10-K

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

x Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the fiscal year ended June 30, 2005

or

¨ 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: 001-31265

AVATECH SOLUTIONS, INC.

(Exact name of registrant as specified in its charter)

DELAWARE	84-1035353
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

10715 Red Run Blvd, Suite 101, Owings Mills, Maryland	21117
(Address of principal executive offices)	(Zip Code)

Registrant’s telephone number, including area code (410) 581-8080

Securities registered pursuant to Section 12(b) of the Act:

Title of Class	Name of Each Exchange on Which Registered
None	None

Securities registered pursuant to Section 12(g) of the Act:

Title of Class

Common Stock, $.01 par value

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statement incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K  x

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 x

The aggregate market value of the voting stock held by non-affiliates of the registrant as of September 23, 2005 was $9,272,577.

The number of shares of common stock outstanding as of September 23, 2005 was 10,908,914.

DOCUMENTS INCORPORATED BY REFERENCE

To the extent specified, Part III of this Form 10-K incorporates information by reference to the Registrant’s definitive proxy statement for its 2005 Annual Meeting of Shareholders (to be filed).

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TABLE OF CONTENTS

PART I		3
ITEM 1.	Business	3
ITEM 2.	Properties	8
ITEM 3.	Legal Proceedings	8
ITEM 4.	Submission of Matters to a Vote of Security Holders	8
PART II		8
ITEM 5.	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	8
ITEM 6.	Selected Financial Data	10
ITEM 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	11
ITEM 7A.	Quantitative and Qualitative Disclosures about Market Risk	23
ITEM 8.	Financial Statements and Supplementary Data	23
ITEM 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosures	23
ITEM 9A.	Controls and Procedures	23
ITEM 9B.	Other Information	23
PART III		24
ITEM 10.	Directors and Executive Officers of the Registrant	24
ITEM 11.	Executive Compensation	24
ITEM 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	24
ITEM 13.	Certain Relationships and Related Transactions	24
ITEM 14.	Principal Accountant Fees and Services	24
PART IV		25
ITEM 15.	Exhibits and Financial Statement Schedules	25

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PART I

ITEM 1. BUSINESS

Background

Avatech Solutions, Inc. was formed as a Delaware corporation on September 9, 1996. During fiscal years 1997 through 1999, the Company consummated business combinations with ten companies that provided design automation software, training, technical support, and professional services to corporations, government agencies, and educational institutions throughout the United States.

In November 2002, Avatech Solutions completed a merger with PlanetCAD, Inc. and became a wholly owned subsidiary of PlanetCAD, Inc., after which PlanetCAD changed its name to Avatech Solutions, Inc. and Avatech changed its name to Avatech Solutions Subsidiary, Inc. As a result of the merger, PlanetCAD’s shareholders retained twenty-five percent of the surviving company and, in exchange for all of the common stock of Avatech Solutions, Inc., Avatech’s shareholders were issued registered shares constituting seventy-five percent of the surviving company’s outstanding common stock. Avatech was deemed to have acquired PlanetCAD because Avatech’s shareholders received the majority of the common stock of the post-merger company. In November 2002, Avatech Solutions, Inc. began trading on the OTC Bulletin Board under the symbol AVSO.OB.

General

The Company is a leader in design and engineering technology solutions with expertise in CAD software, data management, facilities management and process optimization for the manufacturing, engineering, building design and facilities management industries. Avatech specializes in software resale, integration, standards development and deployment, education and technical support, aimed at improving design and documentation efficiencies and the seamless integration of workflow processes. The Company’s sales are to corporations, government agencies, and educational institutions worldwide.

The Company differentiates itself from traditional product resellers through a wide range of value-added services, consisting primarily of training, technical support, and professional services. It also provides software customization, data migration, computer aided design standards consulting, process workflow analysis, and implementation assistance for complex design environments. Its strategic focus is to respond to customers’ requests for interoperability and provide solutions that address broad, enterprise-wide initiatives.

Avatech’s sales and service delivery network consists of approximately 120 employees operating out of sixteen business offices across the United States. The Company has a sales database that has over 180,000 point-of-contact names collected over a sixteen-year time span and an active customer list of approximately 21,000 private firms, federal, state, and local agencies, and colleges and universities.

The Company’s strategy is to continue to grow its core business as an Autodesk reseller, continue to diversify product offerings, increase professional services as a percentage of total revenue, and expand sales of products and services, and its geographic penetration, through acquisitions of companies that fit this strategy, and through the opening of new offices. The Company’s goals for fiscal 2006, if met, will generate positive net income on revenues of $40-45 million, and revenue levels of $100 million by fiscal 2008 through organic growth of existing lines of business and targeted acquisitions.

Avatech has developed a Research and Development team within its professional services group that is charged with the responsibility of developing tools for customers that facilitate workflow processes involving the software products the Company sells, and new products that complement and enhance the features of those software products. This team was instrumental in preparing Proof Positive, a software product the Company acquired as a result of its merger with PlanetCAD, Inc. in 2002, and sold to its major vendor, Autodesk, Inc. in 2005. It is Avatech’s intention to develop similar products for sale to its customers and to third-party software vendors. Consistent with this objective, in April 2005 the Company announced the release of Vault Access, which allows users of Autodesk’s Inventor software to access, view, and print data in Vault, an Autodesk data management software application.

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The Company’s product sales are somewhat cyclic, and increase when the developer of a specific software product offers a new version, promotions or discontinues support of an older product. As is common among software resellers, the Company purchases products from its suppliers with a combination of cash and credit. Avatech does not carry significant inventory, and generally places an order with the supplier only after receiving a firm commitment from its customer and, except in unusual situations, does not allow its customers to return merchandise.

Recent Developments

In January, 2005, Avatech completed the sale to Autodesk, Inc. of all of its ownership interest in Proof Positive, a software product developed by PlanetCAD, Inc, with which it merged in 2002. Net proceeds of the sale were $1.9 million, and are included in revenue for the year ended June 30, 2005.

In February of each year, Avatech enters into a new Channel Partner Agreement with Autodesk, Inc., its major vendor. The agreement dated February 1, 2005 provides significantly enhanced opportunities to increase margins on product sales. The Company is aggressively seeking to maximize all of the opportunities in the new agreement with Autodesk to increase revenue and profitability.

On April 8, 2005, the Company acquired all of the assets, and assumed certain defined liabilities, of Comtrex Corp. Comtrex is an authorized Autodesk reseller with offices in Greensboro, Charlotte, and Morrisville, North Carolina, that had developed a similar strategy by emphasizing service offerings in connection with the sale of Autodesk products. The Company hired 14 employees formerly employed by Comtrex and expects this acquisition to increase revenue by approximately $3 million on an annual basis, and to be accretive to earnings.

On March 31, 2005, Avatech was authorized by Autodesk, Inc. to resell its new product data management application known as ProductStream, and immediately qualified for funding from Autodesk to help fund its investment in new resources, primarily employees and marketing initiatives, to capitalize on this new product offering.

In July 2003, the Company entered into an Authorized Reseller Agreement with Dassault Systèmes to market and distribute Dassault’s SmarTeam PLM products in the United States. In connection with this arrangement, Dassault provided certain financial assistance, including funds to create a dedicated PLM sales force and related marketing efforts. In fiscal year 2005, the Company determined that the resources that it was employing to fulfill the Dassault Reseller Agreement could be better utilized in other areas of its operations in order to achieve its growth targets. Therefore, in July 2005 the Company made the decision to discontinue its relationship with Dassault and restructured the loan that it had received in connection with its agreement with Dassault. Under the amended and restated loan agreement, the maturity of the loan was shortened from July 2013 to July 2007, with amortization of one-half the principal balance, plus accrued interest, over eight quarterly periods, and a balloon payment of the remaining one-half of the principal balance, due with accrued interest, on July 1, 2007. All material affirmative and negative covenants, and a financial covenant, were eliminated. The Company believes this debt restructuring will permit it to expand its business without the need for covenant waivers from this lender in the future.

In July 2005, the Company completed a limited offering of Convertible Preferred Stock (Series E) which raised a total of $1,191,000 for working capital purposes. Investors in this offering will receive an annual dividend of 10%, paid quarterly and were granted certain conversion rights and stock warrants. The number of common shares that would be issued under these conversion rights total 1,832,308 and the warrants, if exercised, would result in 366,475 common shares issued.

Products

Substantially all of Avatech’s business consists of the sale of prepackaged software and associated services to customers in the United States. Sales are focused on the following three major product categories and associated value-added services.

Design Automation. More than 90% of total revenues arise from the resale of design software developed by Autodesk, Inc. (Autodesk) for the building design and land development, manufacturing, utilities, and

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telecommunications industries, and the delivery of related services from the sales of these products. These product sales are primarily packaged software programs installed on a user workstation, on a local area network server, or in a hosted environment. The programs perform and support a wide variety of functions related to design, drafting, manufacturing, workflow automation, and document management activities.

In addition to Autodesk offerings, Avatech also provides other solutions to its design automation customers, such as electronic document management software from Cyco Software, Inc., which provides methodical and organized processes to store, retrieve, manage, and version design files, drawings, and related documents such as customer correspondence, inventory lists, digital images, and other items. The Company also provides a variety of services along with our design automation software sales, to assist our customers in maximizing the benefits from these software applications. These services include training, technical support, and professional services.

Product Lifecycle Management. Product lifecycle management, or PLM, software products help businesses manage the lifecycle of a product, from design through obsolescence, or the lifecycle of information, including design information. Currently, the Company is an authorized reseller of Autodesk’s PLM solution known as “ProductStream” and expects to generate significant revenues in the future from the sale of this and other PLM products and services to its large installed base of customers and prospective customers.

Facilities Management. Physical assets, such as real estate, buildings, equipment, materials, and furniture make up a significant percentage of an organization’s total asset value. These assets are used by many different business units, departments, and individuals, and must be accurately managed in order to extend asset life cycles and keep operating costs at a minimum.

In 2003, the Company entered into an authorized reseller agreement with Archibus, Inc., a world leader in facilities and infrastructure management products, with more than 100,000 enterprise users, and one million web users worldwide, authorizing it to sell Archibus’ FM solution throughout the U.S. Its flagship product, ARCHIBUS/FM, is a powerful suite of integrated applications that creates a single, comprehensive repository of information on an organization’s people, places, processes and physical assets.

Total Infrastructure and Facilities Management (TIFM) solutions enable organizations to make informed strategic and business decisions that optimize return on investment, lower asset life cycle costs, and increase enterprise-wide productivity and profitability. Organizations of all sizes, spanning the financial, educational, governmental, healthcare, and manufacturing industries, use TIFM to deliver timely, relevant facilities information as part of their strategic business plans.

Geographic Information Systems (GIS) software permits users to link together disparate data files (maps, aerial photos, tax records, marketing data, etc.) and provide the user with a unified image and knowledge base of a specific geographic location or building location. When integrated with Internet browsers and document management tools into a facilities management solution, users gain substantial knowledge about their buildings, their neighborhoods, and their documents, providing increased effectiveness and cost containment.

New technology based on powerful desktop computer hardware has enabled software developers to offer products that are easier to use and less expensive than the previous applications, thus expanding the volume of purchases, installation, and level of usage from the traditional civil engineering, utilities, public works, and transportation logistics markets and into the emergency services and Homeland Security segments.

The Company sells, customizes, and implements facilities management solutions through its dedicated salespeople, technical specialists and a network of strategic partners. It also provides GIS database development services to facilities management customers, both through its employees and strategic partners.

Services

Avatech offers training courses in over thirty different subjects related to various software solutions offered at nineteen training facilities and through mobile labs that it can send to a customer site or other off-site facilities. Training is led by 17 employees who serve as class instructors and have formal training or successful industry experience in the topics they teach. The Company also provides training services that are highly tailored to meet the needs of a particular customer, including company-specific operational topics, customized product usage, and other general technology or process training. As part of the training offering, the Company has developed and deployed an

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Internet based assessment tool that allows its clients to test their employees’ knowledge and ability to use the software tools.

The Company provides end-user and corporate technical support services through its National Support Center (NSC) located in Omaha, Nebraska. A staff of five full-time product and technology consultants assists customers calling with questions about product features, functions, usability issues, and configurations. The NSC offers services through multiple access levels including prepaid services, actual elapsed time, and annual support contracts. Customers can communicate with the NSC through e-mail, telephone, and fax channels.

Other professional services include project-focused offerings such as software customization, data migration, computer aided design standards consulting, supplemental staffing for design work, drawing digitization, and symbol library development. Avatech has employed two project managers and four industry specialists who provide professional services to its design automation customers.

Markets and Competition

Design Automation. In the design automation market, Avatech focuses on providing enterprise solutions to small- and medium-sized businesses with under one billion dollars of annual revenue, primarily in the architecture, engineering, and construction (AEC) market and the mechanical design and manufacturing (MDM) market. The AEC market is comprised of design services focused on the construction of large physical assets such as buildings, roads, factories, utility companies, and commercial infrastructure projects. The MDM market is primarily focused on the design, tooling, assembly, and testing of instruments, electronic devices, machines, mechanical devices, and power-driven equipment. The Company also sells prepackaged design automation software to small companies with less than fifty million dollars of annual revenue on an order-fulfillment basis through its call center in Tampa, Florida.

While several local and regional competitors exist in the various geographic territories where the Company conducts business, it has a competitive advantage in terms of geographic reach, comprehensive training and support, and the provision of other products and services and is one of the largest commercial Autodesk resellers in the United States. Two national competitors that could be compared to Avatech in scale, size, geographical reach, and target markets for the resale of Autodesk products are INCAT International, Inc. (INCAT) and RAND A Technology Corporation (RAND).

INCAT is a systems integrator for design automation products with offices located in nine countries and its worldwide headquarters in the United Kingdom. While INCAT is larger than Avatech, the Company estimates that the Autodesk portion of INCAT’s business is less than its Autodesk business. INCAT recently entered into an agreement to be purchased by Tata Motors, a subsidiary of one of the largest conglomerates in India. Avatech cannot yet determine the impact of this transaction on its competitive position with regard to INCAT.

RAND is the largest computer-aided design and engineering technology company worldwide, however the Company believes that its North American Autodesk-related business is larger than that of RAND. It has twenty U.S. offices in the Midwest, Northwest and Florida. RAND operates 104 offices located in twenty-seven countries with its corporate headquarters in Canada.

Product Lifecycle Management. In this market, in which the Company sells Autodesk’s Vault and ProductStream software solutions, they face competition from other Autodesk resellers authorized to sell ProductStream, and face similar competition from local and regional Autodesk resellers in its design automation business.

Facilities Management. The Company provides facilities management solutions to organizations of all sizes, spanning the financial, educational, governmental, healthcare, and manufacturing industries. Its major competitors in facilities management products are CFI, Business Resource Group (“BRG”), and DB Associates. CFI is a privately held company based in Southfield, MI. It provides mainly ARCHIBUS/FM products, as well as consulting services and outsourced staffing, but they are no longer an Autodesk distribution partner. BRG is a privately held company based in Dallas, Texas, whose primary business is the resale of commercial furniture systems. BRG focuses on the ARCHIBUS/FM product line and provides consulting and implementation services and outsourced staffing. DB Associates, parent company of the wholly owned subsidiary, Facilities Resources, Inc. (“FRI”), focuses primarily on furniture management and warehousing services. The Company believes that FRI is

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the largest ARCHIBUS/FM partner by volume. It also believes that its larger employee pool and well-developed customer base give it advantages over these competitors and will contribute to future growth in this market.

Arrangements with Principal Suppliers

Revenues are primarily derived from the resale of vendor software products and services. These sales are made pursuant to channel sales agreements whereby Avatech is granted the authority to purchase and resell the vendor products and services. Under these agreements, the Company either resells software directly to its customers or acts as a sales agent for various vendors and receive commissions for its sales efforts.

The Company enters into an annual Authorized Channel Partner Agreement with Autodesk, Inc. whereby Autodesk appoints it as a non-exclusive partner to market, distribute, and support Autodesk software products. The Company must achieve yearly minimum revenue in the amount of $300,000 from the sale of Autodesk’s software products in order to be eligible to purchase such products directly from Autodesk. For the year ended June 30, 2005, the Company’s revenue from the sale of Autodesk software was approximately $24 million. This agreement authorizes it to sell certain software products to certain customers in specific geographic areas of the United States and there are no clauses in this agreement that limit or restrict the services that it can offer to customers.

