- Quarterly Report (10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended: September 30, 2008

Commission File Number: 001-33667

DIGITALFX INTERNATIONAL, INC.

(Exact name of registrant as specified in its charter)

Florida	65-0358792
(State or other jurisdiction of	(IRS Employer
incorporation or organization)	Identification No.)

3035 East Patrick Lane, Suite 9

Las Vegas, Nevada 89120

(Address of principal executive offices, including zip code)

(702) 938-9300

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x

No o

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

Large Accelerated Filer	o		Accelerated Filer	o
Non-Accelerated Filer	o	(Do not check if smaller reporting company)	Smaller Reporting Company	x

Indicate by check mark whether the Company is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o

No x

As of November 13, 2008, 24,945,655 shares of the registrant’s common stock were outstanding.

TABLE OF CONTENTS

PART I - FINANCIAL INFORMATION		2

Item 1.	Financial Statements	2

	Condensed Consolidated Balance Sheets at September 30, 2008 (Unaudited)
	and December 31, 2007	2

	Condensed Consolidated Statements of Operations (Unaudited)	3

	Condensed Consolidated Statement of Stockholders’ Equity (Deficit) (Unaudited)	4

	Condensed Consolidated Statements of Cash Flows (Unaudited)	5

	Notes to Condensed Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition
	and Results of Operations	31

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	51

Item 4.	Controls And Procedures	51

PART II - OTHER INFORMATION		52

Item 1.	Legal Proceedings	52

Item 4.	Submission of Matters to a Vote of Security Holders	52

Item 6.	Exhibits	53

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

DigitalFX International, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets

( In thousands, except share data)

	September 30,			December 31,
	2008			2007
Assets	(unaudited)
Current assets:
Cash and cash equivalents	$	365		$	5,319
Accounts receivable		45			50
Inventories, net		506			849
Prepaid bandwidth charges, affiliate		245			51
Prepaid expenses and other assets		339			411
Income tax receivable		233			-
Deferred income taxes, net		-			45
Total current assets		1,733			6,725

Restricted cash		-			2,000
Investment in and convertible secured promissory note due from related party		-			225
Investments, net		1,035			1,102
Deferred financing costs		359			961
Property and equipment, net of accumulated depreciation and amortization of $840 and $576, respectively		568			628
Deposits, merchant processors		635			789
Other assets		12			12
Deferred income taxes, net		-			1,995
Total assets	$	4,342		$	14,437

Liabilities and Stockholders’ Equity (Deficit)

Current liabilities:
Accounts payable	$	193		$	383
Accrued expenses		678			1,114
Accrued commissions		1,417			1,619
Capital lease obligation, current		34			-
Convertible notes payable, net		2,620			5,600
Total current liabilities		4,942			8,716

Capital lease obligation		105			-

Total liabilities		5,047			8,716

Commitments and Contingencies

Stockholders’ equity (deficit):
Preferred stock, $0.01 par value, 5,000,000 shares authorized, no shares issued and outstanding		-			-
Common stock, $0.001 par value, 100,000,000 shares authorized, and 24,945,655 and 24,919,710 shares issued and outstanding, respectively		25			25
Additional paid in capital		13,180			12,882
Other comprehensive income (loss)		1			(286	)
Accumulated deficit		(13,911	)		(6,900	)
Total stockholders’ equity (deficit)		(705	)		5,721
Total liabilities and stockholders’ equity (deficit)	$	4,342		$	14,437

S ee Notes to Condensed Consolidated Financial Statements

DigitalFX International, Inc. and Subsidiaries

Condensed Consolidated Statements of Operations

(In thousands, except share and per share data, unaudited)

	Three months Ended September 30,						Nine Months Ended September 30,
	2008			2007			2008			2007

Revenues	$	2,743		$	5,425		$	11,365		$	17,987
Cost of revenues		645			910			2,338			2,782

Gross profit		2,098			4,515			9,027			15,205

Commission expenses		1,197			2,365			4,723			7,880
Other operating expenses		2,005			3,539			7,280			8,780

Operating loss		(1,104	)		(1,389	)		(2,976	)		(1,455	)

Other (income) expense:
Unrealized (gain) loss on investment		(9	)		-			156			-
Unrealized loss on investment in company owned by related party		-			-			325			-
Loss on modification of debt		-			-			1,920			-
Financing costs, net		127			-			555			-
Other income, net		-			71			317			203

Other expense, net		118			71			3,273			203

Loss before provision for income taxes		(1,222	)		(1,318	)		(6,249	)		(1,252	)

Provision (benefit) for income taxes		734			(337	)		762			(281	)

Net loss	$	(1,956	)	$	(981	)	$	(7,011	)	$	(971	)

Net loss per share:
Basic and fully diluted	$	(0.08	)	$	(0.04	)	$	(0.28	)	$	(0.04	)

Weighted average shares outstanding:
Basic and fully diluted		24,953,655			24,112,324			24,933,692			23,797,358

See Notes to Condensed Consolidated Financial Statements

DigitalFX International, Inc. and Subsidiaries

Condensed Consolidated Statement of Stockholders’ Equity (Deficit)

(In thousands, except share data)

Nine Months Ended September 30, 2008 (unaudited)

	Common		Common		Additional			Other Comprehensive			Accumulated
	Shares		Stock		Paid-In Capital			Loss			Deficit			Total

Balance, January 1, 2008		24,919,710	$	25	$	12,882		$	(286	)	$	(6,900	)	$	5,721

Capital contribution by shareholder on modification of debt		-		-		950			-			-			950

Capital contribution by shareholder for services		-		-		160			-			-			160

Exercise of options		25,945		-		7			-			-			7

Extinguishment of beneficial conversion feature on restructure of convertible debt		-		-		(370	)		-			-			(370	)

Fair value of vested options		-		-		455			-			-			455

Adjustment to tax benefits related to stock options and warrants exercised		-		-		(904	)		-			-			(904	)

Fair value adjustment on investment, net of tax		-		-		-			273			-			273

Foreign currency translation adjustment		-		-		-			14			-			14

Net loss for the nine months ended September 30, 2008		-		-		-			-			(7,011	)		(7,011	)

Balance, September 30, 2008		24,945,655	$	25	$	13,180		$	1		$	(13,911	)	$	(705	)

See Notes to Condensed Consolidated Financial Statements

DigitalFX International, Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows

(In thousands, unaudited)

	Nine Months Ended September 30,
	2008			2007
Operating activities:
Net loss	$	(7,011	)	$	(971	)

Adjustment to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		264			225
Equity based compensation expense		455			394
Amortization of financing costs and debt discount		356			-
Capital contribution from shareholder for services		160			-
Unrealized loss on investment		480			-
Unrealized loss on investment in company owned by related party		325			-
Loss on modification of debt		1,920			-
Deferred income taxes		996			(291	)
Common stock issued for services		-			185
Changes in assets and liabilities:
Accounts receivable		5			(48	)
Inventory		344			(797	)
Prepaid expenses and other assets		(200	)		(774	)
Accounts payable and accrued expenses		(829	)		958
Due to affiliate		-			(187	)

Net cash used in operating activities		(2,735	)		(1,306	)

Investing activities:
Purchase of investments		-			(1,691	)
Purchase of convertible secured promissory note from related party		-			(225	)
Exercise of warrants to acquire interest in company owned by related party		(100	)		-
Purchases of property and equipment		(204	)		(297	)

Net cash used in investing activities		(304	)		(2,213	)

Financing activities:
Proceeds from issuance of common stock, net		7			38
Proceeds from capital lease financing		149			-
Payments on capital lease		(10	)		-
Repayment of convertible notes		(2,075	)		-

Net cash provided by (used in) financing activities		(1,929	)		38

Foreign currency translation		14			1

Change in cash and cash equivalents		(4,954	)		(3,480	)
Cash and cash equivalents, beginning of period		5,319			5,754

Cash and cash equivalents, end of period	$	365		$	2,274

Supplemental Cash Flow Information:
Cash paid for income taxes	$	-		$	116
Cash paid for interest	$	288		$	-
Non-Cash Investing and Financing Activities:
Reduction of tax benefit related to stock options and warrants	$	904		$	962
Tax effect of loss on investment	$	140		$	373
Repayment of convertible notes from restricted cash	$	2,000		$	93

See Notes to Condensed Consolidated Financial Statements

DigitalFX International, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(In Thousands, Except for Share and Per Share Data)

Nine Months Ended September 30, 2008 and 2007 (unaudited)

Note 1. The Company and Basis of Presentation

Company

DigitalFX International, Inc. (the “Company”), a Florida corporation, is a holding company, and a multi-tier Web 2.0 digital media products distribution company , as showcased on its social network www.helloworld.com operated by its wholly-owned subsidiary, DigitalFX Networks, LLC, a Nevada limited liability company (“DigitalFX Networks”).

The Company develops, hosts and markets proprietary communication and collaboration services, and social networking software applications, including video email, video instant messaging and live webcasting. The portal utilizes a commercial-free, subscription-based Application Service Provider (ASP) model.

The Company sells subscriptions to its portal through a unique multi-tiered affiliate program using non-related independent distributors, known as “Affiliates.” The Company also markets subscriptions directly to “Retail Customers” who purchase them for their personal use. In addition to offering portal subscriptions, the Company sells select products to these Affiliates through its U.S. subsidiary VMdirect, L.L.C., a Nevada limited liability company (“VMdirect”), and its wholly-owned U.K. and Ireland subsidiaries to assist them in building their businesses and in selling subscriptions to the portal.

The Company has developed an additional portal called FirstStream, www.firststream.com , through which subscriptions are offered by certain qualified Affiliates to small and medium sized businesses. These are sold through DigitalFX Networks.

The Company’s wholly-owned subsidiary, DigitalFX Solutions, LLC, a Nevada limited liability company (“DigitalFX Solutions”), operates its website, www.digitalfxsolutions.com , which offers the Company’s video-enabled web platform to enterprise-sized businesses. In addition, DigitalFX Solutions has an electronics division, whose purpose is to expand the Company’s current product offerings to other electronic devices, supplies, software and components.

The condensed consolidated financial statements include the accounts of the Company, VMdirect and its wholly-owned U.K. and Ireland subsidiaries, and the Company’s wholly-owned Nevada subsidiaries. Inter-company transactions and balances have been eliminated.

These interim condensed consolidated financial statements are unaudited, but in the opinion of management of the Company, contain all adjustments, which include normal recurring adjustments, necessary to present fairly the financial position at September 30, 2008, the results of operations for the three and nine months ended September, 2008 and 2007 and the cash flows for the nine months ended September 30, 2008 and 2007. The Company’s audited financial statements as of and for the years ended December 31, 2007 and 2006 are included in its 10-KSB filing dated March 31, 2008. The results of operations for the three and nine months ended September 30, 2008 are not necessarily indicative of the results of operations to be expected for the fiscal year ending December 31, 2008.

DigitalFX International, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(In Thousands, Except for Share and Per Share Data)

Nine Months Ended September 30, 2008 and 2007 (unaudited)

Merger and Stock Split

On June 15, 2006, Qorus.com, Inc., an inactive Florida corporation (“Qorus”) with no current operations, issued to the members of VMdirect (“Members”) 1,014,589 shares of Series A Convertible Preferred Stock, par value $0.01 per share, of Qorus (the “Preferred Stock”), which were converted into 1,057,547,456 shares of Qorus’ common stock (“Conversion Shares”). The number of shares of Preferred Stock issued to the Members and the number of Conversion Shares gives effect to the issuance of 289,292 membership units by VMdirect for an aggregate purchase price of $625, a transaction that was completed immediately prior to the closing of the transaction with Qorus. The transaction has been accounted for as a reverse merger (recapitalization) with the Company deemed the accounting acquirer, and Qorus the legal acquirer. As such, the financial statements herein reflect the historical activity of VMdirect since its inception, and the historical stockholders’ equity of VMdirect has been retroactively restated for the equivalent number of shares received in the exchange after giving effect to any differences in the par value offset to additional paid in capital. Subsequent to the consummation of this transaction, Qorus changed its name to DigitalFX International, Inc.

On August 1, 2006, the Company affected a 1 for 50 reverse stock split. The effect of this stock split has been retroactively reflected in the financial statements as if the stock split occurred at the beginning of the earliest period reported.

Change in Control

On October 15, 2008, the Company entered into a Framework Agreement with Richard Kall, the Co-Manager of VM Investors, LLC (“VM Investors”), the Company’s majority shareholder, Craig Ellins, VM Investor’s Co-Manager, Chairman of the Company’s Board of Directors (“Board”), and the Company’s Chief Executive Officer and President, and Amy Black, the President of VMdirect, pursuant to which, among other matters, Richard Kall agreed to consummate the transactions under those certain Note Purchase Agreements dated October 15, 2008 (the “Note Purchase Agreements”), among Richard Kall, the Company, and each of Portside Growth and Opportunity Fund, Highbridge International LLC and Iroquois Master Fund, Ltd. (collectively the “Investors”), subject to (a) Craig Ellins, Amy Black, Kevin Keating and Jerry Haleva resigning from all positions with the Company and each of its subsidiaries, (b) the Company reducing the size of its Board to three directors, (c) Richard Kall’s appointment as the Corporation’s Chief Executive Officer and election to the Board as its Chairman, and (d) the election of Richard Kall’s designee to the Board.

On October 13, 2008, each of Kevin Keating and Jerry Haleva resigned from the Board. On October 15, 2008, Craig Ellins resigned as the Chairman of the Board, the Company’s Chief Executive Officer and President, and from all other officer positions held with the Company and each of its subsidiaries, and Amy Black resigned as the President of VMdirect and from all other officer positions held with the Company and each of its subsidiaries. Mr. Ellins also resigned as the Co-Manager of VM Investors. Each of Craig Ellins and Amy Black entered into a Separation and Release Agreement dated October 15, 2008 with the Company pursuant to which the Company paid to each of Craig Ellins and Amy Black deferred compensation accrued for the third quarter of fiscal 2008, and the parties agreed to mutual releases of existing claims.

On October 15, 2008, the Board also adopted resolutions reducing the size of the Board to three directors, appointing Richard Kall as the Company’s Chief Executive Officer and electing Richard Kall as the Chairman of the Board. Prior to the transactions contemplated under the Framework Agreement, Craig Ellins, as the Company’s Chairman of the Board, Chief Executive officer and President, and as the Co-Manager of VM Investors, exercised, with the Board and other executive officers, operational control over the Company, and with the consent of Richard Kall, voting control. As a result of the transactions consummated under the Framework Agreement, Richard Kall, as the sole Manager of VM Investors and the beneficial owner of 64.6% of the Company’s outstanding shares of common stock, will exercise voting control over the Company. In addition, as the Company’s Chairman and Chief Executive Officer, Richard Kall will exercise, with the Board and other executive officers, operational control over the Company.

