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PART I

In addition to historical information, this Annual Report on Form 10-K contains certain forward-looking statements regarding, among other things, the anticipated financial and operating results of the Company. Investors are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. We do not undertake any obligation to publicly release any modifications or revisions to these forward-looking statements to reflect events or circumstances occurring after the date hereof or to reflect the occurrence of unanticipated events. In connection with the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995, we caution investors that future financial and operating results may differ materially from those projected in forward-looking statements made by, or on behalf of, us. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements.

Item 1. Business.

SOURCE OF CERTAIN STATISTICAL AND OTHER INFORMATION

This Annual Report on Form 10-K includes certain statistical and other data with respect to IPIX and its products, services and industries, derived from publicly available reports and other publications referenced in this annual report. These organizations generally use methodologies and conventions that they deem appropriate to measure companies within the relevant industry segment and to measure industry size. These organizations generally indicate that they have obtained information from sources believed to be reliable, but do not guarantee the accuracy or completeness of such information. While IPIX believes this information to be reliable, IPIX has not independently verified such data.

OVERVIEW

IPIX Corporation (“IPIX”) is a leading developer of advanced, 360˚ visual technologies for government and commercial applications. The Company combines experience, patented technology and strategic partnerships to deliver visual business intelligence solutions worldwide.

Expanding market share, partnering with industry leaders, recruiting talented employees, reducing operating costs, and expanding and improving product offerings were the focus of IPIX Corporation’s activities in 2005. IPIX is leveraging its patents and current customer base to broaden its business opportunities as the Internet Protocol (IP) video market continues to become more accepted in the industry. IPIX also passed a major milestone when in 2005 it was awarded a contract from the Defense Advanced Research Projects Agency (DARPA) to create the highest resolution video camera in the world. This contract, when successfully completed, will further advance IPIX’s reputation as a leader in video technologies and visual intelligence.

The DARPA contract was a major milestone in achieving IPIX’s strategic vision for 2005, which included a continued shift of the IPIX business model from a software developer and value-added camera reseller to a visualization systems and solutions development company. This shift included expansion and improvement of IPIX video and digital photography products. Additionally, as a result of IPIX’s expanding relationships with technology companies and key distributors, IPIX cameras have become widely available in many vertical markets and also integrated into a number of specific software platforms -making it a leader in the emerging IP network video space.

New relationships with companies that specialize in network video recorders, analytics, and satellite communications have increased IPIX’s market reach compared to 2004. IPIX has established new distributor agreements with three of the largest security product firms in the U.S., ADI, Anixter and ScanSource, which have deployed third party sales staff in the field to sell IPIX’s 360˚ solutions. In 2005, IPIX solidified partnerships with Aimetis, Object Video and Vistascape for video analytics; ClickIT, Initsys, Integral, Milestone, ONSSI, Petards, and Silicor to offer integrated digital video recorder (DVR)/ network video recorder (NVR) solutions.

The personnel aspect to IPIX’s strategic repositioning involved the hiring of experienced sales professionals and organizing them into market verticals. The teams were then augmented with a staff of inside sales representatives and a seasoned proposal developer. The results of this reorganization in the second half 2005 were felt immediately, first with strategic sales made in the hospitality/gaming/cultural sector; second, with the setup of trial installations in three Fortune 50 retail firms; and third through an increased level of sales through partners. IPIX expects these trends to gain momentum throughout 2006.

The new market-centric direct sales approach includes IPIX showcasing its expertise through a series of regular Webinars in late 2005 and into 2006. These were presented to customers in target verticals and featured third party experts speaking about unique solutions featuring IPIX products. Webinars staged in 2005 tested and proved the concept for 2006 by generating increased leads, creating word of mouth references, and enhancing IPIX’s image among prospects. In the same vein, IPIX provided its vertical sales teams and scientific staff with the proposal support needed to pursue large, complex federal, state and local opportunities.

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Outside the USA, the Company continued to expand and strengthen its network of resellers throughout Canada, Europe and Asia. With the termination in August 2005 of NMI Security PLC’s exclusive distribution arrangement to operate in the United Kingdom, Ireland, Italy and Switzerland, IPIX is now better positioned to penetrate the international market.

While 2005 marked growth in many aspects of IPIX’s business, it was also a time for reducing costs and eliminating operational redundancies. In May the Company completed its relocation from San Ramon, California. In August, the Company reduced its staff in both its Reston, Virginia and Oak Ridge, Tennessee offices. In November, further staff and costs were reduced in Oak Ridge, Tennessee. Although difficult, these cost-cutting measures enabled IPIX to streamline its processes and become more strategic in its focus on technology and vertical markets.

Investment in research and development continued in 2005 resulting in IPIX introducing two significant product upgrades. The CommandView™ Day/Night camera was launched at ISC-West tradeshow in March. The CommandView™ Day/Night enables users to see a 360˚ field of view with little to no available light. IPIX also released version 1.4 of its Interactive Studio™ software for its digital photography products. The most significant part of the upgrade is the integration of a new PhotoVista™ stitching extension licensed from iseemedia. With this tool, users can take advantage of IPIX stitching software without purchasing new cameras. The Company also completed work on three-megapixel versions of its CommandView Dome and Command View Cameras, which were launched in January, 2006. Built in response to retail customers’ escalating demand for greater visibility at the point of sale, the new three-megapixel product lets users see farther with greater clarity and in lower light. The increased precision enhances IPIX’s patented 360° technology, which enables multiple users to simultaneously view different areas from the same camera.

The year 2005 marked the repositioning of IPIX Corporation. New products, new partners, new contracts, the new sales organization, and a new strategic approach to the marketplace have reshaped IPIX’s opportunities as it moves from a partner-driven sales model to a direct sales model (even while the number and quality of partners improves). IPIX believes that the work done in 2005 will position it to increase sales opportunities, increase market visibility, and increase its broadly perceived “thought leadership” in video technology and video solutions.

MARKETS

The Company markets its video and stills products and services to government and commercial sectors for a variety of visual intelligence applications. According to Lehman Brothers, the digital video surveillance market is estimated to be $500 million in 2006, and according to J.P. Freeman, network cameras will outsell analog cameras by 2008.

IPIX targets government agencies with responsibility for security infrastructure protection related to ports, harbors, waterways, dams, conventional and nuclear power stations, utilities, airports and mass transit rail systems. Our product offers solutions to the military in perimeter force protection, unmanned vehicles and special operations. Our marketing to the government sphere addresses the very real need for better security and surveillance as evidenced by the fact that the total federal market for security was approximately $34 billion in 2005, and will reach $52 billion in 2010. Security equipment spending was approximately $2.5 billion in 2005 and is projected to be $3.6 billion in 2010.

IPIX also targets commercial markets such as retail outlets, hotels and casinos, schools and cultural properties with solutions for security, loss prevention, surveillance and market intelligence. Currently, over $46 billion is lost within the retail industry each year in shrinkage, and the average budget for loss prevention is 0.52 percent of a retailer’s total sales.

The Company has hired a direct sales team to drive end-user demand and manage large and national accounts. IPIX also utilizes its network of distributors, resellers and manufacturer’s representatives to reach the market. In addition, IPIX directly targets the real estate and hospitality market, professional photographers, web developers and creators of visual documentation with its still photography solutions.

CERTAIN RISKS AND CONCENTRATIONS.

Accounts receivable are derived from revenue earned from customers located in the U.S. and abroad. The Company performs ongoing credit evaluations of customers’ financial condition and the Company does not require collateral from customers.

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The following table and paragraph summarize the revenue and accounts receivable due from customers who provide IPIX more than 10% of total revenues or who owed IPIX more than 10% of outstanding accounts receivable at December 31:

		Revenues for Years ended December 31,
		2003			2004			2005
U.S. Government			—			—			26	%
British Distributor			—			41	%		14	%
Sentry 360 Security Inc.			—			—			3	%
Homestore			3	%		8	%		—

At December 31, 2005, the U.S. Government and Sentry 360 Security represented 43.5% and 9.8% of accounts receivable, respectively. At December 31, 2004, Homestore and our UK Distributor represented 21% and 11% of accounts receivable, respectively. At December 31, 2003, Homestore and eBay represented 22% and 0% of accounts receivable, respectively. The discontinued operations for 2003 include a one-time $8.0 million license fee from eBay for the Company’s Rimfire technology and other services. As announced in June 2003, the Company amended its then current commercial agreement with eBay. The Company no longer provides any products or services to eBay as of November 1, 2003.

The Company relies on a few main vendors from which we receive high quality material in a reasonable time to manufacture our products.

On October 1, 2004, the license agreement dated January 12, 2001 (the “License Agreement”) between us and Homestore Virtual Tours, Inc. (“Homestore”) was terminated. Under the License Agreement, Homestore had the exclusive right to sell our virtual tour technology to the U.S. residential real estate market and was required to pay us a royalty for each virtual tour sold. As a result of the termination, Homestore no longer has the exclusive right to sell our virtual tour technology to the U.S. residential real estate market, and we may sell, or license another third party to sell, our virtual tour technology into this market. We mutually released each other from any further obligations under the License Agreement.

COMPETITION

IPIX believes it is the recognized brand in the 360° immersive imaging industry. The growth in the industry together with increased global competition has validated the importance of this part of the imaging market. Since the early 1990’s with the introduction of its first video surveillance product, the OMNIview™, through the late 1990’s with its focus on digital photography based virtual tours, and today, with a renewed emphasis on IP enabled digital video cameras, IPIX has set the standard for immersive imaging systems with its patented technology. Even so, the Company faces competition from a wide range of solutions.

