We account for our warrants in accordance with Emerging Issues Task Force Issue No. 00-19, "Accounting for Derivative Financial Instruments Indexed to and Potentially Settled in a Company's Own Stock" ("EITF 00-19") which requires warrants to be classified as permanent equity, temporary equity or as assets or liabilities. In general, warrants that either require net-cash settlement or are presumed to require net-cash settlement are recorded as assets and liabilities at fair value and warrants that require settlement in shares are recorded as equity instruments. Certain of our warrants require settlement in shares and are accounted for as permanent equity. We also have two investor warrants that are classified as liabilities because they include a provision that specifies that we must deliver freely tradable shares upon exercise by the warrant holder. Because there are circumstances, irrespective of likelihood, which may not be within our control that could prevent delivery of registered shares, EITF 00-19 requires the warrants be recorded as a liability at fair value, with subsequent changes in fair value recorded as income (loss) in change in fair value of warrant liability. The fair value of the warrant is determined using a Black-Scholes option pricing model, and is affected by changes in inputs to that model including our stock price, expected stock price volatility and contractual term.

The amount we record as a liability under EITF 00-19 is not, nor do we intend for it to be an admission or stipulation of the amount that we would owe or be obligated to pay the warrant holder in the event of an actual breach by us of the warrant terms. In fact, we have made no determination of the amount of liability, if any, that we would owe to the warrant holder in the event of such a breach.

As part of the process of preparing our consolidated financial statements we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process requires us to estimate our actual current tax expense and to assess temporary differences resulting from book-tax accounting differences for items such as deferred revenue. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not likely, we must establish a valuation allowance. In the event that we determine that we would be able to realize deferred tax assets in the future in excess of the net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made.

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Significant management judgment is required to determine the valuation allowance recorded against our net deferred tax assets, which consist of net operating loss and tax credit carry forwards. We have recorded a valuation allowance of approximately $71.4 million as of March 31, 2009, due to uncertainties related to our ability to utilize most of our deferred tax assets before they expire. The valuation allowance is based on our estimates of taxable income by jurisdiction in which we operate and the period over which our deferred tax assets will be recoverable.

We have received inquiries, demands or audit requests from several states and municipal taxing and 9-1-1 agencies seeking payment of taxes that are applied to or collected from the customers of providers of traditional public switched telephone network services. We have recorded an expense of $72,000 and $375,000 for the years ended March 31, 2009 and 2008, respectively, as our estimate of the increase in probable tax exposure for such assessments. Our cumulative estimate for probable assessments is $0.2 million as of March 31, 2009, which is recorded in the accrued taxes line item in the consolidated balance sheets.

Stock-based compensation expense recognized in the Consolidated Statements of Operations for fiscal 2009 included both the unvested portion of stock-based awards granted prior to April 1, 2006 and stock-based awards granted subsequent to April 1, 2006. Stock options granted in periods prior to fiscal 2007 were measured based on SFAS No. 123 criteria, whereas stock options granted subsequent to April 1, 2006 were measured based on SFAS No. 123(R) criteria. In conjunction with the adoption of SFAS No. 123(R), we changed our method of attributing the value of stock-based compensation to expense from the accelerated multiple-option approach to the straight-line single option method. Compensation expense for all share-based payment awards granted subsequent to April 1, 2006 has been recognized using the straight-line single-option method. Stock-based compensation expense included in fiscal 2009 included the impact of estimated forfeitures. SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. For the periods prior to fiscal 2007, we accounted for forfeitures as they occurred.

To value option grants and stock purchase rights under the Purchase Plan for actual and pro forma stock-based compensation we used the Black-Scholes option valuation model. Fair value determined using the Black-Scholes option valuation model varies based on assumptions used for the expected stock prices volatility, expected life, risk free interest rates and future dividend payments. For fiscal years 2009, 2008 and 2007, we used the historical volatility of our stock over a period equal to the expected life of the options to their fair value. The expected life assumptions represent the weighted-average period stock-based awards are expecting to remain outstanding. These expected life assumptions were established through the review of historical exercise behavior of stock-based award grants with similar vesting periods. The risk free interest was based on the closing market bid yields on actively traded U.S. treasury securities in the over-the-counter market for the expected term equal to the expected term of the option. The dividend yield assumption was based on our history and expectation of future dividend payout.

