UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

Form 10-QSB

(Mark One)

x     QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2007
 
o     TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT

FOR THE TRANSITION PERIOD FROM __________ TO __________
COMMISSION FILE NUMBER ________________________________

LATTICE CORPORATION
(Name of small business issuer in its charter)
 
DELAWARE
 
22-2011859
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)

7150 N. Pennsauken, New Jersey 08109
(Address of principal executive offices)

Issuer’s telephone Number: (856) 910-1166

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 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 x No o

APPLICABLE ONLY TO CORPORATE ISSUERS

State the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date: As of May 21, 2007, the issuer had 16,629,848 outstanding shares of Common Stock, $.01 par value per share.

Transitional Small Business Disclosure Format (check one): Yes o No x

 


LATTICE CORPORATION
MARCH 31, 2007 QUARTERLY REPORT ON FORM 10-QSB
 
TABLE OF CONTENTS
 

 
Page
PART I - FINANCIAL INFORMATION
 
 
 
Item 1.     Financial Statements
2
Item 2.     Management’s Discussion and Analysis or Plan of Operation
13
Item 3.     Controls and Procedures
19
 
 
PART II - OTHER INFORMATION
 
 
 
Item 1.     Legal Proceedings
20
Item 2.     Unregistered Sales of Equity Securities and Use of Proceeds
20
Item 3.     Defaults Upon Senior Securities
20
Item 4.     Submission of Matters to a Vote of Security Holders
20
Item 5.     Other Information
20
Item 6.     Exhibits and Reports on Form 8-K
20
 
 
SIGNATURES
21


1

PART I - FINANCIAL INFORMATION

LATTICE INCORPORATED (FORMALLY SCIENCE DYNAMICS CORPORATION) AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
 

   
March 31, 2007 
  
December 31, 2006 
  
   
(unaudited) 
      
ASSETS
          
Current assets:
          
   Cash and cash equivalents
  
$
240,739
  
$
392,275
  
   Accounts receivable - trade
    
3,087,553
    
2,412,164
  
   Inventories
    
65,674
    
64,442
  
   Other current assets
    
129,741
    
698,514
  
      Total current assets
    
3,523,707
    
3,567,395
  
               
Property and equipment, net
    
33,061
    
37,187
  
Goodwill
    
2,547,866
    
2,547,866
  
Other Intangibles, net
    
6,823,807
    
7,344,235
  
Other assets
    
96,701
    
122,935
  
      Total assets
  
$
13,025,142
  
$
13,619,618
  
               
LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT)
              
Current liabilities:
              
   Customer deposits
  
$
15,000
  
$
15,000
  
   Deferred Revenue
    
33,874
    
62,495
  
   Accounts payable
    
983,671
    
892,773
  
   Accrued expenses
    
940,013
    
1,736,754
  
   Current maturities notes payable
    
1,607,178
    
1,998,189
  
   Derivative Liability
    
13,047,396
    
19,873,782
  
      Total current liabilities
    
16,627,132
    
24,578,993
  
 
Non-Current Deferred Tax Liabilities
    
406,162
    
406,162
  
Minority Interest
    
182,604
    
135,561
  
               
Shareholders' equity - (Deficit)
              
   Preferred stock - .01 par value
              
      10,000,000 shares authorized 8,826,087 and 1,000,000 issued
    
88,261
    
10,000
  
   Common stock - .01 par value, 200,000,000 shares authorized, 16,642,428 and
              
      16.642.428 issued 16,629,848 and 16.629.848 outstanding
              
      in 2007 and 2006 respectively
    
166,425
    
166,425
  
 
   Additional paid-in capital
    
3,205,731
    
25,571,152
  
 
   (Deficit)
    
(36,953,340
)
  
(36,850,842
)
 
 
    
(3,792,923
)
  
(11,103,265
)
   Common stock held in treasury, at cost
    
(397,833
)
  
(397,833
)
 
   Total shareholders' equity (Deficit)
    
(4,190,756
)
  
(11,501,098
)
 
   Total liabilities and shareholders' Equity
  
$
13,025,142
  
$
13,619,618
  
 
 
The accompanying notes are an integral part of these consolidated financial statements 
 
 
2
LATTICE INCORPORATED (FORMALLY SCIENCE DYNAMICS CORPORATION) AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)

   
Three Months Ended March 31,
  
   
2007
  
2006
  
Sales - Technology Products
  
$
289,402
  
$
423,890
  
Sales - Technology Services
    
2,887,079
    
917,917
  
      Total Sales
    
3,176,481
    
1,341,807
  
               
Cost of Sales - Technology Products
    
89,192
    
154,120
  
Cost of Sales - Technology Services
    
1,383,262
    
478,248
  
      Total Cost of Sales
    
1,472,454
    
632,368
  
 
      Total Gross Profit
    
1,704,027
    
709,439
  
Operating costs and expenses:
              
      Research and development
    
109,041
    
109,134
  
      Selling, general and administrative
    
1,649,152
    
504,606
  
 
    
1,758,193
    
613,740
  
 
Operating Income(loss) before other income (expenses)
    
(54,166
)
  
95,699
  
Other income (expense):
              
   Derivative
    
(1,684,074
)
  
—
  
   Extinguishment (gain)
    
2,073,589
    
—
  
   Interest Expense
    
(385,803
)
  
(129,890
)
   Finance Expense
    
(5,000
)
  
(8,043
)
 
   Total Other income (expenses)
    
7,712
    
(137,933
)
               
   Net Income (Loss) before Minority Interest
    
(46,454
)
  
(42,234
)
               
  Minority Interest
    
47,043
    
(7,442
)
               
  Net Loss
  
$
(93,497
)
$
(49,676
)
 
Net Loss per Common Share -Basic and Diluted
  
$
(0.00
)
$
(0.00
)
 
Weighted average shares outstanding basic and diluted
    
16,629,848
    
8,984,150
  

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


3
 
LATTICE INCORPORATED (FORMALLY SCIENCE DYNAMICS CORPORATION) AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
 
   
Three Months Ended March 31,
 
   
2007
  
2006
  
           
Cash flows from operating activities: Net (loss)
  
$
(102,497
)
  
(49,676
)
 
Adjustments to reconcile net (loss) to net cash provided by (used for) operating activities:
              
   Depreciation
    
4,125
    
20,940
  
   Amortization Intangible assets
    
520,428
    
56,690
  
   Financing expense non cash
    
5,000
    
8,043
  
   Derivative Expense
    
1,684,074
    
—
  
   Non Cash interest Derivative
    
113,207
    
36,180
  
   Amortization of Debt Discount
    
205,809
    
—
  
   Extinguishment gain
    
(2,073,589
)
  
—
  
   Minority interest
    
47,043
    
7,442
  
   Stock base compensation
    
61,440
    
—
  
Changes in operating assets and liabilities:
              
  (Increase) decrease in:
              
   Accounts receivable
    
(675,389
)
  
(320,390
)
   Inventories
    
(1,232
)
  
4,106
  
   Other current assets
    
8,090
    
(37,049
)
   Other assets
    
26,235
    
(2,100
)
   Increase (decrease) in:
              
     Accounts Payable and accrued expenses
    
180,911
    
154,883
  
   Customer Deposits
    
—
    
16,111
  
   Deferred revenue
    
(28,621
)
  
—
  
Total adjustments
    
77,531
    
(55,144
)
  Net cash provided by (used for) operating activities
    
(24,966
)
  
(104,820
)
Cash flows from financing activities:
              
  Payments of Short term note payable
    
(45,000
)
  
—
  
  Net borrowing (Payment)on Revolving AR credit facility
    
(81,570
)
  
166,591
  
  Net cash (used in) provided by financing activities
    
(126,570
)
  
166,591
  
  Net increase (decrease) in cash and cash equivalents
    
(151,536
)
  
61,771
  
Cash and cash equivalents - beginning of period
    
392,275
    
53,997
  
Cash and cash equivalents - end of period
  
$
240,739
  
$
115,768
  
 Supplemental Information:
              
Interest Paid
  
$
40,315
  
$
54,527
  

 
The accompanying notes are an integral part of these consolidated financial statements.
 
