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. These financial statements should be read in conjunction with our audited consolidated financial statements and notes thereto included the Company’s annual report on Form 10-KSB for fiscal year ended May 31, 2006.

In the opinion of management, the interim condensed consolidated financial statements reflect all adjustments of a normal recurring nature necessary for a fair presentation of the results for the interim periods. Operating results for the six month period ended November 30, 2006 are not necessarily indicative of the results that may be expected for the year ending May 31, 2007.

Reclassifications
Certain reclassifications have been made to the 2005 financial statements in order for them to conform to the 2006 presentation. Such reclassifications have no impact on the Company’s financial position or results of operations.

Investment in Affiliated Company
The Company has a 50% interest in Phoenix Digital Solutions, LLC (“Phoenix Digital”) (see Note 5). This investment is accounted for using the equity method of accounting since the investment provides the Company the ability to exercise significant influence, but not control, over the investee. Significant influence is generally deemed to exist if the Company has an ownership interest in the voting stock of the investee of between 20% and 50%, although other factors, such as representation on the investee’s Board of Directors, are considered in determining whether the equity method of accounting is appropriate. Under the equity method of accounting, the investment, originally recorded at cost, is adjusted to recognize the Company’s share of net earnings or losses of the investee and is recognized in the condensed consolidated statement of operations in the caption “Equity in earnings of affiliated company.”

Derivative Financial Instruments
In connection with the issuance of certain convertible debentures (see Note 6), the terms of the debentures included an embedded reset conversion feature which provided for a conversion of the debentures into shares of the Company's common stock at a rate which was determined to be variable. The Company determined that the reset conversion feature was an embedded derivative instrument and that the conversion option was an embedded put option pursuant to Statement of Financial Accounting Standards (“SFAS”) No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended, and Emerging Issues Task Force (“EITF”) Issue No. 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock. The accounting treatment of derivative financial instruments required that the Company record the derivatives and related warrants at their fair values as of the inception date of the convertible debenture agreements and at fair value as of each subsequent balance sheet date.  In addition, under the provisions of EITF Issue No. 00-19, as a result of entering into the convertible debenture agreements, the Company was required to classify all other non-employee warrants as derivative liabilities and record them at their fair values at each balance sheet date.  Any change in fair value was recorded as non-operating, non-cash income or expense at each balance sheet date.  If the fair value of the derivatives was higher at the subsequent balance sheet date, the Company recorded a non-operating, non-cash charge.  If the fair value of the derivatives was lower at the subsequent balance sheet date, the Company recorded non-operating, non-cash income.

6


Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated Financial Statements


Derivative Financial Instruments, continued

During the three month periods ended November 30, 2006 and 2005, the Company recognized other income of $0 and $1,181,356, respectively, related to recording the warrant and derivative liabilities at fair value.

During the six month periods ended November 30, 2006 and 2005, the Company recognized other income of $0 and $2,261,155, respectively, related to recording the warrant and derivative liabilities at fair value. At November 30, 2006, there are no derivative liabilities since the related variable debt instruments were settled in full during fiscal 2006. At the settlement date, the remaining warrant liabilities with a value of approximately $6,744,000 were reclassified to additional paid-in capital.

The Company’s derivative instruments were valued using a Monte Carlo simulation model incorporating the instruments’ multiple reset dates.

The following assumptions were used for valuing the embedded derivatives during the six month period ended November 30, 2005:
 
Estimated dividends
None
   
Expected volatility
101 - 229%
   
Risk-free interest rate
3.5 - 5.1%
   
Expected term (years)
2 - 7

Revenue Recognition
The Company recognizes revenue from the sale of its product upon shipment to the customer, at which time title transfers and the Company has no further obligations. Fees for maintenance or support are recorded on a straight-line basis over the underlying period of performance. Revenue from technology license agreements is recognized at the time the Company enters into a contract and provides the customer with the licensed technology. At this point, the Company has performed all of its obligations under contract, the rights to the Company’s technology have been transferred and no significant performance obligations remain.

Net Income (Loss) Per Share
The Company applies SFAS No. 128, Earnings Per Share, for the calculation of "Basic" and "Diluted" earnings (loss) per share. Basic earnings (loss) per share includes no dilution and is computed by dividing income (loss) available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings (loss) per share reflects the potential dilution of securities that could share in the earnings of an entity. For the six months ended November 30, 2006, shares of 100,000 related to the Company’s outstanding warrants and options were not included in the calculation of diluted income per share as they had an anti-dilutive effect. For the three months ended November 30, 2005 and November 30, 2006, 62,135,578 and 40,690,194 potentially dilutive common shares related to the Company’s outstanding convertible debentures, warrants and options were not included in the calculation of diluted loss per share as they had an anti-dilutive effect and for the six months ended November 30, 2005 potential common shares of 16,300,000 relating to the Company’s outstanding options, warrants and convertible debentures were not included in the calculation of diluted income per share as they had an anti-dilutive effect.

7


Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated Financial Statements

Net Income (Loss) Per Share, continued
 
   
Three Months Ended November 30, 2006 
 
   
 Numerator
(Loss)
 
Denominator
(Shares)
 
Per Share
Amount
 
Basic EPS:
              
Net loss
 
$
(1,881,998
)
 
378,817,682
 
$
 
Diluted EPS:
                   
Effect of dilutive securities:                    
Options and  warrants
   
   
       
Loss available to common shareholders
 
$
(1,881,998
)
 
378,817,682
 
$
 

 
   
Three Months Ended November 30, 2005
As restated (See Note 2) 
 
               
   
 Numerator
(Loss)
 
Denominator
(Shares)
 
Per Share
Amount
 
Basic EPS:
              
Net loss
 
$
(100,338
)
 
303,431,364
 
$
 
                     
Diluted EPS:
                   
Effect of  dilutive  securities:
                   
Options and  warrants
   
   
       
                     
Loss available to common shareholders
 
$
(100,338
)
 
303,431,364
 
$
 
                     
 
   
Six Months Ended November 30, 2006 
 
   
 Numerator
(Income)
 
Denominator
(Shares)
 
Per Share
Amount
 
Basic EPS:
              
Net income
 
$
4,108,275
   
373,800,101
 
$
0.01
 
                     
Diluted EPS:
                   
Effect of  dilutive  securities:
                   
Options and  warrants
   
   
46,062,336
       
                     
Income available to common shareholders
 
$
4,108,275
   
419,862,437
 
$
0.01
 
                     
 
8

Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated Financial Statements
 
Net Income (Loss) Per Share, continued
 
   
Six Months Ended November 30, 2005
As restated (See Note 2)
 
   
 Numerator
(Income)
 
Denominator
(Shares)
 
Per Share
Amount
 
Basic EPS:
              
Net income
 
$
7,404,211
   
297,350,377
 
$
0.02
 
                     
Diluted EPS:
                   
Convertible debentures interest
   
30,077
             
Effect of dilutive securities:
                   
Convertible debentures
   
   
11,189,455
       
Options and warrants
   
   
62,135,578
       
                     
Income available to common shareholders
 
$
7,434,288
   
370,675,410
 
$
0.02
 
                     
 
Stock-Based Compensation
 
Change in Accounting Principle
 
Effective June 1, 2006, the Company adopted SFAS No. 123(R), Share-Based Payment, which establishes standards for the accounting of transactions in which an entity exchanges its equity instruments for goods or services, primarily focusing on accounting for transactions where an entity obtains employee services in share-based payment transactions. SFAS No. 123(R) requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments, including stock options, based on the grant-date fair value of the award and to recognize it as compensation expense over the period the employee is required to provide service in exchange for the award, usually the vesting period. SFAS No. 123(R) supersedes the Company’s previous accounting under Accounting Principles Board Opinion (“APB”) No. 25, Accounting for Stock Issued to Employees, for the period beginning June 1, 2006. In March 2005, the SEC issued SAB No. 107, Share-Based Payment, relating to SFAS No. 123(R). The Company has applied the provisions of SAB No. 107 in its adoption of SFAS No. 123(R). Stock-based awards to non-employees are accounted for using the fair value method in accordance with SFAS No. 123, Accounting for Stock Based Compensation.
 