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SFAS No. 123(R) requires us to calculate the additional paid in capital pool ("APIC Pool") available to absorb tax deficiencies recognized subsequent to adopting SFAS No. 123(R), as if we had adopted SFAS No. 123 at its effective date of January 1, 1995. There are two allowable methods to calculate our APIC Pool: (1) the long form method as set forth in SFAS No. 123(R) or (2) the short form method as set forth in FASB Staff Position No. 123(R)-3. We have elected to use the long form method under which we track each award grant on an employee-by-employee basis and grant-by-grant basis to determine if there is a tax benefit or tax deficiency for such award. We then compared the fair value expense to the tax deduction received for each grant and aggregated the benefits and deficiencies to establish the APIC Pool.

Due to the adoption of SFAS No. 123R, some exercises result in tax deductions in excess of previously recorded benefits based on the option value at the time of grant, or windfalls. We recognize windfall tax benefits associated with the exercise of stock options directly to stockholders' equity only when realized. Accordingly, we are not recognizing deferred tax assets for net operating loss carryforwards resulting from windfall tax benefits occurring from April 1, 2006 onward. A windfall tax benefit occurs when the actual tax benefit realized by the company upon an employee's disposition of a share-based award exceeds the deferred tax asset, if any, associated with the award that the company had recorded. We use the "with and without" approach as described in Emerging Issues Task Force ("EITF") Topic No. D-32, in determining the order in which our tax attributes are utilized. The "with and without" approach results in the recognition of the windfall stock option tax benefits only after all other tax attributes of ours have been considered in the annual tax accrual computation. Also, we have elected to ignore the indirect tax effects of share-based compensation deductions in computing our research and development tax and as such, we recognize the full effect of these deductions in the income statement in the period in which the taxable event occurs.

On January 27, 2009, our board of directors approved the acceleration of unvested stock options to purchase 3,902,186 shares of common stock. 1,737,509 of these shares are subject to options held by our executive officers and directors. These options of our executive officers and directors, taken as a whole, have a weighted average exercise price of $1.06 per share and range from $0.63 to $1.79 per share, and a weighted average remaining vesting term of 2.85 years. Approximately $1.1 million of the $2.4 million stock-based compensation charge in the fourth quarter of 2009 applies to the options held by our executive officers and directors.

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SELECTED OPERATING STATISTICS

We periodically review certain key business metrics, within the context of our articulated performance goals, in order to evaluate the effectiveness of our operational strategies, allocate resources and maximize the financial performance of our business. The selected operating statistics include the following:

(1) Includes 1,154 "Find me, Follow me" and 40 8x8 Virtual Office customers acquired in the second quarter of fiscal 2009 from Avtex Solutions, LLC ("Avtex").

(2) Business customer churn is calculated by dividing the number of business customers that terminated (after the expiration of the 30 day trial) during that period by the simple average number of business customers during the period and dividing the result by the number of months in the period. The simple average number of business customers during the period is the number of business customers on the first day of the period plus the number of business customers on the last day of the period divided by two.

(3) Business customers are defined as customers paying for service. Prior to April 1, 2008, 8x8 included customers in the business customer count that were using the service as a trial or evaluation and not yet paying for service. The numbers in this table prior to and after April 1, 2008, only include business customers that are paying for service. Customers that have prepaid for their first month of service and are currently in the 30 day trial period are considered to be customers that are paying for service.

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(4) Business customer average monthly service revenue per customer is service revenue from business customers in the period divided by the number of months in the period divided by the simple average number of business customers during the period.

(5) Total (business, residential and video) subscriber acquisition cost per service is defined as the combined costs of advertising, marketing, promotions, commissions and equipment subsidies during the period divided by the number of gross services added during the period.