Customers

The Company markets its products to private companies, public corporations, government agencies, and educational institutions throughout the United States. In the fiscal year ended June 30, 2005, the revenues generated by our top ten customers represented approximately sixteen percent of consolidated revenues, and no single customer accounted for ten percent or more of our consolidated revenues.

Intellectual Property

The Company regards its technology and other proprietary rights as essential to its business. As such, it relies on copyright, trade secret, confidentiality procedures, contract provisions, and trademark law to protect its technology and intellectual property. Avatech has confidentiality agreements with its consultants and corporate partners and controls access to, and distribution of its products, documentation, and other proprietary information.

Avatech owns several federally registered trademarks, including “AVATECH SOLUTIONS,” and “AVANEWS,” and has other trademark applications pending, but no patents or patent applications pending. There were a number of other trademarks acquired as a result of the merger with PlanetCAD.

This Annual Report contains trademarks and trade names of Avatech Solutions, Inc. and its affiliates as well as those of other companies. All trademarks and trade names appearing in this report are the property of their respective holders.

Employees

At June 30, 2005, the Company had approximately 156 full time employees and two part time employees located in sixteen offices throughout the United States. Approximately 37 of its employees are located its corporate headquarters in Maryland, which also houses a training facility and some sales personnel. None of its employees are represented by collective bargaining agreements, and it has never experienced a work stoppage. The Company believes that its employee relations are good.

Available Information

The Internet website for Avatech Solutions is www.avat.com. The Company makes available free of charge on its website its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports as soon as reasonably practicable after it electronically files with or furnishes such materials to the SEC. The Company’s executive offices are located at 10715 Red Run Blvd, Suite 101, Owings Mills, Maryland 21117 and its telephone number is (410) 581-8080.

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ITEM 2. PROPERTIES

Corporate offices are located in Owings Mills, Maryland where the Company leases approximately 13,430 square feet of office space, pursuant to a lease which expires on July 21, 2011. These facilities house executive and primary administrative offices as well as accounting, order processing operations, IT, sales, and marketing. The Company also leases office space at the following locations:

Location	Square Footage	Term
Colorado—Englewood	5,786	12/31/2008
Colorado—Boulder	3,720	11/1/2007
Connecticut—Meriden	2,679	12/31/2008
Florida—Tampa	4,103	2/28/2009
Iowa—Cedar Rapids	2,525	5/31/2006
Iowa—Des Moines	3,027	7/31/2011
Kentucky—Georgetown	1,297	3/31/2010
Minnesota—St. Paul	2,782	3/31/2007
Nebraska—Omaha	5,473	12/31/2007
North Carolina—Charlotte	3,500	10/31/2006
North Carolina—Greensboro	885	3/31/2006
North Carolina—Morrisville	3,671	6/30/2006
Texas—Irving	6,920	1/31/2008
Virginia—Alexandria	2,800	10/14/2011
Virginia—Richmond	2,250	3/31/2006
Virginia—Virginia Beach	5,887	10/31/2009

Not listed are leases for space that has been vacated if the sublessee’s payments defray, in whole or in substantial part, the Company’s lease payment obligations.

The commercial real estate market is volatile and unpredictable in terms of available space, rental fees, and occupancy rates and preferred locations. The Company cannot be certain that additional space will be available when it is required, or that it will be affordable or in a preferred location.

ITEM 3. LEGAL PROCEEDINGS

From time to time, the Company is involved in legal matters or named as a defendant in legal actions arising from normal operations, or is presented with claims for damages arising out of our actions. Management believes that these matters will not have a material adverse effect on its financial statements.

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

There were no matters submitted to a vote of security holders during the fourth quarter of fiscal year ended June 30, 2005.

PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market Price Data

Prior to Avatech’s merger with PlanetCAD, PlanetCAD’s common stock was listed on the American Stock Exchange under the symbol “PCD”. Since the date of the merger, Avatech’s common stock has been trading on the OTC Bulletin Board under the symbol “AVSO.OB”. The following table indicates the high and low sales prices per share, rounded to the nearest whole cent, as available through the OTC market for all periods presented. The OTC

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quotations represent prices between dealers and do not reflect the retailer markups, markdowns or commissions, and may not represent actual transactions. All prices shown have been restated to reflect the two-for-one stock dividend which was distributed on October 1, 2003 for shareholders of record at September 15, 2003.

Period	High		Low
Fiscal Year Ended June 30, 2004
First Quarter	$	0.34	$	0.10
Second Quarter		1.00		0.17
Third Quarter		0.51		0.21
Fourth Quarter		1.01		0.37
Fiscal Year Ended June 30, 2005
First Quarter	$	0.92	$	0.42
Second Quarter		0.60		0.28
Third Quarter		0.75		0.32
Fourth Quarter		0.70		0.43

Recent Closing Prices

On September 23, 2005, the last closing price for our common stock on the OTC Bulletin Board, as reported by Reuters, was $0.85.

Dividend Information

The Company has never paid cash dividends on its common stock and anticipates that will it continue to retain any earnings for the foreseeable future for use in the expansion and operation of its business.

The Series D Convertible Preferred Stock is eligible for 10% annual, cumulative dividends, payable quarterly, when and as declared by the Board of Directors. These dividends have priority over any declaration or payment of any dividend or other distribution on the Common Stock and all other currently outstanding shares of equity securities. For the year ended June 30, 2005, dividends totaling $77,862 were paid to preferred shareholders.

Number of Stockholders

As of September 23, 2005 there were 258 holders of record of common stock and 16 holders of Series D Convertible Preferred Stock.

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ITEM 6. SELECTED FINANCIAL DATA

The following selected historical annual consolidated financial data is derived from our audited financial statements as of and for the five years ended June 30, 2005. The following consolidated financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes included elsewhere in this Report.

	Year ended June 30,
	2001			2002(2)			2003(1)			2004(1)			2005(3)
Statement of Operations Data:
Revenue:
Product sales	$	18,329,676		$	16,619,444		$	12,369,846		$	17,710,150		$	20,703,025
Service revenues		5,401,091			5,775,045			5,931,623			5,470,360			6,066,242
Commission revenue		3,767,634			4,245,987			4,199,465			4,769,984			5,475,161
Sale of developed software		—			—			—			—			1,900,000
Total revenue		27,498,401			26,640,476			22,500,934			27,950,494			34,144,428
Cost of revenue:
Cost of product sales		12,643,511			11,071,083			8,776,509			12,647,646			13,211,234
Cost of service revenue		3,415,718			3,365,110			3,766,904			4,086,069			4,606,361
Cost of developed software		—			—			—			—			76,853
Total cost of revenue		16,059,229			14,436,193			12,543,413			16,733,715			17,894,448
Gross margin		11,439,172			12,204,283			9,957,521			11,216,779			16,249,980
Other operating expenses:
Selling, general and administrative		10,367,454			11,720,443			12,201,380			11,073,123			13,399,486
Depreciation and amortization		572,430			503,248			411,612			330,926			358,965
Impairment loss		—			284,766			—			—			—
Total other operating expenses		10,939,884			12,508,457			12,612,992			11,404,049			13,758,451
Operating income (loss)		499,288			(304,174	)		(2,655,471	)		(187,269	)		2,491,529
Other non-operating income/(expense):
Gain on the extinguishment of debt		—			—			1,960,646			—			—
Interest and other income (expense)		60,251			48,171			15,642			38,570			106,947
Minority interest		—			—			(94,140	)		(152,500	)		(58,882	)
Interest expense		(553,180	)		(487,230	)		(290,373	)		(351,987	)		(523,737	)
		(492,929	)		(439,059	)		1,591,775			(465,917	)		(475,672	)
Income (loss) from continuing operations before income taxes and cumulative effect of change in accounting principle		6,359			(743,233	)		(1,063,696	)		(653,186	)		2,015,857
Income tax expense (benefit)		7,426			(297,651	)		408,072			29,898			81,780
Income (loss) from continuing operations before cumulative effect of change in accounting principle	$	(1,067	)	$	(445,582	)	$	(1,471,768	)	$	(683,084	)	$	1,934,077
Earnings (loss) from continuing operations per common share — basic	$	(0.00	)	$	(0.07	)	$	(0.18	)	$	(0.08	)	$	0.18
Earnings (loss) from continuing operations per common share — diluted	$	(0.00	)	$	(0.07	)	$	(0.18	)	$	(0.08	)	$	0.14
Weighted average number of common shares outstanding — basic		6,662,568			6,674,979			8,028,030			9,341,785			10,355,150
Weighted average number of common shares outstanding — diluted		6,662,568			6,674,979			8,028,030			9,341,785			13,947,055

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	Year ended June 30
	2001			2002			2003			2004			2005
Balance Sheet Data:
Cash and cash equivalents	$	309,621		$	222,562		$	540,384		$	689,995		$	294,704
Working capital defecit		(3,927,450	)		(1,615,747	)		(3,821,523	)		(2,979,229	)		(1,546,031	)
Total assets		8,377,015			7,108,413			5,271,967			6,566,619			8,219,056
Total debt		6,480,880			5,980,013			2,851,212			4,217,655			5,868,760
Total stockholders’ deficit		(3,424,838	)		(3,737,862	)		(5,974,197	)		(6,388,962	)		(2,702,414	)

(1) In 2003 and 2004, the Company decided to discontinue the operations of PlanetCAD Inc. and close four additional offices located in California, New York, Michigan and Ohio. The results of operations of these operations are treated as discontinued operations and reported as a separate component of operating results in the consolidated statement of operations for all periods presented. A more detailed description of these transactions is provided in Note 4 of the Consolidated Financial Statements.

(2) As of July 1, 2002, the Company adopted Statements of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (“Statement 142”). As a result, goodwill and other intangible assets deemed to have indefinite lives are no longer amortized, but are subject to annual impairment tests. As a result of testing goodwill for impairment upon the adoption of Statement 142, the Company recorded a non-cash impairment charge of $520,000, which is included as a cumulative effect of a change in accounting principle in the 2003 statement of operations. A more detailed description of this transaction is provided in Note 1 of the Consolidated Financial Statements.

(3) In April 2005, the Company acquired the assets and certain liabilities of Comtrex Corporation for aggregate consideration of $573,000. The consolidated financial statements include the results of operations of Comtrex commencing April 8, 2005.

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

THE FOLLOWING DISCUSSION AND ANALYSIS OF THE FINANCIAL CONDITION AND RESULTS OF OPERATIONS SHOULD BE READ IN CONJUNCTION WITH THE CONSOLIDATED FINANCIAL STATEMENTS AND THE RELATED NOTES THERETO INCLUDED ELSEWHERE IN THIS REPORT.

Certain statements set forth below constitute “forward-looking statements”. Such forward-looking statements involve known and unknown risk, uncertainties and other factors including, but not limited to, those discussed in our annual and quarterly reports, that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements implied by such forward-looking statements. These forward-looking statements may generally be identified by the use of the words “may”, “will”, “believe”, “should”, “expect”, “anticipate”, “estimate”, and similar expressions. Given these uncertainties, investors and prospective investors are cautioned not to place undue reliance on such forward-looking statements. We disclaim any obligation to update information contained in any forward-looking statement.

Overview

Avatech is a leading provider of design automation and data management solutions for the manufacturing, building design, engineering, and total infrastructure and facilities management markets. The Company specializes in technical support, training, and consulting aimed at improving design and documentation efficiencies and the seamless integration of workflow processes. These technology solutions enable its customers to enhance productivity, profitability, and competitive position. Avatech is one of the largest Autodesk software integrators worldwide and a leading provider of engineering document management solutions.

The Company has a growth strategy which focuses on new ways of expanding its human resources, product offerings, and geographic presence. This strategy includes-

• focusing on three product groups: Design Automation (DA), Facilities Management (FM), and Data Management (DM);

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• employing highly qualified professionals in specialized areas;

• expanding our product offerings to include various FM and DM software packages, and new, internally-developed proprietary software; and,

• focusing on solutions and services selling.

This strategy was designed to match the Company’s product and service offerings more precisely with the needs of its customers. In July 2003, the Company entered into an Authorized Reseller Agreement with Dassault Systèmes Corp., an international developer and distributor of product life cycle management (PLM) application software and services. In connection with the Reseller Agreement, Dassault provided Avatech with certain financial assistance to create a dedicated PLM sales force and to conduct related marketing efforts. Over the next two years, the Company determined that the resources that it was employing to fulfill the Dassault Reseller Agreement could be better utilized in other areas of its operations in order to achieve its growth targets. Therefore, in July 2005 the Company made the decision to discontinue its relationship with Dassault and restructured the terms of the loan that it had received in connection with its agreement with Dassault.

During fiscal 2003 and 2004, the Company instituted a number of cost containment measures to align its selling, general and administrative expenses with expected revenue levels. These measures included the closing of underperforming offices, terminating approximately 30 employees in June 2003 and the reduction of professional fees, telephone, supplies, marketing, and travel expenses. In addition, Avatech reduced selling, general and administrative expenses related to underperforming offices. In accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-lived Assets,” the results of operations of these operating units are treated as discontinued operations, and reported as a separate component of operating results in the consolidated statements of operations. The consolidated financial statements consistently present these operations as discontinued operations. Unless otherwise indicated, all amounts included in this Discussion and Analysis of Financial Condition and Results of Operations are from continuing operations.

Product Sales- Product sales consist primarily of the resale of packaged design software, including:

• Autodesk design automation software for mechanical, architectural and civil engineering sectors and the Discreet product line for animation;

• Archibus facilities management software for space planning, strategic planning, and lease/property administration;

• Cyco engineering data management solutions using Meridian software; and

• Autodesk data management software.

The Company also offers Autodesk’s subscription programs, which entitle subscribers to receive software upgrades, web support and eLearning lessons directly from Autodesk. Because they do not participate in the delivery of these subscription products or the web support and eLearning lesson benefits, Avatech records the gross profit from the sale of Autodesk software subscriptions as commission revenue. Approximately 91% of our total product revenue is related to the resale of Autodesk products.

Service Revenue- Avatech provides services in the form of training, consulting services, professional services, and technical support to its customers. The Company also offers its customers an assessment tool to analyze the ability and knowledge of current and potential employees in computer aided design. Avatech employs a technical staff of approximately 45 personnel associated with these types of services.

Commission Revenue- The Company generates commission revenue from the resale of Autodesk software to various customers, a number of which Autodesk considers “major accounts.” Autodesk designates these customers as major accounts based on specific criteria, primarily sales volume, and typically gives these customers volume discounts. The Company is responsible for managing and reselling Autodesk products to a number of these major account customers; however, software products are shipped directly from Autodesk to the customers. Avatech receives commissions upon shipment of the products from Autodesk to the customer based on the product sales price.

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Sale of Developed Software and Related Costs- In January 2005, the Company sold a software product, Proof Positive, to Autodesk, Inc. The revenue from that sale was $1,900,000 and is shown as sale of developed software with the corresponding direct costs shown as cost of developed software.

Cost of Product Sales- The cost of product sales consists of the cost of purchasing products from software suppliers or hardware manufacturers as well as the associated shipping and handling costs.

Cost of Service Revenue- Cost of service revenue includes the direct costs associated with the implementation of software and hardware solutions as well as training, support services, and professional services. These costs consist primarily of compensation, benefits, travel, and the costs of third-party contractors engaged by the Company. The cost of service revenue does not include an allocation of overhead costs.

Selling, General and Administrative Expenses- Selling, general and administrative expenses consist primarily of compensation and other expenses associated with the Company’s sales force, management, finance, human resources, and information systems. Advertising and public relations expenses and expenses for facilities, such as rent and utilities, are also included in selling, general and administrative expenses.

Depreciation and Amortization Expenses. Depreciation and amortization expenses represent the period costs associated with our investment in property and equipment, consisting principally of computer equipment, software, furniture and fixtures, and leasehold improvements. The Company computes depreciation and amortization expenses using the straight-line method. Avatech leases all of its facilities and depreciates leasehold improvements over the lesser of the lease term or the estimated useful life of the asset.

Interest Expense. Interest expense consists primarily of interest on a revolving line-of-credit, a note payable to a member of the Board of Directors and a loan from a vendor.

Critical Accounting Policies

General- The consolidated financial statements are impacted by the accounting policies used and the estimates and assumptions made by management during their preparation. Critical accounting policies and estimates that impact the consolidated financial statements are those that relate to software revenue recognition, estimates of bad debts and income taxes. All of these critical accounting policies are discussed with and reviewed by the Company’s Audit Committee on a periodic basis. Presented below is a description of the accounting policies that are most critical to an understanding of the consolidated financial statements.