The Company adopted SFAS No. 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of June 1, 2006, the first day of the Company’s fiscal year 2007. The Company’s condensed consolidated financial statements as of and for the six months ended November 30, 2006 reflect the impact of adopting SFAS No. 123(R). In accordance with the modified prospective transition method, the Company’s condensed consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS No. 123(R). SFAS No. 123(R) requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the Company’s condensed consolidated statement of operations. Prior to the adoption of SFAS No. 123(R), the Company accounted for stock-based awards to employees and directors using the intrinsic value method in accordance with APB No. 25 as allowed under SFAS No. 123. Under the intrinsic value method, no employee stock-based compensation expense had been recognized in the
 
9

Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated Financial Statements
 
Stock-Based Compensation, continued
 
Company’s condensed consolidated statements of operations, other than as related to option grants to employees and directors below the fair market value of the underlying stock at the date of grant.
 
Stock-based compensation expense recognized during the period is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. Stock-based compensation expense recognized in the Company’s condensed consolidated statement of operations for the six months ended November 30, 2006 included compensation expense for share-based payment awards granted prior to, but not yet vested as of May 31, 2006 based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS No. 123 and compensation expense for the share-based payment awards granted subsequent to May 31, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123(R). As stock-based compensation expense recognized in the condensed consolidated statement of operations for the six months ended November 30, 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The estimated average forfeiture rate for the six months ended November 30, 2006, of approximately 5% was based on historical forfeiture experience and estimated future employee forfeitures. The estimated pricing term of option grants for the six months ended November 30, 2006 was one year. In the Company’s pro forma information required under SFAS No. 123 for the periods prior to fiscal 2007, the Company accounted for forfeitures as they occurred.

Summary of Assumptions and Activity
 
The following table illustrates the effect on net income (loss) and net income (loss) per share for the three and six months ended November 30, 2005 as if the Company had applied the fair value recognition provisions of SFAS No. 123 to options granted under the Company's stock option plans. For purposes of this pro forma disclosure, the fair value of the options is estimated using the Black-Scholes option-pricing model and amortized on a straight-line basis to expense over the options' vesting period:
 
   
Three Months Ended
 
 Six Months Ended
 
   
November 30, 2005
(Unaudited)
 
 November 30, 2005
(Unaudited)
 
   
(As restated see Note 2)
 
 (As restated see Note 2)
 
            
Net income (loss) - as reported
 
$
(100,338
)
$
7,404,211
 
               
Add: Share-based employee compensation included
in net income (loss), net of tax effects
   
   
 
               
Deduct: Share-based employee compensation expense determined
under fair value method, net of tax effects
   
   
182,250
 
               
Net income (loss) - pro forma
 
$
(100,338
)
$
7,221,961
 
               
Net income (loss) per common share - as reported
             
Basic
 
$
 
$
0.02
 
Diluted
 
$
 
$
0.02
 
               
Net income (loss) per common share - proforma
             
Basic
 
$
 
$
0.02
 
Diluted
 
$
 
$
0.02
 

10

Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated Financial Statements

Stock-Based Compensation, continued

The fair value of stock-based awards to employees and directors is calculated using the Black-Scholes option pricing model, even though this model was developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which differ significantly from the Company’s stock options. The Black-Scholes model also requires subjective assumptions, including future stock price volatility and expected time to exercise, which greatly affect the calculated values. The expected term of options granted is derived from historical data on employee exercises and post-vesting employment termination behavior. The risk-free rate selected to value any particular grant is based on the U.S. Treasury rate that corresponds to the pricing term of the grant effective as of the date of the grant. The expected volatility for the three and six months ended November 30, 2006 and 2005 is based on the historical volatilities of the Company’s common stock. These factors could change in the future, affecting the determination of stock-based compensation expense in future periods.

   
Three Months
Ended
 
Six Months Ended
 
Three Months
Ended
 
Six Months Ended
 
   
November 30,
2006
(Unaudited)
 
November 30,
2006
(Unaudited)
 
November 30,
2005
(Unaudited)
 
November 30,
2005
(Unaudited)
 
                   
Expected term
   
5
  years    
5
  years    
  years    
5
  years  
Expected volatility
   
156
 
%      
156
 
%      
 
%      
128
 
%
   
Risk-free interest rate
   
4.80
 
%      
4.80 - 5.00
 
%      
 
%      
3.72
 
%    
Expected dividends
   
         
         
         
       

A summary of option activity as of November 30, 2006 and changes during the six months then ended, is presented below:

   
Shares
 
Weighted
Average
Exercise
Price
 
Weighted
Average
Remaining
Contractual
Term 
Years)
 
 Aggregate
Intrinsic
Value
 
                    
Options outstanding at June 1, 2006
   
5,460,000
 
$
0.34
             
Options granted
   
1,730,000
 
$
0.26
             
Options exercised
   
(265,000
)
$
0.10
             
Options forfeited
   
(500,000
)
$
0.09
             
                           
 
Options outstanding November 30, 2006
   
6,425,000
 
$
0.35
   
3.11
 
$
1,997,650
 
                           
 
Options exercisable November 30, 2006
   
6,415,000
 
$
0.35
   
3.11
 
$
1,997,650
 
 
11

Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated Financial Statements
 
The weighted average grant date fair value of options granted during the six months ended November 30, 2006 was $1.10 per option. The total intrinsic value of options exercised during the six months ended November 30, 2006 was $169,500.
 
Stock-Based Compensation, continued
A summary of the status of the Company’s non-vested stock options as of November 30, 2006 and changes during the six months then ended is presented below:

   
Shares
 
Weighted
Average Grant
Date Fair
Value
Per Share
 
           
Non-vested stock options at June 1, 2006
   
345,000
 
$
0.24
 
Non-vested stock options granted
   
1,730,000
 
$
0.99
 
Vested stock options
   
(1,815,000
)
$
0.98
 
Forfeited/cancelled stock options
   
(250,000
)
$
0.06
 
               
Non-vested stock options at November 30, 2006
   
10,000
 
$
0.71
 
               

As of November 30, 2006, there was approximately $2,200 of total unrecognized compensation cost related to employee and director stock option compensation arrangements. That cost is expected to be recognized on a straight-line basis over the next three months. The total fair value of shares vested during the six months ended November 30, 2006 was approximately $1,770,000.

As a result of adopting SFAS No. 123(R) on June 1, 2006, the Company’s loss before provision for income taxes and net loss for the three months ended November 30, 2006 was approximately $194,000 higher than if it had continued to account for share-based compensation under APB No. 25. The Company’s income before income taxes and net income for the six months ended November 30, 2006 was approximately $300,000 lower than if it had continued to account for share-based compensation under APB No. 25. Basic and diluted net income (loss) per share for the three and six months ended November 30, 2006 were not affected by the adoption of SFAS No. 123(R).

The following table summarizes employee stock-based compensation expense related to stock options under SFAS No. 123(R) for the three and six months ended November 30, 2006, which was allocated as follows:
 
     
Three Months
 Ended 
   
Six Months
Ended 
 
     
November 30,
2006 
   
November 30,
2006 
 
Employee stock-based compensation expense included in:
Selling, general and administrative
 
$
194,000
  $ 1,770,000  
               
Employee stock-based compensation expense related to employee stock options
 
$
194,000
  $ 1,770,000  
 
12

Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated Financial Statements

 
Recent Accounting Pronouncements
 
In July 2006, the Financial Accounting Standards Board issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109 (“FIN 48”). This interpretation clarifies the application of SFAS No. 109, Accounting for Income Taxes, by defining criteria that an individual tax position must meet for any part of the benefit of that position to be recognized in a company’s financial statements and also provides guidance on measurement, derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company expects to adopt FIN 48 on June 1, 2007. The Company is currently assessing the impact the adoption of FIN 48 will have on its condensed consolidated financial position and results of operations. 

2. Restatement of Previously Issued Financial Statements

During fiscal 2006, the Company determined that the manner in which it historically accounted for the reset conversion feature and embedded put option of its convertible debentures issued during fiscal 2002 through fiscal 2005 was not in accordance with SFAS No. 133, as amended, and EITF Issue No. 00-19. The Company determined that the reset conversion feature was an embedded derivative instrument and that the conversion option was an embedded put option pursuant to SFAS No. 133. The accounting treatment of derivative financial instruments required that the Company record the derivatives and related warrants at their fair values as of the inception date of the convertible debenture agreements and at fair value as of each subsequent balance sheet date.  In addition, under the provisions of EITF Issue No. 00-19, as a result of entering into the convertible debenture agreements, the Company was required to classify all other non-employee warrants as derivative liabilities and record them at their fair values at each balance sheet date.  Any change in fair value was required to be recorded as non-operating, non-cash income or expense at each balance sheet date.  If the fair value of the derivatives was higher at the subsequent balance sheet date, the Company was required to record a non-operating, non-cash charge.  If the fair value of the derivatives was lower at the subsequent balance sheet date, the Company was required to record non-operating, non-cash income.  Accordingly, in connection with the restatement adjustments, the Company has appropriately reflected the non-operating, non-cash income or expense resulting from the changes in fair value. The Company had previously not recorded the embedded derivative instruments as liabilities and did not record the related changes in fair value.