(6) Business subscriber acquisition cost per service is defined as the combined costs of advertising, marketing, promotions, commissions and equipment subsidies for business services sold during the period divided by the number of gross business services added during the period. The addition of 1,154 Avtex customers that migrated to 8x8 in the second fiscal quarter of 2009 but subscribed to "Find me, Follow me" services rather than 8x8 Virtual Office service, and the $79,230 in expense related to the acquisition of these 1,154 customers, is excluded from this calculation.

(7) Business customer subscriber acquisition cost is business subscriber acquisition cost per service times the average number of services subscribed to per business customer.

(8) Total (business, residential and video) customer churn is calculated by dividing the number of services terminated (after the expiration of the 30 day trial) during that period by the simple average number of services during the period and dividing the result by the number of months in the period.

We believe it is useful to monitor these metrics together and not individually as we do not make business decisions based upon any single metric.

The following discussion should be read in conjunction with our Consolidated Financial Statements and related notes included elsewhere in this Report.

Service revenues consist primarily of revenues attributable to the provision of our 8x8 services and royalties earned under our VoIP technology licenses. We expect that 8x8 service revenues will continue to comprise nearly all of our service revenues for the foreseeable future.

The increase in fiscal year 2009, compared with fiscal year 2008, was primarily attributable to a $9.3 million increase in 8x8 service revenues resulting from the growth of our business service subscriber base. Our business service subscriber base grew from approximately 11,000 customers at the end of fiscal 2008 to approximately 16,000 customers on March 31, 2009. The increase was offset by a decrease of $5.7 million attributable to residential and videophone services and a $0.7 million decrease in revenue attributable to royalties earned. The decrease in service revenues from residential and video customers resulted from a reduction in the number of residential and video lines in service from approximately 107,000 in fiscal 2008 to approximately 82,000 in fiscal 2009. Also, compared with fiscal 2008, there was a $0.6 million reduction in the one time recognition of revenue due to a ruling by the U.S. Court of Appeals for the District of Columbia in June 2007 that interconnected VoIP providers are not required to obtain pre-approval of traffic studies. As a result of the ruling, in the first quarter of fiscal 2008 we retroactively applied our traffic study contribution rate to our historical subscriber retail revenues which resulted in the recognition of revenue of $0.6 million from the reduction of the related accrued liability in the first fiscal quarter of 2008.

The increase in fiscal year 2008, compared with fiscal year 2007, was primarily attributable to an $11.8 million increase in 8x8 service revenues resulting from the growth in the business service subscriber base and an increase in the price of our service instituted on March 1, 2007. The business service subscriber base grew from approximately 7,000 customers at the end of fiscal 2007 to approximately 11,000 on March 31, 2008. Our residential customer base did not significantly change between the end of fiscal 2007 and 2008, as the decline in our existing customer base was offset by the transition of a competitor's

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former customers to the 8x8 residential service. While service revenues increased during fiscal 2008 our wholesale service and royalty revenues declined by $1.3 million primarily due to the termination of our agreement with Bellsouth in the fourth fiscal quarter of 2007 in connection with its merger with AT&T.

The decrease in fiscal year 2008 from fiscal year 2007 was primarily attributable to a $3.4 million decrease in product revenue attributable to residential customers as we redirected our marketing away from residential customers to marketing our services to small businesses. In addition, we waived the regular start-up costs, which include the equipment cost associated with residential service plans, as part of the transition of a competitor's former customers to the 8x8 service. The decrease in residential customer product revenues during fiscal 2008 was partially offset by an increase of $0.8 million in product revenue attributable to the growth in our business customer subscriber base.

No single customer represented more than 10% of our total revenues during fiscal 2009, 2008 or 2007.

The following table illustrates our net revenues by geographic area. Revenues are attributed to countries based on the destination of shipment (in thousands):

The cost of service revenues primarily consist of costs associated with network operations and related personnel, telephony origination and termination services provided by third party carriers and technology license and royalty expenses.

Cost of service revenues for fiscal 2009 compared with fiscal 2008 decreased $1.0 primarily due to a reduction in pricing by third party network service vendors and our use of multiple third party network provider vendors, which allows us to route call traffic to the third party network provider vendor with the most favorable pricing. The reduction in pricing by third party

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network service vendors was partially offset by an increase in personnel and licenses fee costs compared with the prior fiscal year.

