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 December 31, 2005

OR

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

Commission File Number 1-14007

SONIC FOUNDRY, INC.

(Exact name of registrant as specified in its charter)

MARYLAND	39-1783372
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

222 West Washington Ave, Suite 775, Madison, WI 53703

(Address of principal executive offices)

(608) 443-1600

(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  x    No  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

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

State the number of shares outstanding of each of the issuer’s common equity as of the last practicable date:

Class	Outstanding February 2, 2006
Common Stock, $0.01 par value	31,739,023

TABLE OF CONTENTS

		PAGE NO.
PART I	FINANCIAL INFORMATION
Item 1.	Consolidated Financial Statements
	Consolidated Balance Sheets (Unaudited) – December 31, 2005 and September 30, 2005	3
	Consolidated Statements of Operations (Unaudited) – Three months ended December 31, 2005 and 2004	4
	Consolidated Statements of Cash Flows (Unaudited) – Three months ended December 31, 2005 and 2004	5
	Notes to Consolidated Financial Statements (Unaudited)	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	11
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	16
Item 4.	Controls and Procedures	16
PART II	OTHER INFORMATION
Item 6.	Exhibits and Reports on Form 8-K	17

2

Sonic Foundry, Inc.

Consolidated Balance Sheets

(in thousands except for share data)

(Unaudited)

	December 31, 2005			September 30, 2005
Assets
Current assets:
Cash and cash equivalents	$	3,417		$	4,271
Accounts receivable, net of allowances of $115		1,656			2,232
Inventories		598			414
Prepaid expenses and other current assets		231			363
Total current assets		5,902			7,280
Property and equipment:
Leasehold improvements		185			185
Computer equipment		1,734			1,570
Furniture and fixtures		185			185
Total property and equipment		2,104			1,940
Less accumulated depreciation		1,017			933
Net property and equipment		1,087			1,007
Other assets:
Goodwill and other intangibles, net		7,613			7,626
Capitalized software development costs, net of amortization of $1,136 and $1,067		263			332
Total other assets		7,876			7,958
Total assets	$	14,865		$	16,245
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable	$	882		$	1,323
Accrued liabilities		441			780
Unearned revenue		1,100			957
Current portion of capital lease obligation		14			15
Total current liabilities		2,437			3,075
Long-term portion of capital lease		26			28
Other liabilities		19			21
Total liabilities		2,482			3,124
Stockholders’ equity:
Preferred stock, $.01 par value, authorized 5,000,000 shares; none issued and outstanding		—			—
5% preferred stock, Series B, voting, cumulative, convertible, $.01 par value (liquidation preference at par), authorized 10,000,000 shares, none issued and outstanding		—			—
Common stock, $.01 par value, authorized 100,000,000 shares; 31,666,827 and 30,910,409 issued and 31,596,577 and 30,840,159 outstanding at December 31, 2005 and September 30, 2005, respectively		316			309
Additional paid-in capital		170,950			170,083
Accumulated deficit		(158,689	)		(157,077	)
Receivable for common stock issued		(26	)		(26	)
Treasury stock, at cost, 70,250 shares		(168	)		(168	)
Total stockholders’ equity		12,383			13,121
Total liabilities and stockholders’ equity	$	14,865		$	16,245

See accompanying notes

3

Sonic Foundry, Inc.

Statements of Operations

(in thousands except for per share data)

(Unaudited)

	Three Months Ended December 31,
	2005			2004
Continuing Operations
Revenue:
Product sales	$	1,346		$	1,339
Customer support fees		415			189
Other		111			63
Total revenue		1,872			1,591
Cost of revenue		560			536
Gross margin		1,312			1,055
Operating expenses:
Selling and marketing expenses		1,718			1,231
General and administrative expenses		696			815
Product development expenses		534			455
Total operating expenses		2,948			2,501
Loss from operations		(1,636	)		(1,446	)
Other income, net		24			46
Net loss	$	(1,612	)	$	(1,400	)
Net loss per common share:
– basic and diluted	$	(0.05	)	$	(0.05	)
Weighted average common shares
– basic and diluted		31,275,301			29,966,335

See accompanying notes

4

Sonic Foundry, Inc.

