Aeon Global Health Corp. - Quarter Report: 2006 March (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: MARCH 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

Index

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Part I Financial Information

Authentidate Holding Corp. and Subsidiaries

Condensed Consolidated Balance Sheets

( in thousands )

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)

(in thousands, except per share data)

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)

(in thousands)

The accompanying notes are an integral part of the Condensed Consolidated Financial Statements

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Authentidate Holding Corp.

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 nine months ended March 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, 2005 and the attached Management’s Discussion and Analysis of Financial Conditions and Results of Operation.

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):

Common stock equivalents were excluded from the calculation of net loss per share for all periods presented because their impact is antidilutive. At March 31, 2006, employee and non-executive director options (4,920,000), warrants (1,262,000), performance based consultant options (375,000) and convertible preferred stock (500,000) were outstanding. At March 31, 2005, employee and non-executive director options (5,086,000), warrants (1,352,000), and convertible preferred stock (500,000) were outstanding.

3. Stock Based Compensation

Effective July 1, 2005, the Company adopted Statement of Financial Accounting Standard No. 123R, Share Based Payment (“FAS 123R”), which requires all share-based payments, including grants of stock options, to be recognized in the income statement as a compensation expense, based on their fair values. Under the provisions of FAS 123R, the estimated fair value of options granted under the Company’s Employee Stock Option Plan and Non-Executive Director Stock Option Plan are recognized as compensation expense over the option-vesting period. The Company is using the modified prospective method, in which compensation expense is recognized beginning with the effective date of adoption of FAS 123R for all share-based payments (i) granted after the effective date of adoption and (ii) granted prior to the effective date of adoption that were unvested on the date of adoption.

Prior to July 1, 2005, the Company applied APB Opinion No. 25, Accounting for Stock Issued to Employees, in accounting for its employee share-based compensation. Under the provisions of APB 25, no compensation expense was recognized when stock options were granted with exercise prices equal to or greater than market value on the date of grant.

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The effect on net loss and loss per share of utilizing the fair value method for the prior periods in comparison to the current period is as follows (in thousands, except per share data):

For the three and nine months ended March 31, 2006 the Company’s net loss included $525,000 and $1,779,000, respectively, of share-based compensation. Had the Company continued to account for share-based compensation under APB Opinion No. 25, basic and diluted loss per common share for the three and nine months ended March 31, 2006 would have been $0.12 and $0.30 compared to $0.13 and $0.35, respectively. No share based compensation expense was included in the Company’s Statements of Operations for the three and nine months ended March 31, 2005.

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

Share-based compensation expense had no effect the Statements of Cash Flow.

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

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Under the modified prospective method of transition under FAS 123R, the Company is not required to restate its prior period financial statements to reflect expensing of share-based compensation under FAS 123R. Therefore, the results for the 2006 periods are not directly comparable to the same periods in the prior year.

Prior to the adoption of FAS No. 123R, the Company presented cash flows resulting from the tax benefits of deductions from the exercise of stock options as operating cash flows in the Statements of Cash Flows. FAS No. 123R requires cash flows resulting from the tax benefits from tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) to be classified as financing cash flows. The Company did not realize any tax benefits from the exercise of stock options during the three and nine month periods ended March 31, 2006.

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 2006 and fiscal 2005 are as follows:

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”) combined for the period ended March 31, 2006 is as follows (in thousands, except per share and average life data):

There was 6,700 options exercised during the nine month period ended March 31, 2006, the total intrinsic value of those options was $14,000. Additionally, the weighted average, grant date fair value of options granted during the nine-month period ended March 31, 2006 was approximately $0.79 using the Black-Scholes model.

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

As of March 31, 2006, there was $2,773,000 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 15 months.

During the nine months ended March 31, 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.

4. Comprehensive Loss:

Comprehensive loss for the periods is as follows (in thousands):

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 solutions 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 solutions offered in Europe are compliant with the German Signature Act and European guidelines. The software solutions 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, and other non-operating costs to the individual operating segments. These costs 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.

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Segment information is as follows (in thousands):

Net sales from external customers for our Security Software Solutions segment includes revenues from our German operations of approximately $884,000 and $1,988,000 for the three months and nine months ended March 31, 2006, respectively.

