Three Months
		Ended March 31,
		2007			2006
CASH FLOWS FROM OPERATING ACTIVITIES:
Loss from continuing operations			($8,925	)		($148	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization			280			166
Loss on early extinguishment of debt			—			1,964
Change in fair value from revaluation of warrants and embedded conversion features			3,508			(4,768	)
Stock-based compensation expense			891			895
Interest expense related to convertible debt			781			—
Increase in value of life insurance policies			(4	)		(30	)
Changes in operating assets and liabilities
Trade and other accounts receivable			(6	)		142
Inventories			(43	)		—
Prepaid expenses and other current assets			(21	)		(149	)
Accounts payable and accrued liabilities			(232	)		(641	)
Deferred revenue and other current liabilities			137			612
Net cash used in operating activities			(3,634	)		(1,957	)
CASH FLOWS FROM INVESTING ACTIVITIES:
Cash paid to acquire Mobot, Inc., Sponge Ltd., Gavitec AG, and 12Snap AG, net of cash acquired			—			(13,867	)
Acquisition of property and equipment			—			(23	)
Acquisition of patents and other intangible assets			—			(8	)
Advances to discontinued subsidiaries Micro Paint, 12Snap, Telecom Services, Mobot, and Sponge			(1,641	)		(2,470	)
Acquisition related costs			—			(59	)
Payment of purchase price guarantee obligations			(2,372	)		—
Amounts received (issued) under notes receivable			450			(500	)
Net cash used in investing activities			(3,563	)		(16,927	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Borrowing under convertible debt instrument, net of fees of $781 in 2007			6,678			—
Repayments on notes payable and convertible debt instrument			—			(210	)
Net proceeds from issuance of common stock, net of issuance costs of $24 in 2006			—			210
Net proceeds from issuance of Series C convertible preferred stock, net of issuance costs of $2,725 in 2006			—			14,066
Net proceeds from exercise of stock options and warrants			9			8,131
Net cash provided by financing activities			6,687			22,197
EFFECT OF EXCHANGE RATE CHANGES ON CASH FOR CONTINUING OPERATIONS			(8	)		(192	)
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS FROM CONTINUING OPERATIONS			(518	)		3,121
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD			2,813			1,704
CASH AND CASH EQUIVALENTS, END OF PERIOD		$	2,295		$	4,825

 

 

 

3

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SUPPLEMENTAL CASH FLOW INFORMATION:
Interest paid during the period		$	401		$	13
Supplemental disclosure of investing and financing activities:
Unrealized gain (loss) on marketable securities			(26	)		149
Fair value of 258,620,948 shares issued to satisfy purchase price guarantee obligations			12,721			—
Prepaid acquisition costs applied to purchase price			—			168
Fair value of shares and notes receivable from Pickups Plus, Inc. acquired in exchange for Series C Convertible Preferred Stock			—			594
Carrying value of promissory note and accrued interest paid in exchange for Series C Convertible Preferred Stock			—			(3,208	)
Fair value of shares issued to acquire CSI International, Inc., Mobot, Inc., Sponge Ltd., Gavitec AG, 12Snap AG, and BSD Software, Inc.			—			46,964
Change in net assets resulting from acquisitions of CSI International, Inc., Mobot, Inc., Sponge Ltd., Gavitec AG, 12Snap AG, and BSD Software, Inc.			—			60,594
Accretion of dividends on Series C Convertible Preferred Stock			433			137
Fair value of outstanding warrants reclassified to liabilities			—			13,884
Portion of change in fair value of outstanding warrants converted to liabilities recorded to paid-in capital			—			3,790
Initial fair value of Series C Convertible Preferred Stock (host instrument only)			—			4,908
Deferred stock-based financing costs associated with Series C Convertible Preferred Stock			—			3,198
Difference between net proceeds and recorded fair value of Series C Convertible Preferred Stock			—			4,041
Advance receivable from Mobot, Inc. forgiven upon acquisition			—			1,500

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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NEOMEDIA TECHNOLOGIES, INC. AND SUBSIDIARIES

UNAUDITED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1.	BASIS OF PRESENTATION AND NATURE OF BUSINESS OPERATIONS

Basis of Presentation

The condensed consolidated financial statements include the financial statements of NeoMedia Technologies, Inc. and its wholly-owned subsidiaries (“NeoMedia” or the “Company”). The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the instructions to 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 condensed consolidated financial statements. These condensed consolidated financial statements and related notes should be read in conjunction with the Company’s Form 10-K for the fiscal year ended December 31, 2006. In the opinion of management, these condensed consolidated financial statements reflect all adjustments which are of a normal recurring nature and which are necessary to present fairly the condensed consolidated financial position of NeoMedia as of March 31, 2007, the results of operations for the three month periods ended March 31, 2007 and 2006, and cash flows for the three month periods ended March 31, 2007 and 2006. The results of operations for the three month period ended March 31, 2007 are not necessarily indicative of the results which may be expected for the entire fiscal year. All significant intercompany accounts and transactions have been eliminated in preparation of the condensed consolidated financial statements.

Going Concern

The accompanying condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America, which contemplate continuation of the Company as a going concern. Net loss for the three months ended March 31, 2007 was $11,499,000. Net cash used in operations for the three months ended March 31, 2007 was $3,634,000, and net cash used for discontinued operations was $1,609,000 (including operating, investing, and financing activities, as well as effect of exchange rates on cash for discontinued subsidiaries). NeoMedia also has an accumulated deficit of $171,461,000 and a working capital deficit of $66,452,000 as of March 31, 2007, of which $25,949,000 relates to the fair value of derivative financial instruments.

During January 2007, the Company made a strategic decision to sell its 12Snap and Telecom Services businesses. During the year ended December 31, 2006, revenues from these businesses accounted for 91% of NeoMedia's consolidated revenues. In the event that the Company is successful in selling these businesses, revenue, gross margin, and operating expenses would decline materially relative to 2006.

In addition, as of March 31, 2007, NeoMedia owed $1,015,000 to the former shareholders of 12Snap AG relating to a purchase price guarantee obligation associated with NeoMedia’s acquisitions of 12Snap in February 2006. This amount was paid from the proceeds of the Company’s sale of 12Snap during April 2007 (see Note 3).

The items discussed above raise substantial doubts about the Company's ability to continue as a going concern. If the Company's financial resources are insufficient, the Company may require additional financing in order to execute its operating plan and continue as a going concern. The Company cannot predict whether this additional financing will be in the form of equity, debt, or another form. The Company may not be able to obtain the necessary additional capital on a timely basis, on acceptable terms, or at all. In any of these events, the Company may be unable to implement its current plans for expansion, repay its debt obligations as they become due or respond to competitive pressures, any of which circumstances would have a material adverse effect on its business, prospects, financial condition and results of operations. The financial statements do not include any adjustments relating to the recoverability and reclassification of recorded asset amounts or amounts and reclassification of liabilities that might be necessary, should the Company be unable to continue as a going concern.

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Should financing sources fail to materialize, management would seek alternate funding sources such as the sale of common and/or preferred stock, the issuance of debt, or the sale of its marketable assets. Management's plan is to secure adequate funding to bridge the commercialization of its core code-reading business.

 

NeoMedia plans to attempt to address its working capital deficiency by completing the proposed sales of the Micro Paint Repair and NeoMedia Telecom business units, and continuing to reduce its workforce and overhead expenses in non-critical areas. In addition, NeoMedia will attempt to generate additional revenue and profit from the launch of its core code-reading products and the value optimization of its patent portfolio.

In the event that these financing sources do not materialize, or that NeoMedia is unsuccessful in increasing its revenues and profits, NeoMedia will be forced to further reduce its costs, may be unable to repay its debt obligations as they become due, or respond to competitive pressures, any of which circumstances would have a material adverse effect on its business, prospects, financial condition and results of operations. Additionally, if these funding sources or increased revenues and profits do not materialize, and NeoMedia is unable to secure additional financing, NeoMedia could be forced to reduce or curtail its business operations unless it is able to engage in a merger or other corporate finance transaction with a better capitalized entity.

Nature of Business Operations

Prior to 2006, NeoMedia was structured and evaluated by its Board of Directors and management as three distinct business units: NeoMedia Internet Switching Software (NISS), NeoMedia Micro Paint Repair (NMPR), and NeoMedia Consulting and Integration Services (NCIS).

 

During the first quarter of 2006, NeoMedia acquired new subsidiaries 12Snap AG (“12Snap”) of Munich, Sponge Ltd. (“Sponge”) of London, Gavitec AG of Aachen, Germany (“Gavitec”), Mobot, Inc. (“Mobot”) of Lexington, Massachusetts, and BSD Software, Inc. of Calgary, Canada (“BSD”), and wound down its NCIS business unit. As a result, during the year ended December 31, 2006, NeoMedia operated under the following three business units:

 

·

NeoMedia Mobile (NMM) - encompassing NeoMedia's physical-world-to-internet and mobile marketing technologies and products;

·

NeoMedia Telecom Services (NTS) - encompassing the billing, clearinghouse and information management services of Triton Global Business Services, the operating subsidiary of BSD, acquired in March 2006; and

·

NeoMedia Micro Paint Repair (NMPR) - encompassing the micro paint and auto aftermarket accessories manufactured and distributed by NeoMedia.

 

During August 2006, NeoMedia announced that it intended to sell its NMPR business. During the fourth quarter of 2006, NeoMedia divested of its Mobot and Sponge subsidiaries. During January 2007, NeoMedia made the strategic decision with respect to its corporate structure in 2007 and beyond, deciding to shed its remaining non-core 12Snap and NTS business units to focus on the area that management believes will deliver the most value - the core code-reading business. During April 2007, NeoMedia sold the 12Snap business.

As a result of the divestitures of Mobot and Sponge, and the proposed divestitures of NMPR and 12 Snap and NeoMedia Telecom Services, beginning in the first quarter of 2007 NeoMedia evaluated its business as one consolidated business, focusing on its core code-reading business and related intellectual property.

For purposes of these financial statements, NeoMedia Micro Paint Repair, NeoMedia Telecom Services, 12Snap, Sponge, and Mobot are considered discontinued operations as of March 31, 2007 and for the three month periods ended March 31, 2007 and 2006. NeoMedia Micro Paint Repair, NeoMedia Telecom Services, 12Snap, Sponge, and Mobot qualified as separate operating business units because they (i) engaged in business activities that earned revenues and incurred expenses, (ii) had operating results that were regularly reviewed by decision makers for the purposes of allocating resources to the segment, and (iii) had separate discreet financial information.

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NeoMedia is a pioneer in mobile enterprise and marketing technology, bridging the physical and electronic world with innovative direct-to-mobile-Web technology solutions. NeoMedia's flagship qode® service links users to the wireless, electronic world. NeoMedia is headquartered in Fort Myers, Florida, with an office in Aachen, Germany. The qode® suite of easy-to-use, market-driven products and applications is based on a strong foundation of patented technology, comprising the qode® (www.qode.com) platform, qode® reader and qode® window, all of which provide One Click to Content™ connectivity for products, print, packaging and other physical objects to link directly to specific desired content on the mobile Internet.

Reclassifications

Certain amounts in the 2006 condensed consolidated financial statements have been reclassified to conform to the 2007 presentation, most notably, net sales were formerly reported as separate line items “Technology license, service and products,” and “Micro Paint Repair Products and Services.” As a result of the winding down of the former NCIS business unit and the pending sale of the NMPR business unit, revenue from continuing operations now consists of license revenue and is being reported under the caption “Net sales.”

In addition, due to the Company’s decision to sell the Micro Paint Repair business unit, the completed divestitures of Mobot and Sponge during 2006, and the Company’s decision to sell 12Snap and NeoMedia Telecom Services in January 2007, results of operations from each of these units have been reclassified under the caption “Discontinued Operations” for all periods shown on the accompanying condensed consolidated statement of operations, and assets and liabilities relating to these units are combined into the captions “Assets held for sale” and “Liabilities held for sale,” respectively, on the accompanying condensed consolidated balance sheet. Additionally, the statements of cash flows for the three months ended March 31, 2006 have been restated to exclude the cash flows of the discontinued business units.

2.	SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The following significant accounting policies were not applicable as of the filing of its last annual report for the year ended December 31, 2006. For a complete discussion of the Company’s significant accounting policies, please refer to the Company’s annual report on Form 10-K for the fiscal year ended December 31, 2006.

Financial Accounting Standards Board Interpretation No. 48

The Company adopted the provisions of Financial Accounting Standards Board ("FASB") Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109” (“FIN 48”), on January 1, 2007. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with FASB Statement 109, “Accounting for Income Taxes,” and prescribes a recognition threshold and measurement process for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.

Based on its evaluation, the Company has concluded that there are no significant uncertain tax positions requiring recognition in its financial statements. The Company’s evaluation was performed for the tax years ended December 31, 2003, 2004, 2005 and 2006, the tax years which remain subject to examination by major tax jurisdictions as of March 31, 2007.

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The Company may from time to time be assessed interest or penalties by major tax jurisdictions, although any such assessments historically have been minimal and immaterial to the Company’s financial results. In the event the Company has received an assessment for interest and/or penalties, it has been classified in the financial statements as interest expense.

Statement of Financial Accounting Standards No. 155

The company adopted Statement of Financial Accounting number 155 “Accounting for Certain Hybrid Financial Instruments” (FAS 155) in the first quarter of 2007. The Company has adopted FAS 155 on an individual instrument basis and is currently applying FAS 155 to certain of it’s debt obligations. The Company will evaluate and determine on a case by case basis whether to apply FAS 155.

 

Revenue Recognition

NeoMedia derives  revenues from the following  sources:  (1) license revenues relating to patents and internally-developed software, (2) hardware, software, and service revenues related to mobile marketing campaign design and implementation, and (3) sale of its proprietary Micro Paint Repair solution.

 

(1)

Technology license fees, including Intellectual Property licenses, represent revenue from the licensing of NeoMedia’s proprietary  software  tools and  applications products.  NeoMedia licenses its  development  tools and  application  products pursuant to non-exclusive and  non-transferable  license agreements.  The basis for license fee revenue recognition is substantially governed by American  Institute  of  Certified  Public  Accountants  ("AICPA")  Statement of Position 97-2 "Software Revenue  Recognition" ("SOP 97-2"), as amended, and Statement of Position 98-9, Modification of SOP 97-2, “Software Revenue Recognition, With Respect to Certain Transactions.”.  License revenue is recognized if persuasive  evidence of an agreement  exists,  delivery has occurred, pricing is fixed and determinable, and collectibility is probable.  The Company defers revenue related to license fees for which amounts have been collected but for which revenue has not been recognized in accordance with the above, and recognizes the revenue over the appropriate period.

(2)

Technology service and product revenue, which includes sales of software and technology equipment and service fee is recognized  based on guidance  provided in  SEC Staff  Accounting  Bulletin  (“SAB”) No. 104,  "Revenue  Recognition  in Financial Statements,"  as amended (SAB 104).  Software and technology equipment resale revenue is recognized when persuasive evidence of an arrangement exists, the price to the customer is fixed and determinable, delivery of the service has occurred and collectibility is reasonably assured. Service revenues including maintenance fees for providing system updates for software products, user documentation and technical support are recognized over the life of the contract. The Company’s subsidiaries, Mobot (sold during 2006), and Gavitec follow this policy. The Company defers revenue related to technology service and product revenue for which amounts have been invoiced and or collected but for which the requisite service has not been provided. Revenue is then recognized over the matching service period.

(3)

Technology service also includes mobile marketing services to its customers which mobile marketing projects are recognized after the completion of the project and accepted by the customer.  All response and messaging based revenues are recognized at the time such responses are received and processed and the Company recognizes its premium messaging revenues on a net basis based on guidance provided in Emerging Issues Task Force Issues No. 99-19 (EITF 99-19), “Reporting Revenue Gross as Principal or Net as an Agent” and No. 01-09 (EITF 01-09), “Accounting for Consideration Given by a Vendor to a Customer.”  Consulting and management revenues and revenues for periodic services are recognized as services are performed.  NeoMedia uses  stand-alone  pricing to determine an element's  vendor  specific  objective  evidence  (“VSOE”) in order to allocate an arrangement  fee amongst various pieces of a  multi-element  contract.  The Company’s subsidiaries 12Snap and Sponge (sold during 2006) follow this policy. Telecom revenues from NeoMedia’s subsidiary BSD are recognized at the time that calls are accepted by the clearinghouse for billing to customers on a net basis, based on guidance in EITF 99-19. The Company defers revenue related to mobile marketing service fees for which amounts have been invoiced and/or collected but for which revenue has not been recognized. Revenue is then recognized over the matching service period.

 

8

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(4)

Revenue for licensing and exclusivity on NeoMedia’s Micro Paint Repair systems is recognized equally over the term of the contract, which is currently one year.  A portion of the initial fee paid by the customer is allocated to licensing, training costs and initial products sold with the system. Revenue is recognized upon completion of training and shipment of the products, provided there is VSOE in a multiple element arrangement.  Ongoing product and service revenue is recognized as products are shipped and services performed.  The Company defers revenue related to micro paint repair licensing for which amounts have been invoiced and/or collected and revenue is then recognized over the estimated contract period, which is currently one year.

(5)

Sales taxes represent amounts collected on behalf of specific regulatory agencies that require remittance on a specified date. These amounts are collected at the time of sales and are detailed on invoices provided to customers. In compliance with the Emerging Issues Task Force consensus on issue number 06-03 (EITF 06-03), NeoMedia accounts for sales taxes on a net basis.

 

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3.	ACQUISITIONS

During the three months ended March 31, 2006, NeoMedia completed acquisitions of Mobot, Sponge, Gavitec, 12Snap, and BSD. During November 2006, December 2006, and April 2007, NeoMedia divested of a substantial portion of its ownership in Sponge, Mobot, and 12Snap, respectively. NeoMedia is also in the process of attempting to sell its Micro Paint Repair business and Telecom Services business which is comprised of the operations acquired from BSD.