Consolidated Statements of Cash Flows

(in thousands)

(Unaudited)

	Three months ended December 31,
	2005			2004
Operating activities
Net loss	$	(1,612	)	$	(1,400	)
Adjustments to reconcile net loss to net cash used in operating activities:
Amortization of goodwill, other intangibles, and capitalized software development costs		82			82
Depreciation and amortization of property and equipment		84			74
Non-cash compensation charges and charges for stock warrants and options		199			150
Changes in operating assets and liabilities:
Accounts receivable, net		576			45
Inventories		(184	)		(20	)
Prepaid expenses and other current assets		82			48
Accounts payable and accrued liabilities		(780	)		(405	)
Other long-term liabilities		(2	)		—
Unearned revenue		143			(6	)
Total adjustments		202			(33	)
Net cash used in operating activities		(1,412	)		(1,432	)
Investing activities
Purchases of property and equipment		(164	)		(21	)
Net cash used in investing activities		(164	)		(21	)
Financing activities
Proceeds from issuance of common stock, net of issuance costs		725			235
Payments on capital leases		(3	)		—
Net cash provided by financing activities		722			235
Net decrease in cash		(854	)		(1,218	)
Cash and cash equivalents at beginning of period		4,271			7,583
Cash and cash equivalents at end of period	$	3,417		$	6,365

See accompanying notes

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1. Basis of Presentation and Significant Accounting Policies

Sonic Foundry, Inc. (the Company) is in the business of developing automated rich media application software and systems (our “Rich Media” business). Our current operations were formed in October 2001 when we acquired the assets and assumed certain liabilities of Mediasite, Inc.

Interim Financial Data

The accompanying financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States (“GAAP”) for complete financial statements and should be read in conjunction with the Company’s annual report filed on Form 10-K for the fiscal year ended September 30, 2005. In the opinion of management, all adjustments (consisting only of adjustments of a normal and recurring nature) considered necessary for a fair presentation of the results of operations have been included. Operating results for the three-month period ended December 31, 2005 are not necessarily indicative of the results that might be expected for the year ended September 30, 2006.

Revenue Recognition

General

Revenue is recognized when persuasive evidence of an arrangement exists, delivery occurs or services are rendered, the sales price is fixed or determinable and collectibility is reasonably assured. Revenue is deferred when undelivered products or services are essential to the functionality of delivered products, customer acceptance is uncertain, significant obligations remain, or the fair value of undelivered elements is unknown. The Company does not offer customers the right to return product, other than for warranty repairs, and does not offer price protection, rebates and other offerings that occur under sales programs and, accordingly, does not reduce revenue for such programs. The following policies apply to the Company’s major categories of revenue transactions.

Products

Products are considered delivered, and revenue is recognized, when title and risk of loss have been transferred to the customer. Under the terms and conditions of the sale, this occurs at the time of shipment to the customer. Product revenue currently represents sales of our Mediasite product and Mediasite related products such as server software revenue but excludes revenue generated from customer support services, which is included in customer support fees discussed below.

Customer Support Fees

We sell support contracts to our Mediasite customers, typically one year in length and record the related revenue ratably over the contractual period. Our support contracts cover phone and electronic technical support availability over and above the level provided by our distributors, software upgrades, advance replacement and an extension of the standard hardware warranty from 90 days to one year. The manufacturer we contract with to build the units performs hardware warranty service. We also sell installation and training services and host customer Mediasite content. Revenue for those services is recognized when performed in the case of installation and training services and is recognized ratably over the contract period for hosting services. Service amounts invoiced to customers in excess of revenue recognized are recorded as deferred revenue until the revenue recognition criteria are met.

Other

Other revenue consists of software licensing of our Publisher product, custom software development performed under time and materials or fixed fee arrangements and amounts charged for shipping and handling. Software licensing is recorded when persuasive evidence of an arrangement exists, delivery occurs, the sales price is fixed or determinable and collectibility is reasonably assured. Custom software development includes fees recorded pursuant

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to long-term contracts (including research grants), using the percentage of completion method of accounting, when significant customization or modification of a product is required. Shipping and handling is recorded at the time of shipment to the customer.

Revenue Arrangements that Include Multiple Elements

Revenue for transactions that include multiple elements such as hardware, software, training, support or content hosting agreements is allocated to each element based on its relative fair value and recognized for each element when the revenue recognition criteria have been met for such element. Fair value is generally determined based on the price charged when the element is sold separately. In the absence of fair value of a delivered element, revenue is allocated first to the fair value of the undelivered elements and the residual revenue to the delivered elements. The Company recognizes revenue for delivered elements only when all of the following criteria are satisfied: undelivered elements are not essential to the functionality of delivered elements, uncertainties regarding customer acceptance are resolved, and the fair value for all undelivered elements is known.

Shipping and Handling

Costs related to shipping and handling is included in cost of revenue for all periods presented.

Credit Evaluation and Customer Concentration

We perform ongoing credit evaluations of our customers’ financial condition and generally do not require collateral. We maintain allowances for potential credit losses and such losses have been within our expectations.

Cash and Cash Equivalents

For the purposes of the balance sheet and statement of cash flows, the Company considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents.

Inventory Valuation

Inventory consists of raw materials and supplies used in the assembly of Mediasite units, work-in-process and finished Mediasite units. Inventory of completed Mediasite units and spare parts are carried at the lower of cost or market, with cost determined on a first-in, first-out basis.

