Aeon Global Health Corp. - Quarter Report: 2006 December (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

FOR THE QUARTERLY PERIOD ENDED: DECEMBER 31, 2006

FOR THE TRANSITION PERIOD FROM              TO             

COMMISSION FILE NUMBER: 0-20190

Authentidate Holding Corp.

(Exact name of registrant as specified in its charter)

(908) 787-1700

(Registrant’s telephone number, including area code)

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to the filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer  ¨    Accelerated filer  x    Non-accelerated filer  ¨

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

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

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Authentidate Holding Corp.

Form 10-Q

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Authentidate Holding Corp. and Subsidiaries

Condensed Consolidated Balance Sheets

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

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Authentidate Holding Corp. and Subsidiaries

Condensed Consolidated Statements of Operations (Unaudited)

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

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Authentidate Holding Corp. and Subsidiaries

Condensed Consolidated Statements of Cash Flows (Unaudited)

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

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Authentidate Holding Corp. and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

1. Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission and, in the opinion of management, reflect all adjustments, consisting of only normal recurring adjustments, necessary for a fair presentation of the results of the interim periods presented. The condensed consolidated financial statements include the accounts of Authentidate Holding Corp. (AHC) and its subsidiaries DJS Marketing Group, Inc. (“Systems Integration”), Authentidate, Inc., Authentidate International AG, and Trac Medical Solutions, Inc. (collectively “Security Software Solutions”), and its Docstar division, (“Document Management Solutions”) (collectively, the “Company”). All significant intercompany transactions and balances have been eliminated in consolidation. The results of operations for the three and six months ended December 31, 2006 are not necessarily indicative of the results to be expected for the full year. Certain information and footnote disclosures normally included in the annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. These condensed consolidated financial statements should be read in conjunction with the annual consolidated financial statements and notes thereto included in the Company’s Form 10-K for the fiscal year ended June 30, 2006 and the attached Management’s Discussion and Analysis of Financial Conditions and Results of Operations.

2. Loss Per Share

The following table sets forth the calculation of basic and diluted loss per share for the periods presented (in thousands, except per share data):

All common stock equivalents were excluded from the calculation of net loss per share for the periods presented because their impact is antidilutive. At December 31, 2006, employee and non-executive director options (4,303,000), warrants (832,000), performance based consultant options (375,000) and convertible preferred stock (500,000) were outstanding. At December 31, 2005, employee and non-executive director options (4,246,000), warrants (1,262,000), performance based consultant options (375,000) and convertible preferred stock (500,000) were outstanding.

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Authentidate Holding Corp. and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

3. Share-Based Compensation

The impact of share-based compensation expense on the results of operations is as follows (in thousands, except per share data):

Share-based compensation by category is as follows (in thousands):

The Company computed the estimated fair values of all share-based compensation using the Black-Scholes option pricing model and the assumptions set forth in the following table. The Company based its estimate of the life of these options on historical averages over the past five years. The Company retained a third party valuation firm to calculate expected volatility which was based on the Company’s historical stock volatility, historical stock volatility of comparable companies in the industry and implied volatilities based on the spot market for traded options in the Company and comparable companies in the industry. The assumptions used in the Company’s Black-Scholes calculations for fiscal 2007 and 2006 are as follows:

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Authentidate Holding Corp. and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

The Black-Scholes option-pricing model requires the input of highly subjective assumptions. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models may not provide a reliable single measure of the fair value of share-based compensation for employee stock options. Management will continue to assess the assumptions and methodologies used to calculate estimated fair value of share-based compensation as circumstances change and additional data becomes available over time, which may result in changes to these assumptions and methodologies. Such changes could materially impact the Company’s fair value determination.

Stock option activity under the Employees and Non-Executive Directors Stock Option Plans (the “Plans”) for the period ended December 31, 2006 is as follows (in thousands, except per share and average life data):

Non-executive director options are granted at market price and vest on the grant date.

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Authentidate Holding Corp. and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

Unvested options as of December 31, 2006, and changes in such options during the six month period then ended are summarized below (in thousands, except per share and average life data):

As of December 31, 2006, there was $1,115,000 of total unrecognized compensation expense related to unvested share-based compensation arrangements granted under the Plans. This expense is expected to be recognized over a weighted-average period of 23 months.

There were no options exercised during the six month periods ended December 31, 2006 and 2005. The weighted average grant date fair value of options granted during the six month periods ended December 31, 2006 and 2005 was approximately $0.67 and $0.97, respectively. These values were calculated using the Black-Scholes option-pricing model.

The total fair value of shares vested was $844,000 and $625,000 for the six month periods ended December 31, 2006 and 2005, respectively.

During fiscal 2006 the Company issued 375,000 stock options to an independent consultant, exercisable at $3.25 per share. These options do not vest until the consultant realizes at least $1.0 million in sales of the Company’s Security Software Solutions products; therefore no expense has been recorded as no sales have been realized to date. These options are not included in the disclosures above. These options expire at the later of seven years from the grant date or five years from the vesting date.

On January 5, 2007, the Board of Directors granted 400,000 stock options to the Company’s President and Chief Executive Officer in connection with his new employment agreement. These options have an exercise price of $1.50 per share, the fair market value of the stock on the grant date, and vest monthly over the next two years.

On January 17, 2007, the shareholders approved several amendments to the 2001 Non-Executive Director Stock Option Plan whereby non-executive director stock options expire ten years from the original date of grant, non-executive directors will have up to two years to exercise their options after leaving the board and may elect to receive up to 50% of their cash director compensation in restricted common stock of the Company issued at fair value in accordance with the terms of the Plan.

