Enveric Biosciences, Inc. - Quarter Report: 2005 September (Form 10-Q)

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

þ		Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
		For the period ended: September 30, 2005

o		Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
		Commission File Number: 000-26460

SPATIALIZER AUDIO LABORATORIES, INC.

(Exact name of registrant as specified in its charter)

Delaware		95-4484725
(State or other jurisdiction of		(IRS Employer
incorporation or organization)		Identification No.)

2625 Townsgate Road, Suite 330
Westlake Village, California 91361

(Address of principal executive offices)

2025 Gateway Place, Suite 365
San Jose, California 95110

(Address of principal corporate offices)

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days:

Yes þ		No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act):

Yes o		No þ

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act):

Yes o		No þ

As of October 25, 2005, there were 46,975,365 shares of the Registrant’s Common Stock outstanding.

 

 

SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

		September 30,				December 31,
		2005				2004
		(unaudited)
ASSETS
Current Assets:
Cash and Cash Equivalents		$	674,427			$	871,155
Accounts Receivable, net			187,353				325,712
Prepaid Expenses and Deposits			42,280				70,940
Total Current Assets			904,060				1,267,807
Property and Equipment, net			22,469				29,527
Intangible Assets, net			141,256				166,710
Total Assets		$	1,067,785			$	1,464,044
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current Liabilities:
Note Payable			36,361				66,252
Accounts Payable			25,703				71,873
Accrued Wages and Benefits			44,940				50,446
Accrued Professional Fees			22,500				20,000
Accrued Commissions			34,255				32,182
Accrued Expenses			984				32,979
Deferred Revenue							391,395
Total Current Liabilities			164,743				665,127
Commitments and Contingencies
Series B-1, Redeemable Convertible Preferred shares, $.01 par value, 1,000,000 shares authorized, 118,351 shares issued and outstanding at September 30, 2005 and December 31, 2004			1,182				1,182
Shareholders’ Equity:
Common shares, $.01 par value, 65,000,000 shares authorized, 46,975,365 shares issued and outstanding at September 30, 2005 and December 31, 2004			469,754				469,754
Additional Paid-In Capital			46,428,866				46,428,866
Accumulated Deficit			(45,996,760	)			(46,100,885	)
Total Shareholders’ Equity			901,860				797,735
		$	1,067,785			$	1,464,044

SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)

		For the Three Month Period Ended								For the Nine Month Period Ended
		September 30,				September 30,				September 30,				September 30,
		2005				2004				2005				2004
Revenues:
Royalty Revenues			270,914				205,324				1,031,777				610,863
			270,914				205,324				1,031,777				610,863
Cost of Revenues			12,752				26,114				89,514				61,252
Gross Profit			258,162				179,210				942,263				549,611
Operating Expenses:
General and Administrative			116,539				155,268				457,463				528,181
Research and Development			62,068				93,842				244,717				295,630
Sales and Marketing			45,356				11,484				140,810				46,962
			223,963				260,594				842,990				870,773
Operating (Loss)			34,199				(81,384	)			99,273				(321,162	)
Interest and Other Income			3,376				744				9,992				2,633
Interest and Other Expense			(1,030	)			(1,936	)			(5,140	)			(8,702	)
			2,346				(1,192	)			4,852				(6,069	)
Income (Loss) Before Income Taxes			36,545				(82,576	)			104,125				(327,231	)
Income Taxes			—				2,000				—				(400	)
Net Income (Loss)		$	36,545			$	(80,576	)		$	104,125			$	(327,631	)
Basic and Diluted Earnings Per Share		$	0.00			$	(0.00	)		$	0.00			$	(0.01	)
Weighted Average Shares Outstanding			46,975,365				46,975,365				46,975,365				46,975,365

See notes to consolidated financial statements

SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES

		Nine Months Ended September 30,
		2005				2004
Cash Flows from Operating Activities:
Net Income (Loss)		$	104,125			$	(327,631	)
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
Depreciation and Amortization			37,789				52,816
Net Change in Assets and Liabilities:
Accounts Receivable and Employee Advances			138,359				137,382
Prepaid Expenses and Deposits			28,660				(59,644	)
Accounts Payable			(46,170	)			(4,245	)
Accrued Wages and Benefits			(5,506	)			2,925
Accrued Professional Fees			2,500				(5,000	)
Accrued Commissions			2,073				4,692
Accrued Expenses			(31,995	)			3,999
Deferred Revenue			(391,395	)			547,953
Net Cash Provided By (Used In) Operating Activities			(161,560	)			353,247
Cash Flows from Investing Activities:
Purchase/Disp of Property and Equipment			(5,277	)			(3,247	)
Increase in Capitalized Patent and Technology Costs			—				(16,580	)
Net Cash Provided By (Used in) Investing Activities			(5,277	)			(19,827	)
Cash flows from Financing Activities:
Issuance (Repayment) of Notes Payable			(29,891	)			(3,170	)
Net Cash Provided by Financing Activities			(29,891	)			(3,170	)
Increase (Decrease) in Cash and Cash Equivalents			(196,728	)			330,250
Cash and Cash Equivalents, Beginning of Period			871,155				589,797
Cash and Cash Equivalents, End of Period		$	674,427			$	920,047
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Interest		$	5,140			$	6,766
Income Taxes							2,400

See notes to consolidated financial statements

SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES

		Common Shares																Total
		Number of								Additional				Accumulated				Shareholders’
		shares				Par value				paid-in-capital				Deficit				Equity
Balance, December 31, 2004			46,975,365			$	469,754			$	46,428,866			$	(46,100,885	)		$	797,735
Net Income			—				—				—				10,014				10,014
Balance, March 31, 2005			46,975,365			$	469,754			$	46,428,866			$	(46,090,871	)		$	807,749
Net Income															57,566			$	57,566
Balance, June 30, 2005			46,975,365				469,754				46,428,866				(46,033,305	)			865,315
Net Income															36,545			$	36,545
Balance, September 30, 2005			46,975,365				469,754				46,428,866				(45,996,760	)			901,860

See notes to consolidated financial statements

SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

1) Nature of Business

     Spatializer Audio Laboratories, Inc. and subsidiaries (the “Company”) is in the business of developing and licensing technology. The Company’s sales, research and subsidiary administration are conducted out of facilities in San Jose, California.

     The Company’s wholly-owned subsidiary, Desper Products, Inc. (“DPI”), is in the business of developing proprietary advanced audio signal processing technologies and products for consumer electronics, entertainment, and multimedia computing. All Company revenues are generated from this subsidiary.

     The foregoing interim financial information is unaudited and has been prepared from the books and records of the Company. The financial information reflects all adjustments necessary for a fair presentation of the financial condition, results of operations and cash flows of the Company in conformity with generally accepted accounting principles. All such adjustments were of a normal recurring nature for interim financial reporting. Operating results for the three months ended September 30, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005. Accordingly, your attention is directed to footnote disclosures found in the December 31, 2004 Annual Report and particularly to Note 1, which includes a summary of significant accounting policies.

(2) Significant Accounting Policies

     Basis of Consolidation — The consolidated financial statements include the accounts of Spatializer Audio Laboratories, Inc. and its wholly-owned subsidiary, DPI. All significant intercompany balances and transactions have been eliminated in consolidation. Corporate administration expenses are not allocated to subsidiaries.

     Revenue Recognition — The Company recognizes royalty revenue upon reporting of such royalties by licensees. License revenues are recognized when earned, in accordance with the contractual provisions, typically upon our delivery of contracted services or delivery and contractual availability of licensed product. Royalty revenues are recognized upon shipment of products incorporating the related technology by the original equipment manufacturers (OEMs) and foundries, as reported by quarterly royalty statements. The Company recognizes revenue in accordance with SEC Staff Accounting Bulletin (SAB) 104.