In addition, the Company determined the manner in which it accounted for its interest in Phoenix Digital was not in accordance with appropriate accounting literature. Beginning in June 2005, the Company accounted for its interest in Phoenix Digital as a variable interest entity, as defined in FASB Interpretation 46(R). Accordingly, the accounts and transactions of Phoenix Digital were consolidated with those of the Company and the ownership interest of the other member of Phoenix Digital was presented as a minority interest in the condensed consolidated financial statements of the Company for the six month period ended November 30, 2005. The Company has reassessed its accounting for its interest in Phoenix Digital and after further consideration of FIN 46(R) and other authoritative literature, has corrected its accounting policy to account for its interest in Phoenix Digital in accordance with the equity method of accounting for investments, as the Company did not have a controlling financial interest in Phoenix Digital and determined that it was not the primary beneficiary of the relationship.

13

Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated Financial Statements

Restatement of Previously Issued Financial Statements, continued 

The following tables present a summary of the effects of the restatement adjustments on the Company's condensed consolidated statements of operations and cash flows for the three and six month periods ended November 30, 2005: 
 
     
Condensed Consolidated Statement of Operations 
 
Three months ended November 30, 2005    
As Previously
 Reported 
   
Adjustments 
   
As
 Restated 
 
Selling, general and administrative expense  
$
1,623,692
  $
(966,354
$
657,338 
 
Total operating expense
 
$
1,733,245
 
$
(966,354
)
$
766,891
 
Operating loss
 
$
(1,723,043
)
$
966,354
 
$
(756,689
)
Other income
 
$
80,918
 
$
(21,160
)
$
59,758
 
Change in fair value of warrant and
                   
derivative liabilities
 
$
 
$
1,181,356
 
$
1,181,356
 
Equity in loss of affiliated company
 
$
 
$
(472,596
)
$
(472,596
) 
Total other income (expense)
 
$
(31,249
)
$
687,600
 
$
656,351
 
Loss before minority interest in income of
                   
consolidated entity and income taxes
 
$
(1,754,292
)
$
1,653,954
 
$
(100,338
)
Minority interest in loss of consolidated entity
 
$
479,596
 
$
(479,596
)
$
 
Net loss
 
$
(1,274,696
)
$
1,174,358
 
$
(100,338
) 
LOSS PER COMMON SHARE:
                   
Basic
 
$
 
$
 
$
 
Diluted
 
$
 
$
 
$
 
 
 
     
Condensed Consolidated Statement of Operations 
 
Six months ended November 30, 2005    
As Previously
Reported 
   
Adjustments 
   
As
Restated 
 
Selling, general and administrative expense   $
3,299,411 
  $
(1,479,677 
) $
1,819,734 
 
Settlement and license expense
 
$
3,855,132
 
$
(1,937,078
)
$
1,918,054
 
Total operating expense
 
$
7,352,803
 
$
(3,416,755
)
$
3,936,048
 
Operating income
 
$
2,667,469
 
$
3,416,755
 
$
6,084,224
 
Other income (expense)
 
$
134,375
 
$
(40,727
)
$
93,648
 
Change in fair value of warrant and
                   
derivative liabilities
 
$
 
$
2,261,155
 
$
2,261,155
 
Equity in loss of affiliated company
 
$
 
$
(720,165
)
$
(720,165
)
Total other income (expense)
 
$
(180,276
)
$
1,500,263
 
$
1,319,987
 
Income before minority interest in income of
                   
consolidated entity and income taxes
 
$
2,487,193
 
$
4,917,018
 
$
7,404,211
 
Minority interest in loss of consolidated entity
 
$
720,165
 
$
(720,165
)
$
 
Income before income taxes
 
$
3,207,358
 
$
4,196,853
 
$
7,404,211
 
Provision for income taxes
 
$
(40,000
)
$
40,000
 
$
 
Net income
 
$
3,167,358
 
$
4,236,853
 
$
7,404,211
 
INCOME PER COMMON SHARE:
                   
Basic
 
$
0.01
 
$
0.01
 
$
0.02
 
Diluted
 
$
0.01
 
$
0.01
 
$
0.02  
 
14

Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated Financial Statements

Restatement of Previously Issued Financial Statements, continued 
 
     
Condensed Consolidated Statement of Cash Flows 
 
Six months ended November 30, 2005    
As Previously
Reported 
   
Adjustments 
   
As
Restated 
 
Net income
 
$
3,167,358
 
$
4,236,853
 
$
7,404,211
 
Equity in loss of affiliated company
 
$
 
$
720,165
 
$
720,165
 
Change in fair value of derivative liabilities
 
$
 
$
(2,261,155
)
$
(2,261,155
)
Net gain related to warrant re-pricing,
                   
reconveyance and issuance
 
$
 
$
(538,208
)
$
(538,208
)
Issuance of stock, options and warrants
                   
for services and other
 
$
206,250
 
$
(125,000
)
$
81,250
 
Expense related to extension of expiration date of
                   
stock options
 
$
 
$
125,000
 
$
125,000
 
Non-cash interest expense related to warrant
                   
repricing and issuance
 
$
1,397,491
 
$
(1,397,491
)
$
 
Loss in consolidated entity allocated to minority
                   
Interest
 
$
(720,165
)
$
720,165
 
$
 
Changes in accounts payable and accrued liabilities
 
$
(193,321
)
$
11,859
 
$
(181,462
)
Net cash provided by operating activities
 
$
5,599,465
 
$
1,440,330
 
$
7,039,795
 
Investment in affiliated company
 
$
 
$
(2,000,000
)
$
(2,000,000
)
Net cash provided by (used in) investing activities
 
$
83,960
 
$
(2,000,000
)
$
(1,916,040
)
Minority interest investment in consolidated entity
 
$
2,000,000
 
$
(2,000,000
)
$
 
Net cash provided by financing activities
 
$
2,204,131
 
$
(2,000,000
)
$
204,131
 
Net increase in cash and cash equivalents
 
$
7,887,556
 
$
(2,559,670
)
$
5,327,886
 
Cash and cash equivalents, end of period
 
$
8,478,982
 
$
(2,559,670
)
$
5,919,312
 

3. License Agreements

In February 2005, the Company entered into two separate licensing agreements with one customer for the Company’s patent portfolio and Ignite microprocessor technology. The aggregate amount of the two licenses was $3,050,000, of which $2,950,000 was for licensing fees and $100,000 was for maintenance services. Maintenance under the agreement is expected to be provided over a period not to exceed four years. Maintenance revenue recognized during the three months ended August 31, 2006 was $6,250. The payment terms of the agreements required aggregate payments of $300,000 at the time of execution, three quarterly payments of $750,000 each on April 1, August 15, and November 15, 2005 and one final payment of $500,000 on February 15, 2006. The $500,000 payment due on February 15, 2006 was paid in March 2006. Total payments received in fiscal 2005 amounted to $1,050,000 and total payments received in fiscal 2006 amounted to $2,000,000. The agreements also provide for the future payment of royalties to the Company based on sales of product using the Ignite licensed technology. In connection with this license agreement, the Company became obligated to the former co-inventor of the patent portfolio technology for $207,600 pursuant to a July 2004 agreement under which the Company was obligated to pay a percentage of licensed proceeds to the co-inventor. The amount due was payable in four installments of $51,900; $54,063 remains outstanding at November 30, 2006, and is included in accrued contingency fee payable. The co-inventor of the patent portfolio technology filed a lawsuit against the Company (see Note 8 for more information). In December 2006, the lawsuit was settled in principle through mediation and as of the date of this filing, the settlement terms have not been finalized. The Company has accrued an additional amount of $6,300,000 consisting of potential cash and stock settlements relating to the mediation agreement.
 