Software Revenue Recognition- The Company derives most of its revenue from the resale of packaged software products, and historically, the Company has not experienced significant customer returns. Avatech earns service revenue from training and other professional services, which often are related to the products that are sold but are not essential to the functionality of the software. Annual support contracts are also offered to customers for the software products that are sold, or the Company offers maintenance and support services under hourly billing arrangements.

Revenue from software arrangements is recognized in accordance with the provisions of AICPA Statement of Position No. 97-2, Software Revenue Recognition, as amended by SOP No. 98-9, Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions. Prior to recognizing any revenue under these arrangements, (1) persuasive evidence of an arrangement must exist, (2) delivery of the software or service must have occurred, (3) all fees must be assessed as fixed or determinable, and (4) all fees must be probable of collection. The Company determines whether criteria (3) and (4) have been satisfied based on its judgment regarding the fixed nature of the fee charged for services rendered and products delivered and the collectibility of such fee. Revenue recognized in a reporting period could be adversely affected if future changes in conditions related to a transaction cause management to determine these criteria are not met. In the past, it has not been necessary to adjust reported revenues due to changes in conditions, and the Company continues to evaluate current conditions that may affect the nature and timing of our revenue recognition.

Customer arrangements can involve the sale of one or more elements (product, service training, etc.). When this occurs, Avatech allocates revenue to each element if it can determine reliably the relative fair value of each element. The Company limits the assessment of fair value to the price that is charged when the element is sold separately. If the fair value of each element in a multiple element arrangement cannot be reliably determined, and if

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the fair value of any undelivered element cannot also be reliably determined, all revenue under the arrangement is deferred until such time as the only remaining undelivered element is maintenance, or in the absence of maintenance, implementation services, upon which time revenue is recognized over the remaining maintenance or service period. Revenue that is deferred and recognized over a maintenance or service period is recognized in proportion to the services delivered, or ratably if no better measure of performance can be determined. The timing of the revenue that is recognized in future periods from multiple element arrangements with customers will be dependent upon the ability to establish or continue to have vendor-specific objective evidence of the fair value of each of the elements in these types of arrangements.

Bad Debts-The Company maintains an allowance for doubtful accounts for estimated losses which may result from the inability of customers to pay for purchased products and services or for disputes that affect the ability to fully collect accounts receivable. Avatech estimates this allowance by reviewing the status of past-due accounts and records general reserves based on historical bad debt expense. Actual experience has not varied significantly from estimates; however, if the financial condition of the Company’s customers were to deteriorate, resulting in their inability to pay for products or services, there may be a need to record additional allowances in future periods. To mitigate this risk, the Company performs ongoing credit evaluations of its customers.

Income Taxes- At June 30, 2005, the Company recorded deferred tax assets of approximately $3.3 million that were fully offset by a valuation allowance because the Company cannot determine with reasonable assurance that they will be realized. The realization of these deferred tax assets will be dependent on the Company’s ability to generate taxable income in future periods. Although the Company reported income before income taxes of $1.9 million in fiscal year 2005, those earnings included profits from the non-recurring sale of a developed software product in the amount of $1.8 million in the third quarter of fiscal 2005.

The Company’s estimates of the realization of the deferred tax assets may change in future periods if they are able to predict with reasonable assurance that their operations will be profitable. Future reductions in the valuation allowance will reduce current or deferred income tax expense.

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Years Ended June 30, 2003, 2004, and 2005

The following table sets forth the percentages of total revenue represented by selected items reflected in our audited Consolidated Statements of Operations included elsewhere in this report. The year-to-year comparisons of financial results are not necessarily indicative of future results.

	Year ended June 30,
	2003		2004		2005
Revenue:
Product sales	55.0	%	63.4	%	60.6	%
Service revenue	26.4	%	19.6	%	17.8	%
Commission revenue	18.6	%	17.0	%	16.0	%
Sale of developed software	—		—		5.6	%
Total revenue	100.0	%	100.0	%	100.0	%
Cost of Revenue:
Cost of product sales	39.0	%	45.3	%	38.7	%
Cost of service revenue	16.7	%	14.6	%	13.5	%
Cost of developed software	—		—		0.2	%
Total Cost of Revenue	55.7	%	59.9	%	52.4	%
Gross Margin	44.3	%	40.1	%	47.6	%
Other Operating Expenses:
Selling, general and administrative	54.3	%	39.6	%	39.2	%
Depreciation and amortization	1.8	%	1.2	%	1.1	%
Total other operating expenses	56.1	%	40.8	%	40.3	%
Operating income (loss)	(11.8	)%	(0.7	)%	7.3	%
Other non-operating income (expense):
Gain on the extinguishment of debt	8.7	%	0.0	%	0.0	%
Interest and other income	0.1	%	0.1	%	0.3	%
Minority interest	(0.4	)%	(0.5	)%	(0.2	)%
Interest expense	(1.3	)%	(1.3	)%	(1.5	)%
Total other non-operating income (expense)	7.1	%	(1.7	)%	(1.4	)%
Income (loss) from continuing operations before income taxes and cumulative effect of change in accounting principle	(4.7	)%	(2.4	)%	5.9	%
Income tax expense (benefit)	1.8	%	0.1	%	(0.2	)%
Income (loss) from continuing operations before cumulative effect of change in accounting principle	(6.5	)%	(2.5	)%	5.7	%
Income (loss) from continuing operations of discontinued operating segments (including loss on disposal of $354,000 in 2003)	(8.3	)%	(0.8	)%	—
Income (loss) before cumulative effect of change in accounting principle	(14.8	)%	(3.3	)%	5.7	%
Cumulative effect of change in accounting for goodwill	(2.3	)%	—		—
Net income (loss)	(17.1	)%	(3.3	)%	5.7	%

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Year Ended June 30, 2004 Compared to Year Ended June 30, 2005

Revenue

	Year ended June 30,
	2004		2005		% change
Revenue:
Product sales	$	17,710,150	$	20,703,025	16.9	%
Service revenue		5,470,360		6,066,242	10.9	%
Commission revenue		4,769,984		5,475,161	14.8	%
Sale of developed software		—		1,900,000	100.0	%
Total Revenue:	$	27,950,494	$	34,144,428	22.2	%

Total revenue for the year ended June 30, 2005 increased by 22.2%, or $6.2 million, over the prior fiscal year. The Company realized double digit sales growth during fiscal 2005 in all three of its revenue categories, with product sales showing the largest increase, up 16.9% from the prior year. The demand for the Company’s main product line of Autodesk software solutions continues to be very strong and Avatech benefited from that continuing trend. During fiscal 2005, Avatech continued to add to its growing sales force and technical support personnel resulting in a strengthening of its market share in many of the locations in which it operates.

In January 2005 Avatech completed the sale to Autodesk, Inc. of all of its ownership interest in Proof Positive, a software product developed by PlanetCAD, Inc., and acquired by the Company in 2002. Net proceeds of the sale were $1.9 million and are shown as sale of developed software in the Company’s financial statements. In addition, in April 2005 the Company acquired the assets of an Autodesk reseller with three offices in North Carolina which increased its fiscal 2005 sales by approximately $430,000.

Service revenue for fiscal 2005 was $6.1 million, compared to $5.5 million in fiscal 2004, an increase of 10.9%. During fiscal year 2004 and continuing through fiscal 2005, the Company added sales and service delivery resources in order to expand its services operation. As these technical resources complete their training and become experienced in the product and service offerings that the Company sells, they become billable to customers for training, implementation and support services. The Company will continue to invest in this category of its business and expects it to become a larger share of its ongoing revenues in the future.

Avatech’s commission revenue also grew during fiscal year 2005, from $4.8 million in 2004 to $5.5 million, an increase of 14.8%. The growth in this revenue category can be attributed to the continuing industry-wide increase in sales volume related to the associated software products that the Company sells.

Cost of Revenue

	Year ended June 30,
	2004		2005		% change
Cost of revenue:
Cost of product sales	$	12,647,646	$	13,211,234	4.5	%
Cost of service revenue		4,086,069		4,606,361	12.7	%
Cost of developed software		—		76,853	100.0	%
Total cost of revenue	$	16,733,715	$	17,894,448	6.9	%
Gross margin	$	11,216,779	$	16,249,980	44.9	%

Cost of product sales was $13.2 million for fiscal year 2005, compared to $12.6 million for fiscal year 2004, an increase of approximately $564,000, or 4.5%. However, cost of product sales as a percentage of related revenue for fiscal 2005 decreased dramatically to 63.8% from 71.4% in fiscal 2004. The reason for this large reduction is due to the successful efforts of the Company to maximize the sales incentives offered to it by Autodesk by exceeding Autodesk targets for Avatech and focusing on the sales of industry specific products as directed by Autodesk. As the demand for Autodesk products and Avatech’s market share continue to grow, the Company is well positioned to continue to capitalize on the strong market as well as to maximize the incentives that it receives from Autodesk.

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The Company believes that it has a great potential to increase its service revenues and has continued to invest resources in this sector. The training of new sales and technical personnel takes between three and four months before those employees can contribute in a meaningful way to increasing service revenues. As a result, the Company’s cost of service revenue for fiscal 2005 grew at a faster rate than the corresponding service revenue. Cost of service revenue for fiscal 2005 was $4.6 million, compared to $4.1 million for fiscal 2004, increasing 12.7%, or approximately $520,000. Cost of service revenue as a percentage of related revenue for fiscal 2005 increased to 76.1% from 74.7% in fiscal 2004. This increase can be attributed to the costs of training in-house personnel coupled with the need to subcontract certain work to third party providers due to services sales volume and the current shortage of adequately trained personnel. The Company is aggressively recruiting both sales and technical personnel but it does not expect to completely address its personnel shortage until the end of fiscal year 2006.

For the reasons noted above and the sale of Proof Positive to Autodesk, Inc., the Company’s gross margin percentage increased to 47.6% for fiscal 2005, compared to 40.1% in fiscal 2004. The total amount of gross margin increased approximately $5.0 million, or 44.9% from fiscal 2004 to fiscal 2005.

Other Operating Expenses

	Year ended June 30,
	2004		2005		% change
Other operating expenses:
Selling, general and administrative	$	11,073,122	$	13,399,486	21.0	%
Depreciation and amortization		330,926		358,965	8.5	%
Total other operating expenses	$	11,404,048	$	13,758,451	20.6	%

Selling, General and Administrative. Selling, general and administrative expenses for fiscal year 2005 were $13.4 million, compared to $11.1 million for the fiscal year ended June 30, 2004, an increase of $2.3 million. In fiscal year 2004, the Company received a one-time $1.2 million reimbursement from a supplier for marketing expenses resulting in lower reported expenses for that period. In addition, during fiscal year 2005 the Company continued to add to its sales force in order to capitalize on the strong market demand for the products and services that it sells, thus increasing its overall selling, general and administrative expenses.

Depreciation and Amortization. Depreciation and amortization expense for fiscal 2005 was $359,000, compared to $331,000 for fiscal 2004, increasing by $28,000. The increase is due primarily to the amortization of a customer list acquired from Comtrex Corporation in April 2005.

Other Non-operating Income (Expense)

	Year ended June 30,
	2004			2005			% change
Other non-operating income (expense):
Minority interest		(152,500	)		(58,882	)	(61.4	)%
Interest and other income		38,570			106,947		277.2	%
Interest expense		(351,987	)		(523,737	)	48.8	%
Total other non-operating income (expense)	$	(465,917	)	$	(475,672	)	2.1	%

Other non-operating expense was $476,000 and $466,000 in fiscal years 2005 and 2004, respectively. The largest component of this category was interest expense which increased commensurate with the increase in the average outstanding borrowings on the lines of credit. The minority interest represents dividends paid on shares of preferred stock issued by one of our subsidiaries and those shares were converted into common stock in fiscal year 2005.

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Income Tax Expense

	Year ended June 30,
	2004		2005		% change
Income tax expense	$	29,898	$	81,780	173.5	%

Income tax expense was $81,780 and $29,898 in fiscal years 2005 and 2004, respectively. Tax expense in 2004 relates solely to state and local income taxes and in 2005 relates to federal alternative minimum tax, state and local income taxes. Although the Company has significant net operating loss carryforwards, it was required to pay alternative minimum taxes of $50,000 for 2005.

Year Ended June 30, 2003 Compared to Year Ended June 30, 2004

Revenue

	Year ended June 30,
	2003		2004		% change
Revenue:
Product sales	$	12,369,846	$	17,710,150	43.2	%
Service revenue		5,931,623		5,470,360	(7.8	)%
Commission revenue		4,199,465		4,769,984	13.6	%
Total Revenue:	$	22,500,934	$	27,950,494	24.2	%

Total Revenue. Total revenue for our fiscal year ended June 30, 2004 was $28.0 million, compared to $22.5 million in fiscal 2003, an increase of $5.5 million. Our total revenue includes product sales, service revenue, and commission revenue.

For fiscal 2004, revenue in two categories—product sales and commission revenue—increased due to a positive general economic turnaround, Autodesk’s new product releases and promotional activities, and demand caused by customers upgrading their software. During fiscal 2004, the Company began to offer PLM and F/AM software products from Dassault and Archibus. Also, during October 2003, Avatech reduced prices when Autodesk reduced the price it pays for products by 20% under a short-term promotional program, which increased the volume of units delivered.

Product Sales. Product sales for fiscal 2004 were $17.7 million, compared to $12.4 million in fiscal 2003, increasing $5.3 million. The increase was due to an improving economy, Autodesk’s reduction in “major accounts,” many of whom then started purchasing from Avatech, and increased commercial customer product and service sales from our new product groups, PLM and F/AM.

Service Revenue. Service revenue for fiscal 2004 was $5.5 million, compared to $5.9 million in fiscal 2003, decreasing $461,000. This decrease in service revenue is the result of the market focusing on product upgrades from discontinued products and a reduction in the number of service employees dedicated to service activities. The Company also experienced an unusually high rate of turnover in service professionals, replacing approximately one-half of its application engineers during fiscal 2004. Although some employee turnover is normal, the higher turnover rate during fiscal 2004 occurred because the Company terminated underperforming service employees and hired better qualified personnel. However, it generally takes three to four months for new service personnel to complete their training, and Avatech was not able to fill vacancies in time to prevent the decrease in service revenue. The Company has reestablished its professional service group with highly qualified personnel, and expects all of the new service professionals to be fully trained by October 2004.

Commission Revenue. Commission revenue for fiscal 2004 was $4.8 million, compared to $4.2 million in fiscal 2003, increasing $571,000. The increase in commission revenue was a result of two factors: an increase in net subscription revenue of approximately $952,000, primarily due to the industry-wide increase in sales volume related to the associated software products; and a decrease of approximately $381,000 in commission revenue from Autodesk major accounts due to Autodesk’s new, more restrictive criteria for major accounts, which reduced the number of customers who qualified for major account discounts. Because many of these customers continued to purchase Autodesk software and related services, some of the revenue from these customers that the Company

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recognized as commission revenue during fiscal 2003 was included in its product sales and service revenue during fiscal 2004.

Cost of Revenue

	Year ended June 30,
	2003		2004		% change
Cost of revenue:
Cost of product sales	$	8,776,509	$	12,647,646	44.1	%
Cost of service revenue		3,766,904		4,086,069	8.5	%
Total cost of revenue	$	12,543,413	$	16,733,715	33.4	%
Gross margin	$	9,957,521	$	11,216,779	12.6	%

Cost of Product Sales. Cost of product sales for fiscal 2004 was $12.6 million, compared to $8.8 million for fiscal 2003, increasing $3.9 million. This increase was primarily due to increased sales volume. Cost of product sales as a percentage of related revenue for fiscal 2004 also increased slightly to 71.4% from 71.0% in the same period in fiscal 2003.

Cost of Service Revenue. Cost of service revenue for fiscal 2004 was $4.1 million, compared to $3.8 million for fiscal 2003, increasing $319,000. Cost of service revenue as a percentage of related revenue for fiscal 2004 increased to 74.7% from 63.5% in the same period in fiscal 2003. The Company attributes this increase in cost of service revenue as a percentage of revenue primarily to its need to subcontract certain work to third party providers in its PLM and F/AM service businesses until the Company’s own service organization is fully staffed and trained. During 2004, the Company was engaged to perform professional services as part of a few large F/AM software implementation projects. In order to provide the appropriate expertise and service the projects, Avatech subcontracted some of this work to third party providers, which resulted in an increase the cost of service revenue.