     Deferred Revenue — The Company receives royalty fee advances from certain customers in accordance with contract terms. The Company does not require advances from all customers. Advances are negotiated on a per contract basis. Cash received in advance of revenue earned from a contract is recorded as deferred revenue until the related contract revenue is earned under the Company’s revenue recognition policy.

     Concentration of Credit Risk — Financial instruments, which potentially subject the Company to concentrations of credit risk, consist principally of cash, cash equivalents and trade accounts receivable. The Company places its temporary cash investments in certificates of deposit in excess of FDIC insurance limits, principally at CitiBank FSB. At September 30, 2005 substantially all cash and cash equivalents were on deposit at two financial institutions.

     At September 30, 2005, three customers, not presented in the order of importance, Matsushita, Sharp and Funai, accounted for 42%, 21% and 20% respectively of our. accounts receivable. At September 30, 2004, four major customers, not presented in order of importance, each accounted for 10% or more of our total accounts receivable: Matsushita, Toshiba, InterVideo and Sharp, each of whom accounted for greater than 10% of our total 2004 accounts receivable. One OEM accounted for 38%, another accounted for 17%, another accounted for 16% and one accounted for 15% of our total accounts receivable at September 30, 2004.

     The Company performs ongoing credit evaluations of its customers and normally does not require collateral to support accounts receivable. Due to the contractual nature of sales agreements and historical trends, no allowance for doubtful accounts has been provided.

     The Company does not apply interest charges to past due accounts receivable.

     Cash and Cash Equivalents — Cash equivalents consist of highly liquid investments with original maturities of three months or less.

     Customers Outside of the U.S. — Sales to foreign customers were 100% and 88% of total sales in the year to date periods ended September 30, 2005 and 2004, respectively. Approximately 62% and 38% of sales were generated in Japan and Korea, respectively, in the nine months ended September 30, 2005.

     Major Customers — During the quarter ended September 30, 2005, four customers, Sharp, Samsung, Funai and Matsushita, not presented in order of importance, accounted for 29%, 29%, 14% and 14% of the Company’s revenue in the quarter ended September 30, 2005. In the nine months ended September 30, 2005, two customers, Samsung and Matsushita, not presented in order of importance, accounted for 38% and 31% of the Company’s revenue.

     Research and Development Costs — The Company expenses research and development costs as incurred, which is presented as a separate line on the statement of operations.

     Property and Equipment — Property and equipment are stated at cost. Major renewals and improvements are charged to the asset accounts while replacements, maintenance and repairs, which do not improve or extend the lives of the respective assets, are expensed. At the time property and equipment are retired or otherwise disposed of, the asset and related accumulated depreciation accounts are relieved of the applicable amounts. Gains or losses from retirements or sales are credited or charged to income. Property and equipment are depreciated over the useful lives of the asset ranging from 3 years to 5 years under the straight line method.

     Intangible Assets — Intangible assets consist of patent costs and trademarks which are amortized on a straight-line basis over the estimated useful lives of the patents which range

from five to twenty years. The weighted average useful life of patents was approximately 11 years. All of our Intangible Assets have finite lives as defined by Statement of Financial Accounting Standard (SFAS) 142.

     Earnings Per Share — Basic earnings (loss) per share is computed by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted earnings (loss) per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. The following table presents contingently issuable shares, options and warrants to purchase shares of common stock that were outstanding during the three month and nine month periods ended September 30, 2005 and 2004 which were not included in the computation of diluted loss per share because the impact would have been antidilutive or less than $0.01 per share:

		2005				2004
Options			2,960,000				3,135,000
Warrants			0				0
			2,960,000				3,135,000

     Stock Option Plan —The Company determines the effect of stock based compensation in accordance with SFAS No. 123, Accounting for Stock-Based Compensation, as amended which permits entities to recognize as expense using the “fair-value” method over the vesting period of all employee stock-based awards on the date of grant. Alternatively, SFAS No. 123 allows entities to continue to utilize the “intrinsic value” method for equity instruments granted to employees and provide pro forma net income (loss) and pro forma earnings (loss) per share disclosures for employee stock option grants after 1994 as if the fair-value-based method defined in SFAS No. 123 has been applied.

     Impairment of Long-Lived Assets and Assets to be Disposed of — The Company adopted the provisions of SFAS No. 144, Accounting for the Impairment of Long-Lived Assets, on January 1, 2002. This Statement requires that long-lived assets and certain identifiable intangibles be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured as the amount by which the carrying amounts of the assets exceed the fair value of the assets.

     Segment Reporting — The Company adopted SFAS 131, Disclosures about Segments of an Enterprise and Related Information (“SFAS No. 131”), in December 1997. MDT has been considered a discontinued operation since September 1998. As of December 31, 2002, the Company has only one operating segment, DPI, the Company’s audio enhancement licensing business.

     Income Taxes — Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

     Recent Accounting Pronouncements — In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123R, “Share Based Payment”. This Statement is a revision of FASB Statement No. 123, “Accounting for Stock-Based Compensation”. This Statement supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees” and its related implementation guidance. This Statement establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. The Statement focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. This Statement does not change the accounting guidance for share-based payment transactions with parties other than employees provided in Statement 123 as originally issued and EITF Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.” This Statement does not address the accounting for employee share ownership plans, which are subject to AICPA Statement of Position 93-6, “Employers’ Accounting for Employee Stock Ownership Plans”. The Securities and Exchange Commission has delayed the adoption requirement of SFAS No. 123R until the first annual period beginning after December 15, 2005. We expect to adopt SFAS No. 123R on January 1, 2006 as required.

     In May 2005 the FASB issued SFAS 154 “Accounting Changes and Error Corrections”. This Statement replaces APB Opinion No. 20, “Accounting Changes”, and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements”, and changes the requirements for the accounting for and reporting of a change in accounting principle and also corrections of error in previously issued financial statements. This Statement harmonizes US accounting standards with existing international accounting standards by requiring companies to report voluntary changes in accounting principles via a retrospective application, unless impracticable. Also, the reporting of an error correction involves adjustments to previously issued financial statements similar to those generally applicable to reporting an accounting change retrospectively. This pronouncement is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005

     The Company believes that the adoption of these pronouncements may not have a material effect on the Company’s financial position, results from operations or cash flows. This impact cannot be determined at this time, as future option grants are indeterminable.

     Use of Estimates — Management of the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these financial statements in conformity with generally accepted accounting principles. Actual results could differ from those estimates.

     Fair Value of Financial Instruments — The fair and carrying values of cash equivalents, accounts receivable, accounts payable, short-term debt to a related party and accrued liabilities and those potentially subject to valuation risk at December 31, 2004 and September 30, 2005 approximated fair value due to their short maturity or nature.

     The fair values of notes payable to a related party at December 31, 2004 and September 30, 2005 are materially consistent with the related carrying values based on current rates offered to the Company for instruments with similar maturities.

