- Quarterly Report (10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington , D.C. 20549

FORM 10-Q

(Mark one)

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

For the quarterly period ended September 30, 2008

¨	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ______ to _______ .

Commission File Number: 000-4986 2

PROCERA NETWORKS, INC.

(Exact name of registrant as specified in its charter)

Nevada	33-0974674
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification Number)

100 Cooper Court , Los Gatos , California 95032	(408) 354-7200
(Address of principal executive offices, including zip code)	(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o	Accelerated filer þ	Non-accelerated filer o	Smaller reporting company o
		(Do not check if a smaller reporting company)

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

As of November 7, 2008, the registrant had 84,198,491 shares of its common stock, par value $0.001, outstanding.

PROCERA NETWORKS, INC.

INDEX

		Page
PART I. FINANCIAL INFORMATION		3

Item 1.	Consolidated Financial Statements:	3

	Condensed Consolidated Balance Sheets as of September 30, 2008 and December 31, 2007	3

	Condensed Consolidated Statements of Operations and Comprehensive Income for the three and nine months ended September 30, 2008 and 2007	4

	Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2008 and 2007	5

	Notes to Interim Condensed Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	18

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	30

Item 4.	Controls and Procedures	30

PART II. OTHER INFORMATION		31

Item 1.	Legal Proceedings	31

Item 1A.	Risk Factors	32

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	43

Item 3.	Defaults Upon Senior Securities	43

Item 4.	Submission of Matters to a Vote of Security Holders	43

Item 5.	Other Information	43

Item 6.	Exhibits	43

SIGNATURES		43
EXHIBIT 3.4
EXHIBIT 10.1
EXHIBIT 10.2
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1

Index

PART I. FINANCIAL INFORMATION

Item 1.

Consolidated Financial Statements

Procera Networks, Inc.

CONDENSED CONSOLIDATED BALANCE SHEETS

	Sept. 30, 2008 (Unaudited)			Dec 31, 2007

ASSETS
Current Assets:
Cash and cash equivalents	$	4,825,674		$	5,864,648
Accounts receivable, less allowance of $175,135 and $241,062 for September 30, 2008 and December 31, 2007, respectively		3,204,549			1,819,272
Inventories, net		2,120,786			1,320,022
Prepaid expenses and other		1,012,789			520,137

Total current assets		11,163,798			9,524,079

Property and equipment, net		3,272,314			4,476,224
Purchased intangible assets, net		1,324,155			2,403,405
Goodwill		960,209			960,209
Other non-current assets		47,557			47,805

Total assets	$	16,768,033		$	17,411,722

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable	$	1,250,770		$	668,289
Deferred revenue		1,091,369			957,891
Accrued liabilities		1,345,146			1,572,975
Notes payable-current portion		550,000			-
Capital leases payable-current portion		17,205			33,867

Total current liabilities		4,254,490			3,233,022

Non-current liabilities
Deferred rent		24,539			7,797
Deferred tax liability		955,143			1,734,855
Capital leases payable - non-current portion		47,423			62,773

Total liabilities		5,281,595			5,038,447

Commitments and contingencies (Note 13)		---			---

Stockholders' equity:
Preferred stock, $0.001 par value; 15,000,000 shares authorized: none issued and outstanding		---			---
Common stock, $0.001 par value; 130,000,000 shares authorized; 84,142,569 and 76,069,233 shares issued and outstanding at September 30, 2008 and December 31, 2007, respectively		84,143			76,069
Additional paid-in capital		60,705,570			50,058,560
Accumulated other comprehensive gain (loss)		(312,017	)		76,861
Accumulated deficit		(48,991,258	)		(37,838,215	)

Total stockholders' equity		11,486,438			12,373,275

Total liabilities and stockholders' equity	$	16,768,033		$	17,411,722

See accompanying notes to interim condensed consolidated financial statements

Index

Procera Networks, Inc.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS and COMPREHENSIVE INCOME

(Unaudited)

	Three Months Ended						Nine Months Ended
	Sept. 30, 2008			Sept. 30, 2007			Sept. 30, 2008			Sept. 30, 2007

Sales
Product sales	$	2,209,605		$	1,377,830		$	5,748,372		$	5,073,625
Support sales		479,568			267,828			1,271,874			673,962
Total sales		2,689,173			1,645,658			7,020,246			5,747,587
Cost of sales
Product cost of sales		1,788,622			957,357			4,209,445			2,837,300
Support cost of sales		125,654			117,213			423,797			310,176
Total cost of sales		1,914,276			1,074,570			4,633,242			3,147,476

Gross profit		774,897			571,088			2,387,004			2,600,111

Operating expenses:
Engineering		809,201			768,885			2,497,734			2,302,908
Sales and marketing		2,094,101			1,953,365			6,435,501			5,240,486
General and administrative		1,896,837			1,267,291			5,392,988			3,479,012
Total operating expenses		4,800,139			3,989,541			14,326,223			11,022,406

Loss from operations		(4,025,242	)		(3,418,453	)		(11,939,219	)		(8,422,295	)

Other income (expense)
Interest and other income		27,371			26,181			53,254			57,407
Interest and other expense		(14,569	)		(1,034	)		(49,373	)		(14,981	)
Total other income (expense)		12,802			25,147			3,881			42,426

Net loss before taxes		(4,012,440	)		(3,393,306	)		(11,935,338	)		(8,379,869	)
Income tax benefit		259,904			300,537			782,295			805,499
Net loss after taxes		(3,752,536	)		(3,092,769	)		(11,153,043	)		(7,574,370	)

Other comprehensive income (loss), net		(480,689	)		2,316			(388,878	)		26,303
Comprehensive loss	$	(4,233,225	)	$	(3,090,453	)	$	(11,541,921	)	$	(7,548,067	)

Net loss per share - basic and diluted	$	(0.05	)	$	(0.04	)	$	(0.14	)	$	(0.11	)
Shares used in computing net loss per share-basic and diluted		79,018,207			73,089,577			77,424,517			70,141,287

See accompanying notes to interim condensed consolidated financial statements

Index

Procera Networks, Inc.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

	Nine months ended Sept. 30,
	2008			2007

Cash flow from operating activities:
Net loss	$	(11,153,043	)	$	(7,548,067	)
Adjustments to reconcile net loss to net cash used operating activities:
Common stock issued for services rendered		736,000			323,440
Compensation related to stock-based awards		1,289,196			1,330,076
Fair value of warrants issued to non-employees		306,484			-
Depreciation		1,885,042			1,827,731
Inventory reserve		9,636			7,774
Amortization of intangibles		1,079,250			1,079,250
Changes in assets and liabilities:
Trade accounts receivable		(1,659,264	)		(1,785,818	)
Inventories		(1,530,681	)		(601,199	)
Prepaid expenses and other current assets		(508,876	)		(58,614	)
Accounts payable		604,633			904,934
Accrued liabilities, deferred rent		(154,058	)		639,211
Deferred income taxes		(779,712	)		(824,585	)
Deferred revenue		177,651			500,716
Net cash used in operating activities		(9,697,742	)		(4,205,151	)

Cash flows used in investing activities:
Purchase of equipment		(724,362	)		(551,419	)
Net cash used in investing activities		(724,362	)		(551,419	)

Cash flows from financing activities:
Proceeds from sale of common stock		5,829,118			7,354,403
Proceeds from exercise of warrants		2,175,572			674,178
Proceeds from exercise of stock options		318,712			66,277
Proceeds from issuance of debt instruments		550,000			75,666
Capital lease payments		(28,298	)		(26,769	)
Net cash provided by financing activities		8,845,104			8,143,755
Effect of exchange rates on cash and cash equivalents		538,026			(7,137	)
Net increase (decrease) in cash and cash equivalents		(1,038,974	)		3,380,048
Cash and cash equivalents, beginning of period		5,864,648			5,214,177
Cash and cash equivalents, end of period	$	4,825,674		$	8,594,225

SUPLEMENTAL CASH FLOW INFORMATION:
Cash paid for income taxes	$	93,698		$	-
Cash paid for interest	$	1,180		$	2,928

See accompanying notes to interim condensed consolidated financial statements

Index

Procera Networks, Inc

Notes to Interim Condensed Consolidated Financial Statements (unaudited)

DESCRIPTION OF BUSINESS

Procera Networks, Inc. together with its wholly owned consolidated subsidiaries, Netintact AB and Netintact PTY ("Procera" or the "Company") is a leading provider of evolved traffic awareness, control and protection products and solutions for broadband service providers worldwide. Procera’s products offer its customers and their users intelligent traffic identification and control service management solutions, a high degree of accuracy in identifying applications running on provider networks, and the ability to optimize the subscriber experience based on management of the identified network traffic.

More than 400 customers (with over 1,100 systems installed) have chosen our deep packet inspection, or DPI, solution. The company markets its PacketLogic solutions to a number of customers in different industry verticals including: Internet service providers, wireless service providers, cable multi-service operators, telecommunications companies, large businesses operating their own internal networks, and education and government institutions. The company uses a combination of direct sales and channel partners to sell our products and services. The Company also engages a worldwide network of value added resellers to penetrate particular geographic regions and market segments. The direct and indirect sales mix varies by geography and target industry.

The Company was incorporated in 2002 and is a Nevada corporation. On August 18, 2006 , Procera acquired the stock of Netintact AB , a Swedish corporation. On September 29, 2006 , Procera acquired the effective ownership of the stock of Netintact PTY , an Australian company. The common stock of Procera is listed on the American Stock Exchange under the trading symbol “PKT”.

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

Procera has prepared the consolidated financial statements included herein pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations. However, Procera believes that the disclosures are adequate to ensure the information presented is not misleading. The consolidated balance sheet at December 31, 2007 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. These unaudited consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto included in Procera’s Annual Report on Form 10-K for the fiscal year ended December 31, 2007 filed with the SEC on April 2, 2008, as amended .

Procera believes that all necessary adjustments, which consist of normal recurring items, have been included in the accompanying consolidated financial statements to state fairly the results of the interim periods. The results of operations for the interim periods presented are not necessarily indicative of the operating results to be expected for any subsequent interim period or for Procera’s fiscal year ended December 31, 2008 .

Certain amounts in the prior periods presented have been reclassified to conform to the current period financial statement presentation. These reclassifications have no effect on previously report net loss.

The consolidated financial statements present the accounts of Procera and its wholly-owned subsidiaries, Netintact AB and Netintact PTY. All significant inter-company accounts and transactions have been eliminated.

Significant Accounting Policies

There have been no significant changes in Procera's significant accounting policies during the nine months ended September 30, 2008 as compared to what was previously disclosed in Procera's Annual Report on Form 10-K for the year ended December 31, 2007 as filed with the SEC on April 2, 2008, as amended, except as noted below.

Adoption of New Accounting Standards

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements.” SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosure related to the use of fair value measures in financial statements. The provisions of SFAS No. 157 were to be effective for fiscal years beginning after November 15, 2007 . On February 6, 2008 , the FASB agreed to defer the effective date of SFAS No. 157 for one year for certain nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). Effective January 1, 2008 , the Company adopted SFAS No. 157 except as it applies to those nonfinancial assets and nonfinancial liabilities. The adoption of SFAS No. 157 did not have a material impact on the Company’s results of operations or financial position.

Index

Effective January 1, 2008 , the Company adopted SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities – including an amendment of FASB Statement No. 115.” SFAS No. 159 allows an entity the irrevocable option to elect fair value for the initial and subsequent measurement of certain financial assets and liabilities under an instrument-by-instrument election. Subsequent measurements for the financial assets and liabilities an entity elects to fair value will be recognized in the results of operations. SFAS No. 159 also establishes additional disclosure requirements. The Company did not elect the fair value option under SFAS No. 159 for any of its financial assets or liabilities upon adoption. The adoption of SFAS No. 159 did not have a material impact on the Company’s results of operations or financial position.

Foreign Currency

The functional currency of the Company is the U.S. dollar. The financial position and results of operations of the Company’s foreign subsidiaries are measured using the foreign subsidiary’s local currency as the functional currency. Revenues and expenses of such subsidiaries have been translated into U.S. dollars at average exchange rates prevailing during the period. Assets and liabilities have been translated at the rates of exchange on the balance sheet date. The resulting translation gain and loss adjustments are recorded directly as a separate component of shareholders’ equity. Foreign currency translation adjustments resulted in other comprehensive income or expense of $(480,689) and $2,316 during the three month periods ended September 30, 2008 and 2007, respectively and $(388,878) and $26,303 during the nine month periods ended September 30, 2008 and 2007.

Use of Estimates

The preparation of consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures of contingent assets and liabilities. On an ongoing basis, we evaluate the Company’s estimates, including those related to allowance for doubtful accounts and sales returns, the value and marketability of inventory, allowances for expected warranty costs, valuation of long-lived assets, including intangible assets and goodwill, income taxes and stock-based compensation, among others. The company bases its estimates on experience and other criteria and assumptions that are believed to be reasonable under expected business conditions. Actual results may differ from these estimates if alternative conditions are realized.

Revenue Recognition

The Company’s most common sale involves the integration of the Company’s software and a hardware appliance. The software is essential to the functionality of the product. We account for this revenue in accordance with Statement of Position, or SOP, 97-2, Software Revenue Recognition , as amended by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions, for all transactions involving software. We recognize product revenue when all of the following have occurred: (1) we have entered into a legally binding arrangement with a customer resulting in the existence of persuasive evidence of an arrangement; (2) when product title transfers to the customer as identified by the passage of responsibility in accordance with Incoterms 2000; (3) customer payment is deemed fixed or determinable and free of contingencies and significant uncertainties; and (4) collection is probable.

Our product revenue consists of revenue from sales of the Company’s appliances and software licenses. Product sales include a perpetual license to the Company’s software. Shipping charges billed to customers are included in product revenue and the related shipping costs are included in cost of product revenue. Virtually all of the Company’s sales include support services which consist of software updates and customer support. Software updates provide customers access to a constantly growing library of electronic internet traffic identifiers (signatures) and rights to non-specific software product upgrades, maintenance releases and patches released during the term of the support period. Support includes internet access to technical content, telephone and internet access to technical support personnel and hardware support.

Receipt of a customer purchase order is the primary method of determining persuasive evidence of an arrangement exists.

Delivery generally occurs when product title has transferred as identified by the passage of responsibility per the International Chamber of Commerce shipping term (INCOTERMS 2000). The Company’s standard delivery terms are when product is delivered to a common carrier from Procera, or its subsidiaries. However, product revenue based on channel partner purchase orders are recorded based on sell-through to the end user customers until such time as we have established significant experience with the channel partner's ability to complete the sales process. Additionally, when we introduce new products for which there is no historical evidence of acceptance history, revenue is recognized on the basis of end-user acceptance until such history has been established.

Since the Company’s customer orders contain multiple items such as hardware, software, and services which are delivered at varying times, we determine whether the delivered items can be considered separate units of accounting as prescribed under Emerging Issues Task Force ("EITF") Issue No. 00-21, "Revenue Arrangements with Multiple Deliverables" ("EITF 00-21"). EITF 00-21 states that delivered items should be considered separate units of accounting if delivered items have value to the customer on a standalone basis, there is objective and reliable evidence of the fair value of undelivered items, and if delivery of undelivered items is probable and substantially in the Company’s control.

Index

In these circumstances, we allocate revenue to each separate element based on its vendor specific objective evidence of fair value ("VSOE"). VSOE of fair value for elements of an arrangement is based upon the normal pricing and discounting practices for those services when sold separately and for support and updates is additionally measured by the renewal rate offered to the customer. We also consider order size as well as service point (channel versus direct service) in measuring the VSOE of fair value. Through September 30, 2008, in virtually all of the Company’s contracts, the only elements that remained undelivered at the time of product delivery were post contract hardware and software support and software updates when and if available.

When we are able to establish VSOE for all elements of the sales order we separate the deferred items accordingly. Revenue is recognized on the deferred items using either the completed-performance or proportional-performance method depending on the terms of the service agreement. When the amount of services to be performed in the last series of acts is so significant in relation to the entire service contract, that performance is deemed not to have occurred until the final act is completed or when there are acceptance provisions based on customer-specified objectives. Under these conditions, we use the completed-performance method of revenue recognition which is measured by the customer's acceptance. We use the proportional-performance method of deferred revenue recognition when a service contract specifies activities to be performed by the Company and those acts have been repeatedly demonstrated to be within the Company’s core competency. Under this scenario, post contract support revenue is recognized ratably over the life of the contract. The majority of the revenue associated with the Company’s post contract support and service contracts is recognized under the proportional-performance method using the straight line method with the revenue being earned over the life of the contract. If evidence of the fair value of one or more undelivered elements does not exist, all revenue is generally deferred and recognized when delivery of those elements occurs or when fair value can be established. When the undelivered element for which we do not have a fair value is support, revenue for the entire arrangement is bundled and recognized ratably over the support period.

