Faro Technologies Inc. v. Immersion Corporation

     On May 3, 2007, Faro Technologies, Inc. (“Faro”) sued the Company in the Eastern District of Pennsylvania. The complaint alleges patent infringement of Faro’s 5,402,582 patent by the Company’s Microscribe X product. The Company has not yet been served with the complaint, and has not yet had an opportunity to analyze Faro’s claim.

   Other Contingencies

     From time to time, the Company receives claims from third parties asserting that the Company’s technologies, or those of its licensees, infringe on the other parties’ intellectual property rights. Management believes that these claims are without merit. Additionally, periodically, the Company is involved in routine legal matters and contractual disputes incidental to its normal operations. In management’s opinion, the resolution of such matters will not have a material adverse effect on the Company’s consolidated financial condition, results of operations, or liquidity.

     In the normal course of business, the Company provides indemnifications of varying scope to customers against claims of intellectual property infringement made by third parties arising from the use of the Company’s intellectual property, technology, or products. Historically, costs related to these guarantees have not been significant, and the Company is unable to estimate the maximum potential impact of these guarantees on its future results of operations.

     As permitted under Delaware law, the Company has agreements whereby it indemnifies its officers and directors for certain events or occurrences while the officer or director is, or was, serving at its request in such capacity. The term of the indemnification period is for the officer’s or director’s lifetime. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited; however, the Company currently has director and officer insurance coverage that limits its exposure and enables it to recover a portion of any future amounts paid. Management believes the estimated fair value of these indemnification agreements in excess of applicable insurance coverage is minimal.

     See also Note 6 regarding contingencies relating to the 5% Convertible Debenture.

resellers. In all market areas, we also engage in development projects for third parties and government agencies from time to time.

     Our objective is to proliferate our technologies across markets, platforms, and applications so that touch and feel become as necessary as color, graphics, and sound in modern user interfaces. We and our wholly owned subsidiaries hold more than 600 issued or pending patents in the United States of America and other countries, covering various aspects of hardware and software technologies.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

     Our discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these condensed consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates and assumptions, including those related to revenue recognition, stock-based compensation, bad debts, inventory reserves, warranty obligations, patents and intangible assets, contingencies, and litigation. We base our estimates and assumptions on historical experience and on various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates and assumptions.

     We believe the following are our most critical accounting policies as they require our significant judgments and estimates in the preparation of our condensed consolidated financial statements:

   Revenue Recognition — We recognize revenues in accordance with applicable accounting standards, including SAB No. 104, “Revenue Recognition,” EITF No. 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables,” and AICPA SOP 97-2, “Software Revenue Recognition,” as amended. Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred or service has been rendered, the fee is fixed and determinable, and collectibility is probable. We derive our revenues from three principal sources: royalty and license fees, product sales, and development contracts.

      Royalty and license revenue — We recognize royalty and license revenue based on royalty reports or related information received from the licensee as well as time-based licenses of our intellectual property portfolio. Up-front payments under license agreements are deferred and recognized as revenue based on either the royalty reports received or amortized over the license period depending on the nature of the agreement. Advance payments under license agreements that also require us to provide future services to the licensee are deferred and recognized over the service period when VSOE related to the value of the services does not exist.

     We generally recognize revenue from our licensees under one or a combination of the following license models:

     Individual contracts may have characteristics that do not fall within a specific license model or may have characteristics of a combination of license models. Under those circumstances, we recognize revenue in accordance with SAB No. 104, EITF No. 00-21, and SOP 97-2, as amended, to guide the accounting treatment for each individual contract. See also the discussions regarding “Multiple element arrangements” below. If the information received from our licensees regarding royalties is incorrect or inaccurate, our revenues in future periods may be adversely affected. To date, none of the information we have received from our licensees has caused any material reduction in future period revenues.

      Product sales — We recognize revenues from product sales when the product is shipped, provided collection is determined to be probable and no significant obligation remains. We sell the majority of our products with warranties ranging from three to twenty-four months. We record the estimated warranty costs during the quarter the revenue is recognized. Historically, warranty-related costs and related accruals have not been significant. We offer a general right of return on the MicroScribe product line for 14 days after purchase. We recognize revenue at the time of shipment of a MicroScribe digitizer and provide an accrual for potential returns based on historical experience. We offer no other general right of return on our products.

      Development contracts and other revenue — Development contracts and other revenue is comprised of professional services (consulting services and/or development contracts), customer support, and extended warranty contracts. Development contract revenues are recognized under the cost-to-cost percentage-of-completion accounting method based on physical completion of the work to be performed. Losses on contracts are recognized when determined. Revisions in estimates are reflected in the period in which the conditions become known. Customer support and extended warranty contract revenue is recognized ratably over the contractual period.

      Multiple element arrangements — We enter into revenue arrangements in which the customer purchases a combination of patent, technology, and/or software licenses, products, professional services, support, and extended warranties (multiple element arrangements). When VSOE of fair value exists for all elements, we allocate revenue to each element based on the relative fair value of each of the elements.

     Our revenue recognition policies are significant because our revenues are a key component of our results of operations. In addition, our revenue recognition determines the timing of certain expenses, such as commissions and royalties. Revenue results are difficult to predict, and any shortfall in revenue or delay in recognizing revenue could cause our operating results to vary significantly from quarter to quarter and could result in greater or future operating losses.