DigitalFX International, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(In Thousands, Except for Share and Per Share Data)

Nine Months Ended September 30, 2008 and 2007 (unaudited)

October 15, 2008, Richard Kall, the Investors and the Company, entered into certain Note Purchase Agreements pursuant to which Richard Kall agreed to purchase an aggregate of $350,000 of the unpaid principal amount of the Amended and Restated Notes (described in Note 8), Amended and Restated Warrants (described in Note 8) to purchase an aggregate of 90,517 shares of the Company’s common stock, and an aggregate of 120,000 shares of the Company’s common stock (collectively the “Investor Securities”) previously issued to the Investors. Pursuant to the terms of the Note Purchase Agreements, as additional consideration for Richard Kall’s purchase of the Investor Securities, the Investors and Richard Kall agreed to forbear for a period of 30 days from taking any action to enforce their rights as a result of the event of default that occurred on June 30 and September 30, 2008 with respect to the Company’s failure to satisfy one or more financial covenants under the Amended and Restated Notes for the fiscal quarters ended June 30 and September 30, 2008, respectively. Such forbearance period shall extend for up to 90 days if Richard Kall or the Company makes periodic payments to the Investors in the aggregate amount of $500,000 as further provided in the Note Purchase Agreements. The Company is reviewing all of its options in connection with the Amended and Restated Notes, including potentially restructuring the indebtedness to, among other things, revise the financial covenants.

In addition, the Company is currently involved in negotiations with Mr. Kall to provide working capital through a preferred stock equity financing. On November 14, 2008, the Company received $500,000 from Mr. Kall as an advance on the contemplated financing.

While there are currently no other definitive plans for debt or equity financing, we intend to vigorously pursue external financing options during the last quarter of 2008. However, there is no assurance that external financing will be available to us, or if available, that it would be available on terms acceptable to us.

Note 2. Accounting Policies

Use of Estimates and Assumptions

The condensed financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. Preparing condensed financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reported period. Examples of significant estimates used in preparing the accompanying condensed financial statements include, but are not limited to: the fair value of investments in non-marketable securities; the carrying value of notes receivable; the carrying value of long-lived assets; useful lives of property and equipment; revenue recognition; and the valuation allowances for receivables, inventories and sales returns, and the value of stock options issued for the purpose of determining stock-based compensation. Actual results and outcomes may materially differ from management’s estimates and assumptions.

DigitalFX International, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(In Thousands, Except for Share and Per Share Data)

Nine Months Ended September 30, 2008 and 2007 (unaudited)

Cash and Cash Equivalents

The Company considers all highly liquid investments with remaining maturities of three months or less when acquired to be cash equivalents. The Company holds its cash in what it believes to be credit-worthy financial institutions.

At September 30, 2008 and December 31, 2007, the Company had $635 and $789, respectively, of funds held by credit card merchant processors as reserves against any possible charge backs and returns on credit card transactions related to customer disputes that are not offset against the Company’s daily sales deposit activity. These amounts are reflected as Deposit, Merchant Processors on the Company’s consolidated balance sheets.

At December 31, 2007, the Company had $2,000 of funds held by a bank under a letter of credit arrangement pursuant to its Convertible Notes Payable. These amounts are reflected as Restricted Cash on the Company’s consolidated balance sheet as of December 31, 2007. In March, 2008, as described in Note 8, the Company restructured its agreement and these funds were returned to the Investors.

Revenues

The Company generates revenue through (i) sales of affiliate business packages and selling aids to Affiliates which include cameras, sales literature, and training videos, and the initial month’s subscription to its internet-based suite of products which includes a wide spectrum of streaming video content and an integrated suite of streaming media applications, including video email, video chat, and live web-casting, (ii) sales of monthly subscriptions to retail customers and Affiliates with a wide spectrum of streaming video content as well as an integrated suite of streaming media applications, including video email, video chat, and live web-casting, (iii) sales of branded apparel and merchandise, (iv) sales of electronic components and (v) hosting conferences and events.

Affiliate Business Packages

The Company recognizes revenue from the sales of the cameras and selling aids within the business package, including shipping revenue, in accordance with SAB No. 104, when persuasive evidence of an order arrangement exists, delivery has occurred, the sales price is fixed or determinable and collectibility is reasonably assured. Generally, these criteria are met at the time the product is shipped to customers when title and risk of loss have transferred. Sales of the above products, ranging in price from $39.95 to $1,999 USD (pricing not in thousands), entail no post-customer support or delivery of any other items. Allowances for estimated subsequent customer returns are provided when revenues are recorded. Costs incurred for the shipping and handling of its products are recorded as cost of sales.

DigitalFX International, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(In Thousands, Except for Share and Per Share Data)

Nine Months Ended September 30, 2008 and 2007 (unaudited)

The Company recognizes revenue from sale of the Affiliate’s initial month’s subscription to the internet-based suite of products in accordance with generally accepted accounting principals and based on the fair value of such suite of products. Fair value is determinable because the subscription fee is thereafter billed monthly at a fixed rate based on the level of service selected. Access to the internet-based studio suite of the products is delivered together, and the individual products within the suite cannot be sold separately. Access is delivered immediately upon sign up and order acceptance.

A monthly subscription is cancellable at any time. The relevant subscription fee is fully refundable if such cancellation is made in writing in accordance with the Company’s policies but only for the current month.

Monthly Subscriptions

The Company recognizes revenue from sales of a month’s subscription to retail customers and sales to Affiliates for their recurring subscription to the internet-based suite of products in accordance with generally accepted accounting principles and based on the fair value of such suite of products. Fair value is determinable because the subscription fee is billed at a fixed rate based on the level of service selected. Funds collected in advance of the billing period are deferred. A monthly subscription is cancellable at any time. The Company records an allowance for potential chargebacks on subscription fees based on an analysis of historical data for the four months preceding the date of measurement. The accuracy of these estimates is dependent on the rate of future chargebacks being consistent with the historical rate. Increases or decreases to the sales allowance are charged to revenue.

Apparel and Merchandise

The Company also sells select products to Affiliates to assist them in building their businesses and in selling subscriptions to the portal. Revenue for these sales including shipping revenue is recognized when all the criteria of SAB No. 104 described above are met, which is generally upon shipment.

Electronic Components

The Company recognizes revenue from the sales of electronic components in accordance with SAB No. 104, when persuasive evidence of an order arrangement exists, delivery has occurred, the sales price is fixed or determinable and collectibility is reasonably assured. Generally, these criteria are met at the time the product is shipped to customers when title and risk of loss have transferred. Sales of the above products entail no post-customer support or delivery of any other items.

Conferences and Events

The Company also earns fees for certain events it hosts such as sales and training conferences and seminars. Revenue is recognized when all of the criteria of SAB No. 104 described above are met, which is generally after the event has occurred. Amounts collected prior to the event are reflected as deferred revenue, and recognized after the event has occurred. As of September 30, 2008 and December 31, 2007, there was no deferred revenue related to conferences and events.

DigitalFX International, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(In Thousands, Except for Share and Per Share Data)

Nine Months Ended September 30, 2008 and 2007 (unaudited)

Shipping and Handling Fees

Shipping and handling fees are billed to customers and included in revenue. The related costs are included in cost of goods sold. Shipping and handling costs are charged to expense as incurred. Total shipping and handling costs of $58, $235, $104 and $329 are included in cost of goods sold for the three and nine months ended September 30, 2008 and 2007, respectively.

Product Returns and Cancellations

Affiliate business packages and merchandise returned within the first 30 days of purchase are generally refunded at 90 percent of the sales price. Returned products that were damaged during shipment to the customer are replaced immediately at the Company’s expense.

The sales allowance is a monthly estimate of refunds to be issued on affiliate business packages that have been shipped but are still subject to the Company’s return policy at month end. The allowance is based on an analysis of the historical rate of credits and refunds, using the latest four months activity. Increases or decreases to the sales allowance are charged to revenue.

Monthly subscription services are provided immediately upon enrollment and continue until cancelled. The recurring subscription can be cancelled at any time in writing. An allowance is recorded for subscription cancellations based on an analysis of historical data for the four months preceding the date of measurement.

Stock-Based Compensation

The Company periodically issues stock options and warrants to employees and non-employees in non-capital raising transactions for services and for financing costs. The Company adopted SFAS No. 123R, “Accounting for Stock-Based Compensation” effective January 1, 2006, and is using the modified prospective method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS No. 123R for all share-based payments granted after the effective date and (b) based on the requirements of SFAS No. 123R for all awards granted to employees prior to the effective date of SFAS No. 123R that remain unvested on the effective date. The Company accounts for stock option and warrant grants issued and vesting to non-employees in accordance with EITF No. 96-18: “Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services,” and EITF 00-18 “Accounting Recognition for Certain Transactions involving Equity Instruments Granted to Other Than Employees” whereby the fair value of the stock compensation is based on the measurement date as determined at either a) the date at which a performance commitment is reached, or b) at the date at which the necessary performance to earn the equity instrument is complete.

DigitalFX International, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(In Thousands, Except for Share and Per Share Data)

Nine Months Ended September 30, 2008 and 2007 (unaudited)

Valuation Assumptions

The fair value of options and warrants were estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions for the nine months ended September 30, 2008 and 2007:

	September 30, 2008	September 30, 2007
Dividend yield	-0-	-0-
Risk-free interest rate	4.50% - 4.64%	4.50%
Expected volatility	42.00% - 85.83%	42%- 50.00%
Expected life of options	4-6 years	4- 6 years

Earnings (Loss) Per Share

Statement of Financial Accounting Standards No. 128, “Earnings per Share,” requires presentation of basic earnings per share. Basic earnings (loss) per share is computed by dividing earnings (loss) available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflects the potential dilution, using the treasury stock method, that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the Company. In computing diluted earnings per share, the treasury stock method assumes that outstanding options and warrants are exercised and the proceeds are used to purchase common stock at the average market price during the period. Options and warrants will have a dilutive effect under the treasury stock method only when the average market price of the common stock during the period exceeds the exercise price of the options and warrants.

As of September 30, 2008 and 2007, potentially dilutive securities include options to purchase approximately 958,000 and 1,410,000 shares of common stock and warrants to purchase approximately 1,275,000 and 303,000 shares of common stock, respectively.

Potentially dilutive securities were not included in the calculation of loss for the three and nine months ended September 30, 2008 and September 30, 2007, because the Company incurred a loss during such periods and thus their effect would be anti-dilutive, and basic and diluted loss per share are the same.

Member Incentives

The Company’s commission structure is based on a multi-tiered affiliate program. Commissions are recorded for sales, including commissions based on bonus points assigned to products which are independent of the product’s price. Commissions totaled $1,197, $4,723, $2,365 and $7,880 for the three and nine months ended September 30, 2008 and 2007, respectively, and are included in the accompanying condensed consolidated statements of operations.

DigitalFX International, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(In Thousands, Except for Share and Per Share Data)

Nine Months Ended September 30, 2008 and 2007 (unaudited)

Comprehensive Loss

SFAS No. 130, “Reporting Comprehensive Income,” established rules for the reporting and display of comprehensive income and its components. SFAS No. 130 requires unrealized gains or losses on the Company’s foreign currency translation adjustments to be reported as a separate component (comprehensive income/loss) of stockholders’ equity. The components of comprehensive loss are as follows:

	Three Months Ended September 30,						Nine Months Ended September 30,
	2008			2007			2008			2007

Net Income (loss)	$	(1,956	)	$	(981	)	$	$(7,011	)	$	(971	)
Foreign Currency Translation		(4	)		1			14			(1	)
Fair value adjustment on investment		-			76			273			(109	)
Comprehensive Loss	$	(1,960	)	$	(904	)	$	(6,724	)	$	(1,081	)

Fair Value of Financial Instruments

The Company partially adopted SFAS 157, “Fair Value of Financial Instruments,” (SFAS 157) on January 1, 2008, delaying application for non-financial assets and non-financial liabilities as permitted. This statement establishes a framework for measuring fair value, and expands disclosures about fair value measurements.

SFAS 157 establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three levels as follows:

Level 1: quoted prices (unadjusted) in active markets for identical asset or liabilities that the Company has the ability to access as of the measurement date. Financial assets and liabilities utilizing Level 1 inputs include active exchange-traded securities and exchange-based derivatives.

Level 2: inputs other than quoted prices included within Level 1 that are directly observable for the asset or liability or indirectly observable through corroboration with observable market data. Financial assets and liabilities utilizing Level 2 inputs include fixed income securities, non-exchange-based derivatives, mutual funds, and fair-value hedges.

Level 3: unobservable inputs for the asset or liability only used when there is little, if any, market activity for the asset or liability at the measurement date. Financial assets and liabilities utilizing Level 3 inputs include infrequently-traded, non-exchange-based derivatives and commingled investment funds, and are measured using present value pricing models.

In accordance with SFAS 157, the Company determines the level in the fair value hierarchy within which each fair value measurement in its entirety falls, based on the lowest level input that is significant to the fair value measurement in its entirety.

DigitalFX International, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(In Thousands, Except for Share and Per Share Data)

Nine Months Ended September 30, 2008 and 2007 (unaudited)

The following table presents certain investments of the Company’s financial assets measured and recorded at fair value on the Company’s Consolidated Balance Sheets on a recurring basis and their level within the fair value hierarchy during the three and nine months ended September 30, 2008:

		Level 1			Level 2			Level 3			Total
Investments, at fair value		$	219		$	816		$	-		$	1,035

See Note 6 for more information on these investments.

Recent Accounting Pronouncements

In December 2007, the FASB issued FASB Statement No. 141 (R), “Business Combinations” (FAS 141(R)), which establishes accounting principles and disclosure requirements for all transactions in which a company obtains control over another business. Statement 141 (R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Earlier adoption is prohibited.

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51.” SFAS No. 160 establishes accounting and reporting standards that require that the ownership interests in subsidiaries held by parties other than the parent be clearly identified, labeled, and presented in the consolidated statement of financial position within equity, but separate from the parent’s equity; the amount of consolidated net income attributable to the parent and to the noncontrolling interest be clearly identified and presented on the face of the consolidated statement of income; and changes in a parent’s ownership interest while the parent retains its controlling financial interest in its subsidiary be accounted for consistently. SFAS No. 160 also requires that any retained noncontrolling equity investment in the former subsidiary be initially measured at fair value when a subsidiary is deconsolidated. SFAS No. 160 also sets forth the disclosure requirements to identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. SFAS No. 160 applies to all entities that prepare consolidated financial statements, except not-for-profit organizations, but will affect only those entities that have an outstanding noncontrolling interest in one or more subsidiaries or that deconsolidate a subsidiary. SFAS No. 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Earlier adoption is prohibited. SFAS No. 160 must be applied prospectively as of the beginning of the fiscal year in which it is initially applied, except for the presentation and disclosure requirements. The presentation and disclosure requirements are applied retrospectively for all periods presented.

In March 2008, the FASB issued SFAS No. 161 (FAS 161), “Disclosures About Derivative Instruments and Hedging Activities - an amendment of FAS 133.” FAS 161 requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements. FAS 161 is effective for fiscal years beginning after November 15, 2008. The Company does not expect the implementation of FAS 161 to have a material impact on its consolidated financial statements.

The Company does not believe that the adoption of the above recent pronouncements will have a material effect on the Company’s consolidated results of operations, financial position, or cash flows.

DigitalFX International, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(In Thousands, Except for Share and Per Share Data)

Nine Months Ended September 30, 2008 and 2007 (unaudited)

Note 3. Product, Customer and Geographic Information

SFAS No. 131, “Disclosure about Segments of an Enterprise and Related Information,” establishes standards for the reporting of business enterprises of information about operating segments, products and services, geographic areas and major customers. The standard for determining what information to report is based on operating segments within DigitalFX International that are regularly reviewed and used by the chief operating decision-maker in evaluating financial performance and resource allocation.