4

 
LATTICE INCORPORATED (FORMALLY SCIENCE DYNAMICS CORPORATION) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 1- Organization and Summary of Significant Accounting Policies

a) Organization

Lattice Incorporated (Formally known as Science Dynamics Corporation and referred to herein as) (the "Company", "Latiice " ) was incorporated in the State of Delaware May 1973 and commenced operations in July 1977. The Company began as a provider of specialized solutions to the telecom industry. Throughout its history Lattice has adapted to the changes in this industry by reinventing itself to be more responsive and open to the dynamic pace of change experienced in the broader converged communications industry of today. Currently Lattice provides advanced solutions for several vertical markets. The greatest change in operations is in the shift from being a component manufacturer to a solution provider focused on developing applications through software on its core platform technology. To further its strategy of becoming a solutions provider, the Company acquired a majority interest in “SMEI” in February 2005. With the SMEI acquisition, approximately 90% of the Company’s revenues are derived from solution services. In September 2006 the Company purchased all of the issued and outstanding shares of the common stock of Ricciardi Technologies Inc. (“RTI”). RTI was founded in 1992 and provides software consulting and development services for the command and control of biological sensors and other Department of Defense requirements to United States federal governmental agencies either directly or though prime contractors of such governmental agencies RTI’s proprietary products include SensorView, which provides clients with the capability to command, control and monitor multiple distributed chemical, biological, nuclear, explosive and hazardous material sensors. In January, 2007, we changed our name to Lattice Incorporated.


b) Basis of Financial Statement Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Item 310 of Regulation S B. Accordingly; they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. For further information, refer to the financial statements and footnotes thereto included in the Company's annual report for Form 10-KSB for the year ended December 31, 2006. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three month period ended March 31, 200 are not necessarily indicative of the results that may be expected for the year ended December 31, 2007.

The Company’s auditors have expressed a going concern opinion in their audit reports for 2006 and 2005. Management acknowledges the basis for the going concern opinion, given the Company’s historical net losses and working capital deficits. However, it should be noted that the Company has made significant improvements in its operating performance in 2006. The Company has increased its sales by approximately 76.9% compared to 2005, through organic growth and acquisitions, posted positive operating income of $455,886 versus an operating loss of $1,006,881 in 2005 and was able to increase the availability of its revolving credit facility financing from $1M to $2M with the refinancing of the PFC facility with GBBF. Additionally, upon the effectiveness of its restated certificate of incorporation on February 2, 2007, the Company was able to convert its $4.5M note with Barron to Series A Preferred Stock. Given these events collectively and the anticipation that the positive trends will continue, management expects the going concern opinion to be removed from future filings. 

The accompanying financial statements include the operating results of Systems Management Engineering Systems, Inc. (SMEI), a majority owned (86%) subsidiary of Lattice. On February 14, 2005 the Company recorded on its Balance Sheet a Minority Interest Liability of $171,995 representing the net asset value not acquired by the Company. The carrying value of the minority interest of $171,995 has increased to $182,604 at March 31, 2007 giving effect to the SMEI’s net operating results. The carrying value increased by $47,043 in the three months ended March 31, 2007 giving effect to the portion of SMEI’s net operating profit allocable to minority shareholders.

5
c) Principles of Consolidation:

The consolidated financial statements included the accounts of the Company and all of its subsidiaries in which a controlling interest is maintained. All significant inter-company accounts and transactions have been eliminated in consolidation. For those consolidated subsidiaries where Company ownership is less than 100%, the outside stockholders' interests are shown as minority interests.

d) Use of Estimates:

The financial statements have been prepared in accordance with accounting principles generally accepted in the United States (US GAAP). The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts in the financial statements and accompanying notes. These estimates form the basis for judgments made about the carrying values of assets and liabilities that are not readily apparent from other sources. Estimates and judgments are based on historical experience and on various other assumptions that the Company believes are reasonable under the circumstances. However, future events are subject to change and the best estimates and judgments routinely require adjustment. US GAAP requires estimates and judgments in several areas, including those related to impairment of goodwill and equity investments, revenue recognition, recoverability of inventory and receivables, the useful lives long lived assets such as property and equipment, the future realization of deferred income tax benefits and the recording of various accruals. The ultimate outcome and actual results could differ from the estimates and assumptions used. 
 
e) Stock-Based Compensation - On January 1, 2006, the Company adopted the fair value recognition provisions of Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 123(R), Accounting for Stock-Based Compensation, to account for compensation costs under its stock option plans. The Company previously utilized the intrinsic value method under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (as amended) (“APB 25”). Under the intrinsic value method prescribed by APB 25, no compensation costs were recognized for the Company’s stock options because the option exercise price in its plans equals the market price on the date of grant. Prior to January 1, 2006, the Company only disclosed the pro forma effects on net income and earnings per share as if the fair value recognition provisions of SFAS 123(R) had been utilized.
 
In adopting SFAS No. 123, the Company elected to use the modified prospective method to account for the transition from the intrinsic value method to the fair value recognition method. Under the modified prospective method, compensation cost is recognized from the adoption date forward for all new stock options granted and for any outstanding unvested awards as if the fair value method had been applied to those awards as of the date of grant. For the three months ended March 31, 2007 and 2006, stock-based compensation expense was $61,440 and $0.00 respectively. As of March 31, 2007, there was approximately $312,000 of total unrecognized compensation cost related to unvested share-based compensation awards granted under the equity compensation plans which does not include the effect of future grants of equity compensation, if any. $312,000 will be amortized over the weighted average remaining service period of two years.

f) Depreciation, Amortization and Long-Lived Assets

Long-lived assets include:

Property, plant and equipment - These assets are recorded at original cost and increased by the cost of any significant improvements after purchase. The Company depreciates the cost evenly over the assets' estimated useful lives. For tax purposes, accelerated depreciation methods are used as allowed by tax laws.

Goodwill- Goodwill represents the difference between the purchase price of an acquired business and the fair value of the net assets. Goodwill is not amortized. The Company tests goodwill for impairment annually ( or in interim periods if events or changes in circumstances indicate that its carrying amount may not be recoverable) by comparing the fair value of each reporting unit, as measured by discounted cash flows, to the carrying value to determine if there is an indication that potential impairment may exist. One of the most significant assumptions is the projection of future sales. The Company reviews its assumptions each time goodwill is tested for impairment and makes appropriate adjustments, if any, based on facts and circumstances available at that time.

6
Identifiable intangible assets - These assets are recorded at original cost. Intangible assets with finite lives are amortized evenly over their estimated useful lives. Intangible assets with indefinite lives are not amortized.