Video Surveillance Market

In the video surveillance markets, IPIX high-resolution immersive video cameras face competition from analog CCTV camera manufacturers, digital camera manufacturers and from immersive video technology providers.

In the analog CCTV marketplace, analog users enjoy less expensive cameras. This is offset in part by the expense of technical labor needed to lay video cable to each camera; additionally, users tend to require salaried staff to monitor the video feeds from the cameras (except in rare cases where analog cameras feed into a high-end digital video recorder - an unlikely combination given this type of user’s “value” orientation). The IPIX value proposition in the analog space is that one 360° camera can provide visual coverage wide enough to replace up to four low-priced directional (fixed field-of-view) cameras. Additionally, multiple IP cameras can operate on a single network “wire” where analog cameras each need extensive individual cabling. Finally, IPIX cameras have built-in detection, cueing and notification features that make 24 x 7 staff monitoring unnecessary, reducing users’ personnel costs.

A single IPIX camera can also replace an analog CCTV camera with a mechanical pan-tilt-zoom (PTZ) mechanism under certain circumstances. Given the nature of 360° technology, IPIX cameras allow users to not only PTZ in live viewing situations, but also on recorded video, whereas mechanical PTZ cameras can only record images based on where the camera was pointed during the record stage. The IPIX “digital” PTZ can achieve magnification up to ten times. IPIX cameras are complementary to traditional pan-tilt-zoom systems for some outdoor applications since they capture everything all of the time. IPIX cameras, therefore, do not require an operator to notice an incident in order to record it.

In the IP camera marketplace, IPIX offers a competitively priced product that allows a single camera to see an entire environment, unlike competing products with a limited field-of-view. Competing IP cameras with a limited field of view translate into a higher cost solution to achieve the same coverage as an IPIX camera. In markets such as retail, customers are interested in not only preventing theft or liability, but also gaining forensic knowledge for use in court cases; the 360° solution offers a record of the total environment on the sales floor, at the cash register, in the stockroom, in the parking lot, at the loading dock—or anywhere the camera is placed.

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Competitors offering 360˚ technology solutions in the security marketplace have major disadvantages compared to the IPIX patented fisheye lens based approach to video surveillance. Camera-mirror assemblies construct an immersive view with a host of problems: (1) good mirrors are more expensive than good lenses or optics; (2) mediocre mirrors provide lower resolution image capture and heighten distortion; (3) mirrors have significant blind spots; and, (4) the mirror images are not de-warped and are therefore difficult to view.

Other competitors offer multi-camera heads, which are bandwidth and storage intensive, since they require processing data from a large number of cameras. Multi-headed camera devices are configurations of typically five or more cameras that are synchronized together to capture video. In the minimum configuration, five headed cameras are oriented as if in a cube, with the top and four sides each being captured by a separate camera. Software or proprietary hardware is then required to stitch the separate images together into a single frame. In one configuration, 12 cameras are oriented to capture a full sphere whereby no stitching is required. Other variations exist that use flat mirrors or other types of lenses. The major characteristic of all multi-headed camera devices is that an extraordinary amount of data must be captured, recorded and processed for subsequent playback. Also, depending on the number of cameras and the quality of the stitching, there may be artifacts which limit the quality of the image. In contrast, the IPIX solution requires either one or two cameras at most to capture a full environment, reducing software support and processor requirements. Multi-camera solutions also tend to be more expensive than an IPIX solution.

Stills Photography Market

In the visual media and visual documentation markets for immersive still photography, IPIX faces competition from several companies. At the most basic level, options for capturing panoramic images are becoming more ubiquitous in the consumer photography marketplace. Wide field-of-view camera options such as the Advanced Photo System (APS) and tools for stitching multiple images taken by hand offer a very rudimentary solution. This type of panoramic photography is a simulation of 360˚ photography offered by IPIX. The resulting image does not capture a full 360° view, and the images captured are not interactively navigable. Most often, these images are used to make hard copy prints. IPIX believes this type of photography is not suitable for surveillance, visual documentation and forensic analysis markets which require visual intelligence.

IPIX’s immersive still photography products also face competition from mirror-based solutions and from multi-headed cameras systems. These options again fail to capture an entire environment or offer a cost effective solution for most customers. Additionally, IPIX immersive still photography products face competition from panoramic scanning cameras. Scanning cameras are high-quality devices that capture very high resolution panoramic images. These cameras generally range in cost from five to ten times the price of an IPIX camera. They utilize a linear sensor, much like those used in flat bed scanners. This sensor is rotated 360° to capture a complete panorama. Aside from the high costs, these cameras are complex and require the expertise of a professional photographer. Additionally, at the highest resolution, these cameras can take up to 15 minutes to complete a full scan, which renders them inappropriate for 360˚ image capture in scenes where there is motion or a fast, easy solution is necessary.

Traditionally, most direct competition in the 360˚ still photography market has been with single-row panorama stitching solutions. An important feature of these software “stitchers” is that in order to capture a full panorama, depending on the field-of-view of the camera lens, anywhere from 12 to 24 images may be needed in order to capture a 360° panorama. The large number of images complicates the photography process substantially. More images means more files on the computer to track and more chances for something to go wrong in the capture phase. Single row panorama software products do not capture full spherical images. For those professional grade “stitchers” that do support spherical immersive still photography, the entire process steps up to an additional level of complication. A more complicated process is required and the number of images needed increases to 36. Even with the complexities of capture, certain customers do value the higher-quality resolution possible by taking a single row panorama of 12 to 24 images and stitching them together. Through the IPIX Interactive Studio, the Company has strategic partnerships whereby IPIX offers this type of functionality integrated into its own solution.

PRODUCTS

IPIX’s patents and broad product offerings bring to the marketplace the ability to build the world’s best visual database. Its solutions include cameras kits, software tools, services, infrastructure and training to support immersive imaging. Camera systems include all of the components necessary to capture high quality immersive still photography or video.

IPIX products enable users to create 360˚ photographic images or video through the use of a wide angle or fisheye lens. IPIX still photography or video content is either a 360˚ x 180˚ (hemispherical) view taken with a single shot, or a 360˚ x 360˚ view, taken by two back-to-back hemispherical shots. Our technology can also be used for more than two shots to create higher resolution final content.

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Immersive Video Products

The video product portfolio consists of three product lines with various configurations within each product line. The product lines are: CommandView™, CommandView360™ and InSight™ camera systems. The core camera electronics and fisheye lens optics have been designed to be used across the entire product line to achieve economies of scale in manufacturing. These innovative camera systems allow the user to view live and recorded video at user definable frame rates and compression settings to conserve bandwidth and storage requirements.

CommandView™

The CommandView™ camera consists of a two or three mega-pixel sensor, a digital signal processor (DSP) module and a power distribution and communication module. CommandView™ utilizes our fisheye lens that has been optimized for the image sensor in the camera subassembly to provide a high value, highly attractive video surveillance product offering to the security market. CommandView™ comes in multiple configurations: wall-mount, ceiling-mounted dome, and for low intrusive monitoring, a flush mount kit and recessed dome kit.

IPIX believes the uses and applications of the CommandView™ are virtually limitless. Unlike the cameras it replaces, CommandView™ provides complete and continuous situational awareness. The CommandView™ camera sees everything at the same time and monitors everything in its field of view with no blind spots. Users have the ability to pan-tilt-zoom on both live and recorded video with no moving parts, as well as remotely view and manage cameras from an off-site location.

CommandView360™

CommandView360™ utilizes two camera sub-assemblies, mounted back-to-back, and one fisheye lens on each camera to provide full 360° coverage of the area of concern. Full 360° coverage means the camera is monitoring in both the horizontal and vertical dimensions at the same time.

This optical system integrates an optional off-the-shelf third party mechanical pan-tilt-zoom camera that has an optical zoom capability for long range target identification and tracking. Operation of the CommandView360™ with the mechanical pan-tilt-zoom camera is easy and efficient and allows the operator to get on target quickly by using the ‘Assisted Cue and Zoom’ feature of the CommandView360™. Targets of interest are seen through the spherical view of the CommandView360™ and the operator simply ‘mouse-clicks’ on a target of interest in the viewer screen.

The CommandView360™ software performs a mathematical calculation and sends the coordinates of the pixel that the operator ‘mouse-clicked’ on to the mechanical pan-tilt-zoom camera as positioning commands. The mechanical pan-tilt-zoom camera moves to the correct position to ‘capture’ the target and the operator then zooms in for close-up monitoring. The CommandView360™ offers operators the ability to find a target anywhere within a three dimensional space—eliminating the guess work commonly associated with traditional mechanical pan-tilt-zoom cameras.

Designed to provide the highest level of reliable operation for continuous situational awareness, the CommandView360™ is rugged in construction and small in size making it ideal for fixed, outdoor installations where customers need to protect critical infrastructure and key assets.

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InSight™

InSight™ is our entry-level digital camera system using the camera subassembly that forms the foundation of our entire product portfolio. This camera is capable of generating high quality, high resolution images at full motion frame rates that range from 15 frames per second to 48 frames per second, depending upon compression settings and number of users on the network.

The product comes in two configurations. In the ceiling-mount configuration, the user may select a fixed or a directional camera mount. The directional mount allows the user to swivel the camera to adjust the direction in which the camera is pointed. The InSight™ camera may be mounted in a parapet or rampart enclosure for outdoor use. IPIX believes the InSight™ camera fills a void that currently exists in the security video surveillance market for a fixed, high resolution network camera that is capable of delivering video at full-motion frame rates.