Acquisition and Sale of Mobot

On February 9, 2006, NeoMedia and Mobot (based in Lexington, Massachusetts) signed a definitive merger agreement, subject to closing conditions, under which NeoMedia acquired all of the outstanding shares of Mobot in exchange for $3,500,000 cash and $6,500,000 in stock, represented by 16,931,493 shares of NeoMedia common stock (2,604,845 of which were held in escrow for the purpose of securing the indemnification obligations outlined in the purchase agreement). On February 17, 2006, NeoMedia and Mobot completed the closing requirements and the acquisition became effective. In addition to cash and stock, at closing NeoMedia forgave notes payable totaling $1,500,000 due from Mobot. This amount is considered other additional consideration in the purchase price allocation. NeoMedia completed the acquisition of Mobot in an effort to gain entry into the rapidly evolving global mobile marketing industry.

Pursuant to the terms of the merger agreement, the number of shares of NeoMedia common stock that were issued as stock consideration was calculated using a share price of $0.3839, which was the volume-weighted average closing price of NeoMedia common stock for the ten days up to and including February 8, 2006. The merger agreement between NeoMedia and Mobot also contained a provision that, in the event that NeoMedia’s stock price at the time the consideration shares became saleable (either upon effectiveness of a registration statement containing the shares, or under Rule 144) were less than $0.3839, NeoMedia would be obligated to compensate Mobot shareholders in cash for the difference between the price at the time the shares became saleable and $0.3839.

The actual purchase price was based on cash paid, the fair value of NeoMedia stock around the date of the Mobot acquisition, and direct costs associated with the combination. The final purchase price was allocated as follows:

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		(Dollars in
		Thousands)
Value of 16,931,493 shares issued at $0.395 per share (1)		$	6,688
Cash paid			3,500
Direct costs of acquisition			8
Advances to Mobot forgiven at acquisition			1,500
Total Fair Value of Purchase Price			11,696
Assets Purchased:
Cash and cash equivalents		$	328
Accounts receivable			68
Other current assets			49
Property, plant & equipment			30
Intangible assets			13
Customer contracts and relationships			440
Capitalized software platform			4,200
Copyrighted materials			90
Goodwill			6,778
Total Assets Purchased			11,996
Less Liabilities Assumed:
Accounts payable		$	51
Accrued liabilities			132
Deferred revenue			117
Total Liabilities Assumed			300

(1)

- Shares were valued using the average stock price for two days before and two days after the measurement date, as defined in SFAS 141 and EITF 99-12

The combination was accounted for as a purchase business combination as defined by Statement of Financial Accounting Standards No. 141, Business Combinations. The allocation of the purchase price to the assets acquired and liabilities assumed was based on an independent valuation report obtained by the Company.

The values assigned to intangible assets are subject to amortization. The intangible assets were assigned the following lives for amortization purposes:

	Estimated useful
Intangible asset	life (in years)
Customer contracts and relationships	5
Copyrighted materials	5
Capitalized software platform	7

Goodwill consists of the excess of the purchase price paid over the identifiable net assets and liabilities acquired at fair value. Goodwill was determined using the residual method based on an independent appraisal of the assets and liabilities acquired in the transaction. Goodwill is tested for impairment as defined by Statement of Financial Accounting Standards No. 142, ”Goodwill and Other Intangible Assets.”

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On December 6, 2006, NeoMedia and FMS Group, Inc. (“FMS”), a group consisting of former shareholders of Mobot, completed a transaction pursuant to which NeoMedia divested of its ownership interest in Mobot. The principal reasons for NeoMedia divesting of the Mobot business were: (i) a depressed NeoMedia stock price, which led to a large potential cash obligation stemming from the purchase price obligation clause in the original purchase agreement, (ii) the fact that the purchase price obligation would become due no later than February 17, 2007, and (iii) continued operating losses from the Mobot businesses putting strains on NeoMedia’s working capital.

The material terms of the transaction with FMS were as follows:

 

-

NeoMedia transferred 100% of its ownership interest in Mobot to FMS, and in return received 16,000 shares (18% ownership) of FMS, which will operate the Mobot business;

-

All obligations under the original merger agreement, including the purchase price guarantee obligation, were terminated;

-

NeoMedia contributed $67,000 cash to FMS at closing, and an additional $200,000 on December 27, 2006;

-

NeoMedia received 16,931 preference shares in FMS that can be redeemed to reacquire the 16,931,493 original consideration shares originally issued to acquire Mobot. Each preference share can be redeemed for 1,000 shares of the NeoMedia common stock at NeoMedia’s discretion within 15 months of the closing of this transaction, for cash in the amount of 40% of the then-current market value of the underlying NeoMedia shares. After 15 months, the preference shares can be redeemed upon a liquidation event of FMS, for either 1,000 shares of NeoMedia common stock each, or for the current cash equivalent of the shares, at FMS’ discretion;

-

NeoMedia entered into a license agreement with Mobot, pursuant to which NeoMedia received a license to use the Mobot image recognition service for barcode-related applications. The license is exclusive in the Americas, Europe and Australia, restricted in Japan, Korea, and Singapore, and non-exclusive in other areas of the world. The exclusivity is subject to NeoMedia meeting certain minimum transaction volume requirements or making minimum cash payments; and

-

NeoMedia entered into a mutual release with each of the former Mobot shareholders in which the parties released each other from the terms of the original Mobot merger agreement, and the former Mobot shareholders consented to the release of the pending legal action against NeoMedia.

 

Due to NeoMedia’s depressed stock price, the purchase price obligation clause became highly probable beyond a reasonable doubt. NeoMedia’s inability to satisfy the pending obligation was the primary factor for the disposition of Mobot. The value of the purchase price obligation at the time of closing was $5,545,000. Concurrent with the disposition, NeoMedia reduced the fair value of the initial stock consideration by the amount of this contingency. At closing, NeoMedia recorded a loss on the sale of Mobot in the amount of $4,367,000, representing the difference between the fair value of the assets received in the transaction, and the carrying value of the assets at closing as follows:

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		(Dollars
		in Thousands)
Carrying value of asset group at closing
Tangible assets		$	518
Intangible assets			10,971
Liabilities			(324	)
Purchase price guarantee liability			(5,545	)
Net carrying value of asset group			5,620
Fair value of proceeds received
Cash paid			(67	)
Cash paid subsequent to closing but before December 31, 2006			(200	)
Investment in Mobot common stock			1,926
Investment in Mobot special preference shares (put option)			(406	)
Fair value of proceeds received			1,253
Loss on disposal of Mobot		$	4,367

The accompanying condensed consolidated statement of operations presented herein for the three months ended March 31, 2006, contains the results of operations for Mobot for the period from February 18, 2006, through March 31, 2006, under the caption “Loss from discontinued operations.” No results are reflected on the condensed consolidated statement of operations presented herein for the three months ended March 31, 2007, since Mobot was sold prior to the beginning of this period.

 

Acquisition and Sale of Sponge

On February 20, 2006, NeoMedia and Sponge (a London-based company) signed a definitive share purchase agreement, subject to closing conditions, under which NeoMedia acquired all of the outstanding shares of Sponge in exchange for $6,141,000 cash and £6,550,000 (approximately $13.1 million at the time of the agreement), represented by 33,097,135 shares of NeoMedia common stock (3,400,490 of which were held in escrow for the purpose of securing the indemnification obligations outlined in the purchase agreement). The agreement also called for Sponge to earn an additional £2,500,000 (approximately $4.4 million) in the form of NeoMedia common stock if, during the two-year period beginning at closing, the Sponge business earned in excess of £1,300,000 (approximately $2.3 million) in net profits. On February 23, 2006, NeoMedia and Sponge completed the closing requirements and the acquisition became effective. Pursuant to the terms of the merger agreement, the number of shares of NeoMedia common stock to be issued as consideration was calculated using a share price of $0.384, which was the volume-weighted average closing price of NeoMedia common stock for the ten days up to and including February 8, 2006. In the event that NeoMedia’s stock price at the time the consideration shares became saleable (either upon effectiveness of a registration statement containing the shares, or under Rule 144) was less than $0.384, the purchase agreement called for NeoMedia to compensate Sponge shareholders in cash for the difference between the price at the time the shares became saleable and $0.384. NeoMedia completed the acquisition of Sponge in an effort to gain entry into the rapidly evolving global mobile marketing industry.

 

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The actual purchase price was based on cash paid, the fair value of NeoMedia stock around the date of the Sponge acquisition, and direct costs associated with the combination. The final purchase price was allocated as follows:

		(Dollars in
		Thousands)
Value of 33,097,135 shares issued at $0.395 per share (1)		$	13,073
Cash paid			6,141
Direct costs of acquisition			194
Total Fair Value of Purchase Price			19,408
Assets Purchased:
Cash and cash equivalents		$	177
Accounts receivable			617
Other current assets			35
Property, plant & equipment			53
Customer contracts and relationships			400
Capitalized software platform			1,300
Brand name			800
Copyrighted materials			50
Goodwill			16,692
Total Assets Purchased			20,124
Less Liabilities Assumed:
Accounts payable		$	190
Accrued liabilities			322
Other current liabilities			204
Total Liabilities Assumed			716

(1)

- Shares were valued using the average stock price for two days before and two days after the measurement date, as defined in SFAS 141 and EITF 99-12

The combination was accounted for as a purchase business combination as defined by Statement of Financial Accounting Standards No. 141, Business Combinations. The allocation of the purchase price to the assets acquired and liabilities assumed is based on an independent valuation report obtained by the Company.

The values assigned to intangible assets are subject to amortization. The intangible assets were assigned the following lives for amortization purposes:

	Estimated useful
Intangible asset	life (in years)
Customer contracts and relationships	5
Copyrighted materials	5
Capitalized software platform	7
Brand name	10

Goodwill consists of the excess of the purchase price paid over the identifiable net assets and liabilities acquired at fair value. Goodwill was determined using the residual method based on an independent appraisal of the assets and liabilities acquired in the transaction. Goodwill is tested for impairment as defined by Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets.”

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On November 14, 2006, NeoMedia and Sponge signed a definitive share purchase and settlement agreement, pursuant to which NeoMedia divested of a material portion of its ownership interest in Sponge. The principal reasons for NeoMedia divesting of the Sponge business were: (i) a depressed NeoMedia stock price, which led to a large potential cash obligation stemming from the purchase price obligation clause in the original purchase agreement, (ii) the fact that the purchase price obligation would become due no later than February 23, 2007, and (iii) the return of the original consideration shares for retirement.

 

-

NeoMedia returned 92.5% of NeoMedia’s ownership interest in Sponge, retaining 7.5% ownership of Sponge,

-

NeoMedia relinquished its Board of Directors positions at Sponge,

-

the 33,097,135 shares of NeoMedia common stock that were issued as consideration to acquire Sponge were returned to us and retired;

-

all obligations under the original merger agreement, including the purchase price guarantee obligation, were terminated; and

-

Sponge returned $100,000 cash (net of attorney fees) to NeoMedia at closing and $150,000 cash to NeoMedia on March 7, 2007.

 

Due to NeoMedia’s depressed stock price, the purchase price obligation clause became highly probable beyond a reasonable doubt. NeoMedia’s inability to satisfy the pending obligation was the primary factor for the disposition of Mobot. The value of the purchase price obligation at the time of closing was $10,088,000. Concurrent with the disposition, NeoMedia reduced the fair value of the initial stock consideration by the amount of this contingency. At closing, NeoMedia recorded a loss on the disposal of Sponge in the amount of $5,051,000, representing the difference between the fair value of the assets received in the transaction, and the carrying value of the assets at closing, as follows:

		(Dollars
		in Thousands)
Carrying value of asset group at closing
Tangible assets		$	2,042
Intangible assets			19,091
Liabilities			(2,093	)
Purchase price guarantee liability			(10,088	)
Net carrying value of asset group			8,952
Fair value of proceeds received
Cash received			35
Cash paid subsequent to December 31, 2006			150
Investment in Sponge common stock			1,399
Return of 33,097,135 shares of NeoMedia common stock			2,317
Fair value of proceeds received			3,901
Loss on disposal of Sponge		$	5,051

The accompanying condensed consolidated statement of operations presented herein for the three months ended March 31, 2006, contains the results of operations for Sponge for the period from February 24, 2006, through March 31, 2006 under the caption “Loss from discontinued operations.” No results are reflected on the condensed consolidated statement of operations presented herein for the three months ended March 31, 2007, since Sponge was sold prior to the beginning of this period.

15

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Acquisition of Gavitec

On February 17, 2006, NeoMedia and Gavitec (based in Aachen, Germany) signed a definitive sale and purchase agreement, subject to closing conditions, under which NeoMedia acquired all of the outstanding shares of Gavitec in exchange for $1,800,000 cash and $5,200,000 common stock, represented by 13,660,511 shares of NeoMedia common stock (1,366,051 of which were held in escrow until December 31, 2006 for the purpose of securing the indemnification obligations outlined in the purchase agreement, and were subsequently released). Pursuant to the terms of the merger agreement, the number of shares of NeoMedia common stock to be issued as consideration was calculated using a share price of $0.389, which was the volume-weighted average closing price of NeoMedia common stock for the ten days up to and including February 16, 2006. On February 23, 2006, NeoMedia and Gavitec completed the closing requirements and the acquisition became effective.

Gavitec AG was founded in 1997 as a specialized provider and manufacturer of products and solutions for mobile marketing and mobile information technology. Using its software, Gavitec offers its clients standardized or individual solutions in the areas of mobile marketing, mobile ticketing, mobile couponing, and mobile payment systems. NeoMedia completed the acquisition of Gavitec in an effort to gain entry into the rapidly evolving global mobile marketing industry.

The actual purchase price was based on cash paid, the fair value of NeoMedia stock around the date of the Gavitec acquisition, and direct costs associated with the combination. The final purchase price has been allocated as follows:

		(Dollars in
		Thousands)
Value of 13,660,511 shares issued at $0.386 per share (1)		$	5,273
Cash paid			1,800
Direct costs of acquisition			114
Total Fair Value of Purchase Price			7,187
Assets Purchased:
Cash and cash equivalents		$	74
Accounts receivable			173
Inventory			106
Other current assets			53
Property, plant & equipment			15
Intangible assets			3
Capitalized software platform			4,600
Copyrighted materials			50
Goodwill			3,418
Total Assets Purchased			8,492
Less Liabilities Assumed:
Accounts payable		$	113
Accrued liabilities			24
Deferred revenue			117
Deferred tax liability			706
Other current liabilities			244
Total Liabilities Assumed			1,204

(1)

- Shares were valued using the average stock price for two days before and two days after the measurement date, as defined in SFAS 141 and EITF 99-12

16

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The combination was accounted for as a purchase business combination as defined by Statement of Financial Accounting Standards No. 141, Business Combinations. The allocation of the purchase price to the assets acquired and liabilities assumed is based on an independent report obtained by the Company. The allocation was subject to change resulting from the purchase price guarantee contingency described above.

The values assigned to intangible assets are subject to amortization. The intangible assets were assigned the following lives for amortization purposes:

	Estimated useful
Intangible asset	life (in years)
Copyrighted materials	5
Capitalized software platform	7
Brand name	10

Goodwill consists of the excess of the purchase price paid over the identifiable net assets and liabilities acquired at fair value. Goodwill was determined using the residual method based on an independent appraisal of the assets and liabilities acquired in the transaction. Goodwill is tested for impairment as defined by Statement of Financial Accounting Standards No. 142, ”Goodwill and Other Intangible Assets.” An additional amount of $706,000 was allocated to goodwill of Gavitec related to the deferred tax liability associated with the intangible assets in excess of Gavitec’s net operating loss carry forward deferred tax asset.

In the event that NeoMedia’s stock price at the time the consideration shares became saleable (either upon effectiveness of a registration statement containing the shares, or under Rule 144) was less than $0.389, NeoMedia was obligated to compensate Gavitec shareholders in cash for the difference between the price at the time the shares became saleable and $0.389. On January 23, 2007, NeoMedia entered into an agreement with the former shareholders of Gavitec, whereby this purchase price obligation was to be satisfied through the payment by NeoMedia of (i) $1,800,000 in cash, payable no later than February 28, 2007 (subsequently extended to March 31, 2007), and (ii) 61,000,000 shares of NeoMedia common stock to be issued no later than February 28, 2007. NeoMedia also agreed to pay interest accrued on the purchase price in the amount of $481,000 and reimburse $100,000 of costs related to the acquisition to the primary former shareholder of Gavitec no later than February 28, 2007. NeoMedia issued the shares and made cash payments of $2,113,000 during March 2007. Accordingly, as of March 31, 2006, the balance on the accrual was $268,000, representing the remaining interest payments which are to be made during 2007.

The accompanying consolidated statement of operations presented herein for the three months ended March 31, 2007, contains the results of operations for Gavitec for the entire period. The accompanying consolidated statement of operations presented herein for the three months ended March 31, 2006, contains the results of operations for Gavitec for the period from February 24, 2006, through March 31, 2006. Pro-forma results of operations for the three months ended March 31, 2006 are presented at the end of this Note 3.

 

Acquisition of 12Snap

On February 10, 2006, NeoMedia and 12Snap signed a definitive sale and purchase agreement, subject to closing conditions, under which NeoMedia acquired all of the outstanding shares of 12Snap in exchange for $2,500,000 cash and $19,500,000 common stock, represented by 49,294,581 shares of NeoMedia common stock. On February 28, 2006, NeoMedia and 12Snap completed the closing requirements and the acquisition became effective. Pursuant to the terms of the merger agreement, the number of shares of NeoMedia common stock to be issued as consideration was calculated using a share price of $0.3956, which was the volume-weighted average closing price of NeoMedia common stock for the ten days up to and including February 9, 2006.  

 

17

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12Snap AG is headquartered in Munich, Germany, with branches in Düsseldorf, New York, London, Milan, Stockholm and Vienna. 12Snap combines the know-how in mobile applications, mobile loyalty and mobile marketing. In the mobile marketing space, 12Snap creates and implements national and pan-European mobile marketing campaigns for international brands; its mobile loyalty business unit offers customer loyalty programs for companies and brands, and its mobile applications business unit is the center for development and software. NeoMedia completed the acquisition of 12Snap in an effort to gain entry into the rapidly evolving global mobile marketing industry.