Effective January 17, 2007, the Board of Directors amended the terms of existing stock options previously granted to the Company’s current employees whereby such options expire ten years from the original grant date.

4. Comprehensive Loss:

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Authentidate Holding Corp. and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

5. Segment Information

FAS 131, Disclosures about Segments of an Enterprise and Related Information, requires certain financial and supplementary information to be disclosed about operating segments of an enterprise. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. Our chief operating decision maker is our Chief Executive Officer.

The Company is organized into three businesses or operating segments based on software and service offerings. The Security Software Solutions business is engaged in the development and sale of secure workflow management applications that generally incorporate its proprietary content authentication technology in the form of the United States Postal Service Electronic Postmark^® (EPM); and electronic signing software for use with electronic billing and archiving solutions in the European market. The content authentication technology (EPM) enables the user to have a digital record of a transaction created and stored with the USPS that can be used to verify the content, date, time and parties related to the transaction. Our software applications offered in Europe are compliant with the German Signature Act and European guidelines. The software applications and services offered by this segment are sold through a direct sales effort and reseller arrangements. The Document Management Solutions business is engaged in the development and sale of document imaging and management software. Sales are made primarily through a national network of resellers and in some cases include related hardware products to provide a turn-key solution to customers. The Systems Integration business provides software support, software and hardware integration services and hardware to customers primarily in the Albany, New York area. The Company does not allocate indirect expenses such as public company costs, share-based compensation expense, finance, legal and other non-operating costs to the individual operating segments. These costs generally apply to all of the Company’s businesses and are reported as corporate expenses for segment reporting purposes. Corporate assets consist primarily of cash and cash equivalents, marketable securities, fixed assets and goodwill.

On January 10, 2007, the Company announced that it had entered into a non-binding letter of intent for the sale of the Document Management Solutions and System Integration businesses to a group headed by two members of the businesses’ current senior management team. According to the letter of intent, the Company will receive approximately $8.5 million for the businesses and related assets, which include cash of $750,000 and the land and building located in Schenectady, New York. Approximately $7 million of the selling price will be received in cash and the Company will finance the balance through a 15 year note. No assurances, however, can be given that we will be successful in completing this transaction on these terms, or at all.

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Authentidate Holding Corp. and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

Segment information is as follows:

Net sales from external customers for our Security Software Solutions segment includes revenues from our German operations of approximately $568,000 and $1,082,000 for the three and six month periods ended December 31, 2006 and $606,000 and $1,104,000 for the three and six month periods ended December 31, 2005, and assets of approximately $1,228,000 and $1,014,000 at December 31, 2006 and 2005, respectively.

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Authentidate Holding Corp. and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

6. Marketable Securities

The Company classifies investments known as auction rate securities as marketable securities on its balance sheet. The auction rate securities are generally triple A or double A rated. The interest yield generally resets every 35 days or sooner and the securities are purchased at par value and sold at par value with no adjustment to market value required. Many of the securities are insured by a third party insurance company and the issuer is sometimes a municipality or a corporation run by a municipality.

7. Inventories

Inventories, which are included in other current assets, consist of the following (in thousands):

8. Goodwill and Other Intangible Assets

The Company performs an annual valuation of goodwill at the end of the fiscal year. Any adverse development or change in our business during the year would require an interim assessment. For the six months ended December 31, 2006 there were no adverse developments or changes that required such an assessment and the carrying amount of goodwill has not changed. Goodwill relates solely to our Security Software Solutions business and approximately $7,291,000 relates to our business in Germany.

Other intangible assets consist of the following (in thousands):

The Company amortizes other intangible assets under the straight line method. Amortization expense was approximately $128,000 for the six months ended December 31, 2006. Amortization expense for the next five fiscal years is expected to be as follows (in thousands):

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Authentidate Holding Corp. and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

9. Shareholders’ Equity

The changes in Shareholders' Equity for the six months ended December 31, 2006 are summarized as follows (in thousands):

During the six months ended December 31, 2006, no stock options or common stock warrants were exercised.

10. Preferred Stock

As of October 1, 2004, the Company has the right to repurchase the outstanding Series B preferred stock at a redemption price equal to $25.00 per share, plus accrued and unpaid dividends. The holder of such shares has the right to convert shares of preferred stock into an aggregate of 500,000 shares of our common stock at a conversion rate of $1.40 per share. In the event the Company elects to redeem these securities, the holder will be able to exercise its conversion right subsequent to the date that we issue a notice of redemption but prior to the deemed redemption date as would be set forth in such notice. The Series B preferred stock was originally issued in a private financing in October 1999 and the conversion and redemption features were amended in October 2002 to provide for the rights and obligations described in this note.