In certain contracts, billing terms are agreed upon based on performance milestones such as the execution of measurement test, a partial delivery or the completion of a specified service. Payments received before the unconditional acceptance of a specific set of deliverables are recorded as deferred revenue until the conditional acceptance has been waived.

The Company’s fees are typically considered to be fixed or determinable at the inception of an arrangement, generally based on specific products and quantities to be delivered. Substantially all of the Company’s contracts do not include rights of return or acceptance provisions. To the extent that the Company’s agreements contain such terms, we recognize revenue once the acceptance provisions or right of return lapses. Payment terms to customers generally range from net 30 to 90 days. In the event payment terms are provided that differ from the Company’s standard business practices, the fees are deemed to not be fixed or determinable and revenue is recognized when the payments become due, provided the remaining criteria for revenue recognition have been met.

We assess the ability to collect from the Company’s customers based on a number of factors, including credit worthiness of the customer and past transaction history of the customer. If the customer is not deemed credit worthy, we defer all revenue from the arrangement until payment is received and all other revenue recognition criteria have been met.

Deferred Revenue

The Company’s most common sale includes a perpetual license for software, a hardware appliance along with post contract support and unspecified updates. Where the VSOE of the future deliverable is identifiable, that revenue is initially included in deferred revenue and recognized ratably over the term of the agreement on a straight-line basis. If the VSOE of the future deliverable is not identifiable, the total revenue is deferred and recognized over the term of the agreement.

STOCK-BASED COMPENSATION

The Company accounts for stock-based compensation in accordance with the provisions of SFAS No. 123 (revised 2004), "Share-Based Payment" ("SFAS No. 123(R)"), which requires that the costs resulting from all share-based payment transactions be recognized in the financial statements at their fair values. Accordingly, stock-based compensation cost is measured at grant date, based on the fair value of the award, and is recognized as an expense over the employee requisite service period. All of the Company’s stock compensation is accounted for as an equity instrument.

Stock Option Plans

In August 2003, October 2004 and October 2007 our board of directors and stockholders adopted the 2003 Stock Option Plan, the 2004 Stock Option Plan and the 2007 Equity Incentive Plan, respectively. The aggregate number of shares authorized for issuance under the 2003 Stock Option Plan and the 2004 Stock Option Plan (together, the “Prior Plans”) was 2,500,000 and, 5,000,000, respectively. The 2007 Equity Incentive Plan (the “2007 Plan”) consolidates and replaces the Prior Plans.

Index

Subject to adjustment upon certain changes in capitalization, the aggregate number of shares of common stock of the Company that may be issued pursuant to stock awards under the 2007 Plan shall not exceed 5,000,000 shares of Common Stock, plus an additional number of shares in an amount not to exceed 7,389,520 comprised of: (i) that number of shares subject to the Prior Plans on the date the 2007 Plan was adopted by the Board and available for future grants plus (ii) the number of shares subject to currently outstanding stock awards issued under the Prior Plans that return to the share reserve from time to time after the date the 2007 Plan was adopted by the Board. The following description of the 2007 Plan is a summary and qualified in our entirety by the text of the Plan. The purpose of the Plan is to enhance our profitability and stockholder value by enabling us to offer stock-based incentives to employees, directors and consultants. The Plan authorizes the grant incentive stock options, nonstatutory stock options, restricted stock awards, restricted stock unit awards, stock appreciation rights, performance stock awards, performance cash awards, and other stock-based award to employees, directors and consultants. Under the Plan, we may grant incentive stock options within the meaning of Section 422 of the Internal Revenue Code of 1986 and non-qualified stock options. Incentive stock options may only be granted to our employees.

As of September 30, 2008, 2,533,916 shares were available for future grants under the 2007 Plan. The options under the 2007 Plan and Prior Plans vest over varying lengths of time pursuant to various option agreements that we have entered into with the grantees of such options. The Plan is administered by the board of directors. Subject to the provisions of the Plan, the board of directors has authority to determine the employees, directors and consultants who are to be awarded stock awards and the terms of such awards, including the number of shares subject to such awards, the fair market value of the common stock subject to options, the exercise price per share and other terms.

Incentive stock options must have an exercise price equal to at least 100% of the fair market value of a share on the date of the award and generally cannot have duration of more than 10 years. If the grant is to a stockholder holding more than 10% of our voting stock, the exercise price must be at least 110% of the fair market value on the date of grant. Terms and conditions of awards are set forth in written agreements between us and the respective option holders. Awards under the Plan may not be made after the tenth anniversary of the date of our adoption but awards granted before that date may extend beyond that date.

Optionees have no rights as stockholders with respect to shares subject to option prior to the issuance of shares pursuant to the exercise thereof. An option becomes exercisable at such time and for such amounts as determined by the board of directors. An optionee may exercise a part of the option from the date that part first becomes exercisable until the option expires. The purchase price for shares to be issued to an employee upon his exercise of an option is determined by the board of directors on the date the option is granted. The Plan provides for adjustment as to the number and kinds of shares covered by the outstanding options and the option price therefore to give effect to any stock dividend, stock split, stock combination or other reorganization.

The fair value of options granted is estimated on the date of grant using a Black-Scholes option pricing model. Expected volatilities are calculated based on the historical volatility of the Company's Common Stock. Management monitors share option exercise and employee termination patterns to estimate forfeiture rates within the valuation model. The expected holding period of options is based on the simplified method noted in SAB 107. The risk-free interest rate for periods within the expected life of the option is based on the interest rate of U.S. Treasury notes in effect on the date of the grant. The following assumptions were used in determining the fair value of stock based awards granted during the three and nine months ended September 30, 2008 and 2007:

	Three months ended Sept. 30,						Nine months ended Sept. 30,
	2008			2007			2008			2007
Expected term (years)		6.8			5.4			6.9			5.5
Expected volatility		93	%		94	%		94	%		94	%
Risk-free interest rate		3.70	%		4.85	%		3.09	%		4.84	%
Dividend yield		0	%		0	%		0	%		0	%

The dividend yield of zero is based on the fact that the Company has never paid cash dividends and has no present intention to pay cash dividends. Expected volatility is based on historical volatility of the Company’s common stock. The risk-free interest rates are taken from the 3-year and 7-year daily constant maturity rate as of the grant dates as published by the Federal Reserve Bank of St. Louis and represent the yields on actively traded Treasury securities comparable to the expected term of the options. The expected life of the options granted in 2008 and 2007 is calculated using the simplified method which uses the midpoint between the vesting period and the contractual grant date.

The Company recorded $465,510 and $789,466 of stock compensation expense for the three months ended September 30, 2008 and 2007, respectively and $1,289,196 and $1,330,076 for the nine months ended September 30, 2008 and 2007, respectively. The effect of recording stock based compensation on net loss and basic and diluted earnings per share for the three and nine month periods ended September 30, 2008 and 2007 respectively is as follows:

Index

	Three Months ended				Nine Months Ended
	Sept. 30, 2008		Sept. 30, 2007		Sept. 30, 2008		Sept. 30, 2007

Stock-based compensation expense	$	465,510	$	789,466	$	1,289,196	$	1,330,076
Tax effect on stock-based compensation		-		-		-		-

Net effect on net loss	$	465,510	$	789,466	$	1,289,196	$	1,330,076

Effect on basic and diluted net loss per share	$	0.01	$	0.01	$	0.02	$	0.02

The amounts of share-based compensation expense are classified in the consolidated statements of operations as follows:

	Three Months ended				Nine Months Ended
	Sept. 30, 2008		Sept. 30, 2007		Sept. 30, 2008		Sept. 30, 2007

Cost of goods sold	$	18,193	$	5,729	$	31,434	$	34,916
Research and development		72,267		139,768		213,136		284,378
Selling, general and administrative		375,050		643,969		1,044,626		1,010,782

Stock-based compensaton before income taxes		465,510		789,466		1,289,196		1,330,076

Income tax benefit		-		-		-		-
Total stock-based compensation expenses after income tax	$	465,510	$	789,466	$	1,289,196	$	1,330,076

No stock-based compensation has been capitalized in inventory due to the immateriality of such amounts.

General Share-Based Award Information

The following table summarizes the Company’s stock option activity for the nine months ended September 30, 2008:

	Shares Available For Grant			Number of Options Outstanding			Weighted Average Exercise Price		Weighted Average Remaining Contractual Life (in years)	Aggregate Intrinsic Value

Balance at December 31, 2007		714,357			6,675,163		$	1.42
Authorized		5,000,000			-			-
Granted		(4,999,823	)		4,999,823		$	1.36
Exercised		-			(486,877	)	$	0.65
Cancelled		1,819,382			(1,819,382	)	$	1.65

Balance at Sept. 30, 2008		2,533,916			9,368,727		$	1.39	8.6	$	416,230

Options vested and expected to vest at Sept. 30, 2008					8,797,437		$	1.37	8.5	$	456,915

Options vested and exercisable					3,689,401		$	1.43	8.2	$	355,764

Index

During the three and nine month periods ended September 30, 2008, 219,495 and 836,670 options vested, respectively. The total fair value of the options that vested (including those canceled) during the same periods was approximately $235,000 and $946,000, respectively. The weighted average grant date fair value of options granted during the three month periods ended September 30, 2008 and 2007 was $1.41 and $2.96, respectively

As of September 30, 2008, the total compensation cost related to non-vested stock option awards not yet recognized was $4,885,987, net of estimated forfeitures. Total compensation cost will be recognized over an estimated weighted average amortization period of 3.1 years. The Company has not capitalized any compensation cost, or modified any of its stock option grants during the nine months ended September 30, 2008. During the three and nine months ended September 30, 2008, 90,745 and 486,877 options were exercised, respectively, and no cash was used to settle equity instruments granted under the Plans.

The Company’s closing stock price on September 30, 2008 was $0.85 per share. The intrinsic value of vested stock options outstanding as of September 30, 2008 was $416,230.

Dilutive Effect of Employee Stock Options

Basic shares outstanding as of September 30, 2008 and 2007 were 9,368,727 shares and 6,001,000 shares, respectively. No incremental shares were included in the calculation of diluted net income per share for the periods as to do so would be antidilutive. SFAS No. 128, “Earnings per Share,” requires that employee equity share options, nonvested shares and similar equity instruments granted by the Company be treated as potential common shares in computing diluted earnings per share. Diluted shares outstanding include the dilutive effect of in-the-money options which is calculated based on the average share price for each fiscal period using the treasury stock method. There was no dilutive effect of in-the-money employee stock options as of September 30, 2008 and 2007 due to the Company incurring a net loss for the nine months ended September 30, 2008 and 2007, respectively.

NET LOSS PER SHARE

Basic earnings per share ("EPS") is computed by dividing net loss by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur from common shares issuable through stock options, warrants and other convertible securities, if dilutive. The following table is a reconciliation of the numerator (net loss) and the denominator (number of shares) used in the basic and diluted EPS calculations and sets forth potential shares of common stock that are not included in the diluted net loss per share calculation as their effect is antidilutive:

	Three months						Nine months
	ended Sept. 30,						ended Sept. 30,
	2008			2007			2008			2007
Numerator - basic and diluted	$	(3,752,536	)	$	(3,092,769	)	$	(11,153,043	)	$	(7,574,370	)

Denominator - basic and diluted
Weighted average common shares outstanding		79,018,207			73,089,577			77,424,517			70,141,287
Total		79,018,207			73,089,577			77,424,517			70,141,287
Net loss per share - basic and diluted	$	(0.05	)	$	(0.04	)	$	(0.14	)	$	(0.11	)
Antidilutive securities:
Options issued		9,368,727			6,001,000			9,368,727			6,001,000
Warrants		4,302,414			7,769,117			4,302,414			8,080,790
Incentive shares and warrants		–			4,902,000			–			4,902,000
Total antidilutive securities		13,671,141			18,672,117			13,671,141			18,983,790

RECENT ACCOUNTING PRONOUNCEMENTS

Financial Accounting Standard No. 157–Fair Value Measurements

In February 2008, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position (“FSP”) No. FAS 157-2, “Effective Date of FASB Statement No. 157” (“FSP FAS 157-2”), which delays the effective date of Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements” (“SFAS 157”) for all non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually) for fiscal years beginning after November 15, 2008, and interim periods within those fiscal years for items within the scope of this FSP. The Company is currently evaluating the impact of adopting FSP FAS 157-2 for non-financial assets and non-financial liabilities on its consolidated financial position, cash flows, and results of operations.

Index

Financial Accounting Standard No. 160–Noncontrolling Interests in Consolidated Financial Statements–an Amendment of Accounting Research Bulletin No. 51

In December 2007, the FASB issued Financial Accounting Standard No. 160, Noncontrolling Interests in Consolidated Financial Statements–an Amendment of Accounting Research Bulletin No. 51 , or FAS 160. FAS 160 requires reporting entities to present noncontrolling (minority) interests as equity (as opposed to as a liability or mezzanine equity) and provides guidance on the accounting for transactions between an entity and noncontrolling interests. FAS 160 is effective for fiscal years beginning on or after December 15, 2008, except for the presentation and disclosure requirements which will be applied retrospectively for all periods presented. We do not believe that FAS 160 will have any material impact on our consolidated financial statements.

Financial Accounting Standard No. 141(revised 2007)–Business Combinations (Revised)

In December 2007, the FASB issued Financial Accounting Standard No. 141(revised 2007), Business Combinations , or FAS 141(R). FAS 141(R) requires the acquiring entity in a business combination to recognize the full fair value of assets acquired and liabilities assumed in the transaction (whether a full or partial acquisition); establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed; requires expensing of most transaction and restructuring costs; and requires the acquirer to disclose to investors and other users all of the information needed to evaluate and understand the nature and financial effect of the business combination. FAS 141(R) applies to all transactions or other events in which the reporting entity obtains control of one or more businesses, including those sometimes referred to as "true mergers" or "mergers of equals" and combinations achieved without the transfer of consideration, for example, by contract alone or through the lapse of minority veto rights. FAS 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. We do not believe that FAS 141(R) will have any material impact on our consolidated financial statements.

In December 2007, the SEC issued Staff Accounting Bulletin No. 110, or SAB 110. SAB 110 expresses the views of the staff regarding the use of a "simplified" method, as discussed in SAB No. 107, Share-Based Payment , in developing an estimate of the expected term of "plain vanilla" share options in accordance with SFAS No. 123(R). We do not expect SAB 110 to have a material impact on our results of operations or financial condition.

In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities” (“FAS 161”). FAS 161 requires entities to provide enhanced disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“FAS 133”) and its related interpretations, and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. FAS 161 is effective for fiscal years and interim periods beginning after November 15, 2008 , and early adoption is permitted. The Company does not believe that the adoption of FAS161 will have any material affect on our financial condition and results of operations but may require additional disclosures if the Company enters into derivative and hedging activities.

In April 2008, the FASB issued FASB Staff Position (“FSP”) No. FAS 142-3, “Determination of the Useful Life of Intangible Assets,” (“FSP No. 142-3”). The intent of this FSP is to improve consistency between the useful life of a recognized intangible asset under SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”), and the period of expected cash flows used to measure the fair value of the intangible asset under SFAS No. 141R. FSP No. 142-3 will require that the determination of the useful life of intangible assets acquired after the effective date of this FSP shall include assumptions regarding renewal or extension, regardless of whether such arrangements have explicit renewal or extension provisions, based on an entity’s historical experience in renewing or extending such arrangements. In addition, FSP No. 142-3 requires expanded disclosures regarding intangible assets existing as of each reporting period. FSP 142-3 is effective for financial statements issued for fiscal years beginning after December 15, 2008 , and interim periods within those years. Early adoption is prohibited. The Company is currently evaluating the impact that FSP No. 142-3 will have on our financial statements .

In May 2008, the FASB issued Financial Accounting Standard (FAS) No. 162, “The Hierarchy of Generally Accepted Accounting Principles.” The statement is intended to improve financial reporting by identifying a consistent hierarchy for selecting accounting principles to be used in preparing financial statements that are prepared in conformance with generally accepted accounting principles. Unlike Statement on Auditing Standards (SAS) No. 69, “The Meaning of Present in Conformity With GAAP,” FAS No. 162 is directed to the entity rather than the auditor. The statement is effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board (PCAOB) amendments to AU Section 411, “The Meaning of Present Fairly in Conformity with GAAP,” and is not expected to have any impact on the Company’s results of operations, financial condition or liquidity.

