could this mean another Swartz-like deal?

F-56

Phoenix Digital Solutions, LLC

Notes to Financial Statements

1. Organization and Business

Phoenix Digital Solutions, LLC (the “Company”) is a Delaware limited liability company organized on June 7, 2005. Through a commercialization agreement dated June 7, 2005, the Company holds the rights to certain patents of its members. The Company receives license fees from license agreements entered into between licensees and a member of the Company and distributes license fee proceeds to its members.

Liquidity Risks and Management’s Plans

During the years ended May 31, 2008, 2009 and 2010, the Company has experienced a decline in license revenues. At August 10, 2010, the Company’s cash and cash equivalents balance was $1,177,211. The ability of PDS to continue as a going concern is dependent on its ability to generate or obtain sufficient cash to meet its obligations on a timely basis. The Company will need to generate proceeds from new license agreements or obtain equity or debt financing to fund its planned operating expenses and working capital requirements for the foreseeable future. Currently, the Company has no commitments to obtain additional capital from sources outside of that which may be contributed by the members, and there can be no assurance that financing will be available in amounts or on terms acceptable to the Company, if at all.

Because of the uncertain nature of the negotiations that lead to license revenues, pending litigation with companies which the members believe have infringed on their patent portfolio, the possibility of legislative action regarding patent rights, petitions with the USPTO to re-examine certain of the patents, the possible effect of new judicial interpretations of patent laws, and current litigation between the members of PDS, there is no assurance that the Company will receive any future revenues from license agreements, or if it does, that such license revenues in the future will be consistent with amounts received in the past.

In the event the Company is unable to successfully generate proceeds from license agreements at historical levels or obtain additional capital, it is unlikely that the Company will have sufficient cash flows and liquidity to finance its business operations as currently contemplated. Accordingly, in the event new financing is not obtained, the Company will likely reduce general and administrative expenses, including legal fees, litigation activity and other licensing costs, until it is able to obtain sufficient financing to do so.

2. Summary of Significant Accounting Policies

Limited Liability Company Operating Agreement

As a limited liability company, each member’s liability is limited to the capital invested. Allocation of profits, losses and distributions is in accordance with the terms as defined in the operating agreement.

The Company is treated as a partnership for federal income tax purposes. Consequently, federal income taxes are not payable by the Company. The Company’s net income or loss is allocated among the members in accordance with the operating agreement of the Company and members are taxed individually on their share of the Company’s earnings. The State of California assesses a limited liability company fee based on the Company’s income in addition to a flat limited liability company tax. Accordingly the financial statements reflect a provision for these California taxes.

Use of Estimates

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

F-57

Phoenix Digital Solutions, LLC

Notes to Financial Statements (Continued)

Summary of Significant Accounting Policies (continued)

Revenue Recognition

The Company generally recognizes revenue upon receipt of the license proceeds from the licensee at which time all obligations of the Company have been performed under the license agreements (see Note 3).

Cash Equivalents

The Company considers all highly liquid investments with a maturity of three months or less at the date of acquisition to be cash equivalents.

Financial Instruments and Concentrations

Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash and cash equivalents.

Credit Risk

At May 31, 2010 and 2009, the Company’s cash and cash equivalents balance consisting of money market accounts not subject to FDIC insurance was $779,932 and $1,343,582, respectively. The Company limits its exposure of loss by maintaining its cash with a financially stable financial institution.

Intellectual Property Rights

The Company relies on a combination of patents, trademarks, copyrights, trade secret laws, confidentiality procedures and licensing arrangements to protect its intellectual property rights. The Company currently has seven U.S. patents, one European patent, and one Japanese patent issued. A successful challenge to its ownership of the technology or the proprietary nature of the intellectual property would materially damage the Company’s business prospects. Any issued patent may be challenged and invalidated.

3. Licenses Receivable

The Company generally recognizes revenue upon receipt of the license proceeds from the licensee at which time all obligations of the Company have been performed under the license agreements.

At May 31, 2010, the balance in licenses receivable consists of a license agreement for which partial payment was made in fiscal 2010 and the remaining payment of $2,000,000 was received by the Company during July 2010.

At May 31, 2009, the balance in licenses receivable consists of a license received during May 2009, but deposited to an incorrect bank account and a license agreement signed in April 2009 for which partial payment was made in fiscal 2009 and the remaining payment was received in June and July 2009.

4. Formation and Commercialization Agreement

The Company has two members: Technology Properties Limited Inc. (“TPL”), and Patriot Scientific Corporation (“PTSC”). Each member owns 50% of the membership interests of the Company. Each member has the right to appoint one member of the three member management committee. The two appointees are required to select a mutually acceptable third member of the management committee.