   Stock-based Compensation — We account for stock-based compensation in accordance with SFAS No. 123R. We elected the modified-prospective method, under which prior periods are not revised for comparative purposes. Under the fair value recognition provisions of this statement, stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense on a straight-line basis over the requisite service period, which is the vesting period.

      Valuation and amortization method — We use the Black-Scholes model, single-option approach to determine the fair value of stock options and employee stock purchase plan shares. All share-based payment awards are amortized on a straight-line basis over the requisite service periods of the awards, which are generally the vesting periods. The determination of the fair value of stock-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of complex and subjective variables. These variables include actual and projected employee stock option exercise behaviors, our expected stock price volatility over the term of the awards, risk-free interest rate, and expected dividends.

      Expected term — We estimate the expected term of options granted by using the simplified method as prescribed by SAB No. 107.

      Expected volatility — We estimate the volatility of our common stock taking into consideration our historical stock price movement, the volatility of stock prices of companies of similar size with similar businesses, if any, and our expected future stock price trends based on known or anticipated events.

      Risk-free interest rate — We base the risk-free interest rate that we use in the option pricing model on U.S. Treasury zero-coupon issues with remaining terms similar to the expected term on the options.

      Expected dividend — We do not anticipate paying any cash dividends in the foreseeable future and therefore use an expected dividend yield of zero in the option pricing model.

      Forfeitures — We are required to estimate future forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. We use historical data to estimate pre-vesting option forfeitures and record stock-based compensation expense only for those awards that are expected to vest. Changes in estimated forfeitures will be recognized through a cumulative catch-up adjustment in the period of change and will also impact the amount of compensation expense to be recognized in future periods.

     If factors change and we employ different assumptions for estimating stock-based compensation expense in future periods, or if we decide to use a different valuation model, the future periods may differ significantly from what we have recorded in the current period and could materially affect our operating results.

     The Black-Scholes model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable, characteristics not present in our option grants and employee stock purchase plan shares. Existing valuation models, including the Black-Scholes and lattice binomial models, may not provide reliable measures of the fair values of our stock-based compensation. Consequently, there is a risk that our estimates of the fair values of our stock-based compensation awards on the grant dates may bear little resemblance to the actual values realized upon the exercise, expiration, early termination, or forfeiture of those stock-based payments in the future. Certain stock-based payments, such as employee stock options, may expire and be worthless or otherwise result in zero intrinsic value as compared to the fair values originally estimated on the grant date and reported in our financial statements. Alternatively, value may be realized from these instruments that are significantly higher than the fair values originally estimated on the grant date and reported in our financial statements. There currently is no market-based mechanism or other practical application to verify the reliability and accuracy of the estimates stemming from these valuation models, nor is there a means to compare and adjust the estimates to actual values.

     See Note 9 to the condensed consolidated financial statements for further information regarding the SFAS No. 123R disclosures.

   Accounting for Income Taxes — We use the asset and liability method of accounting for income taxes. Under this method, income tax expense is recognized for the amount of taxes payable or refundable for the current year. In addition, deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and tax credit carryforwards. Management must make assumptions, judgments and estimates to determine our current provision for income taxes and also our deferred tax assets and liabilities and any valuation allowance to be recorded against a deferred tax asset.

     Our judgments, assumptions and estimates relative to the current provision for income tax take into account current tax laws, our interpretation of current tax laws and possible outcomes of current and future audits conducted by foreign and domestic tax authorities. We have established reserves for income taxes to address potential exposures involving tax positions that could be challenged by tax authorities. Although we believe our judgments, assumptions and estimates are reasonable, changes in tax laws or our interpretation of tax laws and any future tax audits could significantly impact the amounts provided for income taxes in our condensed consolidated financial statements.

     Our assumptions, judgments, and estimates relative to the value of a deferred tax asset take into account predictions of the amount and category of future taxable income, such as income from operations or capital gains income. Actual operating results and the underlying amount and category of income in future years could render inaccurate our current assumptions, judgments, and estimates of recoverable net deferred taxes. Any of the assumptions, judgments and estimates mentioned above could cause our actual income tax obligations to differ from our estimates, thus materially impacting our financial position and results of operations.

   Long-term Liabilities — In 2003, we executed a series of agreements with Microsoft as described in Note 8 to the condensed consolidated financial statements that provided for settlement of our lawsuit against Microsoft as well as various licensing, sublicensing, and equity and financing arrangements. We accounted for the proceeds received under the agreements as a long-term customer advance based on certain provisions that would result in payment of funds to Microsoft. Upon Microsoft’s election to convert its shares of our Series A Preferred Stock into common stock, we reduced the long-term customer advance from Microsoft to the minimum amount we would be obligated to pay Microsoft upon a settlement of the Sony Computer Entertainment Lawsuit as set forth in our agreements with Microsoft.

The remainder of the consideration was transferred to common stock in 2004. Per the conditions as set forth in our agreements with Microsoft, in the event that we elected to settle the action in the United States District Court for the Northern District of California entitled Immersion Corporation v. Sony Computer Entertainment of America, Inc., Sony Computer Entertainment Inc. and Microsoft Corporation , Case No. C02-00710 CW (WDB), as such action pertains to Sony Computer Entertainment, we would be obligated to pay Microsoft a minimum of $15.0 million for amounts up to $100.0 million received from Sony Computer Entertainment on account of our granting certain rights, plus 25% of amounts over $100.0 million up to $150.0 million, and 17.5% of amounts over $150.0 million.