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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. Revisions in Classification of Certain Securities

As reported on the Company’s Form 10K/A for the year ended June 30, 2004, the Company reclassified auction rate securities from cash and cash equivalents to marketable securities. As a result of this change, the Statement of Cash Flows for the nine months ended March 31, 2005 has been amended in this Form 10Q. The Company has included $6,450,000 as “Net sales (purchases) of marketable securities”. As a result, the total “Net cash used in investing activities” has been amended from $2,248,000 to $8,697,000. Total Net decrease in cash and cash equivalents” has been amended from $8,439,000 to $14,889,000. Furthermore, “Cash and cash equivalents, end of period” has been amended from $21,350,000 to $27,801,000 as $56,075,000 of auction rate securities were reclassified to marketable securities as of March 31, 2005.

8. Inventories

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

9. Goodwill and Other Intangible Assets

The Company performs an annual valuation of goodwill during the fourth quarter of each fiscal year. Any adverse development or change in our business would require an interim assessment. For the nine months ended March 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 Securities Software Solutions business and approximately $7,341,000 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. As of March 31, 2006, amortization expense for other intangible assets for the next five fiscal years ending 2010 is as follows (in thousands):

Other intangible asset amortization expense for the three and nine periods ended March 31, 2006 was $42,000 and $129,000, respectively.

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10. Shareholders’ Equity

The changes in Shareholders’ Equity for the nine months ended March 31, 2006 are summarized as follows (in thousands):

During the three and nine months ended March 31, 2006, 6,700 stock options were exercised and no common stock warrants were exercised.

11. 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.

12. 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. This award has been recorded as an expense during the quarter ended March 31, 2006. The Company 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. On May 1, 2006, the court denied the Company’s 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. The Company is further reviewing the court’s decisions and is considering its alternatives, including appealing the verdict.

We are also 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. This complaint 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., 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. Plaintiffs have not yet filed their arbitration brief. We intend to defend the action vigorously. Management believes that the resolution of this claim will not have a material adverse effect on our financial condition. However, there can be no assurance 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 position.

In June, July 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 these actions allege that defendants violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Sections 11, 12(a), and 15 of the Securities Act of 1933. The alleged class period is August 6, 2002 through May 27, 2005. The securities law claims are based on the allegation that we failed to disclose that the USPS could cancel its August 2002 contract with

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us if we did not meet certain performance metrics, and when we disclosed on September 8, 2004 that we failed to comply with those metrics and on May 27, 2005 that we had received a second notice from the USPS that we had failed to obtain the minimum revenue required under the agreement, the market price of our stock declined. The class action complaints seek unspecified monetary damages. On October 5, 2005 the Court granted the motion of one plaintiff, the Illinois State Board of Investment, to be appointed as lead plaintiff under the Private Securities Litigation Reform Act. The caption of the case is In re Authentidate Holding Corp. Securities Litigation., C.A. No. 05 Civ. 5323 (LTS). Plaintiff filed an amended consolidated complaint on January 3, 2006. The amended complaint asserts the same claims as the prior complaint and also alleges that Authentidate violated the federal securities laws by misrepresenting that it possessed certain patentable technology. Defendants’ motion to dismiss the amended complaint was filed on March 6, 2006. Oral argument on the motion to dismiss is scheduled for June 30, 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 are 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. Defendants moved to dismiss this complaint on January 13, 2006. On March 10, 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, which the court indicated would be granted. Plaintiffs filed this motion on April 18, 2006 and the Court entered an order dismissing the consolidated complaint on May 5, 2006.

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. The plaintiff in the state court action is expected to file an amended complaint.

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 our 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. Based on the facts of which we are currently aware, management believes that the resolution of all of our claims with TimeCertain will not have a materially 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.

On July 31, 2002, we entered into a strategic alliance agreement with the United States Postal Service to serve as a preferred provider of the USPS Electronic Postmark^® (EPM) service. Under the terms of the agreement, our subsidiary, Authentidate, Inc., provides the management, technology and

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support for the United States Postal Service’s EPM system. The USPS is the vendor of the EPM to the end user. The USPS Electronic Postmark^® provides evidence that the content of a document or file existed at a specific date and time and is intended to protect the integrity of the document or file by ensuring that it cannot be altered without detection. The EPM uses our patent pending technology offering highly sophisticated encryption methodology ensuring document authenticity and is intended to be able to be added to any application regardless of the computing platform or operating system.