Inventory consists of the following (in thousands):

	12/31/05		9/30/05
Raw materials and supplies	$	10	$	10
Work in process		24		38
Finished goods		564		366
	$	598	$	414

Stock Based Compensation

The Company maintains an employee qualified stock option plan under which the Company may grant options to acquire up to 7.0 million shares of common stock. The Company also maintains a non-qualified plan under which 3.8 million shares of common stock can be issued and a directors’ stock option plan under which 900 thousand shares of common stock may be issued to non-employee directors. Each non-employee director, who is re-elected or who is continuing as a member of the board of directors on the annual meeting date and on each subsequent meeting of stockholders, is granted options to purchase 20 thousand shares of common stock.

Each option entitles the holder to purchase one share of common stock at the specified option price. The exercise price of each option granted under the plans was set at the market price of the Company’s common stock at the respective grant date. Options vest at various intervals and expire at the earlier of termination of employment, discontinuance of service on the board of directors, ten years from the grant date or at such times as are set by the Company at the date of grant.

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Effective October 1, 2005, the Company adopted the provisions of Statement of Financial Accounting Standard No. 123R, “Share-Based Payment – an Amendment of FASB Statement Nos. 123 and 95”, (“SFAS 123R”) for its stock option plans. The Company previously accounted for these plans under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, (“APB 25”) and related interpretations and disclosure requirements established by Statement of Financial Accounting Standard No. 123, Accounting for Stock-Based Compensation, (“SFAS 123”), as amended by Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure.

The Company adopted SFAS 123R using the modified prospective method. Under this transition method, compensation cost recognized in the first quarter of fiscal year 2006 includes the cost for all stock options granted prior to, but not yet vested as of October 1, 2005. This cost was based on the grant-date fair value estimated in accordance with the original provisions of SFAS 123. The cost for all share-based awards granted subsequent to September 30, 2005, represents the grant-date fair value that was estimated in accordance with the provisions of SFAS 123R. Results for prior periods have not been restated. Compensation cost for options will be recognized in earnings, net of estimated forfeitures, on a straight-line basis over the requisite service period. There were no capitalized stock-based compensation costs at December 31, 2005. Stock-based compensation expense in the table below does not reflect any income tax effect, which is consistent with the Company’s treatment of net operating loss carry forwards and offsetting valuation allowance.

Upon the adoption of SFAS 123R, the Company changed its option valuation model from the Black-Scholes model to a lattice valuation model for all stock options granted subsequent to September 30, 2005. The lattice valuation model is a more flexible analysis to value employee options because of its ability to incorporate inputs that change over time, such as actual exercise behavior of option holders. The Company used historical data to estimate the option exercise and employee departure behavior used in the lattice valuation model. Expected volatility is based on historical volatility of the Company’s stock. The Company uses historical data to estimate option exercise and employee termination within the valuation model. The Company considers all employees to have similar exercise behavior and therefore has not identified separate homogenous groups for valuation. The expected term of options granted is derived from the output of the option pricing model and represents the period of time that options granted are expected to be outstanding. The risk-free rate for periods within the contractual term of the options is based on the U.S. Treasury yields in effect at the time of grant.

The fair value of each option grant is estimated using the assumptions in the following table:

	Three months ended December 31,
	2005	2004
Method	Lattice	Black-Scholes
Expected life (years)	4.9 years	3 years
Risk-free interest rate	4.46%	3.08%
Expected volatility	70.83%	97.85%
Expected Dividend yield	0%	0%

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The following table illustrates the effect on net income and earnings per share as if the Company had applied the fair-value recognition provisions of SFAS 123 to stock option plans for the three months ended December 31, 2004 and is presented for purposes of this pro forma disclosure.

(in thousands)	Three months ended December 31, 2004
Net loss as reported	$	(1,400	)
Stock-based compensation expense determined under fair value based method for options		(147	)
Pro forma net loss	$	(1,547	)
Pro forma net loss per share – basic and diluted	$	(0.05	)

The value of the options is estimated using a Black Scholes option-pricing method and amortized to expense over the options vesting period. A summary of option activity as of December 31, 2005 and changes during the three months then ended is presented below (in thousands, except per share data):

Options	Shares		Weighted- Average Exercise Price		Weighted- Average Remaining Contractual Period	Aggregate Intrinsic Value
Outstanding October 1, 2005	4,587,764		$	2.28	6.4	$	318,109
Granted	346,000			1.15	9.9		4,700
Exercised	(9,000	)		1.09	4.9		0
Forfeited	(374,333	)		3.22	5.5		0
Outstanding December 31, 2005	4,550,431		$	2.12	6.7	$	322,809

A summary of the status of the Company’s non-vested shares as of December 31, 2005 and changes during the three months then ended is presented below:

Non-vested Shares	Shares		Weighted-Average Grant Date Fair Value
Non-vested at October 1, 2005	1,006,347		$	0.88
Granted	346,000			0.63
Vested	(205,660	)		0.57
Forfeited	(1,000	)		0.66
	1,145,687		$	0.86

As of December 31, 2005, there was $564 thousand of total unrecognized compensation cost related to non-vested share-based compensation, including $51 thousand of estimated forfeitures.