Other recent accounting pronouncements issued by the FASB (including its Emerging Issues Task Force ("EITF"), the American Institute of Certified Public Accountants ("AICPA"), and the SEC did not or are not believed by management to have a material impact on the Company's present or future financial statements.

Index

INVENTORIES

Inventories are stated at the lower of cost, which approximates actual costs on a first in, first out basis, or market. Inventories at September 30 , 2008 and December 31, 2007 consisted of the following:

	September 30,			December 31,
	2008			2007

Finished goods		1,290,980		$	1,062,398
Work in process		562,099			21,287
Raw materials		316,138			292,825
Reserve for obsolescence		(48,431	)		(56,488	)

Inventories, net	$	2,120,786		$	1,320,022

GOODWILL AND OTHER INTANGIBLES, NET

Goodwill

In accordance with Statement of Financial Accounting Standards No. 142 Goodwill and Other Intangible Assets (“SFAS 142”), the Company evaluates the carrying value of goodwill in the fourth fiscal quarter of each year and between annual evaluations if events occur or circumstances change that would more likely than not reduce the fair value of the reporting unit below its carrying amount. Such circumstances could include, but are not limited to, (1) a significant adverse change in legal factors or in business climate, (2) unanticipated competition, or (3) an adverse action or assessment by a regulator. When evaluating whether goodwill is impaired, the Company compares the fair value of the reporting unit to which the goodwill is assigned to its carrying amount, including goodwill. If the carrying amount of a reporting unit exceeds its fair value, then the amount of the impairment loss must be measured. The impairment loss would be calculated by comparing the implied fair value of the reporting unit’s goodwill to its carrying amount. In calculating the implied fair value of goodwill, the fair value of the reporting unit is allocated to all of the other assets and liabilities of that unit based on their fair values. The excess of the fair value of a reporting unit over the amount assigned to its other assets and liabilities is the implied fair value of goodwill. An impairment loss would be recognized when the carrying amount of goodwill exceeds its implied fair value.

The Company’s annual evaluations of the carrying value of goodwill, completed in the fourth fiscal quarter of 2007 in accordance with SFAS 142, resulted in no impairment losses. As of September 30, 2008 and 2007, the goodwill attributed to the acquisition of Netintact AB and Netintact PTY was $960,209.

Other Intangible Assets

As a result of the acquisitions of Netintact AB and Netintact PTY, privately held software companies, in 2006, the Company acquired assets of approximately $11.1 million other than goodwill. Of the $11.1 million of acquired assets, $4.3 million was assigned to intangible customer lists, $2.2 million to management information software, and $4.6 million to product software. These assets are subject to depreciation and amortization. The $11.1 million of acquired assets have an average useful life of approximately 3 years.

The Intangible portion of acquired assets consists of the following at September 30, 2008:

		Gross Intangible				Accumulated Amortization				Net Intangible Assets
Netintact customer base		$	4,317,000			$	(2,992,845	)		$	1,324,155

The table below summarizes the approximate amortization expense for the following annual periods subsequent to September 30, 2008 assuming no future acquisitions, dispositions or impairments of intangible assets:

Three month period ending December 31, 2008	$	359,750
Year ending December 31, 2009		964,405
Thereafter		–

Projected amortization after September 30, 2008	$	1,324,155

Index

7 .

PROPERTY AND EQUIPMENT

Property and equipment at September 30, 2008 and December 31, 2007 consisted of the following:

	September 30,			December 31,
	2008			2007

Machinery and equipment	$	1,292,213		$	736,439
Office furniture and equipment		170,796			90,672
Computer equipment		282,833			256,850
Software		6,852,568			6,856,063
Auto		70,531			75,877
Accumulated depreciation		(5,396,627	)		(3,539,677	)

Property and equipment, net	$	3,272,314		$	4,476,224

ACCRUED LIABILITIES

Accrued liabilities at September 30 , 2008 and December 31, 2007 consisted of the following:

	September 30,		December 31,
	2008		2007

Payroll and related	$	582,527	$	620,191
Audit and legal services		230,226		196,000
Sales, VAT, income taxes		45,774		140,175
Sales commissions		200,272		299,926
Warranty		123,432		64,864
Inventory receipts not invoiced		-		211,606
Other		162,915		40,213

Total	$	1,345,146	$	1,572,975

Warranty Reserve

The Company provides a warranty for its products and establishes an allowance at the time of sale which is sufficient to cover costs during the warranty period. The warranty period is generally one year . This reserve is included in accrued liabilities.

Changes in the warranty reserve during the three and nine months ended September 30, 2008 and 2007 were as follows:

	Three months ended Sept. 30,				Nine months ended Sept. 30,
	2008		2007		2008		2007

Beginning balance	$	83,307	$	33,899	$	64,864	$	20,950
Less warranty expenditures plus additional provisions		40,125		6,788		58,568		19,737

Ending balance	$	123,432	$	40,687	$	123,432	$	40,687

CONCENTRATION OF CREDIT RISK

For the nine months ended September 30, 2008, revenues from our two la rgest customers accounted for 13 % and 10 % of revenues, with no other single customer accounting for more than 10% of revenues. For the same period in 2007, four customers represented 16%, 14%, 13% and 10% of total net revenue. During the three month period ending September 30, 2008, two customers represented 17% and 10% of our net revenue and during the same period ending 2007, one customer represented 12% of net revenue . Below is a representation of the historical percentage of total net sales for any customer who exceeded net sales in excess of 10% during either of the three or nine month periods ending September 30, 2008 or 2007.

Index

	Three months ended Sept. 30,		Nine months ended Sept. 30,
Customers	2008	2007	2008	2007
A	- %	- %	10 %	- %
B	- %	- %	- %	14 %
C	10 %	8 %	13 %	13 %
D	17 %	12 %	8 %	16 %
E	- %	2 %	- %	10 %

At September 30, 2008, combined accounts receivable from four customers accounted for 15%, 13%, 10% and 10% of total accounts receivable with no other single customer accounting for more than 10% of the accounts receivable balance.

As of September 30, 2008 and 2007, approximately 90% and 90%, respectively, of the Company’s total accounts receivable were due from customers outside the United States .

10.

STOCKHOLDERS’ EQUITY

Common Stock

In August 2008, the Company concluded a private placement transaction with accredited investors for the sale of its common stock. The Company received aggregate proceeds of approximately $5.8 million from the sale of 5,224,666 shares of its unregistered common stock.

During the three and nine month period ended September 30, 2008, option holders exercised rights to purchase 90,745 and 486,877 shares, respectively, of common stock at prices ranging from $0.45 to $ 1.5 9 per share, resulting in net proceeds to the Company of $ 77,449 and $318,712 , respectively.

During the three and nine month period ended September 30, 2008, warrant holders exercised rights to purchase 101,538 and 1,859,620 shares of common st ock respectively at prices ranging from $0.00 (cashless exercise) to $1.37 per share, resulting in net proceeds to the Company of $10,200 and $2 ,175,572 respectively . During the three and nine month periods ended September 30, 2007, warrant holders exercised rights to purchase 416,834 and 1,170,012 shares of our common stock, respectively at prices ranging from $0.40 to $1.25 per share resulting in net proceeds to the company of $452,251 and $674,178, respectively.

Warrants

During the nine months ended September 30, 2008, the board of directors approved the issuance of warrants to service providers to purchase an aggregate of 327,479 shares of the Company’s common stock and extended the expiration date of 85,000 warrants with a fair value of $306,484. The warrants are exercisable at prices of $0.49 to $2.00 per share, vest immediately, and expire on or before the end of September 2009.

A summary of warrant activity for the nine months ended September 30, 2008 is a s follows:

	Warrants
	Number of Shares			Weighted Average Purchase Price
Outstanding December 31, 2007		7,714,407		$	1.15
Issued		54,720			0.60
Exercised		—			—
Cancelled/expired		(39,593	)		2.33

Outstanding March 31, 2008		7,729,534		$	1.14
Issued		255,000			1.12
Exercised		(1,758,082	)		1.29
Cancelled/expired		(72,388	)		0.53

Outstanding June 30, 2008		6,154,064		$	1.11

Issued		17,759			1.75
Exercised		(101,538	)		0.44
Cancelled/expired		(1,767,871	)		1.30
Outstanding September 30, 2008		4,302,414		$	1.05

Index

The chart below illustrates the outstanding warrants as of September 30, 2008 by exercise price and the average contractual life before expiration.

				Weighted Average
				Remaining
Exercise		Number		Contractual Life		Number
Price		Outstanding		(Years)		Exercisable
$	0.01		151,268		0.7		151,268
	0.40		1,038,875		2.4		1,038,875
	0.49		165,000		0.9		165,000
	0.60		569,107		2.9		569,107
	0.75		50,000		0.7		50,000
	1.12		70,000		1.8		70,000
	1.40		360,000		0.8		360,000
	1.42		75,000		0.7		75,000
	1.50		1,380,000		3.2		1,380,000
	1.75		17,759		3.0		17,759
	1.78		100,000		1.4		100,000
	1.86		10,000		0.5		10,000
	2.00		239,988		3.3		239,988
	2.14		75,417		1.3		75,417
$	1.05		4,302,414		2.4		4,302,414

11 .

INCOME TAXES

The Company adopted the provisions of FASB Interpretation No. 48 Accounting for Uncertainty in Income Taxes (“FIN 48”) an interpretation of FASB Statement No. 109 (“SFAS 109”) on January 1, 2007 . As a result of the implementation of FIN 48, the Company recognized no material adjustment in the liability for unrecognized income tax benefits. At December 31, 2007 and 2006, the Company had $194,775 and $176,639 of unrecognized tax benefits respectively, none of which would affect the Company's effective tax rate if recognized.

The Company recognizes interest and penalties related to uncertain tax positions in income tax expense. As of September 30, 2008, the Company has no accrued interest or penalties related to uncertain tax positions. The tax years 2001-2007 remain open to examination by one or more of the major taxing jurisdictions to which we are subject. The Company does not anticipate that the total unrecognized tax benefits will significantly change due to the settlement of audits and the expiration of statutes of limitations prior to September 30, 2009.

In 2002, the Company established a valuation allowance for substantially all of its deferred tax assets. Since that time, the Company has continued to record a valuation allowance. The valuation allowance was calculated in accordance with the provisions of SFAS 109, “Accounting for Income Taxes,” which require that a valuation allowance be established or maintained when it is “more likely than not” that all or a portion of deferred tax assets will not be realized. The Company will continue to reserve for substantially all net deferred tax assets until there is sufficient evidence to warrant reversal.

12 .

COMMITMENTS AND CONTINGENCIES

Legal

The Company is periodically involved in legal actions and claims that arise as a result of events that occur in the normal course of operations. The Company is not currently aware of any legal proceedings or claims that the Company believes will have, individually or in the aggregate, a material adverse effect on the Company's financial position or results of operations.

Operating Leases

The Company leases its operating and office facilities for various terms under long-term, non-cancelable operating lease agreements. The leases expire at various dates through 2014 and provide for renewal options ranging from month-to-month to 5 year terms. In the normal course of business, it is expected that these leases will be renewed or replaced by leases on other properties. The leases provide for increases in future minimum annual rental payments based on defined increases which are generally meant to correlate with the Consumer Price Index, subject to certain minimum increases. Also, the agreements generally require the Company to pay executory costs (real estate taxes, insurance and repairs).

Index

The Company and its subsidiaries have various lease agreements for its headquarters in Los Gatos , California ; Netintact , AB offices in Varberg , Sweden ; Netintact PTY offices in Melbourne , Australia ; and certain office equipment. The leases begin expiring in 2008.

Capital Leases

The Company leases c ertain equipment under capital leases that expire at various dates through 201 2 . Our capital leases are located in Sweden with interest rates ranging from 1-6%. The Company leases facility space under non-cancelable operating leased in California , Sweden and Australia that extend through 2014.

A summary of operating and capital lease commitments as of September 30, 2008 follows :

	Capital		Operating
	Leases		Leases


Three months ending December 31, 2008	$	6,483	$	94,518
Years ending December 31,
2009		13,090		380,736
2010		10,837		386,934
2011		10,837		273,924
2012 and thereafter		28,914		196,725
Total minimum lease payments	$	70,161	$	1,332,837

Less: amount representing interest		5,533
Present value of minimum lease payments		64,628
Less: current portion		17,205
Obligations under capital lease, net of current portion	$	47,423

13 .

SEGMENT INFORMATION

The Company operates in one segment, using one measure of profitability to manage its business. Revenues for geographic regions are based upon the customer’s location. The location of long lived assets is based on physical location of our regional offices. The following are summaries of revenue and long lived assets by geographical region:

	Three months				Nine months
	ended Sept. 30,				ended Sept. 30,
	2008		2007		2008		2007
Country
USA	$	698,109	$	279,594	$	1,695,927	$	1,665,416
Latin America		165,225		249,298		447,305		378,342
Australia		267,392		137,994		837,684		510,358
Middle East		-		-		-		16,043
Asia		579,320		339,787		1,370,455		859,984
Europe		541,174		319,809		1,686,870		1,023,426
Scandinavia		437,953		319,176		982,005		1,294,018

Total	$	2,689,173	$	1,645,658	$	7,020,246	$	5,747,587

Foreign sales as a percentage of total revenues were 74% and 83% for the three months ended September 30, 2008 and 2007, respectively. For the nine months ended September 30, 2008 and 2007, foreign sales as a percentage of total revenues were 76% and 71%, respectively.

The Company’s accounts receivable are derived from revenue earned from customers located in the United States , Australia , Asia, Europe, and the Middle East . The Company performs ongoing credit evaluations of certain customers’ financial condition and, generally, requires no collateral from its customers.

Index

The identification of long lived assets is based on physical location of our regional offices. The following are summaries of the location of our long lived assets by geographical region:

	Period Ended Sept 30,
	2008		2007
Long-lived assets;
United States	$	1,755,562	$	1,334,017
Sweden		3,733,637		7,470,467
Australia		115,036		46,667
Total	$	5,604,235	$	8,851,151

14 .

LIQUIDITY

The Company has sustained recurring losses and negative cash flows from operations. Historically, the Company’s growth has been funded through a combination of private equity and lease financing. As of September 30, 2008, t he Company had approximately $4.8 million of unrestricted cash. During the nine months ended September 30, 2008, the Company received cash funding of approximately $5.8 million from a private placement of common stock, $2.5 million from the exercise of warrants and options and $.6 million the issuance of short term debt instruments. The Company believes that it currently has sufficient cash and financing commitments to meet its funding requirements over the next year. However, the Company has experienced and continues to experience negative operating margins and negative cash flows from operations, as well as an ongoing requirement for additional capital investment. The Company expects that it may need to raise substantial additional capital to fully accomplish its business plan over the next several years. In addition, the Company may wish to selectively pursue possible acquisitions of businesses, technologies, content, or products complementary to those of the Company in the future in order to expand its presence in the marketplace and achieve further operating efficiencies. The Company expects to seek to obtain additional funding through a bank credit facility, another form of debt, or private equity. There can be no assurance as to the availability or terms upon which such financing and capital might be available.

15.

SUBSEQUENT EVENT S

None

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following is a discussion of our results of operations and current financial position. This discussion should be read in conjunction with our unaudited consolidated financial statements and related notes included elsewhere in this report and the audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2007, as amended .

As used in this quarterly report on Form 10-Q, references to the “Company,” “we,” “us,” “our” or similar terms include Procera Networks, Inc. and its consolidated subsidiaries.

Cautionary Note Regarding Forward-Looking Statements

Our disclosure and analysis in this quarterly report on Form 10-Q contain certain “forward-looking statements,” as such term is defined in Section 21E of the Securities Exchange Act of 1934. These statements set forth anticipated results based on management’s plans and assumptions. From time to time, we also provide forward-looking statements in other materials we release to the public as well as oral forward-looking statements. Such statements give our current expectations or forecasts of future events; they do not relate strictly to historical or current facts. We have attempted to identify such statements by using words such as “anticipate,” “estimate,” “expect,” “project,” “intend,” “plan,” “believe,” “will,” “could” and similar expressions in connection with any discussion of future events or future operating or financial performance or strategies. Such forward-looking statements include, but are not limited to, statements regarding:

Index

•

our services, including the development and deployment of products and services and strategies to expand our targeted customer base and broaden our sales channels;

•

the operation of our company with respect to the development of products and services;

•

our liquidity and financial resources, including anticipated capital expenditures, funding of capital expenditures and anticipated levels of indebtedness and the ability to raise capital through financing activities;

•

trends related to and management’s expectations regarding results of operations, required capital expenditures, integration of acquired businesses, revenues from existing and new products and sales channels, and cash flows, including but not limited to those statements set forth below in this Item 2; and

•

sales efforts, expenses, interest rates, foreign exchange rates, and the outcome of contingencies, such as legal proceedings.