Integration with Leading Digital/Network Video Recording Solutions

IPIX offers a surveillance technology unlike any other. However, in order for consumers to take advantage of it, many need to integrate it into their existing surveillance solutions. High-end users of security products need to efficiently manage, store and retrieve their image streams. To meet this need, IPIX formed strategic relationships with many of the industry’s leading video recording providers including ClickIT, Initsys, Integral, Milestone, ONSSI, Petards, and Silicor. Products from these types of vendors are software based and provide a user friendly interface to a network camera that allows the user to build, manage and control a network of digital cameras and record and playback the video outputs of each camera on the network. By integrating the IPIX technology with these leading platforms, IPIX has enabled its patented 360° technology to be used by customers who have previously made a significant infrastructure investment in their CCTV systems or who plan to use these types of systems to manage their surveillance operations in the future. It also allows DVR and NVR companies to offer the most advanced solutions for capturing an entire environment.

Immersive Still Photography Products

IPIX sells complete 360˚ immersive still photography solutions which include fisheye enabled camera systems and IPIX software. The Company also serves the real estate market with a special IPIX Real Estate Wizard and an on-line virtual tour hosting service Host@IPIX. The products are based on patented technology for capturing a full 360° field of view from a digital camera in a manner that is extremely efficient for the user. By integrating the end-to-end process, including production workflow and image editing and output options, our platform enhances the workflow efficiency to provide high quality results.

IPIX Interactive Studio

The IPIX Interactive Studio (“Interactive Studio”) is our strategic platform for creating a de facto standard for the creation of 360˚ photography. The system is compatible with both Windows and Macintosh platforms and is flexible enough to integrate a wide range of traditional media types such as flat images and panoramas into a single workflow. Newly created product enhancements including the I-Linker extension allow customers to extend the usability of their immersive images by creating hotspots and linking images to other types of content such as audio or other immersive images, creating an interactive experience.

IPIX GRIDs System

The IPIX GRIDs System (Geo-Referenced Image Documentation System) provides commercial and government customers with a solution for creating immersive hot-spotted maps. The product utilizes the IPIX Interactive Studio product for immersive image creation and in conjunction with a Global Positioning System receiver, customers can create maps with location data embedded within the image.

SALES AND MARKETING

IPIX sales and marketing work together—both internally and externally—to communicate value propositions, develop sales, and to optimize opportunities.

According to J.P. Freeman, the IP surveillance market is growing at an annual rate of 48 percent such that by 2008 IP cameras will outsell analog cameras. We believe our strong brand recognition positions the Company to capture significant opportunities in this emerging market. However, in 2005 it was necessary to educate the security and surveillance market about the value of 360˚ technology solutions, and the emerging standards of IP video. In 2006 IPIX will continue to educate end users and build its brand through traditional tradeshows, media outreach, public relations, and advertising, but less so than in 2005. Our value proposition will more directly be delivered by our new enterprise sales team and partners.

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As mentioned, IPIX shifted its strategy in 2005 from having generalist sales staff located across the United States and Europe to having a centralized sales force with vertical expertise in its Reston, Virginia office. Teams are focused on large revenue opportunities targeting early adopters of the IP video technology in different vertical markets. Given new solutions offered by vertical focused sales representatives, our teams will stimulate market interest for 360˚ technologies in opportunities where prospects may have only been aware of conventional analog technologies.

The Company’s new relationships with three major security distribution companies—ADI, Anixter, and ScanSource—will create exposure for our technology among large buyers of video technology; IPIX will reach smaller end-users through resellers. Our partner outreach programs will continue to serve and educate security and architectural and engineering consultants who may recommend our technology in new construction and retrofit projects.

IPIX still photography products—software, hardware, and training—were sold worldwide through a tele-sales model in 2005. The tele-sales team is located in the Reston, Virginia office where they handle sales and inquiries. IPIX also manages an on-line store through our Web site (www.ipixstore.com) where customers may purchase our still photography products. Historically, the photography vertical markets have been real estate agents, photographers, and Web developers. The Company has previously marketed to such buyers through Web-based advertising campaigns. However, after combining all product lines under one umbrella in 2005, the Company’s approach is to “cross-sell” photography products to video users and vice versa. This has led to a number of opportunities currently under development in new vertical markets such as government, critical infrastructure and emergency management.

INTELLECTUAL PROPERTY

IPIX relies on a combination of patent, copyright, trade secret and trademark laws and contractual restrictions to establish and protect proprietary rights in its products. Patents are intended to protect and support current and future development of IPIX technology. IPIX currently has over 20 U.S. patents. Provisional patents have been filed on the Gigapixel camera being developed under the DARPA contract. In addition, it holds international counterparts to many U.S. patents in selected countries covering various aspects of products. IPIX has numerous patent applications pending in the United States as well as international counterparts to many of these applications. Finally, it has a non-exclusive and royalty-free license under numerous U.S. and foreign patents from Sarnoff Corporation and from Motorola, Inc. related to immersive imaging technologies and techniques. There can be no assurance that our current and future patent applications will be granted, or, if granted, that the claims covered by the patents will not be reduced from those included in our applications.

IPIX’s success and ability to compete are dependent on its ability to develop and maintain the proprietary aspects of its technology and operate without infringing on the proprietary rights of others. It seeks to limit disclosures about intellectual property by requiring employees, suppliers and customers with access to our proprietary information to execute confidentiality agreements and by restricting access to source code. Despite efforts to protect these proprietary rights, unauthorized parties may attempt to copy aspects of services or software or to obtain and use information that IPIX regards as proprietary. The Company has experienced wrongful use in the past, and although it has taken steps to stop that use, more attempts in the future can be expected. The laws of many countries do not protect proprietary rights to as great an extent as do the laws of the United States. Litigation may be necessary in the future to enforce intellectual property claims, to protect trade secrets, to determine the validity and scope of the proprietary rights of others, or to defend against claims of infringement or invalidity. There can be no assurance that the statutory and contractual arrangements IPIX currently depends upon will provide sufficient protection to prevent misappropriation of its technology or deter independent third-party development of competing technologies.

Claims by third parties that current or future IPIX products infringe upon their intellectual property rights may have a material adverse effect on us. Intellectual property litigation is complex and expensive, and the outcome of this litigation is difficult to predict. IPIX has been involved in litigation relating to the protection of intellectual property rights. Such litigation, and any future litigation, regardless of outcome, may result in substantial expense and significant diversion of management and technical resources. An adverse determination in any litigation may subject IPIX to significant liabilities to third parties, require IPIX to license disputed rights from other parties, if licenses to these rights could be obtained, or require IPIX to cease using the disputed technology.

EMPLOYEES

As of March 1, 2006 we employed 34 full-time employees. Our employees are not represented by any collective bargaining unit. We believe our relations with our employees are good.

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AVAILABLE INFORMATION

Our website is located at www.ipix.com. We make available free of charge through this website all of our Securities and Exchange Commission (“SEC”) filings, including our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and all amendments to those reports, as soon as reasonably practicable after those reports are electronically filed with the SEC (www.sec.gov).

Item 1A. Risk Factors.

Our limited operating history and recent changes in our customer base makes it difficult to evaluate our business

In early 2004, we launched several new products for video surveillance and immersive photography. Additionally, in February 2005, we sold our AdMission business unit. As a result, we have a limited operating history of the Company in 2005 and upon which you can base an evaluation of our business and prospects. Our prospects must be considered in the light of the risks, uncertainties, expenses and difficulties frequently encountered by companies that have undertaken a substantial business restructuring. To address these risks and uncertainties, we must, among other things:

·  maintain and enhance our brand and expand our immersive product and service offerings;
·  expand our customer base for all product offerings;
·  attract, integrate, retain and motivate qualified personnel; and
·  adapt to meet changes in our markets and competitive developments.

We may not be successful in accomplishing these objectives.

We have a history of losses, and we expect to continue to incur losses and may not achieve or maintain profitability.

The extent of our future losses and the timing of profitability are highly uncertain, and we may never achieve profitable operations. As of December 31, 2005, we had a total accumulated deficit of approximately $541 million. Historically, our net sales have varied significantly. We will need to generate additional revenue to achieve profitability in the future. If we are unable to achieve profitability or to maintain profitability if achieved, it may have a material adverse effect on our business and stock price and we may be unable to continue operations at the current levels, if at all. We cannot provide any assurances that we will generate additional revenues or achieve profitability.

Additional capital or strategic alternatives may be required for us to continue our operations and as a result, our independent registered public accounting firm’s report includes an explanatory paragraph that states that significant matters exist that raise substantial doubt about our ability to continue as a going concern.

If we are not successful in increasing our revenues or cutting costs, we may be required to reduce operations further, seek additional equity financing or financing from other sources, or consider other strategic alternatives, including a possible merger, sale of assets or other business combination or restructuring transactions. There can be no assurances that additional financing or strategic alternatives will be obtainable on terms acceptable to us or that any additional financing would not be substantially dilutive to existing stockholders. The holders of our Series B preferred stock have rights that are senior to those of the holders of our common stock in the event of the sale of our Company or in the event of our liquidation, dissolution or winding up. We have included a “going concern” footnote in our audited financial statements for fiscal 2005. See Financial Statements - Note 3.

Our operating results are highly dependent on the development of new products and technologies, and marketing them in order to generate revenue from new markets

Our results are subject to risks related to our significant investment in developing and introducing new products and services. These risks include: (i) difficulties and delays in the development, production, testing and marketing of products and services; (ii) customer acceptance; (iii) the development of industry standards; (iv) the significant amount of resources we must devote to the development of new technology; and (v) the ability to differentiate our products or services and compete with other companies in the same markets.

We may not be able to develop and market new products and technologies and generate revenues. This could have a material adverse effect on our financial results.