(3) Property and Equipment

     Property and equipment, as of December 31, 2004 and September 30, 2005, consists of the following in accordance with application of SFAS 144:

		September				December 31,
		30, 2005				2004
Office Computers, Software, Equipment and Furniture		$	337,144			$	331,867
Test Equipment			73,300				73,300
Tooling Equipment			45,539				45,539
Trade Show Booth and Demonstration Equipment			174,548				174,548
Automobiles			7,000				7,000
Total Property and Equipment			637,531				632,253
Less Accumulated Depreciation and Amortization			615,062				602,727
Property and Equipment, Net		$	22,469			$	29,527

(4) Intangible Assets

     Intangible assets, as of December 31, 2004 and September 30, 2005 consist of the following:

		September 30,				December 31,
		2005				2004
Capitalized Patent, Trademarks and Technology Costs		$	522,827			$	522,827
Less Accumulated Amortization			381,571				356,117
Intangible Assets, Net		$	141,256			$	166,710

     Estimated amortization is as follows:

2005		$	16,702
2006		$	16,702
2007		$	16,702
2008		$	16,702
Thereafter		$	74,448

(5) Notes Payable

     The Company was indebted to the Premium Finance, Inc., an unrelated insurance premium finance company, in the amount of $26,106 at September 30, 2005. This note finances the Company’s annual Directors’ and Officers’ Liability Insurance. This amount bears interest at a fixed rate of 10% annually, is paid in monthly installments of $5,221 that commenced on June 1, 2005 and continues for nine months until the entire balance of principal and interest is paid in full.

     The Company was indebted to the Desper Family Trust, in the amount of $10,254 at September 30, 2005. The Desper Family Trust’s principal beneficiary is the mother of a former director of the Company. This director’s term expired in June 2003 and as such, is not a related party. This note bears interest at a fixed rate of 10% annually, is paid in monthly installments of $5,191 that commenced on December 1, 2003 and continues for twenty-four months until the entire balance of principal and interest is paid in full. All remaining installments are due in no more than twelve months from September 30, 2005.

(6) Shareholders’ Equity

     During the quarter ended September 30, 2005, no shares were issued, cancelled or converted.

     During the quarter ended June 30, 2005, shares were issued, cancelled or converted as follows:

Options to purchase 75,000 and 100,000 shares of common stock previously granted to an employee, at exercise prices of $0.27 and $0.05, respectively, were cancelled upon his resignation from the Company.

     During the quarter ended March 31, 2005, shares were issued, cancelled or converted as follows:

     Options to purchase a total of 500,000 shares of common stock were granted to the CEO related to the extension of his employment agreement. These options vested half on issuance

and half in November, 2005, if the executive is in the employ of the Company. These options may be exercised at a price of $0.10 per share through February, 2010. These options had no value at September 30, 2005.

     During the year ended December 31, 2004, shares were issued or converted as follows:

Unissued Performance Shares held in escrow were cancelled.

Options to purchase 200,000 common shares in exchange for services were issued with a value of $1,000.

Capitalization

Series A Preferred Stock: On December 26, 2002 the Company filed a Certificate of Elimination with the Delaware Secretary of State stating that no shares of the Company’s Series A Preferred Stock are outstanding and that no shares of the Series A Preferred Stock will be issued.

Series B Preferred Stock: On December 26, 2002 the Company filed a Certificate of Elimination with the Delaware Secretary of State stating that no shares of the Company’s Series B Preferred Stock are outstanding and that no shares of the Series B Preferred Stock will be issued.

Series B-1 Redeemable Convertible Preferred Stock: On November 6, 2002 the Board of Directors Designated a Series B-1 Preferred Stock. The series has a par value of $0.01 and a stated value of $10.00 per share and is designated as a liquidation preference. The stock will rank prior to the Company’s common stock. No dividends will be paid on the Series B-1 Preferred Stock. Conversion rights vested on January 1, 2003 to convert the Series B-1 Preferred Stock to common stock at a certain formula based on an average closing share price, subject to a floor of $0.56 and a ceiling of $1.12. At December 29, 2005 certain mandatory conversion requirements exist subject to the above formula. The Series B-1 Preferred Stock has no voting power. Certain restrictions on trading exist based on date sensitive events based on the Company’s Insider Trading Policy. In December 2002, 87,967 shares of Series B-1 Preferred Stock were issued in exchange for the Series B Preferred Stock and 14,795 shares were issued in lieu of the adjusted accrued dividends on the Series B Preferred Stock. In 2004, the Company reflected the issuance of 15,384 shares of Class B-1 Convertible Preferred Stock that was originally recorded in Additional Paid in Capital. This resulted in a reclassification of $154 to Convertible Preferred Stock from APIC.
        .

(7) Stock Options

     In 1995, the Company adopted a stock option plan (the “Plan”) pursuant to which the Company’s Board of Directors may grant stock options to directors, officers and employees. The Plan which was approved by the stockholders authorizes grants of options to purchase authorized but unissued common stock up to 10% of total common shares outstanding at

each calendar quarter, 4,697,537 as of September 30, 2005. Stock options were granted under the Plan with an exercise price equal to the stock’s fair market value at the date of grant. Outstanding stock options under the Plan have five-year terms and vest and become fully exercisable up to three years from the date of grant. The Plan expired in February 2005. To date, the Company has not adopted a new stock option plan.

     There were 500,000 options granted in the quarter ended March 31, 2005 to the CEO related to the extension of his employment agreement. These options vested half on issuance and half in November, 2005, if the executive is in the employ of the Company. These options may be exercised at a price of $0.10 per share through February, 2010. The Company cancelled 175,000 options previously granted to an employee, upon his resignation.

     The Company applies APB Opinion No. 25 in accounting for its Plan and, accordingly, no compensation cost has been recognized for the fair value of its stock options in the consolidated financial statements. Had the Company determined compensation cost based on the fair value at the grant date for its stock options under SFAS No. 123, the Company’s net income would have been reduced to the pro forma amounts indicated below:

		2005				2004
NET INCOME (LOSS):
As Reported		$	104,125			$	(327,631	)
Pro Forma		$	93,625			$	(328,631	)
BASIC AND DILUTED LOSS:
As Reported		$	0.00			$	(0.01	)
Pro Forma		$	0.00			$	(0.01	)

          The per share weighted-average fair value of stock options granted during 2005 was $0.04, on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions: expected dividend yield 0%, risk-free interest rate of 4.5%, expected volatility of 100% and an expected life of 5 years.

     At September 30, 2005, the number of options exercisable was 2,960,000 and the weighted-average exercise price of those options was $0.10.

     There were no warrants outstanding at December 31, 2004 and September 30, 2005.

(8) Commitments and Contingencies

     We also anticipate that, from time to time, we may be named as a party to legal proceedings that may arise in the ordinary course of our business.

Operating Lease Commitments

     The Company is obligated under several non-cancelable operating leases. Future

minimum rental payments at September 30, 2005 for all operating leases were approximately $8,000 through December 2005. Rent expense amounted to approximately $8,000 and $5,400 for the quarters ended September 30, 2005 and 2004, respectively .

(9) Profit Sharing Plan

     The Company has a 401(k) profit sharing plan covering substantially all employees, subject to certain participation and vesting requirements. The Company may elect to make discretionary contributions to the Plan, but has never done so over the life of the Plan.

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

     This information should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004, the audited consolidated financial statements and the notes thereto included in the Form 10-K and the unaudited interim consolidated financial statements and notes thereto included in this report.

Executive Overview

     Revenues increased to $271,000 for the quarter ended September 30, 2005 compared to $205,000 for the quarter ended September 30, 2004, an increase of 32%. Revenues were comprised of royalties pertaining to the licensing of Spatializer® audio signal processing algorithms and circuit designs. A key issue discussed is our ability to obtain and maintain revenue traction when traditional revenue sources are eroding, while being replaced by new revenue sources.

     Net Income was $37,000 for the quarter ended September 30, 2005; $0.00 basic and diluted per share, compared to net loss of $81,000, ($0.00) per share basic, for the quarter ended September 30, 2004. The increased net income for the current period is primarily the result of higher revenue, lower commission expense and lower overhead. A key issue discussed is management’s efforts to increase revenues while managing overhead and maintaining competitiveness during revenue source transition to new markets for the Company.