     In March 2007, we announced the conclusion of our patent infringement litigation against Sony Computer Entertainment at the U.S. Court of Appeals for the Federal Circuit. Sony Computer Entertainment satisfied the District Court judgment against it. As of March 19, 2007, we entered into a new business agreement with Sony Computer Entertainment to explore the inclusion of our technology in PlayStation format products. We have determined that the conclusion of our litigation with Sony Computer Entertainment does not trigger any payment obligations under our Microsoft agreements. However, in a letter sent to us dated May 1, 2007, Microsoft disputed our position and stated that it believes we owe Microsoft at least $27.5 million. If Microsoft brings a lawsuit to further dispute our position, we intend to oppose Microsoft’s claims and vigorously defend our position. The results of any litigation are inherently uncertain, and there can be no assurance that our position will prevail.

     In December 2004, we executed a series of agreements as described in Note 6 to the condensed consolidated financial statements that provided for the issuance of 5% Convertible Debentures and warrants, and that granted certain registration rights to the holders of the 5% Convertible Debentures. We accounted for the issuance of our 5% Convertible Debentures and related warrants in accordance with EITF No. 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios” and other related accounting guidance. We estimated the relative fair value of the various instruments included in the agreements entered into in December 2004 and allocated the relative fair values to be as follows: warrants — $1.7 million, Put Option — $0.1 million, Registration Rights — $0.1 million, issuance costs — $1.3 million, 5% Convertible Debentures — $16.8 million. The 5% Convertible Debentures are being accreted to $20.0 million over their five-year life, resulting in additional interest expense. The value of the warrants is included in Stockholders’ Equity (Deficit), the value of the Put Option and Registration Rights are recorded as liabilities and are subject to future value adjustments, and the value of the 5% Convertible Debentures is recorded as long-term debt.

   Long-term Deferred Revenue — In addition to normal items of deferred revenue due after one year, we had included Sony Computer Entertainment compulsory license fees and interest earned thereon in long-term deferred revenue due to the contingent nature of the court-ordered payments (see Note 7 to the condensed consolidated financial statements). Upon the conclusion of our patent litigation at the U.S. Court of Appeals for the Federal Circuit the contingency on these funds lapsed.

   Recovery of Accounts Receivable — We maintain allowances for doubtful accounts for estimated losses resulting from our review and assessment of our customers’ ability to make required payments. If the financial condition of one or more of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances might be required. To date such estimated losses have been within our expectations.

   Inventory Reserves — We reduce our inventory value for estimated obsolete and slow moving inventory in an amount equal to the difference between the cost of inventory and the net realizable value based upon assumptions about future demand and market conditions. If actual future demand and market conditions are less favorable than those projected by management, additional inventory write-downs may be required.

   Product Return and Warranty Reserves — We provide for estimated costs of future anticipated product returns and warranty obligations based on historical experience when related revenues are recognized, and we defer warranty-related revenue over the related warranty term.

   Intangible Assets — We have acquired patents and other intangibles. In addition, we capitalize the external legal and filing fees associated with patents and trademarks. We assess the recoverability of our intangible assets, and we must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets that affect our consolidated financial statements. If these estimates or related assumptions change in the future, we may be required to record impairment charges for these assets. We amortize our intangible assets related to patents and trademarks, once they issue, over their estimated useful lives, generally 10 years. Future changes in the estimated useful life could affect the amount of future period amortization expense that we will incur. During the three months ended March 31, 2007, we capitalized costs associated with patents and trademarks of $386,000. Our total amortization expense for the same period for all intangible assets was $254,000.

     The above listing is not intended to be a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP, with no need for management’s judgment in their application. There are also areas in which management’s judgment in selecting any available alternative would not produce a materially different result.

RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED MARCH 31, 2007 AND 2006

Overview

     We achieved a 6% increase in revenues during the three months ended March 31, 2007 as compared to the three months ended March 31, 2006 due to increased royalty and license revenue and product sales. The first quarter revenue growth was primarily due to an 18% increase in gaming revenues. Our net income was $122.4 million for the three months ended March 31, 2007 compared to a net loss of $2.9 million for the three months ended March 31, 2006 and was our first profitable quarter as a public company. The increase in net income was primarily due to the litigation conclusion and patent license from Sony Computer Entertainment of $119.9 million and the extinguishment of the liability to Microsoft of $15.0 million.

     In March 2007, we announced the conclusion of our patent infringement litigation against Sony Computer Entertainment at the U.S. Court of Appeals for the Federal Circuit. In satisfaction of the Amended Judgment, we received funds totaling $97.3 million, inclusive of the award for past damages for sales and other activities with respect to the infringing Sony PlayStation system consisting of the PlayStation consoles, Dual Shock controllers, and the 47 games found by the jury to infringe our patents, pre-judgment interest and costs, and post-judgment interest. Additionally we retained the $32.4 million of compulsory license fees and interest thereon previously paid to us by Sony Computer Entertainment pursuant to Court Orders. We also entered into a new business agreement to explore the inclusion of our technology in future PlayStation format products. In addition, in March 2007, Sony Computer Entertainment made a payment of $1.875 million pursuant to rights under the new business agreement.