11. Commitments and Contingencies

We are the defendant in a third party complaint filed by Shore Venture Group, LLC in the United States District Court for the Eastern District of Pennsylvania. The caption of this matter is Berwyn Capital Investments, Inc. v. Shore Venture Group, LLC et al. (defendants and Shore Venture Group, LLC as third party plaintiff) v. Authentidate Holding Corp. and Authentidate, Inc. (third party defendants). The third party complaint was filed against us on May 7, 2001 and Shore Venture is the defendant to an action commenced by Berwyn Capital. The third party complaint alleged a claim for breach of contract and indemnification. A bench trial was held in October, 2002 and we received an adverse verdict in this case on February 14, 2006 wherein the trial judge found Authentidate responsible for monetary damages in the amount of approximately $308,000. We subsequently filed a motion with the court requesting that it reconsider and modify the verdict and Shore Venture filed a similar motion with the court asking the court to increase the amount of interest awarded. Subsequently, Shore Venture Group filed a motion for attorneys’ fees which we opposed. On May 1, 2006, the court denied our motion for reconsideration and granted-in-part and denied-in-part the motion filed by Shore Venture by awarding an aggregate of approximately $35,000 in additional interest to the plaintiff and third party plaintiff. On June 19, 2006, the court denied Shore Venture Group’s motion for attorneys’ fees. On November 13, 2006 we entered into a settlement agreement with Berwyn Capital and on January 19, 2007 we entered into a settlement agreement with Shore Venture Group and Berwyn Capital, pursuant to which each of the parties have agreed to a release of judgment, withdraw their appeals and a termination of all proceedings relating to this matter, without any admissions of wrongdoing or fault on our part. On January 23, 2007 Berwyn Capital, Shore Venture Group and we filed a joint stipulation of dismissal of appeals with the United States Court of Appeals for the 3^rd Circuit and on January 24, 2007 the United States Court of Appeals for the 3^rd Circuit issued an order dismissing the appeals. On January 30, 2007 each of Berwyn Capital and Shore Venture Group filed a satisfaction of judgment with the United States District Court for the Eastern District of Pennsylvania. All amounts paid by us under these settlement agreements were recorded as an expense during the year ended June 30, 2006.

We are the defendant in a claim filed by Shore Venture Group in the federal District Court for the District of New Jersey, under the caption Shore Venture Group, LLC, et al v. Authentidate Holding Corp., Authentidate, Inc. and John T. Botti. The complaint in this case was filed on March 2, 2005 and an amended complaint was filed on or about April 26, 2005. On October 12, 2005, the parties entered into an agreement to arbitrate the claims asserted against us by Plaintiffs. On October 19, 2005, the Court approved and entered a Consent Order referring the case to arbitration by the American Arbitration Association and staying the lawsuit pending resolution of the arbitration. The plaintiffs seek additional shares of the common stock of our subsidiary, Authentidate, Inc.,

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Authentidate Holding Corp. and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

rights under one of our patent applications, and damage in connection with an alleged copyright infringement. We had conducted extensive settlement negotiations with Shore Venture in an effort to resolve all claims between the parties. However, negotiations were unable to result in a mutually agreeable settlement. The lawsuit requested damages, injunctive relief, costs and attorneys’ fees. On October 18, 2006, Shore Venture filed a demand for arbitration with the American Arbitration Association. On December 4, 2006 we filed a response to the demand and are defending the action vigorously. Based on the facts of which we are currently aware, management believes that the resolution of this claim, in the event decided adversely to us, will not have a material adverse effect on our financial condition. However, no assurances can be given that such belief will ultimately prove to be accurate or that other facts adverse to our position currently not known to management will not be uncovered, in which case the ultimate resolution of this claim could potentially have a material adverse effect on our financial condition.

Between June and August 2005, six purported shareholder class actions were filed in the United States District Court for the Southern District of New York against our company and certain of our current and former officers and directors. Plaintiffs in those actions alleged that defendants violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Sections 11 and 15 of the Securities Act of 1933. The securities law claims were based on the allegations that we failed to disclose that our August 2002 agreement with the USPS contained certain performance metrics, and that the USPS could cancel the agreement if we did not meet these metrics; that we did not disclose complete and accurate information as to our performance under, and efforts to renegotiate, the USPS agreement; and that when we did disclose that the USPS might cancel the agreement, the market price of our stock declined. On October 5, 2005 the Court consolidated the class actions under the caption In re Authentidate Holding Corp. Securities Litigation., C.A. No. 05 Civ. 5323 (LTS), and appointed the Illinois State Board of Investment as lead plaintiff under the Private Securities Litigation Reform Act. The plaintiff filed an amended consolidated complaint on January 3, 2006, which asserted the same claims as the prior complaints and also alleged that Authentidate violated the federal securities laws by misrepresenting that it possessed certain patentable technology. On July 14, 2006, the Court dismissed the amended complaint in its entirety; certain claims were dismissed with prejudice and plaintiff was given leave to replead those claims which were not dismissed with prejudice. In August 2006, plaintiff filed a second amended complaint, which does not assert any claims relating to the Company’s patents or under the Securities Act of 1933, but which otherwise is substantially similar to the prior complaint. The second amended complaint seeks unspecified monetary damages. The Company moved to dismiss the second amended complaint on November 13, 2006.

In addition to the class action complaints, four purported shareholder derivative actions were filed against certain former and current directors and officers of the company in June and July 2005 in the United States District Court for the Southern District of New York. These federal court derivative actions were based on substantially the same events and factual allegations as the original class action complaints and asserted claims that Authentidate was injured by an alleged breach of fiduciary duty, waste, mismanagement, violations of Sarbanes-Oxley, and misappropriation of inside information. The derivative complaints sought, among other things, damages, equitable relief, restitution, and payment of costs and expenses incurred in the litigation (including legal fees). Plaintiffs in the derivative actions entered into a Court-approved stipulation providing for the consolidation of their actions and the selection of Maxine Philips as the lead plaintiff. Plaintiffs filed a consolidated complaint on November 14, 2005, which defendants moved to dismiss on January 13, 2006 on the ground that plaintiffs had not made a proper demand on the Board of Directors. On March 20, 2006, before the motion to dismiss was decided, plaintiffs in the federal court derivative action voluntarily dismissed their complaint without prejudice. On April 6, 2006, the court held a hearing to confirm, among other things, that plaintiffs had not received any payment or other consideration for the dismissal of their claims. At the hearing plaintiffs agreed to file a motion seeking court approval for the dismissal. Plaintiffs filed this motion on April 18, 2006 and the court entered an order dismissing the consolidated complaint on May 5, 2006. Subsequently, on May 25, 2006, the plaintiffs sent a letter to the Board of Directors demanding that it file a derivative suit on behalf of the Company which asserts the same claims as the complaint which plaintiffs voluntarily dismissed only weeks earlier.