DigitalFX International’s chief operating decision-maker is considered to be the chief executive officer (CEO). Based on the financial information reviewed by the CEO, the Company has determined that it operates in a single operating segment, specifically, digital web-based communications services.

The following table presents revenue by product category for the three and nine months ended September 30, 2008 and 2007.

	Three Months Ended					Nine Months Ended
Revenue:	September 30, 2008			September 30, 2007		September 30, 2008		September 30, 2007
Subscription fees for access plans and administrative tools	$	2,044		$	4,267	$	7,389	$	12,931
Affiliate business packages		768			876		3,275		3,852
Upgrades to business packages		40			184		303		868
Merchandise, shipping fees and other revenue		(109	)		98		398		336
Total Revenue	$	2,743		$	5,425	$	11,365	$	17,987

DigitalFX International, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(In Thousands, Except for Share and Per Share Data)

Nine Months Ended September 30, 2008 and 2007 (unaudited)

The breakdown of revenues generated by geographic region for the three and nine months ended September 30, 2008 and 2007 is as follows:

	Three Months Ended						Nine Months Ended
	September 30, 2008			September 30, 2007			September 30, 2008			September 30, 2007

United States, Canada & Mexico		86	%		93	%		86	%		92	%
United Kingdom		3	%		2	%		3	%		2	%
Europe		4	%		-			5	%		-
Australia and New Zealand		7	%		5	%		6	%		6	%
		100	%		100	%		100	%		100	%

Assets and liabilities located in countries outside the United States were not material at September 30, 2008.

The breakdown of revenues generated by customer type for the three and nine months ended September 30, 2008 and 2007 is as follows:

	Three Months Ended						Nine Months Ended
	September 30, 2008			September 30, 2007			September 30, 2008			September 30, 2007
Affiliates		83	%		89	%		83	%		91	%
Retail and other customers		17	%		11	%		17	%		9	%
		100	%		100	%		100	%		100	%

DigitalFX International, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(In Thousands, Except for Share and Per Share Data)

Nine Months Ended September 30, 2008 and 2007 (unaudited)

Note 4. Inventories

Inventories, net consisted of the following at September 30, 2008 and December 31, 2007:

	September 30, 2008 (unaudited)			December 31, 2007
Cameras and merchandise	$	327		$	615
Electronic parts and components		163			250
Less: Allowance for obsolete inventory		(16	)		(16	)
	$	506		$	849

T Note 5. Investment In and Convertible Secured Promissory Note due from Related Party

On June 8, 2007, the Company entered into a Subscription, Loan and Rights Agreement (the “SaySwap Agreement”) with SaySwap, Inc. (“SaySwap”) pursuant to which the Company agreed to purchase a Senior Secured Convertible Promissory Note (the “SaySwap Note”) issued by SaySwap in the principal amount of $225, and a warrant (the “SaySwap Warrant”) to purchase 26.1 shares of SaySwap’s common stock. SaySwap is a company that is 60% owned by the Company’s former Chief Operating Officer and members of his immediate family.

The SaySwap Note accrues interest at a rate of 8% per annum and has a maturity date, given certain circumstances, of April 24, 2009, provided, however, that if SaySwap consummates a qualified financing (as defined in the SaySwap Note), SaySwap is required to repay the outstanding principal amount and all accrued interest on the SaySwap Note within 10 days of the consummation of such qualified financing. The Company may also declare the outstanding principal and accrued interest due and payable in the event of a default under the SaySwap Note. The SaySwap Note is convertible, at the Company’s option, into shares of SaySwap’s common stock, at any time prior to 30 days before the maturity date or three days before the consummation of a qualified financing. As security for SaySwap’s obligations under the SaySwap Note, SaySwap also granted to the Company a first priority security interest in all of SaySwap’s assets.

The SaySwap Warrant entitled the Company to purchase 26.1 shares of SaySwap’s common stock at a per share price of $3,831 and expired on May 31, 2010. In February, 2008, the Company exercised the SaySwap Warrant for $100. After the exercise, the Company owned a non-controlling interest in SaySwap of approximately 2%.

Pursuant to the terms of the SaySwap Agreement, the Company is entitled to demand that SaySwap register the shares of SaySwap’s common stock issuable upon conversion of the SaySwap Note or exercise of the SaySwap Warrant (the “Underlying SaySwap Shares”) at such time that SaySwap files a registration statement with the Securities and Exchange Commission.

DigitalFX International, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(In Thousands, Except for Share and Per Share Data)

Nine Months Ended September 30, 2008 and 2007 (unaudited)

At September 30, 2008, the Company assessed its investment for impairment and recorded a charge of $325 to reduce the fair value of its investment in the convertible secured promissory note and the common stock of SaySwap to $0. No interest income has been recognized for the three and nine months ended September 30, 2008 and 2007. The Company will actively pursue collection of the SaySwap note and the related interest, including interest due from April, 2008.

Note 6. Investments

Investments consist of the following at September 30, 2008 and December 31, 2007:

	September 30, 2008							December 31, 2007
	Cost		Unrealized Loss			Net		Cost		Unrealized Loss			Net
Fusion Telecommunications Int’l Inc.	$	700	$	(481	)	$	219	$	700	$	(414	)	$	286
CJ Vision Enterprises, Inc		816		-			816		816		-			816
Transparensee Systems, Inc.		175		(175	)		-		175		(175	)		-
	$	1,691	$	(656	)	$	1,035	$	1,691	$	(589	)	$	1,102

Fusion Telecommunications Int’l Inc.

On May 11, 2007, the Company entered into a Subscription and Rights Agreement with Fusion Telecommunications International, Inc. (“Fusion”) pursuant to which it purchased, for aggregate consideration of $700, 7 units consisting of an aggregate of 700 shares of Fusion’s Series A-2 Cumulative Convertible Preferred Stock (“Series A-2 Preferred Shares”) and warrants to purchase 421,687 shares of Fusion’s common stock. The 700 Series A-2 Preferred Shares are convertible into an aggregate of 843,374 shares of Fusion’s common stock. The warrants have a term of 7.5 years and are exercisable at the per share price of $0.83. Fusion has agreed to register the shares of Fusion’s common stock underlying the Series A-2 Preferred Shares and the warrants.

At September 30, 2008 and December 31, 2007, the fair value of the Company’s common share equivalents in Fusion was $219 and $286, respectively. During the nine months ended September 30, 2008, the Company evaluated its investment in Fusion and determined the decline in the fair value of its investment is considered other than temporary. The Company recorded an unrealized gain (loss) on its investment of $9 and $(481) for the three and nine months ended September 30, 2008, respectively, which is reflected in Other Expenses, net in the Company’s condensed consolidated statements of operations. Prior to the assessment of impairment, the Company reflected its unrealized gains and losses on its investment as a component of Other Comprehensive Income in the Company’s condensed consolidated statements of stockholders’ equity.

DigitalFX International, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(In Thousands, Except for Share and Per Share Data)

Nine Months Ended September 30, 2008 and 2007 (unaudited)

CJ Vision Enterprises, Inc./Pet Express Supply, Inc./Woozyfly, Inc.

On June 1, 2007, the Company subscribed to purchase 72 shares of the Series A Redeemable Convertible Preferred Stock of C J Vision Enterprises, Inc. (“CJVE”), and deposited with CJVE the aggregate purchase price of $216. CJVE’s Series A Redeemable Convertible Preferred Stock will be convertible on a one-for-one basis into shares of CJVE’s common stock, will accrue dividends at a rate of 8% per annum, payable in kind, will be mandatorily redeemable on the fifth anniversary of the date of issuance, and will have a liquidation preference of $3,000 per share plus accrued and unpaid dividends which will be senior to the liquidation preference for CJVE’s common stock. On June 15, 2007, the Company purchased from CVJE 20 shares of the common stock of CJVE for aggregate consideration of $600.

A member of the Board of Directors of CVJE, Emanuel Gerard, was also a member of the Board of Directors of the Company at the time of the investment.

On July 28, 2008, the Company, as a member of the group constituting all the shareholders (the “Shareholders”) of CJVE, entered into a Share Exchange Agreement (the “Exchange Agreement”) with Pet Express Supply, Inc.(“Pet Express”), a publicly traded Nevada corporation, pursuant to which Pet Express purchased from the Shareholders all issued and outstanding shares of CJVE’s common stock, preferred stock and warrants to purchase CJVE stock in consideration for the issuance of 2,235,112 shares of common stock of Pet Express and, to one of the Shareholders, warrants to purchase 629,424 shares of common stock of Pet Express (the “Share Exchange”). As a result of the Exchange Agreement, (i) CJVE became a wholly-owned subsidiary of Pet Express and (ii) Pet Express succeeded to the business of CJVE as its sole business.

The Share Exchange resulted in a change in control of Pet Express with the Shareholders owning 2,235,112 shares of common stock of Pet Express out of a total of 2,935,112 issued and outstanding shares after giving effect to the Share Exchange. The Company exchanged 200,000 shares of common stock and 72 Convertible Preferred Shares of CJVE into 920,000 shares of common stock of Pet Express, thereby holding after the exchange 31.3 percent of the issued capital of Pet Express, and becoming the single largest shareholder of Pet Express.

On September 26, 2008, as a result of a reverse stock split, Pet Express, which was renamed Woozyfly, Inc., issued the Company 4,600,000 additional shares of common stock, bringing the Company’s total ownership to 5,520,000 shares of common stock. Because the Company intends to dispose of its investment prior to the end of 2008, the Company has not consolidated its pro-rata share of Woozyfly Inc.’s income or loss as required under APB 18 for the three and nine months ended September 30, 2008.

While Woozyfly, Inc. is currently trading on the OTC market, its shares are not actively traded. Thus, at September 30, 2008, the Company’s investment in Pet Express is carried at cost of $816, which approximates its fair value.

DigitalFX International, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(In Thousands, Except for Share and Per Share Data)

Nine Months Ended September 30, 2008 and 2007 (unaudited)

Transparensee Systems, Inc.

On June 8, 2007, the Company purchased a Convertible Promissory Note (the “Transparensee Note”) issued by Transparensee in the principal amount of $175. The Transparensee Note accrued interest at a rate of 4.85% per annum and had a maturity date of the earlier of May 14, 2008 or when, upon or after the occurrence of an event of default under the Transparensee Note, such amounts were declared due and payable by the Company or made automatically due and payable in accordance with the terms of the Transparensee Note. Provided that Transparensee obtained the requisite approvals for the creation and designation of a new series to be designated Series A Preferred Stock, the Transparensee Note was automatically convertible, on the maturity date, into shares of Transparensee’s Series A Preferred Stock at a per share price of $2.075, or upon the consent of the requisite shareholders of Transparensee. In the event that the Transparensee Note is automatically converted into shares of Transparensee’s Series A Preferred Stock or common stock, the Company has agreed to enter into a lock-up agreement for a period of 180 days in connection with Transparensee’s intended initial public offering.

On April 1, 2008, Transparansee converted the Transparansee Note into 91,255 shares of Series A Preferred Stock of Transparansee, which are convertible into shares of common stock at the election of the Company. Terms are still being negotiated by the parties.

Transparensee agreed to indemnify the Company, up to a maximum of $75 pro rated over the initial term of the License Agreement, from infringement claims with respect to the licensed software and losses arising in connection therewith. The Company agreed to indemnify Transparensee in connection with claims with respect to any modifications made by the Company to the licensed software, and losses in connection therewith.

At December 31, 2007, the Company assessed its investment for impairment and recorded a charge of $175 which reduced the value of its investment to $0. No interest income has been recognized for the three and nine months ended September 30, 2008 and 2007.

Note 7. Property and Equipment

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

	September 30, 2008 (unaudited)			December 31, 2007
Furniture and fixtures	$	47		$	47
Computers and equipment		441			441
Capital lease equipment		149			-
Purchased software		771			716
		1,408			1,204
Less: accumulated depreciation and amortization		(840	)		(576	)
	$	568		$	628

DigitalFX International, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(In Thousands, Except for Share and Per Share Data)

Nine Months Ended September 30, 2008 and 2007 (unaudited)

All property and equipment above is depreciated over a three year life. Depreciation and amortization expense for the three and nine months ended September 30, 2008 and 2007 was $93, $264, $71 and $138, respectively.

Note 8. Convertible Notes Payable

On November 29, 2007, the Company entered into a Securities Purchase Agreement with Portside Growth and Opportunity Fund, Highbridge International LLC and Iroquois Master Fund, Ltd. (the “Investors”) pursuant to which Company issued on November 30, 2007, an aggregate principal amount of $7,000 of three-year senior secured convertible notes, with a per share conversion price of $2.80 (“Existing Notes”), and five-year warrants (“Existing Warrants”) to purchase an aggregate of 875,000 shares of our common stock at $2.93 per share, to the Investors.

On March 24, 2008, the Company entered into Amendment and Exchange Agreements with the Investors pursuant to which Company agreed, along with the Investors, to restructure the financing consummated under the Securities Purchase Agreement to reduce the amount of the financing to $3,000, with each Investor receiving repayment of its pro-rata share of $4,000, including $2,000 held in a collateral account for certain letters of credit through the exchange of Existing Notes for a combination of amended and restated senior secured convertible notes (“Amended and Restated Notes”) and an aggregate of 1,000,000 shares of our common stock (the “Common Shares”), and through the exchange of Existing Warrants for amended and restated warrants (“Amended and Restated Warrants”). The Amended and Restated Notes have an aggregate principal amount of $3,000 and a term of three years commencing from November 30, 2007. The Amended and Restated Warrants have a term of five years commencing from November 30, 2007 and entitle the Investors to initially purchase an aggregate of 750,002 shares of our common stock (subject to adjustment as provided in the Amended and Restated Warrants, including pursuant to economic anti-dilution adjustments). The Amended and Restated Notes carry interest at 7.50% per annum on the unpaid/unconverted principal balance, payable quarterly in cash, and are secured on a senior basis against all of our assets. The Company is required to make aggregate monthly principal payments of $25, plus accrued interest thereon, beginning July 1, 2008.

The Amended and Restated Notes are convertible into approximately 1,500,000 shares of the Company’s common stock, based on a conversion price of $2.00 per share (subject to adjustment as provided in the Amended and Restated Notes, including pursuant to economic anti-dilution adjustments), which shall reset on March 26, 2009 to the greater of (i) 105% of the arithmetic average of the dollar volume weighted average price of our common stock over each of the five consecutive trading days ending on the trading day immediately prior to March 26, 2009 and (ii) $1.00 (as adjusted for any stock splits, stock dividends, recapitalizations, combinations, reverse stock splits or other similar events); provided however, that in no event shall the adjusted conversion price be greater than $3.00 (as adjusted for any stock splits, stock dividends, recapitalizations, combinations, reverse stock splits or other similar events). The Amended and Restated Warrants have an exercise price of $0.959 per share (subject to adjustment as provided in the Amended and Restated Warrants, including pursuant to economic anti-dilution adjustments).

The Amended and Restated Notes are convertible at the option of the Investors prior to their maturity. Additionally, beginning November 30, 2008, and provided that the Company has complied with certain equity conditions, the Company will be able to require the Investors to convert the Amended and Restated Notes into shares of its common stock if the dollar volume weighted average price of its common stock is $2.75 (subject to adjustment as provided in the Amended and Restated Notes) for twenty (20) out of thirty (30) consecutive trading days.