     During the remainder of 2007, we expect to focus on the execution of sales and marketing plans in our established businesses to increase revenue and make selected investments in product and technology development for longer-term new growth areas. In addition, we have budgeted to continue to protect and defend our extensive intellectual property portfolio across all business segments. Our continued success could be limited by several factors, including the timely release of our new products or our licensees’ products, continued market acceptance of our products and technology, the introduction of new products by existing or new competitors, and the cost of ongoing litigation. For a further discussion of these and other risk factors, see the section titled “Risk Factors.”

Three Months ended March 31, 2007 compared to three months ended March 31, 2006

   Total Revenue — Our total revenue for the first three months of 2007 increased by $382,000 or 6% from the first three months of 2006.

      Royalty and license revenue — Royalty and license revenue is comprised of royalties earned on sales by our TouchSense licensees and license fees charged for our intellectual property portfolio. Royalty and license revenue for the three months ended March 31, 2007 was $2.2 million, an increase of $301,000 or 16% from the three months ended

March 31, 2006. The increase in royalty and license revenue was primarily due to an increase in gaming royalties of $255,000 which includes $107,000 of royalty and license revenue from Sony Computer Entertainment, and an increase in mobile device royalties of $36,000.

     The increase in gaming royalties was mainly due to royalties from Electro Source and royalty and license revenue from Sony Computer Entertainment during the three months ended March 31, 2007, which more than offset the overall decrease in sales by our other licensees of royalty bearing gaming peripherals compared to last year. We did not record any royalties from Electro Source or Sony Computer Entertainment during the three months ended March 31, 2006 (see Note 10 to the condensed consolidated financial statements.) This decrease in sales by our other licensees was primarily due to i) the continued decline in sales of past generation video console systems with the launches of the next-generation console models from Microsoft (Xbox 360), Sony (PlayStation 3), and Nintendo (Wii), and ii) the significant decline in third-party market share of aftermarket game console controllers as market share shifted to first-party peripheral makers due to the launch of the next-generation console models.

     The market share shift to first-party peripheral makers in combination with other actions by Microsoft, Sony, and Nintendo has caused our gaming revenue from existing licensees to decline. Sony announced on May 8, 2006 that the vibration feature that is currently available on controllers for PlayStation and PlayStation 2 would be removed from the new PlayStation 3 controller. The PlayStation 3 console system was launched in late 2006 in the United States and Japan without native vibration or any force feedback capability of any kind. This course of action by Sony has had material adverse consequences on our current and future gaming royalty revenues from third-party licensees since our gaming royalties have primarily been from licensed third-party controller products with vibration or force feedback capabilities that require some degree of vibration and/or force feedback support or compatibility in the video console system to be viable products. Sony has since released an update to the PlayStation 3 that offers limited vibration and force feedback support for some older PS1 and PS2 games and rumble and force feedback controllers compatible with the PS1 and PS2 console systems. We do not know if this situation might change at some point in the life of the PlayStation 3 console system, or whether or to what extent the PlayStation 3 console will be compatible with or support rumble or force feedback in PS3 games or controllers compatible with the PS3 console system. Based on our litigation conclusion and new business agreement with Sony Computer Entertainment (see Note 10 to the condensed consolidated financial statements for more discussion) we will recognize a minimum of $30.0 million as royalty and license revenue through March 31, 2017, approximately $750,000 per quarter. We recognized $107,000 of this amount in the quarter ended March 31, 2007. For the Microsoft Xbox 360 video console system launched in November 2005, Microsoft has, to date, not broadly licensed third parties to produce game controllers. Because our gaming royalties come mainly from third-party manufacturers, unless Microsoft licenses additional third-parties, our gaming royalty revenue will continue to decline. For the Nintendo Wii video console system launched in December 2006, Nintendo has, to date, not yet broadly licensed third parties to produce game controllers for its Wii game console. Because our gaming royalties come mainly from third-party manufacturers, unless Nintendo licenses additional third-party licensees, our gaming royalty revenue will continue to decline.

      Product sales — Product sales for the three months ended March 31, 2007 were $3.6 million, an increase of $224,000 or 7% as compared to the three months ended March 31, 2006. The increase in product sales was primarily due to increased medical product sales of $362,000, mainly due to increased sales of our Virtual IV and endoscopy simulators. This increase in product sales was a result of pursuing a product growth strategy for our medical business, which includes developing new products, leveraging our industry alliances, and expanding international sales. In addition, there was an increase in product sales from touch interface products of $39,000 including increased sales of rotary modules and commercial gaming boards. Touch interface products include touchscreen and touch panel components, rotary modules, and commercial gaming products. Partially offsetting this increase was a decrease in product sales of our 3D products of $177,000 primarily due to decreased sales of our MicroScribe, CyberGrasp ^® , and CyberForce ^® products.

      Development contract and other revenue — Development contract and other revenue is comprised of revenue on commercial and government contracts and extended support and warranty contracts. Development contract and other revenue was $613,000 during the three months ended March 31, 2007, a decrease of $143,000 or 19% as compared to the three months ended March 31, 2006. Government contract revenue decreased by $422,000 primarily due to the completion of work performed under a medical government contract. Partially offsetting this decrease was an increase in commercial contract revenue of $250,000 mainly due to increased development contract revenue from Immersion Medical and increased touch interface product and mobile devices development contract revenue.