We cannot guarantee that any forward-looking statement will be realized. Achievement of future results is subject to risks, uncertainties and potentially inaccurate assumptions. Should known or unknown risks or uncertainties materialize, or should underlying assumptions prove inaccurate, actual results could vary materially from past results and those anticipated, estimated or projected. Investors should bear this in mind as they consider forward-looking statements.

We undertake no obligation to publicly update forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any further disclosures we make on related subjects in our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K. Also note that we provide the following cautionary discussion of risks and uncertainties related to our businesses. These are factors that we believe, individually or in the aggregate, could cause our actual results to differ materially from expected and historical results. We note these factors for investors as permitted by Section 21E of the Securities Exchange Act of 1934. You should understand that it is not possible to predict or identify all such factors. Consequently, you should not consider the following to be a complete discussion of all potential risks or uncertainties.

Our forward-looking statements are subject to a variety of factors that could cause actual results to differ significantly from current beliefs and expectations, identified under the caption "Risk Factors" and elsewhere in this quarterly report on Form 10-Q, as well as general risks and uncertainties such as those relating to general economic conditions and demand for our products and services.

Index

Overview

The rapid growth of and reliance on the Internet by commercial and consumer users together with the uptake of new applications and equipment that facilitate the Internet, have created a need for advanced network awareness, control and protection tools. These tools can be used for analysis of user behavior, for optimum utilization of network investments, to protect the network from malicious traffic, and to monetize the network by offering advanced differentiated services.

Our business is selling advanced network awareness, control and protection tools under our trade name, PacketLogic: a state-of-the-art portfolio of scalable deep packet inspection, or DPI, products that enable new levels of application and subscriber performance. PacketLogic products range from the PL5600 product line, which serves megabit to gigabit per second network applications, commonly referred to as edge applications, to the recently introduced, high-end PL10000 product family, which serves network applications with throughputs of up to 80 gigabits per second. The top end performance of the PL10000 product line can be expected to double to 160 gigabits per second in less than two years with little effort on our part by moving to the next generation industry standard platform provided by several vendors when it is released.

We believe that our PL10000 product line represents a major breakthrough in DPI technology, reaching new levels of accuracy, control and protection while also providing significant scalability and flexibility. We believe our new product line will address the needs of Tier 1 service providers, which we consider to be very large providers of broadband communications services, such as AT&T, Verizon, British Telecom, or NTT DoCoMo. Our goal is to become the leader in DPI solutions to the broadband service provider and enterprise markets on a global basis. We believe the PL10000 product line positions us to capture an increasing share of the fast growing DPI market. We plan to achieve our strategic growth objectives by capturing a substantial portion of the Tier 1 service provider business. We expect to accomplish this by increasing our technology advantage, expanding our field service team, expanding our logistics capability to provide timely and accurate support, and expanding our service-for-fee capability to better accommodate the Tier 1 service providers’ need for customization and integration. Accordingly, the Tier 1 service provider market also represents a significant future revenue opportunity for us.

We face serious competition from other suppliers of standalone DPI products such as Allot Communications, Sandvine, Ellacoya (recently acquired by Arbor) and Packeteer (recently acquired by BlueCoat). We also face competition from vendors supplying platform products with some limited DPI functionality, such as switch/routers, routers, session border controllers and VoIP switches. In addition, we face competition from vendors that integrate an advertised "full" DPI solution into their products such as Juniper, Ericsson and Foundry.

Most of our competitors are larger, more established and have substantially greater financial and other resources. Some competitors may be willing to reduce prices and accept lower profit margins to compete with us. As a result of this competition, we could lose market share and sales, or be forced to reduce our prices to meet competition. However, we do not believe there is an entrenched dominant supplier in our market. Based on our belief in the superiority of our technology, we see an opportunity for us to capture meaningful market share and benefit from what we believe will be strong growth in the DPI market.

Critical Accounting Estimates

Our discussion and analysis of our financial condition and results of operations are based upon financial statements which have been prepared in accordance with generally accepted accounting principles in the United States . The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue, expenses, and other related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate these estimates, and we base our estimates on historical experience and on various other assumptions that are believed to be reasonable. These estimates and assumptions provide a basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions, and these differences may be material. Our significant accounting policies are summarized in Note 2 in our Annual Report on Form 10-K for the year ended December 31, 2007 filed with the SEC on April 2, 2008, as amended .

Index

Management believes that there have been no significant changes during the nine months ended September 30 , 2008 to the items that we disclosed as our critical accounting policies and estimates in the Management’s Discussion and Analysis of Financial Condition and Results of Operations section of our Annual Report on Form 10-K for the year ended December 31, 2007 , filed with the SEC on April 2, 2008 as amended . In accordance with SEC guidance, we believe the following critical accounting policies reflect our most significant estimates, judgments and assumptions used in the preparation of our consolidated financial statements. These critical accounting policies and related disclosures appear in our Annual Report on Form 10-K for the year ended December 31, 2007 as amended .

Revenue recognition;

Stock-based compensation expense;

Long-lived assets, including finite lived purchased intangible assets; and

Deferred tax valuation allowance.

Results of Operations

Subsequent to the acquisition of Netintact AB and Netintact PTY in fiscal year 2006, we began to recognize increased revenues, operating costs, and other expenses associated with our expanded operations and the introduction of Netintact’s PacketLogic product line to a broader customer base.

Index

The following table sets forth our unaudited historical operating results, in dollar amounts and as a percentage of total net revenue for the periods indicated:

	Three Months Ended										Nine Months Ended
	Sept. 30, 2008					Sept. 30, 2007					Sept. 30, 2008					Sept. 30, 2007
	(In thousands except percentages)
Sales
Product sales	$	2,210		82	%	$	1,378		84	%	$	5,748		82	%	$	5,073		88	%
Support sales		479		18	%		268		16	%		1,272		18	%		674		12	%
Total sales		2,689		100	%		1,646		100	%		7,020		100	%		5,747		100	%
Cost of sales
Product cost of sales		1,789		67	%		958		58	%		4,209		60	%		2,837		49	%
Support cost of sales		125		5	%		117		7	%		424		6	%		310		5	%
Total cost of sales		1,914		71	%		1,075		65	%		4,633		66	%		3,147		55	%
Gross profit		775		29	%		571		35	%		2,387		34	%		2,600		45	%

Operating expenses:
Engineering		809		30	%		769		47	%		2,498		36	%		2,303		40	%
Sales and marketing		2,094		78	%		1,953		119	%		6,435		92	%		5,240		91	%
General and administrative		1,897		71	%		1,267		77	%		5,393		77	%		3,479		61	%
Total operating expenses		4,800		178	%		3,989		242	%		14,326		204	%		11,022		192	%

Loss from operations		(4,025	)	-150	%		(3,418	)	-208	%		(11,939	)	-170	%		(8,422	)	-147	%

Other income (expense)
Interest and other income		27		1	%		26		2	%		53		1	%		57		1	%
Interest and other expense		(15	)	-1	%		(1	)	0	%		(49	)	-1	%		(15	)	0	%
Total other income (expense)		12		0	%		25		2	%		4		0	%		42		1	%

Net loss before taxes		(4,013	)	-149	%		(3,393	)	-206	%		(11,935	)	-170	%		(8,380	)	-146	%
Income tax benefit		260		10	%		300		18	%		782		11	%		806		14	%
Net loss after taxes	$	(3,753	)	-140	%	$	(3,093	)	-188	%	$	(11,153	)	-159	%	$	(7,574	)	-132	%

C omparison of three and nine month periods ended September 30, 2008 and 2007

Revenues

Our revenue is derived from sales of our hardware appliances, bundled software licenses (product revenue) , and from product support, training, and other services (support revenue). T he Company currently operates from three legal entities including Procera ( Americas ), Netintact (Europe, Middle East, Africa or EMEA), and Netintact PTY (Asia Pacific or APAC ). The table s below present the breakdown of revenue by entity and by category .

By Entity

	For the three months									For the nine months
	ended Sept. 30,									ended Sept. 30,
	2008			2007						2008			2007
	(in thousands)						Change			(in thousands)						Change

Americas		$	863		$	446		93	%		$	2,143		$	2,035		5	%
EMEA			979			639		53				2,669			2,337		14
APAC			847			561		51				2,208			1,375		61
Total		$	2,689		$	1,646		63	%		$	7,020		$	5,747		22	%

Index

By Category

	For the three months								For the nine months
	ended Sept. 30,								ended Sept. 30,
	(in thousands)					Change			(in thousands)					Change

Net product revenue		$	2,210	$	1,378		60	%		$	5,748	$	5,073		13	%
Net support revenue			479		268		79				1,272		674		89
Total revenue		$	2,689	$	1,646		63	%		$	7,020	$	5,747		22	%

Revenue for the three months ended September 30, 2008 was $2.689 million, an increase of $1.043 million, or 63% from $1.646 million for the three months ended September 30, 2007. During the second quarter of the current year, the Company introduced the PL10000 product line which expands the markets addressable by our products to include large, higher volume and Tier 1 service providers. The lower volume throughput products (1U and 2U) are increasingly delivered through channel partners which are sold at prices lower than if sold direct. The increase in revenue between the three month period ending September 30, 2008 and 2007 resulted from the introduction of the PL10000 product family of approximately $1.3 million, offset by product mix and lower proceeds from distribution channel of approximately $.4 million.

Revenue for the nine months ended September 30, 2008 was $7.020 million, an increase of approximately $1.272 million, or 22% over the nine months ended September 30, 2007. The increase in revenue between these two periods resulted from the introduction of the PL10000 family of approximately $1.6 million, offset by all other products which decreased by approximately $.4 million.

During the first quarter of 2008, the Company implemented changes in sales and marketing management and support personnel. These changes specifically impacted the Americas and EMEA regions resulting in the decline of short term sales productivity. The company expanded its channel presence in the APAC region in the later part of 2007, resulting in improvements over the nine month period ending September 30, 2008 versus the same period in 2007. All regions experienced greater than 50% growth in the three month period ending September 30, 2008 when compared to the same period in 2007.

Cost of Sales

Costs of sales include direct material costs for products sold, direct labor and manufacturing overhead, quality, manufacturing management and adjustments to inventory values, including reserves for slow moving, obsolete inventory, engineering changes. Additional elements of costs of sales include cost of post contract support and the amortization of acquired assets associated with the revenue generation process. The company regularly adjusts the value of assets to reflect the company’s policy of valuing inventory at lower of cost or market on a first-in, first-out basis. The following tables present the breakdown of cost of sales by entity and by category.

By Entity

	For the three months							For the nine months
	ended Sept. 30,							ended Sept. 30,
	2008		2007					2008		2007
	(in thousands)				Change			(in thousands)				Change

Americas	$	700	$	339		107	%	$	1,500	$	1,066		41	%
EMEA		543		194		180			1,265		465		172
APAC		289		160		81			723		471		54
Amortization of Acquired Assets		382		382		-			1,145		1,145		-
Total costs of sales	$	1,914	$	1,075		78	%	$	4,633	$	3,147		47	%

Index

By Category

	For the three months							For the nine months
	ended Sept. 30,							ended Sept. 30,
	2008		2007					2008		2007
	(in thousands)				Change			(in thousands)					Change

Materials	$	916	$	400				$	2,049	$	1,379
Percent of net product revenue		41%		29%		-12	%		36%		27%			-8	%
Applied labor and overhead		302		138					703		387
Percent of net product revenue		14%		10%		-4	%		12%		8%			-5	%
Other indirect costs		188		38					312		(74	)
Percent of net product revenue		9%		3%		-6	%		5%		-1%			-7	%
Product costs		1,406		576					3,064		1,692
Percent of net product revenue		64%		42%		-22	%		53%		33%			-20	%

Support costs		126		117					424		310
Percent of net support revenue		26%		44%		17	%		33%		46%			13	%

Amortization of acquired assets		382		382					1,145		1,145
Percent of net total revenue		14%		23%		9	%		16%		20%			4	%

Total costs of sales	$	1,914	$	1,075				$	4,633	$	3,147
Percent of net total revenue		71%		65%		-6%	%		66%		55%			-11	%

Our product cost of goods sold for the three month period ended September 30, 2008 increased as a percentage of total net product sales by 22% when compared to the three month period ended September 30, 2007. Material costs increased as a percentage of total net product sales by 12% due to early product introduction costs associated with the PL10K product family and higher volume of 1U and 2U products sold through distribution channels. Labor and overheads increased during this period as the Company increased investment in materials and production management. Indirect costs increased by 6% of product sales primarily due to inventory valuation adjustments associated with products planned to be retired upon the introduction of new products in the 1U and 2U family.

Product costs of goods sold for the nine month period ended September 30, 2008 increased as a percentage of product sales by 20% over the nine month period ended September 30, 2007. Direct materials costs as a percentage of net product sales increased by 8% due to the introduction of the PL10K product family, the higher level of 1U and 2U products being sold through distribution channels and product mix. Applied labor and overhead and other indirect costs in 2008 increased compared to the same period in 2007 by 5% as a result of expanding operations and materials management resources. Other product related costs increased by 7% as a result of unfavorable inventory adjustments recorded in 2008 versus favorable adjustments in 2007. In addition, virtually all our products are now produced in the far east resulting in higher freight import/export costs.

Support costs continue to improve as a percentage of revenue over all comparable periods as support revenues continue to grow over time. The amortization of assets acquired in the purchase of Netintact in the third quarter of 2006 is projected to be completed in the third quarter of 2009.

G ross Profit

Our gross profit, as a percentage of net sales, for the three and nine month periods ended September 30, 2008 decreased by 6% and 11% respectively over the same periods in 2007. Gross profits were lower for the three and nine month periods ended September 30, 2008 and 2007 as a result of (i) early product introduction prices versus costs, (ii) inventory adjustments associated with planned product phase out and materials transportation costs, and (iii) an increased investment in operations and materials management.

The following table represents our gross profit by entity:

	For the three months									For the nine months
	ended Sept. 30,									ended Sept. 30,
	2008			2007						2008			2007
	(in thousands)						Change			(in thousands)						Change

Americas	$	163		$	107			52	%	$	643		$	969			(34	) %
EMEA		436			445			(2	)		1,404			1,872			(25	)
APAC		558			401			39			1,485			904			64
Amortization of Acquired Assets		(382	)		(382	)		(0	)		(1,145	)		(1,145	)		(0	)
Total	$	775		$	571			36	%	$	2,387		$	2,600			(8	) %
Percent of net product sales		29%			35%						34%			45%

Index

Operating Expense

Operating expenses for the three and nine mont h periods ended September 30 , 2008 and 2007 are as follows;

	For the three months									For the nine months
	ended Sept. 30,									ended Sept. 30,
	2008			2007						2008			2007
	(in thousands)						Change			(in thousands)						Change

Research and development		$	809		$	769		5	%		$	2,498		$	2,303		8	%
Sales and marketing			2,094			1,953		7				6,435			5,240		23
General and administrative			1,897			1,267		50				5,393			3,479		55
Total		$	4,800		$	3,989		20	%		$	14,326		$	11,022		30	%

Research and Development

Research and development expenses consisted of costs associated with personnel, prototype materials, initial product certifications and equipment costs. Research and development costs are primarily categorized as either sustaining (efforts for products already released) or development costs (associated with new products).

	For the three months									For the nine months
	ended Sept. 30,									ended Sept. 30,
	2008			2007						2008			2007
	(in thousands)						Change			(in thousands)						Change

Research and development		$	809		$	769		5	%		$	2,498		$	2,303		8	%

As a percentage of net revenue			30 %			47 %						36 %			40 %

Research and development expense for the three month period ended September 30, 2008 versus 2007 increased by approximately $41,000 versus the same period in 2007. The primary cost increases included the addition of quality personnel, travel, consultants and recruiting, offset by reduction of stock based compensation expense. In addition, the fair market value of warrants issued to consultants during the quarter increased by approximately $152,000. Research and development expense for the nine month period ended September 30, 2008 versus 2007 increased by approximately $195,000 primarily due to the fair value of warrants issued to consultants, product improvement and prototype materials associated with new products, offset by a reduction in stock based compensation expense.

Included in research and development expense are non-cash costs associated with stock based compensation of $72,267 and $139,768 for the three month periods ended September 30, 2008 and 2007, respectively, and $213,136 and $284,378 for the nine months ended September 30, 2008 and 2007, respectively. In addition, non-cash costs associated with the fair value of warrants issued to consultants who are included in research and development expense are $152,255 and $2,343 for the nine month periods ended September 30, 2008 and 2007, respectively.