Gross Margin. The Company calculates gross margin percentage as the quotient obtained by dividing costs by the related revenue. Overall, the gross margin percentage decreased to 40.1% for fiscal 2004, compared to 44.3% in fiscal 2003, primarily due the combination of the increase cost of service revenue and an overall decrease in service revenue. Avatech currently is focused on developing its PLM and F/AM markets for products and related services, and until such time as it generates significant revenue from these new product and service offerings, the margins will be affected by the investment in a professional, well-trained service staff. The Company ultimately expects its service revenue from F/AM and PLM to increase and for our margins to return to historical levels.

Other Operating Expenses

	Year ended June 30,
	2003		2004		% change
Other operating expenses:
Selling, general and administrative	$	12,201,380	$	11,073,122	(9.2	)%
Depreciation and amortization		411,612		330,926	(19.6	)%
Total other operating expenses	$	12,612,992	$	11,404,048	(9.6	)%

Selling, General and Administrative. Selling, general and administrative expenses for fiscal 2004 were $11.1 million, compared to $12.2 million during the fiscal year ended June 30, 2003, decreasing $1.1 million. Selling, general and administrative expenses as a percent of total revenue were 39.6% during fiscal 2004, and 54.2% during the same period in fiscal 2003. This decrease in selling, general and administrative expenses was principally due to a combination of elements: a $297,000 increase in marketing cooperative credits from Autodesk due to increased sales volume, reimbursement of $1.2 million of the Company’s PLM marketing expenses by Dassault, and our company-wide focus on controlling expenses.

Depreciation and Amortization. Depreciation and amortization expenses for fiscal 2004 were $331,000, compared to $412,000 for fiscal 2003, decreasing $81,000. Depreciation and amortization expenses of property and equipment decreased as a result of an increase in the number of fully depreciated assets compared to the prior period.

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Other Non-operating Income (Expense)

	Year ended June 30,
	2003			2004			% change
Other non-operating income (expense):
Gain on the extinguishment of debt	$	1,960,646		$	—		—
Minority interest		(94,140	)		(152,500	)	62.0	%
Interest and other income		15,642			38,570		146.6	%
Interest expense		(290,373	)		(351,987	)	21.2	%
Total other non-operating income (expense)	$	1,591,775		$	(465,917	)	—

Other non-operating income (expense) was ($466,000) and $1.6 million in fiscal 2004 and fiscal 2003, respectively. The significant increase in other income during the 2003 fiscal year relates to a gain recorded from the extinguishment of debt. In January 1999, the Company borrowed $3.0 million from a significant supplier. In August 2002, Avatech executed an agreement to extinguish the debt for a cash payment of $1.0 million, resulting in a $2.0 million gain on the extinguishment of debt. The minority interest represents dividends paid on shares of preferred stock issued by one of its subsidiaries.

Income Tax Expense

	Year ended June 30,
	2003		2004		% change
Income tax expense	$	408,072	$	29,898	(92.7	)%

Income tax expense was $30,000 and $408,000 in fiscal 2004 and fiscal 2003, respectively. In August 2002, the Company realized a $2.0 million taxable gain from the extinguishment of certain debt, which resulted in recording a net deferred tax asset of $373,000 at June 30, 2002. In 2003, the Company recorded deferred income tax expense of $373,000 related to the estimated reduction in deferred tax assets in 2003. Tax expense in fiscal 2004 relates solely to state and local income taxes. Because the Company has significant net operating loss carryforwards, it does not expect to pay federal income taxes for the foreseeable future.

Cumulative Effect of Change in Accounting Principle

	Year ended June 30,
	2003			2004	% change
Cumulative effect of change in accounting for goodwill	$	(520,000	)	—	—

As of July 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (“Statement 142”). As a result of adopting Statement 142 and performing the required transitional impairment tests, the Company recorded a non-cash charge of $520,000, which is included in cumulative effect of change in accounting principle in the 2003 consolidated statement of operations. The impairment charge relates solely to Avatech of Michigan, a business unit that ceased operations in June 2003.

Liquidity and Capital Resources

Historically, the Company has financed its operations and met its capital expenditure requirements primarily through cash flows provided by operations, borrowings under short-term and long-term debt arrangements, and sales of preferred stock.

The Company’s operating assets and liabilities consist primarily of accounts receivable, accounts payable, and inventory. Changes in these balances are affected principally by the timing of sales and investments in inventory based on expected customer demand. The Company minimizes inventory level through arrangements with suppliers to ship products with an average delivery period of two days and centralized inventory management. The Company purchases approximately 90% of its product from one principal supplier which provides it with $3.0 million of available credit to finance those purchases.

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Prior to the merger with PlanetCAD, Inc. in November 2002, the Company had outstanding $1.7 million of 10% subordinated notes. The notes matured on July 1, 2003 and interest was payable quarterly. On November 19, 2002, with the completion of the merger with PlanetCAD, subordinated note holders owning an aggregate of $1.5 million of subordinated notes exchanged their notes for preferred stock in a subsidiary. These shares automatically converted to common stock in November 2004.

The Company’s investing activities consist principally of investments in computer and office equipment. Capital expenditures for fiscal 2005 were approximately $393,000, compared to $333,000 for the same period in 2004.

On July 22, 2003, the Company entered into a loan agreement with Dassault Systèmes to borrow up to $1.5 million for working capital purposes. In July 2005, the Company renegotiated the repayment terms on the $1,456,000 outstanding balance. The new agreement provides for quarterly principal payments of approximately $91,000 along with accumulated interest charges, at an annual rate of 6%. These quarterly payments began in July 2005 and will continue until July 1, 2007 when the final payment of approximately $727,000 becomes due.

On September 11, 2003, the Company entered into a loan and security agreement with a bank to replace the revolving credit facility with another lending institution. The new loan agreement provided for a $2.5 million revolving line of credit payable within 60 days of demand by the lender. In August 2004, the bank amended the loan and security agreement to increase the credit extended to the lesser of $3.0 million or 85% of the Company’s aggregate outstanding eligible accounts receivable and extended the maturity to September 2006. Borrowings under this line-of-credit bear interest at the greater of 7.5%, or the prime rate plus 2.0% (8.25 % at June 30, 2005) and are secured by the assets of the Company. In addition, the bank has the right to restrict any prepayment of other indebtedness by the Company.

On October 28, 2004, the Company’s wholly-owned subsidiary entered into a loan agreement with the bank to provide for a $700,000 revolving credit facility expiring on October 28, 2005. Borrowings under this credit facility bear interest at the greater of 7.5%, or the prime rate plus 2.0% (7.75% at June 30, 2005) and are secured by the assets of the Company and the guarantee of the Chairman of the Board of Directors.

The total borrowing from the bank under the $3.0 million line and the $700,000 line was approximately $3.2 million at June 30, 2005.

Additionally, the Company has outstanding borrowings of approximately $902,000 (net of unamortized debt discount) at June 30, 2005 that are payable to a director and shareholder. On July 1, 2005, the maturity date of this borrowing was extended to July 1, 2006.

In July 2005, the Company completed a limited offering of Convertible Preferred Stock (Series E) which raised a total of $1.2 million for working capital purposes. Investors in this offering will receive an annual dividend of 10%, paid quarterly, and were granted certain conversion rights and stock warrants. The number of common shares that would be issued under these conversion rights total 1,832,308, and the warrants, if exercised, would result in 366,475 common shares being issued.

Outstanding debt totaled approximately $5.9 million at June 30, 2005, and the Company had a deficiency of working capital of approximately $1.5 million. The working capital deficit was in large part caused by the classification of the lines of credit as current liabilities due to their demand provisions. Despite the existence of the 60-day demand provision on these lines-of-credit, the Company does not believe it is likely that the bank will exercise the demand provisions of the agreements. In addition, the Company fully expects to have a new financing arrangement with another lender by the end of fiscal year 2006 that would extend the maturity of the current lines of credit and provide for an increased borrowing limit. The Company’s working capital needs have stabilized, and management believes the Company’s near-term needs can be met from its available cash resources, cash flows from operations and its lines of credit.

Since Avatech is one of the largest resellers of Autodesk software and since Autodesk has continued to state its intention to continue to strengthen its relationships with its resellers, the Company fully expects to continue to be a leading seller of Autodesk software at margins sufficient to grow its business and improve its financial results. The Company’s Channel Partner Agreement with Autodesk expires on February 1^st of each year, but

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Autodesk has indicated its intention to renew the Agreement on February 1, 2006. In addition, the Company continues to diversify its revenues by increasing its service revenues and the sale of non-Autodesk software.

Below is a summary of our contractual obligations and commitments at June 30, 2005:

	Total		Payments due by period
			Less than 1 year		1 – 3 years		3 – 5 years		More than 5 years
Contractual Obligations
Lines of credit	$	3,197,851	$	3,197,851	$	—	$	—	$	—
Long-term obligations		1,768,740		605,343		1,163,397		—		—
Interest on fixed rate obligations		277,506		209,262		68,244		—		—
Operating leases		4,348,499		1,202,408		1,816,806		963,291		365,994
Note payable to related party and capital lease obligations		1,115,019		95,545		1,019,474		—		—
Total obligations	$	10,707,615	$	5,310,409	$	4,067,921	$	963,291	$	365,994

Quarterly Results of Operations

The following table sets forth unaudited quarterly financial information for each of the eight quarters in the two years ended June 30, 2005. Management believes that this information has been prepared on the same basis as the audited consolidated financial statements appearing elsewhere in this Report and, in management’s opinion, this information includes all adjustments, consisting only of normal recurring adjustments, necessary to fairly present the unaudited quarterly operating results when read in conjunction with our audited consolidated financial statements and the notes thereto appearing elsewhere in this Report. These operating results are not necessarily indicative of results for any future period.

	Three Months Ended
	Sept. 30, 2003			Dec. 31, 2003			Mar. 31, 2004		Jun. 30, 2004			Sept. 30, 2004			Dec. 31, 2004			Mar. 31, 2005		Jun. 30, 2005
Revenues	$	5,866,312		$	7,867,073		$	7,836,045	$	6,381,064		$	6,752,063		$	8,186,433		$	10,438,146	$	8,768,786
Cost of sales		3,541,026			4,980,595			4,385,298		3,826,796			4,089,623			4,646,081			4,389,152		4,769,592
Gross margin		2,325,286			2,886,478			3,450,747		2,554,268			2,662,440			3,540,352			6,048,994		3,998,194
Operating income (loss)		(244,861	)		142,011			398,767		(483,186	)		(675,988	)		160,277			2,162,897		844,343
Net income (loss)		(503,476	)		4,725			170,362		(598,376	)		(813,448	)		9,482			2,024,529		713,514
Earnings (loss) per share-basic	$	(0.04	)	$	(0.00	)	$	0.02	$	(0.06	)	$	(0.09	)	$	(0.00	)	$	0.18	$	0.06
Earnings (loss) per share-diluted	$	(0.04	)	$	(0.00	)	$	0.01	$	(0.06	)	$	(0.09	)	$	(0.00	)	$	0.14	$	0.05
Shares used in basic computation		9,127,160			9,217,874			9,304,794		9,396,846			9,599,659			10,124,694			10,865,042		10,868,326
Shares used in diluted computation		9,127,160			9,217,874			12,377,537		9,396,846			9,599,659			10,124,694			14,092,635		14,112,125

Operating results may vary significantly from quarter to quarter due to a variety of factors. One such significant factor is the potential fluctuation in revenue due to seasonality of the business. Historically, the Company has experienced such seasonal fluctuations in revenue, with increased revenue in the second and third quarters, and lower revenue in its first and fourth quarters. These seasonal fluctuations are often driven by Autodesk’s new product releases and promotional campaigns.

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ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Avatech is exposed to market risk from changes in interest rates associated with its variable rate line-of-credit facility. At June 30, 2005, approximately 58% of its outstanding debt bore interest at variable rates. Accordingly, earnings and cash flow are affected by changes in interest rates, though not by an amount that is material to the Company. Assuming the current level of borrowings at variable rates and assuming a 100 basis point change in the 2005 average interest rate under these borrowings, it is estimated that the 2005 interest expense and net income would have changed by less than $30,000. In the event of an adverse change in interest rates, management would likely take actions to further mitigate its exposure.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The financial statements and supplementary data required by this Item 8 are included in our Consolidated Financial Statements and set forth in the pages indicated in Item 15(a) of this Annual Report.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES

None.

ITEM 9A. CONTROLS AND PROCEDURES

The Company maintains a system of disclosure controls and procedures that is designed to provide reasonable assurance that information, which is required to be disclosed by the Company in the reports that it files or submits under the Securities and Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission, and is accumulated and communicated to management in a timely manner. The Company’s Chief Executive Officer and Chief Financial Officer have evaluated this system of disclosure controls and procedures as of the end of the period covered by this annual report, and believe that the system is effective. There have been no changes in our internal control over financial reporting during the most recent fiscal year that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

ITEM 9B. OTHER INFORMATION

None.

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PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The information with respect to the identity and business experience of the directors of the Company and their remuneration set forth in the section captioned “Election of Directors” in the Company’s definitive Proxy Statement to be filed pursuant to Regulation 14A and issued in conjunction with the 2005 Annual Meeting of Stockholders (the “Proxy Statement”) is incorporated herein by reference. The information with respect to the identity and business experience of executive officers of the Company is set forth in Part I of this Form 10-K. The information with respect to the Company’s Audit Committee is incorporated herein by reference to the section captioned “Committees and Meetings of the Board of Directors” in the Proxy Statement. The information with respect to compliance with Section 16(a) of the Exchange Act is incorporated herein by reference to the section captioned “Compliance With Section 16(a) of the Exchange Act” in the Proxy Statement. The information with respect to the Company’s Code of Ethics is incorporated herein by reference to the section captioned “Code of Ethics” in the Proxy Statement.

ITEM 11. EXECUTIVE COMPENSATION

The information required by this item is incorporated herein by reference to the sections captioned “Compensation of Directors” and “Executive Compensation” in the Proxy Statement.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

The information required by this item is incorporated herein by reference to the sections captioned “Beneficial Ownership of Avatech Solutions, Inc.”, “Share Ownership of Management”, and “Securities Authorized for Issuance under Equity Compensation Plans” in the Proxy Statement.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information required by this item is incorporated herein by reference to the section captioned “Relationships and Related Transactions” in the Proxy Statement.

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

The information required by this item is incorporated herein by reference to the section captioned “Registered Public Accounting Firm” in the Proxy Statement.

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PART IV

ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

1. Financial Statements

	Page
Report of Independent Registered Public Accounting Firm	F-2
Consolidated Balance Sheets as of June 30, 2004 and 2005	F-3
Consolidated Statements of Operations for the Years Ended June 30, 2003, 2004, and 2005	F-5
Consolidated Statements of Stockholders’ Deficit for the Years Ended June 30, 2003, 2004, and 2005	F-6
Consolidated Statements of Cash Flows for the Years Ended June 30, 2003, 2004, and 2005	F-8
Notes to Consolidated Financial Statements	F-9

2. Financial Statement Schedules: Schedule II - Schedule of Valuation and Qualifying Accounts

Report of Independent Registered Public Accounting Firm on Financial Statement Schedule

The Board of Directors and Stockholders

Avatech Solutions, Inc.

We have audited the consolidated financial statements of Avatech Solutions, Inc. as of June 30, 2004 and 2005 and for each of the three years in the period ended June 30, 2005, and have issued our report thereon dated September 21, 2005 (included elsewhere in this Report). Our audits also included the financial statement schedule responsive to Item 15 of this Report. This schedule is the responsibility of the Company’s management. Our responsibility is to express an opinion on this schedule based on our audits.

In our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.

/s/ Ernst & Young LLP

Baltimore, Maryland

September 21, 2005

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Avatech Solutions, Inc. and Subsidiaries Valuation and Qualifying Accounts

			Additions
Description	Balance at beginning of period		Charged to costs and expenses		Charged to other accounts – describe			Deductions – describe			Balance at end of period
Year Ended June 30, 2005:
Deducted from assets accounts:
Allowance for doubtful accounts	$	100,000	$	8,650	$	40,600	(2)	$	—		$	149,250
Valuation allowance for deferred tax assets		3,272,999		—		(754,159	)(6)		—			2,518,840
Year Ended June 30, 2004:
Deducted from assets accounts:
Allowance for doubtful accounts	$	160,000	$	75,000	$	—		$	(135,000	)(1)	$	100,000
Valuation allowance for deferred tax assets		3,072,391		—		200,608	(3)		—			3,272,999
Year Ended June 30, 2003:
Deducted from assets accounts:
Allowance for doubtful accounts:		112,000		118,000		53,000	(2)		(123,000	)(1)		160,000
Valuation allowance for deferred tax assets		1,602,899		—		1,469,492	(4)		—			3,072,391

(1) Uncollectible accounts written off, net of recoveries.

