Overview

NeoMedia provides the infrastructure to make mobile barcode scanning and its associated commerce easy, universal, and reliable - worldwide. Our barcode ecosystem products including mobile barcode reading software, NeoReader, reads and transmits data from 1D and 2D barcodes to its intended destination. Our Code Management (NeoSphere) and Code Clearinghouse (NeoRouter) platforms create, connect, record, and transmit the transactions embedded in the barcodes, like web-URLs, text messages (SMS), and telephone calls, ubiquitously and reliably.

In order to provide complete mobile marketing solutions, NeoMedia also offers barcode scanning hardware that reads barcodes displayed on mobile phone screens. NeoMedia provides infrastructure solutions to enable mobile ticketing and couponing programs - including scanner hardware and system support software for seamless implementation.

This technology is supported by our patents. In addition, NeoMedia has an open standards philosophy designed to make integration and use of the technology easy for handset manufacturers, mobile operators and advertisers; and the user experience safe, reliable and interoperable for consumers.

In 2006, we began divesting our non-core businesses in order to focus our efforts on the area that we believe will deliver the most value - our code-reading business and the related intellectual property. In the fourth quarter of 2006, we disposed of two subsidiaries, Mobot and Sponge. During April 2007, we sold the 12Snap business unit and in October 2007, we completed the sale of our Telecom Services business. In November 2007, we sold our Micro Paint Repair business unit. As a consequence of these divestitures, we evaluated our continuing business as one consolidated business for the entire 2007 reporting year. These divestitures were integral to our turnaround plan and the proceeds received from the sale of our non-core business units have been used to continue with the development of our code-reading business. A major goal of ours is to provide the industrial and carrier-grade infrastructure to enable reliable, scalable and billable commerce that is customer-focused and drives revenue growth.

During 2008 and early 2009 we have made significant changes to strengthen our management team. In June 2008, Mr. Iain A. McCready became our Chief Executive Officer and Chairman of our Board of Directors; in September 2008, Mr. Michael W. Zima became our Chief Financial Officer and Secretary; in January 2009, Ms. Laura Marriott became a Member our Board of Directors; and in March 2009 Mr. Dean Wood became our Vice President - Business Development.

Critical Accounting Policies and Estimates

This discussion and analysis of financial condition and results of operations has been prepared by management based on our consolidated financial statements, which have been prepared in accordance with US GAAP. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, management evaluates our critical accounting policies and estimates, including those related to revenue recognition, valuation of accounts receivable, property, plant and equipment, long-lived assets, intangible assets, derivative liabilities and contingencies. Estimates are based on historical experience and on various other assumptions believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.

We consider the following accounting policies important in understanding the operating results and financial conditions of NeoMedia. These judgments and estimates affect the reported amounts of assets and liabilities and the reported amounts of revenues and expenses during the reporting periods.

· Intangible Asset Valuation - The determination of the fair value of certain acquired assets and liabilities is subjective in nature and often involves the use of significant estimates and assumptions. Determining the fair values and useful lives of intangible assets especially requires the exercise of judgment. While there are a number of different generally accepted valuation methods to estimate the value of intangible assets acquired, we primarily use the weighted-average probability method outlined in FAS 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." This method requires significant management judgment to forecast the future operating results used in the analysis. In addition, other significant estimates are required such as residual growth rates and discount factors. The estimates we have used are consistent with the plans and estimates that we use to manage our business, based on available historical information and industry averages. The judgments made in determining the estimated useful lives assigned to each class of assets acquired can also significantly affect our net operating results.

According to FAS 144, a long-lived asset should be tested for recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. We follow the two-step process outlined in FAS 144 for determining if an impairment charge should be taken: (1) the expected undiscounted cashflows from a particular asset or asset group are compared to the carrying value; if the expected undiscounted cashflows are greater than the carrying value, no impairment is taken, but if the expected undiscounted cashflows are less than the carrying value, then (2) an impairment charge is taken for the difference between the carrying value and the expected discounted cashflows. The assumptions used in developing expected cashflow estimates are similar to those used in developing other information used by us for budgeting and other forecasting purposes. In instances where a range of potential future cashflows is possible, we use a probability-weighted approach to weigh the likelihood of those possible outcomes. In such instances, we use a discount rate equal to the yield on zero-coupon treasury instruments with a life equal to expected life of the assets being tested.