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Our operating results are highly dependent on obtaining adequate supplies of the components of our products

Our ability to meet customer demands depends, in part, on our ability to obtain timely and adequate delivery of quality materials, parts and components from our suppliers and external manufacturing capacity. Although we work closely with our suppliers to avoid these types of shortages, there can be no assurances that we will not encounter these problems in the future. A reduction or interruption in supplies or a significant increase in the price of one or more supplies could have a material adverse effect on our revenues and operating results.

Failure to manage expenses would prevent us from achieving profitability

We may have to increase our operating expenses in order to increase our customer base, enhance our brand image and support our growing infrastructure. In order for us to become profitable, we must increase our revenues and gross profit margins sufficiently to cover current and future operating expenses. If we fail to do so, we may never achieve sustained profitability.

In late 2003, we reduced the number of employees in the business unit that previously supported our largest customer. In February of 2005, we sold this business unit to AdMission Corporation as previously disclosed. During 2005, we further reduced the number of employees in all functional areas of the Company. We continue to streamline our cost structure but recognize the need to increase some sales and marketing costs that directly benefit the sale of security products. As a result, we hope to lower our future break-even revenue level. If we fail to do so, we may be required to implement further cost reductions that could adversely affect our business.

Since the first half of 2000, we have been reducing costs and simplifying our product portfolios in all of our businesses. We discontinued product lines, exited businesses, consolidated operations and reduced our employee population. The impact of these cost-reduction efforts on our revenues and profitability may influence our ability to successfully complete these ongoing efforts; our ability to generate the level of cost savings we expect or that are necessary to enable us to effectively compete; the risk that we may not be able to retain key employees; and the performance of other parties under outsourcing arrangements.

Another cost-reduction action has been to develop outsourcing arrangements for the design and/or manufacture of certain products and components. If these third parties fail to deliver quality products and components on time and at reasonable prices, we could have difficulties fulfilling our orders and our revenues and operating results could be negatively impacted.

Our quarterly results may fluctuate, which could make financial forecasting difficult and increase volatility in our common stock

Our revenues and operating results may vary significantly from quarter-to-quarter. As a result, quarter-to-quarter comparisons of our revenues and operating results may not be meaningful. In addition, due to our limited operating history and restructuring, it may be difficult to predict our future revenues and results of operations accurately. It is likely that, in one or more future quarters, our operating results will fall below the expectations of investors. If this happens, the trading price of our common stock is likely to be materially and adversely affected.

We are dependent on a few products

We anticipate that most of our revenue growth in the future, if any, will come from our visual intelligence technologies within both the commercial and government market segments. We may not be able to successfully increase sales of our current product offering. Additionally, our efforts to market new products and enhancements to our existing products may not be successful. If we are unable to continue to develop our products or if we are not successful in marketing and selling our new products, our financial condition could be materially and adversely affected. Additionally, camera technology is changing rapidly and we cannot be sure that our technology will continue to be attractive to customers or that technological advances will not render some inventory items such as cameras and lenses obsolete.

Our success depends on our ability to protect our intellectual property

We rely on trademark, copyright and patent law, trade secret protection and confidentiality or license agreements with our employees, customers, partners and others to protect our proprietary rights. If we are not successful in protecting our intellectual property, there could be a material adverse effect on our business.

While we believe that our issued patents and pending patent applications help to protect our business, there can be no assurance that:

·  any patent can be successfully defended against challenges by third parties;
·  pending patent applications will result in the issuance of patents;
·  our competitors or potential competitors will not devise new methods of competing with us that are not covered by our patents or patent applications;
·  new prior art will not be discovered which may diminish the value of or invalidate an issued patent; or
·  a third party will have or obtain one or more patents that prevent us from practicing features of our business or will require us to pay for a license to use those features.

 

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Also, our patents, service marks or trademarks may be challenged and invalidated or circumvented. In addition, we are exposed to infringement of our intellectual property in foreign markets because our intellectual property is protected under United States laws that may not extend to foreign uses. We have been and are currently involved in litigation relating to the protection of intellectual property rights and could be involved in future litigation as third parties develop products that we believe infringe on our patents and other intellectual property rights. We have experienced attempts to misappropriate our technology, and we expect those attempts may continue. We have been involved in litigation in which our rights to technology have been challenged. The cost of such litigation, or the determination against us in this type of lawsuit, could have a material adverse effect on our business.

Compliance with changing regulation of corporate governance and public disclosure may result in additional expenses.

Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and NASDAQ National Market rules, are creating uncertainty for companies such as ours. These new or changed laws, regulations and standards are subject to varying interpretations in many cases due to their lack of specificity, and as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies, which could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices. We are committed to maintaining high standards of corporate governance and public disclosure. As a result, our efforts to comply with evolving laws, regulations and standards have resulted in, and are likely to continue to result in, increased general and administrative expenses and a diversion of management time and attention from revenue-generating activities to compliance activities. In particular, our efforts to comply with Section 404 of the Sarbanes-Oxley Act of 2002 and the related regulations regarding our required assessment of the effectiveness of our internal control over financial reporting and our independent registered public accounting firm’s audit of that assessment has required the commitment of significant financial and managerial resources. We expect these efforts to require the continued commitment of significant resources. Further, our board members, chief executive officer and chief financial officer could face an increased risk of personal liability in connection with the performance of their duties. As a result, we may have difficulty attracting and retaining qualified board members and executive officers, which could harm our business. If our efforts to comply with new or changed laws, regulations and standards differ from the activities intended by regulatory or governing bodies due to ambiguities related to practice, our reputation may be harmed.

If we lose key members of our personnel, our future success could be limited

Our future success depends on our ability to attract and retain key management, engineering, technical and other personnel. In addition, we must recruit additional qualified management, engineering, technical and marketing and sales and support personnel for our operations. Competition for this type of personnel is intense, and we may not be successful in attracting or retaining personnel. We do not maintain key person life insurance for any of our personnel. The loss of the services of one or more members of our management group or other key employees or the inability to hire additional qualified personnel will limit our ability to grow our business.

Our success is dependent upon our ability to adapt to technological changes, and if we fail to do so, our offerings may become obsolete

We compete in a market characterized by rapidly changing technology, evolving industry standards, frequent new service and product announcements, introductions and enhancements and changing customer demands. These market characteristics are intensified by the emerging nature of the Internet and the multitude of companies offering Internet-based products and services. Thus, our success depends on our ability to adapt to rapidly changing technologies, to adapt our offerings to evolving industry standards and to continually improve the performance, features and reliability of our offerings in response to competitive products and shifting demands of the marketplace.

We may not be successful in expanding our business into international markets

A part of our long-term strategy has been to expand into international markets. The success of any additional foreign operations will be substantially dependent upon our entering and succeeding in those markets, including through distributors, joint ventures or other indirect strategies. We may experience difficulty in managing international operations as a result of competition, technical problems, distance, language or cultural differences.

As we manage our international efforts, we will be subject to a number of risks, including the following:

·  failure of foreign countries to rapidly adopt digital imaging or other required technologies;
·  unexpected changes in regulatory requirements;
·  slower payment and collection of accounts receivable than in our domestic market; and
·  political and economic instability.

 

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We cannot assure you that we will be able to successfully market our products in foreign markets.

Conversion of Series B Preferred Stock into Common Stock and the payment of accrued dividends associated with such Preferred Stock could adversely affect stockholders

The holders of our Series B preferred stock may at their election convert each share of preferred stock into approximately 9.2 shares of our registered common stock. Accrued dividends on the preferred stock become due and payable upon such conversions. The holder of the preferred stock may elect to receive the dividends in additional common stock or cash. As a result, these conversions could require us to use available funds to finance dividends or dilute existing shareholders by introducing new common stock into the market. As a result, our financial condition or the market price of our common stock could be adversely affected.

Our certificate of incorporation and bylaws contain anti-takeover provisions that may make it more difficult or expensive to acquire us in the future, which could negatively affect our stock price

Our amended and restated certificate of incorporation and amended and restated bylaws and applicable provisions of Delaware law contain several provisions that may make it more difficult for a third party to acquire control of us without the approval of our board of directors. In addition, in October of 2000, our board of directors approved a stockholder rights plan that has the effect of making an acquisition of us prohibitively expensive unless our board of directors approves of the acquisition. The provisions of our certificate and bylaws and the Delaware General Corporation Law may make it more difficult or expensive for a third party to acquire a majority of our outstanding voting common stock or delay, prevent or deter a merger, acquisition, tender offer or proxy contest, which may negatively affect our stock price.

Our market is highly competitive, and our business may suffer if we are unable to compete successfully

The market for our immersive products is rapidly evolving. The market for immersive products and services is also highly competitive. We compete with other providers of immersive imaging technology who develop and market products and services similar to ours. We expect additional competition from other emerging and established companies. There can be no assurance that the Company’s current and potential competitors will not develop products that are more effective than our current or future products, or that our products and technology will not be rendered obsolete by such developments. Some of our competitors have longer operating histories, greater name recognition and significantly greater financial, technical and marketing resources. As a result, they may be able to adapt more quickly to new or emerging technologies and changes in customer requirements or devote greater resources to promotion and sale of their products than us. Our business will suffer if we are unable to compete effectively.

Terrorist activities and resulting military and other actions could adversely affect our business

Terrorist attacks in recent years have disrupted commerce throughout the United States and other parts of the world. The continued threat of terrorism within the United States and abroad, and the continued military action and heightened security measures, may cost significant disruptions to global commerce. Such disruptions could result in a general decrease in corporate spending on information technology or our ability to effectively market and sell our products and services. Such events could have material adverse affect on our business.

Item 1B. Unresolved Staff Comments.

None.