Sales and Marketing

Sales and marketing expenses primarily included personnel costs, sales commissions, and marketing expenses such as trade shows, channel development, and literature.

	For the three months									For the nine months
	ended Sept. 30,									ended Sept. 30,
	2008			2007						2008			2007
	(in thousands)						Change			(in thousands)						Change

Sales and Marketing		$	2,094		$	1,953		7	%		$	6,435		$	5,240		23	%

As a percentage of net revenue			78 %			119 %						92 %			91 %

Sales and marketing expenses for the three month period ended September 30, 2008 increased by approximately $141,000 over the same three month period in 2007. Primary cost increases include costs associated with higher sales volume including commissions and travel, and consultants associated with messaging, offset by reduction in stock based compensation expenses.

Index

Sales and marketing expenses for the nine month period ended September 30, 2008 increased by approximately $1,195,000 over the nine month period ended September 30, 2007. Personnel costs increased as a result of higher sales volumes and the restructuring costs associated with the sales and marketing reorganization which took place during the first quarter of 2008. Marketing related costs increased related to higher public relations, messaging, rebranding and trade show costs. Expense reductions included lower stock based compensation expense.

For the three month periods ended September 30, 2008 and 2007, non-cash costs in sales and marketing expense included stock based compensation of $110,358 and $282,961 respectively and amortization of Netintact related acquisition costs of $359,750 and $359,750 respectively. For the nine month periods ended September 30, 2008 and 2007, non-cash costs in sales and marketing include stock based compensation of $346,224 and $452,166, respectively and amortization of Netintact related acquisition costs of $1,079,250 and $1,079,250 respectively.

General and Administrative

General and administrative expenses consisted primarily of personnel and facilities costs related to our executive, finance, human resources, and legal organizations, fees for professional services, and amortization of intangible assets. Professional services included costs associated with legal, audit, and investor relations consulting costs.

	For the three months									For the nine months
	ended Sept. 30,									ended Sept. 30,
	2008			2007						2008			2007
	(in thousands)						Change			(in thousands)						Change

General and administrative		$	1,897		$	1,267		50	%		$	5,393		$	3,479		55	%

As a percentage of net revenue			71 %			77 %						77 %			61 %

General and administrative expenses for the three months ended September 30, 2008 increased by approximately $630,000, when compared to the three months ended September 30, 2007. Major expense increases in the three month period ended September 30, 2008 versus the same period in 2007 include payroll and related costs, professional services, recruiting fees, legal, audit and bad debt expense incurred in the Americas region. For the nine month period ended September 30, 2008 general and administrative expenses increased by approximately $1,914,000 when compared to the nine months ended September 2007. The primary increases in expenses include payroll and related costs, professional services, legal, audit, recruiting and costs assoicated with the initial submission of a S-1 registration.

Non-cash costs in general and administrative expense for the three month ended September 30, 2008 and 2007 included stock based compensation costs of $264,692 and $361,008 respectively, amortization of Netintact related acquisition costs of $185,333 and $185,333 respectively and the fair value of common shares related to investor relations services of $138,677 and $122,265 respectively. Non-cash costs in general and administrative expense for the nine months ended September 30, 2008 and 2007 included stock based compensation costs of $$364,224 and $558,617 respectively, amortization of Netintact related acquisition costs of $556,000 and $556,000 respectively, the fair value of common shares related to investor relations services of $383,197 and $323,439 respectively and the fair value of warrants issued for service of $0 and $71,962 respectively.

Interest and Other Income (Expense), Net

Net interest and other income decreased by approximately $15,000 during the three month period ended September 30, 2008 as compared to the same period in 2007. Average cash balances were lower during 2008 resulting in lower interest income and interest expense associated with short term debt borrowings commenced during the current quarter. Net interest and other income decreased by approximately $55,000 during the nine month period ended September 30, 2008 versus 2007. Average cash balances and interest rates were higher during 2007, resulting in higher interest income during 2007. The company also incurred higher other expenses in the nine month period ending September 30, 2008 associated with the write off of unamortized facility expenses as a result of moving our main Swedish facility and the interest associated with debt incurred in 2008.

Provision for Income Taxes

The Company is subject to taxation primarily in the U.S. , Sweden , and Australia , as well as State of California . The tax benefit results primarily from the amortization of a purchase accounting adjustment. The Company has established a valuation allowance for substantially all of its deferred tax assets. The valuation allowance was calculated in accordance with the provisions of SFAS No. 109, which require that a valuation allowance be established or maintained when it is “more likely than not” that all or a portion of deferred tax assets will not be realized. The Company will continue to reserve for substantially all net deferred tax assets until there is sufficient evidence to warrant reversal.

Index

Liquidity and Capital Resources

Cash and Cash Equivalents and Investments

The following table summarizes our cash and cash equivalents and investments, which were classified as “available for sale” and consisted of highly liquid financial instruments:

	For the nine months
	ended Sept. 30,
	2008				2007
	(in thousands)

Cash and Cash equivalents
Beginning Balance-January 1,		$	5,865			$	5,214
Ending Balance-September 30			4,826				8,594

Change in Cash and Cash Equivalents		$	(1,039	)		$	3,380

The cash and cash equivalents balance decreased during the nine months ended September 30, 2008 by approximately $1,039,000 and increased during the nine months ended September 30, 2007 by approximately $3,380,000.

	For the nine months
	ended Sept. 30,
	2008			2007
	(in thousands)

Net cash used in by operating activities	$	(9,698	)	$	(4,205	)
Net cash used in investing activities		(724	)		(552	)
Net cash provided by financing activities		8,845			8,144
Effect of exchange rate changes on cash and cash equivalents		538			(7	)

Net increase (decrease) on cash and cash equivalents	$	(1,039	)	$	3,380

During the nine month periods ended September 30, 2008 and 2007, our net cash flow was $(1,039,000) and $3,380,000 respectively. Our net loss, adjusted for non cash items resulted in use of cash of $(5,847,000) and $(2,980,000) respectively during the same time period. During the nine month period ended September 30, 2008, investments is assets, net of liabilities were $(3,850,000) primarily due to investment in inventory and receivables due to growth in sales and the resulting impact of a longer sales cycles for our newest product line. During the nine month period ended September 30, 2007, investments in assets, net of liabilities were $(1,265,000) primarily due to investment in accounts receivable.

In the nine months ended September 30, 2008, we generated $8,845,000 from investment activities, primarily from an August 2008 private investment financing of $5,829,000, and the exercise of warrants issued with our December 2004 private investment financing. During the same period in 2007, our cash flow from financing activities was $8,144,000, primarily as a result of a private investment financing of $7,354,000 which was completed in July 2007 and the exercise of warrants and stock options.

We believe that we will be able to sustain a modest level of growth with our existing cash, cash equivalents and short-term investments, along with the cash that we expect to generate from operations, for anticipated cash needs for working capital and capital expenditures throu gh September 3 0, 2009. If necessary, we would consider curtailing some of our operating expenditures and reduce our operating expense categories if we believe that sufficient cash in not available. In order to grow beyond this modest level, we will seek to sell additional equity or debt securities, obtain a credit facility or enter into development or license agreements with third parties. The sale of additional equity or convertible debt securities could result in dilution to our stockholders. If additional funds are raised through the issuance of debt securities, these securities could have rights senior to those associated with our common stock and could contain covenants that would restrict our operations. Any corporate collaboration or licensing arrangements may require us to relinquish valuable rights. Additional financing may not be available at all, or in amounts or upon terms acceptable to us. If adequate funds are not available, we may be required to delay, reduce the scope of or eliminate our commercialization efforts or one or more of our research and development programs.

Our management routinely and actively pursues various funding options, including equity offerings, equity-like financing, strategic corporate alliances, business combinations and even the establishment of product related research and development limited partnerships, to obtain additional financing to continue the development of our products and bring them to commercial markets. Should the Company be unable to raise adequate financing or generate sufficient revenue in the future, short-term and long-term operations may need to be scaled back or discontinued.

Index

Off Balance Sheet Arrangements

As of September 30, 2008, the Company had no off-balance sheet items as described by Item 303(a) (4) of SEC Regulation S-K. We have not entered into any transactions with unconsolidated entities whereby we have financial guarantees, subordinated retained interests, derivative instruments, or other contingent arrangements that expose us to material continuing risks, contingent liabilities, or any other obligations under a variable interest in an unconsolidated entity that provides us with financing, liquidity, market risk, or credit risk support.

Contractual Obligations

As of September 30, 2008, the Company certain equipment under capital leases that expire at various dates through 2012. Our capital leases are located in Sweden with interest rates ranging from 1-6%. The Company leases facility space under non-cancelable operating leased in California , Sweden and Australia that extend through 2014.

Procera also leases office space and under non-cancelable operating leases with various expiration dates through 2014. The details of these contractual obligations are further explained in item 12 of our Notes to Interim condensed consolidated financial statements

Deferred Revenue

The following table describes our unearned deferred revenue as of September 30, 2008 and December 31, 2007:

	Sept. 30, 2008		Dec. 31, 2007		Increase
	(in thousands)
Deferred revenue	$	1,091	$	958		$	133	14	%

Product sales include post contract support and hardware maintenance services which are deferred until earned. The contract period typically is one year but can range up to three years. Additionally, when we introduce new products for which there is no historical evidence of acceptance history, revenue is deferred until receipt of end-user acceptance until such history has been established. The increase in deferred revenue is reflective of an increasing base of customers and related support contract renewals on historical sales.

Material Commitments of Capital

We use third-party contract manufacturers to assemble and test our products. In order to reduce manufacturing lead-times and ensure a n adequate supply of inventory , our agreements with some of these manufacturers allow them to procure long lead -time component inventory on their behalf based on a rolling produ ction forecast provided by the C ompany. We may be contractually obligated to purchase long lead-time component inventory procured by certain manu facturers in accordance with our forecasts. In addition, we issue purchase orders to our third-party manufacturers that may not be cancelable at any time. As of September 30 , 2008, we had no open non-cancelable purchase orders with third-party manufacturers.

Index

New Accounting Pronouncements

Financial Accounting Standard No. 157 - Fair Value Measurements

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” (SFAS 157). SFAS 157 establishes a framework for measuring fair value in accordance with generally accepted accounting principles and expands disclosures about fair value measurements. The statement defines fair value as the exit price that would be received to sell an asset or paid to transfer a liability. Fair value is a market-based measurement that should be determined using assumptions that market participants would use in pricing an asset or liability. The statement establishes a three-level hierarchy to prioritize the inputs used in measuring fair value.

In February 2008, the FASB issued FASB Staff Position (FSP) 157-b which delayed the effective date of SFAS 157 for one year for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). SFAS 157 and FSP 157-b are effective for financial statements issued for fiscal years beginning after November 15, 2007. We have elected a partial deferral of SFAS 157 under the provisions of FSP 157-b and, effective January 1, 2008, the Company adopted SFAS 157 for those assets and liabilities that are remeasured at fair value on a recurring basis. Our partial adoption of SFAS 157 did not have a material effect on our consolidated financial statements as of and for the three months ended September 30 , 2008.

Financial Accounting Standard No. 159—The Fair Value Option for Financial Assets and Financial Liabilities

In February 2007, the FASB issued Financial Accounting Standard No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” or FAS 159. FAS 159 permits an entity to choose, at specified election dates, to measure eligible financial instruments and certain other items at fair value that are not currently required to be measured at fair value. An entity shall report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. Upfront costs and fees related to items for which the fair value option is elected shall be recognized in earnings as incurred and not deferred. FAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. FAS 159 are effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. At the effective date, an entity may elect the fair value option for eligible items that exist at that date. The entity shall report the effect of the first re-measurement to fair value as a cumulative-effect adjustment to the opening balance of retained earnings. We have elected not to apply the fair value option to any eligible assets or liabilities held as of December 31, 2007 or for any eligible assets or liabilities arising during the three months ended March 31, 2008.

Financial Accounting Standard No. 160—Noncontrolling Interests in Consolidated Financial Statements – an Amendment of Accounting Research Bulletin No. 51

In December 2007, the FASB issued Financial Accounting Standard No. 160, “Noncontrolling Interests in Consolidated Financial Statements—an Amendment of Accounting Research Bulletin No. 51,” or FAS 160. FAS 160 requires reporting entities to present noncontrolling (minority) interests as equity (as opposed to as a liability or mezzanine equity) and provides guidance on the accounting for transactions between an entity and noncontrolling interests. FAS 160 is effective for fiscal years beginning on or after December 15, 2008, except for the presentation and disclosure requirements which will be applied retrospectively for all periods presented. We do not believe that FAS 160 will have any material impact on our consolidated financial statements.

Financial Accounting Standard No. 141(R)—Business Combinations (Revised)

In December 2007, the FASB issued Financial Accounting Standard No. 141(R), “Business Combinations,” or FAS 141(R). FAS 141(R) requires the acquiring entity in a business combination to recognize the full fair value of assets acquired and liabilities assumed in the transaction (whether a full or partial acquisition); establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed; requires expensing of most transaction and restructuring costs; and requires the acquirer to disclose to investors and other users all of the information needed to evaluate and understand the nature and financial effect of the business combination. FAS 141(R) applies to all transactions or other events in which the reporting entity obtains control of one or more businesses, including those sometimes referred to as “true mergers” or “mergers of equals” and combinations achieved without the transfer of consideration, for example, by contract alone or through the lapse of minority veto rights. FAS 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. We do not believe that FAS 141R will have any material impact on our consolidated financial statements.

Index

In December 2007, the SEC issued Staff Accounting Bulletin No. 110 (“ SAB 110”). SAB 110 expresses the views of the staff regarding the use of a “simplified” method, as discussed in SAB No. 107, “Share-Based Payment”, in developing an estimate of the expected term of “plain vanilla” share options in accordance with SFAS No. 123 (R). We do not expect SAB 110 to have a material impact on our results of operations or financial condition.

Item 3.

Quantitative and Qualitative Disclosures about Market Risk.

Market risk represents the risk of loss that may impact our financial position, results of operations or cash flows due to adverse changes in market prices, including interest rate risk and other relevant market rate or price risks. We do not use derivative financial instruments in our investment portfolio.

We are exposed to some market risk through interest rates related to our investment of current cash and cash e quivalents of approximately $4.8 million at September 30 , 2008. Based on this balance, a change of one percent in interest rate would cause an annual change in interest income of $ 48 ,000. The risk is not considered material and we manage such risk by continuing to evaluate the best investment rates available for short-term high quality investments.

Foreign Currency Rate Fluctuations

The Company's earnings and cash flows at its subsidiaries Netintact AB and Netintact PTY are subject to fluctuations due to changes in foreign currency rates. The Company believes that changes in the foreign currency exchange rate would not have a material adverse effect on its results of operations as the majority of its foreign transactions are delineated in each subsidiary's functional currency which are the Australian Dollar or the Swedish Krona .

Item 4.

Controls and Procedures.

Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting (“Internal Control”) as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Management understands that a material weakness is a significant deficiency (within the meaning of Public Company Accounting Oversight Board Auditing Standard No. 2), or combination of significant deficiencies, that results in there being more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.

Management assessed the effectiveness of the company’s Internal Control as of December 31, 2007 using the criteria issued by the Committee of Sponsoring Organizations of the Treadway Commission ( COSO ) in Internal Control-Integrated Framework and identified a material weakness in its Annual Report on Form 10-K for the fiscal year ended December 31, 2007. Additionally, our independent registered public accounting firm has tested our internal control over financial reporting for the year ended December 31, 2007 , and has provided an adverse audit opinion on the Company’s control over financial reporting.

This material weakness was described as follows, and this information should be read together with management’s complete report as included with the company’s Annual Report on Form 10-K:

Material Weakness

We did not complete our 10-K and financial reports in sufficient time to allow for review and comment which resulted in a significant number of last minute changes. We intend to implement a plan for the year end close that permits earlier completion of financial statements and required filings with the SEC in a timely manner.

Based on the assessment conducted and the evaluation of relevant criteria, management concluded that, as of December 31, 2007, the company’s Internal Control was not effective.

Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures (“Disclosure Controls”), as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act that are designed to ensure that information required to be disclosed in our Exchange Act reports, including the company’s Quarterly Report on Form 10-Q, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and 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.

Index

In designing and evaluating the Disclosure Controls, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

As required by Rule 13a-15(b) and 15d-15(b) under the Exchange Act, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. As described above, we identified a material weakness as of December 31, 2007 that we had not fully remediated as of September 30, 2008 . The company’s Chief Executive Officer and Chief Financial Officer have concluded that, as a result of that material weakness that remains outstanding, the Company’s Disclosure Controls, as of September 30 , 2008, were, therefore, still not effective.