15

Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated Financial Statements
 
4. Investment in Debt Securities

On November 22, 2006, the Company entered into a 120 day revolving line of credit with Holocom Networks (“Holocom”) for a maximum amount of $700,000. The line of credit is collateralized by the patents and trademarks of Holocom Networks. On the date of origin, the Company advanced Holocom Networks $350,000 and on December 5, 2006 the Company advanced $170,000 under terms of the agreement. The line carries a floating interest rate which is defined as 2% above the prime rate as announced by Bank of America. At November 30, 2006, the interest rate on the note was 10.25%.

The borrower is required to make minimum monthly payments on the line consisting of unpaid and accrued interest on the first day of the month following the initial advance.

At the time of this filing, the Company was in negotiations with representatives of the management and the investors of Holocom Networks that were expected to lead to the conversion of the Company’s cash advances under the line of credit to an equity investment in a reorganized Holocom entity. Further advances in connection with the Holocom investment are anticipated. The Company is accounting for its investment in debt at cost. The Company monitors the value of its investment in debt for indicators of impairment, including changes in market conditions and /or the operating results of its underlying investment that may result in the inability to recover the carrying value of the investment. The Company will record an impairment charge if and when it believes the investment has experienced a decline that is other than temporary. At November 30, 2006, the Company has determined that there is no impairment of its investment in debt securities.

5. Investment in Affiliated Company/License Agreement

On June 7, 2005, the Company entered into a Master Agreement (the “Master Agreement”) with Technology Properties Limited Inc., a California corporation (“TPL”), and Charles H. Moore (“Moore”), the co-inventor of certain of the Company’s technology, pursuant to which the Company and Moore resolved all legal disputes between them. Pursuant to the Master Agreement, the Company and TPL entered into the Limited Liability Company Operating Agreement of Phoenix Digital Solutions, LLC (the “LLC Agreement”) into which the Company and Moore contributed their rights to certain of the Company’s technologies. The Company believes, based upon consultation with its attorneys, it was not required by applicable law or other existing agreements to obtain approval for the contribution of the license rights to Phoenix Digital from stockholders or any parties other than its various warrant holders.

The Company and TPL each own 50% of the membership interests of Phoenix Digital, and each have the right to appoint one member of the three-member management committee. The two appointees are required to select a mutually acceptable third member of the management committee. Pursuant to the LLC Agreement, the Company and TPL agreed to establish a working capital fund for Phoenix Digital of $4,000,000, of which the Company’s contribution was $2,000,000. The working capital fund increases to a maximum of $8,000,000 as license revenues are achieved. The Company and TPL are obligated to fund future working capital requirements at the discretion of the management committee of Phoenix Digital in order to maintain working capital of not more than $8,000,000. Neither the Company nor TPL is required to contribute more than $2,000,000 in any fiscal year. Distributable cash and allocation of profits and losses will be allocated to the members in the priority defined in the LLC Agreement. Phoenix Digital has committed to pay a quarterly amount ranging between $500,000 and $1,000,000 (based upon a percentage of the working capital fund balance of Phoenix Digital) for supporting efforts to secure licensing agreements by the other member on behalf of Phoenix Digital. During the six months ended November 30, 2006, Phoenix Digital paid $1,968,000 to TPL pursuant to this commitment.
 
16

Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated Financial Statements

The Company is accounting for its investment in Phoenix Digital under the equity method of accounting, and accordingly has recorded its 50% share of Phoenix Digital’s net income of $18,744,991 during the six months ended November 30, 2006 as an increase in its investment. Cash distributions of $15,099,267 received from

Investment in Affiliated Company/License Agreement, continued

Phoenix Digital during the six months ended November 30, 2006 have been recorded as a reduction in the
Company’s investment. The Company’s investment in Phoenix Digital is $7,598,638 at November 30, 2006 and has been recorded as “Investment in Affiliated Company”. The Company has recorded its 50% share of Phoenix Digital’s net income (loss) as “Equity in Earnings of Affiliated Company” in the accompanying condensed consolidated statements of operations for the six months ended November 30, 2006 and 2005.

Concurrently with forming Phoenix Digital, the Company entered into a license agreement with a third party pursuant to which it received $10,000,000, which amount was recorded as license revenue during the quarter ended August 31, 2005. In connection with entering into the license agreement and forming Phoenix Digital, the Company incurred various cash and non-cash expenses. Direct, incremental cash costs incurred with the transactions included $170,000 paid to a committee of the Company’s board of directors for their efforts in consummating the transactions, approximately $1,328,000 paid to certain of the Company’s warrant holders to obtain their approval of the agreement and release of their lien and blocking rights. Additionally, $960,000 was paid to the former co-inventor of the technology.

The Company also granted new warrants and agreed to re-price other outstanding warrants in order to obtain the necessary approvals from certain security interest holders as well as to obtain the release of their security interests in the Company’s intellectual property, and to finalize the LLC Agreement. The Company granted a warrant to TPL to acquire up to 3,500,000 shares of the Company’s common stock at a per share price of $0.125. The warrant has a term of seven years. At the date of grant, the right to acquire 1,400,000 common shares vested. The right to acquire the remaining 2,100,000 shares will vest in 700,000 increments only upon the Company’s common stock attaining a per share stock price of $0.50, $0.75 and $1.00. On February 21, 2006, February 22, 2006 and March 1, 2006 the rights to acquire the remaining 700,000 share increments vested as the Company’s stock price reached $0.50, $0.75 and $1.00, respectively. As additional consideration to the warrant holders for providing approval for the transaction, the Company agreed to reset the per share exercise price of approximately 35,000,000 warrants to $0.015 for which the warrant holders also conveyed other warrants to acquire 12,000,000 shares back to the Company. Further, the Company issued additional warrants to acquire approximately 290,000 shares of the Company’s common stock at a per share price of $0.03. The warrants issued and re-priced were valued using a Monte Carlo simulation model and the following assumptions: volatility of 101% to 229%, no dividends, risk-free interest rates of approximately 3.5% to 5.1%, and contractual terms ranging from two to seven years. The fair value of the warrants issued and re-priced in excess of previously recorded expense was approximately $83,000 and the fair value of the reconveyed warrants was approximately $622,000. These amounts, together with the direct, incremental cash costs previously described, are recorded as an expense and included in settlement and license expense in the three months ended August 31, 2005.

During the six months ended November 30, 2006, Phoenix Digital entered into licensing agreements with third parties, pursuant to which it received aggregate proceeds of $32,699,000. License proceeds of $8,850,000 relating to an additional license agreement signed in November 2006 are to be received in January 2007. Phoenix Digital has recorded this amount as a license receivable. During December 2006, Phoenix Digital entered into licensing agreements with aggregate proceeds of $7,320,000.

The condensed balance sheet and statement of income of Phoenix Digital at November 30, 2006 and for the six months then ended are as follows:
 
17

Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated Financial Statements

 
Condensed Balance Sheet      
ASSETS:
     
Cash
 
$
7,731,427
 
License fees receivable
   
8,850,000
 
Prepaid expenses
   
15,000
 
Total assets
 
$
16,596,427
 
Investment in Affiliated Company/License Agreement, continued
       
         
LIABILITIES AND MEMBERS’ EQUITY:
       
Accounts payable
 
$
1,172,314
 
Members’ equity
   
15,424,113
 
Total liabilities and members’ equity
 
$
16,596,427
 
         
Condensed Statement of Income
       
         
Revenues
 
$
41,549,000
 
Operating expenses
   
4,271,666
 
 
       
Operating income
   
37,277,334
 
 
       
Interest income
   
212,648
 
 
       
Net income
 
$
37,489,982
 

6. Convertible Debentures

From fiscal 2002 through fiscal 2005, the Company raised approximately $5,400,000 through the issuance of convertible debentures, having stated interest rates ranging from 8% to 12%, to a limited group of investors. The convertible debentures entitled the debenture holders to convert the principal, and any accrued interest thereon, into shares of the Company’s common stock for up to two years from the date of issuance.
 
The debentures were initially convertible into shares of common stock at conversion prices ranging from approximately $0.02 to $0.10 per share. The debentures contained provisions which allowed for the conversion rate to be reset on a periodic basis based on a comparison of the market price of the Company's common stock to the conversion price of the debentures. On those measurement dates where the market price was less than the conversion rate, a new conversion rate was set based on a weighted average of the market price for the ten days prior to the reset measurement date. As of May 31, 2005, the reset conversion rate on debentures outstanding ranged from $0.02 to $0.04.
 