· Derivative Financial Instruments - We generally do not use derivative financial instruments to hedge exposures to cash-flow risks or market-risks that may affect the fair values of our financial instruments. However, certain financial instruments, such as warrants and the embedded conversion features of our convertible preferred stock and convertible debentures, which are indexed to our 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 our control. In such instances, net-cash settlement is assumed for financial accounting and reporting purposes, even when the terms of the underlying contracts do not provide for net-cash settlement. Derivative financial instruments are initially recorded, and continuously carried, at fair value.

Determining the fair value of these complex derivative financial instruments involves judgment and the use of certain relevant assumptions including, but not limited to, interest rate risk, credit risk, equivalent volatility and conversion/redemption privileges. The use of different assumptions could have a material effect on the estimated fair value amounts.

For certain of our convertible debentures, we have elected not to separately account for the embedded conversion feature as a derivative instrument but to account for the entire hybrid instrument at fair value in accordance with FAS
155 "Accounting for Certain Hybrid Financial Instruments". For the remaining convertible debentures and our convertible preferred stock, the underlying instruments are carried at amortized cost and the embedded conversion feature is accounted for separately at fair value in accordance with FAS 133 "Accounting for Derivative Instruments and Hedging Activities" and EITF Issues 00-19 "Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock" and 07-5 "Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity's Own Stock".

· Financial Instruments and Concentrations of Credit Risk - Our financial instruments consist of cash and cash equivalents, accounts receivable, cash surrender value of life insurance policy, accounts payable, accrued expenses, notes payable, derivative financial instruments, other current liabilities, convertible preferred stock, and convertible debenture financing. We believe the carrying values of cash and cash equivalents, accounts receivable, cash surrender value of life insurance policy, accounts payable, accrued expenses, notes payable, and other current liabilities approximate their fair values due to their short-term nature. Our convertible preferred stock and convertible debentures are either recognized as hybrid financial instruments and carried at fair value in accordance with FAS 155 or are carried at amortized cost, with separate recognition of the fair value of any embedded derivative instrument liabilities, including the conversion feature. At December 31, 2008, the face value of debentures carried at amortized cost exceeded their carrying amount by approximately $1.1 million. At December 31, 2008 the face value of debentures carried at fair value exceeded their carrying amount by approximately 9.0 million.

· Revenue Recognition - We derive revenues from the following sources: (1) license revenues relating to patents and internally-developed software, and
(2) hardware, software, and service revenues related to mobile marketing campaign design and implementation.

o Technology license fees, including Intellectual Property licenses, represent revenue from the licensing of our proprietary software tools and applications products. We license our development tools and application products pursuant to non-exclusive and non-transferable license agreements. The basis for license fee revenue recognition is substantially governed by American Institute of Certified Public Accountants ("AICPA") Statement of Position 97-2 "Software Revenue Recognition" ("SOP 97-2"), as amended, and Statement of Position 98-9, Modification of SOP 97-2, "Software Revenue Recognition, With Respect to Certain Transactions". License revenue is recognized if persuasive evidence of an agreement exists, delivery has occurred, pricing is fixed and determinable, and collectability is reasonably assured. We defer revenue related to license fees for which amounts have been collected but for which revenue has not been recognized in accordance with the above criteria, and recognize that revenue when the criteria are met.

o Technology service and product revenue, which includes sales of software and technology equipment and service fees is recognized based on guidance provided in SAB 104, "Revenue Recognition in Financial Statements" as amended. Software and technology equipment resale revenue is recognized when persuasive evidence of an arrangement exists, the price to the customer is fixed and determinable, delivery of the service has occurred and collectability is reasonably assured. Service revenues including maintenance fees for providing system updates for software products, user documentation and technical support are recognized over the life of the contract. We defer revenue related to technology service and product revenue for which amounts have been invoiced and or collected but for which the requisite service has not been provided. Revenue is then recognized over the matching service period.