Our independent registered public accounting firm PMB Helin Donovan, LLP has not audited the financial statements and notes thereto included elsewhere in this Quarterly Report on Form 10-Q, nor have they attested to, or reported on, our remediation efforts.

Changes in Internal Control Over Financial Reporting

Based on the findings noted above, management has initiated an evaluation process and initial remediation actions to address the material weakness as well as significant deficiencies. These remediation efforts, which are discussed below, are reasonably likely to materially affect our Internal Control.

Remediation of Certain Controls Associated with the Financial Reporting and Preparation of Financial Statements

Management introduced new procedures in the first and second quarter of 2008 to address the financial reporting issues.

These new procedures require the Company’s financial group to collect, analyze and monitor all necessary and relevant supporting documentation for account balances and any adjustments. Management also introduced additional procedures to ensure a more thorough review of financial data in the financial reporting and close process. Management believes that these additional procedures may have effectively remediated certain aspects of this material weakness, although management continues to assess the efficacy of these changes.

In the first nine months of 2008, management began to evaluate its personnel, develop a plan to enhance the current staff’s capabilities and assess whether additional resources with appropriate accounting knowledge and experience were required. Management will continue to evaluate and to implement remediation efforts with respect to the identified weaknesses. Management does not expect to be able to report that its Internal Control is effective until it is able to remediate these matters.

PART II. OTHER INFORMATION

Item 1.

Legal Proceedings.

We may at times be involved in litigation in the ordinary course of business. We will also, from time to time, when appropriate in management’s estimation, record adequate reserves in our financial statements for pending litigation. Currently, there are no pending material legal proceedings to which we are a party or to which any of our property is subject.

Index

Item 1A. Risk Factors.

Risks Related to Our Business

We have a limited operating history on which to evaluate our company.

We were founded in 2002 and became a public company in October 2003 upon our merger with Zowcom, Inc., a publicly-traded Nevada corporation having no operations. Prior to our acquisitions of the Netintact companies, we were a development stage company, devoting substantially all our efforts and resources to developing and testing new products and preparing for the introduction of our products into the marketplace. During this period, we generated insignificant revenues from sales of our products. We completed our share exchange with Netintact AB on August 18, 2006 and Netintact PTY on September 29, 2006. The products we sell are derived primarily from Netintact. While we have the experience of Netintact operations on a stand-alone basis, we have had limited operating history on a combined basis upon which we can evaluate our business and prospects. We have yet to develop sufficient experience regarding actual revenues to be achieved from our combined operations.

We have only recently launched many of our products and services on a worldwide basis. Therefore, investors should consider the risks and uncertainties frequently encountered by companies in new and rapidly evolving markets, which include the following:

successfully introducing new products;

successfully servicing and upgrading new products once introduced;

increasing brand name recognition;

developing new, strategic relationships and alliances;

managing expanding operations and sales channels;

successfully responding to competition; and

attracting, retaining and motivating qualified personnel.

If we are unable to address these risks and uncertainties, our business, results of operations and financial condition could be materially and adversely affected.

We expect losses for the foreseeable future.

For the fiscal years ended December 31, 2007, December 31, 2006 and January 1, 2006 we had losses from operations of $13.6 million, $7.8 million and $6.7 million, respectively. We expect to continue to incur losses from operations for the foreseeable future. These losses will result primarily from costs related to investment in sales and marketing, product development and administrative expenses. If our revenue growth does not occur or is slower than anticipated or our operating expenses exceed expectations, our losses will be greater. We may never achieve profitability.

We may need to raise further capital, which could dilute or otherwise adversely affect your interest in our company.

We believe that our existing cash, cash equivalents and short term investments, along with the cash that we expect to generate from operations, together with debt or equity financing that management believes is available, will be sufficient to meet our anticipated cash needs for working capital and capital expenditures through September 30 , 2009 .

However, a number of factors may negatively impact our expectations, including, without limitation:

lower than anticipated revenues;

higher than expected cost of goods sold or operating expenses; or

the inability of our customers to pay for the goods and services ordered.

We believe the general economic and credit market crisis have created a more difficult environment for obtaining equity and debt financing. If additional funds are raised through the issuance of equity or convertible debt securities, the percentage ownership of our stockholders will be reduced, stockholders may experience additional dilution and such securities may have rights, preferences and privileges senior to those of our common stock. There can be no assurance that additional financing will be available on terms favorable to us or at all, especially in light of the current economic environment. If adequate funds are not available on acceptable terms, we may not be able to fund expansion, take advantage of unanticipated growth or acquisition opportunities, develop or enhance services or products or respond to competitive pressures. In addition, we may be required to cancel product development programs and/or lay-off employees. Such inability to raise additional financing could have a material adverse effect on our business, results of operations and financial condition.

Index

Our PacketLogic family of products is currently our only suite of products. All of our current revenues and a significant portion of our future growth depend on our ability to continue its commercialization.

All of our current revenues and much of our anticipated future growth depend on our ability to continue and grow the commercialization of our PacketLogic family of products. We do not currently have plans or resources to develop additional product lines, so our future growth will largely be determined by market acceptance of our PacketLogic products. If customers do not adopt, purchase and deploy our PacketLogic products, our revenues will not grow and may decline.

Future financial performance will depend on the introduction and acceptance of our PL10000 product line and our future generations of PacketLogic products.

Our future financial performance will depend on the development, introduction and market acceptance of new and enhanced products that address additional market requirements in a timely and cost-effective manner. In the past, we have experienced delays in product development and such delays may occur in the future.

We recently introduced our PL10000 product line. When we announce new products or product enhancements that have the potential to replace or shorten the life cycle of our existing products, customers may defer purchasing our existing products. These actions could harm our operating results by unexpectedly decreasing sales and exposing us to greater risk of product obsolescence.

Competition for experienced personnel is intense and our inability to attract and retain qualified personnel could significantly interrupt our business operations.

Our future performance will depend, to a significant extent, on the ability of our management to operate effectively, both individually and as a group. We are dependent on our ability to attract, retain and motivate high caliber key personnel. We have recently expanded and plan to continue to expand in all areas and will require experienced personnel to augment our current staff. We expect to recruit experienced professionals in such areas as software and hardware development, sales, technical support, product marketing and management. We currently plan to expand our indirect channel partner program and we need to attract qualified business partners to broaden these sales channels. Economic conditions may result in significant competition for qualified personnel and we may not be able to attract and retain such personnel. Our business will suffer if it encounters delays in hiring these additional personnel.

Our performance is substantially dependent on the continued services and on the performance of our executive officers and other key employees, including our CEO, James Brear, and our CTO, Alexander Haväng . Mr. Brear joined the Company and became our CEO in February 2008. The loss of the services of any of our executive officers or other key employees could materially and adversely affect our business. We believe we will need to attract, retain and motivate talented management and other highly skilled employees in order to execute on our business plan. We may be unable to retain our key employees or attract, assimilate and retain other highly qualified employees in the future. Competitors and others have in the past, and may in the future, attempt to recruit our employees. In California , where we are headquartered, non-competition agreements with employees are generally unenforceable. As a result, if a California employee leaves the Company he or she will generally be able to immediately compete against us.

We currently do not have key person insurance in place. If we lose one of the key officers, we must attract, hire, and retain an equally competent person to take his or her place. There is no assurance that we would be able to find such an employee in a timely fashion. If we fail to recruit an equally qualified replacement or incur a significant delay, our business plans may slow down or stop. We could fail to implement our strategy or lose sales and marketing and development momentum.

Also, we have recently reorganized our sales and marketing efforts, including a significant reduction in workforce in these areas and the announcement of two new senior sales management personnel. This reduction in our workforce may impair our ability to recruit and retain qualified employees in the future, and there can be no assurance that these personnel additions or our reorganization efforts will have the positive effect on our business operations as planned by management.

We need to increase the functionality of our products and offer additional features in order to be competitive.

The market in which we operate is highly competitive and unless we continue to enhance the functionality of our products and add additional features, our competitiveness may be harmed and the average selling prices for our products may decrease over time. Such a decrease would generally result from the introduction of competing products and from the standardization of DPI technology. To counter this trend, we endeavor to enhance our products by offering higher system speeds and additional features, such as additional protection functionality, supporting additional applications and enhanced reporting tools. We may also need to reduce our per unit manufacturing costs at a rate equal to or faster than the rate at which selling prices decline. If we are unable to reduce these costs or to offer increased functionally and features, our profitability may be adversely affected.

Index

Failure to expand our sales teams or educate them about technologies and our product families may harm our operating results.

The sale of our products requires a concerted effort that is frequently targeted at several levels within a prospective customer's organization. We may not be able to increase net revenue unless we expand our sales teams to address all of the customer requirements necessary to sell our products. We have recently reorganized our sales and marketing efforts, including a significant reduction in workforce in these areas and the addition of two senior sales management personnel. We expect to continue hiring in this area, but there can be no assurance that these personnel additions or our reorganization efforts will have the positive effect on our business operations as planned by management.

We cannot assure you that we will be able to integrate our employees into the company or to educate current and future employees in regard to rapidly evolving technologies and our product families. Failure to do so may hurt our revenue growth and operating results.

Increased customer demands on our technical support services may adversely affect our relationships with our customers and our financial results.

We offer technical support services with our products. We may be unable to respond quickly enough to accommodate short-term increases in customer demand for support services. We also may be unable to modify the format of our support services to compete with changes in support services provided by actual or potential competitors. Further customer demand for these services, without corresponding revenues, could increase costs and adversely affect our operating results. If we experience financial difficulties, do not maintain sufficiently skilled workers and resources to satisfy our contracts, or otherwise fail to perform at a sufficient level under these contracts, the level of support services to our customers may be significantly disrupted, which could materially harm our relationships with these customers and our results of operations.

We must continue to develop and increase the productivity of our indirect distribution channels to increase net revenue and improve our operating results.

A key focus of our distribution strategy is developing and increasing the productivity of our indirect distribution channels through resellers and distributors. If we fail to develop and cultivate relationships with significant resellers, or if these resellers are not able to execute on their sales efforts, sales of our products may decrease and our operating results could suffer. Many of our resellers also sell products from other vendors that compete with our products. We cannot assure you that we will be able to enter into additional reseller and/or distribution agreements or that we will be able to manage our product sales channels. Our failure to do any of these could limit our ability to grow or sustain revenue. In addition, our operating results will likely fluctuate significantly depending on the timing and amount of orders from our resellers. We cannot assure you that our resellers and/or distributors will continue to market or sell our products effectively or continue to devote the resources necessary to provide us with effective sales, marketing and technical support. Such failure would negatively affect revenue and our potential to achieve profitability.

We may be unable to compete effectively with other companies in our market sector which are substantially larger and more established and have greater resources.

We compete in a rapidly evolving and highly competitive sector of the networking technology market, on the basis of price, service, warranty and the performance of our products. We expect competition to persist and intensify in the future from a number of different sources. Increased competition could result in reduced prices and gross margins for our products and could require increased spending by us on research and development, sales and marketing and customer support, any of which could have a negative financial impact on our business. We compete with Cisco Systems/P-Cube, Allot, Arbor/ Ellacoya, BlueCoat/Packeteer, Juniper, Ericsson Foundry Networks and Sandvine, as well as other companies which sell products incorporating competing technologies. In addition, our products and technology compete for information technology budget allocations with products that offer monitoring capabilities, such as probes and related software. Lastly, we face indirect competition from companies that offer broadband service providers increased bandwidth and infrastructure upgrades that increase the capacity of their networks, which may lessen or delay the need for bandwidth management solutions.

Some of our competitors are substantially larger than we are and have significantly greater name recognition and financial, sales and marketing, technical, manufacturing and other resources and more established distribution channels than we do. These competitors may be able to respond more rapidly to new or emerging technologies and changes in customer requirements or devote greater resources to the development, promotion and sale of their products than we can. We have encountered, and expect to encounter, customers who are extremely confident in, and committed to, the product offerings of our competitors. Furthermore, some of our competitors may make strategic acquisitions or establish cooperative relationships among themselves or with third parties to increase their ability to rapidly gain market share by addressing the needs of our prospective customers. These competitors may enter our existing or future markets with solutions that may be less expensive, provide higher performance or additional features or be introduced earlier than our solutions. Given the potential opportunity in the bandwidth management solutions market, we also expect that other companies may enter with alternative products and technologies, which could reduce the sales or market acceptance of our products and services, perpetuate intense price competition or make our products obsolete. If any technology that is competing with ours is or becomes more reliable, higher performing, less expensive or has other advantages over our technology, then the demand for our products and services would decrease, which would harm our business.

Index

If we are unable to effectively manage our anticipated growth, we may experience operating inefficiencies and have difficulty meeting demand for our products.

We seek to manage our growth so as not to exceed our available capital resources. If our customer base and market grow rapidly, we would need to expand to meet this demand. This expansion could place a significant strain on our management, products and support operations, sales and marketing personnel and other resources, which could harm our business.

If demand for our products and services grows rapidly, we may experience difficulties meeting the demand. For example, the installation and use of our products requires training. If we are unable to provide training and support for our products, the implementation process will be longer and customer satisfaction may be lower. In addition, our management team may not be able to achieve the rapid execution necessary to fully exploit the market for our products and services. We cannot assure you that our systems, procedures or controls will be adequate to support the anticipated growth in our operations. The failure to meet the challenges presented by rapid customer and market expansion would cause us to miss sales opportunities and otherwise have a negative impact on our sales and profitability.

We may not be able to install management information and control systems in an efficient and timely manner, and our current or planned personnel, systems, procedures and controls may not be adequate to support our future operations.

We have limited ability to protect our intellectual property and defend against claims which may adversely affect our ability to compete.

For our primary line of PacketLogic products, we rely on trade secret law, contractual rights and trademark law to protect our intellectual property rights. We cannot assure you that the actions we have taken will adequately protect our intellectual property rights or that other parties will not independently develop similar or competing products that do not infringe on our patents. We enter into confidentiality or license agreements with our employees, consultants and corporate partners, and control access to and distribution of our software, documentation and other proprietary information. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise misappropriate or use our products or technology.

In an effort to protect our unpatented proprietary technology, processes and know-how, we require our employees, consultants, collaborators and advisors to execute confidentiality agreements. These agreements, however, may not provide us with adequate protection against improper use or disclosure of confidential information. These agreements may be breached, and we may not become aware of, or have adequate remedies in the event of, any such breach. In addition, in some situations, these agreements may conflict with, or be subject to, the rights of third parties with whom our employees, consultants, collaborators or advisors have previous employment or consulting relationships. Also, others may independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets.

Our industry is characterized by the existence of a large number of patents and frequent claims and related litigation regarding patent and other intellectual property rights. If we are found to infringe on the proprietary rights of others, or if we agree to settle any such claims, we could be compelled to pay damages or royalties and either obtain a license to those intellectual property rights or alter our products so that they no longer infringe upon such proprietary rights. Any license could be very expensive to obtain or may not be available at all. Similarly, changing our products or processes to avoid any claims of infringement may be costly or impractical. Litigation resulting from claims that we are infringing the proprietary rights of others could result in substantial costs and a diversion of resources, and could have a material adverse effect on our business, financial condition and results of operations.

If we are unable to have our products manufactured quickly enough to keep up with demand, our operating results could be harmed.

If the demand for our products grows, we will need to increase our capacity for material purchases, production, test and quality control functions. Any disruptions in product flow could limit our revenue growth and adversely affect our competitive position and reputation, and result in additional costs or cancellation of orders under agreements with our customers.

While our PacketLogic products are software based, we rely on independent contractors to manufacture the hardware components on which are products are installed and operate. We are reliant on the performance of these contractors to meet business demand, and may experience delays in product shipments from contract manufacturers. Contract manufacturer performance problems may arise in the future, such as inferior quality, insufficient quantity of products, or the interruption or discontinuance of operations of a manufacturer, any of which could have a material adverse effect on our business and operating results.

Index

We do not know whether we will effectively manage our contract manufacturers or that these manufacturers will meet our future requirements for timely delivery of product components of sufficient quality and quantity. We also intend to regularly introduce new products and product enhancements, which will require that we rapidly achieve volume production by coordinating our efforts with those of our suppliers and contract manufacturers. The inability of our contract manufacturers to provide us with adequate supplies of high-quality product components may cause a delay in our ability to fulfill orders and may have a material adverse effect on our business, operating results and financial condition.

As part of our cost-reduction efforts, we will endeavor to lower per unit product costs from our contract manufacturers by means of volume efficiencies and the utilization of manufacturing sites in lower-cost geographies. However, we cannot be certain when or if such price reductions will occur. The failure to obtain such price reductions would adversely affect our gross margins and operating results.