Concurrent with the issuance of the convertible debentures, the Company issued to the debenture holders warrants to purchase shares of the Company's common stock. These warrants are exercisable for five years from the date of issuance at either initial negotiated exercise prices or prices equal to 115% of the volume weighted average price for our common stock for the ten days previous to the debenture date. The warrant exercise price is generally subject to being reset on each six-month anniversary of its issuance; however, if the warrant holder elects to have the warrant shares registered, then the exercise price is fixed at the price in effect on the date of the election.
 
Except for one debenture issued on March 23, 2004, the Company is responsible for registering the resale of the shares of its common stock which will be issued on the conversion of the debentures. As of May 31, 2005, there were six registration statements. The convertible debentures were secured by substantially all assets of the Company.
 
18

Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated Financial Statements
 
The terms of the convertible debentures included certain features that were considered embedded derivative financial instruments, such as the conversion feature and a reset conversion feature which provided for a conversion of the debentures into shares of the Company’s common stock at a rate which was determined to be variable. Because the debentures were not conventional convertible debt, the Company was also required to record the related warrants at their fair values. The total of the derivative and warrant liabilities at May 31, 2005 was $9,274,712, consisting of the fair value of the conversion feature and reset feature of $3,602,365
 
Convertible Debentures, continued 
 
and the fair value of the warrants of $4,029,634. In addition, under the provisions of EITF Issue No. 00-19, as a result of entering into the convertible debenture agreements, the Company was required to classify all other non-employee warrants as derivative liabilities and record them at their fair values at each balance sheet date. The total fair value of the non-employee warrants at May 31, 2005 was $1,642,713.
 
During the six months ended November 30, 2005, the value of the warrant and derivative liabilities decreased by $2,261,155, which is reflected as a component of other income (expense) in the accompanying condensed consolidated statements of operations.
 
During the three months ended August 31, 2005, holders of debentures with a principal balance of $132,500 converted their debentures, together with accrued interest thereon of approximately $6,000, into 8,295,789 shares of the Company’s common stock. No shares were converted during the three month period ended November 30, 2005. As of May 31, 2006, all outstanding debentures were repaid or converted into shares of the Company’s common stock. As a result of the settlement of the remaining debentures during 2006, the Company reclassified $6,743,935 related to the fair values of all outstanding warrants at the date of settlement to additional paid-in capital.

The following table presents the status and activity of the Company’s convertible debentures as of May 31, 2006:
 
                 
Principal 
               
Shares 
       
                 
 Balance  
         
Effective 
   
Converted  
   
Warrant 
 
     
Dates of  
   
Original 
   
at May 31,  
   
Conversion Prices 
   
 Registration  
   
May 31, as of 
   
 Shares  
 
Series    
Issuance 
   
Principal 
   
2006 
   
Initial 
   
Reset 
   
Date 
   
  2006 
   
Issued 
 
                                                   
A
   
4/23/02-
 
$
1,000,000
 
$
 
$
0.08616-
 
$
0.04190-
   
10/29/2002
   
24,099,548
   
12,859,175
 
 
    6/10/02                
0.10289
   
0.04457
                   
                                                   
B
   
8/23/02-
   
605,000
   
   
0.05126-
   
0.04381-
   
3/7/2003
   
14,777,350
   
11,234,835
 
   
1/24/03
               
0.0727
   
0.04722
                   
                                                   
C
   
3/24/02-
   
510,000
   
   
0.041-
   
0.041-
   
6/26/2003
   
10,470,554
   
9,377,943
 
   
6/9/03
               
0.065
   
0.065
                   
                                                   
D
   
8/1/03-
   
547,500
   
   
0.0172-
   
0.0172-
   
11/18/2003
   
25,178,803
   
22,455,355
 
   
10/21/03
               
0.048
   
0.0477
                   
                                                   
E
   
12/1/03-
   
1,527,500
   
   
0.0267-
   
0.0267-
   
6/7/2004
   
46,794,618
   
30,395,392
 
   
5/11/04
               
0.10
   
0.10
                   
                                                   
F
   
3/23/04
   
723,168
   
   
0.09
   
0.09
   
Not Registered
   
20,877,430
   
8,035,192
 
                                                   
G
   
9/28/04-
   
232,500
   
   
0.016710-
   
0.01670-
   
5/22/2006
   
8,267,358
   
8,259,678
 
   
1/17/05
             
0.04
   
0.04
                   
                                                   
G
   
11/17/04-
   
257,500
   
   
0.016710-
   
0.01670-
   
Not Registered
   
14,107,672
   
13,431,137
 
     
11/18/04
               
0.04
   
0.04
                   
         
$
5,403,168
   
                     
164,573,333
   
116,048,707
 
 
19

Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated Financial Statements

No convertible debentures or warrants in connection with convertible debentures were issued during the year ended May 31, 2006.

The Company recorded the fair value of the derivative instruments and warrants as a debt discount which was amortized to interest expense over the term of the convertible debentures. During the six months ended November 30, 2005, the Company recorded interest expense of $280,801 related to the amortization of the debt discount.

7. Stockholders’ Equity

During July 2006, the Company commenced its Board of Director approved stock buyback program in which the Company repurchases its outstanding common stock from time to time on the open market. As part of the program the Company purchased 4,874,827 shares of its common stock at an aggregate cost of $4,024,395 during the six months ended November 30, 2006.

The following table summarizes equity transactions during the six months ended November 30, 2006:
 
     
Common Stock
   
Additional
Paid-in
 
 
Accumulated
   
Treasury
 
     
Shares
   
Amounts
   
Capital
   
Deficit
   
Stock
 
Balance June 1, 2006
   
366,199,765
 
$
3,661
 
$
69,551,981
 
$
(58,728,091
)
$
 
                                 
Exercise of warrants and options at $0.02 to $0.40 per share
   
537,500
   
6
   
97,844
   
   
 
Cashless exercise of warrants
   
22,459,880
   
225
   
(225
)
 
   
 
Extension of stock options previously issued to a consultant
   
   
   
324
   
   
 
Non-cash compensation
   
   
   
1,773,102
   
   
 
Repurchase of common stock for treasury
   
   
   
   
   
(4,024,395
)
Net income
   
   
   
   
4,108,275
   
 
Balance November 30, 2006
   
389,197,145
 
$
3,892
 
$
71,423,026
 
$
(54,619,816
)
$
(4,024,395
)

 
As of November 30, 2006, 125,000 options were outstanding pursuant to our 1996 Stock Option Plan exercisable at a range of $0.07 to $0.08 per share expiring through 2009; 600,000 options were outstanding pursuant to our 2001 Stock Option Plan exercisable at a range of $0.07 to $0.86 per share expiring through 2011; 2,150,000 options were outstanding pursuant to our 2003 Stock Option Plan exercisable at a range of $0.05 to $0.17 per share expiring through 2011; and 2,050,000 options were outstanding pursuant to our 2006 Stock Option Plan exercisable at $0.70 per share expiring through 2011. Some of the options outstanding under these plans are not presently exercisable and are subject to meeting vesting criteria.

During the quarter ended August 31, 2006, we issued options to acquire 1,500,000 shares of our common stock at a per share price of $0.17 to an officer outside of the above referenced plans.

During the quarter ended November 30, 2006, we issued options to acquire 230,000 shares of our common stock at a per share price of $0.86 to employees pursuant to the 2001 Stock Option Plan.

During the six months ended November 30, 2006, directors exercised stock options to purchase 265,000 shares of common stock for aggregate proceeds of $25,600.

During the six months ended November 30, 2006, we recorded $1,773,102 of non cash compensation expense related to stock options issued and vesting of stock options and warrants previously granted.
 
20

Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated Financial Statements

As of November 30, 2006, we had warrants outstanding to purchase 29,921,015 common shares at exercise prices ranging from $0.02 to $1.00 per share, expiring at various dates through 2012. Some of those outstanding warrants were not exercisable as of November 30, 2006 as they are subject to meeting vesting criteria. During the six months ended November 30, 2006, we issued no warrants to purchase shares of common stock, investors exercised warrants to purchase 272,500 shares of common stock for proceeds of $72,250 and the Company had investors exercise warrants of 22,732,380 to purchase 22,459,880 shares of common stock on a cashless basis.