· Valuation of Accounts Receivable - Judgment is required when we assess the likelihood of ultimate realization of recorded accounts receivable, including assessing the likelihood of collection and the credit-worthiness of customers. If the financial condition of our customers were to deteriorate or their operating climate were to change, resulting in an impairment of either their ability or willingness to make payments, an increase in the allowance for doubtful accounts would be required. Similarly, a change in the payment behavior of customers generally may require an adjustment in the calculation of an appropriate allowance. Each month we assess the collectability of specific customer accounts, the aging of accounts receivable, our history of bad debts, and the general condition of the industry. If a major customer's credit worthiness deteriorates, or our customers' actual defaults exceed historical experience, our estimates could change and impact our reported results. We believe that the current allowance for doubtful accounts receivable is adequate to cover the expected level of uncollectible accounts receivable as of the balance sheet date. For the years ended December 31, 2008 and 2007, our bad debt recovery was $58,000 and expense was $78,000, respectively.

· Inventory - Inventories are stated at the lower of cost (using the first-in, first-out method) or market. We continually evaluate the composition of our inventories assessing slow-moving and ongoing products and maintain a reserve for slow-moving and obsolete inventory as well as related disposal costs. As of December 31, 2008 and 2007, we recorded a reserve for inventory shrinkage and obsolescence of $81,000 and $80,000, respectively.

· Stock-based Compensation - We record stock-based compensation in accordance with FAS 123(R), "Share-Based Payment", which requires measurement of all employee stock-based compensation awards using a fair-value method and the recording of such expense in the consolidated financial statements. We apply the Black-Scholes-Merton option pricing model and recognize compensation cost on a straight-line basis over the vesting periods for the awards. Inherent in this model are assumptions related to expected stock-price volatility, option life, risk-free interest rate and dividend yield.

Although the risk-free interest rate and dividend yield are less subjective assumptions, typically based on factual data derived from public sources, the expected stock-price volatility, forfeiture rate and option life assumptions require a greater level of judgment which make them critical accounting estimates. We use an expected stock-price volatility assumption that is based on historical volatilities of our stock, and estimate the forfeiture rates and option life based on historical data of prior options. Because these assumptions are based on historical information, actual future expenses may differ materially from the current estimates which are based on these assumptions.

· Contingencies - We are subject to proceedings, lawsuits and other claims related to lawsuits and other regulatory proceedings that arise in the ordinary course of business. We are required to assess the likelihood of any adverse judgments or outcomes of these matters as well as potential ranges of probable losses. A determination of the amount of the loss accrual required, if any, for these contingencies, is made after careful analysis of each individual issue. We generally accrue attorney fees and interest in addition to an estimate of the expected liability. We consult with legal counsel and other experts where necessary to assess any contingencies. The required accrual may change in the future due to new developments in each matter or changes in approach, such as a change in settlement strategy, in dealing with these matters.

· Income Tax Valuation Allowance - Deferred tax assets are reduced by a valuation allowance when, in the opinion of our management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. We have recorded a 100% valuation allowance as December 31, 2008 and 2007.

· Foreign Currency Translation - the U.S. dollar is the functional currency of our operations, except for our operations at NeoMedia Europe, which use the Euro as their functional currency. Foreign currency transaction gains and losses are reflected in income. Translation gains and losses arising from translating the financial statements of NeoMedia Europe into U.S. dollars for reporting purposes are included in "Accumulated other comprehensive income (loss)."

Discontinued Operations

Our consolidated financial information presents the net effect of discontinued operations for all periods presented separate from the results of our continuing operations in accordance with FAS 144 "Accounting for the Impairment or Disposal of Long-Lived Assets".

AutoXperience

As of November 30, 2007, we discontinued the operations of AutoXperience. We retained all liabilities of AutoXperience, including liabilities for taxes arising prior to the closing of the business, employee termination and related expenses, and any contingent liabilities arising prior to the closing date. As of December 31, 2008, these liabilities have been substantially settled.

During the year ended December 31, 2007, we recognized a loss of $0.9 million from discontinued operations related to AutoXperience.