At least annually, The Company reviews all long-lived assets for impairment. When necessary, charges are recorded for impairments of long-lived assets for the amount by which the present value of future cash flows, or some other fair value measure, is less than the carrying value of these assets.

g) Derivative Financial Instruments

The Company generally does not use derivative financial instruments to hedge exposures to cash-flow or market risks. However, certain other financial instruments, such as warrants and embedded conversion features that are indexed to the Company’s common stock, are classified as liabilities when either (a) the holder possesses rights to net-cash settlement or (b) physical or net-share settlement is not within the control of the Company. In such instances, net-cash settlement is assumed for financial accounting and reporting, even when the terms of the underlying contracts do not provide for net-cash settlement. Such financial instruments are initially recorded at fair value and subsequently adjusted to fair value at the close of each reporting period.

h) Recent Accounting Pronouncements In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, (“FAS 159”). FAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. FAS 159 is effective for fiscal years beginning after November 15, 2007. The Company does not believe that FAS 159 will have any material effect on its financial statements.
 
Note 2- Acquisition of "RTI" Stock


On September 19, 2006, the Company, closed on its Stock Purchase Agreement with Ricciardi Technologies Inc. (RTI) and the holders of all of the outstanding common stock of RTI. The Company completed the acquisition of 19,685 shares of the outstanding common stock of RTI which shares constitute 100% of the issued and outstanding shares of capital stock of RTI on a fully diluted basis. As consideration for such shares of RTI the Company paid (i)$3,500,000 in cash, and issued (ii) 5,000,000 shares of common stock, (iii)a $500,000 promissory note payable in full twelve months from the closing, and (iv)1,000,000 shares of the Company's Series B Convertible Preferred stock. Each share of Series B Preferred Stock will automatically convert into common stock on September 18, 2007, at the conversion rate of 8 1/3 shares of common stock, subject to adjustment in the event of stock dividends, splits and other distributions. The Company may at any time until September 18, 2007 redeem the Series B Preferred Stock at a redemption price of $0.50 per share. To secure the indemnification obligations of the former RTI stockholder, a portion of the purchase price, consisting of $350,000 and 5,833,333 shares of common stock was placed in escrow for a period of 18 months. The common stock issued was valued based upon an average of five days preceding and five days following the date that the Company and RTI agreed to all significant terms of the Agreement, and such terms were publicly disseminated.

As part of the purchase price the Company agreed to pay the former RTI stockholders up to an additional $1,500,000 depending on RTI's EBITDA for the twelve-month period ending on the first anniversary of the Closing date. If RTI's EBITDA is at least $2,250,000 but less than $2,500,000, the former RTI stockholders receive $750,000 and if the EBITDA for such twelve month period is at least $2,500,000, they will receive $1,500,000.

Pursuant to the RTI agreement the Company is to deliver to the RTI employees incentive stock options to purchase 200,000 shares of common stock at an exercise price of $0.60. In addition, during the two years following the closing, the Company shall grant the RTI employees an additional 50,000 shares in each year of the two year period at an exercise price equal to the market price on the date of issuance. These options have three year vesting and a ten year life.

7
The total purchase price amounted to $7,820,617 and was allocated as follows, based upon the fair value of assets acquired and liabilities assumed:

Category
 
Amount
 
Current assets
 
$
1,230,027
 
Property and equipment
 
 
1,473
 
Intangible assets
 
 
7,490,612
 
Deposits
 
 
9,406
 
Current liabilities
 
 
(910,901
)
 
 
$
7,820,617
 

Intangible assets acquired consisted of the following:
 
 
  
Life
  
 
  
Customer relationships
    
5
  
$
3,382,517
  
Know how and processes
    
5
    
2,924,790
  
Goodwill
    
—
    
484,033
  
Contractual backlog
    
1
    
534,272
  
Employment contract
    
1
    
165,000
  
 
    
 
$
7,490,612
  
 
The Company recorded amortization of $463,738 in March 31, 2007 related to the intangible assets listed above. The Company believes that the expansion into this business affords it an opportunity for synergy, thus justifying the amount of goodwill attributed to the acquisition of RTI. Due to certain limitations imposed by the Internal Revenue Service, the Company does not expect goodwill to result in any deductible amounts in the near future.


8

Note 3- Segment Reporting 

Management views its business as two operating units, Technology Products and Technology Services.
 
 
  
Three Months Ended
  
 Three Months Ended
  
 
  
March 31, 2007
  
March 31, 2005
  
Revenue
              
Technology Products
  
$
289,402
  
$
423,890
  
Technology Services
    
2,887,079
    
917,917
  
Total Consolidated Revenue
  
$
3,176,481
  
$
1,341,807
  
Gross Profit
          
Technology Products
  
$
200,210
  
$
269,770
  
Technology Services
    
1,503,817
    
439,669
  
Total Gross Profit
  
$
1,704,027
  
$
708,439
  
 
Note 4 - Notes payable

Notes payable consists of the following as of March 31, 2007 and December 31, 2006:

 
  
2007
  
2006
  
 
  
 
  
 
  
Revolving credit facility (a)
    
509,178
 
$
590,749
  
Notes Payable - Stockholders/Officers (b)
    
848,000
    
893,000
  
Short term notes payable (c)
    
250,000
   
250,000
 
Convertible note (d)
    
—
    
264,440
 
Total notes payable
    
1,607,178
   
1,998,189
  
Less current maturities, associated with notes payable
    
(1,607,178
)
  
(1,998,189
)
               
Long-term debt
  
$
—
  
$
—
  

9

(a) Revolving Line of credit
 
On November 10, 2006, the Company secured a Line of Credit facility with Greater Bay Business Funding ("GBBF") for $2,000,000. The line is primarily secured by the Company's accounts receivables. The Advance Rate is 85%. Interest on the line will be charged at the rate of prime plus 6%. Upon securing the line with GBBF, the Company repaid in full and closed out the credit facility with Presidential Financial Group. The total outstanding balance on this facility as of March 31, 2007 and December 31, 2006 was $509,178 and $590,749 respectively. Additionally, the Company incurred an up-front fee of $20,000 which is being amortized ratably over the twelve month term of the facility. As of March 31, 2007, 11,667 remain unamortized
 
(b) Notes Payable Stockholders/officers
 
The Company has a short-term loan payable with a former officer and stockholder of the Company amounting to $98,000, this note bears interest of 8% per annum. The note is an unsecured demand note.
 
At December 31, 2006 the Company has a short term notes payable of $250,000 with a director of the Company. This note is collateralized by proceeds from the future sale of the New Jersey Net Operating Loss in 2006, upon approval from the State of NJ. In the event, the Company is not approved for this program; the Company will repay this note and accrued interest from operating cash flows. The note bears interest at 20% per annum and is payable at maturity date of December 31, 2007.
 
As part of the RTI acquisition the Company issued a note in the amount of $500,000 to the former Stockholders of RTI as part of the purchase price. The note is payable no later than September 17, 2007 and bears an interest rate of 10% per annum.

(c) Short term notes

In connection with the September 18, 2006 omnibus amendment and waiver agreement with Laurus the Company entered into a Term Note for $250,000 with Laurus. The Term Note bears interest at a rate per annum equal to the prime rate published in The Wall Street Journal from time to time, plus 3%, but shall not be less than 8%. Interest payments are due monthly, in arrears, commencing on September 19, 2006 and ending on the maturity date which is September 18, 2007.
 