     Net cash used in operating activities was $24,000 for the quarter ended September 30, 2005, as compared to net cash provided by operating activities of $526,000 in the quarter ended September 30, 2004. The decrease in cash flows from operations for the quarter ended September 30, 2005, against the comparable quarter last year was primarily a result of the receipt in the prior year quarter of prepaid royalties, which gave rise to deferred revenue, partially offset by a larger net loss. In the current quarter, approximately $79,000 of revenue was a “non-cash” item, resulting from the final recognition of such deferred revenue. A key issue is the Company’s ability to generate positive cash flow, or if needed, raise additional capital to fund its business.

     The business environment in which we operate is highly competitive and as result, we face substantial risk. These risks should be studied and understood, as outlined in Risk Factors later in this document.

Approach to MD&A

     An important demonstration of our commitment to our stockholders is a clear explanation of the Company’s operating results, risks and opportunities. The purpose of MD&A is to provide our shareholders and other interested parties with information necessary to gain an understanding of our financial condition, changes in financial condition and results of operations. As such, we seek to satisfy three principal objectives:

•

to provide a narrative explanation of a company’s financial statements “in plain

			English” that enables the average investor to see the company through the eyes of management;
	•		to enhance the overall financial disclosure and provide the context within which financial information should be analyzed; and
	•		to provide information about the quality of, and potential variability of, a company’s earnings and cash flow, so that investors can ascertain the likelihood that and relationship of past performance being indicative of future performance.

     We believe the best way to achieve this is to give the reader:

	•		An understanding of our operating environment and its risks
	•		An outline of critical accounting policies
	•		A review of our corporate governance structure
	•		A review of the key components of the financial statements and our cash position and capital resources
	•		A review of the important trends in the financial statements and our cash flow
	•		Disclosure on our internal controls and procedures

Operating Environment

     We operate in a very competitive business environment. This environment impacts us in the following ways, further discussed in greater detail under Risk Factors:

	•		Because The Market In Which We Operate Is Highly Competitive, We Face Significant Pricing Pressure and Competition.
	•		We Rely on the Schedules and Cooperation of Chip Makers or Other Third Parties to Deliver Our Technology in Consumer Products. These Third Parties Have Their Own Priorities and Alliances that May Delay or Thwart our Sales Efforts to Potential Customers
	•		If New Product Development Is Delayed, We Will Experience Delays In Revenues and Competitive Products May Reach The Market Before Our Products.

The personal computer (PC) and consumer electronics markets are under intense pressure, primarily from retailers, to reduce selling prices, with resultant pressure to reduce costs. The cellular phone market is affected by similar pressure from cellular system operators to provide low-cost handsets. In addition, pricing action by our competitors may be very aggressive. Cost reductions are driven by lower cost sourcing, often in China, design simplification and reduction in or substitution of features. While we present a value proposition that stresses the cost reducing capabilities of our audio solutions through improved performance from lower cost components as well as product differentiation that

Spatializer technology can deliver, all such features are closely scrutinized by potential customers’ product marketing and engineering departments. This makes it more challenging to secure new design wins, particularly in product categories that have become commoditized, such as the case with DVD players. It also may result in the elimination of features, including ours, if cost is of paramount importance. When this occurs, we receive very short notice and revenues from such an account will typically begin a steep decline in the subsequent quarter, resulting in period-to-period fluctuation. This also results limited visibility with regard to future revenues and their impact on our operating results. Our response has been to strengthen our value proposition, more aggressively price and include additional features in our products. We have also entered new product categories, such as cellular phones, with different competitive pressure, but where we believe the demand for our technology will be more compelling than the consumer electronics market. We also emphasize to our overseas sales representatives the need for close customer support, with the objective that both new opportunities and possible difficulties are brought to light as soon as possible.

Manufacturer’s design-in cycles for our technology range from four to twelve months, from the decision to adopt our technology to actual cash flow. Many of our customers operate under very fluid development schedules. These schedules are prone to delays at the manufacturer level and in some cases, manufacturer’s new products may be cancelled or marketing plans modified due to market testing or resource allocation. Since these events are beyond our control, it is difficult to absolutely project when new deals will begin generating revenues or if signed deals will generate financial results. For this reason, we do not typically announce new deals until the target product is being introduced. Even then, we have no control over whether the announced marketing plans will not be modified which might negatively impact our financial performance.

Spatializer does not develop or market semiconductors. That is why we carry no inventory or have order backlogs that typically are good indicators of near term performance. Rather, we develop audio algorithms that are embedded on third party processors or semiconductors used by our customers. Whether such processors become an industry standard, or gain wide acceptance in the market, is speculative. While our algorithms are implemented on a wide array of processors, often times a customer uses a processor where there is no such implementation, or where a competing solution has been implemented. In this case, our customers must request that our algorithm be implemented. While these requests may be honored, processor manufacturers must schedule such implementation as their resources or corporate strategies allow. Some chip makers, particularly in the cellular phone market, have already incorporated solutions from our competitors as a component of the chip itself, making it costly and time consuming to implement alternate solutions like ours. In addition, standards may be adopted by cellular phone system operators or manufacturers that may impede or prevent the penetration of non-standard technology onto their platforms. Therefore, the supply-chain is often quite long and complicated, which potentially can result in delays or deadlines that may not always coincide with our customer’s requirements and which are beyond the control of our company.

Therefore, when reviewing the operating results or drawing conclusions with regard to future performance, these competitive forces and uncertainties must be taken into consideration. Without absolute long-term visibility, it is difficult to draw such conclusions in absolute terms. Further, the dynamic nature of the business environment creates the potential for both positive and negative fluctuations in near and long term operating performance. While

management strives to mitigate these risks, as outlined in Risk Factors, it is not possible to be fully immune from such dynamics.

Critical Accounting Policies

     Our discussion and analysis of our financial condition and results of operations are based upon our consolidated statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses based on historical experience and various other factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. In consultation with our Board of Directors and Audit Committee, we have identified three accounting policies that we believe are critical to an understanding of our financial statements. These are important accounting policies that require management’s most difficult, subjective judgments.

     The first critical accounting policy relates to revenue recognition. We recognize royalty revenue upon receipt of a quarterly royalty report from our licensees. These royalty reports reflect royalty on units of product containing our technology that were shipped by the licensee in the quarter. License revenues are recognized when earned, in accordance with the contractual provisions, typically on delivery of services or availability and delivery of licensed technology. Royalty revenues are recognized upon shipment of products incorporating the related technology by the foundries. These revenues are reported to us by our licensees in formal, written royalty reports, which serve as the basis for our quarterly revenue accruals. Infrequently, certain written reports are received after our required reporting deadlines, sometimes due to contractual requirements. In such cases, management tries to obtain verbal reports or informal reports from the licensee. In the absence of such information, management may utilize conservative estimates based on information received or historical trends. In such isolated cases, management strives to under-estimate such revenues to err on the side of caution. In the event such estimates are used, the revenue for the following quarter is adjusted based on receipt of the written report. In addition, any error in licensee reporting, which is very infrequent, is adjusted in the subsequent quarter when agreed by both parties as correct.

     The second critical accounting policy relates to research and development expenses. We expense all research and development expenses as incurred. Costs incurred to establish the technological feasibility of our algorithms (which is the primary component of our licensing) is expensed as incurred and included in Research and Development expenses. Such algorithms are refined based on customer requirements and licensed for inclusion in the customer’s specific product. There are no production costs to capitalize as defined in Statement on Financial Accounting Standards No. 86.

     The third critical accounting policy relates to intangible assets. Our intangible assets consist primarily of patents. We capitalize all costs directly attributable to patents and trademarks, consisting primarily of legal and filing fees, and amortize such costs over the remaining life of the asset (which range from 3 to 20 years) using the straight-line method. In accordance with SFAS 142, “Goodwill and Other Intangible Assets”, only intangible assets with finite lives are amortized. Non-amortized intangible assets are instead subject to annual impairment testing.