On December 13, 2005, a purported shareholder derivative action was filed in the Supreme Court of New York, Schenectady County, entitled Elkin v. Goldman et al., No. 2005-2240. Plaintiff in that action demanded that our Board of Directors file a derivative action on behalf of the Company against nine of its current and former directors and officers. The complaint asserts the same claims that are alleged in the first federal court derivative actions. The Board of Directors, following a recommendation from a committee of the Board composed of outside, non-employee directors who were advised by independent outside counsel, concluded that commencing litigation, as demanded by Elkin, is not in our best interest.

In addition, in August 2005, we were notified of the filing of a complaint in which the plaintiff alleges that our products and systems incorporating secure time stamping technology, including but not limited to the USPS Electronic Postmark system, infringes certain of the plaintiff’s patent rights. The complaint was filed in the United States District Court for the Middle District of Florida and is entitled TimeCertain LLC vs. Authentidate Holding Corporation, Authentidate, Inc. and NCipher Inc. As relief, the complaint seeks, among other things, injunctive relief and damages. The complaint was served on September 21, 2005, and our Answer and Counterclaim was timely filed on November 10, 2005. We are in the discovery phase of the case and are vigorously defending this action. On October 23, 2006, the parties engaged in Court ordered mediation which resulted in an impasse. A Markman hearing to

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Authentidate Holding Corp. and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

determine the meaning of the claims of the patents at issue occurred on November 27, 2006. On December 8, 2006 the Court issued a proposed Order and on December 22, 2006 the Court issued a final Order construing the claims of the patents at issue. The claim construction Order was very favorable for us and adopted the meanings that we propounded for the claim terms. Based on the facts of which we are currently aware, management believes that this matter will be settled shortly and the resolution of all of our issues with TimeCertain will not have a material adverse effect on our financial condition. However, no assurances can be given that such belief will ultimately prove to be accurate or that other facts adverse to our position currently not known to management will not be uncovered, in which case the ultimate resolution of this claim could potentially have a material adverse effect on our financial condition.

We are engaged in no other litigation which would be anticipated to have a material adverse effect on our financial condition, results of operations or cash flows.

In July 2002, we entered into an agreement with the USPS to provide the management, technology and support for the USPS EPM System. The USPS is the vendor of the EPM to the end user or application solution provider and we serve as a preferred provider of the EPM service. The USPS EPM incorporates our proprietary content authentication technology. From September 2004 through October 2005, we received several letters from the USPS regarding our failure to satisfy the performance metrics under our agreement. In its last letter dated October 2005, the USPS notified us of our continuing failure to satisfy the performance metrics under the agreement, but also stated that it had elected not to terminate the agreement at this time and will continue to fulfill its obligations under the agreement as long as it remains in effect. We have been in negotiations with the USPS to amend the agreement and develop a new arrangement. No assurances, however, can be given that we will be successful in completing these negotiations or that the USPS will not terminate the agreement at any time. Further, the initial term of our alliance agreement with the USPS will expire in July 2007 unless the parties agree to extend the agreement. No assurances can be given that the parties will agree to extend the agreement.

Further, in October 2006, the USPS released a Request for Information (RFI) for Time and Date Stamp Technology and Management to identify additional companies that may be interested in, and potentially capable of, providing the USPS EPM service. This exercise would enable the USPS to explore alternative business models for the EPM service, with a view to promoting wider adoption of the service across multiple business segments. We have submitted our response to the RFI and continue to operate under our strategic alliance agreement with the USPS. We are currently the only provider designated by the USPS to offer the EPM service.

We have entered into various agreements by which we may be obligated to indemnify the other party with respect to certain matters. Generally, these indemnification provisions are included in contracts arising in the normal course of business under which we customarily agree to hold the indemnified party harmless against losses arising from a breach of representations related to such matters as intellectual property rights. Payments by us under such indemnification clauses are generally conditioned on the other party making a claim. Such claims are generally subject to challenge by us and to dispute resolution procedures specified in the particular contract. Further, our obligations under these arrangements may be limited in terms of time and/or amount and, in some instances, we may have recourse against third parties for certain payments made by us. It is not possible to predict the maximum potential amount of future payments under these indemnification agreements due to the conditional nature of our obligations and the unique facts of each particular agreement. Historically, the Company has not made any payments under these agreements that have been material individually or in the aggregate. As of December 31, 2006, we were not aware of any obligations under such indemnification agreements that would require material payments.