Stockholders’ Equity, continued

In connection with a previous debt agreement, the Company entered into an Antidilution Agreement (the “Antidilution Agreement”) with Swartz Private Equity, LLC (“Swartz”) wherein the Company was obligated to issue to Swartz warrants equal to 11% of the common stock issued between January 28, 2002 and March 11, 2002, 20% of the common stock issued between March 12, 2002 and April 1, 2003, and after April 1, 2003, 30% of the common stock issued to any parties other than Swartz. There were no warrants issued during the three month periods ended August 31, 2006 and 2005, nor were warrants issued during September 2006, in connection with the Antidilution agreement. On October 10, 2006, the Company entered into an Approval Rights Agreement and Termination of Antidilution Agreement and Addendum to Warrants (the “Termination Agreement”) with Swartz to terminate the Antidilution Agreement. In consideration for entering into the Termination Agreement, the Company agrees to obtain Swartz’s written approval at least 30 days prior to entering into (i) any acquisition of any business entity or asset of any kind where the aggregate number of shares of common stock and derivative securities (on a fully diluted basis) issued as consideration for the acquisition equals or exceeds 10% of the number of shares of common stock of the Company outstanding at the time of the acquisition (on a fully diluted basis) or (ii) any acquisition (regardless of size) by the Company of any business entity or asset of any kind that is not unanimously approved by the Company’s board of directors.

8. Commitments and Contingencies

Litigation

Beatie and Osborne, LLP v. Patriot Scientific Corporation
 
Beatie and Osborne, LLP is a New York law firm that formerly represented the Company in the Inventorship Litigation and the Infringement Litigation. On March 8, 2005, Beatie and Osborne were disqualified by United States District Judge Jeremy Fogel in the Inventorship Litigation. Beatie and Osborne thereafter withdrew from the representation of the Company in the Infringement Litigation. Beatie and Osborne initiated litigation in the Supreme Court of New York on June 8, 2005 claiming breach of contract, quantum merit, and unjust enrichment and alleging claims against the Company, and former Company representatives, Jeffrey Wallin and Lowell Giffhorn, for fraud and interference with contractual relationship. Beatie and Osborne claimed a contingency fee under the terms of its contingency fee agreement with respect to licensing agreements entered into, and possibly with respect to license agreements to be entered into, by the Company. The Company caused a removal of the Beatie and Osborne lawsuit to the United States District Court for the Southern District of New York and moved to transfer the action to the Southern District of California. The transfer motion was denied on May 9, 2006, but Wallin and Giffhorn were ordered dismissed from the action at that time. The circumstances of the disqualification of Beatie and Osborne in the Inventorship Litigation and its withdrawal from the Infringement Litigation were claimed by the Company to have worked a forfeiture of any rights in Beatie and Osborne to a contingency fee of any kind. In July 2006, the Company and Beatie and Osborne reached a settlement agreement whereby the Company paid Beatie and Osborne $340,000 and Beatie and Osborne retained $96,000 of the Company's funds in its possession through a retainer account. This settled the case in full.
 
21

Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated Financial Statements
 
Patriot Scientific Corporation v. Russell Fish
 
On April 6, 2006, we filed a declaratory relief lawsuit against Russell Fish and The Fish Family Trust in the United States District Court for the Southern District of California. As a consequence of licensing agreements entered into by or on behalf of Patriot, by Patriot's previous management, Mr. Fish presented demands for payment by us under his July 2004 agreement related to the Inventorship Litigation. We contended that Mr. Fish had been paid all sums that may have been owed to him. Our action sought declaratory relief that no further sums were owed to Mr. Fish. Also, on April 6, 2006, Fish and, later, Robert Anderson, allegedly as trustee of The Fish Family Trust, filed a lawsuit against the Company in the District Court of Dallas County, Texas. The case was subsequently removed to the United States District Court for the Northern District of Texas. The lawsuit was based on an alleged breach of the contract entered into on July 27, 2004 and sought enforcement of the contract or damages. The California action was transferred to the Northern District of Texas. Mediation commenced on September 11, 2006. In December 2006, the Fish lawsuit was settled in principle through mediation. Settlement terms have not been finalized as of this filing date nor is there an executed settlement agreement in place. In light of the mediation and after consulting with counsel, we feel we are close to a settlement agreement even though there is no guarantee that that will take place nor is it enforceable until an agreement has been signed. As a result, during the six months ended November 30, 2006, the Company recorded $6,300,000 of settlement and license expense relating to the mediation agreement with Fish. The amount consists of $3,000,000 to be paid in cash and 5,500,000 million shares of stock at an average price of $0.60 per share. In addition to those terms, the mediation terms further provide the Company will pay Fish the equivalent of 4% of 50% of the next $100 million of gross license fees as they are collected by Phoenix Digital and as distributions are made to Patriot, after excluding the first $20 million collected by Phoenix Digital after December 1, 2006. Patriot's commitment to make payments to Fish related to such future license revenues will not exceed $2 million.
 
Lowell Giffhorn Arbitration
 
On September 23, 2005, Lowell Giffhorn, a former executive officer and a former director of Patriot, submitted a demand for arbitration with the American Arbitration Association related to the termination of Mr. Giffhorn's employment with the Company. Mr. Giffhorn asserts that the termination of his employment with the Company was unlawful, retaliatory, wrongful, violated public policy, violated the covenant of good faith and fair dealing and violated securities laws. Mr. Giffhorn has demanded damages of approximately $4,500,000 (excluding claims for punitive damages and attorneys fees). The Company denies the allegations and believes the claims to be frivolous and totally devoid of merit. The Company has retained litigation counsel and intends to vigorously defend the claims. The amount, if any, of ultimate liability with respect to the foregoing cannot be determined. Despite the inherent uncertainties of litigation, the Company at this time does not believe that Mr. Giffhorn's claim will have a material adverse impact on its financial condition, results of operations, or cash flows.
 
Patent Litigation
 
Pursuant to the joint venture that the Company entered into in June 2005 with Technology Properties Ltd. (in settlement of inventorship/ownership litigation between the parties, and in return for a 50-50 sharing of net licensing and enforcement revenues), the Company granted Technology Properties Ltd. (TPL) the complete and exclusive right to enforce and license its microprocessor patent portfolio. The Company then dismissed its patent infringement claims against Fujitsu Computer Systems, Inc.; Matsushita Electric Corporation of America; NEC Solutions (America) Inc.; Sony Electronics Inc.; and Toshiba America Inc., which had been pending in the Federal District Court for the Northern District of California. Thereafter, TPL, on behalf of the TPL/Patriot joint venture and Patriot, filed patent infringement actions against the foregoing defendants (except Sony) in the Federal District Court for the Eastern District of Texas, which litigation is currently pending. Litigation is not currently pending with regard to Fujitsu.
 
In February 2006, a license agreement was entered into with Fujitsu Corporation regarding the Company's patent portfolio, and in connection with that transaction, litigation involving Fujitsu and TPL and the Company in both California and Texas was dismissed. A Claims Construction Hearing has been scheduled with Fujitsu on May 3, 2007 in district court.
 
Profit Sharing Plan

The Company has a savings and profit-sharing plan that allows participants to make contributions by salary reduction pursuant to Section 401(k) of the Internal Revenue Code. At the Company’s discretion, the Company may match contributions at 20% of the employee’s contribution up to 6% of the employee’s salary. The Company contributions are vested 20% per year beginning with the first year of service. The Company made no matching contributions to the plan in fiscal 2006. On December 31, 2005, the Company terminated the plan.

22

Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated Financial Statements

Commitments and Contingencies, continued
 
401(k) Plan

In January 2006, the Company adopted a retirement plan that complies with Section 401(k) of the Internal Revenue Code. All employees are eligible to participate in the plan. The Company matches 50% of each participant’s voluntary contributions, subject to a maximum contribution of 6% of the participant’s compensation. Participants fully vest in the Company’s contributions after three years of vesting service. The Company’s matching contributions for the six months ended November 30, 2006 were $5,607.

Employment Contract

During the quarter ended August 31, 2005, the Company terminated two of its officers, each of whom had an employment contract with the Company. One of the officers agreed to accept as severance approximately $150,000 and to have the maturity date of options held by him extended for one year. Further, the Company agreed to accelerate the vesting of all outstanding options held by the officer and to extend their term to June 2006. The Company recorded an expense of approximately $125,000 related to this option modification in the quarter ended August 31, 2005.