(2) Allowance recorded upon acquisition.

(3) Increase in valuation allowance, net of temporary differences.

(4) Increase in valuation allowance, net of temporary differences and reversal of income tax benefit recorded in prior period.

(5) Income tax benefit recorded, net of temporary differences.

(6) Decrease in valuation allowance, net of temporary differences.

All other financial statement schedules are not required under the related instructions or are inapplicable and therefore have been omitted.

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3. Exhibits required to be filed by Item 601 of Regulation S-K

Exhibit No.	Description of Exhibit
2.1	Agreement and Plan of Merger a
3.1	Restated Certificate of Incorporation b
3.2	First Amendment to Restated Certificate of Incorporation b
3.3	Reverse Split Amendment to Restated Certificate of Incorporation a
3.4	Amendment of PlanetCAD’s Certificate of Incorporation to change the name of PlanetCAD, Inc. to Avatech Solutions, Inc. a
3.5	Certificate of Designation, Preferences and Rights of Series A Junior Participating Preferred Stock c
3.6	Certificate of Designation, Preferences and Rights of Series B Convertible Preferred Stock d
3.7	Certificate of Designation, Preferences and Rights of Series C Convertible Preferred Stock e
3.8	Certificate of Amendment to Certificate of Designation of Series C Convertible Preferred Stock f
3.9	Certificate of Designation, Preferences and Rights of Series D Convertible Preferred Stock f
3.10	Certificate of Elimination of Series A Junior Participating Preferred Stock f
3.11	Certificate of Elimination of Series C Convertible Preferred Stock f
3.12	Certificate of Amendment to Certificate of Designation of Series D Convertible Preferred Stock f
3.13	Certificate of Amendment to Amended and Restated Certificate of Incorporation k
3.14	By-Laws b
10.01	Autodesk Authorized Channel Partner Agreement by and among Avatech Solutions, Inc. and Autodesk, Inc. effective as of February 1, 2003 e
10.02	Autodesk Authorized Channel Partner Agreement by and among Avatech Solutions, Inc. and Autodesk, Inc. effective as of February 1, 2004 f
10.03	Loan Agreement by and between Avatech Solutions Subsidiary, Inc. and a Strategic Partner dated July 22, 2003, as amended (portions of this exhibit have been omitted and filed separately with the U.S. Securities and Exchange Commission pursuant to a request for confidential treatment) g
10.04	Security Agreement by and between Avatech Solutions Subsidiary, Inc. and a Strategic Partner dated July 22, 2003 (portions of this exhibit have been omitted and filed separately with the U.S. Securities and Exchange Commission pursuant to a request for confidential treatment) g
10.05	Demand Promissory Note by and between Avatech Solutions Subsidiary, Inc. and Key Bank and Trust in the amount of $2,000,000 dated September 11, 2003 g
10.06	Loan and Security Agreement by and between Avatech Solutions Subsidiary, Inc. and Key Bank and Trust dated September 11, 2003 g
10.07	Lease by and between Merritt-DM1, LLC and Avatech Solutions, Inc. effective June 1, 2004 k
10.08	Form of Promissory Note, principal amount $500,000.00, issued by Avatech Solutions, Inc. in favor of W. James Hindman dated May 28, 2003 g
10.09	Warrants to purchase up to 32,400 shares of common stock issued by Avatech to W. James Hindman dated May 28, 2003 g
10.10	Affidavit and Discharge of Indebtedness by W. James Hindman g
10.11	Form of 10% Subordinated Note with attached Warrant issued by Avatech Solutions, Inc. to certain note holders in connection with Avatech Solutions Subsidiary, Inc.’s 1998 $2,600,000 Subordinated Debt Offering, dated January 1, 2004 f

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10.12	Form of 12 % Subordinated Note issued by Avatech Solutions, Inc. to certain note holders in connection with Avatech Solutions Subsidiary, Inc.’s 1998 $2,600,000 Subordinated Debt Offering dated January 1, 2004 f
10.13	Form of Purchase Agreement for Series D Convertible Preferred Stock f
10.14	2002 Stock Option Plan a
10.15	Restricted Stock Award Plan e
10.16	Avatech Solutions, Inc. Employee Stock Purchase Plan i
10.17	Employment Agreement by and between Eric L. Pratt and Avatech Solutions, Inc. effective April 15, 2003 h
10.18	Employment Agreement by and between Scott N. Fischer and Avatech Solutions, Inc. dated as of March 17, 2003 g
10.19	Separation Agreement between Scott Fischer and Avatech Solutions, Inc. dated as of March 10, 2004 j
10.20	Employment Agreement by and between Donald R. “Scotty” Walsh and Avatech Solutions, Inc. dated July 1, 2003 g
10.21	Employment Agreement by and between Beth O. MacLaughlin and Avatech Solutions Subsidiary, Inc. dated as of August 7, 2003 k
10.22	Employment Agreement by and between W. Scott Harris and Avatech Solutions Subsidiary, Inc. dated as of June 1, 2004 k
10.23	Employment Agreement by and between Christopher D. Olander and Avatech Solutions Subsidiary, Inc. dated June 18, 2004 k
10.24	Form of Promissory Note, principal amount $902,168.80, issued by Avatech Solutions, Inc. in favor of W. James Hindman dated April 1, 2004 j
10.25	Warrants to purchase up to 51,828 shares of common stock issued by Avatech to W. James Hindman dated April 1, 2004 k
10.26	Employment Agreement by and between Eric L. Pratt and Avatech Solutions Subsidiary, Inc. dated June 1, 2004. k
10.27	Asset Purchase Agreement by and among Avatech Solutions, Inc., Comtrex Corp., Richard L. Aquino, and Stanton L. Hilburn dated April 8, 2005 l
10.28	Autodesk Authorized Channel Partner Agreement with Avatech Solutions, Inc., dated February 1, 2005 l
10.29	Change in Terms Agreement between Avatech Solutions Subsidiary, Inc. and K Bank, dated November 22, 2004 m
10.30	Amendment to Loan and Security Agreement between Avatech Solutions Subsidiary, Inc. and K Bank, dated December 15, 2004 m
10.31	Amendment to Subordination Agreement between Avatech Solutions Subsidiary, Inc., K Bank, and Dassault Systemes, dated December 15, 2004 m
10.32	Letter Agreement between Avatech Solutions, Inc. and W. James Hindman, with stock purchase warrant, dated December 6, 2004 m
10.33	Employment Agreement between Avatech Solutions Subsidiary, Inc. and Catherine Dodson, dated November 15, 2004 m
10.34	Software Transfer Agreement between Avatech Solutions, Inc. and Autodesk, Inc. dated January 26, 2005 m
10.35	Amended and Restated Demand Promissory Note from Avatech Solutions Subsidiary, Inc. to K Bank, dated November 24, 2004 m
10.36	Modification Agreement between Avatech Solutions Subsidiary, Inc., K Bank, Avatech Solutions, Inc. and Technical Learningware Company, dated November 24, 2004 n
10.37	Second Amended and Restated Demand Promissory Note from Avatech Solutions Subsidiary, Inc. to K Bank dated October 22, 2004 n

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10.38	Second Modification Agreement between Avatech Solutions Subsidiary, Inc. and K Bank, dated October 22, 2004 n
10.39	Business Loan Agreement between Avatech Solutions Subsidiary, Inc. and K Bank, dated October 28, 2004 n
10.40	$700,000 Promissory Note from Avatech Solutions Subsidiary, Inc. to K Bank, dated October 28, 2004 n
10.41	Commercial Security Agreement between Avatech Solutions Subsidiary, Inc. and K Bank, dated October 28, 2004 n
10.42	Commercial Guaranty from Avatech Solutions, Inc. to K Bank, dated October 28, 2004 n
10.43	Commercial Guaranty from W. James Hindman to K Bank, dated October 28, 2004 n
14.1	Code of Business Conduct and Ethics o
21.1	Subsidiaries of the Registrant i
23.1	Consent of Ernst & Young LLP *
24.1	Power of Attorney o
31.1	Rule 15d-14(a) Certification of Chief Executive Officer*
31.2	Rule 15d-14(a) Certification of Chief Financial Officer*
32.1	Section 1350 Certifications*

* Filed herewith

a. Incorporated by reference to our Registration Statement on form S-4 filed on May 30, 2002, File No. 333-89386.

b. Incorporated by reference to our Registration Statement on form SB-2 filed on November 21, 2000, File No. 333-50426.

c. Incorporated by reference to our Registration Statement on form 8-A filed on March 11, 2002, File No. 001-31265.

d. Incorporated by reference to our Current Report on form 8-K, filed on May 28, 2002, File No. 001-31265.

e. Incorporated by reference to our Amended Registration Statement on form S-1, filed on April 11, 2003, File No. 333-104035.

f. Incorporated by reference to our Quarterly Report on form 10-Q, filed on February 13, 2004, File No. 001-31265.

g. Incorporated by reference to our Annual Report on form 10-K, filed on October 3, 2003, File No. 001-31265.

h. Incorporated by reference to our Amended Registration Statement on form S-1, filed on June 4, 2003, File No. 333-104035.

i. Incorporated by reference to our Definitive Proxy Statement on form 14A, filed on May 7, 2004, File No. 001-31265.

j. Incorporated by reference to our Quarterly Report on form 10-Q, filed on May 17, 2004, File No. 001-31265.

k. Incorporated by reference to our Registration Statement on form S-1, filed on July 19, 2004, File No. 333-114230.

l. Incorporated by reference to our Quarterly Report on form 10-Q, filed on May 13, 2005, File No. 001-31265.

m. Incorporated by reference to our Quarterly Report on form 10-Q, filed on February 15, 2005, File No. 001-31265

n. Incorporated by reference to our Quarterly Report on form 10-Q, filed on November 15, 2004, File No. 001-31265

o. Incorporated by reference to our Annual Report on form 10-K, filed on September 28, 2004, File No. 001-31265.

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereto duly authorized.

	AVATECH SOLUTIONS, INC.
Date: September 28, 2005	By:	/s/    DONALD R. (SCOTTY) WALSH
		Donald R. (Scotty) Walsh
		Chief Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

By:	/s/    EDGAR D. ARONSON	By:	/s/    W. JAMES HINDMAN
	Edgar D. Aronson, Director		W. James Hindman, Director
	September 28, 2005		September 28, 2005
	By: Christopher D. Olander, Attorney-in-fact		By: Christopher D. Olander, Attorney-in-fact
By:	/s/    GARNETT Y. CLARK, JR.	By:	/s/    ROBERT POST
	Garnett Y. Clark, Jr. , Director		Robert Post, Director
	September 28, 2005		September 28, 2005
	By: Christopher D. Olander, Attorney-in-fact		By: Christopher D. Olander, Attorney-in-fact
By:	/s/    GEORGE COX	By:	/s/    Donald “Scotty” Walsh
	George Cox, Director		Donald “Scotty” Walsh, Director
	September 28, 2005		September 28, 2005
	By: Christopher D. Olander, Attorney-in-fact
By:	/s/    EUGENE J. FISCHER	By:	/s/    Lawrence Rychlak
	Eugene J. Fischer, Director		Lawrence Rychlak, Chief Financial Officer
	September 28, 2005		September 28, 2005
	By: Christopher D. Olander, Attorney-in-fact

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FINANCIAL STATEMENTS AND SCHEDULES

Avatech Solutions, Inc.

Index to Consolidated Financial Statements

	Page
Report of Independent Registered Public Accounting Firm	F – 2
Consolidated Balance Sheets	F – 3
Consolidated Statements of Operations	F – 5
Consolidated Statements of Stockholders’ Deficit	F – 6
Consolidated Statements of Cash Flows	F – 8
Notes to Consolidated Financial Statements	F – 9

F - 1

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders

Avatech Solutions, Inc.

We have audited the accompanying consolidated balance sheets of Avatech Solutions, Inc. and subsidiaries as of June 30, 2004 and 2005, and the related consolidated statements of operations, stockholders’ deficit and cash flows for each of the three years in the period ended June 30, 2005. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Avatech Solutions, Inc. and subsidiaries at June 30, 2004 and 2005, and the consolidated results of their operations and their cash flows for each of the three years in the period ended June 30, 2005, in conformity with U.S. generally accepted accounting principles.

As discussed in Note 1 to the consolidated financial statements, in 2002 the Company changed its method of accounting for goodwill.

/s/ Ernst & Young LLP

Baltimore, Maryland

September 21, 2005

F - 2

Avatech Solutions, Inc. and Subsidiaries

Consolidated Balance Sheets

	June 30
	2004		2005
Assets
Current assets:
Cash and cash equivalents	$	689,995	$	294,704
Accounts receivable, less allowance of $100,000 in 2004 and $149,250 in 2005		3,906,724		5,807,859
Other receivables		366,475		189,383
Inventory		215,321		530,715
Prepaid expenses and other current assets		469,590		227,010
Total current assets		5,648,105		7,049,671
Property and equipment:
Computer software and equipment		2,396,593		2,719,876
Office furniture and equipment		881,036		910,353
Leasehold improvements		197,245		277,570
		3,474,874		3,907,799
Less accumulated depreciation and amortization		2,921,705		3,214,961
		553,169		692,838
Customer list, net of accumulated amortization of $17,483		—		262,241
Goodwill		52,272		52,272
Other assets		313,073		162,034
Total assets	$	6,566,619	$	8,219,056

F - 3

Avatech Solutions, Inc. and Subsidiaries

Consolidated Balance Sheets (Continued)

	June 30
	2004			2005
Liabilities and stockholders’ deficit
Current liabilities:
Accounts payable and accrued expenses	$	5,257,848		$	3,378,858
Accrued compensation and related benefits		347,020			400,819
Borrowings under lines-of-credit		1,640,180			3,197,851
Current portion of long-term debt		92,544			605,343
Deferred revenue		956,636			572,113
Other current liabilities		333,106			440,718
Total current liabilities		8,627,334			8,595,702
Long-term debt		1,606,206			1,163,397
Note payable to related party		878,725			902,169
Other long-term liabilities		318,316			260,202
Commitments and contingencies		—			—
Minority interest		1,525,000			—
Stockholders’ deficit:
Series D Convertible Preferred Stock, $0.01 par value; 1,297,537 shares authorized, issued and outstanding at June 30, 2004 and 2005; aggregate liquidation preference of $778,522 at June 30, 2004 and 2005		12,975			12,975
Common stock, $0.01 par value; 80,000,000 shares authorized; issued and outstanding shares of 9,460,380 at June 30, 2004 and 10,868,330 at June 30, 2005		94,605			108,683
Additional paid-in capital		3,737,574			5,475,967
Accumulated deficit		(10,234,116	)		(8,300,039	)
Total stockholders’ deficit		(6,388,962	)		(2,702,414	)
Total liabilities and stockholders’ deficit	$	6,566,619		$	8,219,056

See accompanying notes.

F - 4

Avatech Solutions, Inc. and Subsidiaries

Consolidated Statements of Operations

	Year ended June 30
	2003			2004			2005
Revenues:
Product sales	$	12,369,846		$	17,710,150		$	20,703,025
Service revenue		5,931,623			5,470,360			6,066,242
Commission revenue		4,199,465			4,769,984			5,475,161
Sale of developed software		—			—			1,900,000
		22,500,934			27,950,494			34,144,428
Cost of revenue:
Cost of product sales		8,776,509			12,647,646			13,211,234
Cost of service revenue		3,766,904			4,086,069			4,606,361
Cost of developed software		—			—			76,853
		12,543,413			16,733,715			17,894,448
Gross margin		9,957,521			11,216,779			16,249,980
Other operating expenses:
Selling, general and administrative		12,201,380			11,073,122			13,399,486
Depreciation and amortization		411,612			330,926			358,965
		12,612,992			11,404,048			13,758,451
Operating income (loss)		(2,655,471	)		(187,269	)		2,491,529
Other income (expense):
Gain on the extinguishment of debt		1,960,646			—			—
Minority interest		(94,140	)		(152,500	)		(58,882	)
Interest and other income		15,642			38,570			106,947
Interest expense		(290,373	)		(351,987	)		(523,737	)
		1,591,775			(465,917	)		(475,672	)
Income (loss) from continuing operations before income taxes and cumulative effect of change in accounting principle		(1,063,696	)		(653,186	)		2,015,857
Income tax expense		408,072			29,898			81,780
Income (loss) from continuing operations before cumulative effect of change in accounting principle		(1,471,768	)		(683,084	)		1,934,077
Loss from operations of discontinued operating segments (including loss on disposal of $354,000 in 2003)		(1,856,538	)		(243,681	)		—
Income (loss) before cumulative effect of change in accounting principle		(3,328,306	)		(926,765	)		1,934,077
Cumulative effect of change in accounting for goodwill		(520,000	)		—			—
Net income (loss)	$	(3,848,306	)	$	(926,765	)	$	1,934,077
Earnings (loss) from continuing operations before cumulative effect of change in accounting principle per common share – basic	$	(0.18	)	$	(0.08	)	$	0.18
Earnings (loss) from continuing operations before cumulative effect of change in accounting principle per common share – diluted	$	(0.18	)	$	(0.08	)	$	0.14
Earnings (loss) per common share – basic	$	(0.48	)	$	(0.11	)	$	0.18
Earnings (loss) per common share –diluted	$	(0.48	)	$	(0.11	)	$	0.14

See accompanying notes.