 
 
 
(d) 2006 Barron Financing Agreement

Convertible Promissory Notes

On September 19, 2006, the Company entered into a financing arrangement that provided for the issuance of $4,500,000, 6.0% Convertible Promissory Notes, due May 31, 2007, and warrants to purchase 25,000,000 shares of common stock. Proceeds, which were net of $404,851 in cash financing costs, amounted to $4,045,149. Proceeds from this financing arrangement were allocated to the fair value of the conversion option and warrants, based upon their fair values, because share-settlement of these instruments is not within the Company’s control. The following table reflects the components of the initial allocation:

Financial instrument:
      
Warrant derivative
  
$
13,895,090
  
Compound derivative
    
8,113,451
  
Convertible notes payable
    
--
  
Financing costs, net of cash costs of $404,851
    
(867,357
)
Day-one derivative loss
    
(17,096,035
)
   
$
4,045,149
  
 
The derivative warrants were issued in two traunches, each having terms of five years. The traunches have exercise prices of $0.5 and $1.20, respectively. The Company fair valued the derivative warrants using the Black-Scholes-Merton Technique using a volatility factor of 90.76% and a risk free interest rate of $4.69%. The Company uses the Black-Scholes-Merton valuation technique for warrants because this technique embodies all of the assumptions necessary to fair value non-complex instruments.

The compound derivative comprises certain derivative features embedded in the host convertible note payable contract including the conversion feature, anti-dilution protections and certain redemption features. These instruments were combined into one compound derivative and bifurcated from the host instrument at fair value. The Company applied the Monte-Carlo valuation technique to fair value this derivative because Monte Carle embodies all assumptions (including credit risk, interest rate risk, conversion/redemption behaviors) necessary to fair value complex, compound derivative financial instruments.

Since the derivative financial instruments are required to be recorded, both initially and subsequently at fair values, there were insufficient proceeds to allocate any amount to the Convertible Notes Payable and, accordingly, it has no carrying value on the inception date. In addition, proceeds were insufficient to record the fair values of the derivative financial instruments, resulting in a day-one derivative loss of $17,096,035. It should be noted that derivative instruments will be adjusted to fair value at each reporting date. Fair values are highly influenced by our trading stock price and volatility, changes in our credit risk and market interest rates.

 
 
 
The Company amortized the discount on the Convertible Notes Payable resulting from the initial allocation over the term of the debt instrument using the effective method.

On February 2, 2007, upon filing of the Restated Certificate of Incorporation, the Convertible Notes Payable was automatically converted into Series A Preferred Stock. Based upon the Company’s evaluation of the terms and conditions of the Series A Preferred Stock, the Company concluded that the Preferred Stock was more akin to equity rather than debt and thus have been classified as stockholders’ equity. Since the conversion features on the debenture had been bifurcated from the convertible debt host contract and recorded as a liability, there was no equity conversion feature remaining in the debt instrument for accounting purposes. Therefore, for accounting purposes, both liabilities (i.e. the debt host contract and the bifurcated derivative liability) were subject to extinguishment accounting.

On February 7, 2007, the Company entered into an amendment agreement in which the investors amended the Securities Purchase Agreement and Registration Rights Agreement, and provided for (i) the waiver of all accrued and unpaid liquidated damages for not filing the registration statement in 60 days as is required in the registration rights agreement and (ii) the extension to a later date of certain mandated events, such as the re-composition of the Board. On February 7, 2007, the Company issued warrants to purchase 1.9 million shares of common stock as compensation to the investors for this amendment, valued at approximately $1,031,000 using the Black-Scholes-Merton technique. Since the warrants met the eight conditions for equity classification provided in EITF 00-19, the fair value of these warrants was classified as equity. This debt modification was deemed to be a modification rather than a debt extinguishment since it did not rise to the requirements of EITF 96-19 to be deemed a debt extinguishment. The Company recorded the modification in conjunction with the preferred stock conversion which resulted in a derivative expense of $838,709 for the amount of the warrant consideration that was allocated to the derivative instruments and an extinguishment gain of $1,199,589 related to the conversion.

In accordance with FAS 5, the Company had accrued a liability for the liquidated damages of $874,000. Upon receipt of the waiver of the liquidating damages, this amount was recorded as a gain on extinguishment.

During December 2006, the Financial Accounting Standards Board issued FASB Staff Position (FSP) EITF 00-19-2, Accounting for Registration Payment Arrangements, which amended Financial Accounting Standard No. 133 Accounting for Derivative Financial Instruments and Hedging Activities. Generally, the amendment provides for the exclusion of registration payments, such as the liquidated damages that the Company has incurred, from the consideration of classification of financial instruments, previously required under FAS133 and EITF 00-19. Rather, registration payments are to be accounted for pursuant to Financial Accounting Standard No. 5 Accounting for Contingencies, which provides for the recognition of registration payments when they are both probably and reasonably estimable. The FSP was adopted by the Company on January 1, 2007, as was required by the new accounting pronouncement. However, the Company had previously applied the view (provided in EITF 05-04) that registration payments required recognition pursuant to FAS 5.
 
Adoption of the FSP involved management’s reevaluation of the conditions for equity or liability classification of existing derivative financial instruments pursuant to the revised criteria of EITF 00-19. As a result of the reevaluation, management concluded that the warrants, associated with the 2006 Barron financing agreement, and classified as liabilities, did not meet the eight conditions for equity classification provided in EITF 00-19, and are continued to be recorded as liabilities and adjusted to fair value each quarter. There were two traunches of Series C warrants to purchase 4,891,000 shares of common stock each that had been considered “tainted” due to the conversion features in the Barron financing. These warrants were initially recorded as liabilities when the Company entered into the Barron financing on September 19, 2006 at which time it lost the ability to net share-settle all of its obligations. The company affected a 1 for 10 reverse stock split February 2, 2007 at which time it regained the ability to net share-settle all of its obligations. Since the Series C warrants met the eight conditions for equity classification provided in EITF 00-19, the fair value of these warrants ($462,517) was reclassified to equity. The fair value of the warrants was determined using the Black-Scholes-Merton valuation technique.

 
 
 
 Note 5 - Derivative Financial Instruments

The balance sheet caption derivative liabilities consist of (i) embedded conversion features and (ii) the Warrants, issued in connection with the 2005 Laurus Financing Arrangement, the 2006 Omnibus Amendment and Waiver Agreement with Laurus, and the 2006 Barron Financing Arrangement. These derivative financial instruments are indexed to an aggregate of 27,358,333 and 6,307,242 shares of the Company’s common stock as of March 31, 2007 and 2006, respectively, and are carried at fair value. The following tabular presentations set forth information about the derivative instruments for the quarter ended March 31, 2007 and 2006:

Derivative income (expense)
  
Quarter ended
March 31, 2007
  
Quarter ended
March 31, 2006
  
Conversion features
  
$
( 1,305,829
)
$
264,752
  
Warrant derivative
  
$
( 322,600
)
$
105,275
  

Liabilities
March 31, 2007
March 31, 2006
  
Compound derivative
  
$
-
    
($ 255,462
)
Warrant derivative
    
($ 13,033,396
)
  
($ 207,000
)

 
Freestanding derivative instruments, consisting of warrants and options that arose from the Laurus and Barron financing are valued using the Black-Scholes-Merton valuation methodology because that model embodies all of the relevant assumptions that address the features underlying these instruments. Significant assumptions used in the Black Scholes models included: conversion or strike prices ranging from $0.1 - $1.10; volatility factors ranging from 88.21% - 148.83% based upon forward terms of instruments; terms-remaining term for all instruments; and a risk free rate ranging from 4.54% - 4.65%. Fair value for forward-based features (principally the interest reset feature) is determined using the income approach; generally discounted cash flows.