The actual purchase price was based on cash paid, the fair value of NeoMedia stock around the date of the 12Snap acquisition, and direct costs associated with the combination. The final purchase price has been allocated as follows:

		(Dollars in
		Thousands)
Value of 49,294,581 shares issued at $0.394 per share (1)		$	19,422
Cash paid			2,500
Direct costs of acquisition			114
Total Fair Value of Purchase Price			22,036
Assets Purchased:
Cash and cash equivalents		$	465
Investment in marketable securities			951
Accounts receivable			2,683
Other current assets			554
Property, plant & equipment			224
Intangible assets			93
Customer contracts and relationships			400
Capitalized software platform			4,400
Brand name			1,600
Copyrighted materials			50
Goodwill			18,390
Total Assets Purchased			29,810
Less Liabilities Assumed:
Accounts payable		$	977
Accrued liabilities			989
Deferred revenue			1,434
Other current liabilities			225
Notes payable			4,149
Total Liabilities Assumed			7,774

(1)

- Shares were valued using the average stock price for two days before and two days after the measurement date, as defined in SFAS 141 and EITF 99-12

 

The combination was accounted for as a purchase business combination as defined by Statement of Financial Accounting Standards No. 141, Business Combinations. The allocation of the purchase price to the assets acquired and liabilities assumed is based on an independent valuation report obtained by the Company. The allocation is subject to change resulting from the purchase price guarantee contingency described above.

18

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The values assigned to intangible assets are subject to amortization. The intangible assets were assigned the following lives for amortization purposes:

	Estimated useful
Intangible asset	life (in years)
Customer contracts and relationships	5
Copyrighted materials	5
Capitalized software platform	7
Brand name	10

Goodwill consists of the excess of the purchase price paid over the identifiable net assets and liabilities acquired at fair value. Goodwill was determined using the residual method based on an independent appraisal of the assets and liabilities acquired in the transaction. Goodwill is tested for impairment as defined by Statement of Financial Accounting Standards No. 142, ”Goodwill and Other Intangible Assets.”

During the first quarter of 2007, NeoMedia initiated an action plan to sell its 12Snap business. During the three months ended March 31, 2007, and the year ended December 31, 2006, NeoMedia recorded impairment charges of $2,467,000 and $18,327,000, respectively, to adjust the carrying value of the 12Snap asset group to the expected net proceeds from the sale of the assets. Prior to the impairment charge, the asset group consisted primarily of goodwill and other intangible assets recorded upon purchase of 12Snap by NeoMedia during the first quarter of 2006. In connection with its decision to sell the 12Snap business in the first quarter of 2007, NeoMedia revised its expected cashflow to reflect the estimated net cash proceeds that the Company anticipates receiving in a sale transaction. The operations of 12Snap are classified as discontinued operations during the three months ended March 31, 2007 and 2006. The criteria for discontinued operations classification were met during the three months ended March 31, 2007. (See Note 4)

Pursuant to the terms of the original purchase agreement, in the event that NeoMedia’s stock price at the time the consideration shares became saleable (either upon effectiveness of a registration statement containing the shares, or under Rule 144) was less than $0.3956, NeoMedia was obligated to compensate 12Snap shareholders in cash for the difference between the price at the time the shares became saleable and $0.3956. On February 22, 2007, the shares became eligible for resale under Rule 144. The actual calculated purchase price obligation to NeoMedia based on the volume weighted average closing price of NeoMedia stock for the ten days up to and including February 22, 2007 was $16,233,000. Because the amount of the purchase price guarantee became measurable and highly probable of occurrence beyond a reasonable doubt, as of December 31, 2006, NeoMedia reduced the fair value of the initial stock consideration by the amount of the contingency. During the three months ended March 31, 2007, NeoMedia issued 197,620,948 shares of its common stock in satisfaction of a portion of the purchase price obligation totaling $9,427,000, and made cash payments against the liability totaling $259,000. The balance on the purchase price obligation as of March 31, 2007 was $6,547,000, of which $1,760,000 is presented as liabilities held for sale. During April 2007, NeoMedia made additional cash payments of $75,000 and further reduced the balance through the forgiveness of $1,758,000 of obligation in connection with the sale of 12Snap. The Company is currently negotiating payment terms for the balance of the obligation.

On April 4, 2007, NeoMedia reached an agreement with Bernd Michael (the “Buyer”), a private investor and former shareholder of 12Snap prior to NeoMedia’s acquisition of 12Snap, pursuant to which the Buyer acquired from NeoMedia 90% of the shares of 12Snap, subject to the following material terms and conditions:

 

·

$1,100,000 was paid in cash at closing, of which $1,015,000 was applied toward amounts owed to silent partners of 12Snap

 

·

$500,000 was placed into an escrow account for 90 days to secure warranty claims;

 

·

The Buyer waived his portion of the purchase price guarantee obligation in the amount of $880,000;

 

19

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·

The Buyer returned to NeoMedia 2,525,818 NeoMedia shares previously issued to Buyer;

 

·

12Snap management waived their portion of the purchase price guarantee obligation in the amount of $880,000;

 

·

12Snap management returned to NeoMedia 5,225,039 shares of NeoMedia common stock previously issued to 12Snap management;

 

·

NeoMedia will retain a 10% ownership in 12Snap, subject to an option agreement pursuant to which NeoMedia has the right to sell and Buyer has the right to acquire the remaining 10% stake held by NeoMedia for a purchase price of $750,000 after December 31, 2007; and

 

·

12Snap and NeoMedia will execute a cooperation agreement pursuant to which 12snap will remain NeoMedia preferred partner and enjoy most favored prices, and 12snap will perform certain research and development functions for NeoMedia.

 

The accompanying condensed consolidated statement of operations presented herein for the three months ended March 31, 2007 reflects the results of operations for 12Snap for the entire period under the caption “Loss from discontinued operations.” The accompanying condensed consolidated statement of operations presented herein for the three months ended March 31, 2006 reflects the results of operations for 12Snap for the period from February 24, 2006, through March 31, 2006 under the caption “Loss from discontinued operations.”

 

Acquisition of BSD

On March 21, 2006, NeoMedia completed its acquisition of BSD Software, Inc. of Calgary, Alberta, Canada, for 7,123,698 shares of NeoMedia common stock. Pursuant to the terms of the merger agreement, the number of shares of NeoMedia common stock to be issued as consideration was calculated using a share price of $0.3467, which was the volume-weighted average closing price of NeoMedia common stock for the five days preceding March 21, 2006. BSD owns 90% of the outstanding shares of Triton Global Business Services, Inc., a provider of live and automated operator calling services and e-business support, including billing, clearinghouse and information management services, to companies in the telecommunications industry.

NeoMedia completed the acquisition of BSD for the purpose of increasing its revenue and profit through establishment of a Telecom Services business unit, as well as gaining access to the Canadian telecom industry in order to penetrate that market with the products of the NeoMedia Mobile division.

The actual purchase price was based on cash paid, the fair value of NeoMedia stock around the date of the BSD acquisition, and direct costs associated with the combination. The purchase price has been allocated as follows:

20

---

 

		(Dollars in
		Thousands)
Value of 7,123,698 shares issued at $0.352 per share (1)		$	2,508
Direct costs of acquisition			7
Total Fair Value of Purchase Price			2,515
Assets Purchased:
Cash and cash equivalents		$	55
Accounts receivable			1,733
Other current assets			13
Property, plant & equipment			61
Customer contracts and relationships			1,300
Copyrighted materials			130
Goodwill			4,402
Total Assets Purchased			7,694
Less Liabilities Assumed:
Accounts payable		$	2,424
Accrued liabilities			1,224
Notes payable			1,531
Total Liabilities Assumed			5,179

(1)

- Shares were valued using the average stock price for two days before and two days after the measurement date, as defined in SFAS 141 and EITF 99-12

The combination was accounted for as a purchase business combination as defined by Statement of Financial Accounting Standards No. 141, Business Combinations. The allocation of the purchase price to the assets acquired and liabilities assumed is based on an independent valuation report obtained by the Company.

The values assigned to intangible assets are subject to amortization. The intangible assets were assigned the following lives for amortization purposes:

	Estimated useful
Intangible asset	life (in years)
Customer contracts and relationships	5
Copyrighted materials	5

Goodwill consists of the excess of the purchase price paid over the identifiable net assets and liabilities acquired at fair value. Goodwill was determined using the residual method based on an independent appraisal of the assets and liabilities acquired in the transaction. Goodwill is tested for impairment as defined by Statement of Financial Accounting Standards No. 142, ”Goodwill and Other Intangible Assets.”

During the first quarter of 2007, NeoMedia initiated an action plan to sell this business. The operations of this business are classified as discontinued operations during the three months ended March 31, 2007 and 2006. The criteria for discontinued operations classification were met during the three months ended March 31, 2007. (See Note 4)

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The accompanying condensed consolidated statement of operations presented herein for the three months ended March 31, 2007 reflects the results of operations for BSD for the entire period under the caption “Loss from discontinued operations.” The accompanying condensed consolidated statement of operations presented herein for the three months ended March 31, 2006 reflects the results of operations for BSD for the period from March 22, 2006, through March 31, 2006 under the caption “Loss from discontinued operations.”

Pro Forma Financial Information (Unaudited)

Pro-forma results of operations as if NeoMedia was combined with Gavitec as of January 1, 2006 are as follows:

					Loss		Weighted
			Loss		per Share		Average
	Total		from		from		Common
	Net		Continuing		Continuing		Shares
	Sales		Operations		Operations		Outstanding
NeoMedia	$404		($263)		$0.00		527,991,819
Gavitec	122		(239)
Pro forma adjustments	(33)	(A)	110	(A)	$0.00	(A)(B)	67,200,319	(B)
Pro forma combined	$493		($392)		$0.00		595,192,138

_________________

Basis of Presentation: NeoMedia acquired Mobot, Sponge, Gavitec, 12Snap, and BSD during the three months ended March 31, 2006. During November and December 2006, NeoMedia divested of Mobot and Sponge. During April 2007, NeoMedia divested of 12Snap. During the first quarter of 2007, NeoMedia decided to sell its Telecom Services business, comprised of the operations of BSD. Because the results of BSD, 12Snap, Mobot, and Sponge have already been removed from NeoMedia's continuing operations and classified as discontinued operations for the three months ended March 31, 2006, these entities have not been included in the pro forma results shown above. However, the pro forma shares issued as consideration for the acquisitions of Gavitec, 12Snap, and BSD are reflected in the pro forma loss per share and weighted average common shares outstanding. The pro forma shares issued as consideration for the acquisitions of Mobot and Sponge, and NeoMedia shares returned in the sale of Sponge, are not reflected in the pro forma weighted average common shares outstanding, since for pro forma purposes the acquisition and disposal transactions are assumed to have occurred on January 1, 2006. Since the results of Gavitec were included in NeoMedia’s consolidated financial results for the entire three month period ended March 31, 2007, separate pro forma results are not shown above for this period.

(A) - Adjustment is to reflect operations of Gavitec from February 23, 2006 (closing date of acquisition) through March 31, 2006, and to reflect amortization of Gavitec intangible assets for the period January 1, 2006 through February 23, 2006. Results of operations for Gavitec from February 23, 2006 through March 31, 2006 are included in NeoMedia's operations for the three months ended March 31, 2006.

(B) - Adjustment for shares that would have been issued in connection with the acquisitions of Gavitec, 12Snap, and BSD if they had occurred on January 1, 2006. The adjustment between the reported and the pro forma number of weighted average shares outstanding is caused by (i) the weighting of the pro forma shares for the three months ended March 31, 2006, whereas in the reported number the shares were only outstanding from the closing date of each acquisition through March 31, 2006, and (ii) the number of pro forma shares being higher than the actual shares issued due to a lower stock price on the pro forma date of issuance than the actual date of issuance. Using the stock price around January 1, 2006, the pro forma number of shares that would have been issued was:

		Gavitec			12Snap			BSD			Total
Total stock consideration		$	5,400,000		$	19,500,000		$	2,279,263		$	27,179,263
Stock price on pro forma acquisition date		$	0.290		$	0.290		$	0.290
Pro forma number of consideration shares			18,620,690			67,241,379			7,859,527			93,721,596

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Tax Implications of Acquisitions

For income tax purposes, amounts assigned to particular assets acquired and liabilities assumed in the business combinations are different than amounts used for financial reporting. The differences in assigned values for financial reporting and tax purposes result in temporary differences. In applying SFAS 109, “Accounting for Income Taxes”, the Company is required to recognize the tax effect of these temporary differences and, accordingly, a deferred tax liability has been recognized. The Company determined that its pre-existing and acquired deferred tax assets, and those acquired, including those subject to limitations, were more likely than not to be realized to offset the deferred tax liability. The reduction in the valuation allowance resulting in an asset was used to offset the deferred tax liability arising from the business combinations, pursuant to SFAS 109.

In addition, the acquisitions of Sponge, Gavitec, 12Snap, and BSD involve a change of control of foreign entities, and as a result any net operating loss carryforward in existence prior to the acquisition may have limited or no use for NeoMedia.

Intangible Assets

As of March 31, 2007, NeoMedia had intangible assets used in its continuing operations with original historical cost as follows:

		(US dollars in thousands)
		Gavitec			Other			Total
Proprietary Software		$	4,600		$	763		$	5,363
Copyrighted Materials			58			---			58
Patents			---			4,888			4,888
Total		$	4,658		$	5,651		$	10,309

As of March 31, 2007, accumulated amortization on NeoMedia's intangible assets used in its continuing operations was:

		(US dollars in thousands)
		Gavitec			Other			Total
Proprietary Software		$	722		$	690		$	1,412
Copyrighted Materials			11			---			11
Patents			---			2,124			2,124
Total		$	733		$	2,814		$	3,547

As of March 31, 2007, the carrying value of NeoMedia's intangible assets used in its continuing operations was:

		(US dollars in thousands)
		Gavitec			Other			Total
Proprietary Software		$	3,878		$	73		$	3,951
Copyrighted Materials			47			---			47
Patents			---			2,764			2,764
Total		$	3,925		$	2,837		$	6,762

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Estimated future amortization expense on NeoMedia’s intangible assets is expected to be:

		(US dollars in thousands)
		Proprietary Software			Copyrighted Materials			Patents			Total
2007 (remaining 9 months)		$	510		$	7		$	224		$	741
2008			662			10			295			967
2009			631			10			284			925
2010			629			10			264			903
2011			629			2			170			801
Thereafter			890			8			1,527			2,425
Total		$	3,951		$	47		$	2,764		$	6,762

It is important to note that actual amortization expense could differ materially from the table due to subjective factors such as changes in assumptions of useful lives or impairment charges. The weighted average remaining life for the intangible assets was approximately 9.6 years as of March 31, 2007.

As of March 31, 2007, the following intangible assets relating to discontinued operations were included in “Assets held for sale” on the accompanying consolidated balance sheet:

		(US dollars in thousands)
		12snap			BSD			Micro Paint			Total
Customer Contracts, net		$	193		$	1,083		$	54		$	1,330
Proprietary Software, net			2,332			---			7			2,339
Brand Name, net			850			---			---			850
Copyrighted Materials, net			24			108			23			155
Patents, net			---			---			1,318			1,318
Goodwill, net			---			4,402			1,068			5,470
Total		$	3,399		$	5,593		$	2,470		$	11,462

Goodwill

As of March 31, 2007, goodwill consisted of $3,418,000 associated with NeoMedia’s acquisition of Gavitec. As of March 31, 2007, NeoMedia also had recorded goodwill in the amount of $1,068,000 and $4,402,000 relating to its Micro Paint Repair and Telecom Services businesses, respectively, that are held for sale. These amounts are included in “Assets held for sale” on the accompanying consolidated balance sheet.

24

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4.	DISCONTINUED OPERATIONS AND ASSETS AND LIABILITIES HELD FOR SALE

Micro Paint Repair Business Unit

During August 2006, NeoMedia decided to sell its Micro Paint Repair business unit. The Company is currently in the process of negotiating with potential buyers with respect to the sale.

NeoMedia has analyzed the pertinent facts of the proposed transaction with respect to the criteria outlined in SFAS 144, and has determined that all of the criteria have been met and continue to be met. Accordingly, NeoMedia is reporting the operating results of the MPR business unit as Discontinued Operations, and the assets and liabilities as Held for Sale for all periods presented in this filing. Assets Held for Sale are not depreciated or amortized.

Sponge and Mobot Businesses

In the fourth quarter of 2006, NeoMedia disposed of two subsidiaries, Sponge and Mobot. All assets and liabilities associated with these two subsidiaries were disposed in the sale and removed from NeoMedia’s consolidated balance sheet. In accordance with SFAS 144, NeoMedia is reporting the operating results of these two subsidiaries as Discontinued Operations for all periods presented in this filing. NeoMedia has analyzed the applicable accounting literature found in the SEC Staff Accounting Bulletin (SAB) Topic 5E, Accounting Principles Board (APB) Opinion 29, APB 18, Statement of Financial Accounting Standards (SFAS) 141, SFAS 144, and Emerging Issues Task Force (EITF) issue 01-2, and determined that the criteria for reporting the disposal of a business and reporting of discontinued operations have been met.

12Snap Business

In January 2007, NeoMedia management determined that it would focus on its core code-reading business in North America, the UK, mainland Europe, and China. In conjunction with this direction, the Company decided to sell its 12Snap business unit. On April 4, 2007, NeoMedia completed the sale of 12Snap. NeoMedia has analyzed the pertinent facts of the proposed transaction with respect to the criteria outlined in SFAS 144, and has determined that all of the criteria were met as of March 31, 2007 and continue to be met. Accordingly, NeoMedia is reporting the operating results of the 12Snap business unit as Discontinued Operations, and the assets and liabilities as Held for Sale for all periods presented in this filing. Assets Held for Sale are not depreciated or amortized. The disposal transaction will be reflected in NeoMedia’s financial statements for its fiscal quarter ended June 30, 2007.