There are certain original equipment manufacturer (“OEM”) sourced components which, if the supplier were to fail to adequately supply to us, our products sales may suffer.

Reliance upon OEMs, as well as industry supply conditions generally involves several additional risks, including the possibility of a shortage of components and reduced control over delivery schedules (which can adversely affect our distribution schedules), and increases in component costs (which can adversely affect our profitability). Most all our hardware products, or the components of our hardware components, are based on industry standards and are therefore available from multiple manufacturers. If our supplier were to fail to deliver, alternative suppliers are available, although qualification of the alternative manufacturers and establishment of reliable suppliers could result in delays and a possible loss of sales, which could affect operating results adversely. However, in some specific cases we have single-sourced components, because alternative sources are not currently available. If these components were to become not available, we could experience more significant, though temporary, supply interruptions, delays, or inefficiencies, adversely affecting our results of operations.

If our products contain undetected software or hardware errors, we could incur significant unexpected expenses and lose sales.

Network products frequently contain undetected software or hardware errors, failures or bugs when new products or new versions or updates of existing products are first released to the marketplace. For example, we recently announced the introduction of our PL10000 product line. As with any new product introduction, previously unaddressed errors in our PL10000 product line's accuracy or reliability, or issues with its performance, may arise. We expect that such errors or component failures will be found from time to time in the future in new or existing products, including the components incorporated therein, after the commencement of commercial shipments. These problems may have a material adverse effect on our business by causing us to incur significant warranty and repair costs, diverting the attention of our engineering personnel from new product development efforts, delaying the recognition of revenue and causing significant customer relations problems. Further, if our products are not accepted by customers due to defects, and such returns exceed the amount we accrued for defect returns based on our historical experience, our operating results would be adversely affected.

Our products must properly interface with products from other vendors. As a result, when problems occur in a computer or communications network, it may be difficult to identify the sources of these problems. The occurrence of hardware and software errors, whether or not caused by our products, could result in the delay or loss of market acceptance of our products and any necessary revisions may cause us to incur significant expenses. The occurrence of any such problems would likely have a material adverse effect on our business, operating results and financial condition.

Sales of our products to large broadband service providers can involve a lengthy sales cycle, which may cause our revenues to fluctuate from period to period and could result in us exp ended significant resources without making any sales.

Our sales cycles are generally lengthy, as our customers undertake significant testing to assess the performance of our products within their networks. As a result, we may invest significant time from initial contact with a customer until that end-customer decides to incorporate our products in its network. We may also expend significant resources attempting to persuade large broadband service providers to incorporate our products into their networks without any measure of success. Even after deciding to purchase our products, initial network deployment of our products by a large broadband service provider may last several years. Carriers, especially in North America , often require that products they purchase meet Network Equipment Building System, or NEBS, certification requirements, which relate the reliability of telecommunications equipment. While our PacketLogic products and future products are and are expected to be designed to meet NEBS certification requirements, they may fail to do so.

Due to our lengthy sales cycle, particularly to larger customers, and our revenue recognition practices, we expect our revenue may fluctuate dramatically from period to period. In pursuing sales opportunities with larger enterprises, we expect that we will make fewer sales to larger entities, but that the magnitude of individual sales will be greater. As such, when we recognize a large sale, particularly given our small size, we may report rapid revenue growth in the period that the revenue from the large sale, which may not be repeated in an immediately subsequent period. As such, our revenues could fluctuate dramatically from period to period, which could cause the price of our common stock to similarly fluctuate. In addition, even once we have received commitments from a customer to purchase our products, in accordance with our revenue recognition practices we may not be able to recognize and report the revenue from that purchase for months or years. As a result, there could be significant delays in our receipt and recognition of revenue following sales orders for our products.

Index

In addition, if a competitor succeeds in convincing a large broadband service provider to adopt that competitor's product, it may be difficult for us to displace the competitor because of the cost, time, effort and perceived risk to network stability involved in changing solutions. As a result we may incur significant expense without generating any sales.

Our operating results could be adversely affected by product sales occurring outside the United States and fluctuations in the value of the United States Dollar against foreign currencies.

A significant percentage of PacketLogic sales are generated outside of the United States . PacketLogic sales and operating expenses denominated in foreign currencies could affect our operating results as foreign currency exchange rates fluctuate. Changes in exchange rates between these foreign currencies and the U.S. Dollar will affect the recorded levels of our assets and liabilities as foreign assets and liabilities are translated into U.S. Dollars for presentation in our financial statements, as well as our net sales, cost of goods sold, and operating margins. The primary foreign currencies in which we have exchange rate fluctuation exposure are the European Union Euro, the Swedish Krona and the Australian Dollar. As we expand, we could be exposed to exchange rate fluctuations in other currencies. Exchange rates between these currencies and U.S. Dollars have fluctuated significantly in recent years and may do so in the future. Hedging foreign currencies can be difficult. We cannot predict the impact of future exchange rate fluctuations on our operating results. We currently do not hedge any foreign currencies.

Legislative actions, higher insurance costs and new accounting pronouncements are likely to impact our future financial position and results of operations.

Legislative and regulatory changes and future accounting pronouncements and regulatory changes have, and will continue to have, an impact on our future financial position and results of operations. In addition, insurance costs, including health and workers' compensation insurance premiums, have been increasing on an historical basis and are likely to continue to increase in the future. Recent and future pronouncements associated with expensing executive compensation and employee stock option may also impact operating results. These and other potential changes could materially increase the expenses we report under generally accepted accounting principles, and adversely affect our operating results.

Our internal controls may be insufficient to ensure timely and reliable financial information.

Effective internal controls over financial reporting are necessary for us to provide reliable financial reports and effectively prevent fraud. We believe we need to correct a material weakness and significant deficiencies in our internal controls and procedures for financial reporting. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with Generally Accepted Accounting Principles. A company's internal control over financial reporting includes those policies and procedures that:

pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company;

provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with Generally Accepted Accounting Principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and

provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.

A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.

We described a material weakness with our internal controls under Item 9A of our Annual Report for the year ended December 31, 2007, as follows: we did not complete our annual report on Form 10-K and financial reports in sufficient time to allow for review and comment, which resulted in a significant number of last minute changes and could have resulted in material errors to the financial statements. We also identified significant deficiencies in our internal controls.

Failure to address the identified weakness and significant deficiencies in a timely manner might increase the risk of future financial reporting misstatements and may prevent us from being able to meet our filing deadlines with the SEC. Under the supervision of our Audit Committee, we are continuing the process of identifying and implementing corrective actions where required to improve the design and effectiveness of our internal control over financial reporting, including the enhancement of systems and procedures. Significant additional resources will be required to establish and maintain appropriate controls and procedures and to prepare the required financial and other information. We have a small accounting staff and limited resources and expect that we will continue to be subject to the risk of additional material weaknesses and significant deficiencies.

Index

Even after corrective actions are implemented, the effectiveness of our controls and procedures may be limited by a variety of risks including:

faulty human judgment and simple errors, omissions or mistakes;

collusion of two or more people;

inappropriate management override of procedures; and

the risk that enhanced controls and procedures may still not be adequate to assure timely and reliable financial information.

If we fail to have effective internal controls and procedures for financial reporting in place, we could be unable to provide timely and reliable financial information. Additionally, if we fail to have effective internal controls and procedures for financial reporting in place, it could adversely affect our financial reporting requirements under future government contracts.

Accounting charges may cause fluctuations in our annual and quarterly financial results which could negatively impact the market price of our common stock.

Our financial results may be materially affected by non-cash and other accounting charges. Such accounting charges may include:

amortization of intangible assets, including acquired product rights;

impairment of goodwill;

stock-based compensation expense; and

impairment of long-lived assets.

The foregoing types of accounting charges may also be incurred in connection with or as a result of business acquisitions. The price of our common stock could decline to the extent that our financial results are materially affected by the foregoing accounting charges. Our effective tax rate may increase, which could increase our income tax expense and reduce our net income. Our effective tax rate could be adversely affected by several factors, many of which are outside of our control, including:

changes in the relative proportions of revenues and income before taxes in the various jurisdictions in which we operate that have differing statutory tax rates;

changing tax laws, regulations and interpretations in multiple jurisdictions in which we operate, as well as the requirements of certain tax rulings;

changes in accounting and tax treatment of stock-based compensation;

the tax effects of purchase accounting for acquisitions and restructuring charges that may cause fluctuations between reporting periods; and

tax assessments, or any related tax interest or penalties, which could significantly affect our income tax expense for the period in which the settlements take place.

The price of our common stock could decline to the extent that our financial results are materially affected by the foregoing.

Our headquarters are located in Northern California where disasters may occur that could disrupt our operations and harm our business.

Our corporate headquarters are located in Silicon Valley in Northern California . Historically, this region has been vulnerable to natural disasters and other risks, such as earthquakes, which at times have disrupted the local economy and posed physical risks to us and our local suppliers. In addition, terrorist acts or acts of war targeted at the United States , and specifically Silicon Valley , could cause damage or disruption to us, our employees, facilities, partners, suppliers, distributors and resellers, and customers, which could have a material adverse effect on our operations and financial results. We currently have significant redundant capacity in Sweden in the event of a natural disaster or catastrophic event in Silicon Valley . In the event of such an occurrence, our business could nonetheless suffer. The operations in Sweden are subject to disruption by extreme winter weather.

Index

Acquisitions may disrupt or otherwise have a negative impact on our business.

We may seek to acquire or make investments in complementary businesses, products, services or technologies on an opportunistic basis when we believe they will assist us in executing our business strategy. Growth through acquisitions has been a viable strategy used by other network control and management technology companies. In 2006, we completed acquisitions of the Netintact entities. These and any future acquisitions could distract our management and employees and increase our expenses.

In addition, following any acquisition, including our acquisition of the Netintact entities, the integration of the acquired business, product, service or technology is complex, time consuming and expensive, and may disrupt our business. These challenges include the timely and efficient execution of a number of post-transaction integration activities, including:

integrating the operations and technologies of the two companies;

retaining and assimilating the key personnel of each company;

retaining existing customers of both companies and attracting additional customers;

leveraging our existing sales channels to sell new products into new markets;

developing an appropriate sales and marketing organization and sales channels to sell new products into new markets;

retaining strategic partners of each company and attracting new strategic partners; and

implementing and maintaining uniform standards, internal controls, processes, procedures, policies and information systems.

The process of integrating operations and technology could cause an interruption of, or loss of momentum in, our business and the loss of key personnel. The diversion of management's attention and any delays or difficulties encountered in connection with an acquisition and the integration of our operations and technology could have an adverse effect on our business, results of operations or financial condition. Furthermore, the execution of these post-transaction integration activities will involve considerable risks and may not come to pass as we envision. The inability to integrate the operations, technology and personnel of an acquired business with ours, or any significant delay in achieving integration, could have a material adverse effect on our business and, as a result, on the market price of our common stock.

Furthermore, we issued equity securities to pay for the Netintact acquisitions which had a dilutive effect on its existing shareholders and we may have to incur debt or issue equity securities to pay for any future acquisitions, the issuance of which could be dilutive to our existing stockholders.

Risks Related to Our Industry

Demand for our products depends, in part, on the rate of adoption of bandwidth-intensive broadband applications, such as peer-to-peer, or P2P, and latency-sensitive applications, such as voice-over-Internet protocol, or VoIP, Internet video and online video gaming applications.

Our products are used by broadband service providers and enterprises to provide awareness, control and protection of Internet traffic by examining and identifying packets of data as they pass an inspection point in the network, particularly bandwidth-intensive applications that cause congestion in broadband networks and impact the quality of experience of users. In addition to the general increase in applications delivered over broadband networks that require large amounts of bandwidth, such as P2P applications, demand for our products is driven particularly by the growth in applications which are highly sensitive to network delays and therefore require efficient network management. These applications include VoIP, Internet video and online video gaming applications. If the rapid growth in adoption of VoIP and in the popularity of Internet video and online video gaming applications does not continue, the demand for our products may not grow as anticipated.

If the bandwidth management solutions market fails to grow, our business will be adversely affected.

The market for bandwidth management solutions is in an early stage of development. We cannot accurately predict the future size of the market, the products needed to address the market, the optimal distribution strategy, or the competitive environment that will develop. In order for us to execute our strategy, our potential customers must recognize the value of more sophisticated bandwidth management solutions, decide to invest in the management of their networks and the performance of important business software applications and, in particular, adopt our bandwidth management solutions. The growth of the bandwidth management solutions market also depends upon a number of factors, including the availability of inexpensive bandwidth, especially in international markets, and the growth of wide area networks. The failure of the market to rapidly grow would adversely affect our sales and sales prospects, leading to sustained financial losses and a decline in the trading price of our common stock.

Index

The market for our products in the network provider market is still emerging and our growth may be harmed if carriers do not adopt DPI solutions.

The market for DPI technology is still emerging and the majority of our sales to date have been to small and midsize broadband service providers and enterprises. We believe that the Tier 1 carriers, as well as cable and mobile operators, present a significant market opportunity and are an important element of our long term strategy, but they are still in the early stages of adopting and evaluating the benefits and applications of DPI technology. Carriers may decide that full visibility into their networks or highly granular control over content based applications is not critical to their business. They may also determine that certain applications, such as VoIP or Internet video, can be adequately prioritized in their networks by using router and switch infrastructure products without the use of DPI technology. They may also, in some instances, face regulatory constraints that could change the characteristics of the markets. Carriers may also seek an embedded DPI solution in capital equipment devices such as routers rather than the stand-alone solution offered by us. Furthermore, widespread adoption of our products by carriers will require that they migrate to a new business model based on offering subscriber and application-based tiered services. If carriers decide not to adopt DPI technology, our market opportunity would be reduced and our growth rate may be harmed.

The network equipment market is subject to rapid technological progress and to compete we must continually introduce new products or upgrades that achieve broad market acceptance.

The network equipment market is characterized by rapid technological progress, frequent new product introductions, changes in customer requirements and evolving industry standards. If we do not regularly introduce new products or upgrades in this dynamic environment, our product lines will become obsolete. Developments in routers and routing software could also significantly reduce demand for our products. Alternative technologies could achieve widespread market acceptance and displace the technology on which we have based our product architecture. We cannot assure you that our technological approach will achieve broad market acceptance or that other technology or devices will not supplant our products and technology.

Our products must comply with evolving industry standards and complex government regulations or else our products may not be widely accepted, which may prevent us from growing our net revenue or achieving profitability.

The market for network equipment products is characterized by the need to support new standards as they emerge, evolve and achieve acceptance. We will not be competitive unless we continually introduce new products and product enhancements that meet these emerging standards.

We may not be able to effectively address the compatibility and interoperability issues that arise as a result of technological changes and evolving industry standards. Our products must be compliant with various United States federal government requirements and regulations and standards defined by agencies such as the Federal Communications Commission, in addition to standards established by governmental authorities in various foreign countries and recommendations of the International Telecommunication Union. If we do not comply with existing or evolving industry standards or if we fail to obtain timely domestic or foreign regulatory approvals or certificates, we will not be able to sell our products where these standards or regulations apply, which may prevent us from sustaining our net revenue or achieving profitability.

Risks Related to Ownership of Our Common Stock

Our common stock price is likely to be highly volatile.

The market price of our common stock is likely to be highly volatile as is the stock market in general, and the market for small cap and micro cap technology companies, such as ourselves, in particular, has been highly volatile. For example, between January 1, 2008 and November 7, 2008, the closing price of our common stock has ranged from a low of $0.59 per share to a high of $2. 33 per share. Investors may not be able to resell their shares of our common stock following periods of volatility because of the market's adverse reaction to volatility. In addition our stock is thinly traded. We cannot assure you that our stock will trade at the same levels of other stocks in our industry or that in general, stocks in our industry will sustain their current market prices. Factors that could cause such volatility may include, among other things:

actual or anticipated fluctuations in our quarterly operating results;

announcements of technological innovations by our competitors;

changes in financial estimates by securities analysts;

conditions or trends in the network control and management industry;

Index

changes in the market valuations of other such industry related companies;

the acceptance by institutional investors of our stock;

rumors, announcements or press articles regarding our operations, management, organization, financial condition or financial statements;

our gain or loss of a significant customer; or

the stock market in general, and the market prices of stocks of technology companies in particular, have experienced extreme price volatility that has adversely affected, and may continue to adversely affect, the market price of our common stock for reasons unrelated to our business or operating results.

Holders of our common stock may be diluted in the future.