The Amended and Restated Notes and the Amended and Restated Warrants provide that the Company shall not be obligated to issue shares of common stock upon conversion of the Amended and Restated Notes and the exercise of the Amended and Restated Warrants in excess of 45,000,000 in the aggregate.

DigitalFX International, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(In Thousands, Except for Share and Per Share Data)

Nine Months Ended September 30, 2008 and 2007 (unaudited)

The maturity date of the Amended and Restated Notes is November 29, 2010. The Investors are entitled to accelerate the maturity date in the event that there occurs an event of default under the Amended and Restated Notes, including, without limitation, if the Company fails to register for resale the Common Shares and the shares underlying the Amended and Restated Notes and Amended and Restated Warrants, if the Company fails to pay any amount under the Amended and Restated Notes when due, if a judgment is rendered against the Company in an amount set forth in the Amended and Restated Notes, if the Company breaches any representation or warranty under the Securities Purchase Agreement or other transaction documents, or if the Company fails to comply with the specified covenants set forth in the Amended and Restated Notes. Among the other covenants, the Amended and Restated Notes contain financial covenants whereby the Company will be required to achieve specified EBITDA and revenue targets in each of the fiscal quarters during which the Amended and Restated Notes are outstanding. Any failure to achieve an EBITDA or revenue target will be considered a breach of the financial covenant.

Upon the occurrence of an event of default under the Amended and Restated Notes, the Investors may require the Company to redeem all or any portion of the Amended and Restated Notes by delivering written notice thereof to the Company. The portion of the Amended and Restated Notes being redeemed shall be redeemed by the Company at a price equal to the greater of (i) the product of (A) the amount being redeemed and (B) the applicable redemption premium (between 100% and 125%) and (ii) the product of (A) the number of shares of the Company’s common stock issuable upon the conversion of such amount and (B) the greater of (I) the closing sale price of the Company’s common stock on the date immediately preceding such event of default, (II) the closing sale price of the Company’s common stock on the date immediately after such event of default and (III) the closing sale price of the Company’s common stock on the date the Investor delivers a redemption notice in connection with an event of default.

In connection with the restructuring transaction, VM Investors (whose members include Craig Ellins, the Company’s former Chief Executive Officer, and Amy Black, the former President of VMdirect), agreed to transfer 1,000,000 shares of the Company’s common stock back to the Company, valued at $950.

Maxim Group L.L.C. acted as placement agent in connection with the transaction. For their services as placement agent, the Company was required to pay Maxim an aggregate commission in cash equal to 8% of the gross proceeds from the sale of the Existing Notes and Existing Warrants, a non-accountable expense allowance of 1% of the gross proceeds from the sale of the Existing Notes and Existing Warrants, plus a warrant to purchase 7% of the shares underlying the Existing Notes and Existing Warrants issuable to the Investors. The Company issued a warrant to purchase 236,250 shares (subject to adjustment as provided in the Amended and Restated Warrants, including pursuant to economic anti-dilution adjustments) of its common stock with an exercise price of $2.93 and a term of 5 years to Maxim and paid Maxim a fee of $460.

DigitalFX International, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(In Thousands, Except for Share and Per Share Data)

Nine Months Ended September 30, 2008 and 2007 (unaudited)

At December 31, 2007, prior to the restructuring transaction, the initial fair value of the conversion feature was $370 and the initial fair value of the warrants was $1,070 based upon the relative value of the Black Sholes valuation of the warrants and the underlying debt amount. For the Black Sholes calculation, the Company assumed no dividend yield, a risk free interest rate of 4.63%, expected volatility of 68.38% and an expected term of the warrants of 5 years. At March 31, 2008, after the restructuring transaction, the fair value of the conversion feature was reduced to $0 and adjusted to paid-in capital, and the fair value of the warrants was reduced to $376, resulting in a charge of $536. The fair value of the warrants is reflected by the Company as a valuation discount and offset to the carrying value of the notes and will be amortized over the remaining term of the notes.

At December 31, 2007, prior to the restructuring transaction, deferred financing costs, which consist of cash paid at closing of the notes and the fair value of the warrants issued to the placement agent totaled $961. At March 31, 2008, after amortization of $83 recognized up to the restructuring transaction, the Company recognized a charge of $436. The remaining deferred financing costs after the restructuring transaction totaled $442, which will be amortized over the remaining term of the notes.

The restructuring transaction substantially amended the terms of the Securities Purchase Agreement. Pursuant to EITF 96-19, “Debtor’s Accounting for a Modification or Exchange of Debt Instruments,” a substantial modification in terms of an existing debt, should be reported as a debt extinguishment. The Company’s modification of terms as described above resulted in a loss on modification of debt of $1,920, which is reflected in the Company’s consolidated statements of operations for the six months ended June 30, 2008. The loss on modification of debt consisted of a write down of deferred financing costs of $436, modification of the Investor’s warrants of $534 and the issuance of 1,000,000 shares of common stock with a fair market value of $950.

For the three months ended June 30, 2008 and September 30, 2008, the Company determined that it did not meet its financial covenants pursuant to the Amended and Restated Notes. As described in Note 1, on October 15, 2008, the Company, Richard Kall and the Investors entered into the Note Purchase Agreements pursuant to which Richard Kall agreed to purchase an aggregate of $350,000 of the unpaid principal amount of the Amended and Restated Senior Secured Convertible Notes, Amended and Restated Warrants to purchase an aggregate of 90,517 shares of the Company’s common stock, and an aggregate of 120,000 shares of common stock (collectively the “Investor Securities”) previously issued to the Investors. Pursuant to the terms of the Note Purchase Agreements, as additional consideration of Richard Kall’s purchase of the Investor Securities, the Investors and Richard Kall agreed to forbear for a period of 30 days from taking any action to enforce their rights as a result of the event of default that occurred on June 30 and September 30, 2008 with respect to the Company’s failure to satisfy one or more financial covenants under the Amended and Restated Senior Secured Convertible Notes for the fiscal quarters ended June 30 and September 30, 2008, respectively. Such forbearance period shall extend for up to 90 days if Richard Kall or the Company makes periodic payments to the Investors in the aggregate amount of $500,000 as further provided in the Note Purchase Agreements. Under the terms of the Note Purchase Agreements, the Company also agreed to either file a post-effective amendment to the Registration Statement on Form S-3 or file a new registration statement on an appropriate form to reflect the changes made as a result of the transactions occurring under the Note Purchase Agreements. In the immediate future the Company intends to review all of its options in connection with the Amended and Restated Notes, including potentially restructuring the indebtedness to, among other things, revise the financial covenants.

DigitalFX International, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(In Thousands, Except for Share and Per Share Data)

Nine Months Ended September 30, 2008 and 2007 (unaudited)

As of September 30, 2008, the amount due to the Investors was $2,925 and the unamortized valuation discount was $305 which will be amortized over the remaining term of the Notes.

Note 9. Stock Options and Warrants

Options

The Company’s 2006 Stock Incentive Plan was adopted by its board of directors and became effective in August, 2006. The total number of shares reserved for issuance under this plan was 1,537,501. The number of shares reserved for issuance under the 2006 Stock Incentive Plan is subject to an annual increase on the first day of each fiscal year during the term of the 2006 Stock Incentive Plan, beginning January 1, 2007, in each case in an amount equal to the lesser of (i) 1,000,000 shares of common stock, (ii) 5% of the outstanding shares of common stock on the last day of the immediately preceding year, or (iii) an amount determined by the Company’s board of directors. Any shares of common stock subject to an award, which for any reason expires or terminates unexercised, are again available for issuance under the 2006 Stock Incentive Plan. On July 23, 2008, the Company’s board of directors and shareholders voted to increase the total number of shares reserved for issuance under the 2006 Stock Incentive Plan to 5,000,000.

The 2006 Stock Incentive Plan will terminate after 10 years from the effective date, unless it is terminated earlier by the Company’s board of directors. The plan authorizes the award of stock options, stock purchase grants, stock appreciation rights and stock units.

The 2006 Stock Incentive Plan provides for the grant of both incentive stock options that qualify under Section 422 of the Internal Revenue Code and nonqualified stock options. Incentive stock options may be granted only to the Company’s employees or to employees of any of the Company’s parents or subsidiaries. All awards other than incentive stock options may be granted to the Company’s employees, officers, directors, consultants, independent contractors and advisors or employees, officers, directors, consultants, independent contractors and advisors of any of the Company’s parents or subsidiaries. The exercise price of incentive stock options must be at least equal to the fair market value of the Company’s common stock on the date of grant. The exercise price of incentive stock options granted to 10% shareholders must be at least equal to 110% of that value. The exercise price of nonqualified stock options will be determined by the administrator of the plan when the options are granted. The term of options granted under the Company’s 2006 Stock Incentive Plan may not exceed 10 years and typically vest over four years, with 25% of the options vesting after 12 months and 75% vesting monthly over the remaining three years.

As of September 30, 2008, 4,181,897 shares were available for grant under the 2006 Stock Incentive Plan.

DigitalFX International, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(In Thousands, Except for Share and Per Share Data)

Nine Months Ended September 30, 2008 and 2007 (unaudited)

The following is a summary of option activity (including plan and non-plan options) for the year ended December 31, 2007 and nine months ended September 30, 2008 (in thousands, except per share data):

	Shares			Range of Exercise Prices		Weighted Average Exercise Price
Outstanding at December 31, 2007		1,374			$0.26-$7.75		$3.14
Granted		949			$0.55- $1.21		$0.92
Exercised		(26	)		$.26-$.33		$.29
Cancelled		(1,339	)		$.26-$7.75		$3.30
Outstanding at September 30, 2008		958			$0.26-$1.21		$1.05
Exercisable at September 30, 2008		402			$0.26-$1.21		$1.17

The following table summarizes information regarding options outstanding at September 30, 2008:

	Shares		Exercise Price		Weighted Average Exercise Price		Weighted Average Remaining Contractual Term (months)		Aggregate Intrinsic Value
Shares Granted Quarter Ended December 31, 2005		139		$0.26		$0.26		4		-
Shares Granted Quarter Ended June 30, 2008		819		$0.55 -$1.21		$.94		100		-
Outstanding at September 30, 2008		958		$0.26-$1.21		$1.05		104	$	-
Exercisable at September 30, 2008		402		$0.26-$1.21		$1.17		92		-

There were 25,945 stock options exercised during the nine months ended September 30, 2008 from which the Company received $9 in cash proceeds. The Company recognized compensation expense from vesting of stock options of $455 and $294 for the nine months ended September 30, 2008 and 2007, respectively, and had estimated future compensation expense from these stock options of $1,292 at September 30, 2008 which will be recognized over the remaining estimated weighted useful life of the options.

Warrants

As fully described in Note 8, on November 30, 2007, the Company entered into a Securities Purchase Agreement with certain Investors pursuant to which the Company agreed to issue an aggregate principal amount of $7,000 of three-year senior secured convertible notes and five-year warrants to purchase an aggregate of 875,000 shares of the Company’s common stock at an exercise price of $2.93. In March 2008, the agreement was restructured and the Existing Warrants were exchanged for amended and restated warrants. The Amended and Restated Warrants have a term of five years commencing from November 30, 2007 and entitle the Investors to initially purchase an aggregate of 750,002 shares of our common stock at an exercise price of $.959. The warrants vested immediately at the grant date.

DigitalFX International, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(In Thousands, Except for Share and Per Share Data)

Nine Months Ended September 30, 2008 and 2007 (unaudited)

The value of these warrants was included in the determination of the loss on the modification of debt as described in Note 8.

The following is a summary of stock warrant activity for the year ended December 31, 2007 and the nine months ended September 30, 2008 (in thousands, except per share data):

	Shares			Range of Exercise Prices		Weighted Average Exercise Price
Outstanding at December 31, 2007		1,400			$0.26-$2.93		$2.38
Granted		750			$0.959		$0.959
Exercised		-			-		-
Cancelled		(875	)		$2.93		$2.93
Outstanding at September 30, 2008		1,275			$0.26-$2.93		$1.17
Exercisable at September 30, 2008		1,275			$0.26-$2.93		$1.17

The following table summarizes information regarding warrants outstanding at September 30, 2008:

	Shares		Exercise Price		Weighted Average Remaining Contractual Term (months)		Aggregate Intrinsic Value
Outstanding at September 30, 2008		1,275		$0.26-$2.93		48	$	-
Exercisable at September 30, 2008		1,275		$0.26-$2.93		48	$	-

Note 10. Related Parties

RazorStream, LLC

On January 29, 2007, the Company entered into an Amended and Restated License, Hosting and Services Agreement (the “Amended Agreement”) with RazorStream, LLC (“RazorStream”), a company controlled by VM Investors. The Amended Agreement amends and restates the Licensing, Hosting and Services Agreement effective May 1, 2005, between VMdirect and RazorStream.

Pursuant to the terms of the Amended Agreement, RazorStream will provide hosting, maintenance and support services for each individual website operated by the Company or any third party authorized by the Company. While the initial term of the Amended Agreement ended on January 15, 2008, the Amended Agreement remains operative thereafter unless terminated by either party upon 60 days prior written notice. Under the terms of the Amended Agreement, for each individual website operated by the Company or any third party authorized by the Company, RazorStream (a) charges the Company $5 per new subscriber account exceeding 20,000 accounts (purchasable in 20,000 account increments); (b) is entitled to (1) ten percent (10%) of the Company’s total gross revenue from all active subscriber accounts, with a minimum amount of $0.69 per each such subscriber account per month, and (2) some portion of revenue to be mutually agreed upon by the parties for all advertising-based “free” subscriber accounts (which the Company does not currently provide), provided, however that such terms will provide for a minimum amount of $0.25 per each such subscriber account per month (which cost the Company will account for as marketing expense); and (c) effective February 1, 2007, is entitled to a minimum guarantee of $50,000 per month that is non-refundable but that will be credited against the above fees. The Company may, from time to time, engage RazorStream for non-recurring engineering services at a rate of $200 per hour. The fees above apply independently to each individual website operated by the Company or any third party authorized by the Company, and no fees charged with respect to any individual website, and no subscriber account applied with respect to any individual website, shall be aggregated with any fees or subscriber accounts, respectively, applied to any other website.

DigitalFX International, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(In Thousands, Except for Share and Per Share Data)

Nine Months Ended September 30, 2008 and 2007 (unaudited)

In connection with the services discussed above, the Company incurred expenses of $336, $1,070, $586 and $1,631 during the three and nine months ended September 30, 2008 and 2007, respectively. At September 30, 2008 and December 31, 2007, the accompanying consolidated balance sheets reflect prepaid bandwidth charges, affiliates of $245 and $51, respectively, which represent amounts paid in advance to RazorStream for services discussed above.

In addition, RazorStream, in conjunction with a newly established company controlled by Razorstream’s majority shareholders,, is in process of developing a unique internet appliance (“Set Top Box”) which will allow users the ability to access their DigitalFX Studio features, stream high resolution on demand audio and video content and participate in the social network, all from their television. During 2007, the Company incurred development costs related to the Set Top Box to RazorStream totaling $225. The Company also made payments to third party vendors related to the Set Top Box project for inventory and product development totaling $430, and $281 during the nine months ended September 30, 2008 and 2007, respectively. The Company expects to enter into an agreement to formalize the terms of its rights related to this product or in the newly established company in late 2008.