Cost of service revenues for fiscal 2008 compared with fiscal 2007 decreased $2.3 million also due to a price reduction by third party network service vendors and our switch to the use of multiple third party network provider vendors throughout fiscal 2007 and 2008. The cost of service revenues as a percentage of service revenues decreased substantially from fiscal 2007 to fiscal 2008 due to a reduction in pricing by third party network service vendors combined with an increase in the percentage of total revenue from business customers. The cost of service revenues as a percentage of service revenues is less for business customers than for residential customers.

The cost of product revenues consist of costs associated with systems, components, system manufacturing, assembly and testing performed by third party vendors, estimated warranty obligations and direct and indirect costs associated with product purchasing, scheduling, quality assurance, shipping and handling. We generally do not charge residential subscribers for the terminal adapters used to provide our service when they subscribe through our website. We also have offered incentives to customers who purchase terminal adapters and telephones in our retail channels to offset the customer's cost of the equipment purchased from a retailer. We allocate a portion of service revenues to product revenues but these revenues are less than the cost of the terminal adapters.

The increase in the cost of product revenues for fiscal 2009 from fiscal 2008 was primarily due to a $2.0 million increase in the shipment of equipment to our business customers. The increase in cost of product revenues was partially offset by a $1.7 million decrease in shipments of equipment to residential subscribers and a $0.4 million reduction in freight costs. The cost of product revenues as a percentage of product revenues decreased in part due to a reduction in discounting of product sales by our sales force in fiscal 2009.

The decrease in the cost of product revenues for fiscal 2008 from fiscal 2007 was primarily due to a $1.1 million reduction in shipments of residential and videophone equipment and a $0.5 million reduction in product reserves as we eliminated a royalty expense accrual after determining that we were unlikely to pay such royalties in the future.

Cost of product revenues during fiscal 2008 included an increase of $0.3 million for shipments of equipment attributable to growth in our business customer subscriber base and a $0.1 million increase in costs from the write-off of equipment shipped to a failed retailer. The cost of product revenues as a percentage of product revenue increased due to an increase in shipments of equipment to residential subscribers who switched to our service when one of our competitors shut down and terminated its service offering.

Historically, our research and development expenses have consisted primarily of personnel, system prototype design, and equipment costs necessary for us to conduct our development and engineering efforts. We expense research and development costs, including software development costs, as they are incurred.

The increase in research and development expenses for fiscal 2009 from fiscal 2008 was primarily attributable to an increase in personnel and contractor headcount expenses, including a $0.3 million increase in SFAS 123(R) stock-based compensation expense.

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The decrease in research and development expenses for fiscal 2008 from fiscal 2007 was primarily attributable to a $0.3 million decrease in contractor headcount expenses. In addition, departures by employees that we did not replace in fiscal 2008 reduced total research and development expenses.

Selling, general and administrative expenses consist primarily of personnel and related overhead costs for sales, marketing, customer support, finance, human resources and general management. Such costs also include outsourced customer service call center operations, sales commissions, as well as trade show, advertising and other marketing and promotional expenses.

The increase in selling, general and administrative expenses for fiscal 2009 from fiscal 2008 was primarily due to a $4.1 million increase in employee and temporary personnel costs, including a $1.5 million increase in SFAS 123(R) stock-based compensation expense, $0.5 million increase in advertising, public relations and other marketing and promotional expenses, a $0.2 million increase in travel and meal expenses, a $0.1 million increase in printing expenses, and a $0.1 million increase in expensed equipment and software. This increase was partially offset by a $1.5 million decrease in sales agent and retailer commissions, a $0.9 million decrease in sales and use tax expenses as we began to collect and remit taxes in states outside of California, a $0.3 million decrease in accounting and tax fees, and a $0.2 million decrease in credit card processing fees.

The increase in selling, general and administrative expenses for fiscal 2008 from fiscal 2007 was primarily due to a $2.3 million increase in additional employee and temporary personnel costs and a $1.4 million increase in advertising, public relations, and other marketing and promotional expenses. This increase was partially offset by a $0.9 million decrease in sales agent and retailer commissions and a $0.5 million decrease in sales and use tax expenses as we began to collect and remit taxes in states outside of California.