Embedded derivative instruments consist of multiple individual features that were embedded in the convertible debt instruments. The Company evaluated all significant features of the hybrid instruments and, where required under current accounting standards, bifurcated features for separate report classification. These features were, as attributable to each convertible note, aggregated into one compound derivative financial instrument for financial reporting purposes. During the first quarter of 2007, the embedded derivatives were recorded at fair value prior to the conversion into shares of Series A Preferred Stock. The compound embedded derivative instruments are valued using the Flexible Monte Carlo methodology because that model embodies certain relevant assumptions (including, but not limited to, interest rate risk, credit risk, and Company-controlled redemption privileges) that are necessary to value these complex derivatives. Significant assumptions included in the Flexible Monte Carlo included: conversion or strike price of $0.23; volatility factor of 157.20% based upon forward terms of instruments; terms-remaining term for all instruments; equivalent interest rate risk of 11.81% and equivalent yield rate of 11.59%.

Equivalent amounts reflect the net results of multiple modeling simulations that the Monte Carlo Simulation methodology applies to underlying assumptions.
 
Note 6 Common Stock/Preferred Stock
 
February 2, 2007 the Company affected a one-for-ten reverse stock split restating the common shares from 166,424,280 to 16,642,428.. All reference to shares has been restated to reflect the reverse.

 
February 2, 2007 the Company file a restated certificate of incorporation with the State of Delaware, upon the effectiveness the principal and interest due on the Barrons note was automatically converted into7,826,087 shares of the Company's Series A Preferred Stock as is determined by dividing the principal amount of the note by the Conversion Price, which initially is $.575.
 
Each share of Series A Preferred Stock is convertible into 25 shares of common stock subject to adjustment in certain instances, including the issuance by the Company of common stock at a price which is less than the conversion price applicable to the Series A Preferred Stock, which is initially $0.023 per share, subject to adjustment

13
 
Note 7-Stock Based Compensation
 
a)  2002 Employee Stock option plan

On November 6, 2002 the stockholders approved the adoption of The Company's 2002 Employee Stock Option Plan. Under the Plan, options may be granted which are intended to qualify as Incentive Stock Options ("ISOs") under Section 422 of the Internal Revenue Code of 1986 (the"Code") or which are not ("Non-ISOs") intended to qualify as Incentive Stock Options thereunder. The maximum number of options made available for issuance under the Plan are two million (2,000,000) options. The options may be granted to officers, directors, employees or consultants of the Company and its subsidiaries at not less than 100% of the fair market value of the date on which options are granted. The term of each Option granted under the Plan shall be contained in a stock option agreement between the Optionee and the Company.

On January 1, 2006 the Company adopted Statement of Financial Accounting Standards ("SFAS") No.123 (Revised 2004), "Share Based Payment," ("SFAS 123R"), using the modified prospective method. In accordance with SFAS 123R, the Company measures the cost of employee services received in exchange for an award of
equity instruments based on the grant-date fair value of the award. That cost is recognized over the period during which an employee is required to provide service in exchange for the award - the requisite service period. The Company determines the grant-date fair value of employee share options using the Black-Scholes option-pricing model.

Under the modified prospective approach, SFAS 123R applies to new awards and to awards that were outstanding on January 1, 2006 that are subsequently modified, repurchased or cancelled. Under the modified prospective approach, compensation cost recognized for the first quarter of fiscal 2006 includes compensation cost for all share-based payments granted prior to, but not yet vested on, January 1, 2006, based on the grant-date fair value estimated in accordance with the pro forma provisions of SFAS 123, and compensation cost for
all share-based payments granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123R. Prior periods were not restated to reflect the impact of adopting the new standard.
 
   
Number of
 
Number of
 
Weighted-
 
 
 
Options
 
Options
 
Average
 
 
 
Available
 
Outstanding
 
Exercise Price
  
Balance January 1, 2007
    
467,000
    
1,371,000
  
$
1.00
  
Options granted under Plan
    
—
    
—
        
Options expired
    
—
    
—
        
Balance March 31, 2007
    
467,000
    
1,371,000
  
$
1.00
  
 
No options were issued in March 31, 2007 and 2006.

The weighted-average fair value per share of the options granted during 2007 and 2006 was estimated on the date of grant using the Black-Scholes option pricing model, The following assumptions were used to estimate the fair value of the options at grant date based on the following:

14

   
2007
 
2006
 
Risk-Free interest rate
    
4.65
%
  
4.92
%
Expected dividend yield
          
—
  
Expected stock price volatility
    
156
%
  
156
%
Expected option Life
    
10 years
    
10 years
  
 
Warrants

On February 8, 2007 the company issued a warrant to purchase 1,900,000 shares of its common stock at an exercise price of $0.50, as consideration for an amendment to the September 19, 2006 Securities purchase agreement, which extended the filing date of a registration statement from 60 days from September 19, 2006 to no later than February 12, 2007. It also extended the date to have an independent board, and an audit committee comprised of not less than three directors, a majority of whom are independent directors, and a compensation committee to February 12, 2007
 
15
Item 2.  Management’s Discussion and Analysis or Plan of Operation.
 
GENERAL OVERVIEW
 
Lattice Incorporated (Formally Science Dynamics Corporation) was incorporated in the State of Delaware in May 1973 and commenced operations in July 1977. We have been developing and delivering secure technologically advanced communication solutions for over twenty-five years and recently expanded our product offering to include IT solutions with the acquisition of 86% of Systems Management Engineering, Inc. ("SMEI") on February 14, 2005. In September 2006, pursuant to a Stock Purchase Agreement, dated as of September 12, 2006 (the "RTI Agreement"), the Company purchased all of the issued and outstanding shares of the common stock of Ricciardi Technologies Inc. ("RTI"). RTI was founded in 1992 and provides software consulting and development services for the command and control of biological sensors and other Department of Defense requirements to United States federal governmental agencies either directly or though prime contractors of such governmental agencies RTI's proprietary products include SensorView, which provides clients with the capability to command, control and monitor multiple distributed chemical, biological, nuclear, explosive and hazardous material sensors. RTI is headquartered in Manassas, Virginia. The purchase of RTI's common stock was completed on September 19, 2006.
 
For the quarter ended March 31, 2007, the company has continued to demonstrate improved operating performance. The positive “Adjusted Operating Income” (reported operating loss of ($54,166) plus non-cash depreciation and amortization of $524,553 and share-based compensation of $61,440). These results are especially encouraging when compared to the same period a year ago which shows an increase in Adjusted Operating Income of 200%+. The company's improved results are a direct reflection of the company's efforts to manage our costs effectively, the acquisition of “RTI” in the third quarter of 2006 and the expansion of our existing contracts and addition of new contracts.
 
The Company's management believes “Adjusted Operating Income”, a non-GAAP financial measure, is an important financial metric to monitor operating performance. The Company also believes “Adjusted Operating Income" provides meaningful insight to its investors in understanding the Company's operating performance.
 