Stock-based compensation recorded in the three month period ended December 31, 2005 of $182 thousand was allocated $111 thousand to selling and marketing expenses, $29 thousand to general and administrative expenses and $42 thousand to product development expenses. Cash received from Option exercises under all stock option plans for the three months ended December 31, 2005 and 2004 was $10 thousand and $169 thousand, respectively. There were no tax benefits realized for tax deductions from Option exercises for the three months ended December 31, 2005 and 2004, respectively. The Company currently expects to satisfy share-based awards with registered shares available to be issued.

9

Per share computation

The numerator for the calculation of basic and diluted earnings per share is net loss. The following table sets forth the computation of basic and diluted loss per share:

	Three months ended December 31,
	2005	2004
Denominator
Denominator for basic and diluted loss per share – weighted average common shares	31,275,301	29,966,335
Securities outstanding during each year, but not included in the computation of diluted earnings per share because they are antidilutive:
Options and warrants	5,820,571	6,434,384

Accounting Pronouncements

In November 2004, the FASB issued SFAS Statement No. 151, “Inventory Costs – an amendment of ARB No. 43” (“SFAS 151”), which is the result of its efforts to converge U.S. accounting standards for inventories with International Accounting Standards. SFAS No. 151 requires idle facility expenses, freight, handling costs, and wasted material (spoilage) costs to be recognized as current-period charges. It also requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS No. 151 will be effective for inventory costs incurred during fiscal years beginning after June 15, 2005. We are evaluating the impact of this standard on our financial statements. The Company does not expect that the adoption of SFAS 151 will have a material impact on the company’s financial position, results of operations or cash flows.

The Company does not expect that the adoption of other recent accounting pronouncements will have a material impact on its financial statements.

2. Related Party Transactions

During the three month period ended December 31, 2004, the Company recorded Mediasite product and customer support revenue related to $99 thousand of billings to MSKK, a Japanese reseller in which the Company has an equity interest. No billings were recorded during the three months ended December 31, 2005.

3. Purchase Commitments

The Company enters into unconditional purchase commitments on a regular basis for the supply of Mediasite product. Obligations to purchase approximately $890 thousand over the next fiscal quarter remain. This commitment is not recorded on the Company’s Balance Sheet. There are no obligations under this commitment past September 30, 2006. The Company had $1.0 million of purchase commitments as of December 31, 2004.

The Company engaged a manufacturer to build a replacement component for its Mediasite product according to designs proprietary to the Company. The Company had a commitment of approximately $147 thousand to the manufacturer at December 31, 2005 and expects the project to be completed in late fiscal 2006.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Risks and Uncertainties

The following discussion of the consolidated financial position and results of operations of the Company should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere in this form 10-Q and the Company’s annual report filed on form 10-K for the fiscal year ended September 30, 2005. In addition to historical information, this discussion contains forward-looking statements such as statements of the Company’s expectations, plans, objectives and beliefs. These statements use such words as “may,” “will,” “expect,” “anticipate,” “believe,” “plan,” and other similar terminology.

Actual results could differ materially from expectations due to changes in the market acceptance of our products, competition, market introduction or product development delays; all of which would impact our strategy to develop a network of inside regional sales managers and distribution partners that target customer opportunities for multi-unit and repeat purchases. If the Company does not achieve multi-unit and repeat purchases our business will be harmed.

Other factors that may impact actual results include: our ability to effectively integrate acquired businesses, global and local business conditions, legislation and governmental regulations, competition, our ability to effectively maintain and update our product portfolio, shifts in technology, political or economic instability in local markets, and currency and exchange rate fluctuations, as well as other issues which may be identified from time to time in Sonic Foundry’s Securities and Exchange Commission filings and other public announcements.