Telecom Services Business

In connection with its January 2007 decision to focus on its core code-reading business, the Company also decided to sell the NeoMedia Telecom Services business unit. NeoMedia has analyzed the pertinent facts of the proposed transaction with respect to the criteria outlined in SFAS 144, and has determined that all of the criteria were met as of March 31, 2007 and continue to be met. Accordingly, NeoMedia is reporting the operating results of the NeoMedia Telecom Services business unit as Discontinued Operations, and the assets and liabilities as Held for Sale for all periods presented in this filing. Assets Held for Sale are not depreciated or amortized.

25

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The operating results of the Micro Paint Repair, Sponge, Mobot, 12Snap, and Telecom Services businesses classified as discontinued operations are shown in the following table. These results include a gain on extinguishment of debt realized by Telecom Services in the amount of $257,000, and an impairment charge to reduce 12Snap assets to their fair market value in the amount of $2,467,000 in the three months ended March 31, 2007. There is not any tax expense or benefit to report due to NeoMedia’s net operating loss carry forward tax position.

		Three months ended March 31, 2007
		Micro			Telecom
		Paint Repair			Services			12Snap			Mobot			Sponge			Total
Net Sales		$	326		$	302		$	2,621		$	----		$	---		$	3,249
Loss from discontinued operations		$	(591	)	$	(3	)	$	(1,954	)	$	(11	)	$	(15	)	$	(2,574	)

		Three months ended March 31, 2006
		Micro			Telecom
		Paint Repair			Services			12Snap			Mobot			Sponge			Total
Net Sales		$	377		$	27		$	896		$	57		$	291		$	1,648
Loss from discontinued operations		$	(451	)	$	(429	)	$	(56	)	$	(282	)	$	49		$	(1,169	)

 

26

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The assets and liabilities of the Micro Paint Repair, 12Snap, and Telecom Services businesses classified as held for sale are shown in the following table. There are no assets or liabilities associated with the Sponge or Mobot subsidiaries as of the balance sheet dates of March 31, 2007 or 2006.

 

		As of March 31, 2007
		Micro			Telecom
		Paint Repair			Services			12Snap			Total
ASSETS
Current assets:
Cash & Cash Equivalents		$	68		$	14		$	824		$	906
Trade Accounts Receivable, net			223			1,727			820			2,770
Inventory			236			---			---			236
Prepaid expenses and other current assets			49			12			380			441
Total Current Assets			576			1,753			2,024			4,353
Leasehold improvements and property and equipment, net			139			40			180			359
Goodwill and other intangible assets, net			2,470			5,593			3,399			11,462
Total Assets Held for Sale		$	3,185		$	7,386		$	5,603		$	16,174
LIABILITIES
Current Liabilities:
Accounts Payable		$	88		$	1,656		$	525		$	2,269
Accrued expenses			24			4			2,099			2,127
Taxes Payable			10			1,023			---			1,033
Deferred revenue & Other			329			69			1,584			1,982
Total Liabilities Held for Sale		$	451		$	2,752		$	4,208		$	7,411

 

27

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		As of December 31, 2006
		Micro			Telecom
		Paint Repair			Services			12Snap			Total
ASSETS
Current assets:
Cash & cash equivalents		$	81		$	72		$	721		$	874
Trade accounts receivable, net			196			1,577			1,842			3,615
Inventory			154			---			---			154
Investment in marketable securities			---			---			---			---
Prepaid expenses and other current assets			36			12			407			455
Total Current Assets			467			1,661			2,970			5,098
Leasehold improvements and property and equipment, net			135			48			200			383
Goodwill and other intangible assets, net			2,470			5,593			5,876			13,939
Other long term assets			---			---			---			---
Total Assets Held for Sale		$	3,072		$	7,302		$	9,046		$	19,420
LIABILITIES
Current Liabilities:
Accounts payable		$	25		$	1,854		$	640		$	2,519
Accrued expenses			22			6			2,144			2,172
Taxes payable			8			1,037			---			1,045
Deferred revenue & other			352			73			4,096			4,521
Total Liabilities Held for Sale		$	407		$	2,970		$	6,880		$	10,257

Inventory included in assets held for sale is as follows:

		March 31,			December 31,
		2007			2006
Raw materials		$	130		$	90
Work-in-process			---			---
Finished goods			106			64
Total		$	236		$	154

Results of operations for all discontinued business units are included in the line item entitled “Loss from discontinued operations” on the accompanying consolidated statement of operations for all periods presented. Balance sheet items for all discontinued business units are included in the line items entitled “Assets held for sale” and “Liabilities held for sale” on the accompanying consolidated balance sheet for all periods presented. As a result, pro forma results of operations as if the sale of each entity had occurred at the beginning of the period reported, and pro forma balance sheets as if the sale of each entity had occurred at the balance sheet dates presented, are not shown separately in this footnote.

As of March 31, 2007, NeoMedia also had recorded goodwill in the amount of $1,068,000 and $4,402,000 relating to its Micro Paint Repair and Telecom Services businesses, respectively, that are held for sale. These amounts are included in “Assets held for sale” on the accompanying consolidated balance sheet.

28

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5.

FINANCING

Series C Convertible Preferred Stock

The Company entered into a Securities Purchase Agreement, dated February 17, 2006 (the “Agreement”) with Cornell Capital Partners LP, an accredited investor (the “Purchaser”). Pursuant to the Agreement, the Purchaser agreed to purchase 8% cumulative Series C convertible preferred stock to be fully converted three (3) years from the date of issuance in the aggregate amount of $22,000,000. Net consideration from this arrangement amounted to $17,854,000, comprised of cash of $14,066,000, marketable securities with a calculated fair value of $579,000 and a purchase value of $2,000,000, and the extinguishment of $3,209,000 of preexisting indebtedness. In addition, the Purchaser withheld $2,725,000 commitment and structuring fees from the gross proceeds. The Agreement also provided for the issuance to the Purchaser, at no additional cost to the Purchaser, warrants to purchase shares of the Company's common stock. The Agreement also called for the Purchaser to acquire an additional $5,000,000 of Series C convertible preferred stock on the date a registration statement filed by the Company was declared effective by the U.S. Securities and Exchange Commission. In connection with the Agreement, the Company also entered into a registration rights agreement with the Purchaser that required the Company to (i) file a registration statement with the SEC registering the resale of the shares of common stock issuable upon conversion of the preferred stock and the exercise of the warrants, (ii) achieve effectiveness by December 1, 2006, and (iii) maintain effectiveness of the registration statement. NeoMedia failed to meet these requirements, accordingly the Company is subject to liquidated damages amounting to 1% of the outstanding amount of Series C preferred stock per month, not to exceed $1,200,000.

At any time from the closing date until February 17, 2009, the Purchaser has the right to convert the preferred stock, in whole or in part, into common stock of the Company at the then effective conversion price, which varies relative to the Company’s trading stock price, as follows: The lower of $0.50 per share, or 97% of the lowest closing bid price (as reported by Bloomberg) of the common stock for the 30 trading days immediately preceding the conversion date. The conversions are limited such that the holder cannot exceed 4.99% ownership, unless the holders waive their right to such limitation. The limitation will terminate under any event of default.

On November 29, 2006, the Purchaser exercised the conversion of 378 shares of the Series C convertible preferred stock for 6,631,579 shares of NeoMedia’s common stock, leaving a balance of 21,622 shares of Series C convertible preferred stock outstanding.

The Series C convertible preferred stock, at the option of the holder, affords the Purchaser anti-dilution protection should, at any time while the Series C preferred stock instruments are outstanding, the Company offer, sell or grant any option to purchase or offer, sell or grant any right to re-price its securities, or otherwise dispose of or issue any common stock or common stock equivalents, entitle any person to acquire shares of common stock at an effective price per share less than the then effective conversion price (excluding employee stock options), as calculated by the formula described above; then, in such instance, the conversion price for the convertible preferred stock shares shall be reduced to the lower price. In case of any such adjustment in the effective conversion price for the convertible preferred shares, this could significantly dilute existing investors.

 

Under the Series C Agreement, the Purchaser also received “A” warrants, “B” warrants and “C” warrants to purchase 20,000,000, 25,000,000, and 30,000,000 shares of NeoMedia’s common stock, respectively, exercisable in three separate traunches at a price of $0.50, $0.40 and $0.35, respectively, per share, subject to adjustment, included under anti-dilution protection similar to that described above. As an inducement to enter into subsequent financing arrangements related to Cornell Debentures, the warrants were repriced on December 29, 2006 to $0.04 per share, subject to all the original terms and conditions of the respective warrant agreements. The Company recorded an additional warrant liability of $250,000 related to the repricing. The warrants have a five-year contractual life. NeoMedia can force exercise of the warrants if the closing bid price of NeoMedia stock is more than $0.10 greater than the exercise price of any of the warrants for 15 consecutive trading days. It is important to note that the warrants held by Cornell Capital Partners contain a provision that, if at the time of exercise, NeoMedia is in default of the warrant agreement, the holder can perform a “cashless” exercise of the warrants and in lieu of making payment of the exercise price in cash, elect instead to withhold shares as consideration for the exercise price. In the event of such a “cashless” exercise, NeoMedia would not receive any cash proceeds upon the exercise of such warrants. NeoMedia is currently in default of the Investor Registration Rights Agreement entered into on February 17, 2006, in connection with the Series C convertible preferred stock, which called for a registration statement containing the shares underlying the Series C convertible preferred stock to be filed by June 1, 2006 and declared effective by December 1, 2006. Such a default of the Investor Registration Rights Agreement constitutes an event of default under the warrant agreements issued in connection with the Series C convertible preferred stock. As a result, Cornell Capital Partners currently has the right to exercise on a cashless basis 75,000,000 of the warrants they hold that were issued in connection with the Series C convertible preferred stock.

29

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The 8% cumulative Series C convertible preferred stock contains consequences in case of default. Events of default which could subject the Company to penalties, damages, and liabilities as specified in the Agreement include:

 

·

Any case or action of bankruptcy or insolvency commenced by the Company or any subsidiary, against the Company or adjudicated by a court against the Company for the benefit of creditors;

 

·

Any default in its obligations under a mortgage or debt in excess of $100,000;

 

·

Any cessation in the eligibility of the Company’s stock to be quoted on a trading market;

 

·

Failure to timely file the registration statement covering the shares related to the conversion option, or failure to make the registration statement effective timely (NeoMedia is in default of this provision);

 

·

Any lapse in the effectiveness of the registration statement covering the shares related to the conversion option, the warrants as described and transacted in the securities purchase agreement and accompanying documents;

 

·

Any failure to deliver certificates within the specified time; and

 

·

Any failure, by the Company, to pay in full the amount of cash due pursuant to a buy-in or failure to pay any amounts owed on account on account of an event of default within 10 days of the date due.

 

Other provisions included in the Agreement include the following:

 

·

The 8% cumulative Series C convertible preferred stock is convertible into common stock, at the option of the Purchaser, at any time after the effective date;

 

·

Conversions can be made in increments and from time to time;

 

·

The 8% cumulative Series C convertible preferred stock has voting rights on an “as converted” basis, meaning the Purchaser is entitled to vote the number of shares of common stock into which the 8% cumulative Series C convertible preferred stock was convertible as of the record date for a meeting of shareholders;

 

·

As promptly as practicable after any conversion date and subject to an effective registration statement or an exemption from registration, the Company shall cause its transfer agent to deliver a certificate representing the converted shares, free of any legends and trading restrictions for the number of shares converted;

 

30

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·

The Company will reserve and keep available authorized and unissued registered shares available to be issued upon conversion;

 

·

Purchaser will not be responsible for any transfer taxes relative to issuance of shares;

 

·

If the Company offers, sells or grants stock at an effective per share price less than the then Conversion Price, then the Conversion Price shall be reduced to equal the effective conversion, exchange or purchase price for such common stock or common stock equivalents;

 

Due to the current default status, the Purchaser has certain material additional rights in this financing arrangement that did not exist prior to default. Specifically,

·

The full fair value of the Series C convertible preferred stock is now callable in the amount of $21,657,000;

 

·

The warrants can be exercised on a cashless basis as described above;

 

·

The requirement for the Purchaser to maintain an ownership interest in NeoMedia of less than 4.99% is waived;

 

·

NeoMedia is responsible for liquidated damages as described above.

 

In addition, the accounting for the Series C convertible preferred stock reflects certain specific accounting rules and regulations that are applicable under the default provision:

·

Prior to the default, NeoMedia was accreting dividends on the Series C convertible preferred stock, using the effective interest method, through periodic charges to additional paid in capital. Due to the default status, NeoMedia accreted dividends to the full fair value of the Series C convertible preferred stock during the fourth quarter of 2006.

 

·

The Series C convertible preferred stock is now reported as demand debt in the current liabilities section of the balance sheet, pursuant to the guidance outlined in SFAS 150.

 

 

At the inception date of February 17, 2006, a summary of the allocation of the components of the transaction was as follows:

Instrument:
Convertible preferred stock (1)		$	1,711,000
Common stock warrants (2)			16,172,000
Embedded conversion feature			1,935,000
Debt extinguishment loss (3)			(1,964,000	)
Total gross proceeds		$	17,854,000

____________________

 

(1)

The discount to the face value of the 8% cumulative Series C convertible preferred stock that resulted from the allocation along with deferred costs was being accreted through periodic charges to additional paid-in capital using the effective interest method, prior to the accretion to full fair value due to NeoMedia’s being in default of the registration rights agreement

(2)

The Company issued additional warrants to purchase aggregate 75,000,000 shares of common stock in connection with the 8% cumulative Series C convertible preferred stock. The Company also issued 2,000,000 warrants (valued at $447,000) as financing fees.

(3)

The financing arrangement settled face value $3,209,000 of preexisting indebtedness. The debt extinguishment loss was calculated as the amount that the fair value of securities issued (using a relative fair value basis) exceeded the Company’s carrying value.

 

31

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In accordance with Statement of Financial Accounting Standards No. 133, ‘Accounting for Derivative Instruments and Hedging Activities’, (“FASB 133”), the Company determined that the conversion feature of the Series C convertible preferred stock met the criteria of an embedded derivative and therefore the conversion feature of the Series C convertible preferred stock needed to be bifurcated and accounted for as a derivative. The Series C convertible preferred stock does not meet the definition of “conventional convertible debt” because the number of shares which may be issued upon the conversion of the Series C convertible preferred stock is not fixed. Furthermore, there is no cap on the number of shares that could be issued upon conversion. Therefore, the conversion feature fails to qualify for equity classification under EITF 00-19, and must be accounted for as a derivative liability.

The carrying value of the 8% cumulative Series C convertible preferred stock amounted to $21,657,000 at March 31, 2007. The face value of Series C convertible preferred stock at March 31, 2007 was also $21,657,000 as the instrument was written up to full fair value during the fourth quarter of 2006 due to NeoMedia’s current default position. Derivative financial instruments arising from the issuance of Series C convertible preferred stock are initially recorded and continuously carried at fair value. Upon conversion of any derivative financial instrument, the change in fair value from the previous reporting date to the date of conversion is recorded to income (loss), and then the carrying value is recorded to paid-in capital, provided all other criteria for equity classification are met. The following tabular presentation reflects the components of derivative financial instruments related to the Series C convertible preferred stock on the Company’s balance sheet at March 31, 2007:

(Assets) Liabilities:		March 31, 2007
Common stock warrants		$	2,700,000
Embedded conversion feature			2,908,000
Other warrants (1)			782,000
		$	6,390,000

____________________

(1)

The fair values of certain other derivative financial instruments (warrants) that existed at the time of the issuance of Series C convertible preferred stock were reclassified from stockholders’ equity to liabilities when, in connection with the issuance of Series C convertible preferred stock, the Company no longer controlled its ability to share-settle these instruments. These derivative financial instruments had fair values of $14,331,000, $977,000 and $782,000 on February 17, 2006, December 31, 2006, and March 31, 2007, respectively. The decrease in fair value of these other derivative financial instruments resulted from a decrease in NeoMedia’s share price between February 17, 2006, December 31, 2006, and March 31, 2007. The change in fair value is reported as “Gain on derivative financial instruments” on the condensed consolidated statement of operations during each period. These warrants will be reclassified to stockholders’ equity when the Company reacquires the ability to share-settle the instruments.

 

32

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The following tabular presentation reflects the number of common shares into which the aforementioned derivative financial instruments are convertible or exercisable into at March 31, 2007:

		Shares of common stock
Common stock warrants			75,000,000
Embedded conversion feature (1)			607,422,165
Other warrants			33,325,000
			715,747,165

____________________

(1)

The terms of the embedded conversion features in the Series C convertible preferred stock provide for variable conversion rates that are indexed to the Company’s trading common stock price. As a result, the number of indexed shares is subject to continuous fluctuation. For presentation purposes, the number of shares of common stock into which the embedded conversion feature was convertible as of March 31, 2007 was calculated as the face value of $21,622,000 plus assumed dividends of $1,946,000 if declared, divided by 97% of the lowest closing bid price for the 30 trading days preceding March 31, 2007, which was $0.04 per share.

 

As of March 31, 2007 cumulative dividends earned but not declared in excess of the carrying value are $1,946,000.

Derivative income associated with adjustments recorded to reflect the aforementioned derivatives at fair value amounted to $2,828,000 and $4,768,000 during the three months ended March 31, 2007 and 2006, respectively. These amounts are reported as “Gain on derivative financial instruments” in the accompanying condensed consolidated statement of operations.