To date, we have not achieved the revenue metrics required under our agreement with the United States Postal Service. We received a third letter from the USPS in October 2005, which letter stated the Company continues to fail to attain the performance metrics required by the Strategic Alliance Agreement. However, the USPS also stated it has 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. The Company and the United States Postal Service have continued to discuss various amendments to the original agreement and we believe these discussions will lead to changes to the contract that we and the United States Postal Service will both agree to and which will enable us to continue our relationship with the United States Postal Service. No assurances can be given that we will be successful in completing these negotiations or that we will we will comply with the current performance metrics in a timely manner, and the USPS may terminate the agreement at any time.

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 March 31, 2006, we were not aware of any obligations under such indemnification agreements that would require material payments.

Management’s Discussion and Analysis of

Financial Condition and Results of Operations

Item 2.

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, 2005 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.

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Overview

Authentidate Holding Corp., through its subsidiaries, 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 solutions 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. 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 solutions that incorporate our 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. 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 solutions offered in Europe are compliant with the German Signature Act and European guidelines. We sell our software solutions 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 April 2005, we developed a new service to authenticate documents received by fax and in October 2005 we announced CareFax™, a web-based, HIPAA compliant fax automation and workflow solution that addresses compliance needs associated with document processing in the healthcare sector. CareFax™ was initially targeted at the medical supply healthcare sector which continues to be fax intensive. Our CareCert™ service, which was developed in 2004, offers healthcare providers an electronic, paperless solution for processing critical documents. We intend to continue our efforts to market our software solutions 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 28% of consolidated revenues for the three and nine month periods ended March 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 and implementations can have a significant impact on quarterly 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 United States Postal Service’s EPM system. The USPS is the vendor of the EPM to the end user and we serve as a preferred provider of the EPM service. The USPS EPM incorporates our proprietary content authentication technology. To date, we have not achieved the revenue metrics included in our strategic alliance agreement with the United States Postal Service. From September 2004 through October 2005, we received several letters from the USPS regarding our performance under the agreement with respect to such metrics and we have been engaged in negotiations with the USPS to, among other things, modify this provision of the 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 has 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

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continued our efforts to cure the default and to negotiate an appropriate modification to our agreement. No assurances, however, can be given that we will be successful in completing these negotiations or that we will comply with the current performance metrics in a timely manner, and the USPS may terminate the agreement at any time.

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. In 2005, we continued our reduced emphasis on hardware sales and improved our gross margins. In 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. We intend to pursue these strategies to grow our business in the future.

Our Document Management Solutions business represented approximately 34% and 36%, respectively, of consolidated revenues for the three and nine month periods ended March 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 quarterly results. We believe our results over a longer period of time provide better visibility into our performance.

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 38% and 36%, respectively, of consolidated revenues for the three and nine month periods ended March 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. Quarterly 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.

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.

Principles of Consolidation

The financial statements include the accounts of Authentidate Holding Corp. and its subsidiaries. Intercompany transactions and balances have been eliminated. Equity investments where we do not exercise significant influence over the investee are accounted for under the cost method.

Cash Equivalents

We consider all highly liquid investments with maturities of three months or less when purchased to be cash equivalents. At March 31, 2006 and June 30, 2005, cash equivalents consisted primarily of investments of high quality short term investments such as commercial paper and overnight interest bearing deposits.

Marketable Securities

Our marketable securities are generally comprised of auction rate securities rated AAA or AA by one or more national rating agencies. The auction rate securities have contractual maturities of up to 30 years, but generally have interest re-set dates that occur every 7, 28 or 35 days and despite the long-term nature of their stated contractual maturities, we have the ability to quickly liquidate these securities at

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ongoing auctions every 35 days or less. We classify our investments in auction rate securities as “available for sale.” These investments are recorded at cost which approximates fair market value due to their variable interest rates, which typically reset every 7, 28 or 35 days. As a result, we had no cumulative gross unrealized holding gains (losses) or gross realized gains (losses) from our current investments. All income generated from these investments was recorded as interest income. Because we do not hold any auction rate security longer than one year, such securities have been classified as current assets.

Accounts Receivable

Accounts receivable represent receivables, net of allowances for doubtful accounts. The allowance for doubtful accounts reflects our best estimate of probable losses inherent in the accounts receivable balance. We determine the allowance based on known troubled accounts, historical experience and other currently available evidence.

Inventories

Inventories are stated at the lower of cost or market and are valued at average cost.

Long-Lived Assets

Long-lived assets, including property and equipment, software development costs, patent costs, trademarks and licenses are reviewed for impairment 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.

Property and Equipment