Overview

Sonic Foundry, Inc. is in the business of developing complete, economical, timesaving and easy-to-use solutions for one-to-many communications (our “Rich Media” business). The Rich Media business was formed in October 2001, when our wholly-owned subsidiary, Sonic Foundry Systems Group, Inc. acquired the assets and assumed certain liabilities of Mediasite, Inc. Our internally developed software code, coupled with our acquired systems technology, includes advanced publishing tools and media access technologies operating across multiple digital delivery platforms to significantly enhance a host of enterprise-based media applications. Our solutions are based on unique technologies that enhance media communications through the extensive use of rich media, defined as a media element that combines graphics, text, video, audio and metadata in a single data file. Our technology evolved from a four-year Carnegie Mellon University research effort funded by major government (DARPA, NSF, NASA) and private organizations (CNN, Intel, Boeing, Microsoft, Motorola, Bell Atlantic). Our core product is the family of Mediasite presentation recorders (“Mediasite”), complete presentation recording systems for live or on-demand viewing over the Internet, intranet or recording to physical media. Related products and services include server software applications and customer support, installation, training and content hosting services.

Critical Accounting Policies

We have identified the following as critical accounting policies to our Company and have discussed the development, selection of estimates and the disclosure regarding them with the audit committee of the board of directors:

• Revenue recognition and allowance for doubtful accounts;

• Impairment of long-lived assets;

• Valuation allowance for net deferred tax assets; and

• Accounting for stock based compensation.

Revenue Recognition and Allowance for Doubtful Accounts

We recognize revenue for product sales and licensing of software products upon shipment, provided that collection is determined to be probable and no significant obligations remain. The Company does not offer rights of return and typically delivers products either to value added resellers based on end-user customer orders or direct to the end user. We

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sell post-contract support (“PCS”) contracts on our Mediasite units. Revenue is recorded separately from the sale of the product and recognized over the life of the support contract using vendor specific objective evidence of the value of the support services. Please refer to Note 1 of our Notes to Consolidated Financial Statements for further information on our revenue recognition policies.

The preparation of our consolidated financial statements also requires us to make estimates regarding the collectability of our accounts receivables. We specifically analyze the age of accounts receivable and historical bad debts, customer concentrations, customer credit-worthiness and current economic trends when evaluating the adequacy of the allowance for doubtful accounts.

Impairment of long-lived assets

We assess the impairment of goodwill and capitalized software development costs on an annual basis or whenever events or changes in circumstances indicate that the fair value of these assets is less than the carrying value. Factors we consider important which could trigger an impairment review include the following:

• poor economic performance relative to historical or projected future operating results;

• significant negative industry, economic or company specific trends;

• changes in the manner of our use of the assets or the plans for our business; and

• loss of key personnel

If we determine that the fair value of goodwill is less than its carrying value, based upon the annual test or the existence of one or more of the above indicators of impairment, we would then measure impairment based on a comparison of the implied fair value of goodwill with the carrying amount of goodwill. To the extent the carrying amount of goodwill is greater than the implied fair value of goodwill, we would record an impairment charge for the difference.

We evaluate all of our long-lived assets, including intangible assets other than goodwill, for impairment in accordance with the provisions of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”. Long-lived assets and intangible assets other than goodwill are evaluated for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable based on expected undiscounted cash flows attributable to that asset. Should events indicate that any of our long-lived assets are impaired; the amount of such impairment will be measured as the difference between the carrying value and the fair value of the impaired asset and recorded in earnings during the period of such impairment.

Valuation allowance for net deferred tax assets

Deferred income taxes are provided for temporary differences between financial reporting and income tax basis of assets and liabilities, and are measured using currently enacted tax rates and laws. Deferred income taxes also arise from the future benefits of net operating loss carryforwards. For the US operations, a valuation allowance equal to 100% of the net deferred tax assets has been recognized due to uncertainty regarding future realization.

Accounting for stock based compensation

The Company adopted SFAS 123R using the modified prospective method. Under this transition method, compensation cost recognized in the first quarter of fiscal year 2006 includes the cost for all stock options granted prior to, but not yet vested as of October 1, 2005. This cost was based on the grant-date fair value estimated in accordance with the original provisions of SFAS 123. The cost for all share-based awards granted subsequent to September 30, 2005, represents the grant-date fair value that was estimated in accordance with the provisions of SFAS 123R. Results for prior periods have not been restated. Compensation cost for options will be recognized in earnings, net of estimated forfeitures, on a straight-line basis over the requisite service period.

Upon the adoption of SFAS 123R, the Company changed its option valuation model from the Black-Scholes model to a lattice valuation model for all stock options granted subsequent to September 30, 2005. The lattice valuation model is a more flexible analysis to value employee Options because of its ability to incorporate inputs

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that change over time, such as actual exercise behavior of Option holders. The Company used historical data to estimate the Option exercise and employee departure behavior used in the lattice valuation model. Expected volatility is based on historical volatility of the Company’s stock. The Company uses historical data to estimate option exercise and employee termination within the valuation model. The Company considers all employees to have similar exercise behavior and therefore has not identified separate homogenous groups for valuation. The expected term of Options granted is derived from the output of the option pricing model and represents the period of time that Options granted are expected to be outstanding. The risk-free rate for periods within the contractual term of the Options is based on the U.S. Treasury yields in effect at the time of grant.