For the three months ended March 31, 2007 and 2006, the Company's “Adjusted Operating Income” reconciles to reported operating income as follows:
 
 
  
For the three months ended
March 31,
  
 
  
2007
  
2006
  
Reported Operating Income (Loss)
  
$
(54,166
)
$
95,699
  
 
              
Add-back:
              
Non-cash Depreciation & Amortization expenses
  
$
524,553
  
$
77,630
  
Share-based Compensation
  
$
61,440
  
$
—
  
 
              
Adjusted Operating Income
 
$
531,827
  
$
173,329
  
 
16

We intend to continue the expansion of our sales efforts both within the federal government secure software solutions space and commercial accounts. We continue to build upon our recent success in these markets by expanding our marketing efforts through our direct sales strategy. Our strong contract backlog has given us an opportunity to expand our existing revenue base. With regards to our acquisition strategy, we will continue to pursue profitable companies with proprietary products and services we can sell to our existing customers and which have synergies with our existing business.

Item 2.  Management’s Discussion and Analysis or Plan of Operation.

The information in this report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. This Act provides a "safe harbor" for forward-looking statements to encourage companies to provide prospective information about themselves so long as they identify these statements as forward looking and provide meaningful cautionary statements identifying important factors that could cause actual results to differ from the projected results. All statements other than statements of historical fact made in this report are forward looking. In particular, the statements herein regarding industry prospects and future results of operations or financial position are forward-looking statements. Forward-looking statements reflect management's current expectations and are inherently uncertain. Our actual results may differ significantly from management's expectations.

The following discussion and analysis should be read in conjunction with the financial statements and notes thereto included elsewhere in this report and with our annual report on Form 10-KSB for the fiscal year ended December 31, 2006. This discussion should not be construed to imply that the results discussed herein will necessarily continue into the future, or that any conclusion reached herein will necessarily be indicative of actual operating results in the future. Such discussion represents only the best present assessment of our management.


Revenues for the three months ended March 31, 2007 were $3,176,481, compared to $1,341,807 for the three months ended March 31, 2006. This represents an increase of $1,834,674, or 237% comparing the two periods. The increase in revenue for the three months ended March 31, 2007 includes the results of “RTI” which was acquired in the third quarter of 2006. Excluding the “RTI” acquisition, revenues increased by $376,319 or 28% compared to the year ago period.
 
Product revenues decreased $134,488, or 32%, during the three months ended March 31, 2007 compared to the same period in fiscal 2006. Product revenues are sensitive to unit shipments on a quarter to quarter basis and should be viewed on a full year basis.

Service revenues increased $2,084,196, or 227% to $3,002,113 during the three months ended March 31, 2007 compared to the same period in fiscal 2006. The increase in revenues included the results of”RTI” which was acquired in the third quarter of 2006. Excluding “RTI”, service revenues increased by $625,841 or 68%.

Gross profit increased by $994,588, or 140%, to $1,704,027 for the three months ended March 31, 2007 compared to $709,439 for the three months ended March 31, 2006. The increase in gross profit included the results of “RTI” acquired in the third quarter of 2006. Excluding RTI, gross margin increased by $174,588 or 25%, which was in line with our revenue growth.

For the three months ended March 31, 2007, Research and development expenses were $109,041 compared to $109,134 for the three months ended March 31, 2006.

For the three months ended March 31, 2007, selling, general and administrative expenses totaled $1,649,152 compared to $504,606 for the period ended March 31, 2006 for an increase of $1,144,546, or 227%.

The increase in selling, general and administrative expenses included the results of “RTI”, which was acquired in the third quarter of 2006. Excluding RTI, selling, general and administrative increased $274,688 or 54%. The increase in baseline selling, general and administrative expenses was primarily attributable to: non-cash share-based compensation of $61,440 in the current quarter, executive salaries of $56,000 (waived in the first quarter of 2006), and an overall increase in operating expenses.

17
Interest and finance expense was $390,803 and $137,933 for the three months ended March 31, 2007 and 2006, respectively. This was an increase of $252,870. Included in the current quarter expense of $390,803 was non-cash amortization totaling $315,000 of debt discount and finance fees related to the $4.5M Barron convertible promissory note. The note was converted to equity (Series “A” Preferred Stock) during the current quarter.


Our net loss was $102,497 for the three months ended March 31, 2007 compared to a net loss of $49,676 for the three months ended March 31, 2006. The current quarter net loss included non-cash amortization expenses related to acquired intangibles totaling $520,428 compared to amortization expense of $56,690 in the year ago period.
 
Liquidity and Capital Resources

As of March 31, 2007 our cash balance was $240,739, compared to $392,275 at December 31, 2006. Total current assets at March 31, 2007 were $3,523,707 compared to $3,567,395 at December 31, 2006. Current liabilities totaling $16,627,132 at March 31, 2007 which includes non-cash derivative liabilities of $13,047,396. Excluding the non-cash derivative liabilities, current liabilities totaled $3,579,736 at March 31, 2007. We currently plan to use our cash balance and cash generated from operations for increasing our working capital reserves and paying down short term debt coming due in the next twelve months. Management believes that the current cash on hand, additional cash expected from operations in fiscal 2007 and the availability on our line of credit facility will be sufficient to cover our working capital requirements for fiscal 2007.

Our accounts receivable at March 31, 2007 was $2,980,145, compared to $2,412,164 at December 31, 2006. The change in accounts receivable is primarily due to; slower collections with certain government agencies.

We have approximately $1,100,000 of short term debt coming due by end of fiscal 2007. We plan to pay this with proceeds generated from anticipated operating cash flows, our current cash position and the availability on our line of credit facility. Our outstanding balance on the $2.0M line of credit facility was $509,000 at March 31, 2007.
 
At March 31, 2007 the Company had no long term debt.
 
Financings

In September 2006, pursuant to a Stock Purchase Agreement, dated as of September 12, 2006 (the "RTI Agreement"), the Company purchased all of the issued and outstanding shares of the common stock of Ricciardi Technologies Inc. ("RTI"). RTI was founded in 1992 and provides software consulting and development services for the command and control of biological sensors and other Department of Defense requirements to United States federal governmental agencies either directly or though prime contractors of such governmental agencies RTI's proprietary products include SensorView, which provides clients with the capability to command, control and monitor multiple distributed chemical, biological, nuclear, explosive and hazardous material sensors. RTI is Headquartered in Manassas, Virginia. The purchase of RTI's common stock was completed on September 19, 2006.
 
Pursuant to the RTI Agreement, the consideration for stock of RTI consisted of (a) $3,500,000, which was paid from the proceeds of the sale of the Note and Warrants to Barron Partners LP (as descussed below) (b) 5,000,000 shares of common stock, (c) a $500,000 promissory note (the "RTI Note"), which if not paid sooner must be paid in full on the earlier of (i) twelve months from the closing date of the transaction, which was September 19, 2006 (the "closing date")   or (ii) the consummation of a transfer of all or substantially all of the assets or equity securities of the Company to a third party, and (b) 1,000,000 shares of the Company's Series B Convertible Preferred Stock. To secure the indemnification obligations of the former RTI stockholders, a portion of the purchase price, consisting of $350,000 and 583,333 shares of common stock was placed in escrow for a period of 18 months, subject to any claims that may arise under the agreement during the 18-month warranty survival period.
 