Fair value considerations for derivative financial instruments:

Freestanding derivative instruments, consisting of warrants that arose from the financing and those reclassified as described above are valued using the Black-Scholes-Merton valuation methodology because that model embodies all of the relevant assumptions that address the features underlying these instruments. Significant assumptions included in this model as of March 31, 2007 are as follows:

	Three months ended March 31, 2007				Three months ended March 31, 2006
	Cornell				Cornell
	Capital				Capital
Holder	Partners		Other		Partners		Other
Instrument	Warrants		Warrants		Warrants		Warrants
Exercise price	$0.04		$0.01 - $3.45		$0.35 - $0.50		$0.01 - $3.45
Term (years)	3.88		0.2 - 3.88		4.88		1.0 - 4.88
Volatility	107.81%-131.04%		115.73%-131.04%		70.80%		52.56% -70.80%
Risk-free rate	4.54%		4.54%		3.65%		3.65%

Embedded derivative financial instruments, arising from the Series C convertible preferred stock, consist of multiple individual features that were embedded in the instrument. The Company evaluated all significant features of the instruments as required under current accounting standards and aggregated such instruments into one compound derivative financial instrument for financial reporting purposes. The compound embedded derivative instruments are valued using the Flexible Monte Carlo methodology because that model embodies certain relevant assumptions (including, but not limited to, interest rate risk, credit risk, and conversion/redemption privileges) that are necessary to value these complex derivatives.

33

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Assumptions included exercise estimates/behaviors and the following other significant estimates:

	Three months ended March 31,
Instrument	2007		2006
Conversion prices	$0.04		$0.95 - $1.29
Remaining terms (years)	1.88		2.88
Equivalent volatility	117.69%-119.64%		52.56% - 56.47%
Equivalent interest-risk adjusted rate	4.54% - 14.26%		8.17% - 8.58%
Equivalent credit-risk adjusted yield rate	62.50%		14.50%

 

Equivalent amounts reflect the net results of multiple modeling simulations that the Monte Carlo Simulation methodology applies to underlying assumptions. The assumptions included in the Monte Carlo Simulation calculation are highly subjective and subject to interpretation.

$5 Million Secured Convertible Debenture - August 2006

The Company entered into a Securities Purchase Agreement, dated August 24, 2006, (the “Agreement”) with Cornell Capital Partners LP, an accredited investor (the “Purchaser”). Pursuant to the Agreement, the Purchaser agreed to purchase 10% secured convertible debentures maturing two years from the date of issuance in the aggregate amount of $5,000,000. The Agreement also provided for the issuance to the Purchaser, at no additional cost to the Purchaser, warrants to purchase shares of the Company's common stock. In connection with the Agreement, the Company also entered into a registration rights agreement with the Purchaser that required the Company to (i) file a registration statement with the SEC registering the resale of the shares of common stock issuable upon conversion of the convertible debenture and the exercise of the warrants, (ii) achieve effectiveness within a stated period and (iii) maintain effectiveness of the registration statement. Failure to meet these requirements will require the Company to incur liquidated damages amounting to 2% of the principal per month, but in no event shall consideration paid as liquidated damages exceed $1,000,000. The debentures are secured by substantially all of the Company’s assets.

At any time from the closing date until August 24, 2008, the Purchaser has the right to convert the convertible debenture into common stock of the Company at the then effective conversion price, which varies relative to the Company’s trading stock price, as follows: $0.15 per share, or 90% of the lowest closing bid price (as reported by Bloomberg) of the common stock for the 30 trading days immediately preceding the conversion date. The conversion was limited such that the holder cannot exceed 4.99% ownership, unless the holders waive their right to such limitation. The limitation will terminate under any event of default.

The convertible debenture, at the option of the holder, affords the Purchaser anti-dilution protection should, at any time while the convertible debenture is outstanding, the Company offer, sell or grant any option to purchase or offer, sell or grant any right to re-price its securities, or otherwise dispose of or issue any common stock or common stock equivalents, entitle any person to acquire shares of common stock at an effective price per share less than the then effective conversion price (excluding employee stock options), as calculated by the formula described above; then, in such instance, the conversion price for the convertible debenture shall be reduced to the lower price. In case of any such adjustment in the effective conversion price for the convertible debenture, this could significantly dilute existing investors.

 

34

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Under the Agreement, the Purchaser also received “A” warrants, “B” warrants, “C” warrants and “D” warrants to purchase an aggregate of up to 175,000,000 shares of common stock, exercisable in four separate traunches at a price of $0.15, $0.25, $0.20 and $0.05 respectively per share, subject to adjustment, included under anti-dilution protection similar to that described above. As an inducement to enter into a subsequent financing arrangement with the Purchaser, the warrants were repriced on December 29, 2006 to $0.04 per share, subject to all the original terms and conditions of the respective warrant agreements. The Company recorded an additional warrant liability of $452,000 related to this repricing. The warrants have a five-year contractual life. NeoMedia can force exercise of the warrants if the closing bid price of NeoMedia stock is more than $0.10 greater than the exercise price of any of the warrants for 15 consecutive trading days. It is important to note that the warrants held by Cornell Capital Partners contain a provision that, if at the time of exercise, NeoMedia is in default of the warrant agreement, the holder can perform a “cashless” exercise of the warrants and in lieu of making payment of the exercise price in cash, elect instead to withhold shares as consideration for the exercise price. In the event of such a “cashless” exercise, NeoMedia would not receive any cash proceeds upon the exercise of such warrants. NeoMedia is currently in default of the Investor Registration Rights Agreement entered into on August 24, 2006, in connection with the secured convertible debenture, which called for a registration statement containing the shares underlying the secured convertible debenture to be declared effective by November 22, 2006. Such a default of the Investor Registration Rights Agreement constitutes an event of default under the warrant agreements issued in connection with the secured convertible debenture. As a result, Cornell Capital Partners currently has the right to exercise on a cashless basis 175,000,000 of the warrants they hold that were issued in connection with the secured convertible debenture.

The convertible debenture contains consequences in case of default. Events of default which could subject the Company to penalties, liabilities, and foreclosure upon the assets of the Company as specified in the Agreement include:

 

·

Any case or action of bankruptcy or insolvency commenced by the Company or any subsidiary, against the Company or adjudicated by a court against the Company for the benefit of creditors;

 

·

Any default in its obligations under a mortgage or debt in excess of $100,000;

 

·

Any cessation in the eligibility of the Company’s stock to be quoted on a trading market;

 

·

Failure to timely file the registration statement covering the shares related to the conversion option, or failure to make the registration statement effective timely. NeoMedia is currently in default of this provision;

 

·

Any lapse in the effectiveness of the registration statement covering the shares related to the conversion option, the warrants as described and transacted in the securities purchase agreement and accompanying documents;

 

·

Any failure to deliver certificates within the specified time; and

 

·

Any failure, by the Company, to pay in full the amount of cash due pursuant to a buy-in or failure to pay any amounts owed on account on account of an event of default within 3 days of the date due.

 

Other provisions included in the Agreement include the following:

 

·

The convertible debenture is convertible into common stock, at the option of the Purchaser, at any time after the effective date;

 

·

As promptly as practicable after any conversion date, and subject to an effective registration statement or an exemption from registration the Company shall cause its transfer agent to deliver a certificate representing the converted shares, free of any legends and trading restrictions for the number of shares converted;

 

·

The Company will reserve and keep available authorized and unissued registered shares available to be issued upon conversion;

 

·

Purchaser will not be responsible for any transfer taxes relative to issuance of shares;

 

35

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·

If the Company offers, sells or grants stock at an effective per share price less than the then Conversion Price, then the Conversion Price shall be reduced to equal the effective conversion, exchange or purchase price for such common stock or common stock equivalents;

 

·

Pursuant to the terms of the convertible debenture agreement between NeoMedia and Cornell signed in connection with the convertible debenture sale, without Cornell’s consent NeoMedia cannot

 

-

issue or sell any shares of Common Stock or preferred stock without consideration or for consideration per share less than the closing bid price immediately prior to its issuance,

 

-

issue or sell any preferred stock, warrant, option, right, contract, call, or other security or instrument granting the holder thereof the right to acquire common stock for consideration per share less than the closing bid price immediately prior to its issuance,

 

-

enter into any security instrument granting the holder a security interest in any of its assets of, or

 

-

file any registration statements on Form S-8.

 

·

Pursuant to a security agreement between NeoMedia and the Purchaser signed in connection with the convertible debenture, the Purchaser has a security interest in all of NeoMedia’s assets.

 

NeoMedia is currently in default of the Investor Registration Rights Agreement entered into on August 24, 2006, in connection with the secured convertible debenture, because the registration statement to register the shares underlying the secured convertible debenture was not declared effective by the specified date. Due to the current default status, the Purchaser has certain material additional rights in this financing arrangement that did not previously exist. Specifically,

·

The full fair value of the secured convertible debenture is now callable in the amount of $5,000,000;

 

·

The warrants can be exercised on a cashless basis as described above;

 

·

NeoMedia is responsible for liquidated damages; NeoMedia has accrued $999,000 as the expected fair value of liquidated damages relating to the secured convertible debenture as of March 31, 2007, and paid $490,000 of the accrued liquidated damages as of March 31, 2007;

 

·

The requirement for the Purchaser to maintain an ownership interest in NeoMedia of less than 4.99% is terminated;

 

The accounting for the secured convertible debenture reflects certain specific accounting rules and regulations that are applicable under the default provision:

·

Prior to the default, NeoMedia was accreting the debt discount on the secured convertible debenture, using the effective interest method, through periodic charges to interest expense. Due to the default status, during the fourth quarter of NeoMedia accreted debt discount to the full fair value of the secured convertible debenture.

 

·

The secured convertible debenture is reported as debt in the current liabilities section of the balance sheet rather than long term because the debenture is callable as demand debt due to the default.

 

36

---

 

At the inception date of August 24, 2006, a summary of the allocation of the components of the transaction was as follows:

Instrument:
Convertible debenture (1)		$	---
Common stock warrants (2)			18,507,000
Embedded conversion feature			970,000
Derivative loss			(14,477,000	)
Total gross proceeds		$	5,000,000

____________________

(1)

There were insufficient proceeds to allocate amounts to the host debentures. Accordingly, for purposes of application of the effective interest method, the company applied the 1% convention which provides for recognition of 1% of the future value as amortization in the first period.

(2)

The Company issued warrants to purchase aggregate 175,000,000 shares of common stock in connection with the convertible debenture, as described above.

 

In accordance with Statement of Financial Accounting Standards No. 133, ‘Accounting for Derivative Instruments and Hedging Activities’, (“FASB 133”), the Company determined that the conversion feature of the debenture met the criteria of an embedded derivative and therefore the conversion feature of the debenture needed to be bifurcated and accounted for as a derivative. The debenture does not meet the definition of “conventional convertible debt” because the number of shares which may be issued upon the conversion of the debenture is not fixed. Furthermore, there is no cap on the number of shares that could be issued upon conversion. Therefore, the conversion feature fails to qualify for equity classification under EITF 00-19, and must be accounted for as a derivative liability.

Due to NeoMedia’s current default position, during the fourth quarter of 2006 the debenture was written up to the full face value of $5,000,000, which was also the carrying value of the convertible debenture as of March 31, 2007. Derivative financial instruments arising from the issuance of convertible debentures are initially recorded, and continuously carried, at fair values. Upon conversion of any derivative financial instrument, the change in fair value from the previous reporting date to the date of conversion is recorded to income (loss), and then the carrying value is recorded to paid-in capital, provided all other criteria for equity classification are met. The following tabular presentation reflects the components of the derivative financial instruments related to this convertible debenture:

(Assets) Liabilities:		March 31, 2007
Common stock warrants		$	7,207,000
Embedded conversion feature			2,528,000
		$	9,735,000

The following tabular presentation reflects the number of common shares into which the aforementioned derivative financial instruments are convertible into at March 31, 2007:

		Shares of common stock
Common stock warrants			175,000,000
Embedded conversion feature (1)			138,888,889
			313,888,889

____________________

(1)

The terms of the embedded conversion features in the convertible debenture provide for variable conversion rates that are indexed to the Company’s trading common stock price. As a result, the number of indexed shares is subject to continuous fluctuation. For presentation purposes, the number of shares of common stock into which the embedded conversion feature was convertible as of March 31, 2007 was calculated as the face value of $5,000,000, divided by 90% of the lowest closing bid price for the 30 trading days preceding March 31, 2007.

 

37

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Derivative income for the three months ended March 31, 2007 and 2006 associated with adjustments recorded to reflect the aforementioned derivatives at fair value amounted to $2,206,000 and $0, respectively, and is reported as “Gain on derivative financial instruments” in the accompanying consolidated statement of operations.

Fair value considerations for derivative financial instruments:

Freestanding derivative instruments, consisting of warrants that arose from the financing are valued using the Black-Scholes-Merton valuation methodology because that model embodies all of the relevant assumptions that address the features underlying these instruments. Significant assumptions included in this model as of March 31, 2007 are as follows:

Holder	Cornell Capital Partners
Instrument	Warrants
Exercise price	$0.04 - $0.05
Remaining Term (years)	4.4
Volatility	158.45%
Risk-free rate	4.54%

Embedded derivative financial instruments, arising from the convertible debenture, consist of multiple individual features that were embedded in the instrument. The Company evaluated all significant features of the instruments as required under current accounting standards, and aggregated such instruments into one compound derivative financial instrument for financial reporting purposes. The compound embedded derivative instruments are valued using the Flexible Monte Carlo methodology because that model embodies certain relevant assumptions (including, but not limited to, interest rate risk, credit risk, and conversion/redemption privileges) that are necessary to value these complex derivatives.

Assumptions included exercise estimates/behaviors and the following other significant estimates:

Instrument:	Features
Conversion prices	$0.036
Remaining terms (years)	1.4
Equivalent volatility	116.93%
Equivalent interest-risk adjusted rate	12.11%
Equivalent credit-risk adjusted yield rate	34.23%

Equivalent amounts reflect the net results of multiple modeling simulations that the Monte Carlo Simulation methodology applies to underlying assumptions. The assumptions included in the Monte Carlo Simulation calculation are highly subjective and subject to interpretation.

$2.5 Million Secured Convertible Debenture - December 2006

The Company entered into a Securities Purchase Agreement, dated December 29, 2006, (the “Agreement”) with Cornell Capital Partners LP, an accredited investor (the “Purchaser”). Pursuant to the Agreement, the Purchaser agreed to purchase 10% secured convertible debentures maturing two years from the date of issuance in the aggregate amount of $2,500,000. NeoMedia received cash proceeds from the transaction of $2,230,000 net of $270,000 fees paid to the Purchaser. The Agreement also provided for the issuance to the Purchaser, at no additional cost to the Purchaser, warrants to purchase shares of the Company's common stock. In connection with the Agreement, the Company also entered into a registration rights agreement with the Purchaser that requires the Company to (i) file a registration statement with the SEC registering the resale of the shares of common stock issuable upon conversion of the convertible debenture and the exercise of the warrants by May 31, 2007, (ii) achieve effectiveness within 90 days of filing, and (iii) maintain effectiveness of the registration statement. Failure to meet these requirements will require the Company to incur liquidated damages amounting to 2% of the principal per month, but in no event shall consideration paid as liquidated damages exceed $500,000.

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The Debentures are secured according to the terms of a pledge and security agreement dated August 23, 2006 and entered into in connection with a previous $5 million secured convertible debenture with the Purchaser, pursuant to which the Company agreed to provide to Purchaser a security interest in its assets to secure the Company's obligations under the financing transaction.

At any time from the closing date until December 29, 2008, the Purchaser has the right to convert the convertible debenture into common stock of the Company at the then effective conversion price, which varies relative to the Company’s trading stock price, as follows: $0.06 per share, or 90% of the lowest closing bid price (as reported by Bloomberg) of the common stock for the 30 trading days immediately preceding the conversion date. The conversion is limited such that the holder cannot exceed 4.99% ownership, unless the holders waive their right to such limitation. The limitation will terminate under any event of default.

The convertible debenture, at the option of the holder, affords the Purchaser anti-dilution protection should, at any time while the convertible debenture is outstanding, the Company offer, sell or grant any option to purchase or offer, sell or grant any right to re-price its securities, or otherwise dispose of or issue any common stock or common stock equivalents, entitle any person to acquire shares of common stock at an effective price per share less than the then effective conversion price (excluding employee stock options), as calculated by the formula described above; then, in such instance, the conversion price for the convertible debenture shall be reduced to the lower price.

 

Under the terms of the agreement, the Purchaser also received warrants to purchase an aggregate of up to 42,000,000 shares of common stock. The warrants are exercisable at a price of $0.06 per share, subject to adjustment, included under anti-dilution protection similar to that described above. The warrants have a five-year contractual life. NeoMedia can force exercise of the warrants if the closing bid price of NeoMedia stock is more than $0.10 greater than the exercise price of any of the warrants for 15 consecutive trading days. It is important to note that the warrants held by Cornell Capital Partners contain a provision that, if at the time of exercise, NeoMedia is in default of the warrant agreement, the holder can perform a “cashless” exercise of the warrants and in lieu of making payment of the exercise price in cash, elect instead to withhold shares as consideration for the exercise price. In the event of such a “cashless” exercise, NeoMedia would not receive any cash proceeds upon the exercise of such warrants. NeoMedia is currently in default of the Investor Registration Rights Agreement entered into on December 29, 2006, in connection with the secured convertible debenture. Such a default of the Investor Registration Rights Agreement constitutes an event of default under the warrant agreements issued in connection with the secured convertible debenture. As a result, Cornell Capital Partners currently has the right to exercise on a cashless basis the 42,000,000 of warrants they hold that were issued in connection with the secured convertible debenture.

The convertible debenture contains consequences in case of default. Events of default which could subject the Company to penalties, liabilities, and foreclosure upon the assets of the Company as specified in the Agreement include:

 

·

Any case or action of bankruptcy or insolvency commenced by the Company or any subsidiary, against the Company or adjudicated by a court against the Company for the benefit of creditors;

 

·

Any default in its obligations under a mortgage or debt in excess of $100,000;

 

·

Any cessation in the eligibility of the Company’s stock to be quoted on a trading market;

 

·

Failure to timely file the registration statement covering the shares related to the conversion option, or failure to make the registration statement effective timely;

 

39

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·

Any lapse in the effectiveness of the registration statement covering the shares related to the conversion option, the warrants as described and transacted in the securities purchase agreement and accompanying documents;

 

·

Any failure to deliver certificates within the specified time; and

 

·

Any failure, by the Company, to pay in full the amount of cash due pursuant to a buy-in or failure to pay any amounts owed on account on account of an event of default within 3 days of the date due.