Results of Continuing Operations

Revenue

Revenues from our business include the sales of Mediasite and server software products and related customer support contracts and services, such as content hosting, sold separately as well as fees charged for the licensing of indexing related software and custom software development. We market our products to educational institutions, corporations and government agencies that need to deploy, manage, index and distribute video content on Internet-based networks. We reach both our domestic and international markets through reseller networks, a direct sales effort and partnerships with system Integrators.

Revenues in Q1-2006 totaled $1.9 million compared to Q1-2005 sales of $1.6 million. Sales consisted of the following:

• Product revenue from sale of Mediasite capture units was consistent in both Q1-2005 and Q1-2006 at $1.3 million and reflected an increase in the average selling price due primarily to a decrease in incentive pricing offered to resellers as had historically been made at quarter end and due to an increase in server software license fees included in product revenue. Offsetting the increased revenue associated with an increase in average selling price was a decrease in units shipped.

	Q1-2006	Q1-2005
Units sold	79	92
Mobile to rack ratio	1.8 to 1	0.9 to 1
Average sales price, excluding support (000’s)	$17.1	$14.5
Mediasite gross margins, excluding support	68%	68%

• Customer support revenue represents the portion of fees charged for Mediasite SmartServe service contracts amortized over the length of the contract, typically 12 months, as well as training and installation services. Customer support revenue increased from $189 thousand in Q1-2005 to $415 thousand in Q1-2006, due primarily to support contracts on new Mediasite capture units as well as renewals of support contracts entered into in prior years. At December 31, 2005 $1.1 million of unrecognized support revenues remained in unearned revenues, of which we expect to realize $390 thousand in the upcoming quarter.

• Other revenue relates to freight charges billed separately to our customers and certain custom software engineering projects.

• We expect quarterly revenues to increase significantly through Fiscal 2006.

Gross Margin

Total gross margins for Q1-2006 were $1.3 million or 70% compared to Q1-2005 of $1.1 million or 66%. The significant components of cost of revenue include:

• Material and freight costs for the Mediasite capture units. Costs for Q1-2006 Mediasite material and other costs amounted to $417 thousand, along with $46 thousand of freight and labor costs, resulted in Mediasite gross margins – including support revenue – of 74% compared to $453 thousand and resulting gross margins of 71% in Q1-2005. The gross margin on Mediasite sales varies with product mix; our rack units typically carry a higher margin than our mobile units. Mediasite customer support revenues, server and certain custom engineering software projects do not carry a cost over and above limited royalty fees and staff cost included in operating expenses - - significantly enhancing Mediasite product margins. We expect margins for Fiscal 2006 to be in the low 70’s% range.

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• Amortization of Mediasite acquisition amounts assigned to purchased technology and other identified intangibles effect both periods at approximately $82 thousand per quarter and will continue over the next year for the identified intangibles of the Mediasite purchase.

Operating Expenses

Selling and Marketing Expenses

Selling and marketing expenses include wages and commissions for sales, marketing, business development and technical support personnel, print advertising and various promotional expenses for our products. Timing of these costs may vary greatly depending on introduction of new products and services or entrance into new markets.

Q1-2006 compared to Q1-2005

Selling and marketing expenses increased $487 thousand or 40% from $1.2 million in Q1-2005 to $1.7 million in Q1-2006 resulting from:

• Q1-2006 salary, commissions, bonuses and benefits exceeded Q1-2005 by $191 thousand due to the growth in sales staff.

• Q1-2006 travel, supplies, postage, meeting and allocated expenses increased $160 thousand as a result of an increase in staff.

• Q1-2006 non-cash stock compensation of $111 thousand associated with the adoption of SFAS 123R on October 1, 2005.

As of December 31, 2005 we had 33 employees in Selling and Marketing. We anticipate continued growth in selling and marketing headcount in the remainder of fiscal 2006.

General and Administrative Expenses

General and administrative (“G&A”) expenses consist of personnel and related costs associated with the facilities, finance, legal, human resource and information technology departments, as well as other expenses not fully allocated to functional areas.

Q1-2006 compared to Q1-2005

G&A decreased $119 thousand or 15% from $815 thousand in Q1-2005 to $696 thousand in Q1-2006. Some significant differences between the periods include:

• Professional fees decreased $58 thousand from the prior year due to reduced accounting, legal and consulting costs.

• Salary and benefit expense decreased $42 thousand due in part to allocation of operations staff to cost of revenues.

• Q1-2006 non-cash stock compensation of $29 thousand associated with the adoption of SFAS 123R on October 1, 2005.