Corporate Governance

     Audit Committee

     This committee, chaired by Mr. Gilbert Segel, is directed to review the scope, cost and results of the independent audit of our books and records, the results of the annual audit with management and the internal auditors and the adequacy of our accounting, financial, and operating controls; to recommend annually to the Board of Directors the selection of the independent auditors; to approve proposals made by our independent auditors for consulting work; and to report to the Board of Directors, when so requested, on any accounting of financial matters.

     Compensation and Stock Committee

     Our Compensation and Stock Option Committee (the “Compensation Committee”) currently consists of Messrs. Pace and Segel, each of whom is a non-employee director of the Company and a “disinterested person” with respect to the plans administered by such committee, as such term is defined in Rule 16b-3 adopted under the Securities Exchange Act of 1934, as amended, and the rules and regulations thereunder (collectively, the “Exchange Act”). The Compensation Committee reviews and approves annual salaries, bonuses and other forms and items of compensation for our senior officers and employees. Except for plans that are, in accordance with their terms or as required by law, administered by the Board of Directors or another particularly designated group, the Compensation Committee also administers and implements all of our stock option and other stock-based and equity-based benefit plans (including performance-based plans), recommends changes or additions to those plans or awards under the plans.

     Our Audit Committee and Compensation and Stock Committee charters are available in print to any stockholder upon request in writing to our corporate office at 2025 Gateway Place, Suite 365, San Jose, CA 95110.

Special Committee

In November of 2005, the Board of Directors created a Special Committee to review certain strategic opportunities as they arise and to obtain additional information regarding such opportunities for consideration and evaluation by the Board of Directors. The Special Committee consists of Messrs. Mandell, Pace and Segel.

Key Components of the Financial Statements and Important Trends

     The financial statements, including Balance Sheet, results of operations, cash flow and Changes in Stockholders’ Equity should be read in conjunction with the Consolidated Financial Statements and Notes thereto included elsewhere in this report. MD&A explains the key components of each of these financial statements, key trends and reasons for reporting period-to-period fluctuations.

     The Balance Sheet provides a snapshot view of our financial condition at the end of our fiscal year. A balance sheet helps management and our stockholders understand the financial strength and capabilities of our business. Balance sheets can help identify and analyze trends, particularly in the area of receivables and payables. A review of cash compared to the

comparable year and in relation to ongoing profit or loss can show the ability of the Company to withstand business variations. The relationship between Current Assets and Current Liabilities i.e. working capital (current assets less current liabilities) measures how much in liquid assets a company has available to build its business. The presence of Deferred Revenue indicates cash received on revenue to be earned over the next twelve months. Receivables that are substantially higher than revenue for the quarter may indicate a slowdown of collections, with an impact on future cash position. This is addressed further in MD&A under Liquidity and Capital Resources.

     The Consolidated Statement of Operations tells the reader whether the Company had a profit or loss. It shows key sources of revenue and major expense categories. It is important to note period-to-period comparisons of each line item of this statement, reasons for any fluctuation and how costs are managed in relation to the overall revenue trend of the business. These statements are prepared using accrual accounting under generally accepted accounting standards. This is addressed further in MD&A under Revenues and Expenses.

     The Consolidated Statement of Cash flows explains the actual sources and uses of cash. Some expenses of the Company, such as depreciation and amortization do not result in a cash outflow in the current period, since for example, the underlying patent expenditure or asset purchase was made years earlier. New capital expenditures, on the other hand, resulted in a disbursement of cash, but will be expensed in the Statement of Operations over its useful life. Fluctuations in Receivables and payables also explain why the net change in cash is not equal to the loss reported on the Statement of Operations. Therefore, it is possible that the impact of a net loss on cash is less or more than the actual amount of the loss. This is discussed further in MD&A under Liquidity and Capital Resources.

     The Consolidated Statement of Changes in Stockholders’ Equity shows the impact of the operating results on the Company’s equity. In addition, this statement shows new equity brought into the Company through stock sales or stock option exercise. This is discussed further in MD&A under Liquidity and Capital Resources

Results of Operations

Revenues

     Revenues increased to $271,000 for the quarter ended September 30, 2005 compared to $205,000 for the quarter ended September 30, 2004, an increase of 32%. Revenues were comprised of royalties pertaining to the licensing of Spatializer audio signal processing algorithms and circuit designs. Revenues in the nine months ended September 30, 2005 were $1,032,000, compared to revenues of $611,000 in the comparable period last year, an increase of 69%.The increase in revenue for the three and nine month periods resulted from the greater usage of our technology in cellular phones and expansion of revenue from a key consumer electronics manufacturer. Current operating results are not indicative of future performance.

Gross Profit

     Gross profit for the three months ended September 30, 2005 was $258,000 (95% of revenue) compared to gross profit of $179,000 (87% of revenue) in the comparable period last year, an increase of 44%. Gross profit for the nine months ended September 30, 2005

were $942,000 (91% of revenue) compared to $550,000 (90% of revenue) in the comparable period last year. Gross profit in the three and nine-month periods increased due to increased revenue. Gross margins increased primarily due to commission adjustments in the third quarter based on actual commission payments in Q3 as compared to accruals in the prior quarter.

Operating Expenses

     Operating expenses in the three months ended September 30, 2005 were $224,000 (83% of revenue) compared to operating expenses of $261,000 (127% of revenue) in the comparable period last year, a decrease of 14%. Operating expenses in the nine months ended September 30, 2005 were $843,000 (82% of revenue) compared to $871,000 (143% of revenue) in the comparable nine-month period last year. The decrease in operating expenses for the three months and equivalent expenses in the nine-month period ended September 30, 2005 resulted primarily from lower off-shore based engineering expenses, lower general and administrative expenses due to completion of legal expense review, offset by higher accounting expenses related to Sarbanes-Oxley compliance and higher international sales travel expense.

General and Administrative

     General and administrative expenses in the three months ended September 30, 2005 were $117,000 (43% of revenue) compared to general and administrative expenses of $155,000 (76% of revenue) in the comparable period last year, a decrease of 25%. General and administrative expenses in the nine months ended September 30, 2005 were $457,000 (44% of revenue) compared to $528,000 (86% of revenue) in the comparable nine month period last year. The decrease in general and administrative expense for the three and nine month periods resulted primarily from the charging of sales related travel for the CEO to sales and marketing expense, as opposed to general and administrative expense and reduction in legal expense due to the completion of our legal expense review. This was partially offset by higher Sarbanes-Oxley compliance expense and slightly higher occupancy expense associated with the relocation of the corporate offices to slightly larger space.

Research and Development

     Research and Development expenses in the three months ended September 30, 2005 were $62,000 (26% of revenue) compared to research and development expenses of $94,000 (46% of revenue) in the comparable period last year, a decrease of 34%. Research and Development expenses for the nine months ended September 30, 2005 were $245,000 (25% of revenue) compared to $296,000 (48% of revenue) in the comparable nine month period last year. The decrease in three and nine month research and development expenses resulted from the elimination of an in-house applications engineering position and the offsetting use of lower cost off-shore applications engineering to expand our technology availability on various processors.

Sales and Marketing

     Sales and Marketing expenses in the three months ended September 30, 2005 were $45,000 (17% of revenue) compared to sales and marketing expenses of $11,000 (5% of revenue) in the comparable period last year, an increase of 309%. Sales and Marketing expenses for the nine months ended September 30, 2005 were $141,000 (14% of revenue)

compared to $47,000 (8% of revenue) in the comparable nine month period last year. The increase in sales and marketing expense in the three and nine month periods resulted primarily from the charging of CEO sales related travel to sales and marketing instead of general and administrative expense, as was the practice in the previous year, increased sales and marketing travel and the addition of a part time marketing coordinator.