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Forward-Looking Statements and Factors That May Affect Future Results

Certain statements in this Form 10-Q, including information set forth under Item 2 Management’s Discussion and Analysis of Financial Condition and Results of Operations constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 (the “Act”). We desire to avail ourselves of certain “safe harbor” provisions of the Act and are therefore including this special note to enable us to do so. Forward-looking statements in this Form 10-Q or hereafter included in other publicly available documents filed with the Securities and Exchange Commission, reports to our stockholders and other publicly available statements issued or released by us involving known and unknown risks, uncertainties and other factors which could cause our actual results, performance (financial or operating) or achievements to differ from the future results, performance (financial or operating) or achievements expressed or implied by such forward-looking statements. Such future results are based upon our management’s best estimates based upon current conditions and the most recent results of operations. These risks include, but are not limited to risks associated with the market acceptance of our products and services, competition, pricing, technological changes, technological implementation of the Authentidate business plan, related decisions by the USPS, and other risks as discussed in our filings with the Securities and Exchange Commission, in particular our Annual Report on Form 10-K for the year ended June 30, 2006 and subsequently filed Quarterly Reports on Form 10-Q, all of which risk factors could adversely affect our business and the accuracy of the forward-looking statements contained herein.

Overview

Authentidate Holding Corp. (AHC), is a world wide provider of secure enterprise workflow management applications. Through its subsidiaries, AHC provides software applications and services that address a variety of business needs for our customers, including reducing costs, improving productivity and enhancing compliance with regulatory requirements. Our scalable software applications focus on workflow management, content authentication and electronic signature services. We also provide document management solutions and security products and services.

For a number of years, we have experienced net losses and negative cash flow from operating activities. Our principal activities during this period have focused on developing new products, hiring management, refining our business strategies and repositioning our businesses for growth. Although we believe we are well positioned for such growth, we expect to continue to generate net losses and negative cash flow for the foreseeable future as we expand our operations. See “Liquidity and Capital Resources”.

We are organized into three businesses or operating segments based on software and service offerings. Each of these businesses serves different markets and has different opportunities and challenges.

On January 10, 2007, the Company announced that it had entered into a non-binding letter of intent for the sale of the Document Management Solutions and System Integration businesses to a group headed by two members of the businesses’ current senior management team. According to the letter of intent, the Company will receive approximately $8.5 million for the businesses and related assets, which include cash of $750,000 and the land and building located in Schenectady, New York. Approximately $7 million of the selling price will be received in cash and the Company will finance the balance through a 15 year note. No assurances, however, can be given that we will be successful in completing this transaction on these terms, or at all.

An overview of our businesses follows.

Security Software Solutions

The Security Software Solutions business is engaged in the development and sale of secure workflow management applications that incorporate our proprietary content authentication technology in the form of the USPS Electronic Postmark ^® (EPM), and electronic signing software for use with electronic billing and archiving solutions in the European market. Our content authentication technology (EPM) enables the user to have a digital record of a transaction created and stored with the USPS that can be used to verify the content, date, time and parties related to the transaction. Our software applications offered in Europe are compliant with the German Digital Signature Act and European guidelines. We sell our software applications and services through a direct sales effort and reseller arrangements.

During 2005 we shifted to our current solutions-based market approach to facilitate the adoption of our content authentication technology (EPM) in the US and have continued our focus on the healthcare sector. Through August 2006, we developed several applications to complement our CareCert ™ service which was developed in 2004 including CareFax™ and an Electronic Claims Attachment (ECA) application. Building on our experience with customers in our target markets, in October 2006, we announced the

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launch of Inscrybe Healthcare™, a new web-based information exchange platform for the healthcare industry. Inscrybe Healthcare accommodates interchangeable modes of communication including the web and faxes, and is designed to enable healthcare industry participant, such as physicians, hospitals, home health agencies, equipment providers, pharmacies, payors, regulators and others to securely exchange a variety of documents, such as medical records and forms for approving and supporting claims, without requiring major changes in their day-to-day operations. We also launched a digital Plan of Care service module for the Inscrybe Healthcare platform, which is designed to enable home health agencies to exchange and authenticate Medicare-required documentation with physicians, incorporating digital signature and trusted third-party verification capabilities. Our applications for electronic, paperless processing of critical claims documents, fax automation of workflows that continue to be fax intensive and electronic claims attachments formerly known as CareCert™, CareFax™ and ECA are now being offered as modules of Inscrybe Healthcare. We plan to develop additional modules to provide customers with an integrated suite of applications to serve their business needs.

In November 2006, we began a beta test of TrueBlue™, our new web-based electronic document authentication and exchange service targeted primarily at office professionals in a variety of document intensive market sectors. TrueBlue brings together the power of online communications with a number of essential features such as e-signature capabilities and content authentication using the EPM that can be flexibly combined and applied to a wide variety of uses. A commercial launch of TrueBlue is scheduled for the second half of our 2007 fiscal year.

We intend to continue our efforts to market our software applications and services in the US and European markets. We also intend to focus on identifying additional applications and markets where our technology can address customer needs.

Our Security Software Solutions business represented approximately 24% and 25% of consolidated revenues for the three and six month periods ended December 31, 2006. Revenues consist principally of transaction fees for hosted applications, software license fees, hosting fees and maintenance charges. Growth in our Security Software Solutions business is affected by a number of factors, including general economic and business conditions, and is characterized by long sales cycles. The timing of customer contracts, implementations and ramp-up to full utilization can have a significant impact on results and we believe our results over a longer period of time provide better visibility into our performance.