F - 5

Avatech Solutions, Inc. and Subsidiaries

Consolidated Statement of Stockholders’ Deficit

	Convertible Preferred Stock
	Series C					Series D			Common Stock
	Number of Shares		Par Value			Number of Shares	Par Value		Number of Shares	Par Value		Additional Paid-In Capital			Accumulated Deficit			Total
Balance at July 1, 2002	—		$	—		—	$	—	6,662,010	$	66,621	$	1,654,562		$	(5,459,045	)	$	(3,737,862	)
Issuance of shares of common stock to purchase PlanetCAD, Inc.	—			—		—		—	2,235,864		22,359		1,262,641			—			1,285,000
Issuance of warrants in conjunction with notes payable	—			—		—		—	—		—		36,288			—			36,288
Issuance of Series C Convertible Preferred Stock for cash	172,008			1,720		—		—	—		—		288,963			—			290,683
Net loss	—			—		—		—	—		—		—			(3,848,306	)		(3,848,306	)
Balance at June 30, 2003	172,008			1,720		—		—	8,897,874		88,980		3,242,454			(9,307,351	)		(5,974,197	)
Issuance of common stock as compensation	—			—		—		—	562,506		5,625		96,446			—			102,071
Conversion of Series C Convertible Preferred Stock into Series D Convertible Preferred Stock	(172,008	)		(1,720	)	484,487		4,845	—		—		(3,125	)		—			—
Issuance of Series D Convertible Preferred Stock and warrants to purchase common stock	—			—		813,050		8,130	—		—		419,945			—			428,075
Preferred stock dividends	—			—		—		—	—		—		(56,305	)		—			(56,305	)
Issuance of warrants to purchase common stock	—			—		—		—	—		—		38,159			—			38,159
Net loss	—			—		—		—	—		—		—			(926,765	)		(926,765	)
Balance at June 30, 2004	—		$	—		1,297,537	$	12,975	9,460,380	$	94,605	$	3,737,574		$	(10,234,116	)	$	(6,388,962	)

F - 6

Avatech Solutions, Inc. and Subsidiaries

Consolidated Statement of Stockholders’ Deficit (Continued)

	Convertible Preferred Stock
	Series C			Series D			Common Stock
	Number of Shares	Par Value		Number of Shares	Par Value		Number of Shares		Par Value			Additional Paid-In Capital			Accumulated Deficit			Total
Balance at June 30, 2004	—	$	—	1,297,537	$	12,975	9,460,380		$	94,605		$	3,737,574		$	(10,234,116	)	$	(6,388,962	)
Issuance of common stock as compensation	—		—	—		—	61,258			613			33,587			—			34,200
Issuance of common stock upon the exercise of warrants	—		—	—		—	381,011			3,810			149,820			—			153,630
Issuance of common stock under Employee Stock Purchase Plan	—		—	—		—	312,870			3,128			79,609			—			82,737
Conversion of preferred stock of subsidiary into common stock	—		—	—		—	680,760			6,807			1,518,193			—			1,525,000
Issuance of common stock upon the exercise of stock options	—		—	—		—	2,051			20			600			—			620
Issuance of warrants to purchase common stock	—		—	—		—	—			—			34,146			—			34,146
Preferred stock dividends	—		—	—		—	—			—			(77,862	)		—			(77,862	)
Forfeiture of restricted common stock issued as compensation	—		—	—		—	(30,000	)		(300	)		300			—			—
Net income	—		—	—		—	—			—			—			1,934,077			1,934,077
Balance at June 30, 2005	—	$	—	1,297,537	$	12,975	10,868,330		$	108,683		$	5,475,967		$	(8,300,039	)	$	(2,702,414	)

See accompanying notes.

F - 7

Avatech Solutions, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

	Year ended June 30
	2003			2004			2005
Cash flows from operating activities
Net income (loss)	$	(3,848,306	)	$	(926,765	)	$	1,934,077
Adjustments to reconcile net income (loss) to net cash used in operating activities:
Provision for bad debts ( bad debt recoveries, net)		118,046			74,821			(6,250	)
Gain on extinguishment of debt		(1,960,646	)		—			(11,217	)
Depreciation and amortization		665,990			330,926			358,965
Deferred income taxes		373,000			—			—
Impairment loss		256,864			—			—
Non-cash stock compensation expense		—			102,071			34,200
Cumulative effect of change in accounting principle		520,000			—			—
Write-off of in-process research and development		282,000			—			—
Loss on disposal of property and equipment		116,862			62,785			—
Amortization of debt discount charged to interest expense		6,325			37,633			25,995
Changes in operating assets and liabilities:
Accounts receivable and other receivables		787,249			(954,897	)		(1,485,912	)
Inventory		209,136			(68,444	)		(297,646	)
Prepaid expenses and other current assets		235,997			19,857			252,585
Other assets		—			(256,782	)		151,039
Accounts payable and accrued expenses		725,490			168,641			(2,160,473	)
Accrued compensation and related benefits		109,014			(7,535	)		41,281
Deferred revenue		(142,874	)		219,673			(389,968	)
Other current liabilities		(10,000	)		(30,312	)		95,878
Net cash used in operating activities		(1,555,853	)		(1,228,328	)		(1,457,446	)
Cash flows from investing activities
Purchase of property and equipment		(273,088	)		(332,564	)		(392,999	)
Proceeds from sale of property and equipment		7,325			46,177			—
Proceeds from sale of available-for-sale securities		625,000			—			—
Acquisition costs related to PlanetCAD merger		(612,782	)		—			—
Cash received from PlanetCAD merger		995,425			—			—
Net cash provided by (used in) investing activities		741,880			(286,387	)		(392,999	)
Cash flows from financing activities
Proceeds from borrowings under line-of-credit		29,490,344			31,964,775			42,069,933
Repayments of borrowings under line-of-credit		(29,278,536	)		(31,953,574	)		(40,612,381	)
Proceeds from issuance of long-term debt		175,000			1,500,000			—
Proceeds from issuance of notes payable to related parties		1,500,000			—			—
Repayments of long-term debt		(1,000,000	)		(51,250	)		(103,403	)
Proceeds from issuance of preferred stock		290,683			330,244			—
Proceeds from issuance of common stock upon exercise of stock options and warrants		—			—			236,981
Dividends paid to preferred shareholders		—			(56,305	)		(77,862	)
Change in other assets related to financing costs		(45,696	)		(62,071	)		—
Change in other current liabilities related to financing		—			37,498			—
Change in other long-term liabilities		—			(44,991	)		(58,114	)
Net cash provided by financing activities		1,131,795			1,664,326			1,455,154
Net increase (decrease) in cash and cash equivalents		317,822			149,611			(395,291	)
Cash and cash equivalents—beginning of year		222,562			540,384			689,995
Cash and cash equivalents—end of year	$	540,384		$	689,995		$	294,704

See accompanying notes.

F - 8

Avatech Solutions, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

1. Summary of Significant Accounting Policies

Nature of Business and Basis of Presentation

Avatech Solutions, Inc. provides design automation software, hardware, training, technical support and professional services to corporations, government agencies and educational institutions throughout the United States.

The consolidated financial statements include the accounts of Avatech Solutions, Inc. and its majority-owned subsidiaries (the “Company” or Avatech). All intercompany accounts and transactions between the Company and its consolidated affiliated companies have been eliminated in consolidation.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

Cash and Cash Equivalents

The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents.

Inventory

Inventory, consisting of computer software and hardware, is stated at the lower of first-in, first-out cost, or market.

Property and Equipment

Property and equipment is stated at cost. Depreciation for computer software and equipment and office furniture and equipment is provided for by the straight-line method over estimated useful lives ranging from three to seven years. Leasehold improvements are amortized over the lesser of the lease term or the useful life of the asset using the straight-line method.

Impairment of Long-Lived Assets Excluding Goodwill

Long-lived assets, excluding goodwill, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or group of assets may not be fully recoverable. These events or changes in circumstances may include a significant deterioration of operating results, changes in business plans, or changes in anticipated future cash flows. If an impairment indicator is present, the Company evaluates recoverability by a comparison of the carrying amount of the assets to future undiscounted net cash flows expected to be generated by the assets. Assets are grouped at the lowest level for which there are identifiable cash flows that are largely independent of the cash flows generated by other asset groups. If the assets are impaired, the impairment recognized is measured by the amount by which the carrying amount exceeds the fair value of the assets. Fair value is generally determined by estimates of discounted cash flows. The discount rate used in any estimate of discounted cash flows would be the rate required for a similar investment of like risk.

Goodwill and Accounting Change

Goodwill is the excess of the purchase price paid over the fair value of the identifiable net assets acquired in purchase business combinations. Prior to July 1, 2002, goodwill was amortized on a straight-line basis over 15 to 20 years. As of July 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (“Statement 142”) and recorded a cumulative effect of a change in accounting principle of $520,000 upon adoption. Under Statement 142, goodwill and other intangible assets deemed to have indefinite lives are no longer amortized, but are subject to annual impairment tests. Impairment is the condition that exists

F - 9

when the carrying amount of goodwill exceeds its implied fair value. The implied fair value of goodwill is the amount determined by deducting the estimated fair value of all tangible and identifiable intangible net assets of the reporting unit to which goodwill has been allocated from the estimated fair value of the reporting unit. If the recorded value of goodwill exceeds its implied value, an impairment charge is recorded for the excess.

There were no changes in the carrying amount of goodwill of $52,272 for the years ended June 30, 2004 and 2005.

Stock Options and Stock Granted to Employees

The Company records compensation expense for all stock-based compensation plans using the intrinsic value method prescribed by APB Opinion No. 25, Accounting for Stock Issued to Employees (“APB No. 25 “). Under APB No. 25, compensation expense is recorded ratably over the vesting period to the extent that the fair value of the underlying stock on the date of grant exceeds the exercise or acquisition price of the stock or stock-based award. Financial Accounting Standards Board Statement No. 123, Accounting for Stock Based Compensation, (“Statement 123”) encourages companies to recognize expense for stock-based awards based on their estimated fair value on the date of grant. Statement 123 requires the disclosure of pro forma income and earnings per share data in the notes to the financial statements if the fair value method is not adopted.

The following table illustrates the effect on net income (loss) and earnings (loss) per share as if the Company had applied the fair value recognition provisions of Statement 123 to stock-based employee compensation:

	Year ended June 30
	2003			2004			2005
Net income (loss) as reported	$	(3,848,306	)	$	(926,765	)	$	1,934,077
Add: Stock-based employee compensation cost included in net loss, net of income taxes		—			102,071			34,200
Less: Total stock-based employee compensation expense determined under fair value based method for all awards, net of income taxes		(191,855	)		(253,450	)		(309,364	)
Pro forma net income (loss)		(4,040,161	)		(1,078,144	)		1,658,913
Less: Preferred stock dividends		—			(56,305	)		(77,862	)
Pro forma net income (loss) attributable to common shareholders	$	(4,040,161	)	$	(1,134,449	)	$	1,581,051
Earnings (loss) per common share – basic (as reported)	$	(0.48	)	$	(0.11	)	$	0.18
Earnings (loss) per common share – basic (pro forma)	$	(0.50	)	$	(0.12	)	$	0.15
Earnings (loss) per common share – diluted (as reported)	$	(0.48	)	$	(0.11	)	$	0.14
Earnings (loss) per common share – diluted (pro forma)	$	(0.50	)	$	(0.12	)	$	0.12

To determine the pro forma data as required by Statement 123, the Company used stock option pricing models to measure the fair value of stock options as of the date of grant. For all stock options granted prior to November 19, 2002, the date the Company’s common stock became publicly traded and had a readily determinable market value, the Company used the minimum value method to calculate pro forma stock compensation expense. For all stock options grated after this date, the Company used the Black-Scholes option pricing model.

F - 10

The minimum value method calculates the fair value of options as the excess of the estimated fair value of the underlying stock at the date of grant over the present value of both the exercise price and the expected dividend payments, each discounted at the risk-free rate, over the expected life of the option. The Black-Scholes option pricing model was developed for estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. Because the Company’s stock options have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its stock-based awards. The following are the assumptions made in computing the fair value of stock-based awards:

	Year ended June 30
	2003			2004			2005
Average risk-free interest rate		3.03	%		3.28	%		3.54% - 3.98	%
Dividend yield		0	%		0	%		0	%
Expected life		5 years			5 years			5 –6.2 years
Expected volatility		1.95			2.58			2.58 – 3.20
Weighted average fair value of granted options	$	0.86		$	0.52		$	0.47

Revenue Recognition and Accounts Receivable

Software products are sometimes sold in an arrangement that includes implementation services or maintenance services. Maintenance services are limited to help desk support and training. The Company allocates the total arrangement fee among each element based on vendor-specific objective evidence of the relative fair value of each of the elements. The Company limits its assessment of fair value of each element to the price charged when the same element is sold separately. If the fair value of each element in a multiple element arrangement cannot be reliably determined, and if the fair value of any undelivered element cannot also be reliably determined, all revenue under the arrangement is deferred until such time as the only remaining undelivered element is maintenance, or in the absence of maintenance, implementation services, upon which time revenue is recognized over the remaining maintenance or service period. Revenue that is deferred and recognized over a maintenance or service period is recognized in proportion to the services delivered, or ratably if no better measure of performance can be determined.

Revenues for software product sales are recognized as revenue when four criteria are met. These four criteria are (i) a signed purchase order has been obtained (ii) delivery of the software has occurred (iii) the fee is fixed or determinable and (iv) the fee is probable of collection. Software product sales billed and not recognized as revenue are included in deferred revenue. The Company generally does not require collateral for accounts receivable. The Company provides a 30-day return policy to its customers. The Company has historically not experienced significant returns, and accordingly, allowances for returned products are not recorded.

Maintenance services are sold for stated periods or for stated numbers of hours. Revenues are recognized ratably over the service period for arrangements to provide maintenance over a stated period. Revenues for maintenance delivered on an hourly basis are recognized as the services are delivered. Revenues from implementation and training services are recognized as the services are provided. Advance payments for these services are deferred and recognized in the periods when the services are performed.

The Company also receives commissions from vendors for transactions in which the Company essentially acts as an agent for the vendor. In these transactions, the Company does not take title to the product, have responsibility for the delivery of any services, or have risk of loss for collection. These commissions are recorded as revenue when earned.

Deferred Costs

The Company records as deferred costs any incremental direct costs associated with revenue that has been deferred in accordance with the Company’s revenue recognition policy. Deferred costs principally consist of product costs, and are classified in other assets in the accompanying balance sheets. These costs are subsequently recognized in earnings in the same proportion as the related revenue recognized.

Allowance for Doubtful Accounts

The Company uses estimates to determine the amount of the allowance for doubtful accounts necessary to reduce accounts receivable to its expected net realizable value. The Company estimates the amount of the required allowance by reviewing the status of past-due receivables and analyzing historical bad debt trends. Actual collection experience has not varied significantly from estimates, due primarily to credit policies, collection experience, and a lack of concentration of accounts receivable. The Company charges-off receivables deemed to be uncollectible to the allowance for doubtful accounts. Accounts receivable balances are not collateralized.

F - 11

Cost of Product Sales

Cost of product sales includes the costs of purchasing software and hardware from suppliers and the associated shipping and handling costs.

Cost of Service Revenue

Cost of service revenue consists primarily of direct employee compensation and related benefits, the cost of subcontracted services and direct expenses billable to customers. Cost of service revenue does not include an allocation of overhead costs.

Warranty Costs

The Company does not provide for warranty costs for its products as such costs are incurred by the manufacturer of the products.