Net Income (Loss)

     Net Income was $37,000 for the quarter ended September 30, 2005; $0.00 basic and diluted per share, compared to net loss of $81,000, ($0.00) per share basic, for the quarter ended September 30, 2004. Net income in the nine months ended September 30, 2005 was $104,000, $0.00 basic and diluted per share, compared with net loss of ($328,000) ($0.01) basic per share in the comparable period last year. The reduced net loss in the three month period resulted from increased revenues, lower overhead and lower commissions. Net income in the nine month period as compared to the net loss in the comparable nine-month period resulted primarily from increased royalty revenue.

     At September 30, 2005, we had $674,000 in cash and cash equivalents as compared to $871,000 at December 31, 2004. The decrease in cash and cash equivalents results from a decrease in deferred revenue, partially offset by a decrease in accounts receivable. While we were at approximately a break-even in the third quarter, approximately $78,000 of gross profit was a “non-cash” item since the cash giving rise to the deferred revenue had been received in the prior year. We had working capital of $739,000 at September 30, 2005 as compared with working capital of $603,000 at December 31, 2004. Working capital increased slightly due to reductions in deferred revenue on recognition of such revenue, partially offset by decreases in accounts receivable during the interim nine month period.

     In the fourth quarter of 2003, we negotiated and completed the conversion of a $112,500 related party 10% demand note to a three-year 10% term note. Principal and interest of $5,191 is paid monthly, which we pay on a current basis. Since the director who was an indirect beneficiary of the demand note completed his term as director and did not stand for re-election to the Board of Directors in September 2003, the demand note is classified as a note payable at September 30, 2005. There are no installments due in more than twelve months as of September 30, 2005.

     Future payments due under operating lease obligations as of September 30, 2005 are described below:

		Payment due by period
						Less than												More than
Contractual obligations		Total				1 year				1-3 years				3-5 years				5 years
Operating Lease Obligations		$	32,844			$	6,569			$	26,275
Total		$	32,844			$	6,569			$	26,275

     Our future cash flow will come primarily from the audio signal processing licensing,

OEM royalties and from possible share issuances including warrants and options. We are actively engaged in negotiations for additional audio signal processing licensing arrangements which we believe should generate additional cash flow without imposing any substantial costs on us. We anticipate that there may continue to be dislocations of individual licensing programs due to continuing pressure to reduce costs, particularly in the DVD player segment. We currently believe that growth from other licensing arrangements, which include new markets such as cellular phones, and other arrangements that are pending but not announced or in negotiation, will substantially offset any revenue shortfalls from market dynamics or transitioning platforms. The four new or expanded licensing deals from such sources that generated approximately 60% of fiscal 2004 revenue support this belief. Further, our cost reduction initiative which was initially implemented in the fourth quarter of 2003 has lowered the revenues needed to reach the break-even point.

     The fluid, competitive and dynamic nature of the market continues to add a degree of uncertainty to our operations. The operations of our business, and those of our competitors, may also be impacted by the continued trend in the semiconductor industry to offer free, but minimal audio solutions to certain product classes to maintain and attract market share. This challenges our ability to convert business opportunities to licensing agreements in those segments that allow us to maintain or rapidly increase revenue. As a result, we must develop and license its products and software solutions in a market that treats some audio products, including those of our competitors, on a commodity basis in those cases where the OEM product is considered a commodity product. While our software applications deliver what we and most manufacturers who listen to it believe is a significantly superior audio experience, the competitive market forces that pressure manufacturers to reduce their costs may create some resistance to new technology adoption or use. In addition, certain of our competitors appear to be pursuing a business plan that disregards commercially reasonable pricing to achieve a larger market penetration even if the penetration will not provide for viable margins or returns. We have responded by offering additional products targeted to each price/quality segment of the market and continue to aggressively pursue new opportunities in emerging product categories such as cellular phones and notebook computers that complements our existing core business. In addition, our products have been positioned as a means for manufacturers to save money while delivering an enhanced audio experience. Nevertheless, these market conditions and competitive forces make it more challenging for us, and our rational commercial competitors, to enhance their operating results.

     To the extent we maintain or exceed our projected revenues and are not required to fund significant contingencies, we should be able to continue to retain our current cash reserves and therefore, maintain our liquidity position at a consistent level both on a short-term and long-term basis. To the extent that we do not achieve current operating levels or are required to fund contingencies, we will be required to use some of our cash reserves and this could impact our longer term liquidity. In addition, we wish to achieve accelerated growth and to take advantage of the dynamic market forces in which we operate, rather than to be affected by them. Under these current assumptions, we believe our current cash reserves and cash generated from our existing operations and customer base should be sufficient for us to meet our operating obligations and the anticipated additional research and development for our audio technology business for at least the next 12 months. However, our assumptions are subject to material change, based on the dynamics of our business and the marketplace. We will also continue to consider and evaluate capital investment or business arrangements with financial or strategic participants or investors as such opportunities become available to us on terms that enhance shareholder value and better support our business strategy.

Net Operating Loss Carry forwards

     At December 31, 2004, we had net operating loss carry forwards for Federal income tax purposes of approximately $26,500,000 which are available to offset future Federal taxable income, if any, through 2013. Approximately $21,700,000 of these net operating loss carry forwards is subject to an annual limitation of approximately $1,000,000.

Recently Issued Accounting Pronouncements

     In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123R, “Share Based Payment”. This Statement is a revision of FASB Statement No. 123, “Accounting for Stock-Based Compensation”. This Statement supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees” and its related implementation guidance. This Statement establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. The Statement focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. This Statement does not change the accounting guidance for share-based payment transactions with parties other than employees provided in Statement 123 as originally issued and EITF Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.” This Statement does not address the accounting for employee share ownership plans, which are subject to AICPA Statement of Position 93-6, “Employers’ Accounting for Employee Stock Ownership Plans”. The Securities and Exchange Commission has delayed the adoption requirement of SFAS No. 123R until the first annual reporting period beginning after December 15, 2005. We expect to adopt SFAS No. 123R on January 1, 2006 as required.

In May 2005 the FASB issued SFAS 154 “Accounting Changes and Error Corrections”. This Statement replaces APB Opinion No. 20, “Accounting Changes”, and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements”, and changes the requirements for the accounting for and reporting of a change in accounting principle and also corrections of error in previously issued financial statements. This Statement harmonizes US accounting standards with existing international accounting standards by requiring companies to report voluntary changes in accounting principles via a retrospective application, unless impracticable. Also, the reporting of an error correction involves adjustments to previously issued financial statements similar to those generally applicable to reporting an accounting change retrospectively. This pronouncement is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005

Factors That May Affect Future Results

     This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended, reflecting management’s current expectations. Examples of such forward-looking statements include our expectations with

respect to our strategy. Although we believe that our expectations are based upon reasonable assumptions, there can be no assurances that our financial goals will be realized. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements, or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Numerous factors may affect our actual results and may cause results to differ materially from those expressed in forward-looking statements made by or on behalf of our company. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words, “believes,” “anticipates,” “plans,” “expects” and similar expressions are intended to identify forward-looking statements. The important factors discussed under the caption “Factors That May Affect Future Results” in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, herein, among others, would cause actual results to differ materially from those indicated by forward-looking statements made herein and represent management’s current expectations and are inherently uncertain. Investors are warned that actual results may differ from management’s expectations. We assume no obligation to update the forward-looking information to reflect actual results or changes in the factors affecting such forward-looking information.

Because The Market In Which We Operate Is Highly Competitive, We Face Significant Pricing Pressure and Competition.