NeoMedia Micro Paint Repair

On November 15, 2007, we entered into an Asset Purchase Agreement with Micro Paint Holdings Ltd. ("Buyers"), pursuant to which Buyers purchased from us all the assets of NeoMedia Micro Paint Repair, exclusive of the assets of AutoXperience.

The total selling price for the assets was $2.2 million, of which $1.5 million in cash and $0.2 million in stock of Buyers was received at closing. The remaining purchase price of $0.5 million was held in escrow pending the settlement of post-closing items. The escrow amount was partially settled in 2008 as an accommodation for several post closing items including an allowance for damaged inventory related to the sale. However, $0.2 million was determined to be uncollectible and reserved in 2008. This reserve was included in our loss from discontinued operations for the year ended December 31, 2008. At September 30, 2007, in accordance with FAS 144, we analyzed the undiscounted cashflows from the Micro Paint asset group compared to its carrying values, and determined that an impairment of $0.6 million was required in order for the remaining carrying value of the net assets to equal the anticipated sale proceeds. The entire write-down was applied to goodwill, leaving a balance of $0.5 million in goodwill. At the time of the sale, we recognized a net loss of $0.5 million, net of transaction costs in connection with the sale, which was recorded as a loss on disposal of subsidiaries in the Consolidated Statement of Operations for the year ended December 31, 2007. The carrying amounts of assets and liabilities disposed of in relation to this sale totaled approximately $1.4 million, consisting of $1.9 million in goodwill and other intangibles, net of amortization, $0.3 million of other assets, offset by $0.3 million of deferred revenue and $0.5 million in cumulative currency translation adjustments. During the year ended December 31, 2008 we recognized a loss from discontinued operations of $258,000 for various incidental and wind-down expenses related to NeoMedia Micro Paint Repair.

On November 25, 2008 we settled a claim brought by the Federal Aviation Administration related to a spillage of a small quantity of MPR's products in 2007 for $7,500. This settlement was included in our loss from discontinued operations in 2008.

NeoMedia Telecom Services

On October 30, 2007, we entered into an Asset Purchase Agreement with the former owners of NeoMedia Telecom Services, pursuant to which the former owners of NeoMedia Telecom Services purchased from us all the assets of NeoMedia Telecom Services.

The total selling price for the assets was $1.4 million, less costs of sale which included 6,190,476 shares of NeoMedia stock valued at $130,000 issued as additional consideration to the buyer in the transaction. As a result of the sale, we recognized a net loss of $3.4 million, which was recorded as a loss on disposal of subsidiaries in the Consolidated Statement of Operations for the year ended December 31, 2007. The carrying amounts of assets and liabilities disposed of in relation to this sale totaled approximately $4.5 million, consisting of $5.1 million of intangibles, net of amortization, $0.5 million in cumulative currency translation adjustments, offset by $1.1 million in other liabilities.

12Snap

On April 4, 2007, we entered into an Asset Purchase Agreement with Bernd Michael, a private investor and former shareholder of 12Snap prior to our acquisition of 12Snap, pursuant to which Mr. Michael purchased from us 90% of the assets of 12Snap, and we retained a 10% ownership of 12Snap, subject to an option agreement pursuant to which we had the right to sell and Mr. Michael had the right to acquire the remaining 10% stake held by us for a purchase price of $0.8 million after December 31, 2007. We exercised this option and realized these proceeds on January 28, 2008.

The total fair value of the proceeds received for the assets was $4.6 million, of which $1.0 million cash was paid directly to and applied to amounts owed to a group of former shareholders of 12Snap, $0.6 million cash was received by us, $1.8 million of guarantee purchase price obligations were waived, 7,750,857 shares of NeoMedia stock valued at $0.4 million was returned to us and retired, and we retained a 10% ownership interest in 12Snap valued at $0.8 million. As a result of the sale, we recognized a net loss of $2.7 million, net of transaction costs in connection with the sale, which was recorded as a loss on disposal of subsidiaries in the Consolidated Statement of Operations for the year ended December 31, 2007. The carrying amounts of assets and liabilities disposed of in relation to this sale totaled approximately $7.3 million, consisting of $5.8 million of intangibles, net of amortization and $1.5 million of other assets. During the year ended December 31, 2008 we recognized a loss from discontinued operations of $65,000 for various incidental and wind-down expenses related to 12 Snap. At December 31, 2008, we have a continuing purchase price obligation of $4.6 million related to our original purchase of 12Snap.