     We categorize our geographic information into four major regions: North America, Europe, Far East, and Rest of the World. In the first three months of 2007, revenue generated in North America, Europe, Far East, and Rest of the World represented 67%, 17%, 14%, and 2%, respectively, compared to 74%, 15%, 10%, and 1%, respectively, for the first three months of 2006. The shift in revenues among regions was mainly due to an increase in revenue in the Far East

from touch interface product royalties and development contracts, an increase in mobility royalty revenue, and an increase in product sales from medical customers in the Far East, primarily Medtronic, offset by a decrease in revenue from U.S. government contracts due to the completion of those projects in 2006.

   Cost of Product Sales — Our cost of product sales consists primarily of materials, labor, and overhead. There is no cost of product sales associated with royalty revenue or development contract revenue. Cost of product sales was $1.5 million, an increase of $188,000 or 14% for the three months ended March 31, 2007 as compared to the three months ended March 31, 2006. The increase in cost of product sales was primarily due to increased direct material costs of $151,000 and an increase in overhead costs of $62,000 offset in part by decreased royalties of $22,000. The increase in direct material costs was a result of increased product sales and a shift in product mix that included sales of our lower margin Virtual IV medical simulator. Overhead costs increased, in part, as a result of increased salary expense primarily due to the costs of programs to improve quality processes within our manufacturing operations.

   Sales and Marketing — Our sales and marketing expenses are comprised primarily of employee compensation and benefits costs, advertising, trade shows, brochures, market development funds, travel, and an allocation of facilities costs. Sales and marketing expenses were $2.7 million, a decrease of $374,000 or 12% in the first three months of 2007 compared to the comparable period in 2006. The decrease was primarily due to decreased salaries, benefits, and overhead expense of $181,000, a decrease in travel expense to support sales and marketing efforts of $55,000, decreased shows and exhibits expense of $47,000, decreased advertising and public relations costs of $35,000, a reduction in bad debt expense of $34,000 and decreased professional consulting and license fees of $11,000. The decreased compensation, benefits, and overhead expense was primarily due to decreased sales and marketing headcount and decreased stock-based compensation expense. We expect to continue to focus our sales and marketing efforts on medical, mobile device, and touchscreen market opportunities to build greater market acceptance for our touch

technologies. We expect to continue to invest in sales and marketing in future periods to exploit market opportunities for our technology.

   Research and Development — Our research and development expenses are comprised primarily of employee compensation and benefits, consulting fees, tooling and supplies, and an allocation of facilities costs. Research and development expenses were $2.5 million, an increase of $814,000 or 47% in the first three months of 2007 compared to the same period in 2006. The increase was primarily due to increased compensation, benefits, overhead of $637,000, an increase in professional consulting expense of $115,000, and an increase in travel expenses of $63,000. The increased compensation, benefits, and overhead expense was primarily due to increased engineering headcount and increased stock-based compensation expense. We anticipate research and development costs will increase in absolute dollars in 2007 compared to 2006. We believe that continued investment in research and development is critical to our future success, and we expect to make targeted investments in areas of product and technology development to support future growth.

   General and Administrative — Our general and administrative expenses are comprised primarily of employee compensation and benefits, legal and professional fees, office supplies, travel, and an allocation of facilities costs. General and administrative expenses were $3.3 million, an increase of $448,000 or 16% in the first three months of 2007 compared to the same period in 2006. The increase was primarily due to increased legal, professional, and license fee expense of $359,000, increased seminars of $32,000, increased compensation, benefits, overhead of $26,000, and increased public company expense of $23,000. The increased legal, professional, and license fee expenses were primarily due to increased audit, tax, and accounting fees, increased general legal costs, and increased consulting costs. We expect that the dollar amount of general and administrative expenses to continue to be a significant component of our operating expenses. We will continue to incur costs related to litigation as we continue to defend our intellectual property.

   Amortization of Intangibles — Our amortization of intangibles is comprised primarily of patent amortization and other intangible amortization. Amortization of intangibles increased by $44,000 or 21% in the first three months of 2007 compared to the same period in 2006. The increase was primarily attributable to the increased cost and number of patents being amortized.

   Litigation Conclusions and Patent License — In March 2007, we concluded our patent infringement litigation against Sony Computer Entertainment at the U.S. Court of Appeals for the Federal Circuit. In satisfaction of the Amended Judgment, we received funds totaling $97.3 million, inclusive of the award for past damages, pre-judgment interest and costs, and post-judgment interest. Additionally, we retained $32.4 million of compulsory license fees and interest thereon previously paid to us by Sony Computer Entertainment pursuant to Court Orders. See Note 15 to the condensed consolidated financial statements for further discussion of this litigation. As of March 19, 2007 both parties entered into an agreement whereby we granted Sony Computer Entertainment and its affiliates a worldwide, non-transferable, non-exclusive license of our patents for the going-forward use, development, manufacture, sale, lease, importation, and distribution of its current and past PlayStation and related products. The license does not cover adult, foundry, medical, automotive, industrial, mobility, or gambling products. We also granted to Sony Computer Entertainment a license of our patents for the use, development, manufacture, sale, lease, importation, and distribution, by Sony Computer Entertainment and through third parties, of haptic game devices for use on those Sony PlayStation consoles. We also granted Sony Computer Entertainment certain other licenses, an option to obtain licenses in the future with respect to future gaming products, certain releases and covenants not to sue. Sony Computer Entertainment granted us certain covenants not to sue and agreed to pay us twelve quarterly installments of $1.875 million (for a total of $22.5 million) beginning on March 31, 2007 and ending on December 31, 2009, and may pay us certain other fees and royalty amounts. In total, we will receive a minimum of $152.2 million through the conclusion of the litigation and the separate patent license. We engaged an independent firm of financial advisors to assist with the determination of the fair value of all the elements of both the litigation conclusion and patent license. In accordance with EITF No. 00-21, we allocated the present value of the total payments, equal to $149.9 million, between each element based on their relative fair values. Under this allocation, we recorded $119.9 million as litigation conclusions and patent license income and the remaining $30.0 million is allocated to deferred license revenue. We recorded $107,000 as revenue, in the three-month period ended March 31, 2007. We will record the remaining $29.9 million as revenue, on a straight-line basis, over the remaining capture period of the patents licensed, ending March 19, 2017. We have accounted for future payments in accordance with APB No. 21 “Interest on Receivables and Payables.” Under APB No. 21, we determined the present value of the $22.5 million future payments to equal $20.2 million. We will account for the difference of $2.3 million as interest income as each $1.875 million payment installment becomes due.