Each share of Series B Preferred Stock will automatically convert into common stock on September 18, 2007, at the conversion rate of 8 1/3 shares of commons stock, subject to adjustment in the event of stock dividends, splits and other distributions, combinations of shares or reverse splits or other recapitalizations. The Company may at any time until September 18, 2007, redeem the Series B Preferred Stock at a redemption price of $0.50 per share.
 
18
As part of the purchase price for price for RTI stock, the Company agreed to pay the former RTI stockholders up to an additional $1,500,000 depending on the technology’s services segment EBITDA for the twelve-month period ending on the first anniversary of the Closing Date. If the segments EBITDA is at least $2,250,000 but less than $2,500,000, the former RTI stockholders receive $750,000, and if the EBITDA for such twelve month period is at least $2,500,000, the former RTI stockholders will receive $1,500,000.
 
Pursuant to the RTI Agreement, the Company is to deliver to the RTI's employee’s incentive stock options to purchase 200,000 shares of common stock at an exercise price equal to the greater of: (i) the market price on the closing date and (ii) the volume-weighted average price per share for the fifteen (15) days prior to the Closing Date. The grant of the options shall be subject to approval by the Company, with approval not to be unreasonably withheld. During the two years following the closing, the Company shall grant the RTI employees incentive stock options to purchase 50,000 shares in each year of the two year period. These options shall have an exercise price equal to the greater of: (i) the closing market price and (ii) the volume-weighted average price per share for the fifteen (15) days prior to the date of each such grant. The options will have a ten-year term and shall vest equally in each year in first three years and such vesting shall accelerate if (i) such employee is terminated without cause or without good reason or (ii) upon a change of control of the Company.
 
Pursuant to the RTI Agreement, to secure the Company's payment obligations under the RTI Note, the Company and each owner of the issued and outstanding shares of RTI's capital stock executed a Pledge Agreement. Pursuant to the Pledge Agreement, 15.24% of the share of RTI's capital stock purchased by the Company is being held in escrow until the payment in full by the Company' of the RTI Note.
 
The RTI transaction was financed through a private placement with Barron Partners LP, a private investment partnership based in New York. The Company sold Barron a convertible subordinated promissory note in the principal amount of $4.5 million (the "Note"), a warrant to purchase up to 12.5 million shares of the company's common stock at an exercise price of $0.50 per share and a warrant to purchase up to 12.5 million shares of the Company's common stock at an exercise price of $1.25 per share which expire in Sept, 2011. The private placement closed on September 19, 2006. As a result of the filing of our amended and restated certificate of incorporation with the State of Delaware, on February 2, 2007, the principal and interest due on the Barron note automatically converted into 7,826,087 shares of series A preferred stock.
 
Each share of Series A Preferred Stock is convertible into 2.5 shares of common stock subject to adjustment in certain instances, including the issuance by the Company of common stock at a price which is less than the conversion price applicable to the Series A Preferred Stock (the "Series A Conversion Price"), which is initially $.23 per share, subject to adjustment.
 
The Purchase Agreement as well as the certificate of designation for the Series A Preferred Stock and Warrants provide for an adjustment in the conversion price of the note and Series A Preferred Stock and the exercise price of the Warrants if the Company's earnings before interest, taxes, depreciation and amortization is less than a specified amount per share, on a fully-diluted basis, with a maximum reduction of 30% for each year. The target EBITDA per share is $0.19 for 2006 and $0.549 for 2007. The amount of reduction per year is the percentage shortfall. Thus, a 15% shortfall will result in a 15% reduction in the applicable conversion or exercise price then in effect. For purpose of determining fully-diluted, all shares of Common Stock issuable upon conversion of convertible securities and upon exercise of warrants and options shall be deemed to be outstanding, regardless of whether (i) such shares are treated as outstanding for determining diluted earnings per share under GAAP, (ii) such securities are "in the money," or (iii) such shares may be issued as a result of the 4.9% Limitation. The per share amounts are adjusted in accordance with GAAP to reflect any stock dividend, split, distribution, reverse split or combination of shares or other recapitalization, including the reverse split effected by the restated certificate of incorporation.

19
 On February 8, 2007 the company issued a warrant to purchase 1,900,000 shares of its common stock at an exercise price of $0.50, as consideration for an amendment to the September 19, 2006 Securities purchase agreement, which extended the filing date of a registration statement from 60 days from September 19, 2006 to no later than February 12, 2007. It also extended the date to have an independent board, and an audit committee comprised of not less than three directors, a majority of whom are independent directors, and a compensation committee to February 12, 2007 (will be tied to the derivatives)
 
The Company entered into a Omnibus Amendment and Waiver Agreement with Laurus Master Fund, LTD ("Laurus"), dated September 18, 2006 (the "Laurus Agreement") for the purpose of amending, restating and waiving certain terms of (i) the Amended and Restated Secured Convertible Term Note, issued as of February 11, 2005 and amended and restated as of July 21, 2006 (as amended and restated, amended, modified and supplemented from time to time, the "Term Note") by the Company to Laurus, (ii) the Securities Purchase Agreement, dated as of February 11, 2005 (as amended, modified or supplemented from time to time, the "Purchase Agreement") by and between the Company and Laurus, (iii) the Common Stock Purchase Warrant, issued as of February 11, 2005 by the Company to Laurus (as amended and restated, amended, modified and supplemented from time to time, the "Initial Warrant"), (iv) the Common Stock Purchase Warrant, issued as of November 18, 2005 by the Company to Laurus (as amended and restated, amended, modified and supplemented from time to time, the "Additional Warrant") and (v) the Forbearance Agreement, dated as of July 21, 2006 between the Company and Laurus (as amended, modified or supplemented from time to time, the "Forbearance Agreement"). The Company issued 100,000 common shares and paid $500,000 in cash in conjunction with the July 21, 2006 agreement. 
 
Pursuant to the Laurus Agreement, on September 19, 2006, Laurus waived each Event of Default that may have arisen under Section 4.1 of the Term Note and Section 3 of the Forbearance Agreement solely as a result of the failure by the Company to make the $32,656 in interest payments due to Laurus on September 1, 2006.
 
Pursuant to Laurus Agreement, on September 19, 2006, in exchange for the cancellation of the term note in the principal amount of $2,000,000, the Company (a) paid $500,000 in principal amount of the Term Note, (b) issued an amendment and restated note in the principal amount of $250,000, and (c) issued a warrant to purchase up to 1,458,333 shares of common stock (subject to adjustment), upon the cashless exercise by the holder thereof for an imputed exercise price of $0.10 per share.
 
Pursuant to a letter agreement between the Company and the Keshet Fund LP and Keshet L.P. (collectively the "Keshet"), the Company agreed to issue 300,000 shares of common stock in consideration for the cancellation of all payment obligations arising under the convertible notes issued to Keshet by the Company. Additionally, the Keshet will, at the Company's expense, terminate all of its agreements with the Company, other than in respect of (x) indemnification and expense reimbursement provisions of such agreements and such other provisions thereof as expressly survive the payment in full of the Obligations and (y) any options and/or warrants received by Keshet from the Company.
 
Between April 14, 2006 and May 11, 2006 the Company sold 2,274,951 shares of common stock and 1,161,587 warrants to purchase additional shares of common stock to various accredited investors in a private placement. The Company received proceeds of $1,293,906 and exchanged $100,000 of accrued expenses for a total of $1,393,906. The Company used these proceeds for working capital purposes and to reduce short term debt.