 

Other provisions included in the Agreement include the following:

 

·

The convertible debenture is convertible into common stock, at the option of the Purchaser, at any time after the effective date;

 

·

As promptly as practicable after any conversion date, and subject to an effective registration statement or an exemption from registration the Company shall cause its transfer agent to deliver a certificate representing the converted shares, free of any legends and trading restrictions for the number of shares converted;

 

·

The Company will reserve and keep available authorized and unissued registered shares available to be issued upon conversion;

 

·

Purchaser will not be responsible for any transfer taxes relative to issuance of shares;

 

·

If the Company offers, sells or grants stock at an effective per share price less than the then Conversion Price, then the Conversion Price shall be reduced to equal the effective conversion, exchange or purchase price for such common stock or common stock equivalents;

 

·

Pursuant to the terms of the convertible debenture agreement between NeoMedia and Cornell signed in connection with the convertible debenture sale, without Cornell’s consent NeoMedia cannot

 

-

issue or sell any shares of Common Stock or preferred stock without consideration or for consideration per share less than the closing bid price immediately prior to its issuance,

 

-

issue or sell any preferred stock, warrant, option, right, contract, call, or other security or instrument granting the holder thereof the right to acquire common stock for consideration per share less than the closing bid price immediately prior to its issuance,

 

-

enter into any security instrument granting the holder a security interest in any of its assets of, or

 

-

file any registration statements on Form S-8.

 

·

In addition, pursuant to a security agreement between NeoMedia and the Purchaser signed in connection with the convertible debenture, the Purchaser has a security interest in all of NeoMedia’s assets.

 

NeoMedia is currently in default of the Investor Registration Rights Agreement entered into on December 29, 2006, in connection with the secured convertible debenture, because the registration statement to register the shares underlying the secured convertible debenture issued on August 24, 2006 was not declared effective by the specified date. Due to the current default status, the Purchaser has certain material additional rights in this financing arrangement that did not previously exist. Specifically,

 

40

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·

The full fair value of the secured convertible debenture is now callable in the amount of $2,500,000;

 

·

The warrants can be exercised on a cashless basis as described above;

 

·

NeoMedia is responsible for liquidated damages of 2% of the principal up to a maximum of $500,000;

 

·

The requirement for the Purchaser to maintain an ownership interest in NeoMedia of less than 5% is terminated;

 

The accounting for the secured convertible debenture reflects certain specific accounting rules and regulations that are applicable under the default provision:

·

NeoMedia incurred a charge to income from continuing operations at the time of the issuance of this secured convertible debenture to recognize the liability of the debenture at redemption value by fully writing off the debt discount.

 

·

The secured convertible debenture is reported as debt in the current liabilities section of the balance sheet rather than long term, because the debenture is callable as demand debt due to the default.

 

41

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At the inception date of December 29, 2006, a summary of the allocation of the components of the transaction is as follows:

 

Instrument:
Convertible debenture		$	2,500,000
Common stock warrants (1)			2,159,000
Embedded conversion feature			1,579,000
Derivative loss			(1,238,000	)
Interest expense(2)			(2,770,000	)
Total gross proceeds		$	2,230,000

____________________

(1)

The Company issued warrants to purchase aggregate 42,000,000 shares of common stock in connection with the convertible debenture, as described above.

(2)

Due to the default status, the debentures were accreted up to the full fair value of $2,500,000 at inception and the financing costs of $270,000 were expensed to interest expense.

 

In accordance with Statement of Financial Accounting Standards No. 133, ‘Accounting for Derivative Instruments and Hedging Activities’, (“FASB 133”), the Company determined that the conversion feature of the debenture met the criteria of an embedded derivative and therefore the conversion feature of the debenture needed to be bifurcated and accounted for as a derivative. The debenture does not meet the definition of “conventional convertible debt” because the number of shares which may be issued upon the conversion of the debenture is not fixed. Furthermore, there is no cap on the number of shares that could be issued upon conversion. Therefore, the conversion feature fails to qualify for equity classification under EITF 00-19, and must be accounted for as a derivative liability.

The following tabular presentation reflects the number of common shares into which the aforementioned derivative financial instruments are indexed March 31, 2007:

		Shares of common stock
Common stock warrants			42,000,000
Embedded conversion feature (1)			69,444,444
			111,444,444

 

(1)

The terms of the embedded conversion features in the convertible debenture provide for variable conversion rates that are indexed to the Company’s trading common stock price. As a result, the number of indexed shares is subject to continuous fluctuation. For presentation purposes, the number of shares of common stock into which the embedded conversion feature was convertible as of March 31, 2007 was calculated as the face value of $2,500,000, divided by 90% of the lowest closing bid price for the 30 trading days preceding March 31, 2007.

 

Derivative loss for the three months ended March 31, 2007 and 2006 associated with adjustments recorded to reflect the aforementioned derivatives at fair value amounted to $101,000 and $0, respectively, and is reported as “Gain on embedded conversion features of derivative financial instruments” in the accompanying consolidated statement of operations.

Fair value considerations for derivative financial instruments:

Freestanding derivative instruments, consisting of warrants that arose from the financing are valued using the Black-Scholes-Merton valuation methodology because that model embodies all of the relevant assumptions that address the features underlying these instruments. Significant assumptions included in this model as of March 31, 2007 are as follows:

42

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Holder	Cornell Capital Partners
Instrument	Warrants
Exercise price	$0.06
Remaining Term (years)	4.75
Volatility	158.45%
Risk-free rate	4.54%

 

Embedded derivative financial instruments, arising from the convertible debenture, consist of multiple individual features that were embedded in the instrument. The Company evaluated all significant features of the hybrid instruments and, where required under current accounting standards, bifurcated features for separate report classification. These features were aggregated into one compound derivative financial instrument for financial reporting purposes. The compound embedded derivative instruments are valued using the Flexible Monte Carlo methodology because that model embodies certain relevant assumptions (including, but not limited to, interest rate risk, credit risk, and conversion/redemption privileges) that are necessary to value these complex derivatives.

Assumptions included exercise estimates/behaviors and the following other significant estimates:

Instrument:	Features
Conversion prices	$0.036
Remaining terms (years)	1.75
Equivalent volatility	118.76%
Equivalent interest-risk adjusted rate	13.83%
Equivalent credit-risk adjusted yield rate	35.08%

Equivalent amounts reflect the net results of multiple modeling simulations that the Monte Carlo Simulation methodology applies to underlying assumptions. The assumptions included in the Monte Carlo Simulation calculation are highly subjective and subject to interpretation.

$7.5 Million Secured Convertible Debenture - March 2007

The Company entered into a Securities Purchase Agreement, dated March 27, 2007, (the “Agreement”) with Cornell Capital Partners LP, an accredited investor (the “Purchaser”). Pursuant to the Agreement, the Purchaser agreed to purchase 13% secured convertible debentures maturing two years from the date of issuance in the aggregate amount of $7,459,000. NeoMedia received cash proceeds from the transaction of $5,000,000, net of $781,000 fees paid to the Purchaser, and $1,678,000 payment of accrued interest and liquidated damages related to previous financings with Purchaser. The Agreement also provided for the issuance to the Purchaser, at no additional cost to the Purchaser, warrants to purchase shares of the Company's common stock. In connection with the Agreement, the Company also entered into a registration rights agreement with the Purchaser that requires the Company to (i) file a registration statement with the SEC registering the resale of the shares of common stock issuable upon conversion of the convertible debenture and the exercise of the warrants within 30 days of receipt of a request for filing from the Purchaser, (ii) achieve effectiveness within 120 days of receipt of a request for filing from the Purchaser, and (iii) maintain effectiveness of the registration statement. Failure to meet these requirements will require the Company to incur liquidated damages amounting to 2% of the principal per month, but in no event shall consideration paid as liquidated damages exceed $1,790,000.

The Debentures are secured according to the terms of a pledge and security agreement dated August 24, 2006 and entered into in connection with a previous $5 million secured convertible debenture with the Purchaser, pursuant to which the Company agreed to provide to Purchaser a security interest in its assets to secure the Company's obligations under the financing transaction. The Debentures are additionally secured by a patent security agreement entered into on March 27, 2007.

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At any time from the closing date until March 27, 2009, the Purchaser has the right to convert the convertible debenture into common stock of the Company at the then effective conversion price, which varies relative to the Company’s trading stock price, as follows: $0.05 per share, or 90% of the lowest closing bid price (as reported by Bloomberg) of the common stock for the 30 trading days immediately preceding the conversion date. The conversion is limited such that the holder cannot exceed 4.99% ownership, unless the holders waive their right to such limitation. The limitation will terminate under any event of default.

The convertible debenture, at the option of the holder, affords the Purchaser anti-dilution protection should, at any time while the convertible debenture is outstanding, the Company offer, sell or grant any option to purchase or offer, sell or grant any right to re-price its securities, or otherwise dispose of or issue any common stock or common stock equivalents, entitle any person to acquire shares of common stock at an effective price per share less than the then effective conversion price (excluding employee stock options), as calculated by the formula described above; then, in such instance, the conversion price for the convertible debenture shall be reduced to the lower price.

 

Under the terms of the agreement, the Purchaser also received warrants to purchase an aggregate of up to 125,000,000 shares of common stock. The warrants are exercisable at a price of $0.04 per share, subject to adjustment, included under anti-dilution protection similar to that described above. The warrants have a five-year contractual life. The warrants do not contain a forced exercise attribute similar to previously issued warrants. It is important to note that the warrants contain a provision that, if at the time of exercise, NeoMedia is in default of the warrant agreement, the holder can perform a “cashless” exercise of the warrants and in lieu of making payment of the exercise price in cash, elect instead to withhold shares as consideration for the exercise price. In the event of such a “cashless” exercise, NeoMedia would not receive any cash proceeds upon the exercise of such warrants. NeoMedia is currently in default of the Investor Registration Rights Agreement entered into on March 27, 2007, due to a pre-existing default on its previous financing arrangements with the Buyer. Such a default of the Investor Registration Rights Agreement constitutes an event of default under the warrant agreements issued in connection with the secured convertible debenture. As a result, Cornell Capital Partners currently has the right to exercise on a cashless basis the 125,000,000 of warrants they hold that were issued in connection with the secured convertible debenture.

The convertible debenture contains consequences in case of default. Events of default which could subject the Company to penalties, liabilities, and foreclosure upon the assets of the Company as specified in the Agreement include:

 

·

Any case or action of bankruptcy or insolvency commenced by the Company or any subsidiary, against the Company or adjudicated by a court against the Company for the benefit of creditors;

 

·

Any default in its obligations under a mortgage or debt in excess of $100,000;

 

·

Any cessation in the eligibility of the Company’s stock to be quoted on a trading market;

 

·

Failure to timely file the registration statement covering the shares related to the conversion option, or failure to make the registration statement effective timely;

 

·

Any lapse in the effectiveness of the registration statement covering the shares related to the conversion option, the warrants as described and transacted in the securities purchase agreement and accompanying documents;

 

·

Any failure to deliver certificates within the specified time; and

 

44

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·

Any failure, by the Company, to pay in full the amount of cash due pursuant to a buy-in or failure to pay any amounts owed on account on account of an event of default within 3 days of the date due.

 

Other provisions included in the Agreement include the following:

 

·

The convertible debenture is convertible into common stock, at the option of the Purchaser, at any time after the effective date;

 

·

As promptly as practicable after any conversion date, and subject to an effective registration statement or an exemption from registration the Company shall cause its transfer agent to deliver a certificate representing the converted shares, free of any legends and trading restrictions for the number of shares converted;

 

·

The Company will reserve and keep available authorized and unissued registered shares available to be issued upon conversion;

 

·

Purchaser will not be responsible for any transfer taxes relative to issuance of shares;

 

·

If the Company offers, sells or grants stock at an effective per share price less than the then Conversion Price, then the Conversion Price shall be reduced to equal the effective conversion, exchange or purchase price for such common stock or common stock equivalents;

 

·

Pursuant to the terms of the convertible debenture agreement between NeoMedia and Cornell signed in connection with the convertible debenture sale, without Cornell’s consent NeoMedia cannot

 

-

issue or sell any shares of Common Stock or preferred stock without consideration or for consideration per share less than the closing bid price immediately prior to its issuance,

 

-

issue or sell any preferred stock, warrant, option, right, contract, call, or other security or instrument granting the holder thereof the right to acquire common stock for consideration per share less than the closing bid price immediately prior to its issuance,

 

-

enter into any security instrument granting the holder a security interest in any of its assets of, or

 

-

file any registration statements on Form S-8.

 

·

In addition, pursuant to a security agreement between NeoMedia and the Purchaser signed in connection with the convertible debenture, the Purchaser has a security interest in all of NeoMedia’s assets.

 

NeoMedia is currently in default of the Investor Registration Rights Agreement entered into on March 27, 2007, in connection with the secured convertible debenture, because the registration statement to register the shares underlying the secured convertible debenture issued on August 24, 2006 was not declared effective by the specified date. Due to the current default status, the Purchaser has certain material additional rights in this financing arrangement that did not previously exist. Specifically,

·

The full fair value of the secured convertible debenture is now callable in the amount of $7,459,000;

 

·

The warrants can be exercised on a cashless basis as described above;

 

45

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·

NeoMedia is responsible for liquidated damages of 2% of the principal per month up to a maximum of $1,790,000;

 

·

The requirement for the Purchaser to maintain an ownership interest in NeoMedia of less than 5% is terminated;

 

The accounting for the secured convertible debenture reflects certain specific accounting rules and regulations that are applicable under the default provision:

·

NeoMedia incurred a charge to income from continuing operations at the time of the issuance of this secured convertible debenture to recognize the liability of the debenture at redemption value by fully writing off the debt discount.

 

·

The secured convertible debenture is reported as debt in the current liabilities section of the balance sheet rather than long term, because the debenture is callable as demand debt due to the default.

 

46

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At the inception date of March 27, 2007, a summary of the allocation of the components of the transaction is as follows:

 

Instrument:
Convertible debenture		$	10,836,000
Common stock warrants (1)			5,638,000
Payment of liquidating damages (2)			(1,312,000	)
Payment of interest due(3)			(366,000	)
Derivative loss			(9,015,000	)
Interest expense(4)			(781,000	)
Total gross proceeds		$	5,000,000

____________________

(1)

The Company issued warrants to purchase aggregate 125,000,000 shares of common stock in connection with the convertible debenture, as described above.

(2)

Liquidating damages arising from the February 2006 preferred financing arrangement and the August 2006 debenture financing arrangement were paid from the proceeds of this debenture arrangement in the amount of $1,312,000.

(3)

Interest payments of $366,000 toward the August 2006 and December 2006 debenture financings were made from the proceeds of this debenture arrangement.

(4)

Due to the default status, the financing costs of $781,000 were expensed to interest expense.

 

The Company evaluated the terms and features of the common stock and warrants under FAS 155 “Accounting for Certain Hybrid Financial Instruments an amendment of FASB Statements No. 133 and 140” which permits fair value re-measurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation. During the evaluation, the Company determined (i) the hybrid debt instrument embodied certain derivative features that were not clearly and closely related to the host debt instrument and, (ii) the warrants did not meet all of the established criteria for equity classification. Additionally, the secured convertible debenture extended a right to the holder to accelerate repayment of the debt (default put) and contains cash penalties upon the occurrence of certain contingent events. In order for contingently exercisable call and puts to be considered clearly and closely related, they can be indexed only to interest rates or credit risk, not another factor that does not possess the same risk as debt. Since the default put is indexed to other than interest rates or credit risk and it may be triggered upon events that are not within our control, is not deemed to be clearly and closely related to the host debt instrument. The warrants did not meet all of the established criteria for equity classification provided in EITF 00-19.

The Company evaluates each financing arrangement for the applicability of FAS 155 on a case by case basis. The Company applied FAS 155 to the March 2007 $7.5 million debenture financing arrangement.

The above instruments are being carried at their respective fair values with the changes in the fair value of the secured convertible debenture and related derivatives recorded in the statement of operations.

The following tabular presentation reflects the number of common shares into which the aforementioned derivative financial instruments are indexed March 31, 2007:

		Shares of common stock
Common stock warrants			125,000,000
Embedded conversion feature (1)			206,668,080
			331,668,080

(1)

The terms of the embedded conversion features in the convertible debenture provide for variable conversion rates that are indexed to the Company’s trading common stock price. As a result, the number of indexed shares is subject to continuous fluctuation. For presentation purposes, the number of shares of common stock into which the embedded conversion feature was convertible as of March 31, 2007 was calculated as the face value of $7,459,000, divided by 90% of the lowest closing bid price for the 30 trading days preceding March 31, 2007.

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Derivative loss for the three months ended March 31, 2007 and 2006 associated with adjustments recorded to reflect the aforementioned derivatives at fair value amounted to $8,640,000 and $0, respectively, and is reported as “Gain on embedded conversion features of derivative financial instruments” in the accompanying consolidated statement of operations.

Fair value considerations for derivative financial instruments:

Freestanding derivative instruments, consisting of warrants that arose from the financing are valued using the Black-Scholes-Merton valuation methodology because that model embodies all of the relevant assumptions that address the features underlying these instruments. Significant assumptions included in this model as of March 31, 2007 are as follows:

Holder	Cornell Capital Partners
Instrument	Warrants
Exercise price	$0.04
Remaining Term (years)	5.00
Volatility	158.45%
Risk-free rate	4.54%

Embedded derivative financial instruments, arising from the convertible debenture, consist of multiple individual features that were embedded in the instrument. The Company evaluated all significant features of the hybrid instruments and, where required under current accounting standards, bifurcated features for separate report classification. These features were aggregated into one compound derivative financial instrument for financial reporting purposes. The compound embedded derivative instruments are valued using the Flexible Monte Carlo methodology because that model embodies certain relevant assumptions (including, but not limited to, interest rate risk, credit risk, and conversion/redemption privileges) that are necessary to value these complex derivatives.