The Company has not reached an agreement with the other officer; however, it accrued approximately $50,000 during the three month period ended August 31, 2005 for amounts which it believes may be due to this individual. The former officer has filed a complaint against the Company seeking arbitration and claiming he is owed approximately $4,500,000 (see above). The Company believes the claim is without merit and intends to vigorously defend itself. 

Guarantees and Indemnities

The Company has made certain guarantees and indemnities, under which it may be required to make payments to a guaranteed or indemnified party. The Company indemnifies its directors, officers, employees and agents to the maximum extent permitted under the laws of the State of Delaware. In connection with its facility leases, the Company has indemnified its lessors for certain claims arising from the use of the facilities. The duration of the guarantees and indemnities varies, and in many cases is indefinite. These guarantees and indemnities do not provide for any limitation of the maximum potential future payments the Company could be obligated to make. Historically, the Company has not been obligated to make any payments for these obligations and no liabilities have been recorded for these guarantees and indemnities in the accompanying condensed consolidated balance sheets.

9. Subsequent Events

During the period December 1, 2006 through January 12, 2007, Phoenix Digital entered into license agreements with third parties, with aggregate proceeds totaling $7,320,000.
 
23

Patriot Scientific Corporation
Notes to Unaudited Condensed Consolidated Financial Statements

On December 20, 2006, the Company received proceeds of $1,950 from the issuance of 25,000 shares of common stock in connection with the exercise of stock options by a director.

During December 2006 and January 2007, the Company purchased 3,132,500 shares of its common stock at an aggregate cost of $1,960,305 under its stock buyback program.
 
As stated in Notes 3 and 8 above, during December 2006, the Fish lawsuit was settled in principle through mediation. Settlement terms have not been finalized as of this filing date nor is there a settlement agreement in place. Please see Notes 3 and 8 for more information.

24

 
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

THE FOLLOWING DISCUSSION INCLUDES FORWARD-LOOKING STATEMENTS WITH RESPECT TO OUR FUTURE FINANCIAL PERFORMANCE. ACTUAL RESULTS MAY DIFFER MATERIALLY FROM THOSE CURRENTLY ANTICIPATED AND FROM HISTORICAL RESULTS DEPENDING UPON A VARIETY OF FACTORS, INCLUDING THOSE DESCRIBED BELOW UNDER THE SUB-HEADING, "RISK FACTORS" SEE ALSO OUR ANNUAL REPORT ON FORM 10-KSB FOR THE YEAR ENDED MAY 31, 2006.

Overview

During the fiscal years ended May 31, 2005 and May 31, 2006, the Company entered into agreements for the licensing of its technology with Advanced Micro Devices Inc. ("AMD") and Intel Corporation, among the largest of the microprocessor manufacturers. During the 2006 fiscal year, the Company entered into licensing agreements with Hewlett-Packard, Fujitsu and Casio through its joint venture entity, Phoenix Digital. Additional licensing agreements for the use of the Company’s technology were signed through its joint venture entity during the six months ended November 30, 2006. We believe that these agreements represent validation of the Company's position that its intellectual property was and is being infringed by major manufacturers of microprocessor technology. Also, we believe the agreements demonstrate the value of the Company's intellectual property in that they are "arms length" transactions with major electronics manufacturers.

In June 2005, the Company entered into a series of agreements with Technology Properties Limited, Inc. (“TPL”) and others to facilitate the pursuit of infringers of its intellectual property. The Company intends to continue its joint venture with TPL to pursue license agreements with infringers of its technology. Management believes that utilizing the option of working through TPL, as compared to creating and using a Company licensing team for those activities, avoids a competitive devaluation of the Company’s principal assets and is a prudent way to achieve the desired results as the Company seeks to obtain fair value from users of its intellectual property.
 
RESTATEMENT OF PREVIOUSLY ISSUED FINANCIAL STATEMENTS
 
On September 8, 2006, the Company determined that the manner in which it had accounted for the reset conversion feature and embedded put option of certain of its convertible debentures was not in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 133, Accounting For Derivative Instruments and Hedging Activities, as amended, and Emerging Issues Task Force (“EITF”) Issue No. 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock. The Company determined that the reset conversion feature was an embedded derivative instrument and that the conversion option was an embedded put option pursuant to SFAS No. 133. The accounting treatment of derivative financial instruments required that the Company record the derivatives and related warrants at their fair values as of the inception date of the convertible debenture agreements and at fair value as of each subsequent balance sheet date.  In addition, under the provisions of EITF No. 00-19, as a result of entering into the convertible debenture agreements, the Company was required to classify all other non-employee warrants as derivative liabilities and record them at their fair values at each balance sheet date.  Any change in fair value was required to be recorded as non-operating, non-cash income or expense at each balance sheet date.  If the fair value of the derivatives was higher at the subsequent balance sheet date, the Company was required to record a non-operating, non-cash charge.  If the fair value of the derivatives was lower at the subsequent balance sheet date, the Company was required to record non-operating, non-cash income.  Accordingly, in connection with its restatement adjustments, the Company has appropriately reflected the non-operating, non-cash income or expense resulting from changes in fair value. The Company had previously not recorded the embedded derivative instruments as a liability and did not record the related changes in fair value. The Company did not have any derivative instruments at May 31, 2006 as all derivative instruments were settled prior to May 31, 2006.
 
25

 
In addition, the Company determined the manner in which it accounted for its interest in Phoenix Digital was not in accordance with appropriate accounting literature. Beginning in June 2005, the Company accounted for its interest in Phoenix Digital as a variable interest entity, as defined in FASB Interpretation 46(R). Accordingly, the accounts and transactions of Phoenix Digital were consolidated with those of the Company and the ownership interest of the other member of Phoenix Digital was presented as a minority interest in the condensed consolidated financial statements of the Company for the periods August 31, 2005, November 30, 2005 and February 28, 2006. The Company has reassessed its accounting for its interest in Phoenix Digital and after further consideration of FIN 46(R) and other authoritative literature, has corrected its accounting policy to account for its interest in Phoenix Digital in accordance with the equity method of accounting for investments, as the Company did not have a controlling financial interest in Phoenix Digital and determined that it was not the primary beneficiary of the relationship.

Based on the foregoing, the Company’s Board of Directors determined that the Company was required to restate its financial results for the year ended May 31, 2005 and for the three month periods ended August 31, 2005, November 30, 2005 and February 28, 2006.
 
See Note 2 to the accompanying condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for a summary of the effects of the restatement adjustments on the Company's condensed consolidated financial statements. The information provided in this Management's Discussion and Analysis of Financial Condition and Results of Operations reflects the effect of the restatement adjustments.

Critical Accounting Policies and Estimates

Our condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America, which require us to make estimates and judgments that significantly affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Actual results could differ from those estimates, and such differences could affect the results of operations reported in future periods. We believe the following critical accounting policies affect our most significant estimates and judgments used in the preparation of our condensed consolidated financial statements.

1. Revenue Recognition

Accounting for revenue recognition is complex and affected by interpretations of guidance provided by several sources, including the Financial Accounting Standards Board (“FASB”) and the Securities and Exchange Commission (“SEC”). This guidance is subject to change. We follow the guidance established by the SEC in Staff Accounting Bulletin No. 104, as well as generally accepted criteria for revenue recognition, which require that, before revenue is recorded, there is persuasive evidence of an arrangement, the fee is fixed or determinable, collection is reasonably assured, and delivery to our customer has occurred. Applying these criteria to certain of our revenue arrangements requires us to carefully analyze the terms and conditions of our license agreements. Revenue from our technology license agreements is generally recognized at the time we enter into a contract and provide our customer with the licensed technology. We believe that this is the point at which we have performed all of our obligations under the agreement; however, this remains a highly interpretive area of accounting and future license agreements may result in a different method of revenue recognition. Fees for maintenance or support of our licenses are recorded on a straight-line basis over the underlying period of performance.

2. Assessment of Contingent Liabilities

We are involved in various legal matters, disputes, and patent infringement claims which arise in the ordinary conduct of our business. We accrue for estimated losses at the time when we can make a reliable estimate of such loss and it is probable that it has been incurred. By their very nature, contingencies are difficult to estimate. We continually evaluate information related to all contingencies to determine that the basis on which we have recorded our estimated exposure is appropriate.