In July 2002, we entered into an agreement with the USPS to provide the management, technology and support for the USPS EPM System. The USPS is the vendor of the EPM to the end user or application solution provider and we serve as a preferred provider of the EPM service. The USPS EPM incorporates our proprietary content authentication technology. From September 2004 through October 2005, we received several letters from the USPS regarding our failure to satisfy the performance metrics under our agreement. In its last letter dated October 2005, the USPS notified us of our continuing failure to satisfy the performance metrics under the agreement, but also stated that it had elected not to terminate the agreement at this time and will continue to fulfill its obligations under the agreement as long as it remains in effect. We have been in negotiations with the USPS to amend the agreement and develop a new arrangement. No assurances, however, can be given that we will be successful in completing these negotiations or that the USPS will not terminate the agreement at any time. Further, the initial term of our alliance agreement with the USPS will expire in July 2007 unless the parties agree to extend the agreement. No assurances can be given that the parties will agree to extend the agreement.

In October 2006, the USPS released a Request for Information (RFI) for Time and Date Stamp Technology and Management to identify additional companies that may be interested in, and potentially capable of, providing the USPS EPM service. This exercise would enable the USPS to explore alternative business models for the EPM service, with a view to promoting wider adoption of the service across multiple business segments. We have submitted our response to the RFI and continue to operate under our strategic alliance agreement with the USPS. We are currently the only provider designated by the USPS to offer the EPM service.

Document Management Solutions

The Document Management Solutions business is engaged in the development and sale of document imaging and management software. Sales are made primarily through a national network of resellers and in some cases include related hardware products to provide a turn-key solution to customers. Since fiscal 2006, in addition to our on-going reseller efforts, we have been identifying vertical markets where direct and OEM sales approaches would be effective channels for growth. As discussed more fully above, we have entered into a non-binding letter of intent to sell this business.

Our Document Management Solutions business represented approximately 44% of consolidated revenues for the three and six month periods ended December 31, 2006. Revenues consist principally of software license fees, maintenance charges and hardware sales. Sales in our Document Management Solutions business are affected by a number of factors, including general economic and business conditions, which can have a significant impact on results. We believe our results over a longer period of time provide better visibility into our performance.

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Systems Integration

The Systems Integration business provides software support, software and hardware integration services and hardware to customers primarily in the Albany, New York area. Our Systems Integration business represented approximately 32% and 31% of consolidated revenues for the three and six month periods ended December 31, 2006. Revenues consist principally of hardware sales and professional service fees. Growth in this business is affected by a number of factors, including general economic and business conditions. Our results depend on the timing of customer contracts and implementations as well as the level of hardware sales. Our results over a longer period of time provide a better indication of the performance of this business. As discussed more fully above, we have entered into a non-binding letter of intent to sell this business.

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States and the rules of the Securities and Exchange Commission. The preparation of our condensed consolidated financial statements and related notes in accordance with generally accepted accounting principles requires us to make estimates, which include judgments and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses, and related disclosure of contingent assets and liabilities. We have based our estimates on historical experience and on various assumptions that we believe to be reasonable under the circumstances. We evaluate our estimates on a regular basis and make changes accordingly. Actual results may differ from these estimates under different assumptions or conditions. To the extent that there are material differences between these estimates and actual results, our financial condition or results of operations will be affected.

A critical accounting estimate is based on judgments and assumptions about matters that are uncertain at the time the estimate is made. Different estimates that reasonably could have been used or changes in accounting estimates could materially impact our financial statements. We believe that the policies described below represent our critical accounting policies, as they have the greatest potential impact on our financial statements. However, you should also review our Summary of Significant Accounting Policies beginning on page F-8 of the notes to our consolidated financial statements contained in our Annual Report on Form 10-K for the fiscal year ended June 30, 2006.

Long-Lived Assets

Long-lived assets, including property and equipment, software development costs, patent costs, trademarks and licenses are reviewed for impairment using an undiscounted cash flow approach whenever events or changes in circumstances such as significant changes in the business climate, changes in product offerings, or other circumstances indicate that the carrying amount may not be recoverable.

Software Development Costs

Software development and modification costs incurred subsequent to establishing technological feasibility are capitalized and amortized based on anticipated revenue for the related product with an annual minimum charge equal to the straight-line amortization over the remaining economic life of the related products (generally three years). Amortization expense is included in cost of sales.

Goodwill

Goodwill is reviewed for impairment annually or whenever events such as significant changes in the business climate, changes in product offerings, or other circumstances indicate that the carrying amount may not be recoverable. We perform our annual goodwill impairment test at the end of each fiscal year using a discounted cash flow approach.

Revenue Recognition

Revenue is derived from hosted application transaction fees, software licenses, hardware sales, maintenance arrangements, hosting services, Electronic Postmark (EPM) sales and post contract customer support services. Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the selling price is fixed and collectibility is reasonably assured. Multiple-element arrangements are assessed to determine whether they can be separated into more than one unit of accounting. A multiple-element arrangement is separated into more than one unit of accounting if all of the following criteria are met: the delivered item has value to the customer on a stand alone basis; there is objective and reliable evidence of the fair value of the undelivered items in the arrangement, if the arrangement includes a general right of return relative to the delivered items, and delivery or performance of the undelivered item is considered probable and substantially in our control. If these criteria are not met, then revenue is deferred until such criteria are met or until the period over which the last undelivered element is delivered, which is typically the life of the contract

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agreement. If these criteria are met, we allocate total revenue among the elements based on the sales price of each element when sold separately which is referred to as vendor specific objective evidence or VSOE.