Item 2. Properties.

On April 18, 2005 IPIX Corporation (the "Company") entered into a sublease agreement (the "Sublease") with Thomas Group, Inc. (the "Sublessor") with respect to the Company's new corporate headquarters in Reston, Virginia for our sales, marketing, engineering and corporate offices. The Sublease is for a period of 31 months beginning April 15, 2005. The base rent is approximately $297,668 per year and will increase by approximately three (3%) percent each year beginning April 1, 2006. In addition to the base rent, the Company is responsible for any increases in operating expenses and property taxes billed to the landlord and paid by the Sublessor. The Company is also responsible for the costs of tenant improvement. All terms and conditions of the master lease between the Sublessor and REC Partners, L.P. dated February 15, 2000 are incorporated into and made part of the Sublease.

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As of December 31, 2005, we leased approximately 20,000 square feet of space in Oak Ridge, Tennessee and approximately 25,500 square feet in San Ramon, California. On March 13, 2006, the Company agreed to terminate, effective March 8, 2006, the lease agreement it entered into on February 3, 2005 with Oak Ridge Technical Center Partners - One, L.P. The terms of the agreement to terminate included IPIX’s agreement to pay Oak Ridge Technical Center Partners - One, L.P. (1) a one-time, lump-sum payment in the amount of $198,500, due and payable immediately; (2) prorated rent through March 8, 2006 - $5,606, and (3) prorated Tenant Improvement expense though March 8, 2006 - $596. Oak Ridge Technical Center Partners - One, L.P. has agreed to: (1) act as intermediary in the sale of IPIX’s furniture to a third party for $40,000; and (2) deduct that amount from the above payments due from IPIX.

We are marketing the San Ramon property for sublease and have sub-let approximately 6,673 square feet in San Ramon as of December 31, 2005. We are actively marketing the remaining space to potential sub-tenants. If we are unable to successfully sublease our vacated and unoccupied office space, or if any of our current sub-tenants fail to make required lease payments, our business, financial condition, results of operations and cash flows may be adversely affected. (See Note 11 to our consolidated financial statements included elsewhere in this Form 10-K.)

 

Item 3. Legal Proceedings

On June 15, 2003, the Company filed an action against Mr. Ford Oxaal and his company, Minds-Eye-View, (together, “Oxaal”) in the United States District Court for the Eastern District of Tennessee. In the complaint, the Company asserted claims for patent infringement, false designation of origin, false description or representation, unfair or deceptive acts and tortious interference in connection with Oxaal’s competing software product marketed under the name “Click Away.” On August 8, 2003, Oxaal filed its answer asserting counterclaims for non-infringement, invalidity, unenforceability, breach of contract, patent misuse, Lanham Act violations and tortious interference. The Company denied all of Oxaal’s allegations. The case was stayed pending settlement negotiations, which have since terminated. On March 15, 2005, a motion was filed by the Company to vacate the stay so that the lawsuit can proceed in due course. In September, 2005, the court decided to continue the stay until the Grandeye litigation is completed.

On March 14, 2005, Grandeye, Ltd. filed suit against IPIX in the U.S. District Court for the Eastern District of Virginia, Norfolk Division, seeking a declaratory judgment that (1) its Halocam products do not infringe any valid claim of U.S. Patents No. 5,359,363 (“the ‘363 patent”), 6,603,502 B2 (“the ‘502 patent”), and Re 36,207 (“the ‘207 patent”), all three of which are owned by IPIX; (2) these three patents are invalid; and (3) these three patents are unenforceable as a result of inequitable conduct committed during prosecution of the patent applications leading to the patents. Grandeye also asserted various state law claims alleging damage to its business relationships as a result of alleged statements and conduct of IPIX. Grandeye also included in its Complaint a claim for antitrust violations but has since dismissed that antitrust claim with prejudice. IPIX has asserted substantial defenses to Grandeye’s claims and filed a counter-suit against Grandeye for infringement of the ‘363 patent, ‘502 patent, and ‘207 patent. IPIX has vigorously defended, and continues to defend, its positions. IPIX has filed a motion seeking summary judgment as to Grandeye’s state law claims, and Grandeye has filed a motion seeking a summary judgment that its Halocam SP products do not infringe any claims of the ‘363 patent, ‘502 patent, or ‘207 patent. The parties have opposed each other’s motions and the parties’ arguments regarding both summary judgment motions were heard by the Court on January 18, 2006. The Court held a hearing during the period November 7-10, 2005, at which the parties presented their positions regarding the proper construction of the terms in the patents’ claims. The Court has vacated the trial date in the case, and stayed all proceedings for 90 days, so that it can review and decide the parties’ cross motions for summary judgment. The Court indicated that it should have a written decision on these motions at the end of the 90 day stay period.

The Company intends to vigorously defend each of the above referenced lawsuits. Because of the inherent uncertainties related to this type of litigation, the Company is unable to predict the ultimate outcome of these cases, or the likelihood or amount of our potential liability, if any, of these cases. However, if the Company is not successful in defending or settling these matters, these cases could have a material adverse effect on the business, financial condition, results of operations or cash flows of the Company. The Company will incur substantial costs in defending these lawsuits.

Like many companies whose success is dependent on emerging technologies and intellectual property, the Company is subject to potential technology related claims such as product state-of-the-art technology and associated marketability. The Company may be subject to claims from distributors and others regarding their purchases from the Company related to subsequent technological advances and the associated market price considerations. The Company is not currently a party to any other legal proceedings, the adverse outcome of which, individually or in the aggregate, is believed could have a material adverse effect on the business, financial condition, results of operations or cash flows of the Company.

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Item 14. Principal Accountant Fees and Services

The information called for by this item is incorporated herein by reference to IPIX’s Proxy Statement for its Annual Meeting of Stockholders to be held on or about June 23, 2006, to be filed with the SEC pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended.

PART IV

 

 

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IPIX CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. THE COMPANY

IPIX Corporation (“IPIX” or “Company”), formerly Internet Pictures Corporation, provides mission-critical imaging solutions for commerce, communication and security applications. The Company’s solutions create, process and manage a rich variety of media including still images, 360° by 360° immersive images and video. During 2004, the Company focused on realigning its core competencies with its strategic business goals. The InfoMedia business unit, formerly responsible for the development, marketing and sales of immersive photography products, was integrated with the security business unit. The still photography product teams now work closely with the video product teams leveraging mature development processes and expertise, and the sales and marketing of each product line is conducted as a coordinated effort. In markets where customers benefit from combined products (video and stills) in a single offering, this new structure allows IPIX to do so seamlessly. In addition, in February 2005 we sold the AdMission business unit, which developed and sold products to the on-line advertising market. In accordance with Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standard (“FAS”) No.144, “Accounting for the Impairment or Disposal of Long-Lived Assets"(“FAS 144”), the assets and liabilities related to the AdMission business unit were classified as held for sale at December 31, 2004, and the operations of this business unit were considered discontinued operations (see Note 4).

The Company’s extensive intellectual property covers patents for 360° imaging, video and surveillance applications.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

PRINCIPLES OF CONSOLIDATION. The consolidated financial statements include the accounts of IPIX Corporation and its wholly-owned subsidiaries, Interactive Pictures Corporation, Interactive Pictures UK Limited, Internet Pictures (Canada) and PW Technology, Inc. The consolidation of these entities will collectively be referred to as the Company. All significant intercompany balances and transactions have been eliminated.

FOREIGN CURRENCY TRANSLATION. The functional currency of the Company’s Canadian and United Kingdom subsidiaries is the U.S. dollar. Monetary assets and liabilities denominated in foreign currencies are translated into the Company’s functional currency, U.S. dollars, at the exchange rate prevailing at the balance sheet date. Non-monetary assets and liabilities and transactions are translated at exchange rates prevailing at the respective transaction dates. Revenue and expenses are translated at the average rates of exchange during the year. Translation gains and losses are recorded in accumulated other comprehensive income. Transaction exchange gains and losses are included in the statement of operations and have not been material for any periods presented. As of December 31, 2003, the Company ceased operations in its Canadian and United Kingdom subsidiaries. Such subsidiaries have been liquidated. Accordingly, the balance in the accumulated other comprehensive loss account was recognized in the statement of operations for the year ended December 31, 2003.

CASH, CASH EQUIVALENTS, RESTRICTED CASH AND SHORT-TERM INVESTMENTS. The Company considers all highly liquid debt instruments with an original maturity or remaining maturity at date of purchase of three months or less to be cash equivalents. All other liquid investments are classified as either short-term or long-term investments.

Management determines the appropriate classification of investment securities at the time of purchase and re-evaluates such designation as of each balance sheet date.

At December 31, 2004 and 2005, the Company had a certificate of deposit of $1.45 million and $1.48 million, respectively, each with a remaining maturity of six months and an interest rate of 1.64% and 1.64%, respectively. The certificates of deposit are classified as short-term investments. At December 31, 2004, $0.55 million of those investments had been provided as collateral for a letter of credit related to certain capital lease obligations and, accordingly, classified as restricted. In the third quarter of 2005, the Company bought out the capital lease and the restricted cash was released.

Interest income includes interest earned on our cash reserves.

CERTAIN RISKS AND CONCENTRATIONS. Financial instruments that potentially subject the Company to a concentration of credit risk consist of cash and cash equivalents, restricted cash and short-term investments and accounts receivable. Cash, cash equivalents and restricted cash and short-term investments are deposited with high quality financial institutions. Accounts receivable are derived from revenue earned from customers located in the U.S. and abroad. The Company performs ongoing credit evaluations of customers’ financial condition and the Company does not require collateral from customers.