     The PC and consumer electronics markets are under intense pressure, primarily from retailers, to reduce selling prices, with resultant pressure to reduce costs. The cellular phone market is affected by similar pressure from cellular system operators to provide low-cost handsets. In addition, certain of our competitors appear to be pursuing a business plan that disregards commercially reasonable pricing to achieve a larger market penetration even if the penetration will not provide for viable margins or returns. Cost reductions are driven by lower cost sourcing, often in China, design simplification and reduction in or substitution of features. Therefore, we are seeking commercial acceptance of our products in highly competitive markets. We have responded by offering additional products targeted to each price and quality segment of the market, more aggressively price and feature enrich our products and enter new segments, such as cell phones, with different competitive pressure. While we present a value proposition that stresses the cost reducing capabilities of our audio solutions through improved performance from lower cost components as well as product differentiation that Spatializer technology can deliver, all such features are closely scrutinized by potential customers’ product marketing and engineering. This makes it more challenging to secure new design wins, particularly in product categories that have become commoditized, such as the case with DVD players. It also may result in the elimination of features, including ours, if cost is of paramount importance. There is no assurance that our present or contemplated future products will achieve or maintain sufficient commercial acceptance, or if they do, that functionally equivalent products will not be developed by current or future competitors who had access to significantly greater resources or which are willing to “give away” their products.

We Rely on the Schedules and Cooperation of Chip Makers or Other Third Parties to Deliver Our Technology in Consumer Products. These Third Parties Have Their Own Priorities and Alliances That May Delay or Thwart our Sales Efforts to Potential Customers.

Spatializer does not develop or market semiconductors. That is why we carry no inventory or have order backlogs that typically are good indicators of near term performance. Rather, we develop audio algorithms that are embedded on third party processors or semiconductors used by our customers. While our algorithms are implemented on a wide array of processors, often times a customer uses a processor where there is no such implementation, or where a competing solution has been implemented. In this case, our customers request that our algorithm be implemented. While these requests are typically honored, processor manufacturers must schedule such implementation as their resources or corporate strategies allow. Therefore, the supply-chain is often quite long and complicated, which potentially can result in delays or deadlines that may not always coincide with our customer’s requirements and which are beyond the control of our company. In addition, standards may be adopted by cellular phone system operators or manufacturers that may impede or prevent the penetration of non-standard technology onto their platforms. While our efforts are focused on promoting our technology to such potential customers, there is no assurance that we will be successful in making our technology a standard. Lastly, actual usage of our technology and the resultant incurring of royalties payable, is controlled solely by our licensees. We have no consultative rights in the use of our technology once licensed. Changes in marketing plans calling for the use of our technology can be effected by a licensee for any number of reasons, including market acceptance, pricing strategies or other competitive or subjective reasons. Such changes could have a significant impact on our revenue stream and cash flow.

If New Product Development Is Delayed, We Will Experience Delays In Revenues And Competitive Products May Reach The Market Before Our Products.

     Since our inception, we have experienced delays in bringing new products to market and commercial application as a result of delays inherent in technology development, financial resource limits and industry responses and maturity. These delays have resulted in delays in the timing of revenues and product introduction. In the future, delays in new product development or technology introduction on behalf of us, our OEMs of consumer electronics and multimedia computer products, integrated circuit (IC) foundries or our software producers and marketers could result in further delays in revenues and could allow competitors to reach the market with products before us. In view of the emerging nature of the technology involved, and the rapidly changing character of the entire media, internet and computer markets, our expansion into other technology areas and the uncertainties concerning the ability of our current products and new products to achieve meaningful commercial acceptance, there can be no assurance of when or if we will achieve or sustain profitability.

     Manufacturer’s design-in cycles for our technology range from four to twelve months, from the decision to adopt our technology to cash flow. These schedules are also prone to delays at the manufacturer level and in some cases, manufacturer’s new products may be cancelled due to market testing or resource allocation. Since these events are beyond our control, it is difficult to absolutely project when new deals will begin generating revenues or if signed deals will generate financial results. For this reason, we do not typically announce

new deals until the target product is being introduced.

Our Operating Results Fluctuate and If We Are Unable to Achieve or Sustain Profitability in the Future or Obtain Future Financing Our Business Operations May Fail

     We have experienced a loss from operations in two of the last four years. We experienced declining losses in the third and fourth quarters of 2004, and a profit in the first two quarters of fiscal 2005 and a small loss in the current quarter. However, cash flow has been negative in the first nine months of 2005. While our objective and full effort is on managing a profitable business, due to the market conditions and factors outlined above and below and their impact on fluctuations in operating expenses and revenues,, we cannot provide assurance that we will be able to generate a positive profit position in any given future period. We cannot guarantee that we will increase sales of our products and technologies, or that we will successfully develop and market any additional products, or achieve or sustain future profitability, and we may have to rely on the sale of shares or on debt financings in the future, which may have a dilutive effect on our existing shareholders. Further, we cannot assure you that debt or equity financing will be available as required and if not available, we would have to further scale down operations or even cease operations.

Because Our Relative Size and Power Is Small Compared To That of Our Customers, Our Business Leverage With Some Customers Is Generally Weak and Communication Not Always Transparent

     We deal with some of the largest global consumer electronics makers in the world, the vast majority of which are in Asia. Spatializer is a small company and there are other options for manufacturers, including those from our competitors, their chip suppliers, or eliminating the use of audio enhancement technology altogether. As such, our leverage with our customers is generally weak. In addition, the culture in our local markets may not dictate clear, direct and transparent communication of business plans or technology usage as is the culture in our home country. When this occurs, we could receive very short notice of discontinued use of our technology and revenues from such an account would typically begin a steep decline in the subsequent quarter, resulting in period-to-period fluctuation. This also results in limited visibility with regard to future revenues and its impact on our operating results. Our response has been to strengthen our business relationships with more onsite visits, increase our understanding of cultural differences and focus more intently on service. We also emphasize to our overseas sales representatives the need for close customer support, with the objective that both new opportunities and possible difficulties are brought to light as soon as possible.

We Expect That We Will Continue to be Dependent upon a Limited Number of OEMs for a Significant Portion of Our Net Sales in Future Periods

     Although no OEM is presently obligated either to purchase a specified amount of products or to provide us with binding forecasts of product purchases for any period, we anticipate being dependent upon a limited number of OEMs for a large portion of our net sales. Our three largest customers in the quarter ended September 30, 2005 accounted for 33%, 25% and 15% of our net sales. The loss of any one of our major customers or licensees would significantly reduce our revenues and harm our ability to achieve or sustain acceptable levels of operating results. The loss, or signing of a similarly sized account or accounts would have

a material short term impact on our operations and there is no assurance that we will not lose all or some of the revenues from one or more of these accounts. While we are working to broaden the sources of our royalty streams, there can be no assurance that we will be successful in retaining or attracting such key accounts and broadening such revenue stream sources.

     Demand for Our Products is Subject to Risks Beyond Our Control.

     Our products are typically one of many related products used by consumer electronic users. As a result, demand for our products is therefore subject to many risks beyond our control, including, among others:

	•		competition faced by our OEM customers in their particular end markets;
	•		the technical, sales and marketing and management capabilities of our OEM customers;
	•		the pressure faced by our OEM customers to reduce cost

     There can be no assurance that we will not lose sales in the future as a result of the pressure to reduce costs faced by our customers. The reduction of orders from our significant OEM customers, or the discontinuance of our products by our end users may subject us to potential adverse revenue fluctuations.

Because The Technology Environment In Which We Operate Is Rapidly Changing, We May Not Be Successful In Establishing And Maintaining The Technological Superiority Of Our Products Over Those Of Our Competitors.