Advertising Costs

Costs incurred for producing and communicating advertisements are expensed as incurred and included in selling, general and administrative expenses in the accompanying statements of operations. Advertising expenses approximated $780,000, $813,000 and $1,098,000 for years ended June 30, 2003, 2004 and 2005, respectively.

Business Segment Reporting

The Company’s operations are reviewed by the Company’s chief operating decision maker as a single segment.

Income Taxes

The Company uses the liability method to account for income taxes. Income tax expense includes income taxes currently payable and deferred taxes arising from temporary differences between financial reporting and income tax bases of assets and liabilities. Deferred income taxes are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse.

Stock Split

The Company’s board of directors authorized a three-for-one stock split in the form of a stock dividend to be distributed to stockholders of record on September 15, 2003. All share and per share data for periods prior to the stock split included in the consolidated financial statements have been restated to reflect the split.

Recent Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (“Statement 123(R)”), which is a revision of Statement 123. Statement 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their estimated fair values. Pro forma disclosure is no longer an alternative.

The Company will adopt the provisions of Statement 123(R) on July 1, 2005, using the modified prospective method. Unvested stock-based awards issued prior to November 19, 2002, the date that the Company’s common stock became publicly traded and disclosed in the accompanying consolidated financial statements using the minimum value method (rather than the estimated fair value using the Black-Scholes option pricing model), will be accounted for at the date of adoption using the intrinsic value method originally applied to those awards. Awards issued after November 19, 2002 and through June 30, 2005 which have not vested will be accounted for at the date of adoption using the same estimate of the grant-date fair value determined using the Black-Scholes option pricing model and disclosed in the historical financial statements in accordance with the provisions of Statement No. 123. (See also Note 1, Stock Options and Stock Granted to Employees.)

F - 12

As permitted by SFAS No. 123, the Company currently accounts for share-based payments to employees using the intrinsic value method and, accordingly, recognizes no compensation cost when employee stock options are granted with exercise prices equal to the quoted market value of the underlying shares on the date of grant. In addition, the Company’s employee stock purchase plan, accounted for as a non-compensatory plan under APB No. 25, will be accounted for as a compensatory plan under Statement 123(R), absent certain changes to the plan’s existing provisions. Accordingly, the adoption of Statement 123(R)’s fair value method may have a significant impact on the Company’s results of operations, although it will have no impact on its overall financial position. The impact of adoption of Statement 123(R) cannot be predicted at this time because it will depend significantly on levels of share-based payments granted in the future. Assuming that no additional share-based payments were granted in fiscal year 2006, compensation expense will increase by approximately $78,000 in fiscal year 2006 as a result of adopting Statement 123(R).

2. Supplemental Disclosure of Cash Flow Information

The Company paid interest of approximately $282,000, $235,000 and $604,000 in 2003, 2004 and 2005, respectively.

In 2004, the Company issued Series D Preferred Stock valued at $98,000 to reduce the value of a related party note payable.

3. Business Combinations

Merger with PlantCAD, Inc

On November 19, 2002, the Company consummated a merger with PlanetCAD Inc., whereby shareholders of the Company exchanged their shares of the Company’s common stock for common stock of PlanetCAD. Upon completion of the merger, the shareholders of the Company owned 75% of the outstanding common stock of PlanetCAD. PlanetCAD develops, markets, and supports cycle time reduction software solutions that integrate engineering processes and data for the manufacturing supply chain. In connection with the merger, options and warrants to purchase the common stock of the Company were converted into options and warrants to acquire common stock of the post-merger entity based on the merger exchange ratio.

For accounting purposes, the Company was deemed to have acquired PlanetCAD, as its shareholders own a majority of the outstanding common stock of the surviving entity. Upon the completion of the merger, the Company had 8,897,874 shares of outstanding common stock, 6,662,010 of which were issued to shareholders of Avatech upon the closing date. The results of operations of PlanetCAD are included in the accompanying 2003 statement of operations since November 1, 2002, or the effective date of the merger. The purchase method of accounting was used to record the acquisition, and the cost of acquiring PlanetCAD of $2.2 million, including estimated acquisition costs of $1.0 million, was assigned to acquired assets and liabilities based on their estimated fair value, as determined by an independent appraisal.

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The purchase price allocation to acquired assets and liabilities at the acquisition date is summarized below:

Assets
Cash	$	995,000
Accounts receivable		120,000
Investments		625,000
Prepaid expenses and other current assets		611,000
Property and equipment		337,000
Acquired technology and other amortizable intangible assets		216,000
Total assets	$	2,904,000
Liabilities
Accounts payable and accrued expenses		720,000
Deferred revenue		229,000
Total liabilities	$	949,000
Cost of net assets acquired, excluding acquired in-process research and development assets of $282,000	$	1,955,000

The value allocated to projects identified as in-process research and development of PlanetCAD products was charged to expense immediately following the completion of the merger and is included in the loss from operations of discontinued operating segments in the accompanying 2003 statement of operations. This write-off was necessary because the acquired in-process research and development had not yet reached technological feasibility and has no future alternative uses, and the related products under development may not achieve commercial viability. The value of acquired technology was determined by taking into account risks related to the characteristics and applications of the developed technology, existing and future markets and assessments of the stage of the developed technology’s life cycle. This analysis resulted in a valuation for developed technology that had reached technological feasibility and therefore was capitalized. The developed technology and other intangible assets were amortized on a straight-line basis over 4 to 6 years.

In May 2003, the Company sold the software acquired from PlanetCAD and discontinued the acquired PlanetCAD operations. Accordingly, pro forma operating data of PlanetCAD is not relevant to an understanding of the potential future effects of these operations on consolidated results of operations, and therefore is not presented. See Note 4 for additional information.

Acquisition of Comtrex Corporation

In April 2005, the Company acquired all of the assets of Comtrex Corporation, an authorized Autodesk reseller with offices in Greensboro, Charlotte and Morrisville, North Carolina. The purchase price for the acquired assets was the assumption of liabilities of approximately $573,000.

The fair values of the assets acquired and the liabilities assumed at the date of acquisition are as follows:

Accounts receivable, net of allowance for doubtful accounts of $40,600	$	224,865
Inventory		17,748
Prepaid expenses and other current assets		23,271
Office furniture and other equipment		27,348
Customer list		279,724
Total assets acquired	$	572,956
Accounts payable	$	281,483
Accrued compensation		12,518
Deferred revenue		5,445
Other current liabilities		98,740
Notes payable		174,770
Total liabilities assumed	$	572,956

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The following unaudited consolidated pro forma results of operations of the Company give effect to the acquisition of Comtrex, assuming that it occurred on July 1, 2003.

	Year ended June 30
	2004			2005
Revenues	$	31,862,000		$	37,100,000
Net income (loss)	$	(614,000	)	$	2,168,000
Earnings (loss) per common share- basic	$	(0.07	)	$	0.20
Earnings (loss) per common share- diluted	$	(0.07	)	$	0.16

The intangible asset resulting from this acquisition is attributed to the fair value of the Comtrex customer list which has an estimated useful life of four years. Future expected amortization expense is approximately $136,000 for fiscal year 2006, $60,000 for fiscal year 2007, and $30,000 for fiscal years 2008 and 2009.

4. Discontinued Operations of PlanetCAD and Certain Operating Segments

In June 2003, due to poor operating results, the Company closed three offices in New York, Michigan and Ohio. These locations were authorized software dealers subject to the Company’s channel partner agreement with its principal supplier. By virtue of these closings, the Company is no longer authorized to market or distribute software products subject to the channel partner agreements in those states. In connection with the closure of these locations, the Company recognized a loss on disposal of approximately $179,000 in June 2003.

The Company closed another office located in California in August 2003, which was also an authorized software dealer for which the Company is no longer authorized to market or distribute software products subject to the channel partner agreement with its principal supplier. In connection with the closing of the California office, the Company did not incur a gain or loss.

In addition, the Company in May 2003 decided to discontinue the PlanetCAD business it acquired in November 2002. These operations were conducted from the Company’s Boulder, Colorado office, which was closed in June 2003. The software product technology developed by PlanetCAD was sold in May 2003 to an unrelated third party in the United Kingdom for $1,200,000 and the Company recorded a loss on disposal of approximately $175,000 in June 2003.

These discontinued operations were components of the Company as their operations and cash flows were clearly distinguished, operationally and for financial reporting purposes, from the rest of the Company. The operations and cash flows of the components have been eliminated from the ongoing operations of the Company, and the Company will not have any significant continuing involvement in the operations of the components. Accordingly, the historical results of operations of these components are presented in the accompanying consolidated statements of operations as a separate component of operations classified as discontinued operations.

Summarized operating results of the discontinued operations are as follows:

	For the year ended June 30,
	2003			2004
Revenue:
Reseller locations	$	1,585,320		$	42,532
PlanetCAD operations		659,153			30,474
Total revenue	$	2,244,473		$	73,006
Pre-tax income (loss):
Reseller locations	$	61,770		$	(89,666	)
PlanetCAD locations		(1,564,308	)		(154,015	)
Total pre-tax loss	$	(1,502,538	)	$	(243,681	)

5. Borrowings Under Lines-of-Credit

The Company maintains a $3.0 million line of credit with a bank payable within 60 days of demand and expiring in September 2006. Outstanding borrowings are limited to 85% of the Company’s aggregate outstanding eligible accounts receivable, bear interest at the greater of 7.5%, or the prime rate plus 2.0% (8.25% at June 30, 2005) and are secured by the assets of the Company. In addition, the bank has the right to restrict any prepayment of other indebtedness by the Company.

On October 28, 2004, a wholly-owned subsidiary entered into a loan agreement with the bank to provide for a $700,000 revolving credit facility expiring on October 28, 2005. Borrowings under this credit facility bear interest

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at the greater of 7.5%, or the prime rate plus 2.0% (8.25% at June 30, 2005) and are secured by the assets of the Company and the guarantee of the Chairman of the Board of Directors. In December 2004, the Company paid the Chairman a commitment fee of $28,000 in cash and issued warrants to purchase 100,000 shares of common stock for $0.35 per share in consideration for the guarantee. The estimated fair value of the warrants of $34,136 was determined using a generally accepted valuation model.

The outstanding borrowings from the bank under the $3.0 million line and the $700,000 line were $3,197,857 at June 30, 2005. Because the interest rate adjusts with changes in the prime rate, the estimated fair value of the borrowings under the line of credit is equal to the carrying amount.

6. Long-Term Debt and Gain on the Extinguishment of Debt

Loans From Software Vendor

On July 22, 2003, the Company entered into a marketing and channel distribution agreement with a software vendor. Under this agreement, the Company provided marketing, distribution and related services for the vendor’s products. In connection with this agreement, the software vendor agreed to fund certain marketing costs incurred by the Company. Additionally, the arrangement provided for a loan by the software vendor to fund working capital needs related to the distribution of these products.

The terms of the loan agreement provided for a loan of $1,500,000 with repayment of principal plus interest at 6% per annum in thirty-five equal quarterly installments commencing in January 2005. In July 2005 the Company made the decision to discontinue its relationship with the vendor and restructured the loan. The new terms of the loan provide for quarterly principal payments of approximately $91,000 plus interest at an annual rate of 6%. These quarterly payments began in July 2005 and will continue until July 1, 2007 when the final payment of approximately $727,000 is due. The balance of this loan was $1,500,000 and $1,455,882 at June 30, 2004 and 2005, respectively.

Subordinated Notes Payable

At June 30, 2004 and 2005, the Company had outstanding notes payable of $198,750 and $172,500, respectively, due on July 1, 2005 and subordinated to other borrowings. The notes accrued interest at rates ranging from 10% to 12% per annum, payable quarterly and were repaid on July 1, 2005.

Note Payable To Related Party

On May 28, 2003, the Company issued a $1.0 million senior subordinated note to a director and shareholder. The note was issued in consideration for cash of $500,000 and satisfaction of a $500,000 note originally issued in August 2002. The note accrued interest at 12% per annum, with quarterly interest payments due commencing September 1, 2003, and matured on July 1, 2004. In connection with the issuance of the notes, the director and shareholder received warrants to purchase 97,200 shares of common stock for $0.27 per share that expire on June 1, 2008. These warrants were valued at $36,288 using the Black-Scholes option pricing model, and resulted in a debt discount of $36,288 being recorded and amortized over the term of the note as additional interest expense.

On April 1, 2004, the Company satisfied the note by issuing a new note to the director and shareholder with a face value of $902,000 that matured on July 1, 2005. The new note accrues interest at 12% per annum, with interest payments paid each quarter commencing July 1, 2004. In connection with the issuance of the new note, the director and shareholder was issued warrants to purchase 51,838 shares of common stock for $0.45 per share expiring on April 1, 2009. These warrants were valued at $24,000 using the Black-Scholes option pricing model, and resulted in debt discount of $24,000 that is being amortized over the term of the note as additional interest expense. On July 1, 2005, the maturity date of this borrowing was extended to July 1, 2006. In consideration for the extension of the loan’s maturity, the Company issued warrants to purchase 38,878 shares of common stock for $0.60 per share expiring on June 1, 2010. Using the Black-Scholes option pricing model, these warrants were valued at $23,327.

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Debt Maturities

The fair value of long-term debt at June 30, 2004 and 2005 approximates its carrying value based on assessment of market interest rates for similar instruments at those dates. The following summarizes the maturities of long-term debt and note payable to related party as of June 30, 2005:

Year ending June 30:
2006	$	605,343
2007		1,306,304
2008		759,262
	$	2,670,909

Gain on Extinguishment of Debt

At June 30, 2002, the Company was obligated to one of its suppliers under a note agreement in the amount of $2.96 million, bearing interest at 6.5% per annum. In August 2002, the Company entered into an agreement to extinguish the outstanding $2.96 million debt for a cash payment of $1.0 million and compliance with certain non-financial covenants. The gain on the extinguishment of the debt of $1.96 million was recorded in August 2002.

7. Preferred Stock

At June 30, 2003, the Company had issued and outstanding 172,008 shares of Series C Convertible Preferred Stock (“Series C”). On December 31, 2003, the Series C was converted into 484,487 shares of newly authorized Series D Convertible Preferred Stock (“Series D”).

During fiscal year 2004, the Company issued 813,050 shares of Series D for net cash proceeds totaling $330,000 and a reduction in notes payable to a related party of $98,000. In connection with the issuance of Series D, 1,730,043 warrants were granted to preferred shareholders. The warrants entitle the holder to purchase common stock at an exercise price of $0.45 per share up to one year after the date of grant.

At June 30, 2004 and 2005, 1,297,537 shares of Series D Convertible Preferred Stock were outstanding with the following terms:

Redemption Feature

The preferred stock is redeemable in the event that the Company is engaged in a business combination that is approved by the Board of Directors and subsequently submitted and approved by a vote of the Company’s shareholders. Any director who holds shares of Series D is not eligible to vote on the proposed business combination. The redemption price is $0.60 per share plus an amount equal to all declared and unpaid dividends accrued on such shares since the original issue date.

Voting Rights

Each holder of the preferred stock shall vote together with all other classes and series of stock of the Company as a single class on all actions. Each share shall entitle the holder to one vote per share of common stock into which the preferred stock is then convertible on each such action.

Dividend Rate

The holders of the Series D are entitled to receive cumulative dividends at a rate of 10.0% per annum when and as declared by the Board of Directors. Dividends are paid quarterly to preferred shareholders.

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Conversion Feature

The preferred stock is convertible at any time beginning 120 days after the original issuance date at the option of the holder and automatically converts into common stock if the common stock trades for more than $2.25 per share for 60 consecutive trading days.

Each share of preferred stock is convertible into shares of common stock by multiplying the appropriate conversion rate in effect by the number of shares of preferred stock being converted. Currently, the conversion rate is two shares of common stock for each share of Series D; however, this rate may be adjusted due to stock splits, dividends, and other events defined in the stock purchase agreement.

Liquidation Preference

In the event of a liquidation, dissolution or winding up of the Company, the holders of Series D are entitled to receive for each share, prior and in preference to any distribution of any of the assets or surplus funds to the holders of common stock, an amount equal to $0.60 per share plus all accumulated but unpaid dividends. If upon the occurrence of such event, the assets and funds thus distributed among the holders are insufficient to permit the payment of the preferential amount, then the entire assets and funds of the Company legally available for distribution shall be distributed ratably among the preferred stockholders.

8. Minority Interest

In fiscal year 2002, the Company issued convertible preferred stock through one of its subsidiaries. Dividends were paid each quarter from available cash of the subsidiary at a rate of 10% per annum. The dividends on the subsidiary’s preferred stock were recorded as minority interest expense in the consolidated statements of operations. Each share of preferred stock automatically converted into 3.3 shares of common stock of the parent on November 19, 2004. The preferred stock is presented as minority interest in the accompanying balance sheet at June 30, 2004.