     Under the terms of a series of agreements that we entered into with Microsoft in 2003, in the event we had elected to settle the action in the United States District Court for the Northern District of California entitled Immersion Corporation v. Sony Computer Entertainment of America, Inc., Sony Computer Entertainment Inc. and Microsoft Corporation , Case No. C02-00710 CW (WDB), as such action pertains to Sony Computer Entertainment, we would be obligated to pay Microsoft a minimum of $15.0 million for amounts up to $100.0 million received from Sony Computer Entertainment on account of our granting certain rights, plus 25% of amounts over $100.0 million up to $150.0 million, and 17.5% of amounts over $150.0 million. The patent infringement litigation with Sony Computer Entertainment was concluded in March 2007 at the U.S. Court of Appeals for the Federal Circuit without settlement. We have determined that the conclusion of our litigation with Sony Computer Entertainment does not trigger any payment obligations under our Microsoft agreements. Accordingly, the liability of $15.0 million that was in the financial statements at December 31, 2006 was extinguished, and we have accounted for this sum as litigation conclusions and patent license income in the three-month period ended March 31, 2007. However, in a letter sent to us dated May 1, 2007, Microsoft disputed our position and stated that it believes we owe Microsoft at least $27.5 million. If Microsoft brings a lawsuit to further dispute our position, we intend to oppose Microsoft’s claims and vigorously defend our position. The results of any litigation are inherently uncertain, and there can be no assurance that our position will prevail.

     In February 2006, we announced that we had settled our legal differences in our complaint for patent infringement against Electro Source and that both parties had agreed to dismiss all claims and counterclaims relating to this matter. In addition to the Confidential Settlement Agreement, Electro Source entered into a worldwide license to our patents for vibro-tactile devices in the consumer gaming peripheral field of use. According to the terms of the agreement, Electro Source will make royalty payments to us based on sales by Electro Source of spinning mass vibro-tactile gamepads, steering wheels, and other game controllers for dedicated gaming consoles, such as the Sony PlayStation and PlayStation 2, the Nintendo GameCube, and the Microsoft Xbox and Xbox 360. In March 2006, Electro Source paid us $650,000 and we recorded that as litigation conclusions and patent license income during the three months ended March 31, 2006.

   Interest and Other Income — Interest and other income consists primarily of interest income and dividend income from cash and cash equivalents, and other income from recoveries of prior write-offs of investments. Interest and other income increased by $258,000 in the first three months of 2007 compared to the same period in 2006. This was primarily the result of increased interest income on increased cash and cash equivalents invested after the receipt of the judgment from Sony Computer Entertainment in March 2007. Interest income earned on the payments from Sony Computer Entertainment up until the judgment became final had been included in deferred revenue. We expect interest income to increase throughout the remainder of the year due to interest earned on our increased cash and cash equivalent’s balance.

   Interest Expense — Interest expense consists primarily of interest and accretion expense on our 5% Convertible Debentures. Interest expense decreased by $1,000 in the first three months of 2007 compared to the same period in 2006.

   Provision for Income Taxes — For the three months ended March 31, 2007, we recorded a provision for income taxes of $8.5 million on a pre-tax income of $131.0 million, yielding an effective tax rate of 6.5%. For the three months ended March 31, 2006, we recorded a provision for income taxes of $102,000 on a pre-tax loss of $2.8 million yielding an effective tax rate of (3.6)%. The provision for income tax for the three months ended March 31, 2007 utilized a significant portion of our net operating loss carryforwards to offset taxable income that were previously fully reserved thereby reducing the overall effective tax rate. We released $47.0 million of the deferred tax valuation allowance in the first three months ended March 31, 2007 as the income in the first quarter utilized a substantial portion of the deferred tax assets. The provision for income tax for the three months ended March 31, 2006 was based on federal and state alternative minimum income tax payable on taxable income. Although we incurred pre-tax losses in the first three months of 2006, the sums received from Sony Computer Entertainment and interest thereon included in long term deferred revenue, approximating $5.3 million for the first three months of 2006 were taxable, giving rise to an overall taxable profit.