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		Revenues for Years ended December 31,
		2003			2004			2005
U.S. Government			—			—			26	%
British Distributor			—			41	%		14	%
Sentry 360 Security Inc.			—			—			3	%
Homestore			3	%		8	%		—

At December 31, 2005, the U.S. Government and Sentry 360 Security represented 43.5% and 9.8% of accounts receivable, respectively. At December 31, 2004, Homestore and our UK Distributor represented 21% and 11% of accounts receivable, respectively. At December 31, 2003, Homestore and eBay represented 22% and 0% of accounts receivable, respectively. The discontinued operations for 2003 include a one-time $8.0 million license fee from eBay for the Company’s Rimfire technology and other services. As announced in June 2003, the Company amended its then current commercial agreement with eBay. The Company no longer provides any products or services to eBay as of November 1, 2003.

The Company relies on a few main vendors from which we receive high quality material in a reasonable time to manufacture our products.

On October 1, 2004, the license agreement dated January 12, 2001 (the “License Agreement”) between us and Homestore Virtual Tours, Inc. (“Homestore”) was terminated. Under the License Agreement, Homestore had the exclusive right to sell our virtual tour technology to the U.S. residential real estate market and was required to pay us a royalty for each virtual tour sold. A copy of the license agreement was filed as Exhibit 10.16 to our quarterly report on Form 10-Q filed with the Securities and Exchange Commission on April 2, 2001. As a result of the termination, Homestore no longer has the exclusive right to sell our virtual tour technology to the U.S. residential real estate market, and we may sell, or license another third party to sell, our virtual tour technology into this market. We mutually released each other from any further obligations under the License Agreement.

INVENTORY. Inventory, which consists primarily of digital cameras and related hardware, is stated at the lower of cost or market, with costs determined using first-in, first out method (FIFO). The Company conducts a physical inventory quarterly and routinely reviews material for any impairment either because of technical obsolescence or because the inventory exceeds by a material amount the forecasts for Company sales. The Company records a provision for obsolete or excess inventory whenever impairment has been identified.

PREPAID EXPENSES. Prepaid expenses consist primarily of pre-payments of insurance, rent, maintenance and trade deposits which will be reflected as an expense during the periods benefited.

COMPUTER HARDWARE, SOFTWARE AND OTHER. Computer hardware and software are recorded at cost and are depreciated using the straight-line method over estimated useful lives, which range from two to three years. Furniture and fixtures are depreciated using the straight-line method over the estimated useful life, which range from two to five years. Leasehold improvements are amortized using the straight-line method over the term of the lease or estimated useful life, which ranges from one to five years. Routine maintenance and repair costs are expensed as incurred. The costs of major additions, replacements and improvements are capitalized. Gains and losses from disposals are included in operations as incurred.

ACCOUNTING FOR LONG-LIVED ASSETS. The carrying value of intangible assets, computer hardware and software and other long-lived assets is reviewed on a regular basis for the existence of facts, both internally and externally, that may suggest impairment. The Company recognizes impairment losses whenever events or circumstances result in the carrying amount of the assets exceeding the sum of the expected future cash flows associated with such assets. The measurement of the impairment losses to be recognized is based on the difference between the discounted cash flows from such assets and the carrying amounts of the assets. In December of 2005, the Company identified certain fixed assets that we plan to sell. These assets were identified and an appropriate valuation allowance was determined. The assets will not be depreciated further. These assets are presented on the consolidated balance sheet as assets held for sale net of the appropriate valuation allowance.

GOODWILL AND OTHER INTANGIBLES. Under Financial Accounting Standards Board Statement of Financial Accounting Standards 142,“Goodwill and Other Intangibles” (FAS 142), the Company no longer amortizes goodwill but rather evaluates goodwill for impairment on an annual basis and on an interim basis if events or changes in circumstances between annual impairment tests indicate that the asset might be impaired. The Company periodically reviews the net realizable value of its intangible assets, including goodwill, through an assessment of the estimated future cash flows related to such assets. The reviews determine whether future cash flows over the remaining estimated useful lives of the assets provide for recovery of the assets. In assessing the recoverability of goodwill, the Company must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the goodwill. These estimates include forecasted revenues and operating expenses, which are inherently difficult to predict. The Company’s assumptions about fair values require significant judgment because broad economic factors, industry factors and technology considerations can result in variable and volatile fair values.

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INCOME TAXES. The Company uses the asset and liability method of accounting for income taxes, which requires the recognition of deferred tax liabilities and assets for expected future tax consequences of temporary differences between the carrying amounts and the tax basis of assets and liabilities. A valuation allowance against deferred tax assets is recorded if, based upon available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. Tax credits are accounted for as a reduction of tax expense in the year in which the credits reduce taxes payable.

The Company did not recognize deferred income taxes for temporary differences associated with its investment in the foreign subsidiaries because the differences are essentially permanent in duration.

As of December 31, 2003, the Company has ceased operations in its Canadian and United Kingdom subsidiaries; accordingly, the balance in the intercompany accounts with these subsidiaries has been recognized for tax purposes only in the results of operations for the year ended December 31, 2003. In addition, the Company has liquidated its Canadian and United Kingdom subsidiaries. Prior to 2003, Interactive Pictures UK Limited was not included in the tax filing of its parent, IPIX Corporation. As a result, Interactive Pictures UK Limited filed a separate return with the United Kingdom tax authorities. Prior to 2003, Internet Pictures (Canada), Inc. was not included in the tax filing of its parent, IPIX Corporation. As a result, Internet Pictures (Canada), Inc. filed a separate return with Canadian tax authorities.

REVENUE RECOGNITION. We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the contract price is fixed or determinable, and collectibility is reasonably assured.

We derive revenue from sales of our hardware, sales of licenses and keys for our software and professional services we provide to customers. Professional service revenues include effort performed under government contracts. Formerly professional services consisted of transaction hosting revenue where a reseller uses image management products to enhance their on-line offering. Transaction hosting revenue was primarily performed by the AdMission business unit which was discontinued in 2004 and sold in the first quarter of 2005.

Transaction hosting revenue (which is included in discontinued operations) was recognized ratably as transactions were performed provided there was persuasive evidence of an arrangement, the fee was fixed or determinable and collection of the resulting receivable was reasonably assured.

Hardware and software revenue is recognized upon shipment, if the contract shipping term is FOB shipping point, and upon delivery, if the contract shipping term is FOB destination, provided there are no uncertainties surrounding product acceptance, persuasive evidence of an arrangement exists, there are no significant vendor obligations, the fees are fixed or determinable and collection is reasonably assured. Initial license fees are recognized when a contract exists, the fee is fixed or determinable, software delivery has occurred and collection of the receivable is reasonably assured. If there are continuing obligations, then license fees are recognized ratably over the life of the contract. Revenue from hardware and software sales to distributors is recognized upon shipment (“sell-in”) if the distributor relationship does not create substantial uncertainty regarding fixed or determinable fees and collectibility. If at the beginning of an arrangement we determine the arrangement fee is not, or is presumed to not be, fixed or determinable, or there is uncertainty over collectibility, revenue is deferred and subsequently recognized as amounts become due or collected.

The Company recognizes revenue in accordance with Statement of Position (“SOP”) No. 97-2, “Software Revenue Recognition” and SOP No. 98-9, “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions.” If a contract requires significant production, modification or customization of the software, the arrangement is accounted for as a long-term service contract. If it does not, software revenue is realizable when the following criteria are met: persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the seller’s price to the buyer is fixed or determinable and collectibility is reasonably assured.

Other criteria that must be met include the determination of whether the revenue in multiple-element arrangements can be recognized separately for each element as performance occurs and the determination of the fee based on vendor-specific objective evidence (“VSOE”) of fair value for each element. The Company determines VSOE of fair value of each element by the price charged when the same element is sold separately or based on Management’s established prices for elements such as professional rates on comparable service contracts or the price of software with the same functionality available in the industry. If management is unable to determine the VSOE of a delivered element, the revenue is recognized by the residual method. As performance occurs, the fee for the delivered item is determined by the total fee of the arrangement less the total fair value of the undelivered elements. The total fair value of the undelivered elements is deferred and subsequently recognized as performance occurs. If management is unable to determine the VSOE of an undelivered element, all revenue from the contract is deferred until the VSOE is established or all performance has occurred. If the only undelivered element without VSOE of fair value is services that can be accounted for separately, the entire fee is recognized over the service period.

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Our professional service revenue under government contracts consist primarily of services provided by our employees, consultants and the pass through of costs for equipment or other third party services. Cost of services consists primarily of compensation expenses for program personnel, the fringe benefits associated with this compensation, consulting labor and other direct expenses incurred to complete programs, including cost of equipment. The current government contract is a cost-plus-fixed-fee contract. Revenues for cost-reimbursement contracts are recorded as reimbursable costs are incurred, including a pro-rata share of the contractual fees.

The Company recognizes other professional service revenue from long-term service contracts in accordance with Accounting Research Bulletin (“ARB”) No. 45, “Long-Term Construction Type Contracts,” using the relevant guidance in SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts,” as determined by the terms and conditions of the Company’s contracts with its customers. Revenue is typically recognized ratably over the contractual periods or as services are performed. In addition, when professional service contracts involve software that is essential to the functionality of the delivered software product, revenue from the entire arrangement is recognized as services are performed on a percentage of completion method or not until the contract is completed. In fixed price contracts, revenue is recognized based on the percentage of completion method, income is recognized at a consistent profit margin over the period of performance based on estimated profit margins at completion of the contract. This method of accounting requires estimating the total revenues and total contract cost at completion of the contract. Estimated losses on contracts at completion are recognized when identified.