Our interest income and other, net, primarily consists of interest and investment income earned on our cash, cash equivalents and investment balances. This item consisted of interest income alone in 2009. Other income in fiscal 2008 included $1.2 million from the sale of two patents.

The increase in other income for fiscal 2008 from fiscal 2007 consists primarily of $1.2 million from the sale of two patents offset by a reduction in interest and investment income earned on our cash, cash equivalents and investment balances of $0.2 million due to lower average cash balances and interest rates.

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INCOME ON CHANGE IN FAIR VALUE OF WARRANT LIABILITY

In connection with the sale of shares of our common stock in fiscal 2005 and 2006, we issued warrants in three different equity financings. The warrants included a provision that we must deliver freely tradable shares upon exercise of the warrant. Because there are circumstances that may not be within our control that could prevent delivery of registered shares, EITF 00-19 requires the warrants be recorded as a liability at fair value with subsequent changes in fair value recorded as a gain or loss. The fair value of the warrant is determined using a Black-Scholes option pricing model, and is affected by changes in inputs to that model including our stock price, expected stock price volatility and contractual term. To the extent that the fair value of the warrant liability increases or decreases, we record a loss or income in our statement of operations. The amount we record as a liability under EITF 00-19 is not, nor do we intend for it to be, an admission or stipulation of the amount that we would owe or be obligated to pay the warrant holder in the event of an actual breach by us of the warrant terms. In fact, we have made no determination of the amount of liability, if any, that we would owe to the warrant holder in the event of such a breach.

The decrease in the income from change in fair value of warrants in fiscal 2008 from fiscal 2007 occurred because the fair value of warrants and warrant liability declined due to a reduction in our stock price, expected stock price volatility and contractual life of the warrants. Furthermore, on August 29, 2007, we and the warrant holders amended the terms of warrants to purchase 3,659,624 shares of common stock that we had classified as liabilities. The amended warrants met the requirement to be classified as equity and accordingly, they were reclassified from liability to equity. A total of $0.8 million of the income from the change in fair value of the warrants in fiscal 2008 was related to the amended warrants and $0.9 million was reclassified from liability to equity. The remaining investor warrants for 1,785,714 shares of common stock issued on December 19, 2005 have not been amended and will continue to be accounted for as liabilities until exercised or expiration in December 2010.

We had a $45,000 provision for income taxes for the fiscal year ended March 31, 2009 for state tax in several states and foreign withholding tax on royalty revenue. We had no provision for income taxes in the fiscal years ended March 31, 2008 and 2007.

At March 31, 2009, we had net operating loss carryforwards for federal and state income tax purposes of approximately $153.9 million and $88.1 million, respectively, that expire at various dates beginning in 2013 and continuing through 2029. In addition, at March 31, 2009, we had research and development credit carryforwards for federal and state tax reporting purposes of approximately $3.4 million and $2.8 million, respectively. The federal credit carryforwards will begin expiring in 2010 continuing through 2029, while the California credit will carry forward indefinitely. Under the ownership change limitations of the Internal Revenue Code of 1986, as amended, the amount and benefit from the net operating losses and credit carryforwards may be impaired or limited in certain circumstances.

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At March 31, 2009 and 2008, we had gross deferred tax assets of approximately $71.4 million and $72.1 million, respectively. Because of uncertainties regarding the realization of deferred tax assets, we have applied a full valuation allowance as of March 31, 2009 and 2008.

As of March 31, 2009, we had $16.4 million of cash and cash equivalents. By comparison, at March 31, 2008, we had $11.2 million in cash and cash equivalents, and $3.4 million in investments for a combined total of $14.6 million. We currently have no borrowing arrangements. Our cash and cash equivalents balance increased $5.2 million and the combined balance increased by $1.8 million during fiscal 2009. The increase in cash, cash equivalents and investments was primarily attributable to a $2.3 million of cash from operating activities, and $0.4 million of proceeds from issuance of common stock under employee stock plans, partially offset by $0.8 million of capital expenditures, as discussed below.