   Immersion Computing, Entertainment, and Industrial segment — Revenues from the Immersion Computing, Entertainment, and Industrial segment were $3.8 million, an increase of $310,000 or 9% in the first three months of 2007 compared to the same period in 2006. Royalty and license revenues increased by $302,000, mainly due to increased royalties and license revenue from our licensees that sell console and PC gaming peripheral products including license and royalty revenue from Sony Computer Entertainment, and an increase in mobile device royalties. Development contract revenues increased by $161,000, primarily due to increased revenue on touch interface product and mobile device contracts. Product sales decreased by $153,000, mainly due to decreased sales of our MicroScribe, CyberGrasp, and CyberForce products. Net income for the three months ended March 31, 2007 was $123.3 million, an increase of $125.9 million compared to the same period in 2006. The increase was primarily due to the litigation conclusions and patent license income of $134.9 million (Sony Computer Entertainment of $119.9 million and from Microsoft of $15.0 million), increased gross margin of $314,000 and a decrease in sales and marketing expenses of $280,000. The increases were partially offset by the reduction of litigation settlements of $650,000 from Electro Source in 2006, an increase of research and development expenses of $229,000, an increase in general and administrative expenses of $474,000 and increased provision for income taxes of $8.4 million.

   Immersion Medical segment — Revenues from Immersion Medical were $2.7 million, an increase of $56,000 or 2%, for the first three months of 2007 compared to the same period in 2006. The increase was primarily due to an increase of $362,000 in product sales partially offset by a decrease of $305,000 in development contract revenue. Product sales increased primarily due to increased sales of our Virtual IV and endoscopy simulators. The product sales increase was a result of pursuing a product growth strategy for our medical business, which includes developing new products, leveraging our industry alliances, and expanding international sales. Development contract revenue decreased due to the completion of work performed under a government contract, partially offset by an increase in commercial contract revenue. Net loss for the three months ended March 31, 2007 was $862,000, an increase of $584,000 or 210% compared to the same period in 2006. The increased loss was mainly due to increased operating expenses of $465,000 and decreased gross margin of $116,000 primarily due to increased sales of our lower margin Virtual VI medical simulators offset, in part, by increased sales of higher margin products such as endoscopy simulators. The increased operating expenses included increased research and development expenses partially offset by decreased sales and marketing expenses.

LIQUIDITY AND CAPITAL RESOURCES

     Our cash and cash equivalents consist primarily of cash and money market funds. On March 31, 2007 our cash and cash equivalents totaled $137.6 million, an increase of $105.6 million from $32.0 million on December 31, 2006.

     In December 2004, we issued an aggregate principal amount of $20.0 million of 5% Convertible Debentures. The 5% Convertible Debentures will mature on December 22, 2009. The amount payable at maturity of each 5% Convertible Debenture is the initial principal plus all accrued but unpaid interest thereon, to the extent such principal amount and interest has not been converted into common shares or previously paid in cash. Commencing on the date the 5% Convertible Debentures were issued, interest accrues daily on the principal amount of the 5% Convertible Debenture at a rate of 5% per year. Interest will cease to accrue on that portion of the 5% Convertible Debenture that is converted or paid, including pursuant to conversion right or redemption. The holder of a 5% Convertible Debenture has the right to convert the outstanding principal amount and accrued and unpaid interest in whole or in part into shares of our common shares at a price of $7.0265 per common share.

     In March 2007, we concluded our patent infringement litigation against Sony Computer Entertainment at the U.S. Court of Appeals for the Federal Circuit. In satisfaction of the Amended Judgment, we received funds totaling $97.3 million, inclusive of the award for past damages, pre-judgment interest and costs, and post-judgment interest. Additionally, we retained $32.4 million of compulsory license fees and interest thereon previously paid to us by Sony Computer Entertainment pursuant to Court Orders. Furthermore, we entered into a new business agreement. Under the new business agreement we will receive twelve quarterly installments of $1.875 million for a total of $22.5 million beginning on March 31, 2007 and ending on December 31, 2009.

     Net cash provided by operating activities during the three months ended March 31, 2007 was $98.5 million, a change of $95.7 million from the $2.8 million provided during the three months ended March 31, 2006. Cash provided by operations during the three months ended March 31, 2007 was primarily the result of our net income of $122.4 million, an increase of $14.0 million due to a change in income taxes payable, an increase of $1.9 million due to a change in accounts receivable, an increase of $528,000 due to a change in accrued compensation and other current liabilities, and an increase of $110,000 due to a change in prepaid expenses and other current assets. These increases were offset by a $31.5 million decrease due to a change in deferred revenue and customer advances mainly related to the conclusion of our patent litigation with Sony Computer Entertainment and the extinguishment of the customer advance from Microsoft, a decrease of $5.5 million due to a change in deferred income taxes, a decrease of $1.1 million due to a change in accounts payable due to the timing of payments to vendors and a decrease of $648,000 due to a change in inventories. Cash provided by operations during the three months ended March 31, 2007 was also impacted by noncash charges and credits of $1.7 million, including a credit of $2.9 million from excess tax benefits from stock-based compensation, partially offset by $634,000 of stock-based compensation, $254,000 in amortization of intangibles, $213,000 in depreciation, and $158,000 in accretion expenses on our 5% Convertible Debentures.

     Net cash used in investing activities during the three months ended March 31, 2007 was $549,000, compared to the $478,000 used in investing activities during three months ended March 31, 2006, an increase of $71,000. Net cash used in investing activities during the period consisted of a $386,000 increase in other assets, primarily due to capitalization of external patent filing and application costs and $163,000 used to purchase capital equipment.

     Net cash provided by financing activities during the three months ended March 31, 2007 was $7.5 million compared to $489,000 provided during the three months ended March 31, 2006, or a $7.0 million increase from the prior year. Net cash provided by financing activities for the period consisted primarily of issuances of common stock and exercises of stock options in the amount of $4.5 million, and an increase of $2.9 million from excess tax benefits from tax deductible stock-based compensation.