FAIR VALUE OF FINANCIAL INSTRUMENTS. Carrying amounts of the Company’s financial instruments including short-term investments, accounts receivable, and accounts payable approximate fair value due to their short maturities. Obligations under capital leases are recorded at discounted value of the future lease payments and approximate fair value.

SHIPPING AND HANDLING COSTS. Costs incurred for shipping and handling are included in cost of revenues at the time the related revenue is recognized. Amounts billed to a customer for shipping and handling are reported as revenue.

RESEARCH AND DEVELOPMENT COSTS. Research and development expenditures are expensed as incurred. Research and development costs associated with the contract work on behalf of the U.S. Government are booked to cost of goods sold.

ADVERTISING EXPENSES. All advertising expenditures are expensed as incurred. Advertising expenses for 2003, 2004 and 2005, were $1.5 million, $0.2 million and $0.3 million, respectively.

STOCK-BASED COMPENSATION. The Company has adopted the disclosure provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-based Compensation"(“FAS 123”) as amended by FAS No. 148, “Accounting for Stock-based Compensation.” The Company has elected to continue accounting for stock-based compensation issued to employees using Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (“APB 25”). Under APB 25, compensation expense is based on the difference, if any, on the date of grant, between the fair value of the Company’s stock and exercise price of the option. Stock and other equity instruments issued to non-employees have been accounted for in accordance with FAS 123 and Emerging Issues Task Force Issue No. 96-18, “Accounting for Equity Instruments Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods, or Services,” and valued using the Black-Scholes model.

The following table illustrates the effect on net loss available to common stockholders and earnings per share if the Company had adopted the fair value recognition provisions of FAS 123 to stock-based employee compensation:

		FOR YEARS ENDED DECEMBER 31,
					2003			2004			2005
		(In thousands, except per share data)
Net loss available to common stockholders					$	(392	)	$	(15,609	)	$	(22,459	)
Add employee stock compensation expense included in reported net loss						—			—			819
Less total stock-based employee compensation expense determined under fair value based methods for all awards						(1,472	)		(2,701	)		(3,135	)
Adjusted net loss available to common stockholders					$	(1,864	)	$	(18,310	)	$	(24,775	)
Basic net loss per common share:
Net loss available to common stockholders before pro-forma charge					$	(0.05	)	$	(0.95	)	$	(0.91	)
Net effect of pro-forma charges						(0.20	)		(0.16	)		(0.09	)
Adjusted basic net loss per common share available to common stockholders					$	(0.25	)	$	(1.11	)	$	(1.00	)

 

F - 12

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Under FAS 123, grants under the Employee Stock Purchase Plan (“ESPP”) have a look-back feature and a 15% discount and accordingly would have had compensation expense calculated as a result. The fair value disclosure associated with the ESPP grants is included in the fair value pro-forma information above.

The minimum fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants: expected lives of three to four years in 2003, 2004 and 2005; risk free interest rate of 3.5% to 4.0% in 2003, 4.0% to 5.0% in 2004 and 3.625% to 5.0% in 2005; expected dividends of zero in 2003, 2004 and 2005; and volatility of 114% in 2003, 175% in 2004 and 121% in 2005.

In connection with certain employee and non-employee stock option and restricted stock grants, the Company amortizes unearned stock-based compensation over the vesting period of the related grant using the method prescribed in FASB Interpretation No. 28. Under this method, each vested tranche of options is accounted for as a separate grant awarded for past services. Accordingly, the compensation expense is recognized over the period in which the services have been provided. This method results in higher compensation expense in the earlier vesting periods of the related grants.

ESTIMATES. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. Examples of items affected by certain significant estimates made by management are adequacy of the allowance for doubtful accounts, inventory obsolescence reserve, restructuring charges, sales taxes and the carrying value of goodwill.

SEGMENT INFORMATION

 

SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” requires disclosures of certain information regarding operating segments, products and services, geographic areas of operation and major customers. SFAS No. 131 reporting is based upon the “management approach”: how management organizes the company’s operating segments for which separate financial information is (i) available and (ii) evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. Our chief operating decision maker is its President and Chief Executive Officer, or CEO.

During 2004, we realigned our previous business divisions into one operating segment. Therefore, segment information is no longer relevant for 2005 as our CEO is provided information and evaluates performance for the entire company as a whole rather than in previous operating segments. For 2003 and 2004, we reported segment information for our previous primary business units: Security and InfoMedia.

NET LOSS PER SHARE. The Company computes net loss per common share in accordance with FAS No. 128, “Earnings Per Share”. Basic income (loss) per share is computed by dividing net income (loss) available to common stockholders for the period by the weighted average number of shares of common stock outstanding. Net income (loss) available to common stockholders is calculated as the net income (loss) less cumulative preferred stock dividends for the period. If dilutive, the participation right of the preferred stock is reflected in the calculation of basic income (loss) per share using the “if-converted” method or the two class method if more dilutive. Diluted income (loss) per common share is computed by dividing net income (loss) for the period by the weighted average number of shares of common stock outstanding plus, if dilutive, potential common stock outstanding during the period. Potential common shares are composed of incremental shares of common stock issuable upon the exercise of potentially dilutive stock options and warrants and upon conversion of the Company’s preferred stock.

The following table sets forth potential common shares that are not included in the diluted net loss per share calculation because to do so would be antidilutive for the periods indicated:

		FOR YEARS ENDED DECEMBER 31,
		2003			2004			2005
WEIGHTED AVERAGE EFFECT OF POTENTIAL COMMON SHARES:
Series B preferred stock			10,924,287			2,871,843			2,821,837
Employee stock options			960,851			2,260,097			257,176
Warrants to purchase Series B preferred stock			218,446			338,536			—
TOTAL			12,103,584			5,470,476			3,079,013

In 2005, the Company’s common stock had an average share price of $3.07. The average strike price of the warrants to purchase common stock is $4.51 and the average strike price of employee stock options is $4.45. Not included in the table above are 928,899 shares issuable upon exercise of exercisable options at December 31, 2005 and 2,974,641 shares issuable upon exercise of warrants, all of which have a strike price above the average share price during 2005

F - 13

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In 2004, the Company’s common stock had an average share price of $7.04. The average strike price of the warrants to purchase common stock was $14.48 and the average strike price of employee stock options was $7.63. Not included in the table above are 766,437 shares issuable upon exercise of options and 76,949 shares issuable upon exercise of warrants, all of which have a strike price above the average share price during 2004.

In 2003, the Company’s common stock had an average share price of $2.39. The average strike price of the warrants to purchase common stock was $12.15 and the average strike price of employee stock options was $6.29. Not included in the table above are 989,762 shares issuable upon exercise of options and 1,057,699 shares issuable upon exercise of warrants, all of which have a strike price above the average share price during 2003.

COMPREHENSIVE INCOME (LOSS). The Company follows FAS No. 130, “Reporting Comprehensive Income” (“FAS 130”), which establishes requirements for reporting and displaying comprehensive income (loss) and its components. FAS 130 requires net unrealized gains or losses on the Company’s foreign currency translation adjustments to be reported as accumulated other comprehensive income (loss).

		FOR YEARS ENDED DECEMBER 31,
					2003			2004			2005
		(In thousands)
Net income (loss)					$	1,386		$	(14,735	)	$	(22,020	)
Foreign currency translation adjustment						(3	)		—			—
Comprehensive income (loss)					$	1,383		$	(14,735	)	$	(22,020	)

RECENT ACCOUNTING PRONOUNCEMENTS.

In December 2004, the FASB issued FAS No. 123 (R), “Share-Based Payment” to replace FAS No. 123, “Accounting for Stock-Based Compensation” and APB Opinion No. 25, “Accounting for Stock Issued to Employees.” FAS No. 123 (R) requires, among other things, that all share-based payments to employees, including grants of stock options, be measured based on their grant-date fair value and recognized as expense in the financial statements effective for interim or annual periods beginning after June 15, 2005. Unless observable market prices exist, the grant-date fair value is estimated using an appropriate option-pricing model as determined by Management. Management must also make certain assumptions about employee exercise habits, forfeiture rates and select an appropriate amortization methodology for recognizing compensation expense. The Statement requires a modified prospective method of adoption. Companies may also elect to restate their previously issued financial statements to provide consistency across all periods presented under a modified retrospective method. Management believes the adoption of FAS No. 123(R) will have a material impact on the Company’s consolidated results of operations and earnings per share but has not yet determined the method of adoption that will be applied or whether adoption will result in expense amounts materially different from those currently provided under the pro forma disclosures.

In April 2005, the Securities and Exchange Commission announced the adoption of a new rule that amends the effective date of FAS No. 123(R). The effective date of the new standard under these new rules for our consolidated financial statements is January 1, 2006. Adoption of this statement will have a significant impact on the consolidated results of operations and earnings per share as the Company will be required to expense the fair value of stock option grants and stock purchases under the employee stock purchase plan rather than disclose the impact on the Company’s consolidated net loss within the footnotes, as is the Company’s current practice.

In November 2005, the FASB issued FSP FAS123(R)-3, Transition Election to Accounting for the Tax Effects of Share-Based Payment Awards. This FSP requires an entity to follow either the transition guidance for the additional-paid-in-capital pool as prescribed in SFAS No. 123(R), Share-Based Payment, or the alternative transition method as described in the FSP. An entity that adopts SFAS No. 123(R) using the modified prospective application may make a one-time election to adopt the transition method described in this FSP. An entity may take up to one year from the later of its initial adoption of SFAS No. 123(R) or the effective date of this FSP to evaluate its available transition alternatives and make its one-time election. This FSP became effective in November 2005. We continue to evaluate the impact that the adoption of this FSP could have on our financial statements.