Assumptions included exercise estimates/behaviors and the following other significant estimates:

Instrument:	Features
Conversion prices	$0.036
Remaining terms (years)	2.00
Equivalent volatility	123.41%-123.49%
Equivalent interest-risk adjusted rate	9.31%-9.32%
Equivalent credit-risk adjusted yield rate	16.63%-16.66%

Equivalent amounts reflect the net results of multiple modeling simulations that the Monte Carlo Simulation methodology applies to underlying assumptions. The assumptions included in the Monte Carlo Simulation calculation are highly subjective and subject to interpretation.

The fair value of derivative financial instruments recorded as of March 31, 2007 (unaudited) and December 31, 2006 respectively was:

Warrants and embedded conversion features in preferred stock		$	6,390		$	9,217
Warrants and embedded conversion features in debentures			18,634			15,679
Fair value of future payment obligation			620			564
Special preference stock of Mobot			305			359
Total derivative financial instruments		$	25,949		$	25,819

 

48

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Standby Equity Distribution Agreements with Cornell

On October 27, 2003, NeoMedia and Cornell Capital Partners (“Cornell”) entered into a $20 million Standby Equity Distribution Agreement (the “2003 SEDA”). The agreement provided for a maximum “draw” of $280,000 per week, not to exceed $840,000 in any 30-day period, and Cornell was obligated to purchase up to $20 million of the Company’s common stock over a two-year period. The SEDA became effective during January 2004, and expired after a two-year term in January 2006. During the three months ended March 31, 2007 and 2006, NeoMedia sold shares of its common stock to Cornell pursuant to the 2003 SEDA as follows:

		Three Months Ended March 31,
		2007			2006
Number of shares sold to Cornell			---			751,880
Gross Proceeds from sale of shares to Cornell		$	---		$	234,000
Less: discounts and fees*			---			(24,000	)
Net Proceeds from sale of shares to Cornell		$	---		$	210,000

* Pursuant to the terms of the 2003 SEDA, stock was valued at 98% of the lowest closing bid price during the week it was sold.

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6.	INVESTMENT IN MARKETABLE SECURITIES AND OTHER LONG-TERM ASSETS

On February 25, 2005, NeoMedia invested $250,000 in exchange for 8,333,333 shares of Pickups Plus, Inc (“PUPS”) restricted common stock. On February 17, 2006, as a component of net proceeds from the issuance of 8% Series C convertible preferred stock, NeoMedia received marketable securities with a fair value of $579,000, of which, $200,000 represented 20,000,000 shares of PUPS common stock and $379,000 in notes designated as held to maturity. PUPS is a franchiser of retail automotive parts and accessories stores catering to the light truck market, and also provides new vehicle preparation, environmental protection packages, detailing and reconditioning products and services. In accordance with Statements of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” the investment in PUPS is being recorded as available-for-sale securities and reported at fair value. Accordingly, unrealized gains and losses on the equity securities are reflected in the condensed consolidated statement of operations and comprehensive income (loss). Investment in marketable securities consist of the fair market value of the PUPS common stock of $31,000 as of March 31, 2007.

Other long term assets and investments consist of the following as of March 31, 2007:

		As of March 31, 2007
		Cost			Unrealized Holding Gains (Losses)			Impairment Amount Realized			Carrying Value
Held to maturity, notes receivable PUPS		$	379,000		$	---			($379,000	)	$	---
Investment in Mobot			1,926,000			---			---			1,926,000
Investment in Sponge			1,399,000			---			---			1,399,000
Total		$	3,704,000		$	---			($379,000	)	$	3,325,000

Held to maturity securities consist of four notes receivable from PUPS with a face value of $1,611,000 and a fair value of $0. NeoMedia incurred an impairment charge in the fourth quarter of 2006 to reduce the carrying value of the notes receivable to their expected realizable value. The notes are delinquent and accrue interest at rates between 12 - 24%. NeoMedia has not recorded any interest since the Company is using the cost recovery method.

Investment in Mobot consists of shares of FMS Group, representing NeoMedia’s 18% ownership of FMS Group, which currently operates the Mobot business.

Investment in Sponge consists of shares of Sponge, representing NeoMedia’s 7.5% ownership of Sponge.

 

50

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7.	FINANCIAL INSTRUMENTS

 

The carrying amount of the Company's cash equivalents, accounts receivable, prepaid expenses, other current assets, cash surrender value of life insurance policy, accounts payable and accrued expenses, accrued salaries and benefits, and payable to merchants approximates their estimated fair values due to the short-term maturities of those financial instruments.

Rates currently available to the Company for debt with similar terms and remaining maturities are used to estimate fair value of existing debt.

 

It is not practicable to estimate the fair value of the Company’s investment of 250,000 shares of preferred stock of Intactis Software, Inc., because of the lack of quoted market prices and the inability to estimate fair value without incurring excessive costs. During 2005, NeoMedia recorded an impairment of the carrying value of its investment in Intactis of $250,000, reducing the net carrying value to $0.

 

For all available-for-sale investment securities, the carrying values represent fair value of the securities and unrealized gain (losses) that are other than temporary are recognized as other comprehensive income (loss). NeoMedia does not hold these securities for speculative or trading purposes (See Note 6).

 

8.	COMPUTATION OF NET INCOME (LOSS) PER SHARE

Basic net loss per share is computed by dividing net loss by the weighted average number of shares of common stock outstanding during the period. During the three months ended March 31, 2007 and 2006, the Company reported net loss per share, and as such basic and diluted loss per share were equivalent. The Company has excluded all outstanding stock options, warrants and convertible securities from the calculation of diluted net loss per share because these securities are anti-dilutive for all years presented. The shares excluded from the calculation of diluted net loss per share are detailed in the table below:

		Three Months Ended March 31,
		2007			2006
Outstanding stock options			106,978,761			124,005,799
Outstanding warrants			441,325,000			108,325,000
Series C Convertible Preferred Stock*			607,422,165			66,707,095
Convertible Debt*			415,001,413			---

 

*Quantity of shares indexed to financing agreements.

 

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9.	STOCK BASED COMPENSATION

Equity-based Compensation Plans

Effective March 27, 1998, NeoMedia adopted the 1998 Stock Option Plan making available for grant to employees of NeoMedia options to purchase up to 8,000,000 shares of NeoMedia's common stock. The stock option committee of the Board of Directors has the authority to determine to whom options will be granted, the number of options, the related term, and exercise price. The option exercise price may be less than the fair market value per share of NeoMedia's common stock on the date of grant. Options generally vest 20% upon grant and 20% per year thereafter. The options expire ten years from the date of grant. As of March 31, 2007, options to purchase 145,450 shares of common stock remained available for issuance under the 1998 Stock Option Plan.

Effective June 6, 2002, NeoMedia adopted its 2002 Stock Option Plan. The 2002 Stock Option Plan provides for authority for the stock option committee of the Board of Directors to grant non-qualified stock options with respect to a maximum of 10,000,000 shares of common stock. The option exercise price may be less than the fair market value per share of NeoMedia's common stock on the date of grant, and may be granted with any vesting schedule as approved by the stock option committee. As of March 31, 2007, options to purchase 20,000 shares of common stock remained available for issuance under the 2002 Stock Option Plan.

Effective September 24, 2003, NeoMedia adopted its 2003 Stock Option Plan. The 2003 Stock Option Plan provides for authority for the Board of Directors to the grant non-qualified stock options with respect to a maximum of 150,000,000 shares of common stock. The option exercise price may be less than the fair market value per share of NeoMedia's common stock on the date of grant, and may be granted with any vesting schedule as approved by the stock option committee. As of March 31, 2007, options to purchase 106,957,765 shares of common stock remained available for issuance under the 2003 Stock Option Plan.

Effective December 16, 2005, NeoMedia adopted its 2005 Stock Option Plan. The 2005 Stock Option Plan provides for authority for the Board of Directors to the grant non-qualified stock options with respect to a maximum of 60,000,000 shares of common stock. The option exercise price may be less than the fair market value per share of NeoMedia's common stock on the date of grant, and may be granted with any vesting schedule as approved by the stock option committee. As of March 31, 2007, NeoMedia has not registered the 60,000,000 shares underlying the options in the 2005 Stock Option Plan, and as a result options to purchase all 60,000,000 shares of common stock remained available for issuance under the 2005 Stock Option Plan.

Effective October 31, 2003, NeoMedia adopted the 2003 Stock Incentive Plan. Under the terms of the 2003 Stock Incentive Plan, NeoMedia has set aside up to 30 million shares of common stock to be issued to pay compensation and other expenses related to employees, former employees, consultants, and non-employee directors. As of March 31, 2007, 1,632,815 shares of common stock remained available for issuance under the 2003 Stock Incentive Plan.

 

Stock Option Repricing - February 2007

On February 1, 2007, NeoMedia instituted a stock option repricing plan as a retention tool to align its employees with the new vision of NeoMedia. Under the Plan, NeoMedia repriced 50,148,750 stock options held by current employees, contractors, and directors.

Options for employees of NeoMedia’s ongoing operations were repriced as follows: (i) options that were vested as of February 1, 2007, were repriced to $0.045 per share, which was the last sale price on February 1, 2007, (ii) options that are scheduled to vest during the remainder of 2007 were repriced to $0.075, (iii) options that vest during 2008 were repriced to $0.125, and (iv) options that vest during 2009 were repriced to $0.175. Options will continue to vest on their regular schedule, which generally is 25% upon grant and 25% on each subsequent anniversary date.

The Company also repriced options for outside directors as follows: options with an exercise price below $0.24 were repriced to $0.045, and options with an exercise price $0.24 or higher were repriced to $0.075.

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In addition, the Company repriced options held by employees of its held for sale Micro Paint repair and Telecom Services businesses, such that all vested options were repriced to $0.045 per share, and all unvested options will vest upon sale of the respective business unit at an exercise price of $0.075 per share, with a 12-month period to exercise.

NeoMedia accounted for the repricing of stock options in accordance with FASB Statement No. 123, Accounting for Stock-Based Compensation (“Statement 123(R)”). NeoMedia calculated the fair value of the modified and the repriced options using the original terms and the modified terms as of the repricing date, and recorded the incremental cost of the modified option over the original option as additional compensation cost. Costs related to fully vested options including accelerated vesting were expensed immediately and the costs related to unvested stock options will be recognized over the remaining vesting period of the option. Unrecognized compensation expense relating to the original option grant will continue to be recognized as if the repricing had not occurred.  

In connection with the option repricing, NeoMedia recognized additional stock based compensation expense as follows:

		Three months ended
		March 31,
		2007			2006
Stock option repricing expense allocated to:		(in thousands)
Sales and marketing expense		$	110		$	---
General and administrative expense			115			---
Research and development expense			64			---
Total stock option repricing expense included in continuing operations			289			---
Plus: stock option repricing expense included in discontinued operations			355			---
Total stock option repricing expense reflected in net loss		$	644		$	---

The weighted-average grant-date fair value of options repriced on February 1, 2007, using the options’ modified terms, was $0.03. As of March 31, 2007, there was $474,000 of total unrecognized compensation cost related to nonvested options repriced on February 1, 2007. That cost is expected to be recognized over a weighted-average period of 0.8 years.

Stock Incentive Plan

Under the shareholder-approved 2003 Stock Incentive Plan, NeoMedia has set aside up to 30,000,000 shares of common stock to be issued to pay compensation and other expenses related to employees, former employees, consultants, and non-employee directors. During the three months ended March 31, 2007 and 2006, NeoMedia issued shares from the 2003 Stock Incentive Plan as follows:

		Three Months Ended March 31,
		2007			2006
		(in thousands)
Shares issued under 2003 Stock Incentive Plan			92,593			52,632
Aggregate grant date fair value of shares issued		$	5,000		$	16,000
Expense recognized		$	5,000		$	16,000

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Adoption of FASB Statement No. 123

Prior to January 1, 2006, NeoMedia accounted for its stock option plans under the recognition and measurement provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations, as permitted by Statement 123(R). No stock-based employee compensation cost was recognized in the statement of operations for the fiscal years or interim periods ended prior to December 31, 2005, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. Effective January 1, 2006, NeoMedia adopted the fair value recognition provisions of Statement 123(R), using the modified-prospective-transition method. Under that transition method, compensation cost recognized in 2006 includes: (a) compensation cost for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of Statement 123, and (b) compensation cost for all share-based payments granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of Statement 123(R). Results for prior periods were not restated.

Total stock based compensation recognized during three month periods ended March 31, 2007 and 2006, inclusive of expense associated with the option repricing and stock incentive plan described above, was:

		Three months ended
		March 31,
		2007			2006
Stock based compensation allocated to:		(in thousands)
Sales and marketing expense		$	345		$	429
General and administrative expense			388			350
Research and development expense			157			129
Total stock based compensation included in continuing operations			890			908
Plus: stock based compensation included in discontinued operations			538			621
Total stock based compensation expense reflected in net loss		$	1,428		$	1,529

Estimated income tax benefits recognized during the year ended December 31, 2006 were offset by a valuation allowance since realization was not reasonably assured. Prior to the adoption of Statement 123(R), it was NeoMedia’s policy to present all tax benefits of deductions resulting from the exercise of stock options as operating cash flows in its statement of cash flows, however, due to NeoMedia’s tax loss carryforward, any such benefits were always fully offset by a valuation allowance. Statement 123(R) requires the cash flows resulting from the tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) to be classified as financing cash flows. NeoMedia will use this presentation if and when it has exhausted its tax loss carryforward.

The weighted-average grant-date fair value of options granted during the three months ended March 31, 2007 and 2006 was $0.25 and $0.11, respectively. The total intrinsic value of options exercised during the three months ended March 31, 2007 and 2006 was $33,000 and $156,000, respectively. Total cash received from options exercised was $9,000 and $131,000, respectively, for the three months ended March 31, 2007 and 2006. As of March 31, 2007, there was $4,877,000 of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the Plans. That cost is expected to be recognized over a weighted-average period of 1.2 years.

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NeoMedia used the following assumptions for grants during the three months ended March 31, 2007 and 2006:

	Three Months ended March 31,
	2007		2006
Volatility	115.05%		56.00%
Expected dividends	---		---
Expected term (in years)	3		3
Risk-free rate	4.35%		4.35%

Subsequent Stock Based Compensation Events

 

On April 12, 2007, NeoMedia entered into an agreement with Thornhill Capital LLC (“Thornhill”), an independent consultant, pursuant to which NeoMedia agreed to reprice up to 10,000,000 warrants held by Thornhill upon achievement of certain performance conditions. Upon signing of the agreement, which calls for the termination of any obligations due from NeoMedia to Thornhill under the terms of a previous consulting agreement between the parties and Thornhill’s commitment to assist with the development of the China market for NeoMedia’s technology products, 2,000,000 warrants were repriced from $0.227 to $0.048, 1,000,000 warrants were repriced from $0.11 to $0.048, and 500,000 warrants were repriced from $0.11 to $0.048. In addition, the following warrants could be subject to future repricing if certain milestones are met: (i) 2,000,000 warrants will be repriced from $0.227 to $0.048 upon execution of a contract outlining mutually agreed payment terms for amounts owed to NeoMedia by Automart, a customer of NeoMedia’s Micro Paint Repair business unit, (ii) 3,500,000 warrants will be repriced from $0.328 to $0.048 upon receipt of payment by NeoMedia from Automart, (iii) 500,000 warrants will be repriced from $0.11 to $0.048 on October 12, 2007 if Thornhill is still assisting with the development of the China market, and (iv) 500,000 warrants will be repriced from $0.11 to $0.048 on April 12, 2008 if Thornhill is still assisting with the development of the China market.

 

On April 12, 2007, NeoMedia entered into an agreement with two independent consultants, pursuant to which NeoMedia issued 830,000 fully vested shares of common stock from its 2003 Stock Incentive Plan in exchange for Edgar consulting, printing, and filing services to be performed over the next two years.

 

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10.	SEGMENT REPORTING

 

As of March 31, 2007, NeoMedia was structured and evaluated by its Board of Directors and management as one operating unit, comprised of the Company’s core code-reading technology and related intellectual property. NeoMedia is headquartered in Ft. Myers, Florida, and operates principally in the United States, and in Europe through its office in Aachen, Germany.

Following its acquisitions of Mobot, Sponge, Gavitec, 12Snap, and BSD during the first quarter of 2006, NeoMedia operated as three business segments: NeoMedia Mobile, NeoMedia Micro Paint Repair, and NeoMedia Telecom Services. During August 2006, NeoMedia made the strategic decision to sell the Micro Paint Repair business. During November and December 2006, NeoMedia sold Mobot and Sponge. During the first quarter of 2007, NeoMedia decided to sell 12Snap and Telecom Services, and re-focus its resources on its core code-reading business. As a result of the re-focus, NeoMedia is evaluated as, and will report as, one operating segment during 2007.

Consolidated net sales and net loss from continuing operations for the three month periods ended March 31, 2007 and 2006, and identifiable assets as of March 31, 2007 by geographic area were as follows:

		(dollars in thousands)
		Three Months Ended
		March 31,
		2007			2006
Net Sales:
United States		$	176		$	166
Germany			223			33
Total		$	399			199
Net Loss from Continuing Operations:
United States			($8,780	)		($29	)
Germany			(145	)		($119	)
Total			($8,925	)		($148	)
Identifiable Assets
United States (1)		$	13,072
Germany			4,433
Total		$	17,505

_______________________

(1)

Segment reporting excludes Micro Paint Repair, Mobot, Sponge, 12Snap and Telecom Services business units which are classified as discontinued operations during the three months ended March 31, 2007 and 2006, and the related assets and liabilities held for sale.

 

Operating costs included in one segment may benefit other segments, and therefore these segments are not designed to measure operating income or loss directly related to the products included in each segment.

During August 2006, NeoMedia announced that it was selling its NMPR business. During the fourth quarter of 2006, NeoMedia divested of its Mobot and Sponge subsidiaries. During January 2007, NeoMedia made the strategic decision with respect to its corporate structure in 2007 and beyond, deciding to shed its remaining non-core 12Snap and NTS business units to focus on the area that management believes will deliver the most value - the core code-reading business. During April 2007, NeoMedia sold the 12Snap business.