We are authorized to issue up to 130,000,000 shares of common stock and 15,000,000 shares of preferred stock. Our Board of Directors will have the ability, without seeking stockholder approval, to issue additional shares of common stock and/or preferred stock in the future for such consideration as our Board of Directors may consider sufficient. The issuance of additional common stock and/or preferred stock in the future will reduce the proportionate ownership and voting power of our common stock held by existing stockholders. At November 7 , 2008 there were 84,198,491 shares of common stock outstanding, warrants to purchase 4,302,414 shares of common stock, and stock options to purchase 9,326,400 shares of common stock. In addition, we have an authorized reserve of 2,520,321 shares of common stock which we may grant as stock options or other equity awards pursuant to our stock option plans.

Any future issuances of our common stock would similarly dilute the relative ownership interest of our current stockholders, and could also cause the trading price of our common stock to decline.

Shares eligible for future sale by our current stockholders may adversely affect our stock price.

Sales of substantial amounts of common stock, including shares issued upon the exercise of outstanding options and warrants, could adversely affect the prevailing market price of our common stock and could impair our ability to raise capital at that time through the sale of our securities.

Sales of a substantial number of shares of common stock after the date of this prospectus could adversely affect the market price of our common stock and could impair our ability to raise capital through the sale of additional equity securities. As of November 7, 2008 we had 84,198,491 shares of common st ock outstanding.

As of November 7 , 2008, we had warrants outstanding that are exercisable for the purchase of an aggregate of 4,302,414 or shares of our common stock, and outstanding options that are exercisable for the pur chase of an aggregate of 9,326,400 shares of our common stock. If, and to the extent, outstanding options or warrants are exercised, you will experience dilution to your holdings. In addition, shares issuable upon exercise of our outstanding warrants and stock options may be immediately sold pursuant to an effective registration statement. If a warrant or option holder exercises a warrant or an option at an exercise price that is less than the prevailing market value of our common stock, the holder may be motivated to immediately sell the resulting shares to realize an immediate gain, which could cause the trading price of our common stock to decline.

In connection with our acquisition of the Netintact entities in 2006, we entered into a lock-up agreement with the former Netintact shareholders under which they agreed not to sell the approximately 19,000,000 shares of our common stock that were issued to them as consideration for the acquisition or issuable upon exercise of warrants issued in connection with the acquisition. One- third of the shares and shares issuable on exercise of warrants were released from the lock-up on the first year anniversaries of the acquisitions, on August 18, 2007 and September 29, 2007. An additional third, totaling appr oximately 6,333,333 shares, was released on the second anniversaries of the acquisitions, with 6,040,000 shares being released on August 18, 2008 and 293,333 shares being released on September 29, 2008. The balance of the shares will be released on the third year anniversaries of the acquisitions, with 6,040,000 shares being released on August 18, 2009 and 293,333 shares being released on September 29, 2009. Once released from lock-up, the shares are freely tradable and may generally be sold without restriction, which could cause the trading price of our common stock to decline.

The American Stock Exchange may delist our securities, which could limit investors' ability to transact in our securities and subject us to additional trading restrictions.

Our shares of common stock are listed on the American Stock Exchange. Maintaining our listing on the American Stock Exchange requires that we fulfill certain continuing listing standards including maintaining a trading price for our common stock that the American Stock Exchange does not consider unduly low and adhering to specified corporate governance requirements. If the American Stock Exchange delists our securities from trading, we could face significant consequences, including:

Index

a limited availability for market quotations for our securities;

reduced liquidity with respect to our securities;

a determination that our ordinary share is a "penny stock," which will require brokers trading in our ordinary shares to adhere to more stringent rules and possibly result in a reduced level of trading activity in the secondary trading market for our ordinary shares;

a limited amount of news and analyst coverage for our company; and

a decreased ability to issue additional securities or obtain additional financing in the future.

In addition, we would no longer be subject to American Stock Exchange rules, including rules requiring us to have a certain number of independent directors and to meet other corporate governance standards. Our failure to be listed on the American Stock Exchange or another established securities market would have a material adverse effect on the value of your investment in us.

If our common stock is not listed on the American Stock Exchange or another national exchange, the trading price of our common stock is below $5.00 per share and we have net tangible assets of $5,000,000 or less, the open-market trading of our common stock will be subject to the "penny stock" rules promulgated under the Securities Exchange Act of 1934. If our shares become subject to the "penny stock" rules, broker-dealers may find it difficult to effectuate customer transactions and trading activity in our securities may be adversely affected. Under these rules, broker-dealers who recommend such securities to persons other than institutional accredited investors must:

make a special written suitability determination for the purchaser;

receive the purchaser's written agreement to the transaction prior to sale;

provide the purchaser with risk disclosure documents which identify certain risks associated with investing in "penny stocks" and which describe the market for these "penny stocks" as well as a purchaser's legal remedies; and

obtain a signed and dated acknowledgment from the purchaser demonstrating that the purchaser has actually received the required risk disclosure document before a transaction in a "penny stock" can be completed.

As a result of these requirements, the market price of our securities may be depressed, and you may find it more difficult to sell our securities.

Nevada law and our articles of incorporation and bylaws contain provisions that may discourage, delay or prevent a change in our management team that our stockholders may consider favorable or otherwise have the potential to impact our stockholders' ability to control our company.

Nevada law and our articles of incorporation and bylaws contain provisions that may have the effect of preserving our current management or may impact our stockholders' ability to control our company, such as:

authorizing the issuance of "blank check" preferred stock without any need for action by stockholders;

eliminating the ability of stockholders to call special meetings of stockholders;

restricting the ability of stockholders to take action by written consent; and

establishing advance notice requirements for nominations for election to the Board of Directors or for proposing matters that can be acted on by stockholders at stockholder meetings.

These provisions could allow our Board of Directors to affect your rights as a stockholder since our Board of Directors can make it more difficult for common stockholders to replace members of the Board. Because our Board of Directors is responsible for appointing the members of our management team, these provisions could in turn affect any attempt to replace our current management team. In addition, the issuance of preferred stock could make it more difficult for a third party to acquire us and may impact the rights of common stockholders. All of the foregoing could adversely affect your rights as a stockholder of our company and/or prevailing market prices for our common stock.

To date, we have not paid any cash dividends and no cash dividends will be paid in the foreseeable future.

Index

We do not anticipate paying cash dividends on our common stock in the foreseeable future, and we cannot assure an investor that funds will be legally available to pay dividends, or that, even if the funds are legally available, the dividends will be paid.

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds.

On July 14, 2008, we issued 15,000 unregistered shares of our common stock to a warrant holder upon the cash exercise of the warrant by the holder at a per share exercise price of $0.68, for net proceeds to us of $10,200.

On August 16, 2008, we completed the sale of 5,244,666 shares of our restricted common stock for the prices between $1.10 and $1.17 per share for a total of $5,828,962 to institutional and accredited investors. Placement agents received a total of 17,759 warrants at a per share price of $1.75 and cash compensation of $48,837.

On August 25, 2008, the company issued 490,000 shares of our common stock for inventor relations services to be performed during the next year with a fair value of $686,000

On September 10, 2008, a warrant holder exercised their warrant rights to acquire 86,538 shares of our common stock in a cashless exchange for 125,000 warrant rights.

On September 30, 2008, the company issued 17,241 shares of our common stock for services performed with a fair value of $50,000.

For each of the foregoing issuances, we relied on the exemption provided by Section 4(2) of the Securities Act of 1933 as amended.

Item 3.

Defaults Upon Senior Securities.

Not applicable.

Item 4.

Submission of Matters to a Vote of Security Holders.

None

Item 5.

Other Information.

On November 4, 2008, Procera entered into an amendment to its separation and consulting agreement with David Stepner dated September 12, 2008. The September 12, 2008 agreement incorrectly stated that as of his separation date from Procera, Dr. Stepner was vested as to 150,000 shares of a 300,000 share restricted stock award, when in fact Dr. Stepner had not yet vested in any of these shares. The amendment corrects this misstatement and provides for the continued vesting of the 300,000 unvested shares during Dr. Stepner's consulting period with Procera, with all 300,000 of such shares vesting in full on November 7, 2008.

Item 6.

Exhibits

3.1		Articles of Incorporation filed on July 10 2001 included as Exhibit 3.1 to our form SB-2 filed on February 11, 2002 and incorporated herein by reference.

3.2		Certificate of Amendment to Articles of Incorporation filed on October 12, 2005 included as Exhibit 99.1 to our form 8-K filed on October 13, 2005 and incorporated herein by reference.

3.3		Certificate of Amendment to Articles of Incorpo ration filed on April 28, 2008 included as Exhibit 3.3 to our form 10-Q filed on May 12, 2008 and incorporated herein by reference.

3.4		Amended and Restated Byl aws adopted on August 16, 2007 included as Exhibit 3.4 to our form 10-Q filed on May 12, 2008 and incorporated herein by reference.

4.1		Form of Subscription Agreement for July 2007 offering included as Exhibit 10.1 to our form 8-K filed on July 19, 2007 and incorporated herein by reference.

4.2		Form of Registration Rights Agreement for July 2007 offering included as Exhibit 10.2 to our form 8-K filed on July 19, 2007 and incorporated herein by reference.

4.3		Form of Warrant Agreement for July 2007 offering included as Exhibit 4.3 to our form SB-2 filed on October 5, 2007 and incorporated herein by reference.

4.4		Form of Subscription Agreement for November 2006 offering included as Exhibit 2.1 to our form 8-K filed on December 5 , 2006 and incorporated herein by reference.

4.5		Form of Registration Rights Agreement for November 2006 offering included as Exhibit 2.3 to our form 8-K filed on December 5 , 2006 and incorporated herein by reference.

4.6		Form of Warrant agreement for November 2006 offering included as Exhibit 2.2 to our form 8-K filed on December 5 , 2006 and incorporated herein by reference.

4.7		Form of Subscription Agreement for February 2006 offering included as Exhibit 10.1 to our form 8-K filed on March 1, 2006 and incorporated herein by reference.

Index

4.8		Form of Amendment to Stock Subscription Agreement for February 2006 offering included as Exhibit 10.2 to our form 8-K filed on March 1, 2006 and incorporated herein by reference.

4.9		Form of Registration Rights Agreement for February 2006 offering included as Exhibit 10.4 to our form 8-K filed on March 1, 2006 and incorporated herein by reference.

4.10		Form of Subscription Agreement for December 2004 offering included as Exhibit 10.1 to our form 8-K filed on January 4, 2005 and incorporated herein by reference.

4.11		Form of Registration Rights Agreement for December 2004 offering included as Exhibit 10.2 to our form 8-K filed on January 4, 2005 and incorporated herein by reference.

4.12		Form of Warrant agreement for December 2004 offering included as Exhibit 10.3 to our form 8-K filed on January 4, 2005 and incorporated herein by reference.

4.13		Form of Warrant Agreement for December 2004 offering included as Exhibit 10.4 to our form 8-K filed on January 4, 2005 and incorporated herein by reference.

4.14		Form of Subscription Agreement for June 2003 offering included as Exhibit 4.13 to our form SB-2 filed on October 5, 2007 and incorporated herein by reference.

4.15		Form of Registration Rights Agreement for June 2003 offering included as Exhibit 4.14 to our form SB-2 filed on October 5, 2007 and incorporated herein by reference.

4.16		Form of Warrant Agreement for June 2003 offering included as Exhibit 4.15 to our form SB-2 filed on October 5, 2007 and incorporated herein by reference.

4.17		Form of Subscription Agreement for September 2008 offering included as Exhibit 10.1 to our form 8-K filed on August 28, 2008 and incorporated herein by reference.

4.18		Amendment No. 1 to Subscription Agreement by and between the Company and Thomas A Saponas entered into as of September 12, 2008 included as Exhibit 10.2 to our form 8-K/A filed on September 17, 2008 and incorporated herein by reference.

10.1		Separation and Consulting Agreement by and between the Company and David E. Stepner entered into as of September 12, 2008*

10.2		Amendment to Separation and Consulting Agreement by and between the Company and David E. Stepner entered into as of November 4, 2008.*

Index

31.1		Certification of James F. Brear, Principal Executive Officer, pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities and Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*

31.2		Certification of Thomas H. Williams, Principal Financial Officer, pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities and Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*

32.1		Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, executed by James F. Brear, Principal Executive Officer, and Thomas H. Williams, Principal Financial Officer.*

____________

*	Filed concurrently herewith.

Index

SIGNATURES

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


	Procera Networks, Inc.

	By:	/s/ Thomas H. Williams
Date: November 12 , 2008		Thomas H. Williams, Chief Financial Officer
		(Principal Financial Officer)

Index

Exhibit Index

3.1		Articles of Incorporation filed on July 16, 2001 included as Exhibit 3.1 to our form SB-2 filed on February 11, 2002 and incorporated herein by reference.

3.2		Certificate of Amendment to Articles of Incorporation filed on October 12, 2005 included as Exhibit 99.1 to our form 8-K filed on October 13, 2005 and incorporated herein by reference.

3.3		Certificate of Amendment to Articles of Incorporation filed on April 28, 2008 i ncluded as Exhibit 3.3 to our form 10-Q filed on May 12, 2008 and incorporated herein by reference.

3.4		Amended and Restated Bylaws adopted on August 16, 2007 i ncluded as Exhibit 3.4 to our form 10-Q filed on May 12, 2008 and incorporated herein by reference.

4.1		Form of Subscription Agreement for July 2007 offering included as Exhibit 10.1 to our form 8-K filed on July 19, 2007 and incorporated herein by reference.

4.2		Form of Registration Rights Agreement for July 2007 offering included as Exhibit 10.2 to our form 8-K filed on July 19, 2007 and incorporated herein by reference.

4.3		Form of Warrant Agreement for July 2007 offering included as Exhibit 4.3 to our form SB-2 filed on October 5, 2007 and incorporated herein by reference.

4.4		Form of Subscription Agreement for November 2006 offering included as Exhibit 2.1 to our form 8-K filed on December 5 , 2006 and incorporated herein by reference.

4.5		Form of Registration Rights Agreement for November 2006 offering included as Exhibit 2.3 to our form 8-K filed on December 5 , 2006 and incorporated herein by reference.

4.6		Form of Warrant agreement for November 2006 offering included as Exhibit 2.2 to our form 8-K filed on December 5 , 2006 and incorporated herein by reference.

4.7		Form of Subscription Agreement for February 2006 offering included as Exhibit 10.1 to our form 8-K filed on March 1, 2006 and incorporated herein by reference.

4.8		Form of Amendment to Stock Subscription Agreement for February 2006 offering included as Exhibit 10.2 to our form 8-K filed on March 1, 2006 and incorporated herein by reference.

4.9		Form of Registration Rights Agreement for February 2006 offering included as Exhibit 10.4 to our form 8-K filed on March 1, 2006 and incorporated herein by reference.

4.10		Form of Subscription Agreement for December 2004 offering included as Exhibit 10.1 to our form 8-K filed on January 4, 2005 and incorporated herein by reference.

4.11		Form of Registration Rights Agreement for December 2004 offering included as Exhibit 10.2 to our form 8-K filed on January 4, 2005 and incorporated herein by reference.

4.12		Form of Warrant agreement for December 2004 offering included as Exhibit 10.3 to our form 8-K filed on January 4, 2005 and incorporated herein by reference.

4.13		Form of Warrant Agreement for December 2004 offering included as Exhibit 10.4 to our form 8-K filed on January 4, 2005 and incorporated herein by reference.

4.14		Form of Subscription Agreement for June 2003 offering included as Exhibit 4.13 to our form SB-2 filed on October 5, 2007 and incorporated herein by reference.

4.15		Form of Registration Rights Agreement for June 2003 offering included as Exhibit 4.14 to our form SB-2 filed on October 5, 2007 and incorporated herein by reference.

4.16		Form of Warrant Agreement for June 2003 offering included as Exhibit 4.15 to our form SB-2 filed on October 5, 2007 and incorporated herein by reference.

4.17		Form of Subscription Agreement for September 2008 offering included as Exhibit 10.1 to our for 8-K filed on August 28, 2008 and incorporated herein by reference.

4.18		Amendment No. 1 to Subscription Agreement by and between the Company and Thomas A Saponas entered into as of September 12, 2008 included as Exhibit 10.2 to our for 8-K/A filed on September 17, 2008 and incorporated herein by reference.

10.1		Separation and Consulting Agreement by and between the Company and David E. Stepner entered into as of September 12, 2008.*

10.2		Amendment to Separation and Consulting Agreement by and between the Company and David E. Stepner entered into as of November 4, 2008.*

31.1		Certification of James F. Brear, Principal Executive Officer, pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities and Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*

31.2		Certification of Thomas H. Williams, Principal Financial Officer, pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities and Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*

32.1		Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, executed by James F. Brear, Principal Executive Officer, and Thomas H. Williams, Principal Financial Officer.*