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In June 2005, the FASB issued FAS No. 154, Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20, Accounting Changes, and FASB No. 3, Reporting Accounting Changes in Interim Financial Statements. The Statement applies to all voluntary changes in accounting principle, and changes the requirements for accounting for and reporting of a change in accounting principle. FAS 154 requires retrospective application to prior periods’ financial statements of a voluntary change in accounting principle unless it is impracticable. It is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Earlier application is permitted for accounting changes and corrections of errors made occurring in fiscal years beginning after June 1, 2005. The Company does not expect the effect of FAS 154 will have material impact on its financial statements.

In November 2005, the FASB issued Staff Position (“FSP”) FAS115-1/124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, which addresses the determination as to when an investment is considered impaired, whether that impairment is other than temporary, and the measurement of an impairment loss. This FSP also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The guidance in this FSP amends FASB Statements No. 115, Accounting for Certain Investments in Debt and Equity Securities, and No. 124, Accounting for Certain Investments Held by Not-for-Profit Organizations, and APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock. This FSP is effective for reporting periods beginning after December 15, 2005. We do not believe the adoption of this FSP will have a material impact on our financial statements.

RECLASSIFICATIONS. Certain amounts reported in the previous periods have been reclassified to conform to the current period presentation. As previously discussed, AdMission business unit has been sold and its operations have been reclassed to discontinued operations in all years presented. The Company also no longer reports on multiple segments having consolidated its operations into a single segment. Prior periods have been restated for comparability.

3. GOING CONCERN CONSIDERATIONS

The accompanying consolidated financial statements have been presented in accordance with U.S. GAAP, which assume the continuity of the Company as a going concern. During the year ended December 31, 2005 and in the prior fiscal years, the Company has experienced, and continues to experience, certain issues related to cash flow and profitability. These factors raise substantial doubt about the Company’s ability to continue as a going concern. The Company completed a $10 million private placement of common stock, including additional investment rights and warrants to a group of existing and new institutional investors on June 21, 2005. Management monitors the Company’s cash position carefully and evaluates its future operating cash requirements with respect to its strategy, business objectives and performance. The Company completed the sale of the AdMission business unit to AdMission Corporation in the first quarter of 2005. During the first two quarters of 2005, we incurred certain costs for accountant and lawyer fees, buyout of an equipment lease and abandonment of an operating lease as a result of the sale of the AdMission business unit. (See Note 4)

On November 18, 2005, the Company issued a press release announcing action taken to further streamline the Company's structure and reduce cost. The action taken was intended to reduce personnel costs, facility costs and expenses. As a result of these actions, the Company reduced its total headcount by 15 staff positions. A restructuring charge, of approximately $612,000 was recorded in the fourth quarter of 2005 which included $570,000 for activities associated with the Company’s operations at Oak Ridge, Tennessee as well as $42,000 associated with the previously discussed closure of the Company’s operations in California.

 

The Company has a limited operating history as it will operate in 2006 and upon which an evaluation of its business and prospects in 2006 may be made. In addition, the Company is subject to generally prevailing economic conditions and, as such, the Company’s operating results in 2006 will be dependent upon its ability to provide quality products and services, the success of its customers and the appropriations processes of various commercial and governmental entities. Management believes the Company will have to acquire additional working capital through financing to supplement working capital from operations to meet its funding needs for 2006. There can be no assurance that such additional financing will be available or if available, that such financing can be obtained on terms satisfactory to the Company. If the Company is not able to raise additional funds, it may be required to significantly curtail its operations which would have an adverse effect on its financial position, results of operations and cash flow. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. The Company finished 2005 with approximately $6.34 million in cash reserves (cash and cash equivalents of $4.86 million and short-term investments of $1.48 million). Management expects to continue to make investments in the sale and marketing of new products for the security market, which may consume available cash reserves.

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4. DISCONTINUED OPERATIONS

On February 11, 2005, the Company and AdMission Corporation, a privately held Delaware corporation (“AdMission”), closed the transactions under the asset purchase agreement dated January 11, 2005 between the parties (the “Asset Purchase Agreement”). Pursuant to the terms of the Asset Purchase Agreement, IPIX sold to AdMission certain of its assets (including certain patent rights and other intellectual property) and contracts relating to its IPIX AdMission business unit (the “AdMission Business”). In consideration for the sale, IPIX received 1,035,000 shares of the Series A Convertible Preferred Stock of AdMission and a warrant to purchase 200,000 shares of the Common Stock of AdMission. Additionally, AdMission assumed certain liabilities associated with the AdMission business unit. In accordance with FAS 144, the assets and liabilities related to the AdMission business were classified as held for sale at December 31, 2004, and the operations of this business unit were considered discontinued operations for each quarter and for each full year presented. The preferred stock and warrant were recorded as an asset investment in AdMission and subsequently written-down to zero. This write-down was based on Management’s assessment of the fair market value of the investment related to the carrying value of the asset which was based upon AdMission’s first quarter loss until the sale date and the marketability of the private company’s stock. The sale of assets and liabilities to AdMission consists of fixed assets of $253,000, prepaid items of $62,000 and deferred revenue of $62,000. The operating results of AdMission for 2005 were also reclassified to discontinued operations. During the first quarter of 2005, the Company incurred non-cash compensation expenses of $794 thousand associated with the acceleration of stock options related to the sale of the AdMission business unit. In connection with the Asset Purchase Agreement, IPIX and AdMission entered into a Patent Purchase, License and Repurchase Agreement dated as of February 11, 2005 which provides for the transfer to AdMission of certain patents relating to the AdMission Business, the license of those patents back to IPIX for use by IPIX in the conduct of its security sector business and certain other limited uses, and repurchase right by IPIX in the event of certain triggering events by AdMission. The patent agreement remains in effect until all of the patents transferred by the agreement expire. Patent No. 6,732,162 issued March 4, 2004 “Method of Providing Preprocessed Images for a Plurality of Internet Web Sites” expires November 15, 2019. An acquired application 09/357,836 was subsequently issued on March 17, 2005 as patent No. 6,895,557 “Web-based Media Submission Tool” expires July 21, 2019. The agreement does not provide for any payment for the license of the patents. The Company has no expectation of exercising its repurchase right of these patents as there is no present indication that the triggering event will occur. IPIX and AdMission also entered into an IPIX Trademark/Service Mark License Agreement which provides AdMission with an eighteen (18) month royalty-free, nonexclusive license to use certain IPIX marks and certain other trademarks and business brands in connection with the conduct of the AdMission Business.

On February 11, 2005, the Company entered into an AdMission Service Agreement (the Agreement) with AdMission Corporation (AdMission) under which, AdMission will provide hosting services to the Company for certain computer-based applications. The Agreement has variable pricing depending on usage with a minimum financial commitment of $10,000 per month. The Company has not in the past exceeded the usage threshold which would result in payment of fees greater than the minimum and the Company does not foresee paying more than the minimum at any point in the future.

Other than the obligation to provide AdMission with a license of certain IPIX marks and certain other trademarks and business brands pursuant to the IPIX Trademark/Service Mark License Agreement and the requirements of the foregoing Agreement, the Company has no continuing obligations to AdMission.

Net operating revenues, operating expenses and income (loss) reported in discontinued operations for the years ended December 31, 2003, 2004 and 2005 are as follows:

		FOR YEARS ENDED DECEMBER 31,
					2003			2004			2005
		(In thousands)
Revenues					$	26,245		$	1,116		$	159
Cost of Revenues						6,540			2,304			220
Gross profit						19,705			(1,188	)		(61	)
Operating expenses:
Sales and marketing						3,985			1,968			908
Research and development						2,858			1,769			391
Impairment and amortization of intangibles						3,042			—			—
Total operating expenses						9,885			3,737			1,299
Income (loss) from discontinued operations before income tax						9,820			(4,925	)		(1,360	)
Income tax provision						(3,764	)		—			—
Income (loss) from discontinued operations, net of tax					$	6,056		$	(4,925	)	$	(1,360	)

5. RESTRUCTURING AND OTHER

During 2003, 2004 and 2005, the Company recorded as a separate line item in its statements of operations for restructuring charges which consist primarily of expenses associated with reductions in workforce, the consolidation of certain offices, principally lease obligations for vacated offices, as well as a write down of abandoned office equipment and leasehold improvements to net realizable values.

F - 16

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The Company anticipates total costs of approximately $3 million for restructuring during the entire course of its restructuring activities. In 2005, the Company incurred $2.799 million in restructuring expense are delineated in the following table.

		San Ramon			Oak Ridge			Total
Lease		$	1,061		$	304		$	1,365
Severance			362			3			365
Information Systems Relocation						36			36
Fixed Asset Buyout			747						747
Fixed Asset Write-down						221			221
Other			59			6			65
TOTALS		$	2,229		$	570		$	2,799

The activity in the current and long-term restructuring accruals for the years ended December 31, are as follows:

		Balance Dec.31,			Expense in			Payments/ Write-offs			Balance Dec. 31,			Expense in			Payments/			Balance Dec. 31,			Expense in			Payments/ Write-offs			Balance Dec. 31,
		2002			2003			in 2003			2003			2004			in 2004			2004			2005			in 2005			2005
(In thousands)
Severance		$	500		$	—		$	(500	)	$	—		$	—		$	—		$	—		$	365		$	(354	)	$	3
Other			549			89			(267	)		371			170			(284	)		257			2,434			(1,685	)		1,014
Total		$	1,049		$	89		$	(767	)	$	371		$	170		$	(284	)	$	257		$	2,799		$	(2,039	)	$	1,017