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As a result of the divestitures of 12Snap, Mobot and Sponge, and the proposed divestitures of NMPR and NeoMedia Telecom Services, beginning in the first quarter of 2007 NeoMedia evaluated its business as one consolidated business, focusing on its core code-reading business and related intellectual property. Results of these operations are included in discontinued operations in the financial statements presented herein. Since all results from continuing operations are included in one business segment, NeoMedia is not presenting continuing operations by segment for the periods presented herein.

11.

INVENTORY

Inventories for continuing operations, consisting of material, material overhead, labor and processing costs, are stated at the lower of cost (first-in, first-out) or market and consist of the following at March 31, 2007 (unaudited) and December 31, 2006:

		March 31, 2007			December 31, 2006
Raw materials		$	---		$	---
Work-in-process			---			---
Finished goods			123			80
Total		$	123		$	80

12.	ACCRUED LIABILITIES

Accrued liabilities for continuing operations consist of the following as of March 31, 2007 (unaudited) and December 31, 2006:

		March 31, 2007			December 31, 2006
Accruals related to silent partner agreements		$	268		$	213
Accrued legal and accounting costs			455			179
Accruals for disputed services			794			794
Accrued operating expenses			666			728
Payroll related accruals			9			9
Accrued liquidated damages			1,075			2,093
Total		$	3,267		$	4,016

13.	COMMITMENTS AND CONTINGENCIES

NeoMedia is party to various commitments and contingencies, such as:

·

NeoMedia leases its office facilities and certain office and computer equipment under various operating leases which provide for minimum rents and generally include options to renew for additional periods;

·

NeoMedia and its subsidiaries lease office facilities and certain office and computer equipment under various operating leases;

·

NeoMedia is party to various payment arrangements with its vendors that call for fixed payments on past due liabilities;

·

NeoMedia is party to various consulting agreements that carry payment obligations into future years;

·

NeoMedia issued Series C convertible preferred shares with face value of $21,657,000 and convertible debentures with a face value of $14,958,000 that are subject to conversion at future dates, plus the accrued expected value of liquidated damages of $1,075,000 relating to these convertible instruments;

 

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·

On June 15, 2006, the Company issued 3,721,698 shares of its common stock as an initial payment against debt and accrued interest owed to Wayside Solutions, Inc. (“Wayside”), a corporation that had provided financing to BSD prior to the acquisition of BSD by the Company. Prior to the acquisition, the Company reached an agreement with Wayside to pay the outstanding debt due to Wayside subsequent to completion of the acquisition. The shares contain a make-whole provision that calls for additional shares to be issued in the event the value of the original shares at the time of registration is less than the value at the time they were issued; and

·

NeoMedia has accrued the amount of $4,787,000 relating to a purchase price guarantee obligation in connection with its acquisition of 12Snap.

The following table sets forth NeoMedia’s future minimum payments due under operating leases, vendor and consulting agreements, convertible stock agreements, and debt agreements from the Company’s continuing operations:

		(US dollars in thousands)
														Series C
					Vendor &			Subsidiary						Convertible
		Operating			Consulting			Acquisition			Convertible			Preferred
		Leases			Agreements			Commitments			Debentures			Stock			Total
2007 (remaining nine months)		$	243		$	148		$	5,055		$	18,336			21,657		$	45,439
2008			188			94			---			---			---			282
2009			11			10			---			---			---			21
2010			3			---			---			---			---			3
2011			---			---			---			---			---			---
Thereafter			---			---			---			---			---			---
Total		$	445		$	252		$	5,055		$	18,336		$	21,657		$	45,745

In addition, as of March 31, 2007, NeoMedia had future obligations relating to its discontinued Micro Paint Repair, 12Snap, and Telecom Services businesses totaling $3,179,000, most of which is expected to be assumed by the buyers upon the anticipated sale of each business unit. With the sale of 12Snap on April 4, 2007, $2,223,000 of these commitments were transferred to the buyer of 12Snap.

Legal Proceedings

The Company is involved in various legal actions arising in the normal course of business, both as claimant and defendant. While it is not possible to determine with certainty the outcome of these matters, it is possible that the eventual resolution of the following legal actions could have a material adverse effect on the Company’s financial position or operating results.

Scanbuy, Inc.

 

On January 23, 2004, NeoMedia filed suit against Scanbuy, Inc. (“Scanbuy”) in the Northern District of Illinois, claiming that Scanbuy has manufactured, or has manufactured for it, and has used, or actively induced others to use, technology which allows customers to use a built-in UPC bar code scanner to scan individual items and access information, thereby infringing NeoMedia’s patents.  The complaint stated that on information and belief, Scanbuy had actual and constructive notice of the existence of the patents-in-suit, and, despite such notice, failed to cease and desist their acts of infringement, and continue to engage in acts of infringement of the patents-in-suit.  On April 15, 2004, the court dismissed the suits against Scanbuy for lack of personal jurisdiction. 

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On April 20, 2004, NeoMedia re-filed its suit against Scanbuy in the Southern District of New York alleging patent infringement. Scanbuy filed its answer on June 2, 2004. NeoMedia filed its answer and affirmative defenses on July 23, 2004. On January 20, 2007, the court dismissed Scanbuy's request for a summary judgment. Discovery is ongoing.

 

14.

OTHER

Liabilities related to silent partnership arrangements

As of March 31, 2007, NeoMedia owed approximately $1 million relating to silent partner debtholders of 12Snap. Concurrent with the sale of 12Snap on April 4, 2007, the silent partners were paid in full.

 

Debt of NeoMedia Telecom Services

On June 15, 2006, the Company issued 3,721,698 shares of its common stock as an initial payment against debt and accrued interest owed to Wayside Solutions, Inc. (“Wayside”), a corporation that had provided financing to BSD prior to the acquisition of to BSD by the Company. Prior to the acquisition, the Company reached an agreement with Wayside to pay the outstanding debt due to Wayside subsequent to completion of the acquisition. The shares contain a make-whole provision that calls for additional shares to be issued in the event the value of the original shares at the time of registration is less than the value at the time they were issued.

 

15.	SUBSEQUENT EVENTS

Sale of 12Snap - April 2007

On February 28, 2006, NeoMedia acquired all of the outstanding shares of 12Snap in exchange for $2,500,000 cash and $19,500,000 common stock, represented by 49,294,581 shares of NeoMedia common stock. Pursuant to the terms of the merger agreement, the number of shares of NeoMedia common stock to be issued as consideration was calculated using a share price of $0.3956, which was the volume-weighted average closing price of NeoMedia common stock for the ten days up to and including February 9, 2006. Pursuant to the terms of the sale and purchase agreement, in the event that NeoMedia’s stock price at the time the consideration shares became saleable (either upon effectiveness of a registration statement containing the shares, or under Rule 144) was less than $0.3956, NeoMedia was obligated to compensate 12Snap shareholders in cash for the difference between the price at the time the shares became saleable and $0.3956. On February 22, 2007, the shares became eligible for resale under Rule 144. The actual calculated purchase price obligation to NeoMedia based on the volume weighted average closing price of NeoMedia stock for the ten days up to and including February 22, 2007 was $16,233,000.

On April 4, 2007, NeoMedia entered into a material definitive agreement with Bernd M. Michael (the “Buyer”), a private investor and former shareholder of 12Snap prior to NeoMedia’s acquisition of 12Snap, pursuant to which the Buyer purchased from NeoMedia 90% of the shares of 12Snap, subject to the following material terms and conditions:

 

·

$1,100,000 was paid in cash at closing, of which $1,015,000 was applied toward amounts owed to silent partners of 12Snap

 

·

$500,000 was placed into an escrow account for 90 days to secure warranty claims;

 

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·

The Buyer waived his portion of the purchase price guarantee obligation in the amount of $880,000;

 

·

The Buyer returned to NeoMedia 2,525,818 NeoMedia shares previously issued to Buyer;

 

·

12Snap management waived their portion of the purchase price guarantee obligation in the amount of $880,000;

 

·

12Snap management returned to NeoMedia 5,225,039 shares of NeoMedia common stock previously issued to 12Snap management;

 

·

NeoMedia will retain a 10% ownership in 12Snap, subject to an option agreement pursuant to which NeoMedia has the right to sell and Buyer has the right to acquire the remaining 10% stake held by NeoMedia for a purchase price of $750,000 after December 31, 2007; and

 

·

12Snap and NeoMedia will execute a cooperation agreement pursuant to which 12snap will remain NeoMedia preferred partner and enjoy most favored prices, and 12snap will perform certain research and development functions for NeoMedia.

 

Other Events

During April 2007, Announce Mobile, Inc. chose the qode® two-dimensional (2D) barcoding platform for the creation of its Hip2D mobile content solution. With Hip2D, companies can create mobile coupons, interactive products such as movie trailers or music samples to a DVD or CD, scavenger hunts or other detailed product information. The Hip2D platform combines the 2D code with a custom WAP portal or mobile storefront, providing businesses with the ability to deliver interactive content to consumers.

On April 17, 2007, NeoMedia named Jay Bonk, who has been working for the company on a consulting basis, as interim Executive Vice President of Sales and Marketing. Bonk replaces Roger Pavane. A longtime sales executive with Motorola, Bonk’s experience includes 22 years with Motorola, including stints as Vice President of Business Development and Vice President of Global Sales and Marketing.

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

Corporate Structure

During 2006, with its acquisitions of Gavitec, Mobot, 12Snap, and Sponge, NeoMedia implemented an aggressive growth strategy aimed at penetrating the rapidly evolving mobile marketing industry, and capturing a significant portion of early adopting marketers to drive high volumes of physical-world-to-mobile-internet traffic through the NeoMedia engine.

The majority of the consideration issued to acquire Gavitec, Mobot, 12Snap, and Sponge consisted of shares of NeoMedia common stock, the value of which was guaranteed, in cash, to the recipients by NeoMedia from the time of issuance through the time the shares were registered for resale (either upon effectiveness of a registration statement containing the shares, or under Rule 144). As a result of NeoMedia’s declining share price from the first quarter through the end of 2006, the purchase price guarantee obligations relating to these acquisitions became far greater than NeoMedia could reasonably satisfy with cash. Primarily as a result of the pending purchase price guarantee obligations, during the fourth quarter of 2006 NeoMedia divested of the majority of Sponge and Mobot back to their original owners, with the respective purchase price guarantee obligations being terminated as part of each transaction. Additionally, during the first quarter of 2007, NeoMedia satisfied its purchase price guarantee obligation to the former shareholders of Gavitec, and satisfied approximately 71% of the 12Snap purchase price guarantee obligation.

During August 2006, NeoMedia announced that it intended to sell its Micro Paint Repair business. During January 2007, the Company decided to attempt to sell its remaining 12Snap and Telecom Services non-core business units in the most profitable, timely and viable manner possible. 12Snap was sold during April 2007. NeoMedia plans to use the strategic equity earned through the sale of these assets in 2007 to reduce its current burn rate, help the Company move closer to profitability, and provide financial stability by the end of 2007 and become profitable by the first quarter of 2008. Most importantly, the shedding of NeoMedia’s non-core assets affords the Company the ability to focus all its resources on its core business initiatives. Management realizes the challenges that the Company faces in the global application of its technology, and can now present qode® to the industry and the public in a more systematic and focused approach, marketing it as “the next phase of the Internet” and the wireless Web.

The Company continues to focus on becoming the worldwide leader in linking the physical world to the mobile internet. Management believes that the decision to sell the non-core assets has led to a more focused vision for moving the Company forward and creating shareholder value, focusing on the core code-reading business and related intellectual property in North America, the UK, mainland Europe and China.

The Core Business

NeoMedia has made significant inroads into the burgeoning mobile marketing industry and ran many successful physical-world-to-mobile-web campaigns over the past several months.

In North America, qode® technology has been trialed and implemented across a wide variety of products and industries, including:

·

During April 2007, Announce Mobile, Inc. chose the qode® two-dimensional (2D) barcoding platform for the creation of its Hip2D mobile content solution. With Hip2D, companies can create mobile coupons, interactive products such as movie trailers or music samples to a DVD or CD, scavenger hunts or other detailed product information. The Hip2D platform combines the 2D code with a custom WAP portal or mobile storefront, providing businesses with the ability to deliver interactive content to consumers.

·

NeoMedia signed an agreement with Javien Digital Payment solutions under which Javien will incorporate the NeoMedia qode® platform into its Total Commerce Solution™ allowing for a complete billing, couponing and content product acquisition and resolution offering. NeoMedia will earn $0.05 per click and expects each transaction to generate up to four clicks.

 

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·

qode® was featured in an interactive textbook published by Prentice Hall, in which students can link to mobile online content through the qode® reader on their mobile phones.

·

ONE water, the ethical water brand, featured codes on 5 million of its water bottles that link to the mobile internet via qode® starting in December, when the first shipments of more than 5 million bottles bearing qode®. The bottles were sold at more than 4,000 retail outlets throughout the United Kingdom.

·

NeoMedia is partnered with News Group Newspapers, and its market-leading Sunday newspaper, the News of the World®, to use qode® in the United Kingdom to bring television clips of English Premier League soccer to its readers via their mobile phones.

In Europe, Gavitec also designed, implemented, and ran multiple mobile marketing solutions:

·

Gavitec was contracted by AWK Aussenwerbung GmbH, Germany’s second-largest outdoor advertising company, to develop a mobile order-management and control system using Gavitec technology.

·

Gavitec partnered with solution provider TopSolutions to equip Lusomundo, Portugal's leading cinema chain, with admission terminals for mobile tickets that allow movie-goers to obtain tickets through a cash-free Web-based transaction, and receive an electronic ticket as an SMS on their mobile phones.

·

Gavitec ran or participated in other campaigns during 2006 with customers such as McDonald’s Portugal, Amnesty International, Malaysian Railways, World Soccer Games 2006, EMT (Empresa Malagueña de Transportes, a Spanish public transport provider), Ströer, and Bitburger beer.

NeoMedia also made significant inroads into Asia during the past year, as follows:

·

Gavitec signed an exclusive license agreement with mobile marketing specialist Omniprime, pursuant to which Omniprime will sell mobile couponing and ticketing applications in the Philippines using Gavitec’s technology.

·

NeoMedia contracted with five large Chinese insurance companies to adapt qode® to enable millions of policy holders in China to use their cell phones to link directly to their insurance company's Mobile Internet site

·

During January 2007, NeoMedia signed a performance-based agency agreement with NexMobil LLC, pursuant to which NexMobil will sell qode® products and services in the Middle East, India, Korea, and Pakistan.

Building on the deals already completed, NeoMedia will focus on targeting manufacturers within the media and enterprise space, including newspapers, publishers, real estate, physical world advertisers, and beverage producers to design their products to become more interactive. NeoMedia envisions a future in which consumers routinely “qode® it” when they want more information on a product or service. NeoMedia’s goals include hiring a new sales force, while penetrating three verticals with at least six major customers. Another major goal is to partner with at least three major carriers or manufacturers (North American, UK and mainland European) who will embed, adopt and commit to utilize every feature qode® has to offer.

NeoMedia is also making strides to create a global standard for the wireless Web. NeoMedia co-hosted a high-level meeting in London during February 2007 with some of the world’s leading technology firms to begin to define and document this important standards-based initiative. NeoMedia believes the outcome of the meeting was extremely positive and expects, along with its numerous innovative partners, to continue to play an active role in the standardization of the physical-world-to-web initiative. One of NeoMedia’s key initiatives is to evaluate and optimize the value of its and its partners’ collective intellectual property relating to this space.

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NeoMedia has numerous issued patents with others in process and is continuing to seek to optimize the value of its intellectual property portfolio around in the world. On January 20, 2007, Judge John E. Sprizzo dismissed Scanbuy's request for a summary judgment in the Company’s patent infringement case against Scanbuy. While the case is not over yet, NeoMedia continues to remain confident in the final outcome.

In terms of new leadership, the Company expects to name a permanent CEO during 2007. In addition, in April 2007 the Company announced that Jay A. Bonk was named Interim Executive Vice President of Sales and Marketing, replacing Roger Pavane. Mr. Bonk brings 22 year experience with Motorola, Inc., most recently as Vice President of Business Development and Vice President of Sales and Marketing.

Effect of Discontinued Operations on Net Loss and Financial Position

Assets and liabilities of the Micro Paint Repair, 12Snap, and Telecom Services businesses classified as held for sale are shown in the following table. There are no assets or liabilities associated with the Sponge or Mobot subsidiaries as of the balance sheet dates of March 31, 2007 or 2006.

		Micro			Telecom
		Paint Repair			Services			12Snap			Total
As of March 31, 2007
Total Assets Held for Sale		$	3,185		$	7,386		$	5,603		$	16,174
Total Liabilities Held for Sale			451			2,752			4,208			7,411
As of December 31, 2006
Total Assets Held for Sale		$	3,072		$	7,302		$	9,046		$	19,420
Total Liabilities Held for Sale			407			2,970			6,880			10,257

The operating results of the Micro Paint Repair, Sponge, Mobot, 12Snap, and Telecom Services businesses classified as discontinued operations are shown in the following table. There is not any tax expense or benefit to report due to NeoMedia’s net operating loss carry forward tax position.

(dollars in thousands)		Micro
		Paint			Telecom
		Repair			Services			12Snap			Mobot			Sponge			Total
Three months ended March 31, 2007
Net Sales		$	326		$	302		$	2,621		$	---		$	---		$	3,249
Net Income / (Loss)			(591	)		(3	)		(1,954	)		(11	)		(15	)		(2,574	)
Three months ended March 31, 2006
Net Sales		$	377		$	27		$	896		$	57		$	291		$	1,648
Net Income / (Loss)			(451	)		(429	)		(56	)		(282	)		49			(1,169	)

Depreciation and amortization costs suspended on assets held for sale for the three months ended March 31, 2007 are:

(dollars in thousands)		Micro
		Paint			Telecom
		Repair			Services			12Snap			Total
Suspended depreciation		$	69		$	72		$	220		$	361