Other Related Party Transactions

As described in Note 6, the Company has a convertible note receivable with SaySwap totaling $225. SaySwap is a Company that is 60% owned by the Company’s former Chief Operating Officer and members of his immediate family. In February, 2008, the Company exercised the SaySwap warrant in the amount of $100. At June 30, 2008, the Company assessed its investment for impairment and recorded a charge of $325 which reduced the value of its investment in the convertible secured promissory note and the common stock of SaySwap to $0. The Company will actively pursue collection of the SaySwap note and the related interest, including interest due from April, 2008.

As described in Note 7, the Company has an investment in CJVE totaling $816. A member of the Board of Directors of CJVE, Emanuel Gerard, was a member of the Board of Directors of the Company until he resigned from the Board in July 2008.

During the three and nine months ended September 30, 2008, the Company made payments to Vayan Marketing Group, LLC totaling $10 and $25, respectively under a month to month agreement to provide auto-responder services to the Company. An officer of Vayan Marketing Group, LLC is an immediate family member of the Company’s new Chief Executive Officer, Richard Kall.

DigitalFX International, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(In Thousands, Except for Share and Per Share Data)

Nine Months Ended September 30, 2008 and 2007 (unaudited)

On April 21, 2008 VM Investors transferred 100,000 shares of the Company’s common stock to an independent contractor for an entity with which the Company has a reseller agreement. The Company has recorded compensation expense of $80,000, the fair value of the shares on the date of transfer. On April 21, 2008, VM Investors also transferred 100,000 shares of the Company’s common stock to an existing shareholder. The Company has recorded compensation expense of $80,000, the fair value of the shares on the date of transfer. On April 21, 2008, VM Investors also transferred 250,000 shares of the Company’s common stock to an unaffiliated business person. The transfer of the 250,000 shares of the Company’s common stock has been treated as a bona fide gift by VM Investors and is not reflected in the Company’s financial statements. VM Investors controlled 67.7% of the Company’s outstanding common stock at the time of these transactions.

In addition, the Company pays commissions to various family members of the current and previous management in the normal course of business as affiliates of VMdirect.

Note 11. Income Taxes

The provision for income taxes consists of the following for the nine months ended September 30, 2008 and 2007:

	Nine Months Ended September 30, 2008			Nine Months Ended September 30, 2007

Current tax provision - federal	$	(233	)		970
- foreign		-			-
Deferred tax provision - federal		965			(1,232	)
- foreign		30			(19	)
Income tax provision	$	762			(281	)

A reconciliation of the statutory federal income tax provision is as follows for the nine months ended September 30, 2008 and 2007:

	Nine Months Ended September 30, 2008			Nine Months Ended September 30, 2007
Income before income tax provision	$	(6,249	)	$	(1,253	)

Expected tax (federal statutory rate 34%)		(2,125	)		(426	)
Permanent differences		238			145
Valuation allowance		2,634			-
Other		15			-
Income tax provision	$	762		$	(281	)

DigitalFX International, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(In Thousands, Except for Share and Per Share Data)

Nine Months Ended September 30, 2008 and 2007 (unaudited)

Effective January 1, 2007, the Company adopted Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”) —an interpretation of FASB Statement No. 109, Accounting for Income Taxes . The Interpretation addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the financial statements. Under FIN 48, the Company may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement. FIN 48 also provides guidance on derecognition, classification, interest and penalties on income taxes, accounting in interim periods and requires increased disclosures. At the date of adoption, and as of September 30, 2008, the Company does not have a liability for unrecognized tax benefits.

The Company files income tax returns in the U.S. federal jurisdiction. The Company is subject to U.S. federal income tax examinations by tax authorities for periods after June 16, 2006, the date at which the Company completed its reverse merger transaction. In addition, the Company files income tax returns in the United Kingdom and Ireland for the foreign subsidiaries located in these jurisdictions. The Company is subject to tax examinations by tax authorities in these jurisdictions, however, as of December 31, 2007, there are no open foreign tax audits or inquiries relating to the Company’s foreign subsidiaries.

The Company’s policy is to record interest and penalties on uncertain tax provisions as income tax expense. As of September 30, 2008, the Company has no accrued interest or penalties related to uncertain tax positions. During the nine months ended September 30, 2008, the Company reversed its deferred tax asset related to stock options and warrants totaling $904, which was reflected through paid-in capital in the accompanying statement of stockholders’ equity. At September 30, 2008, management determined that its remaining net deferred tax assets of $762 are not realizable and recorded a full valuation allowance.

Note 12. Legal Proceedings

From time to time, the Company may be involved in litigation relating to claims arising out of its operations in the normal course of business. Except as is described below, the Company is not currently party to any legal proceedings , the adverse outcome of which, in management’s opinion, individually or in the aggregate, would have a material adverse effect on the Company’s results of operations or financial position.

On February 7, 2007, VMdirect and DigitalFX Solutions jointly filed a lawsuit in the Superior Court of the State of California for the County of Los Angeles against a former Affiliate of VMdirect alleging a number of complaints including unfair business practice, misappropriation of trade secrets, slander, intentional interference with contractual relationship, intentional interference with prospective economic advantage and breach of contract, and seeking compensatory and punitive damages in amounts to be proved at trial, injunctive relief and attorneys’ fees and costs. Reference is made to the disclosure of this proceeding included in our Quarterly Report on Form 10-Q (File Number 001-33667) filed with the Securities and Exchange Commission on August 14, 2008.

DigitalFX International, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(In Thousands, Except for Share and Per Share Data)

Nine Months Ended September 30, 2008 and 2007 (unaudited)

Since the filing of our Quarterly Report on Form 10-Q (File Number 001-33667) filed with the Securities and Exchange Commission on August 14, 2008, the Company has exchanged motions, petitions, and interrogatories with the former Affiliate.

Management believes there exists no basis for the former Affiliate’s claims and intends to defend this matter vigorously. In the event management’s assessment of the case is incorrect, the economic impact on the Company would be insignificant and would not materially affect its operations.

Note 13. Subsequent Events

In addition to the Change in Control as fully described in Note 1, the following are significant subsequent events of the Company:

On October 13, 2008, the Company’s Board of Directors approved the issuance of 325,000 fully paid shares of the Company’s common stock to certain consultants, Directors and employees.

On October 21, 2008, the Company’s Board of Directors ratified and approved effective as of October 17, 2008 the termination of the Company’s relationship with Mickey Elfenbein, its Chief Operating Officer. The parties continue to negotiate the terms of Mr. Elfenbein’s separation.

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

Forward-Looking Statements

Statements made in this Form 10-Q (the “Quarterly Report”) that are not historical or current facts are “forward-looking statements” made pursuant to the safe harbor provisions of Section 27A of the Securities Act of 1933, as amended (the “Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). We intend that such forward-looking statements be subject to the safe harbors for such statements. We wish to caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made. Any forward-looking statements represent management’s best judgment as to what may occur in the future. These forward-looking statements include the plans and objectives of management for our future growth, including plans and objectives related to the consummation of acquisitions and future private and public issuances of our equity and debt securities. The forward-looking statements included herein are based on current expectations that involve numerous risks and uncertainties. Assumptions relating to the foregoing involve judgments with respect to, among other things, future economic, competitive and market conditions and future business decisions, all of which are difficult or impossible to predict accurately and many of which are beyond our control. Although we believe that the assumptions underlying the forward-looking statements are reasonable, any of the assumptions could be inaccurate and, therefore, there can be no assurance that the forward-looking statements included in this Form 10-Q will prove to be accurate. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation by us or any other person that our objectives and plans will be achieved. We disclaim any obligation subsequently to revise any forward-looking statements to reflect events or circumstances after the date of such statement or to reflect the occurrence of anticipated or unanticipated events.

References to the “Company” refer to DigitalFX International, Inc. The words or phrases “may,” “will,” “expect,” “believe,” “anticipate,” “estimate,” “approximate,” or “continue,” “would be,” “will allow,” “intends to,” “will likely result,” “are expected to,” “will continue,” “is anticipated,” “estimate,” “project,” or similar expressions, or the negative thereof, are intended to identify “forward-looking statements.” Actual results could differ materially from those projected in the forward looking statements as a result of a number of risks and uncertainties, including but not limited to: (a) our failure to implement our business plan within the time period we originally planned to accomplish; and (b) other risks that are discussed in this Form 10-Q or included in our previous filings with the Securities and Exchange Commission (“SEC”).

Description of Business

Corporate History

DigitalFX International, Inc. was incorporated in the State of Florida on January 23, 1991. Prior to November 2001, we provided intelligent message communications services to enterprises in the travel and hospitality sectors. In November 2001, we sold substantially all of our assets to Avery Communications, Inc. after which we continued without material business assets, operations or revenues. On June 22, 2004, we consummated the transactions contemplated by a Securities Purchase Agreement (the “Purchase Agreement”) dated June 10, 2004, by and among our company, Keating Reverse Merger Fund, LLC (“KRM Fund”), Thurston Interests, LLC (“Thurston”) and certain other shareholders of our company. The transactions resulted in a change of control whereby KRM Fund became our majority shareholder. From November 2001 through June 15, 2006, we were a public “shell” company with nominal assets.

On May 23, 2006, we entered into an Exchange Agreement (the “Exchange Agreement”) with VMdirect, L.L.C., a Nevada limited liability company (“VMdirect”), the members of VMdirect holding a majority of its membership interests (together with all of the members of VMdirect, the “VMdirect Members”), and KRM Fund. The closing of the transactions contemplated by the Exchange Agreement occurred on June 15, 2006. At the closing, we acquired all of the outstanding membership interests of VMdirect (the “Interests”) from the VMdirect Members, and the VMdirect Members contributed all of their Interests to us. In exchange, we issued to the VMdirect Members 1,014,589 shares of our Series A Convertible Preferred Stock, par value $0.01 per share (the “Preferred Shares”), which, as a result of the approval by a substantial majority of our outstanding shareholders entitled to vote and the approval by our board of directors on June 22, 2006, of amendments to our articles of incorporation that (i) changed our name to DigitalFX International, Inc., (ii) increased our authorized number of shares of common stock to 100,000,000, and (iii) adopted a 1-for-50 reverse stock split, on August 1, 2006 converted into approximately 21,150,959 shares of our common stock on a post-reverse stock split basis.

At the closing, VMdirect became our wholly-owned subsidiary. The exchange transaction was accounted for as a reverse merger (recapitalization) with VMdirect deemed to be the accounting acquirer, and our company deemed to be the legal acquirer.

On October 15, 2008, we entered into a Framework Agreement with Richard Kall, the Co-Manager of VM Investors, our majority shareholder, Craig Ellins, VM Investor’s Co-Manager and our former Chief Executive Officer, President and Chairman of our Board, and Amy Black, the President of VMdirect, pursuant to which, among other matters, Richard Kall agreed to consummate the transactions under certain Note Purchase Agreements dated October 15, 2008 (the “Note Purchase Agreements”), among Richard Kall, our company, and each of Portside Growth and Opportunity Fund, Highbridge International LLC and Iroquois Master Fund, Ltd. (collectively the “Investors”), subject to (a) Craig Ellins, Amy Black, Kevin Keating and Jerry Haleva resigning from all positions with the Company and each of its subsidiaries, (b) a reduction in the size of our Board to three directors, (c) Richard Kall’s appointment as our Chief Executive Officer and election to our Board as Chairman, and (d) the election of Richard Kall’s designee to the Board.

On October 13, 2008, each of Kevin Keating and Jerry Haleva resigned from the Board. On October 15, 2008, Craig Ellins resigned as the Chairman of the Board, our Chief Executive Officer and President, and from all other officer positions held with our company and each of our subsidiaries, and Amy Black resigned as the President of VMdirect and from all other officer positions held with our company and each of our subsidiaries. Mr. Ellins also resigned as the Co-Manager of VM Investors. On October 15, 2008, the Board also adopted resolutions reducing the size of the Board to three directors, appointing Richard Kall as our Chief Executive Officer and electing Richard Kall as the Chairman of the Board. Prior to the transactions contemplated under the Framework Agreement, Craig Ellins, as our Chairman of the Board, Chief Executive officer and President, and as the Co-Manager of VM Investors, exercised, with the Board and our other executive officers, operational control over our company, and with the consent of Richard Kall, voting control. As a result of the transactions consummated under the Framework Agreement, Richard Kall, as the sole Manager of VM Investors and the beneficial owner of 64.6% of the outstanding shares of our common stock, will exercise voting control over our company. In addition, as the Company’s Chairman and Chief Executive Officer, Richard Kall will exercise, with the Board and our other executive officers, operational control over our company.

Business Overview

We are presently a digital communications and social networking company that, through a multi-tiered affiliate program, has developed and offers The Studio, an all in one solution of proprietary and open source digital communication tools, including streaming video email, instant messaging, live webcasting, podcasting, blogging, video VOIP and digital vault asset management and storage. The Studio gives our customers one easy solution for all online communications, and allows them to create, manage and store their digital assets (pictures, music, videos) with the objective of making their digital lives richer and simpler. All digital assets stored on our servers can be shared among users and friends anywhere in the world.

We differentiate ourselves with the Studio’s inclusion of technology that provides instant transcoding (converting) of video content into different media formats, like Windows to QuickTime, as well as the ability to easily publish video content via numerous methods: blog, podcast, live webcast, video email, or video on-demand.

To showcase the power of the Studio for other social networks or affinity based websites, we created a social networking website, www .hello World.com , operated by our wholly-owned subsidiary, DigitalFX Networks, LLC, a Nevada limited liability company (“DigitalFX Networks”). Customers pay a monthly subscription fee (ranging from $9.95 to $189.95) for an advertising free Studio based on their streaming video and storage needs, and to participate in the social network. DigitalFX Networks also sells as a monthly service (with fees starting at $69) the Studio’s video-enabled web platform to small and medium-sized businesses (“FirstStream”) through www.FirstStream.com . FirstStream allows the business user to manage all incoming text or video emails and reply with streaming video emails from their existing company domains, and to safely store all their digital content, manage all their email communication, and produce live broadcasts to communicate to employees, vendors or customers instantly and with uniformity of message, saving time and travel. These products are primarily marketed through our wholly-owned subsidiary VMdirect which operates a multi-tiered affiliate program and offers its “Affiliates” the tools necessary to effectively market the Studio packages on helloWorld and FirstStream. Our wholly-owned subsidiary, DigitalFX Solutions, LLC, a Nevada limited liability company (“DigitalFX Solutions”), operates our website www.digitalfxsolutions.com , which offers our video-enabled web platform to enterprise-sized businesses.

Our multi-tiered affiliate program drives the growth of our business. Rather than using traditional advertising and marketing methods, we chose to create a multi-tiered affiliate program to develop new customers. Affiliates earn commissions on a monthly residual basis by acquiring new Affiliates and retail customers for DigitalFX properties. Affiliates also earn commissions from the sales activities of other Affiliates who they personally enroll. These rewards are extended for up to eight generations of Affiliates, meaning that an Affiliate earns a commission on the sales of the Affiliates they have personally enrolled as well as on the sales of second-, third-, and fourth-generation Affiliates, potentially eight levels deep.