26


3. Stock Options and Warrants

We account for equity issuances to non-employees in accordance with Statement of Financial Accounting Standards ("SFAS") No. 123, Accounting for Stock Based Compensation , and Emerging Issues Task Force ("EITF") Issue No. 96-18, Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods and Services . All transactions in which goods or services are the consideration received for the issuance of equity instruments are accounted for based on the fair value of the consideration received or the fair value of the equity instrument issued, whichever is more reliably measurable. The measurement date used to determine the fair value of the equity instrument issued is the earlier of the date on which the third-party performance is complete or the date on which it is probable that performance will occur.

Prior to June 1, 2006, we accounted for stock-based compensation issued to employees using the intrinsic value method of accounting prescribed by Accounting Principles Board ("APB") Opinion No. 25, Accounting for Stock Issued to Employees and related pronouncements. Under this method, compensation expense was recognized over the respective vesting period based on the excess, on the date of grant, of the fair value of our common stock over the grant price, net of forfeitures. Deferred stock-based compensation was amortized on a straight-line basis over the vesting period of each grant.

On June 1, 2006, we adopted SFAS No. 123(R), Share-Based Payment, which requires the measurement and recognition of compensation expense for all share-based payment awards made to our employees and directors related to our stock option plans based on estimated fair values. We adopted SFAS No. 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of June 1, 2006, the first day of our fiscal year 2007. Our condensed consolidated financial statements as of and for the six months ended November 30, 2006 reflect the impact of adopting SFAS No. 123(R). In accordance with the modified prospective transition method, our consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS No. 123(R). The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in our consolidated statement of operations. As stock-based compensation expense recognized in the condensed consolidated statement of operations for the six months ended November 30, 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The estimated average forfeiture rate for the six months ended November 30, 2006 of 5% was based on historical forfeiture experience and estimated future employee forfeitures. In our pro forma information required under SFAS No. 123 for the periods prior to fiscal 2007, we accounted for forfeitures as they occurred.

Employee stock-based compensation expense recognized under SFAS No. 123(R) for the six months ended November 30, 2006 was $1,773,102, determined by the Black-Scholes valuation model.

4. Debt Discount

We have issued warrants as part of our convertible debentures and other financings. We value the warrants using the Black-Scholes pricing model based on expected fair value at issuance and the estimated fair value is recorded as debt discount. The debt discount is amortized to non-cash interest over the life of the debenture assuming the debenture will be held to maturity, which is normally two years. If the debenture is converted to common stock previous to its maturity date, any debt discount not previously amortized is expensed to non-cash interest. As of May 31, 2006, the debt discount has been fully amortized as the debt instruments were settled prior to May 31, 2006.

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5. Derivative Financial Instruments

In connection with the issuance of certain convertible debentures, the terms of the debentures included a reset conversion feature which provided for a conversion of the debentures into shares of the Company's common stock at a rate which was determined to be variable. The conversion option was therefore deemed to be an embedded put option pursuant to Statement of Financial Accounting Standards (“SFAS”) No. 133, Accounting For Derivative Instruments and Hedging Activities , as amended, and Emerging Issues Task Force (“EITF”) Issue No. 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock . The Company determined that the reset conversion feature was an embedded derivative instrument and that the conversion option was an embedded put option pursuant to SFAS No. 133. The accounting treatment of derivative financial instruments required that the Company record the derivatives and related warrants at their fair values as of the inception date of the convertible debenture agreements and at fair value as of each subsequent balance sheet date.  In addition, under the provisions of EITF No. 00-19, as a result of entering into the convertible debenture agreements, the Company was required to classify all other non-employee warrants as derivative liabilities and record them at their fair values at each balance sheet date.  Any change in fair value was recorded as non-operating, non-cash income or expense at each balance sheet date.  If the fair value of the derivatives was higher at the subsequent balance sheet date, the Company recorded a non-operating, non-cash charge.  If the fair value of the derivatives was lower at the subsequent balance sheet date, the Company recorded non-operating, non-cash income. As of May 31, 2006, the Company does not have any outstanding derivative instruments as the related debt instruments were settled prior to May 31, 2006.

6. Patents and Trademarks

Patents and trademarks are carried at cost less accumulated amortization and are amortized over their estimated useful lives of four years. The carrying value of patents and trademarks is periodically reviewed and impairments, if any, are recognized when the expected future benefit to be derived from an individual intangible asset is less than its carrying value.

7. Income Taxes

Deferred income taxes are provided for by recognizing temporary differences in certain income and expense items for financial and tax reporting purposes. Deferred tax assets consist primarily of income tax benefits from net operating loss carry-forwards. A valuation allowance has been recorded to fully offset the deferred tax asset as it is more likely than not that the assets will not be utilized. We have historically provided a valuation allowance equal to 100% of our net deferred tax asset. In spite of the net income recorded by us during the quarter ended November 30, 2006, we do not believe that we have ample evidence of overcoming the “more likely than not” criteria established by generally accepted accounting principles. We will continue to monitor our financial operating results, and other factors, to determine when, if ever, we meet this criteria.
 
8. Investment in Affiliated Company
 
The Company has a 50% interest in Phoenix Digital. This investment is accounted for using the equity method of accounting since the investment provides the Company the ability to exercise significant influence, but not control, over the investee. Significant influence is generally deemed to exist if the Company has an ownership interest in the voting stock of the investee of between 20% and 50%, although other factors, such as representation on the investee’s Board of Directors, are considered in determining whether the equity method of accounting is appropriate. Under the equity method of accounting, the investment, originally recorded at cost, is adjusted to recognize the Company’s share of net earnings or losses of the investee and is recognized in the condensed consolidated statement of operations in the caption “Equity in earnings of affiliated company”.

The Company reviews its investment in affiliated company to determine whether events or changes in circumstances indicate that its carrying amount may not be recoverable. The primary factors the Company considers in its determination are the financial condition, operating performance and near term prospects of the investee. If a decline in value is deemed to be other than temporary, the Company would recognize an impairment loss.
 
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Results of Operations

Comparison of the Six Months Ended November 30, 2006 and Six Months Ended November 30, 2005.

In June 2005, we entered into an agreement with Intel Corporation licensing our intellectual property for a one-time payment of $10,000,000. The license revenue was recognized in the quarter ended August 31, 2005. During the six month period ended November 30, 2006 no such agreement was signed by the Company. In connection with entering into the agreement with Intel Corporation, we entered into an agreement with the co-owner of our patented technologies, through which we settled all legal disputes between us and agreed to jointly pursue others who have infringed upon our joint rights. Future licensing agreements for the use of the Company’s technology are being made through a joint venture entity that is accounted for in accordance with the equity method of accounting for investments and, accordingly, the financial results of the joint venture are being recorded in the Other Income section of the Company’s Condensed consolidated Statement of Operations. Product sales amounting to approximately $20,000 and $45,000 were also recorded in the six month periods ended November 30, 2005 and 2006, respectively, in connection with communications products that are no longer marketed by the Company. Inventory associated with the sales of these communications products is carried at zero value and cost of sales is therefore zero. Total revenues amounted to approximately $10,020,000 and $45,000 for the six months ended November 30, 2005 and 2006, respectively.

Research and development expenses decreased from approximately $198,000 for the six months ended November 30, 2005 to zero for the six months ended November 30, 2006. Presently, we do not expect to replace recently discontinued “in house” research and development operations. However, the Company may utilize consultants and other outsourced contractors for research and development activities in future periods.

Selling, general and administrative expenses increased from approximately $1,820,000 for the six months ended November 30, 2005 to approximately $4,469,000 for the six months ended November 30, 2006. Legal and accounting related expenses increased by approximately $791,000 for the six months ended November 30, 2006 compared with the six months ended November 30, 2005 related to legal and accounting matters in connection with the restatement of the Company’s financial statements for the fiscal years 2005, 2004, 2003 and 2002, as well as the quarterly reports for the periods ended August 31, 2005, November 30, 2005 and February 28, 2006. Legal expenses related to a dispute with a former executive officer as well as other legal proceedings involving the interests of a co-inventor of a portion of the Company’s technology and other legal matters contributed to the increase in legal expenses for the six months ended November 30, 2006. Salary costs and related expenses included non-cash expenses associated with the fair value of options granted d