9. Earnings (Loss) Per Share

Basic earnings (loss) per common share is computed as net earnings (loss) available to common stockholders divided by the weighted-average number of common shares outstanding for the period. Diluted earnings (loss) per common share include the potential dilution that would occur from common shares issuable upon the exercise of outstanding stock options and warrants and the conversion of preferred stock. Basic and diluted loss per common share are equal for 2003 and 2004 because the assumed exercise of options and warrants and the conversion of preferred stock is antidilutive. As of June 30, 2005, 4,588,628 shares of common stock were issuable upon the conversion or exercise of options, warrants and preferred stock.

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The following summarizes the computations of basic and diluted loss per common share:

	Year ended June 30
	2003			2004			2005
Numerator:
Income (loss) from continuing operations	$	(1,471,768	)	$	(683,084	)	$	1,934,077
Less: preferred stock dividends		—			(56,305	)		(77,862	)
Income (loss) from continuing operations available to common shareholders		(1,471,768	)		(739,389	)		1,856,215
Loss from discontinued operations, net of income taxes		(1,856,538	)		(243,681	)		—
Cumulative effect of change in accounting for goodwill		(520,000	)		—			—
Net income (loss) available to common shareholders	$	(3,848,306	)	$	(983,070	)	$	1,856,215
Denominator:
Weighted average shares outstanding - basic		8,028,030			9,341,785			10,355,150
Assumed conversion of preferred stock		—			—			2,597,236
Effect of outstanding stock options		—			—			518,615
Effect of outstanding stock warrants		—			—			476,054
Weighted average shares outstanding - diluted		8,028,030			9,341,785			13,947,055
Basic earnings (loss) per common share:
Earnings (loss) from continuing operations available to common shareholders	$	(0.18	)	$	(0.08	)	$	0.18
Loss from operations of discontinued operations, net of income taxes		(0.24	)		(0.03	)		—
Cumulative effect of change in accounting principle		(0.06	)		—			—
Basic earnings (loss) per common share	$	(0.48	)	$	(0.11	)	$	0.18
Diluted earnings (loss) per common share:
Earnings (loss) from continuing operations	$	(0.18	)	$	(0.08	)	$	0.14
Loss from operations of discontinued operations, net of income taxes		(0.24	)		(0.03	)		—
Cumulative effect of change in accounting principle		(0.06	)		—			—
Diluted earnings (loss) per common share	$	(0.48	)	$	(0.11	)	$	0.14
Antidilutive Stock Options		4,231,937			6,956,969			495,261

10. Stock Purchase Warrants

As of June 30, 2005, the Company has outstanding warrants to purchase common stock. A summary of these warrants is as follows:

Number of Shares	Exercise Price		Expiration Date
45,000	$	0.01	August 2013
51,838	$	0.45	April 2009
100,000	$	0.35	December 2007
45,000	$	0.21	July 2005
241,838

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11. Employee Stock Compensation Plans

Employee Stock Option Plans

The Board of Directors may grant options under four stock option plans to purchase shares of the Company’s common stock at a price not less than the fair market value of the common stock at the grant date. The Avatech Solutions, Inc. 2000 Stock Option Plan and the Avatech Solutions, Inc. 2002 Stock Option Plan are the only plans with significant stock option awards available for grant. All plans provide for the granting of either qualified or non-qualified stock options to purchase an aggregate of up to 4,955,000 shares of common stock to eligible employees, officers, and directors of the Company.

A summary of stock option activity and related information is included in the table below:

	Year ended June 30
	2003				2004				2005
	Options		Weighted Average Exercise Price		Options		Weighted Average Exercise Price		Options		Weighted Average Exercise Price
Outstanding at beginning of year	775,950		$	3.81	554,386		$	1.88	1,529,892		$	0.67
Granted	482,442			2.78	1,230,865			0.70	321,000			0.46
Exercised	—			—	—			—	(2,051	)		0.30
Forfeited	(224,431	)		6.40	(255,359	)		3.41	(109,900	)		0.52
Cancelled	(479,575	)		3.79	—			—	—			—
Outstanding at end of year	554,386		$	1.88	1,529,892		$	0.67	1,738,941		$	0.60
Exercisable at end of year	281,713		$	3.28	535,041		$	1.05	1,106,688		$	0.73
Weighted-average remaining contractual life of outstanding options				7.4 Years				8.7 Years				7.2 Years

All options granted have an exercise price equal to the fair value of the Company’s common stock on the date of grant. Exercise prices for options outstanding as of June 30, 2005 ranged from $0.17 to $63.33 as follows:

Range of Exercise Prices	Options Outstanding	Weighted Average Exercise Prices of Options Outstanding		Weighted Average Remaining Contractual Life of Options Outstanding	Options Exercisable	Weighted Average Exercise Prices of Options Exercisable
$0.17 - 0.34	714,404	$	0.20	6.6 years	500,875	$	0.22
0.35 - 0.91	988,000		0.54	7.7 years	573,660		0.58
1.17 - 63.33	36,537		10.10	5.7 years	32,153		11.32
	1,738,941				1,106,688

Stock Option Cancellation Program

In April 2003, the Company offered its employees a voluntary option to surrender and cancel certain outstanding stock option agreements. Under the terms of the arrangement, the employee, if still employed, received an equivalent number of stock options six months and a day after the specific cancellation periods. In conjunction with this arrangement, the Company granted stock options for the purchase of 274,486 shares of common stock in November 2003, with exercise prices equal to the fair value of the Company’s common stock that vest over various periods of up to 24 months.

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Employee Stock Purchase Plan

In June 1996, the Board of Directors adopted, and its stockholders subsequently approved, the Employee Stock Purchase Plan (the “Plan”), under which 100,000 shares of common stock were initially reserved for issuance. As a result of amendments to the Plan there are 1,000,000 shares of common stock authorized for issuance, of which 421,202 were available for future issuance at June 30, 2005.

The Plan is administered by the Compensation Committee of the Board of Directors. Generally, each offering is of six months’ duration, but can extend as long as twenty-seven months. Eligible employees may purchase up to 15% of their compensation in common stock at a price equal to 85% of the lower of the fair value of the common stock at the beginning or end of the offering period.

In fiscal year 2005, the Board of Directors authorized two six-month offerings to all eligible employees, with the first offering concluding on December 31, 2004 and the second offering concluding on June 30, 2005. The Board of Directors instituted a 10,000 share limit per employee for both offering periods. As of June 30, 2005, the balance withheld from employees’ pay totaled $40,934 and in July 2005, 120,394 shares of common stock were issued to employees under the Plan.

Restricted Stock Award Plan

In May 2003, the Company’s Board of Directors approved the Avatech Solutions, Inc. Restricted Stock Award Plan. Employees and consultants of the Company are eligible to receive stock awards under this plan if they are already shareholders or hold options to purchase shares of common stock. Additionally, officers or directors of the Company are eligible to receive restricted stock awards regardless of any pre-existing ownership of common stock or stock options. Vesting for restricted stock awards granted under this plan may vary, but awards will generally vest based on continued service of the recipient or achievement of specific performance goals. The Company has reserved 600,000 shares of common stock for issuance under the Restricted Stock Award Plan.

In July 2003, the Company awarded 570,000 shares of restricted stock to several of its officers and one director. 270,000 shares vested immediately, and 300,000 shares vested over one or two years. The quoted market price of the common stock was $0.17 per share, resulting in compensation expense over the vesting period of approximately $93,000. Through June 30, 2004, 90,000 unvested shares were forfeited by several officers when they voluntarily terminated employment with the Company.

In October 2003, the Company awarded 40,590 shares of unrestricted common stock to certain directors as compensation for service on the Company’s Board of Directors. These shares were issued at $0.29 per share, the quoted market price on the date of grant.

In February and April 2004, the Company awarded 41,915 shares of restricted stock to certain directors as compensation for service on the Company’s Board of Directors. These shares were issued at quoted market prices on the date of grant (weighted-average fair value of $0.40 per share). The aggregate market value of these awards totaled $16,800.

During fiscal year 2005, the Company awarded 61,258 shares of restricted stock to certain directors as compensation for service on the Company’s Board of Directors. These shares were issued at quoted market prices on the date of grant (weighted-average fair value of $0.57 per share). The aggregate market value of these awards totaled $34,800.

For the years ended June 30, 2004 and 2005, the Company recorded aggregate expense of $102,000 and $34,200 for common stock grants to officers and directors.

12. Shares Reserved for Future Issuance

At June 30, 2005, the Company has reserved 4,588,628 shares of common stock for future issuance upon the exercise of any stock options granted under the Company’s stock option plans, exercise of outstanding stock purchase warrants, issuance of restricted stock awards, purchases under the employee stock purchase plan and the conversion of preferred stock.

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13. Income Taxes

Income tax expense (benefit) includes current state income taxes of approximately $35,000, $30,000 and $25,000 for 2003, 2004, and 2005, respectively. In 2003, the Company increased the valuation allowance for the deferred tax assets by $373,000, resulting in additional income tax expense.

Significant components of the Company’s deferred tax assets and liabilities are as follows:

	Year ended June 30
	2004			2005
Deferred tax assets:
Net operating loss carryforward	$	3,178,143		$	2,353,410
AMT credit carryforward		—			50,000
Allowance for doubtful accounts		40,000			59,700
Book over tax depreciation		54,856			55,730
Total deferred tax assets		3,272,999			2,518,840
Valuation allowance for deferred tax assets		(3,272,999	)		(2,518,840	)
Net deferred tax assets	$	—		$	—

The Company has recorded a valuation allowance for its deferred tax assets due to the inability to conclude that it is more likely than not that these assets will be realized from future taxable income.

The Company’s provision for income taxes resulted in effective tax rates attributable to loss from continuing operations before cumulative effect of change in accounting principal that varied from the statutory federal income tax rate of 34%, as summarized in the table below.

	Year ended June 30
	2003			2004			2005
Expected federal income tax expense (benefit) from continuing operations at 34%	$	(361,657	)	$	(222,083	)	$	685,391
Expenses not deductible for income tax purposes		14,074			78,936			51,061
State income taxes, net of federal benefit		23,100			(27,563	)		99,487
Change in valuation allowance for deferred tax assets		732,555			200,608			(754,159	)
Income tax expense (benefit)	$	408,072		$	29,898		$	81,780

At June 30, 2005, the Company has net operating loss carryforwards totaling approximately $5.9 million, which will begin to expire in 2012. Certain net operating loss carryforwards at June 30, 2005 are limited on their use under Internal Revenue Code Section 382.

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14. Commitments and Contingencies

Operating Leases

The Company leases certain office space and equipment under noncancellable operating lease agreements that expire in various years through 2011, and generally do not contain significant renewal options. Future minimum payments under all noncancellable operating leases with initial terms of one year or more consisted of the following at June 30, 2005:

Year ending June 30:
2006	$	1,202,408
2007		1,013,441
2008		803,365
2009		572,854
2010		390,437
2011 and thereafter		365,994
Total minimum lease payments	$	4,348,499

Rent expense consisted of the following:

	Year ended June 30
	2003		2004		2005
Office space	$	1,085,858	$	1,052,934	$	997,273
Equipment		14,695		37,269		13,955
	$	1,100,553	$	1,090,203	$	1,011,228

Rent expense for the years ended June 30, 2003, 2004 and 2005 included amounts paid to related parties of approximately $90,000, $87,000 and $44,000, respectively.

Agreements with Executives

The Company has entered into agreements with certain executives and key management employees that provide for severance payments ranging from three to twelve months of salary and immediate vesting of all stock options not previously vested upon termination of the employee or a change in control of the Company. At June 30, 2005, the total contingency was approximately $679,000.

15. Employee Benefit and Incentive Compensation Plans

Effective January 1, 1998, the Company adopted the Avatech Solutions, Inc. 401(k) Retirement Savings Plan and Trust (the “Plan”). The Plan is a defined contribution plan, which covers substantially all employees of the Company, or its wholly-owned subsidiaries, who have attained age 21 and have completed six months of service. Participants may elect a pre-tax payroll deduction up to $14,000 (if under age 50), or $18,000 (if age 50 or older by December 31, 2005). The Company will match 25% of the participant salary deferrals up to 6% of a participant’s compensation for all participants employed on the last day of the Plan year. The Company may also make discretionary profit-sharing contributions to the Plan for all participants who are employed on the last day of the Plan year. The total amount recorded by the Company as expense during the years ended June 30, 2003, 2004 and 2005 was approximately $78,000, $79,000 and $76,000, respectively.

16. Significant Supplier

Approximately 88%, 94% and 94% of the Company’s inventory purchases for the years ended June 30, 2003, 2004 and 2005, respectively, were from one vendor and approximately 67% and 72% of accounts payable at June 30, 2004 and 2005, respectively, were due to this vendor. Approximately 91% of the Company’s total product revenues are related to this supplier’s products.

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17. Liquidity and Capital Resources and Subsequent Event

The Company has incurred significant operating losses since its inception that have depleted its capital resources. However, operating results improved in recent years and the Company reported net income of $1,934,077 for the year ended June 30, 2005. In addition, in July 2005, the Company raised cash of $1,191,000 through an offering of 1,191 shares of Series E Convertible Preferred Stock with terms similar to the outstanding Series D Convertible Preferred Stock (See Note 7) and is in the process of securing additional financing by obtaining an increased credit limit under a line of credit from a new bank.

Based on the cash generated from the sale of the Series E Convertible Preferred Stock in July 2005, and an evaluation of likely cash to be generated from operations in the near term and other available capital resources, management believes that it has sufficient sources of working capital to fund its operations in the normal course of business through at least July 1, 2007.

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EX-23.1

Exhibit 23.1

Consent of Independent Registered Public Accounting Firm

We consent to the incorporation by reference in the following Registration Statements of our reports dated September 21, 2005, with respect to the consolidated financial statements and schedule of Avatech Solutions, Inc. included in the Annual Report (Form 10-K) for the year ended June 30, 2005.

Registration Statements on Form S-3:

REGISTRATION NUMBER	DATE FILED
333-50426	November 28, 2001
Registration Statements on Form S-8:
REGISTRATION NUMBER	NAME	DATE FILED
333-14429	1996 Amended and Restated 1987 Stock Option Plan 1996 Equity Incentive Plan 1996 Non-Employee Directors’ Stock Option Plan Employee Stock Purchase Plan	October 18, 1996
333-56079	1996 Equity Incentive Plan Employee Stock Purchase Plan	June 4, 1998
333-59569	1998 Non-Officer Stock Option Plan	July 22, 1998
333-85939	1996 Equity Incentive Plan Employee Stock Purchase Plan 1998 Non-Officer Stock Option Plan	August 26, 1999
333-107017	Restricted Stock Award Plan	July 14, 2003
333-108354	2002 Stock Option Plan	August 29, 2003
333-117195	Employee Stock Purchase Plan	July 7, 2004
	/s/    ERNST & YOUNG LLP

Baltimore, Maryland

September 28, 2005

EX-31.1

Exhibit 31.1

CERTIFICATION

I, Donald R. Walsh, certify that:

1. I have reviewed this Annual Report on Form 10-K of Avatech Solutions, 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 officer 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 (the Registrant’s fourth fiscal quarter in the case of an annual report) 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 officer 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: September 28, 2005	/S/    DONALD R. WALSH
	Donald R. Walsh
	Chief Executive Officer

EX-31.2

Exhibit 31.2

CERTIFICATION

I, Lawrence Rychlak, certify that:

1. I have reviewed this Annual Report on Form 10-K of Avatech Solutions, 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 officer 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 (the Registrant’s fourth fiscal quarter in the case of an annual report) 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 officer 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: September 28, 2005	/S/    LAWRENCE RYCHLAK
	Lawrence Rychlak
	Chief Financial Officer

EX-32.1

Exhibit 32.1

SECTION 1350 CERTIFICATIONS

In connection with the Annual Report of Avatech Solutions, Inc. (the “Company”) on Form 10-K for the period ending June 30, 2005 as filed with the Securities and Exchange Commission and to which this Certification is an exhibit (the “Report”), the undersigned hereby certify, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:

(1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company for the periods reflected therein.

Date: September 28, 2005	/s/    DONALD R. WALSH
	Donald R. Walsh
	Chief Executive Officer
	/s/    LAWRENCE RYCHLAK
	Lawrence Rychlak
	Chief Financial Officer