Net cash provided by operating activities for fiscal 2009 was $2.3 million, compared with $3.0 million provided by operating activities for fiscal 2008.

The net cash provided by operating activities for fiscal 2009 resulted primarily from a net loss of $2.5 million, a $3.3 million adjustment for stock compensation, which includes $2.4 million due to the acceleration of unvested employee stock options in January 2009, a $1.3 million adjustment for depreciation, a $1.0 million reduction in accounts receivable related to the payment by nationwide retailers and software licensing and royalty customers, a $0.8 million reduction in deferred cost of goods sold primarily related to sell thru of equipment by retailers and net retailer returns, a $1.3 million increase in other current and noncurrent liabilities primarily due to a license and settlement agreement, a $0.6 million provision for inventory primarily due to $0.5 million of excess inventory related to our business services analog phone, a $0.4 million provision for doubtful accounts primarily related to royalty revenue, and a $0.2 million write off of our legacy billing system recorded as other adjustments to reconcile net loss to net cash provided by operating activities. This was reduced by a $1.4 million increase in inventory due to the procurement of the new business IP phones launched in July 2008, timing of receipt of inventory and net retailer returns, a reduction of $1.3 million due to payment of accrued sales tax, a net $0.2 million increase in accrued taxes, a $0.9 million decrease in deferred revenue related to cash collections of $4.3 million from annual service plans in which the customer pre-pays for 12 months of service offset by a $4.5 million recognition of deferred annual plan revenue, a $0.7 million reduction related to sell thru of equipment by retailers and net retailer returns, and a $0.4 million increase in other current and noncurrent assets primarily related to acquired product rights.

The net cash provided by operating activities for fiscal 2008 resulted primarily from a $1.0 million decrease in inventory due to lower inventory levels of customer premise equipment (CPE), a $0.8 million increase in accrued taxes, a $1.7 million increase in deferred revenue related to cash collections of $4.7 million from annual plan subscriptions primarily due to the transition of a competitor's former customers to the 8x8 residential annual plan service offset by recognition of $3.1 million of annual plan revenue, net of $0.7 million non-cash items including depreciation and amortization, stock compensation expense, and change in fair value of warrant liability. This was reduced by a $1.2 million increase in accounts receivable primarily due to retailer transactions.

Although we have achieved positive cash flows from operations in the fiscal year ended March 31, 2009 and 2008, historical net losses and negative cash flows have been funded primarily through the issuance of equity securities and borrowings. We believe that current cash, cash equivalents and investments will be sufficient to finance our operations for at least the next 12 months. However, we continually evaluate our cash needs and may pursue additional equity or debt financing in order to achieve our overall business objectives. There can be no assurance that such financing will be available, or, if available, at a price or terms that are acceptable to us. Failure to generate sufficient revenues, raise additional capital or reduce certain discretionary spending could have an adverse impact on our ability to achieve our longer term business objectives. In addition, any such financing may be materially dilutive to our existing stockholders.

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Contractual Obligations

Future operating lease payments, net of sublease income, capital lease payments and purchase obligations at March 31, 2009 for the next five years were as follows (in thousands):

In April 2005, June 2006 and March 2007, we entered into a series of noncancelable five year capital lease agreements for office equipment bearing interest at various rates. Assets under capital lease at March 31, 2009 totaled $182,000 with accumulated amortization of $102,000.

We lease our primary facility in Santa Clara, California under a non-cancelable operating lease that expires in fiscal 2010. We also have a leased facility in France. On May 1, 2009, we entered into a three year lease for a new primary facility in Sunnyvale, California. The facility leases include rent escalation clauses and require us to pay utilities and normal maintenance costs. Rent expense is reflected in our consolidated financial statements on a straight-line basis over the term of the leases.

We entered into a new contract with one of our third party customer support vendors containing a minimum monthly commitment of approximately $491,000. The agreement requires 150 day notice to terminate. The total remaining obligation under the contract is $2.5 million.

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Report of Independent Registered Public Accounting Firm