Security Software Solutions segment revenues are derived from hosted application transaction fees, software licenses, maintenance contracts, hosting services, Electronic Post Mark (EPM) sales and post contract customer support services. Revenue from hosted application transaction fees, EPM sales and post contract customer support services is recognized when the related service is provided and, when required, accepted by the customer. Software license revenue is recognized when the criteria discussed above is met. Maintenance and hosting services revenue is recognized over the period in which the service is performed. Revenue from multiple element arrangements that cannot be allocated to identifiable items is recognized ratably over the contract term which is generally one year.

Document Management Solutions segment revenues are derived from software licenses, maintenance contracts and hardware sales. Revenue from software licenses and hardware sales is recognized when the products are delivered to the customer in accordance with the criteria discussed above. Revenue from maintenance contracts is recognized over the period in which the service is performed which is generally one year.

Systems Integration segment revenues are derived from professional service fees and hardware sales. Revenue from professional services is recognized when services are completed and accepted by the customer. Revenue from hardware sales is recognized when the hardware is shipped to the customer.

Management Estimates

Preparing financial statements requires management to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses. Examples include estimates of loss contingencies and product life cycles, assumptions such as elements comprising a software arrangement, including the distinction between upgrades/enhancements and new products; when technological feasibility is achieved for our products; the potential outcome of future tax consequences; and determining when investment or other impairments exist. Actual results and outcomes may differ from management’s estimates, judgments and assumptions. We have based our estimates on historical experience and on various assumptions that are believed to be reasonable under the circumstances and we evaluate our estimates on a regular basis and make changes accordingly. Historically, our estimates relative to our critical accounting estimates have not differed materially from actual results; however, actual results may differ from these estimates under different conditions. If actual results differ from these estimates and other considerations used in estimating amounts reflected in our consolidated financial statements, the resulting changes could have a material adverse effect on our consolidated statement of operations, and in certain situations, could have a material adverse effect on liquidity and our financial condition.

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We write down inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of the inventory and the estimated market value based on assumptions about future demand and market conditions. We make estimates on the future recoverability of capitalized goodwill in the Security Software Solutions segment which is highly dependent on the future success of the marketing and sales of this segment. We record a valuation allowance against deferred tax assets when we believe it is more likely than not that such deferred tax assets will not be realized.

Stock-Based Compensation

We apply Statement of Financial Accounting Standard No. 123R, “Share Based Payment” (FAS 123R) to account for employee and director stock option plans. Share-based employee compensation expense is determined using the Black-Scholes option pricing model which values options based on the stock price at the grant date, the expected life of the option, the estimated volatility, expected dividend payments and the risk-free interest rate over the expected life of the options.

The Company computed the estimated fair values of all share-based compensation using the Black-Scholes option pricing model and the assumptions set forth in the following table. The Company based its estimate of the life of these options on historical averages over the past five years. The Company retained a third party valuation firm to calculate expected volatility which was based on the Company’s historical stock volatility, historical stock volatility of comparable companies in the industry and implied volatilities based on the spot market for traded options in the Company and comparable companies in the industry. The assumptions used in the Company’s Black-Scholes calculations for fiscal 2007 and 2006 are as follows:

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The Black-Scholes option-pricing model requires the input of highly subjective assumptions. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models may not provide a reliable single measure of the fair value of share-based compensation for employee stock options. Management will continue to assess the assumptions and methodologies used to calculate estimated fair value of share-based compensation as circumstances change and additional data becomes available over time, which may result in changes to these assumptions and methodologies. Such changes could materially impact the Company’s fair value determination.

Concentrations of Credit Risk

Financial instruments which subject us to concentrations of credit risk consist of cash and cash equivalents, marketable securities and trade accounts receivable. To reduce credit risk, we place our investments with several high credit quality financial institutions and typically invest in AA or better rated investments. Our credit customers are not concentrated in any specific industry or business. We establish an allowance for doubtful accounts based upon factors surrounding the credit risk of specific customers, historical trends and other information.

The following analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and notes thereto contained elsewhere in this Form 10-Q.

Results of Operations

Three and six months ended December 31, 2006 compared to three and six months ended December 31, 2005.

Net sales decreased slightly to $4,144,000 for the quarter ended December 31, 2006, compared to $4,211,000 for the prior year period. These results reflect a decrease in Security Software Solutions revenues to $1,002,000 compared to $1,253,000 for the prior year which included approximately $310,000 related to the amortization of deferred revenue. Excluding these one-time revenues from the prior year results, Security Software Solutions revenues increased approximately 6% due to increases in transaction volumes and new customers in both our US and German operations. Revenues in our Systems Integration segment increased 4% to $1,305,000, and revenues in our Document Management Solutions segment increased by 8% to $1,837,000. Net sales for the six months ended December 31, 2006 decreased to $7,601,000 from $8,514,000 in the comparable period in 2005. Security Software Solutions results reflect the same trends as above, revenues decreased to $1,885,000 compared to $2,374,000 for the prior year which included approximately $623,000 related to the amortization of deferred revenue and other one-time revenues. Excluding these one-time revenues from the prior year results, Security Software Solutions revenues increased approximately 7%. Revenues in our System Integration segment decreased 20% to $2,358,000 due to lower hardware sales and revenues in our Document Management Solutions segment increased 5% to $3,358,000.