20
Off Balance Sheet Arrangements

We do not have any off balance sheet arrangements that are reasonably likely to have a current or future effect on our financial condition, revenues, results of operations, liquidity or capital expenditures.

Summary of Significant Accounting Policies
 
Use of Estimates - The financial statements have been prepared in accordance with accounting principles generally accepted in the United States (US GAAP). The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts in the financial statements and accompanying notes. These estimates form the basis for judgments made about the carrying values of assets and liabilities that are not readily apparent from other sources. Estimates and judgments are based on historical experience and on various other assumptions that the Company believes are reasonable under the circumstances. However, future events are subject to change and the best estimates and judgments routinely require adjustment. US GAAP requires estimates and judgments in several areas, including those related to impairment of goodwill and equity investments, revenue recognition, recoverability of inventory and receivables, the useful lives long lived assets such as property and equipment, the future realization of deferred income tax benefits and the recording of various accruals. The ultimate outcome and actual results could differ from the estimates and assumptions used.
 
Basis of Financial Statement Presentation - The Company’s auditors have expressed a going concern opinion in their audit reports for 2006 and 2005. Management acknowledges the basis for the going concern opinion, given the Company’s historical net losses and working capital deficits. However, it should be noted that the Company has made significant improvements in its operating performance in 2006. The Company has increased its sales by approximately 76.9% compared to 2005, through organic growth and acquisitions, posted positive operating income of $455,886 versus an operating loss of $1,006,881 in 2005 and was able to increase the availability of its revolving credit facility financing from $1M to $2M with the refinancing of the PFC facility with GBBF. Additionally, upon the effectiveness of its restated certificate of incorporation on February 2, 2007, the Company was able to convert its $4.5M note with Barron to Series A Preferred Stock. Given these events collectively and the anticipation that the positive trends will continue, management expects the going concern opinion to be removed from future filings.
 
Principles of Consolidation - The consolidated financial statements included the accounts of the Company and all of its subsidiaries in which a controlling interest is maintained. All significant inter-company accounts and transactions have been eliminated in consolidation. For those consolidated subsidiaries where Company ownership is less than 100%, the outside stockholders' interests are shown as minority interests.

Derivative Financial Instruments The Company generally does not use derivative financial instruments to hedge exposures to cash-flow or market risks. However, certain other financial instruments, such as warrants and embedded conversion features that are indexed to the Company’s common stock, are classified as liabilities when either (a) the holder possesses rights to net-cash settlement or (b) physical or net-share settlement is not within the control of the Company. In such instances, net-cash settlement is assumed for financial accounting and reporting, even when the terms of the underlying contracts do not provide for net-cash settlement. Such financial instruments are initially recorded at fair value and subsequently adjusted to fair value at the close of each reporting period.

Revenue Recognition - Revenue is recognized when all significant contractual obligations have been satisfied and collection of the resulting receivable is reasonably assured. Revenue from product sales is recognized when the goods are shipped and title passes to the customer.

The company applies the guidance of SOP-97.2 with regards to its software products. Under this guidance, the Company determined that its product sales do not contain multiple deliverables for an extended period beyond delivery where bifurcation of multiple elements is necessary. The software is embedded in the producst sold and shipped. Revenue is recognized upon delivery, installation and acceptance by the customer. PCS (postcontract customer support) and upgrades are billed separately and when rendered or delivered and not contained in the original arrangement with the customer. Installation services are included with the original susotmer arrangement but are rendered at the time of delivery of the product and invoicing.
 
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The Company provides IT and business process outsourcing services under time-and-material, fixed-price contracts, which may extend up to 5 years. Services provided over the term of these arrangements may include, network engineering, architectural guidance, database management, expert programming and functional area expert analysis   Revenue is generally recognized when the product or service is provided and the amount earned is not contingent upon any further event.
 
Depreciation, Amortization and Long-Lived Assets

Long-lived assets include:

Property, plant and equipment - These assets are recorded at original cost and increased by the cost of any significant improvements after purchase. The Company depreciates the cost evenly over the assets' estimated useful lives. For tax purposes, accelerated depreciation methods are used as allowed by tax laws.

Goodwill- Goodwill represents the difference between the purchase price of an acquired business and the fair value of the net assets. Goodwill is not amortized. The Company tests goodwill for impairment annually ( or in interim periods if events or changes in circumstances indicate that its carrying amount may not be recoverable) by comparing the fair value of each reporting unit, as measured by discounted cash flows, to the carrying value to determine if there is an indication that potential impairment may exist. One of the most significant assumptions is the projection of future sales. The Company reviews its assumptions each time goodwill is tested for impairment and makes appropriate adjustments, if any, based on facts and circumstances available at that time.

Identifiable intangible assets - These assets are recorded at original cost. Intangible assets with finite lives are amortized evenly over their estimated useful lives. Intangible assets with indefinite lives are not amortized.

At least annually, The Company reviews all long-lived assets for impairment. When necessary, charges are recorded for impairments of long-lived assets for the amount by which the present value of future cash flows, or some other fair value measure, is less than the carrying value of these assets.
 
Item 3.  Controls and Procedures.

As of the end of the period covered by this report, we conducted an evaluation, under the supervision and with the participation of our chief executive officer and chief financial officer of our disclosure controls and procedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) of the Exchange Act. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are not effective to provide (i) reasonable assurance that information we are required to disclose in this report that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and (ii) that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure. Please see subsection “Significant Deficiencies in Disclosure Controls and Procedures or Internal Controls” below.
 
Significant Deficiencies in Disclosure Controls and Procedures or internal Controls
 
We have identified the following material weakness in our internal controls. The Company has experienced difficulty gaining access to the financial records of its subsidiary Ricciardi Technologies, Inc. The Company’s management is taking corrective actions in order to ensure timely access to such financial records.

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PART II

Item 1.  Legal Proceedings.

We are not a party to any pending legal proceeding, nor is our property the subject of a pending legal proceeding, that is not in the ordinary course of business or otherwise material to the financial condition of our business. None of our directors, officers or affiliates is involved in a proceeding adverse to our business or has a material interest adverse to our business.

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds.
 
Not applicable

Item 3.  Defaults Upon Senior Securities.

Not applicable.

Item 4.  Submission of Matters to a Vote of Security Holders.

Not applicable.

Item 5.  Other Information.

Not applicable.

Item 6.
Exhibits.

Exhibit Number
  
Description
3.10
  
Restated Certificate of Incorporation (Incorporated by reference to the Registration Statement on Form SB-2 filed on February 12, 2007.)
31.1
  
Certification by Chief Executive Officer, required by Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act.
31.2
  
Certification by Chief Financial Officer, required by Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act.
32.1
  
Certification by Chief Executive Officer, required by Rule 13a-14(b) or Rule 15d-14(b) of the Exchange Act and Section 1350 of Chapter 63 of Title 18 of the United States Code.
32.2
  
Certification by and Chief Financial Officer, required by Rule 13a-14(b) or Rule 15d-14(b) of the Exchange Act and Section 1350 of Chapter 63 of Title 18 of the United States Code.


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SIGNATURES

In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
LATTICE INCORPORATED
 
 
 
 
Date: May 21, 2007
By:  
/s/ Paul Burgess
 
Paul Burgess
 
President, Chief Executive Officer and Director
 
 
 
 
Date: May 21, 2007
By:  
/s/ Joe Noto
 
Joe Noto
 
Chief Financial Officer and Principal Accounting Officer

 
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