     We believe that our cash and cash equivalents will be sufficient to meet our working capital needs for at least the next twelve months. We will continue to protect and defend our extensive intellectual property portfolio across all business segments. We anticipate that capital expenditures for the year ended December 31, 2007 will total approximately $1.0 million in connection with anticipated maintenance and upgrades to operations and infrastructure. Additionally, if we acquire one or more businesses, patents, or products, our cash or capital requirements could increase substantially. In the event of such an acquisition, or should any unanticipated circumstances arise that significantly increase our capital requirements, we may elect to raise additional capital through debt or equity financing. Any of these events could result in substantial dilution to our stockholders. Although we expect to be able to raise additional capital if necessary, there is no assurance that such additional capital will be available on terms acceptable to us, if at all.

     Our 5% Convertible Debentures accrue interest at 5% per annum. Accordingly, we are required to make interest payments in the amount of $1.0 million per annum until such time as the 5% Convertible Debentures are either converted to common stock or mature. If the daily volume-weighted average price of our common shares is at or above

200% of the Conversion Price for at least 20 consecutive trading days, and certain other conditions are met, we have the right to (i) require the holder of a 5% Convertible Debenture to convert the 5% Convertible Debenture in whole, including interest, into shares of our common stock at a price of $7.0265 per common share, as may be adjusted under the debenture, as set forth and subject to the conditions in the 5% Convertible Debenture, or (ii) redeem the 5% Convertible Debenture. If we make either of the foregoing elections with respect to any 5% Convertible Debenture, we must make the same election with respect to all 5% Convertible Debentures.

     In March 2007, we announced the conclusion of our patent infringement litigation against Sony Computer Entertainment at the U.S. Court of Appeals for the Federal Circuit. Sony Computer Entertainment satisfied the District Court judgment against it. As of March 19, 2007, we and Sony Computer Entertainment entered into a new business agreement to explore the inclusion of our technology in PlayStation format products. We have determined that we are not obligated under our agreements with Microsoft to make any payment to Microsoft relating to the conclusion of our patent infringement litigation with Sony Computer Entertainment. However, in a letter sent to us dated May 1, 2007, Microsoft disputed our position and stated that it believes we owe Microsoft at least $27.5 million. If Microsoft brings a lawsuit to further dispute our position, we intend to oppose Microsoft’s claims and vigorously defend our position. The results of any litigation are inherently uncertain, and there can be no assurance that our position will prevail.

     With regard to our 5% Convertible Debentures, in the event of a change of control of us, a holder may require us to redeem all or a portion of their 5% Convertible Debenture (“Put Option”). The redeemed portion shall be redeemed at a price equal to the redeemed amount multiplied by 100% of the principal amount of the 5% Convertible Debenture. The Conversion Price will be reduced in certain instances where shares of common stock are sold or deemed to be sold at a price less than the applicable Conversion Price, including the issuance of certain options, the issuance of convertible securities, or the change in exercise price or rate of conversion for options or convertible securities. The Conversion Price will be proportionately adjusted if we subdivide (by stock split, stock dividend, recapitalization, or otherwise) or combine (by combination, reverse stock split, or otherwise) one or more classes of our common stock. So long as any 5% Convertible Debentures are outstanding, we will not, nor will we permit any of our subsidiaries to, directly or indirectly, incur or guarantee, assume or suffer to exist any indebtedness other than permitted indebtedness under the 5% Convertible Debenture agreement. If an event of default occurs, and is continuing with respect to any of our 5% Convertible Debentures, the holder may, at its option, require us to redeem all or a portion of the 5% Convertible Debenture.

RECENT ACCOUNTING PRONOUNCEMENTS

     In June 2006, the FASB issued FIN 48, “Accounting for Uncertainty in Income Taxes . ” FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes.” FIN 48 prescribes a two-step process to determine the amount of benefit to be recognized. First, the tax position must be evaluated to determine the likelihood that it will be sustained upon examination. If the tax position is deemed “more-likely-than-not” to be sustained, the tax position is then measured to determine the amount of benefit to recognize in the financial statements. The tax position is measured at the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement. We adopted the provisions of FIN 48 on January 1, 2007. The adoption of FIN 48 resulted in no adjustment to beginning retained earnings as we had a full valuation allowance on the deferred tax asset as of the adoption date.

     In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 establishes a framework for measuring fair value by providing a standard definition of fair value as it applies to assets and liabilities. SFAS No. 157, which does not require any new fair value measurements, clarifies the application of other accounting pronouncements that require or permit fair value measurements. The effective date for us is January 1, 2008. We are currently evaluating the effect that the adoption of SFAS No. 157 will have on our financial position and results of operations.

     In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” The new Statement allows entities to choose, at specified election dates, to measure eligible financial assets and liabilities at fair value in situations in which they are not otherwise required to be measured at fair value. If a company elects the fair value option for an eligible item, changes in that item’s fair value in subsequent reporting periods must be recognized in current earnings. SFAS No. 159 also establishes presentation and disclosure requirements designed to draw comparison between entities that elect different measurement attributes for similar assets and liabilities. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. Early adoption is permitted subject to specific requirements outlined in the new Statement. We are currently evaluating the effect that the adoption of SFAS No. 159 will have on our financial position and results of operations.