As of December 31, 2005 we had 9 full-time employees in G&A. We do not anticipate significant growth in G&A headcount in fiscal 2006.

Product Development Expenses

Product development expenses include salaries and wages of the software research and development staff and an allocation of benefits, facility and administrative expenses. Fluctuations in product development expenses correlate directly to changes in headcount.

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Q1-2006 compared to Q1-2005

R&D expenses increased $79 thousand, or 17% from $455 thousand in Q1-2005 to $534 thousand in Q1-2006. Some significant differences between the periods include:

• Increased salaries and benefits of $38 thousand

• Q1-2006 non-cash stock compensation of $42 thousand associated with the adoption of SFAS 123R on October 1, 2005.

As of December 31, 2005 we had 16 employees in Research and Development. We do not anticipate significant growth in R&D headcount in fiscal 2006. We do not anticipate that any fiscal 2006 software development efforts will qualify for capitalization under SFAS No. 86 “Accounting for the Cost of Computer Software to be Sold, Leased, or Otherwise Marketed.”

Other Income

Other income is primarily interest income. We are currently investing in certificates of deposit and overnight investment vehicles.

Liquidity and Capital Resources

Cash used in operating activities was consistent in Q1-2006 and Q1-2005 at $1.4 million – with a slight decrease of $22 thousand or 2%. Significant differences in Q1-2006 compared to Q1-2005 included greater increases in inventory and deferred revenue, and greater decreases in accounts payable, accrued liabilities, and accounts receivable.

Cash used in investing activities was $164 thousand in Q1-2006 compared to a use of $21 thousand in Q1-2005. Cash used in investing activities was for the purchase of property and equipment.

Cash provided by financing activities was $720 thousand in Q1-2006 compared to cash provided of $235 thousand in Q1-2005. In Q1-2005 we received $235 thousand in option and warrant exercise proceeds compared to the receipt of $725 thousand from the sale of common stock in Q1-2006.

We expect to reach cash flow breakeven during fiscal 2006 and believe we can fund operations with cash on hand through that point. Despite our belief that we have sufficient cash to fund operations in 2006, we believed it was prudent to raise additional cash through the issuance of common stock. In November 2005, we issued 747 thousand shares of common stock and 149 thousand common stock purchase warrants to certain individual investors, and received net proceeds of $725 thousand.

We expect to continue to acquire property and equipment in fiscal 2006 including equipment associated with our anticipated growth in employees, expansion of our services offering and development of a new hardware component in our Mediasite product. We have no plans to pursue any debt arrangements at this time but may evaluate further operating or capital lease opportunities to finance certain equipment acquisitions. In order to fund long-term cash requirements and/or pursue complimentary business strategies, we may evaluate the issuance of additional stock to investors or strategic partners.

The Company entered into an unconditional purchase agreement during the quarter ended December 2006 for supply of Mediasite capture product. Obligations to purchase $890 thousand over the next fiscal quarter remain. This commitment is not recorded on the Company’s Balance Sheet. There are no obligations under this commitment past September 30, 2006. Purchase commitments as of December 31, 2004 totaled $1.0 million.

The Company engaged a manufacturer to build a replacement component for its Mediasite product according to designs proprietary to the Company. The Company had a commitment of approximately $147 thousand to the manufacturer at December 31, 2005 and expects the project to be completed in late fiscal 2006.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Derivative Financial Instruments

The Company is not party to any derivative financial instruments or other financial instruments for which the fair value disclosure would be required under SFAS No. 133, Derivative Financial Instruments, Other Financial Instruments and Derivative Commodity Instruments. The Company’s cash equivalents consist of overnight investments in money market funds that are carried at fair value. Accordingly, we believe that the market risk of such investments is minimal.

Interest Rate Risk

The Company’s cash equivalents are subject to interest rate fluctuations, however, we believe this risk is immaterial due to the short-term nature of these investments.

Foreign Currency Exchange Rate Risk

All international sales of our products are denominated in US dollars.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

Based on evaluations at December 31, 2005, our principal executive officer and principal financial officer, with the participation of our management team, have concluded that our disclosure controls and procedures (as defined in Rules 13a-15 (e) and 15d-15 (e) under the Securities Exchange Act) are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC.

Changes in Internal Controls

During the period covered by this quarterly report on Form 10-Q, the Company has not made any changes to its internal control over financial reporting (as referred to in Paragraph 4(c) of the Certifications of the Company’s principal executive officer and principal financial officer included as exhibits to this report) that have materially affected, or is reasonably likely to affect the Company’s internal control over financial reporting.