We are currently implementing a plan of diversification that will seek to introduce at least one new consumer product line by early 2009 to augment our present digital media products and, if possible, another line of consumables by third quarter of fiscal 2009. Our Board has recently formed a Product Selection Team, chaired by Richard Kall, our Chairman and Chief Executive Officer, which has been reviewing potential additional product lines in, among other areas, the “green” products area and additional digital media products. At present, we do not expect to engage in the actual production of our products and will source new products from third parties reflecting current trends in the MLM industry. We have not yet reached a decision on whether we would use the vendors’ trademarks and original packaging or purchase products under our own label. Any such decision will depend on the strength of the vendor’s mark and other considerations including costs.

We have engaged an MLM consultant and had numerous discussions with our MLM leaders to identify and design the most effective way to introduce our diversified business model to our Affiliates. We intend to focus on instructing our key Affiliates on how to use our digital media suite to convey our revised focus to Affiliates in their organizations (the down-line). We anticipate that this approach should facilitate growth of our affiliate base.

Results of Operations

Three and Nine Months Ended September 30, 2008 Compared with Three and Nine Months Ended September 30, 2007 (in thousands, except for customer base data)

The following table presents revenue by category for the three and nine months ended September 30, 2008 and 2007.

	Three Months Ended					Nine Months Ended
Revenue:	September 30, 2008			September 30, 2007		September 30, 2008		September 30, 2007
Subscription fees for access plans and administrative tools	$	2,044		$	4,267	$	7,389	$	12,931

Affiliate business packages		768			876		3,275		3,852

Upgrades to business packages		40			184		303		868

Merchandise, shipping fees and other revenue		(109	)		98		398		336
Total Revenue	$	2,743		$	5,425	$	11,365	$	17,987

Revenues decreased $2,681, or 49% and $6,622 or 37% during the three and nine months ended September 30, 2008, respectively from $5,425 to $2,743 and $17,987 to $11,355 in the corresponding periods in 2007. This decrease relates directly to the number of active customers. The following is a breakdown of our active customer base as of September 30, 2008 and 2007:

	September 30, 2008		September 30, 2007
Affiliates		7,342		15,317
Retail subscribers		9,515		14,519
Total active customers		16,857		29,836

Gross Profit

As a percentage of sales, gross profit decreased from 83% of sales to 76% of sales from the three months ended September 30, 2007 to the three months ended September 30, 2008, respectively, and from 85% of sales to 79% of sales for the nine months ended September 30, 2008 to the nine months ended September 30, 2007, respectively. This decrease relates to the lower margin realized on electronic component sales and an increase in shipping costs associated with greater international volume.

Commission Expenses

As a percentage of sales, commission expenses were the same at 44% of sales for the three months ended September 30, 2008 and 2007, and decreased from 43% of sales to 42% of sales for the nine months ended September 30, 2007 to the nine months ended September 30, 2008, respectively. During the second and third quarters of 2008, commission expenses included a one-time charge for commissions paid to consultants for international marketing services. On an on-going basis, we expect commission expenses as a percentage of affiliate sales to stay in the range of 41%-42%.

Other Operating Expenses

The following table represents a breakdown of other operating expenses for the three months ended September 30, 2008 and 2007. These comparisons are not necessarily indicative of future spending.

	Three Months Ended				Nine Months Ended
	September 30, 2008		September 30, 2007		September 30, 2008		September 30, 2007
Salaries, benefits and other compensation	$	1,108	$	1,308	$	3,744	$	3,316
Corporate expenses		203		409		746		1,082
Product development		136		225		530		639
International deployment and administration		84		437		360		727
Merchant fees		106		231		427		776
Marketing expenses		66		152		327		374
General and administrative		303		778		1,146		1,866
Total Other Operating Expenses	$	2,005	$	3,539	$	7,280	$	8,780

Other operating expenses increased as a percentage of revenue from 66% for the three months ended September 30, 2007 to 73% in the corresponding period in 2008 and 49% for the nine months ended September 30, 2007 to 64% for the corresponding period in 2008.

The Company has taken significant steps to control costs and reduce overhead expenses. We have reprioritized a number of initiatives as we strive for simplification and product solidification. As such, the Company recently revised its personnel structure by reducing resources in non-core areas and enhancing personnel focused on the delivery of our new initiatives. We do not believe these revisions have inhibited growth or quality of services. In addition, we have decreased spending on other areas, including outside consultants, legal and international expansion. We expect that our other operating expenses will decrease as a percentage of revenue through these ongoing efforts .

Other expense, net increased by $189 to $118 of expense for the three months ended September 30, 2008 from $71 of income for the corresponding period in 2007 and by $3,475 to $3,273 of expense for the nine months ending September 30, 2008 from $202 of income for the corresponding period in 2007. For the three and nine months ended September 30, 2008, other expense consist of financing costs, net of interest income, associated with the convertible notes of $127 and $555, the unrealized (gain) loss on investments of $(9) and $481 and the loss on extinguishment of debt related to the restructuring of our convertible notes of $0 and $1,920, respectively.

Liquidity and Capital Resources

Our cash requirements are principally for working capital. Historically, we have funded our working capital needs through operations, the sale of equity and debt interests and through additional capital contributions by our former members.

For the nine months ended September 30, 2008, cash used by Operating Activities was $2,735 and consisted of net loss of ($7,011) increased by non-cash items of $4,956 and decreased by $680 due to changes in other operating assets and liabilities. The latter consisted of decreases in cash provided by, prepaid expenses, other assets, and cash used by accounts payable and accrued expenses of $1,029, offset by increases in cash provided by accounts receivables and inventory of $349.

For the nine months ended September 30, 2007, cash used by operating activities was $1,306 and consisted of net loss of ($971), increased by non-cash items of $513 and decreased by $848 due to changes in other operating assets and liabilities. The latter consisted of decreases in cash provided by accounts receivable, prepaid expenses, inventory and affiliate payables of $1,806, net of increases in accounts payable and accrued expenses of $958.

For the nine months ended September 30, 2008, net cash used in Investing Activities related to the exercise of warrants to acquire an interest in SaySwap of $100 and software licenses purchased totaling $204 (including $149 of anti-spam technology financed through a capital lease arrangement). Investing Activities during the nine months ended September 30, 2007 of $2,213 included investments in strategic partners of $1,691, investment in SaySwap of $225 and software license purchases of $162.

For the nine months ended September 30, 2008, net cash used in Financing Activities included proceeds from the exercise of stock options of $7 offset by the cash repayment of $2,000 related to the restructuring of the convertible notes ($2,000 of restricted cash was also repaid as part of the restructuring of the convertible notes and has been reflected in the Non-Cash Investing and Financing Activities in the Consolidated Statements of Cash Flows for the nine months ended September 30, 2008), $75 principal payment on the Amended and Restructured Notes, and proceeds from capital lease financing of anti-spam technology of $149, net of principal payments of $10. For the nine months ended September 30, 2008, net cash provided by Financing Activities included the exercise of stock options and warrants totaling $38.

On November 29, 2007, we entered into a Securities Purchase Agreement with Portside Growth and Opportunity Fund, Highbridge International, LLC and Iroquois Master Fund, Ltd. pursuant to which we issued an aggregate principal amount of $7.0 million of three-year senior secured convertible notes, and five-year warrants to purchase an aggregate of 875,000 shares of our common stock, to the Investors. The transactions contemplated by the Securities Purchase Agreement closed on November 30, 2007, with net proceeds to us of approximately $4.3 million, net of $2 million held in a collateral account for certain letters of credit, after payment of commissions and expenses.

This agreement was substantially restructured on March 24, 2008, when we entered into an Amendment and Exchange Agreement with each of the Investors. Under the terms of the Amendment and Exchange Agreements, we agreed, along with the Investors, to restructure the financing consummated under the Securities Purchase Agreement to reduce the amount of the financing to $3,000,000, with the Investors receiving repayment of their pro-rata share of $4,000,000, including $2,000,000 held in a collateral account for certain letters of credit, through the exchange of Existing Notes for a combination of Amended and Restated Notes and the Common Shares, and through the exchange of Existing Warrants for Amended and Restated Warrants. The Amended and Restated Notes have an aggregate principal amount of $3,000,000 and a term of three years commencing from November 30, 2007. The Amended and Restated Warrants have a term of five years commencing from November 30, 2007 and entitle the Investors to initially purchase an aggregate of 750,002 shares of our common stock (subject to adjustment as provided in the Amended and Restated Warrants, including pursuant to economic anti-dilution adjustments). The Amended and Restated Notes carry interest at 7.50% per annum on the unpaid/unconverted principal balance, payable quarterly in cash, and are secured on a senior basis against all of our assets. We are also required to make aggregate monthly principal payments of $25,000, plus accrued interest thereon, beginning July 1, 2008.

The Amended and Restated Notes are convertible into approximately 1,500,000 shares (subject to adjustment as provided in the Amended and Restated Notes, including pursuant to economic anti-dilution adjustments), based on an initial conversion price equal to $2.00 per share (subject to adjustment as provided in the Amended and Restated Notes, including pursuant to economic anti-dilution adjustments), which shall reset on March 26, 2009 to the greater of (i) 105% of the arithmetic average of the dollar weighted average price of our common stock over each of the five (5) consecutive trading days ending on the trading day immediately prior to March 26, 2009 and (ii) $1.00 (as adjusted for any stock splits, stock dividends, recapitalizations, combinations, reverse stock splits or other similar events); provided however, that in no event shall the adjusted conversion price be greater than $3.00 (as adjusted for any stock splits, stock dividends, recapitalizations, combinations, reverse stock splits or other similar events). The Amended and Restated Warrants have an exercise price of $0.959 per share (subject to adjustment as provided in the Amended and Restated Warrants, including pursuant to economic anti-dilution adjustments).

The Amended and Restated Notes are convertible at the option of the Investors prior to their maturity. Additionally, beginning November 30, 2008, and provided that we have complied with certain equity conditions, we will be able to require the Investors to convert the Amended and Restated Notes to shares of our common stock if the dollar volume weighted average price of our common stock is $2.75 (subject to adjustment as provided in the Amended and Restated Notes) for twenty (20) out of thirty (30) consecutive trading days.

The restructuring transaction closed on March 26, 2008. The remaining proceeds of approximately $2.1 million, after the payment of aggregate transaction expenses, was used for strategic initiatives and general working capital purposes.

Also in connection with the restructuring transaction, we agreed to reimburse the fund manager of one of the Investors for its out-of-pocket expenses incurred in connection with the transactions contemplated by the Securities Purchase Agreement, including the actual and reasonable fees and disbursements of the fund manager’s legal counsel, up to an aggregate amount of $20,000.

For the three months ended September 30, 2008, the Company determined that it did not meet its financial covenants pursuant to the Amended and Restated Notes. The Company has not received notice from the Investors about their intent to request that the Company redeem any or all of the outstanding Amended and Restated Notes.

October 15, 2008, Portside Growth and Opportunity fund, Highbridge International LLC and Iroquois Master Fund, Ltd. (collectively the “Investors”), along with Richard Kall and our company, entered into certain Note Purchase Agreements pursuant to which Richard Kall agreed to purchase an aggregate of $350,000 of the unpaid principal amount of the Amended and Restated Notes, Amended and Restated Warrants to purchase an aggregate of 90,517 shares of our common stock, and an aggregate of 120,000 shares of our common stock (collectively the “Investor Securities”) previously issued to the Investors. Pursuant to the terms of the Note Purchase Agreements, as additional consideration for Richard Kall’s purchase of the Investor Securities, the Investors and Richard Kall agreed to forbear for a period of 30 days from taking any action to enforce their rights as a result of the event of default that occurred on June 30 and September 30, 2008 with respect to our failure to satisfy one or more financial covenants under the Amended and Restated Senior Secured Convertible Notes for the fiscal quarters ended June 30 and September 30, 2008, respectively. Such forbearance period shall extend for up to 90 days if Richard Kall or the Company makes periodic payments to the Investors in the aggregate amount of $500,000 as further provided in the Note Purchase Agreements. In the immediate future we intend to review all of our options in connection with the Amended and Restated Notes, including potentially restructuring the indebtedness to, among other things, revise the financial covenants.

In addition, we are currently involved in negotiations with Richard Kall, our Chairman and Chief Executive Officer, to provide working capital through a preferred stock equity financing. On November 14, 2008, we received $500,000 from Mr. Kall as an advance on the contemplated financing.

Our business benefits from low capital expenditure requirements. Our capital expenditures for 2008 primarily relate to enhancements for software applications.

Backlog

Backlog is only relevant to our affiliate business packages and merchandise sales, as all subscription services are delivered upon enrollment or at monthly renewal. We do not believe that backlog is a meaningful indicator of future business prospects due to the short period of time from affiliate business package and merchandise order to product shipment. Most products are shipped one to two days from the date ordered; therefore, backlog information is not material to an understanding of our business.

Geographic Information

The breakdown of revenues generated by geographic region for the three and nine months ended September 30, 2008 and 2007 is as follows:

	Three Months Ended						Nine Months Ended
	September 30, 2008			September 30, 2007			September 30, 2008			September 30, 2007

United States, Canada & Mexico		86	%		90	%		86	%		92	%
United Kingdom		3	%		3	%		3	%		2	%
Europe		4	%		-			5	%		-
Australia and New Zealand		7	%		7	%		6	%		6	%
		100	%		100	%		100	%		100	%

Critical Accounting Policies

We prepare our Consolidated Financial Statements in conformity with accounting principles generally accepted in the United States, which require us to make estimates and assumptions that affect the reported amounts of assets and liabilities and revenue and expenses during the year. Actual results could differ from those estimates. We consider the following policies to be most critical in understanding the judgments that are involved in preparing our financial statements and the uncertainties that could impact our results of operations, financial condition and cash flows.

Revenue Recognition

We generate revenue through (i) sales of affiliate business packages and selling aids to Affiliates which include cameras, sales literature, and training videos, (ii) sales of monthly subscriptions to retail customers and Affiliates with a wide spectrum of streaming video content as well as an integrated suite of streaming media applications, including video email, video chat, and live web-casting, (iii) sales of branded apparel and merchandise, (iv) sales of electronic components, and (v) hosting conferences and events.

Affiliate Business Packages

We recognize revenue from the sales of affiliate business packages and selling aids, including shipping revenue, in accordance with SAB No. 104, “Revenue Recognition ,” when persuasive evidence of an order arrangement exists, delivery has occurred, the sales price is fixed or determinable and collectibility is reasonably assured. Generally, these criteria are met at the time the product is shipped to our customers when title and risk of loss have transferred. We consider all deliverables to be met at this point. Costs incurred for the shipping and handling of our products are recorded as cost of sales as incurred.

Allowances for subsequent customer returns of affiliate business packages are provided when revenues are recorded. Affiliate business packages returned within the first 30 days of purchase are generally refunded at 90 percent of the sales price. Returned products that were damaged during shipment to the customer are replaced immediately at our expense. On a monthly basis, we calculate a sales allowance which is an estimate of refunds for package returns that are within the 30 day time frame that have not yet been returned or processed. The estimate is based on an analysis of the historical rate of package returns using data from the four months preceding the date of measurement. We have found that this method approximates actual returns for the next 30 days. Increases or decreases to the sales allowance are charged to revenue.