F-58

Phoenix Digital Solutions, LLC

Notes to Financial Statements (Continued)

Formation and Commercialization Agreement (continued)

Pursuant to the LLC Agreement, the members agreed to establish a working capital fund for the Company of $4,000,000, of which each member contributed $2,000,000. The working capital fund increases to a maximum of $8,000,000 as license revenues are achieved. The members are obligated to fund future working capital requirements at the discretion of the management committee of the Company in order to maintain working capital of not more than $8,000,000. Neither member is required to contribute more than $2,000,000 in any fiscal year. During the fiscal year ended May 31, 2010 PTSC and TPL each contributed $580,000 to the Company for working capital requirements. Distributable cash and allocation of profits and losses will be allocated to the members in the priority defined in the LLC Agreement.

On June 7, 2005, the Company entered into a Commercialization Agreement with TPL and PTSC. This Commercialization Agreement allows TPL to commercialize the patent portfolio by entering into settlement and/or license agreements, suing in the name of TPL, PTSC, the Company and Charles Moore, and manage the use of the patent portfolio by third parties.

Under terms of the Commercialization Agreement, the Company is required to pay a quarterly amount ranging between $500,000 and $1,000,000 (based upon a percentage of the working capital fund balance) to TPL for TPL’s supporting efforts to secure licensing agreements for the Company. During the years ended May 31, 2010, 2009 and 2008, the Company expensed $1,500,000, $2,869,114 and $2,952,362, respectively, pursuant to the agreement. The Company is also required to reimburse TPL for payment of all legal and third-party expert fess and other related third party costs and expenses. During the years ended May 31, 2010, 2009 and 2008, the Company expensed $3,684,154, $5,851,514 and $12,894,053, respectively, pursuant to the agreement.

On November 13, 2008, the Company’s management committee resolved to pay TPL 3% of the gross licensing revenue received by the Company for the period June 1, 2008 through May 31, 2009, as reimbursement for certain expenses incurred by TPL in connection with TPL’s activities related to a possible amendment of patent laws in the United States. The aggregate reimbursement under this resolution was not to exceed $1,000,000 for the period June 1, 2008 through May 31, 2009. From November 2008 to May 31, 2009, PDS expensed $571,500 pursuant to this resolution. This amount is not included in the legal and third-party expenses above for fiscal 2009.

On August 17, 2009, the Company’s management committee resolved to pay TPL $500,000 per quarter beginning on June 1, 2009 and continuing through May 31, 2010 relating to TPL’s special work and effort regarding the MMP litigation and U.S. Patent Office re-examinations. In the event that the Company had insufficient funds to make such payments, PTSC was required to advance half of the quarterly amount to the Company. PTSC’s advances to the Company were to be without interest and were to be repaid to PTSC no later than May 31, 2010. During the fiscal year ended May 31, 2010, TPL received $1,500,000 from the Company pursuant to this agreement which is included in the fiscal 2010 legal and third-party expenses above. PTSC did not advance any funds to the Company or TPL under this resolution. On May 31, 2010, the resolution terminated.

All of the amounts are recorded in general and administrative expense in the accompanying statements of income.

F-59

Phoenix Digital Solutions, LLC

Notes to Financial Statements (Continued)

5. Commitments and Contingencies

Guarantees and Indemnities

Under the LLC Operating Agreement, the Company indemnifies its members, managers, officers and employees from any damages and liabilities by reason of their management or involvement in the affairs of the Company as long as the indemnitee acted in good faith and in the best interests of the Company.

Under the Commercialization Agreement, the Company and PTSC hold harmless TPL and its representatives with respect to all claims of any nature by or on behalf of the Company and PTSC related to the preparation, execution and delivery of the Commercialization Agreement.

The duration of the guarantees and indemnities varies, and in many cases is indefinite. These guarantees and indemnities do not provide for any limitation of the maximum potential future payments the Company could be obligated to make. Historically, the Company has not been obligated to make any payments for these obligations and no liabilities have been recorded for these guarantees and indemnities in the accompanying balance sheets.

6. Related Party Transactions

During the fiscal year ended May 31, 2010 TPL and PTSC each contributed $580,000 to the Company for working capital obligations.

During the fiscal years ended May 31, 2010, 2009 and 2008, the Company expensed $14,677, $92,301 and $650,782, respectively, for reimbursement of legal and related fees incurred by PTSC due to patent litigation.

At May 31, 2010, the Company had accounts payable balances of approximately $1,724,000 and $7,000 to TPL and PTSC, respectively, for direct expenses incurred by TPL and PTSC.

At May 31, 2009, the Company had accounts payable balances of approximately $1,482,000 and $5,500 to TPL and PTSC, respectively, for direct expenses incurred by TPL and PTSC.

7. Subsequent Events

During July 2010, the license receivable balance of $2,000,000 was received by the Company.

On July 15, 2010 the Company paid $1,003,095 to PTSC in accordance with terms of PTSC’s $950,000 secured note receivable with TPL due July 12, 2010 which named the Company as jointly and severally liable for payment.