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PART II OTHER INFORMATION

ITEM 6. EXHIBITS

NUMBER	DESCRIPTION
3.1	Amended and Restated Articles of Incorporation of the Registrant, filed as Exhibit No. 3.1 to the registration statement on amendment No. 2 to Form SB-2 dated April 3, 1998 (Reg. No. 333-46005) (the “Registration Statement”), and hereby incorporated by reference.
3.2	Amended and Restated By-Laws of the Registrant, filed as Exhibit No. 3.2 to the Registration Statement, and hereby incorporated by reference.
10.1*	Registrant’s 1995 Stock Option Plan, as amended, filed as Exhibit No. 4.1 to the Registration Statement on Form S-8 on September 8, 2000, and hereby incorporated by reference.
10.2*	Registrant’s Non-Employee Directors’ Stock Option Plan, filed as Exhibit No. 10.2 to the Registration Statement, and hereby incorporated by reference.
10.3*	Employment Agreement between Registrant and Rimas Buinevicius dated as of January 1, 2001, filed as Exhibit 10.4 to the Quarterly Report on Form 10-Q for the quarter ended December 31, 2000, and hereby incorporated by reference.
10.4*	Employment Agreement between Registrant and Monty R. Schmidt dated as of January 1, 2001, filed as Exhibit 10.5 to the Quarterly Report on Form 10-Q for the quarter ended December 31, 2000, and hereby incorporated by reference.
10.5*	Registrant’s Amended 1999 Non-Qualified Plan, filed as Exhibit 4.1 to Form S-8 on December 21, 2001, and hereby incorporated by reference.
10.6	Amended and Restated License Agreement effective October 15, 2001 between Carnegie Mellon University and Mediasite, Inc. filed as Exhibit No. 10.31 to the Quarterly Report on Form 10-Q for the quarter ended March 31, 2002, and hereby incorporated by reference.
10.7	Asset Purchase Agreement among Deluxe Media Services, Inc. the Registrant, Sonic Foundry Media Services, Inc. and International Image Services, Inc., dated April 30, 2003 filed as Exhibit 99.2 to Form 8-K filed on May 21, 2003, and hereby incorporated by reference.
10.8	Amended and Restated Asset Purchase Agreement, incorporated by reference from Appendix A of Schedule 14A filed on June 19, 2003 and hereby incorporated by reference.
10.9	Commercial Lease between West Washington Associates LLC and Sonic Foundry, Inc. regarding 222 West Washington Ave., Suite 775, Madison, WI, dated August 1, 2003 filed as Exhibit 10.21 to Form 10-K filed on December 23, 2003 and hereby incorporated by reference.
31.1	Section 302 Certification of Chief Executive Officer
31.2	Section 302 Certification of Chief Financial Officer
32	Section 906 Certification of Chief Executive Officer and Chief Financial Officer

Registrant will furnish upon request to the Securities and Exchange Commission a copy of all exhibits, annexes and schedules attached to each contract referenced in item 10.

* Compensatory Plan or Arrangement

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SIGNATURES

Pursuant to the requirement 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.

	Sonic Foundry, Inc.       (Registrant)
February 13, 2006	By:	/s/ Rimas P. Buinevicius
		Rimas P. Buinevicius
		Chairman and Chief Executive Officer
February 13, 2006	By:	/s/ Kenneth A. Minor
		Kenneth A. Minor
		Chief Financial Officer and Secretary

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EX-31.1

Exhibit 31.1

CERTIFICATIONS

I, Rimas P. Buinevicius, the Chairman and CEO of Sonic Foundry, Inc., certify that:

1. I have reviewed this quarterly report on Form 10-Q of Sonic Foundry, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

c) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: February 13, 2006

By:	/s/ Rimas P. Buinevicius
By:	Rimas P. Buinevicius
Title:	Chairman and CEO

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EX-31.2

Exhibit 31.2

I, Kenneth A. Minor, the CFO and Secretary of Sonic Foundry, Inc., certify that:

1. I have reviewed this quarterly report on Form 10-Q of Sonic Foundry, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

c) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date February 13, 2006

By:	/s/ Kenneth A. Minor
By:	Kenneth A. Minor
Title:	Chief Financial Officer and Secretary

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EX-32

Exhibit 32

SECTION 906 CERTIFICATION OF CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER

Statement

Solely for the purposes of complying with 18 U.S.C.§1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, we, the undersigned Chief Executive Officer and the Chief Financial Officer of Sonic Foundry, Inc. (the “Company”), hereby certify, based on our knowledge, that the Quarterly Report on Form 10-Q of the Company for the quarter ended December 31, 2005 (the “Report”) fully complies with the requirements of Section 13(a) of the Securities Exchange Act of 1934 and that information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

Dated: February 13, 2006

By:	/s/ Rimas P. Buinivicius
By:	Rimas P. Buinivicius
Title:	Chief Executive Officer
By:	/s/ Kenneth A. Minor
By:	Kenneth A. Minor
Title:	Chief Financial Officer

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