Results of Continuing Operations

Our consolidated financial information presents the net effect of discontinued operations separate from the results our continuing operations. Historical financial information has been reclassified to consistently separate and present the results of discontinued operations, and the discussion and analysis that follow generally focuses on continuing operations. The following table sets forth, for the periods indicated, certain data derived from our consolidated statements of operations as a percentage of revenues.

                                                                   Year Ended December 31,
                                                                 2008                   2007
                                                            (in thousands)         (in thousands)

Net sales                                                  $          1,046       $          1,864
Cost of sales                                                         1,257                  1,431
Gross profit (deficit)                                                 (211 )                  433

Sales and marketing expenses                                          2,177                  2,582
General and administrative expenses                                   5,406                  7,082
Research and development costs                                        1,997                  1,857
Impairment charge                                                       271                  3,065

Operating loss                                                      (10,062 )              (14,153 )

Gain on extinguishment of debt                                        2,405                    347
Gain (loss) from change in fair value of hybrid
financial instruments                                                 3,562                 (7,824 )
Loss from change in fair value of derivative financial
instruments                                                          (2,339 )               (7,640 )
Other interest expense, net                                          (1,262 )               (2,634 )

Loss from continuing operations                            $         (7,696 )     $        (31,904 )

Loss per share from continuing operations,
basic and diluted                                          $          (0.01 )     $          (0.03 )

The loss from continuing operations for the year ended December 31, 2008 was $7.7 million, or $0.01 per share basic and diluted, on revenues of $1.0 million. This compares to a loss from continuing operations for the year ended December 31, 2007 of $31.9 million, or $0.03 per share basic and diluted, on revenues of $1.9 million.

Revenues

                                            Year Ended December 31,
                                            2008               2007
                                                (in thousands)

               Hardware sales           $        320       $        593
               Lavasphere revenue                153                494
               Patent licensing                   52                 85
               Legacy product revenue            345                456
               Other revenue                     176                236
                Total net sales         $      1,046       $      1,864

Year Ended December 31, 2008 Compared With the Year Ended December 31, 2007

Net Sales. Total revenues for the year ended December 31, 2008 were $1.0 million, which represented a decrease of 0.8 million, or 43.9%, from $1.9 million for the year ended December 31, 2007.The decrease in our revenues was primarily due to our focus on development and rollout of our products and services to support the emerging barcode ecosystem which is being defined by bodies such as the Open Mobile Alliance, Ltd. (the "OMA"), the Global System for Mobile Communications Association (the "GSMA") and the Cellular Telephone Industries Association (the "CTIA"). We believe this focus will deliver the most value in the future. Hardware sales were also affected by decreased sales of our older products in anticipation of the new and improved product lines introduced late in 2008. This anticipation of our new hardware products also reduced selling prices as we sold the remaining supplies of older models. Lavasphere revenue, which tends to be project based, decreased due to decreases in client specific software development. Legacy product revenues declined consistent with the lifecycle of these products.

Cost of Sales. Cost of sales was $1.3 million for the year ended December 31, 2008 compared with $1.4 million for the year ended December 31, 2007, a decrease of $0.1 million, or 12.2%. Cost of sales for NeoMedia Europe, related to our hardware products, was $0.3 million and $0.4 million in the years ended December 31, 2008 and 2007, respectively. Amortization costs related to our patents, and the proprietary software of NeoMedia Europe were $1.0 million and $0.7 million for the years ended December 31, 2008 and 2007, respectively.

Sales and Marketing. Sales and marketing expenses were $2.2 million for the year ended December 31, 2008, compared with $2.6 million for the year ended December 31, 2007, a decrease of $0.4 million or 15.7%. Sales and marketing . . .