Monthly Subscriptions

We sell subscriptions for our internet-based studio suite of products through a unique multi-tiered affiliate program using non-related independent distributors, known as Affiliates. We also market subscriptions directly to retail customers who purchase them for their personal use. We recognize revenue when all of the criteria of SAB No. 104 referred to above are met, which is when the subscription is initiated, and then monthly based on an automatic renewal. Our services are provided immediately upon enrollment and continue until cancelled. The recurring subscription can be cancelled at any time in writing. If cancelled within the first 30 days after enrollment, 90% of the fee is refunded, pro-rated for the number of days not used during the month. If a subscription is cancelled after the first month of service, a full refund is issued for the month if the cancellation is received in writing within 48 hours of the renewal billing. No refund is issued if a subscription is cancelled more than 48 hours after the renewal billing for the month. We record an allowance for subscription cancellations based on an analysis of historical data for the four months preceding the date of measurement. We apply a cancellation percentage to subscription revenue that is subject to cancellation within the first 30 days of enrollment or 48 hours of renewal. The accuracy of these estimates is dependent on the rate of future cancellations being consistent with the historical rate. Increases or decreases to the sales allowance are charged to revenue.

Allowance for Doubtful Accounts

Our receivables consist entirely of receivables from credit card companies, arising from the sale of product and services to our customers. We do not record an allowance for doubtful accounts on these receivables, as monies processed by credit card processors are collected 100% within three to five days.

Inventories

Inventories are valued at the lower of cost or market. They are written down, as required, to provide for estimated obsolete or not salable inventory based on assumptions about future demand for our products and market conditions. If future demand and market conditions are less favorable than management’s assumptions, additional inventory write-downs could be required. Likewise, favorable future demand and market conditions could positively impact future operating results if written-off inventory is sold.

Stock-Based Compensation

We periodically issue stock options and warrants to employees and non-employees in non-capital raising transactions for services and for financing costs. We adopted SFAS No. 123R, “Accounting for Stock-Based Compensation” effective January 1, 2006, and are using the modified prospective method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS No. 123R for all share-based payments granted after the effective date and (b) based on the requirements of SFAS No. 123R for all awards granted to employees prior to the effective date of SFAS No. 123R that remain unvested on the effective date. We account for stock option and warrant grants issued and vesting to non-employees in accordance with EITF No. 96-18: “Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services,” and EITF 00-18 “Accounting Recognition for Certain Transactions involving Equity Instruments Granted to Other Than Employees” whereby the fair value of the stock compensation is based on the measurement date as determined at either a) the date at which a performance commitment is reached, or b) at the date at which the necessary performance to earn the equity instrument is complete.

We recognize compensation cost for equity-based compensation for all new or modified grants issued after December 31, 2005. In addition, commencing January 1, 2006, we recognized the unvested portion of the grant date fair value of awards issued prior to adoption of SFAS No. 123R based on the fair value previously calculated for disclosure purposes over the remaining vesting period of the outstanding stock options and warrants.

We estimate the fair value of stock options pursuant to SFAS No. 123R using the Black-Scholes option-pricing model, which was developed for use in estimating the fair value of options that have no vesting restrictions and are fully transferable. This model requires the input of subjective assumptions, including the expected price volatility of the underlying stock and the expected life of stock options. Projected data related to the expected volatility of stock options is based on the average volatility of the trading prices of comparable companies and the expected life of stock options is based upon the average term and vesting schedules of the options. Changes in these subjective assumptions can materially affect the fair value of the estimate, and therefore the existing valuation models do not provide a precise measure of the fair value of our employee stock options.

Recent Accounting Pronouncements

In March 2008, the FASB issued SFAS No. 161 (FAS 161), “Disclosures About Derivative Instruments and Hedging Activities - an amendment of FAS 133.” FAS 161 requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements. FAS 161 is effective for fiscal years beginning after November 15, 2008. We do not expect the implementation of FAS 161 to have a material impact on our consolidated financial statements.

We do not believe that the adoption of the above recent pronouncements will have a material effect on our consolidated results of operations, financial position, or cash flows.

Off-Balance Sheet Arrangements

We have no off-balance sheet arrangements or financing activities with special purpose entities.

RISK FACTORS

INVESTING IN OUR COMMON STOCK INVOLVES A HIGH DEGREE OF RISK. YOU SHOULD CAREFULLY CONSIDER THE FOLLOWING RISK FACTORS AND ALL OTHER INFORMATION CONTAINED IN THIS REPORT BEFORE PURCHASING SHARES OF OUR COMMON STOCK. IF ANY OF THE FOLLOWING RISKS OCCUR, OUR BUSINESS, FINANCIAL CONDITION AND/OR RESULTS OF OPERATIONS COULD BE MATERIALLY AND ADVERSELY AFFECTED. IN THAT CASE, THE TRADING PRICE OF OUR COMMON STOCK COULD DECLINE, AND YOU MAY LOSE SOME OR ALL OF YOUR INVESTMENT.

RISKS RELATING TO OUR BUSINESS

Our operating results may fluctuate significantly based on customer and Affiliate acceptance of our products.

Management expects that we will experience substantial variations in our net sales and operating results from quarter to quarter due to customer acceptance of our products. We rely on sales by our Affiliates to generate significant revenues for us. If customers don’t accept our products, our sales and revenues would decline, resulting in a reduction in our operating income.

Customer interest for our products could also be impacted by the timing of our introduction of new products. If our competitors introduce new products or free products around the same time that we issue new products, and if such competing products are superior to our own, customers’ desire for our products could decrease, resulting in a decrease in our sales and revenues. To the extent that we introduce new products and customers decide not to migrate to our new products from our older products, our revenues could be negatively impacted due to the loss of revenue from those customers. In the event that our newer products do not sell as well as our older products, we could also experience a reduction in our revenues and operating income.

As a result of fluctuations in our revenue and operating expenses that may occur, management believes that period-to-period comparisons of our results of operations are not a good indication of our future performance.

If we do not successfully generate additional products and services, or if such products and services are developed but not successfully commercialized, we could lose revenue opportunities.

Currently, our primary business is the sale of our Studio suite of products to our Affiliates. Our future success depends, in part, on our ability to expand our product and service offerings. To that end we have engage in the process of identifying new product opportunities to provide additional products and related services to our customers. The process of identifying and commercializing new products is complex and uncertain, and if we fail to accurately predict customers’ changing needs and emerging technological trends our business could be harmed. We may have to commit significant resources to commercializing new products before knowing whether our investments will result in products the market will accept. Furthermore, we may not execute successfully on commercializing those products because of errors in product planning or timing, technical hurdles that we fail to overcome in a timely fashion, or a lack of appropriate resources. This could result in competitors providing those solutions before we do and a reduction in net sales and earnings.

The success of new products depends on several factors, including proper new product definition, timely completion and introduction of these products, differentiation of new products from those of our competitors, and market acceptance of these products. There can be no assurance that we will successfully identify new product opportunities, develop and bring new products to market in a timely manner, or achieve market acceptance of our products or that products and technologies developed by others will not render our products or technologies obsolete or noncompetitive.

While we previously achieved an operating profit, we have a history of operating losses and there can be no assurance that we can achieve, maintain or increase profitability.

While we previously achieved operating profits, we did not achieve an operating profit for the nine months ended September 30, 2008, and we have a history of operating losses. Given the competitive and evolving nature of the industry in which we operate, the technical difficulties we experienced with version 5.0 of the DigitalFX Studio product, and potential technical difficulties we may encounter in the future, we may not be able to achieve, sustain or increase profitability and our failure to do so would adversely affect our business, including our ability to raise additional funds. In addition, to the extent we introduce new products that are not accepted by the market, we would continue to experience operating losses. If we continue to experience operating losses through 2009, our shares may be delisted from the American Stock Exchange.

We may not be able to effectively manage our growth.

Our strategy envisions growing our business. To date, our growth has been derived primarily from the growth of our multi-tiered Affiliate base and we intend to continue to employ this growth strategy. To manage anticipated growth, we plan to expand our technology to handle increasing volume on our websites and to expand our administrative and marketing organizations to accommodate larger numbers of our Affiliates. We must also effectively manage our relationships with the increasing number of retail customers/users of our products. We will need to hire, train, supervise and manage new employees. These processes are time consuming and expensive, will increase management responsibilities and will divert management attention. In addition, we have gone through a complete restructuring of senior management and our the new management is focused on turning our company around. Any growth in or expansion of our business is likely to continue to place a strain on our management and administrative resources, infrastructure and systems. We cannot assure you that we will be able to:

·	sufficiently and timely improve our technology to handle increasing volume on our websites;

·	expand our administrative and marketing systems effectively, efficiently or in a timely manner to accommodate increasing numbers of our Affiliates; or

·	allocate our human resources optimally.

Our inability or failure to manage our growth and expansion effectively could result in strained Affiliate and customer relationships based on dissatisfaction with our service to these groups, our failure to meet demand for our products and/or increased expenses to us to resolve these issues, and a consequent significant decrease in the number of our Affiliates and end users. Any significant decrease in our Affiliate base or the number of retail customers, or the election of new Affiliates to sign on for lower level packages would result in a decrease in revenues.

If we continue to experience technological difficulties with our products our Affiliate base could shrink, customer growth could decrease and our business could suffer.

In November 2006, we released the 5.0 version of the DigitalFX Studio that included expanded functionality and features. The testing we conducted did not reveal various technical difficulties that remained with the product. In addition, the 5.0 version rolled out in November 2006 did not contain all of the enhancements that our Affiliates were expecting due to development delays. The result was a product with lower than expected functionality and operating difficulties. As a result of these issues, our Affiliate network has not marketed our products and the business opportunity as widely as projected in our plan. While we have taken steps to ameliorate these difficulties, to the extent that we continue to encounter technical difficulties, and to the extent that enhancements to the products we release or new products have technical difficulties, the reputation of our products could suffer, our Affiliate base could shrink and our ability to generate new customers, and consequently revenue, would be negatively impacted. Our ability to grow our business would also be negatively impacted.

We are presently reviewing other technologies which could replace our core technology. We may experience interruptions in service while we are integrating the new service or a period of instability if the new technology cannot be scaled up.

Eighty-three percent of our revenues for the three months ended September 30, 2008 have been derived from sales of our products and services to our Affiliates, and our future success depends on our ability to grow our Affiliate base, as well as to expand our retail subscriptions and initiate advertising revenue.

To date, our revenue growth has been derived primarily from the growth of our multi-tiered Affiliate base. Rather than using traditional advertising and sales methods, we chose to create a multi-tiered affiliate program to develop new customers. Affiliates earn retail commissions on a monthly residual basis by acquiring new customers for us. Affiliates earn additional commissions from the sales activities of Affiliates who they personally enroll. These rewards are extended for up to eight generations of Affiliates, meaning that an Affiliate earns a commission on the sales of the Affiliates they have personally enrolled as well as on the sales of second-, third-, and fourth-generation Affiliates, potentially eight levels deep. Our Affiliate compensation plan is structured on a 3x8 matrix, meaning Affiliates can each enroll three Affiliates underneath themselves before they begin to build their next organizational level. The layers of three continue down a total of eight levels.

Our success and the planned growth and expansion of our business depend on us achieving greater and broader acceptance of our products and expanding our customer base. There can be no assurance that customers will subscribe to our product offerings or that we will continue to expand our customer base. Though we plan to continue to provide tools to our Affiliates to enable them to generate sales, we cannot guarantee that the time and resources we spend on these efforts will generate a commensurate increase in users of our product offerings. If we are unable to effectively market or expand our product offerings, and if our Affiliate enrollment does not continue to grow, we will be unable to grow and expand our business or implement our business strategy. This could materially impair our ability to increase sales and revenue and materially and adversely affect our margins, which could harm our business and cause our stock price to decline.

Our future success depends largely upon our ability to attract and retain a large active base of Affiliates who purchase and sell our products. We cannot give any assurances that the productivity of our Affiliates will continue at their current levels or increase in the future. Several factors affect our ability to attract and retain a significant number of Affiliates, including:

·	on-going motivation of our Affiliates;

·	general economic conditions;

·	significant changes in the amount of commissions paid;

·	public perception and acceptance of direct selling;

·	public perception and acceptance of us and our products;

·	the limited number of people interested in pursuing direct selling as a business;

·	our ability to provide proprietary quality-driven products that the market demands; and

·	competition in recruiting and retaining active Affiliates.

Our ability to conduct business, particularly in international markets, may be affected by political, economic, legal and regulatory risks, which could adversely affect the expansion of our business in those markets.

Our ability to capitalize on growth in new international markets and to maintain the current level of operations in our existing international markets is exposed to risks associated with international operations, including:

·	the possibility that a foreign government might ban or severely restrict our business method of selling through our Affiliates, or that local civil unrest, political instability or changes in diplomatic or trade relationships might disrupt our operations in an international market;

·	the possibility that a government authority might impose legal, tax or other financial burdens on Affiliates, as direct sellers, or on our company due, for example, to the structure of our operations in various markets;

·	the possibility that a government authority might challenge the status of our Affiliates as independent contractors or impose employment or social taxes on our Affiliates;

·	our ability to staff and manage international operations;

·	handling the various accounting, tax and legal complexities arising from our international operations; and

·	understanding cultural differences affecting non-U.S. customers.

We currently conduct activities in Australia, Canada, Ireland, Mexico, New Zealand, the United Kingdom, Germany and Spain. We have not been affected in the past by any of the potential political, legal or regulatory risks identified above. While we do not consider these risks to be material in the foreign countries in which we currently operate, they may be material in other countries where we may expand our business.

We are also subject to the risk that due to legislative or regulatory changes in one or more of our present or future markets, our marketing system could be found not to comply with applicable laws and regulations or may be prohibited. Failure to comply with applicable laws and regulations could result in the imposition of legal fines and/or penalties which would increase our operating costs. We may also be required to comply with directives or orders from various courts or applicable regulatory bodies to conform to the requirements of new legislation or regulation, which would detract management’s attention from the operation of our business. Further we could be prohibited from distributing products through our marketing system or may be required to modify our marketing system.

Our services are priced in local currency. As a result, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets. We do not currently engage in hedging activities or other actions to decrease fluctuations in operating results due to changes in foreign currency exchange rates, although we may do so when the amount of revenue obtained from sources outside of the United States becomes significant.

We also face legal and regulatory risks in the United States, the affect of which could reduce our sales and revenues.

Our marketing program is subject to a number of federal and state regulations administered by the Federal Trade Commission and various state agencies in the United States, directed at preventing fraudulent or deceptive schemes by ensuring that product sales are made to consumers of the products and that compensation, recognition, and advancement within the marketing organization are based on the sale of products rather than investment in the organization or other non-sales-related criteria. These regulatory requirements do not include “bright line” rules and are inherently fact-based. Thus, even though we believe that our marketing program complies with applicable federal and state laws or regulations, we are subject to the risk that a governmental agency or court could determine that we have failed to meet these requirements in a particular case. Such an adverse determination could require us to make modifications to our marketing system, increasing our operating expenses. The negative publicity associated with such an adverse determination could also reduce Affiliate and end user demand for our products, which would consequently reduce our sales and revenues.

If we incur substantial liability from litigation, complaints, or enforcement actions resulting from misconduct by our multi-level Affiliates, our financial condition could suffer.

Although we use various means to address misconduct by our multi-level Affiliates, including maintaining policies and procedures to govern the conduct of our Affiliates and conducting training seminars, it is still difficult to detect and correct all instances of misconduct. Violations of our policies and procedures by our Affiliates could lead to litigation, formal or informal complaints, enforcement actions, and inquiries by various federal, state, or foreign regulatory authorities against us and/or our Affiliates. Litigation, complaints, and enforcement actions involving us and our Affiliates could consume considerable amounts of financial and other corporate resources, which could have a negative impact on our sales, revenue, profitability and growth prospects.

We have not been, and are not currently, subject to any material litigation, complaint or enforcement action regarding Affiliate misconduct by any federal, state or foreign regulatory authority.

We may be unable to compete successfully against existing and future competitors, which could decrease our revenue and margins and harm our business.

The digital communications and social networking industries are highly competitive. Our future growth and financial success depend on our ability to further penetrate and expand our user base, as well as our ability to grow our revenue models. Our competitors possess greater resources than we do and in many cases are owned by companies with broader business lines. For example, we encounter competition in the social networking space from H www.myspace.com H , a company acquired by News Corporation, and we offer video instant messaging services similar to those offered at H www.skype.com H , a subsidiary of eBay, Inc. There can be no assurance that we will be able to maintain our growth rate or increase our market share in our industry at the expense of existing competitors.

We may not be able to adequately protect our intellectual property rights which would affect our ability to compete in our industry.

Our intellectual property relates to the initiation, receipt and management of digital communications. We rely in part on trade secret, unfair competition, trade dress and trademark law to protect our rights to certain aspects of our intellectual property, including our software technologies, domain names and recognized trademarks, all of which we believe are important to the success of our products and our competitive position. There can be no assurance that any of our trademark applications will result in the issuance of a registered trademark, or that any trademark granted will be effective in thwarting competition or be held valid if subsequently challenged. In addition, there can be no assurance that the actions taken by us to protect our proprietary rights will be adequate to prevent imitation of our products, that our proprietary information will not become known to competitors, that we can meaningfully protect our rights to unpatented proprietary information or that others will not independently develop substantially equivalent or better products that do not infringe on our intellectual property rights.

We could be required to devote substantial resources to enforce and protect our intellectual property, which could divert our resources from the conduct of our business and result in increased expenses. In addition, an adverse determination in litigation could subject us to the loss of our rights to particular intellectual property, could require us to grant licenses to third parties, could prevent us from selling or using certain aspects of our products or could subject us to substantial liability, any of which could reduce our sales and/or result in the entry of additional competitors into our industry.

We may become subject to litigation for infringing the intellectual property rights of others the affect of which could cause us to cease marketing and exploiting our products.

Others may initiate claims against us for infringing on their intellectual property rights. We may be subject to costly litigation relating to such infringement claims and we may be required to pay compensatory and punitive damages or license fees if we settle or are found culpable in such litigation. In addition, we may be precluded from offering products that rely on intellectual property that is found to have been infringed by us. We also may be required to cease offering the affected products while a determination as to infringement is considered and could eventually be required to modify our products to cease the infringing activity. These developments could cause a decrease in our operating income and reduce our available cash flow, which could harm our business and cause our stock price to decline.

We may have to expend significant resources developing alternative technologies in the event that third party licenses for intellectual property upon which our business depends are not available or are not available on terms acceptable to us.

We rely on certain intellectual property licensed from third parties and may be required to license additional products from third parties in the future. There can be no assurance that these third party licenses will be available or will continue to be available to us on acceptable terms or at all. Our inability to enter into and maintain any license necessary for the conduct of our business could result in our expenditure of significant capital to develop or obtain alternate technologies and to integrate such alternate technologies into our current products, or could result in our cessation of the development or sales of products for which such licenses are necessary.

We may be unable to attract and retain qualified, experienced, highly skilled personnel, which could adversely affect the implementation of our business plan.

Our success depends to a significant degree upon our ability to attract, retain and motivate skilled and qualified personnel. In particular, we are heavily dependent on the continued services of Richard Kall and the other members of our senior management team. Mr. Kall has been widely recognized as a leader in the Network Marketing industry with over 30 years of experience. We do not have long-term employment agreements with most members of our senior management team, each of whom may voluntarily terminate his or her employment with us at any time. Following any termination of employment, those employees without employment agreements would not be subject to any non-competition covenants or non-solicitation covenants. The loss of any key employee, including members of our senior management team, could result in a decrease in the efficacy with which we implement our business plan due to the loss of our experienced managers, increased competition in our industry and could negatively impact our sales and marketing operations. The loss of Mr. Kall as a leader in our company could have a detrimental effect on the future of our company. Our inability to attract highly skilled personnel with sufficient experience in our industry could result in less innovation in our products and a consequent decrease in our competitive position, and a decrease in the quality of our service to our Affiliates and end users and a consequent decrease in our sales, revenue and operating income.

Our senior management had limited experience managing a publicly traded company prior to serving as our executive officers. This limited experience may divert our management’s attention from operations and harm our business.

Our management team had limited experience managing the reporting requirements of the federal securities laws prior to serving as our executive officers. Management will be required to implement appropriate programs and policies to comply with existing disclosure requirements and to respond to increased reporting requirements pursuant to Section 404 of the Sarbanes-Oxley Act. These increased requirements include the preparation of an internal report which states the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting and containing an assessment, as of the end of each fiscal year, of the effectiveness of the internal control structure and procedures for financial reporting. Management’s efforts to familiarize itself with and to implement appropriate procedures to comply with the disclosure requirements of the federal securities laws could divert its attention from the operation of our business. Management’s failure to comply with the disclosure requirements of the federal securities laws could lead to the imposition of fines and penalties by the SEC or the cessation of trading of our common stock on The American Stock Exchange (“AMEX”).

If we are not able to respond to the adoption of technological innovation in our industry and changes in consumer demand, our products will cease to be competitive, which could result in a decrease in revenue and harm our business.

Our future success will depend, in part, on our ability to keep up with changes in consumer tastes, offer seamless compatibility with other systems or applications offered by industry leaders, and our continued ability to differentiate our products through implementation of new technologies. We may not, however, be able to successfully do so, and our competitors may be able to implement new technologies at a much lower cost. These types of developments could render our products less competitive and possibly eliminate any differentiating advantage that we might hold at the present time.

RISKS RELATING TO OUR COMMON STOCK

There is limited trading, and consequently limited liquidity, of our common stock.

Prior to August 23, 2007, bid and ask prices for shares of our common stock were quoted on the OTC Bulletin Board under the symbol “DFXN.” On August 23, 2007, our common stock began trading on AMEX. Although our common stock is quoted on AMEX, there is limited trading of our common stock and our common stock is not broadly followed by securities analysts. The average daily volume of our common stock as reported on AMEX for the three-month period ended September 30, 2008 was approximately 12,500 shares. Consequently, shareholders may find it difficult to sell shares of our common stock.

While we are hopeful that we will command the interest of a greater number of investors and analysts, more active trading of our common stock may never develop or be maintained. More active trading generally results in lower price volatility and more efficient execution of buy and sell orders. The absence of active trading reduces the liquidity of our common stock. As a result of the lack of trading activity, the quoted price for our common stock on AMEX is not necessarily a reliable indicator of its fair market value. Further, if we cease to be traded, holders of our common stock would find it more difficult to dispose of, or to obtain accurate quotations as to the market value of, our common stock, and the market value of our common stock would likely decline.

On October 23, 2008 we provided a plan to the Listing Department of the American Stock Exchange advising AMEX of action we will take to regain compliance with AMEX’s continued listing standards. The plan remains subject to review and acceptance by AMEX. If accepted, the plan will continue to be subject to periodic review to determine whether we are making progress consistent with the plan. If the plan is not accepted, or if we do not make progress consistent with the plan, AMEX may initiate delisting procedures as appropriate.

The market price of our common stock is likely to be highly volatile and subject to wide fluctuations, and you may be unable to resell your shares at or above the price at which you purchased such shares.

The market price of our common stock is likely to be highly volatile and could be subject to wide fluctuations in response to a number of factors that are beyond our control, including announcements of new products or services by our competitors. In addition, the market price of our common stock could be subject to wide fluctuations in response to a variety of factors, including:

·	quarterly variations in our revenues and operating expenses;

·	developments in the financial markets, and the worldwide or regional economies;

·	announcements of innovations or new products or services by us or our competitors;

·	fluctuations in merchant credit card interest rates;

·	significant sales of our common stock or other securities in the open market; and

·	changes in accounting principles.

In the past, shareholders have often instituted securities class action litigation after periods of volatility in the market price of a company’s securities. If a shareholder were to file any such class action suit against us, we would incur substantial legal fees and our management’s attention and resources would be diverted from operating our business to respond to the litigation, which could impact our productivity and profitability.

Substantial future sales of our common stock in the public market could cause our stock price to fall.

Upon the effectiveness of any registration statement that we may file with respect to the resale of shares held by our shareholders, a significant number of our shares of common stock may become eligible for sale, or as specified below, these shares could be sold without any restrictions pursuant to other exceptions under the securities laws. The sale of these shares could depress the market price of our common stock. Sales of a significant number of shares of our common stock in the open market could harm the market price of our common stock. A reduced market price for our shares could make it more difficult to raise funds through future offerings of common stock.

On November 30, 2007, upon the expiration of the lock up agreements restricting sales by the selling shareholders listed in the prospectus included on the post-effective amendment to the registration statement on Form SB-2 we filed with the SEC on May 22, 2007, additional shares of our common stock became eligible for unrestricted resale. As additional shares of our common stock become available for resale in the open market (including shares issued upon the exercise of our outstanding options and warrants), the supply of our publicly traded shares will increase, which could decrease its price.

Some of our shares may also be offered from time to time in the open market pursuant to Rule 144, and these sales may have a depressive effect on the market price of our shares. In general, a non-affiliate who has held restricted shares for a period of six months may sell an unrestricted number of shares of our common stock into the market.

The sale of securities by us in any equity or debt financing could result in dilution to our existing shareholders and have a material adverse effect on our earnings.

Any sale of common or convertible preferred stock by us in a future private placement offering could result in dilution to the existing shareholders as a direct result of our issuance of additional shares of our capital stock. In addition, our business strategy may include expansion through internal growth, by acquiring complementary businesses, by acquiring or licensing additional brands, or by establishing strategic relationships with targeted customers and suppliers. In order to do so, or to finance the cost of our other activities, we may issue additional equity securities that could dilute our shareholders’ stock ownership. We may also assume additional debt and incur impairment losses related to goodwill and other tangible assets if we acquire another company and this could negatively impact our earnings and results of operations.

We have not paid dividends in the past and do not expect to pay dividends for the foreseeable future, and any return on investment may be limited to potential future appreciation on the value of our common stock.

We currently intend to retain any future earnings to support the development and expansion of our business and do not anticipate paying cash dividends in the foreseeable future. Our payment of any future dividends will be at the discretion of our board of directors after taking into account various factors, including without limitation, our financial condition, operating results, cash needs, growth plans and the terms of any credit agreements that we may be a party to at the time. To the extent we do not pay dividends, our stock may be less valuable because a return on investment will only occur if and to the extent our stock price appreciates, which may never occur. In addition, investors must rely on sales of their common stock after price appreciation as the only way to realize their investment, and if the price of our stock does not appreciate, then there will be no return on investment. Investors seeking cash dividends should not purchase our common stock.

Our officers, directors and principal shareholders, controlling approximately 69% of our outstanding common stock, can exert significant influence over us and may make decisions that are not in the best interests of all shareholders.

Our officers, directors and principal shareholders collectively control approximately 69% of our outstanding common stock. As a result, these shareholders will be able to affect the outcome of, or exert significant influence over, all matters requiring shareholder approval, including the election and removal of directors and any change in control. In particular, this concentration of ownership of our common stock could have the effect of delaying or preventing a change of control of us or otherwise discouraging or preventing a potential acquirer from attempting to obtain control of us. This, in turn, could have a negative effect on the market price of our common stock. It could also prevent our shareholders from realizing a premium over the market prices for their shares of common stock. Moreover, the interests of this concentration of ownership may not always coincide with our interests or the interests of other shareholders, and accordingly, they could cause us to enter into transactions or agreements that we would not otherwise consider.

Anti-takeover provisions may limit the ability of another party to acquire us, which could cause our stock price to decline.

Our articles of incorporation, as amended, our bylaws and Florida law contain provisions that could discourage, delay or prevent a third party from acquiring us, even if doing so may be beneficial to our shareholders. In addition, these provisions could limit the price investors would be willing to pay in the future for shares of our common stock.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Not applicable.

Item 4. Controls And Procedures

As of September 30, 2008, the end of the period covered by this report, we conducted an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)) under the 1934 Act. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective.

There was no change in our internal control over financial reporting during our most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II - OTHER INFORMATION

Item 1. Legal Proceedings

Except as described below, we are not involved in any legal proceedings that require disclosure in this report.

From time to time, we may be involved in litigation relating to claims arising out of our operations in the normal course of business. Except as is described below, we are not currently party to any legal proceedings, the adverse outcome of which, in management’s opinion, individually or in the aggregate, would have a material adverse effect on our results of operations or financial position.

Management believes there exists no basis for the former Affiliate’s claims and intends to defend this matter vigorously. In the event our management’s assessment of the case is incorrect, or the former Affiliate actually obtains a favorable judgment for the claimed damages, the economic impact on us would be insignificant and would not materially affect our operations.

Item 4. Submission o f Matters to a Vote of Security Holders

We held our annual meeting of shareholders on July 23, 2008. At the annual meeting, there were 24,927,710 shares of our common stock entitled to vote, and 20,117,933 (80.7%) were represented at the annual meeting in person and by proxy. Each of Craig Ellins, Jerry Haleva and Kevin R. Keating were reelected to our board of directors at the annual meeting. Manny Gerard’s term as a director expired at the annual meeting.

The following summarizes vote results for those matters submitted to our shareholders for action at the annual meeting:

1. Proposal to elect Messrs. Ellins, Haleva and Keating to serve as our directors for the ensuing year and until their successors have been elected and qualified.

Director	For	Withheld
Craig Ellins	20,097,647	20,286
Jerry Haleva	20,098,117	19,816
Kevin R. Keating	20,098,117	19,816

2. Proposal to approve an amendment of our 2006 Stock Incentive Plan to increase the number of authorized shares under the plan from 1,537,501 to 5,000,000.

	For	Against	Abstain	Broker Non-Votes
	16,737,877	32,022	1,500	3,346,534

Item 6. Exhibits

See attached Exhibit Index.

SIGNATURES

In accordance with Section 13 or 15(d) of the Exchange Act, the Registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.


	DIGITALFX INTERNATIONAL, INC.

Date: November 14, 2008	By:	/s/ Tracy Sperry
		Tracy Sperry
		Chief Financial Officer

Exhibit Index

Exhibit Number		Exhibit Title

10.1		Form of Indemnification Agreement.
31.1		Certification by Chief Executive Officer pursuant to Rule 13a-14(a) or 15d-14(a) under the Securities Exchange Act of 1934, as amended.
31.2		Certification by Chief Financial Officer pursuant to Rule 13a-14(a) or 15d-14(a) under the Securities Exchange Act of 1934, as amended.
32.1		Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2		Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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