     We operate in a technology environment which is competitive and rapidly changing. While our software applications deliver what we, and most manufacturers who listen to it, believe is a significantly superior audio experience, the competitive market forces that pressure manufacturers to reduce their costs may create some resistance to new technology adoption or use. Our future success is dependent on establishing and maintaining the technological superiority of our products over those of competitors, our ability to successfully identify and bring other compatible technologies and products to market and a recognition by the market of product value. We compete with a number of entities that produce various stereo audio enhancement processes, technologies and products in both traditional two-speaker environments such as consumer electronics and multimedia computing, and in multi-channel, multi-speaker applications such as Home Theater. In the field of 3-D or “virtual audio”, our principal competitors are SRS Labs, Inc., QSound Labs, Inc. and Dolby Laboratories or technologies and products developed by other companies, including entities that have business relationships with us. There can be no assurance that we will be able to favorably compete in this market in the future.

If We Are Unable To Attract And Retain Our Key Personnel, We May Not Be Able To Successfully Operate Our Business.

     Our future success primarily depends on the abilities and efforts of a small number of individuals, with particular management obligations, customer relationships and technical

expertise. Loss of the services of any of these persons could adversely affect our business prospects. There is no assurance that we will be able to retain this group or successfully recruit other personnel, as needed. We compete with other enterprises with stronger financial resources and larger staffs that may offer employment opportunities to our staff which are more desirable than those which we are able to offer. Failure to maintain skilled personnel with the software and engineering skills critical to our business could have an adverse impact upon our business, the results of our operations and our prospects. Currently, all new licenses are negotiated by Henry R. Mandell, our Chief Executive Officer, with whom we have an employment agreement with a term expiring in November 2006.

The Market For Our Stock May Be Not Remain Liquid And The Stock Price May Be Subject To Volatility

     Our stock is quoted on the OTC Bulletin Board, where low trading volume and high volatility is often experienced. While a few firms make a market in our stock, the historically low trading volume and relatively few market makers of our stock makes it more likely that a severe fluctuation in volume, either up or down, will significantly impact the stock price. There can be no assurance that these market makers will continue to quote our stock and a reduction in such market makers would negatively impact trading liquidity. Further, with our constrained resources and increased cost and time associated with implementation of Sarbanes-Oxley, it may not be possible for us to remain listed on the OTC Bulletin Board in the future as a fully reporting company. This and the existing limited market and volume in the trading of our stock, may result in our shareholders having difficulty selling our common stock. The trading price of our Common Stock has been, and will likely continue to be, subject to wide fluctuations in response to quarterly variations in our operating results, announcements of new products or technological innovations by the Company or our competitors, strategic alliances between us and third parties, general market fluctuations and other events and factors, some of which may be beyond our control.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

     We have not been exposed to material future earnings or cash flow fluctuations from changes in interest rates on our short-term investments at September 30, 2005. A hypothetical decrease of 100 basis points in interest rate (ten percent of our overall earnings rate) would not result in a material fluctuation in future earnings or cash flow. We have not entered into any derivative financial instruments to manage interest rate risk or for speculative purposes and we are not currently evaluating the future use of such financial instruments.

Item 4. Controls and Procedures

     The Company carried out an evaluation of the effectiveness of the Company’s disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Securities and Exchange Act of 1934. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer had concluded that the Company’s disclosure controls and procedures as of September 30, 2005 were effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission’s rules and forms and that it is accumulated and communicated to

management, including the Chief Executive Officer, Chief Financial Officer and Audit Committee, as appropriate to allow timely decisions regarding required disclosure . There were no changes in the Company’s internal control over financial reporting that occurred during the quarter ended September 30, 2005 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

     From time to time we may be involved in various disputes and litigation matters arising in the normal course of business. As of October 25, 2005, we are not involved in any legal proceedings that are expected to have a material adverse effect on our consolidated financial position, results of operations or cash flows. However, litigation is subject to inherent uncertainties. Were an unfavorable ruling to occur, given the size of our company, there exists the possibility of a material adverse impact on our results of operations of the period in which the ruling occurs. Our estimate of the potential impact on our financial position or overall results of operations for new legal proceedings could change in the future.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

     There were no unregistered sales of equity securities or repurchases during the period covered by this report.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None

ITEM 6. EXHIBITS

2.1*		Arrangement Agreement dated as of March 4, 1994 among Spatializer-Yukon, DPI and Spatializer-Delaware (Incorporated by reference to the Company’s Registration Statement on Form S-1,Registration No 33-90532, effective August 21, 1995.)
3.1*		Certificate of Incorporation of Spatializer-Delaware as filed February 28, 1994. (Incorporated by reference to the Company’s Registration Statement on Form S-1, Registration No. 33-90532,effective August 21, 1995.)
3.2*		Amended and Restated Bylaws of Spatializer-Delaware. (Incorporated by reference to the Company’s Registration Statement on Form S-1,Registration No. 33-90532, effective August 21, 1995.)
3.3*		Certificate of Designation of Series B 10% Redeemable Convertible Preferred Stock of the Company as filed December 27, 1999(Incorporated by reference to the Company’s Annual Report on Form10-K, for the period ended December 31, 1999.)

3.4*		Certificate of Amendment of Certificate of Incorporation of the Company as filed on February 25, 2000 (Incorporated by reference to the Company’s Annual Report on Form 10-K, for the period ended December 31, 1999.)
3.5*		Certificate of Designation of Series B-1 Redeemable Convertible Preferred Stock as filed December 20, 2002 (Incorporated by reference to the Company’s Annual Report on Form 10-K, for the period ended December 31, 2002.)
3.6*		Certificate of Elimination of Series A Preferred Stock as filed December 26, 2002 (Incorporated by reference to the Company’s Annual Report on Form 10-K, for the period ended December 31,2002.)
3.7*		Certificate of Elimination of Series B Preferred Stock as filed December 26,2002 (Incorporated by reference to the Company’s Annual Report on Form 10-K, for the period ended December 31,2002.)
10.1*		Spatializer-Delaware Incentive Stock Option Plan (1995 Plan). (Incorporated by reference to the Company’s Registration Statement on Form S-1, Registration No. 33-90532, effective August 21,1995.)
10.2*		Spatializer-Delaware 1996 Incentive Plan. (Incorporated by reference to the Company’s Proxy Statement dated June 25, 1996 and previously filed with the Commission.)
10.3*		Form of Stock Option Agreement
10.4*		License Agreement dated June 29, 1994 between DPI and MEC. (Incorporated by reference to the Company’s Registration Statement on Form S-1, Registration No. 33-90532, effective August 21,1995.)
10.5*		Employment Agreement dated November 12, 2004, between the Company and Henry Mandell, as amended. (Incorporated by reference to the Company’s Annual Report on Form 10-K, for the period ended December 31, 2004.)
10.6*		Related Party Promissory Note to the Successor Trustee of the Ira A. Desper Marital Trust dated November 1, 2003. (Incorporated by reference to the Company’s Annual Report on Form 10-K, for the period ended December 31, 2004.)
10.7*		Lease for Office and Research Center in San Jose, CA. (Incorporated by reference to the Company’s Annual Report on Form 10-K, for the period ended December 31, 2004.)
10.8*		License Agreement between Spatializer Audio Laboratories, Inc., Desper Products, Inc. and Samsung Electronics, effective August 22, 2004. (Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended September 30, 2004.)
31.1		Certificate of Chief Executive Officer and Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2**		Certificate of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.1		Certificate of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Dated: November 2, 2005

		SPATIALIZER AUDIO LABORATORIES, INC.
		(Registrant)
		/s/ Henry R. Mandell
		Henry R. Mandell
		Chairman of the Board, Chief Executive Officer
		Chief Financial Officer and Secretary
		(Principal Executive, Financial and Accounting Officer)