Gross margin decreased to $2,252,000, or 54% of sales, for the quarter ended December 31, 2006, compared to $2,543,000, or 60% of sales, for the same period in 2005 due to the shortfall in sales and the increase in amortization expense for software development costs. The decrease in gross margin as a percent of sales for the quarter is due primarily to the one-time revenues discussed above and the increase in amortization expense. Gross margins for the six months ended December 31, 2006 decreased to $4,098,000, or 54% of sales, compared to $4,675,000, or 55% of sales, for the comparable period in 2005, reflecting the trends discussed above offset by an increase in higher margin software revenues in the overall sales mix. For the three and six months periods ended December 31, 2006 gross margins were approximately 50% and 44% for our Security Software Solutions segment, 80% and 81% for our Document Management Solutions segment and 21% and 24% for our Systems Integration segment.

Selling, general and administrative (SG&A) expenses decreased slightly to $5,594,000 for the quarter ended December 31, 2006, compared to $5,778,000 for the same period in 2005. This decrease reflects lower share-based compensation expense for the quarter which was offset in-part by legal expenses for on-going actions of approximately $750,000. SG&A expenses for the six months ended December 31, 2006 decreased to $11,356,000 compared to $11,469,000 for the comparable period in 2005. This decrease is due to lower share-based compensation expense offset primarily by legal expenses for on-going actions of approximately $1,300,000.

Product development expenses increased to $978,000 for the quarter ended December 31, 2006, compared to $879,000 for the comparable period in 2005. Product development spending relates primarily to our investment in our Security Software Solutions

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applications and fluctuates period to period based on the amounts capitalized. Total spending for the quarter, including capitalized amounts, was $1,441,000 compared to $1,488,000 for the prior year. Product development expenses for the six months ended December 31, 2006 increased to $1,947,000 compared to $1,597,000 for the comparable period in 2005. Total spending for the period was $2,792,000 compared to $2,716,000 for the prior year.

Interest and other income decreased by $50,000 to $508,000 for the quarter ended December 31, 2006 and was essentially flat for the six month periods ended December 31, 2006 and 2005. These trends reflect higher interest rates during the 2006 periods, net of the effect of lower cash and investment balances as we continue to invest in our business.

Net loss for the quarter ended December 31, 2006 was $3,812,000, or $0.11 per share, compared to $3,556,000, or $0.10 per share, for the quarter ended December 31, 2005. Net loss for the six months ended December 31, 2006 was $8,107,000, or $0.24 per share, compared to $7,304,000, or $0.21 per share, for the comparable period in 2005. These results reflect the shortfall in sales and the higher legal and product development expenses discussed above. Our net loss relates primarily to our Security Software Solutions business and corporate expenses as we continue to invest in sales, marketing, product development and administrative costs to grow this business.

Liquidity and Capital Resources

Overview

Our operations and product development activities have required substantial capital investment to date. Our primary sources of funds have been the issuance of equity and the incurrence of third party debt. In February 2004, we sold 5,360,370 common shares in private placements pursuant to Section 4(2) of the Securities Act of 1933 and Rule 506, promulgated thereunder. We realized gross proceeds of approximately $73,700,000 from these transactions and received net proceeds of approximately $69,100,000 after payment of offering expenses and broker commissions. We have been using the cash raised in this financing to fund our operations and product development activities since that time.

We have a $2,500,000 revolving line of credit with a financial institution collateralized by all assets of a subsidiary and guaranteed by Authentidate Holding Corp. The agreement restricts the subsidiary from making cash advances to AHC, without obtaining a waiver from the financial institution. The interest rate is prime plus 1.75% with a minimum prime rate of 7%. The subsidiary may borrow on this line based on a formula of qualified accounts receivable and inventory. The outstanding balance on this line of credit was approximately $210,000 at December 31, 2006.

Property, plant and equipment expenditures totaled approximately $214,000, software license expenditures totaled approximately $329,000 and capitalized software development expenditures totaled approximately $845,000 for the six months ended December 31, 2006. We have developed and intend to continue to develop new applications to grow our business and address new markets.

Cash Flows

At December 31, 2006, cash, cash equivalents and marketable securities amounted to approximately $35,982,000 and total assets at that date were $56,745,000. These amounts have decreased since June 30, 2006 by $9,923,000 and $7,789,000, respectively, as we utilized cash principally to fund operating losses, product development activities, changes in working capital and capital expenditures for corporate infrastructure during the six months ended December 31, 2006. Cash used for the period also includes expenditures of approximately $1,800,000 for on-going legal actions and settlements and $360,000 for payment of accrued severance obligations. We expect to continue to use cash to fund operating losses, product development activities and capital expenditures for the foreseeable future.

Net cash used by operating activities for the six months ended December 31, 2006 was $8,522,000 compared to $7,893,000 for the comparable period in 2005. This increase is due primarily to the legal expenditures discussed above, the increase in product development expenses and changes in working capital.

Net cash used by investing activities, excluding purchases and sales of marketable securities, was $1,388,000 for the six months ended December 31, 2006, compared to $2,051,000 for the comparable period in 2005. This decrease relates primarily to the amount of product development spending capitalized in 2006 and the increase in restricted cash during the six months ended December 31, 2005 related to our lease agreement for our executive offices (see “Contractual Commitments” below).

Cash flows from financing activities for the six months ended December 31, 2006 and 2005 were not significant.

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To date we have been largely dependent on our ability to sell additional shares of our common stock or other securities to obtain financing to fund our operating deficits, product development activities and capital expenditures. Under our current operating plan to grow our Security Software Solutions business, our ability to improve operating cash flow has been highly dependent on the market acceptance of our products. We believe we have enough cash, cash equivalents and marketable securities to support our operations for at least the next twelve months.

Our future capital requirements may vary materially from those now planned. The amount of capital that we will need in the future will depend on many factors, including: