U.S. SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-QSB

 

x                              QUARTERLY REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2006

 

o                                 TRANSITION REPORT UNDER SECTION 13 OR 15(D) OF THE EXCHANGE ACT

 

For the Transition Period from              to

 

Commission file number 1-13463

 

BIO-KEY INTERNATIONAL, INC.

(Exact Name of Small Business Issuer as Specified in Its Charter)

DELAWARE

 

41-1741861

(State or Other Jurisdiction of
Incorporation of Organization)

 

(IRS Employer
Identification Number)

 

3349 HIGHWAY 138, BUILDING D, SUITE B, WALL, NJ 07719

(Address of Principal Executive Offices)

 

(732) 359-1100

(Issuer’s Telephone Number)

 

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 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

APPLICABLE ONLY TO ISSUERS INVOLVED IN
BANKRUPTCY PROCEEDINGS DURING THE
PRECEDING FIVE YEARS

 

Check whether the registrant filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Exchange Act after the distribution of securities under a plan confirmed by a court. Yes o No o

APPLICABLE ONLY TO CORPORATE ISSUERS

Indicate by check mark whether the registrant is a shell company (as defined by rule 12b-2 of the Exchange Act)  Yes o No x

State the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date: There were 53,956,837 issued and outstanding shares of the registrant’s common stock, par value $.0001 per share, as of November 10, 2006.

Transitional Small Business Disclosure Format (check one): Yes o No x

 




BIO-KEY INTERNATIONAL, INC.

INDEX

PART I. FINANCIAL INFORMATION

 

 

Item 1—

 

Condensed Consolidated Financial Statements

 

3

 

 

Balance sheets as of September 30, 2006 (unaudited) and December 31, 2005

 

4

 

 

Statements of operations for the three and nine months ended September 30, 2006 (unaudited) and 2005 (as restated)

 

5

 

 

Statements of cash flows for the nine months ended September 30, 2006 (unaudited) and 2005 (as restated)

 

6

 

 

Notes to condensed consolidated financial statements

 

8

Item 2—

 

Management’s Discussion and Analysis of Financial Conditions and Results of Operations

 

25

Item 3—

 

Controls and Procedures

 

39

 

 

 

 

 

PART II. OTHER INFORMATION

 

 

Item 3—

 

Defaults Upon Senior Securities

 

44

Item 6

 

Exhibits

 

45

 

Restatement of Consolidated Financial Statements

As previously reported in our Annual Report on Form 10-KSB/A filed with the Securities and Exchange Commission on June 19, 2006, we have restated our previously reported financial information for the years ended December 31, 2003, 2004 and 2005 and our previously reported unaudited financial statements for the first, second and third quarters of 2003, 2004 and 2005 (the “restatement”).

Our Annual Reports on Form 10-KSB for the years ended 2003 and 2004 and our Quarterly Reports on Form 10-QSB for fiscal 2003 through the third quarter of fiscal 2005 have not been revised to reflect the restatement and the financial statements contained in those reports should not be relied upon. The restated financial statements for years ended December 31, 2003, 2004 and 2005 included in our Annual Report on Form 10-KSB/A for the fiscal year ended December 31, 2005 should be relied upon.

The accompanying condensed consolidated financial statements for the three and nine months ended September 30, 2005 should be read in conjunction with the footnote entitled results by quarter (unaudited) contained in the Company’s Annual Report on Form 10-KSB/A for the fiscal year ended December 31, 2005.

2




PART I

FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS

3




BIO-KEY INTERNATIONAL, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED BALANCE SHEETS

 

 

September 30,

 

December 31,

 

 

 

2006

 

2005

 

 

 

(Unaudited)

 

 

 

ASSETS:

 

 

 

 

 

Cash and cash equivalents

 

$

1,293,599

 

$

1,422,827

 

Receivables

 

 

 

 

 

Billed, less allowance for doubtful receivables of $184,074 and $160,000, respectively

 

3,721,544

 

1,635,371

 

Unbilled

 

38,776

 

201,942

 

Costs and earnings in excess of billings on uncompleted contracts

 

1,448,905

 

4,321,392

 

Inventory

 

26,588

 

8,760

 

Prepaid expenses

 

163,332

 

137,000

 

Total current assets

 

6,692,744

 

7,727,292

 

Equipment and leasehold improvements, net

 

464,417

 

548,267

 

Deposits

 

800,974

 

1,828,560

 

Intangible assets—less accumulated amortization

 

2,703,659

 

3,301,823

 

Deferred financing costs, net

 

231,879

 

1,562,338

 

Goodwill

 

11,389,654

 

11,389,654

 

Total non-current assets

 

15,590,583

 

18,630,642

 

TOTAL ASSETS

 

$

22,283,327

 

$

26,357,934

 

LIABILITIES:

 

 

 

 

 

Current maturities of long-term obligations and related obligations, net of discount

 

$

1,481,611

 

$

6,584,437

 

Accounts payable

 

1,151,100

 

833,608

 

Billings in excess of costs and earnings on uncompleted contracts

 

78,343

 

32,385

 

Accrued liabilities

 

4,393,872

 

5,520,515

 

Deferred rent

 

485,163

 

443,603

 

Deferred revenue

 

5,491,144

 

3,264,283

 

Total current liabilities

 

13,081,233

 

16,678,831

 

Warrants and long-term obligations

 

4,131,950

 

1,483,511

 

Redeemable preferred stock derivatives

 

1,387,238

 

 

Deferred rent

 

498,601

 

867,850

 

Deferred revenue

 

137,879

 

1,163,738

 

Total non-current liabilities

 

6,155,668

 

3,515,099

 

TOTAL LIABILITIES

 

19,236,901

 

20,193,930

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

 

 

 

 

 

 

Series B redeemable convertible preferred stock: authorized, 1,000,000 shares (liquidation preference of $1 per share); issued and outstanding 1,000,000 and 0 shares of $.0001par value respectively, net

 

753,229

 

 

Series C redeemable convertible preferred stock: authorized, 600,000 shares (liquidation preference of $10 per share); issued and outstanding 592,032 and 0 shares of $.0001 par value respectively, net

 

4,878,005

 

 

 

 

5,631,234

 

 

 

 

 

 

 

 

STOCKHOLDERS’ (DEFICIT)/EQUITY:

 

 

 

 

 

Preferred stock — authorized, 5,000,000 shares (liquidation preference of $100 per share) Series A 7% Convertible; issued and outstanding 35,557 and 44,557 shares of $.0001 par value, respectively

 

4

 

4

 

Common stock — authorized, 170,000,000 shares; issued and outstanding; 53,956,837 and 46,306,589 shares of $.0001 par value, respectively

 

5,545

 

4,632

 

Additional paid-in capital

 

51,399,062

 

48,921,316

 

Accumulated deficit

 

(53,989,419

)

(42,761,948

)

TOTAL STOCKHOLDERS’ (DEFICIT)/EQUITY

 

(2,584,808

)

6,164,004

 

TOTAL LIABILITIES AND STOCKHOLDERS’ (DEFICIT)/EQUITY

 

$

22,283,327

 

$

26,357,934

 

 

The accompanying notes to the condensed consolidated financial statements are an integral part of these statements.

4




BIO-KEY INTERNATIONAL, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)

 

 

Three months  ended
September 30,

 

Nine months ended
September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

 

 

(As restated)

 

 

 

(As restated)

 

Revenues

 

 

 

 

 

 

 

 

 

Services

 

$

3,226,184

 

$

2,496,883

 

$

8,397,122

 

$

8,318,624

 

License fees and other

 

973,914

 

735,588

 

2,784,937

 

2,538,990

 

 

 

4,200,098

 

3,232,471

 

11,182,059

 

10,857,614

 

Costs and other expenses

 

 

 

 

 

 

 

 

 

Cost of services

 

612,441

 

503,843

 

2,024,655

 

2,373,535

 

Cost of license fees and other

 

148,275

 

125,633

 

361,334

 

658,875

 

 

 

760,716

 

629,476

 

2,385,989

 

3,032,410

 

Gross Profit

 

3,439,382

 

2,602,995

 

8,796,070

 

7,825,204

 

 

 

 

 

 

 

 

 

 

 

Operating Expenses

 

 

 

 

 

 

 

 

 

Selling, general and administrative

 

2,467,347

 

2,836,875

 

7,834,137

 

8,808,969

 

Research, development and engineering

 

1,653,238

 

1,799,845

 

4,830,186

 

5,545,386

 

 

 

4,120,585

 

4,636,720

 

12,664,323

 

14,354,355

 

Operating loss

 

(681,203

)

(2,033,725

)

(3,868,253

)

(6,529,151

)

Other income (deductions)

 

 

 

 

 

 

 

 

 

Derivative and warrant fair value adjustments

 

547,752

 

3,210,057

 

5,548,604

 

8,160,305

 

Interest income

 

 

6,908

 

 

35,958

 

Interest expense

 

(586,689

)

(1,605,771

)

(4,915,445

)

(2,992,780

)

Loss on extinguishment of debt

 

(5,493,701

)

 

(7,815,717

)

 

Other

 

(18,891

)

(24,816

)

(51,185

)

(45,348

)

 

 

(5,551,529

)

1,586,378

 

(7,233,743

)

5,158,135

 

NET LOSS

 

$

(6,232,732

)

$

(447,347

)

$

(11,101,996

)

$

(1,371,016

)

 

 

 

 

 

 

 

 

 

 

Basic and Diluted Loss to Common Shareholders:

 

 

 

 

 

 

 

 

 

Net loss

 

$

(6,232,732

)

$

(447,347

)

$

(11,101,996

)

$

(1,371,016

)

Convertible preferred stock dividends and accretion

 

(369,200

)

(72,632

)

(581,877

)

(261,152

)

Net loss attributable to common shareholders

 

$

(6,601,932

)

$

(519,979

)

$

(11,683,873

)

$

(1,632,168

)

 

 

 

 

 

 

 

 

 

 

Net Loss Per Share:

 

 

 

 

 

 

 

 

 

Basic

 

$

(0.13

)

$

(0.01

)

$

(0.24

)

$

(0.04

)

Diluted

 

$

(0.13

)

$

(0.02

)

$

(0.24

)

$

(0.09

)

 

 

 

 

 

 

 

 

 

 

Weighted Average Shares Outstanding:

 

 

 

 

 

 

 

 

 

Basic

 

50,733,960

 

45,476,802

 

48,752,262

 

45,129,000

 

Diluted

 

50,733,960

 

53,861,595

 

48,752,262

 

52,017,328

 

 

The accompanying notes to the condensed consolidated financial statements are an integral part of these statements.

5




BIO-KEY INTERNATIONAL, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

 

 

Nine Months Ended September 30,

 

 

 

2006

 

2005

 

CASH FLOW FROM OPERATING ACTIVITIES:

 

 

 

 

 

Net Loss

 

$

(11,101,996

)

$

(1,371,016

))

Adjustments to reconcile net loss to cash used in operating activities:

 

 

 

 

 

Derivative and warrant fair value adjustments

 

(5,548,604

)

(8,160,305

)

Loss on extinguishment of debt

 

7,815,719

 

 

Depreciation

 

203,288

 

179,642

 

Amortization

 

 

 

 

 

Intangible assets

 

647,640

 

1,474,979

 

Deferred financing costs

 

167,275

 

29,621

 

Discounts on convertible debt related to warrants and beneficial conversion features

 

2,515,875

 

1,067,927

 

Allowance for doubtful receivables

 

24,073

 

22,440

 

Deferred rent

 

(327,692

)

(290,807

)

Options and warrants issued for services and other

 

529,055

 

542,758

 

Loss on sale of investment

 

 

20,000

 

Change in assets and liabilities:

 

 

 

 

 

Accounts receivable trade

 

(1,947,080

)

(862,889

)

Costs and earnings in excess of billings on uncompleted contracts

 

2,872,487

 

1,546,812

 

Inventory

 

(17,829

)

26,134

 

Prepaid expenses and other

 

(26,332

)

(221,842

)

Accounts payable

 

317,492

 

(418,332

)

Billings in excess of costs and earnings on uncompleted contracts

 

45,958

 

24,173

 

Accrued liabilities

 

(315,427

)

683,989

 

Deferred revenue

 

1,201,003

 

1,174,224

 

Net cash used in operating activities

 

(2,945,095

)

(4,532,492

)

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

 

Capital expenditures

 

(119,437

)

(144,916

)

Deposits

 

1,027,585

 

1,004,097

 

Patent costs

 

(49,477

)

(56,610

)

Proceeds from sale of marketable debt securities

 

 

980,000

 

Proceeds from sale of trademark

 

 

50,000

 

Net cash provided by investing activities

 

858,671

 

1,832,571

 

CASH FLOW FROM FINANCING ACTIVITIES:

 

 

 

 

 

Net advance to stockholders

 

 

(12,753

)

Issuance of long-term obligations

 

988,000

 

4,920,251

 

Repayment of long term obligations

 

(348,349

)

(1,894,148

)

Preferred stock dividends paid

 

(59,303

)

 

Issuance of common stock

 

1,500,000

 

 

Issuance of bridge note

 

 

250,000

 

Repayment of bridge note

 

 

(250,000

)

Exercise of warrants and options

 

8,400

 

558,787

 

Financing costs

 

(131,552

)

(374,614

)

Net refund of offering costs

 

 

43,356

 

Net cash provided by financing activities

 

1,957,196

 

3,240,879

 

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS

 

(129,228

)

540,958

 

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD

 

1,422,827

 

956,230

 

CASH AND CASH EQUIVALENTS, END OF PERIOD

 

$

1,293,599

 

$

1,497,188

 

 

The accompanying notes to the condensed consolidated financial statements are an integral part of these statements.

 

6




BIO-KEY INTERNATIONAL, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

 

SUPPLEMENTARY DISCLOSURES OF CASH FLOW INFORMATION

 

 

Nine Months Ended September 30,

 

 

 

2006

 

2005

 

 

 

 

 

 

 

Cash paid for:

 

 

 

 

 

Interest

 

1,061,157

 

1,025,873

 

 

 

 

 

 

 

Noncash Investing and Financing Activities:

 

 

 

 

 

Conversion of convertible notes and related obligations, net of discount, and accrued interest into common stock

 

894,123

 

2,126,196

 

Issuance of Series B redeemable preferred stock in exchange for debt and related obligations

 

988,000

 

 

Issuance of Series C redeemable preferred stock in exchange for debt and related obligations

 

5,920,320

 

 

Issuance of common stock in conjunction with refinancing

 

189,000

 

788,284

 

Modification of warrants in conjunction with refinancing

 

110,453

 

 

Issuance of common stock through conversion of dividends outstanding on Series A preferred stock

 

541,398

 

 

Issuance of common stock in exchange for Series A and Series C preferred stock and cumulative dividends in arrears, thereon

 

 

121,822

 

Origination of warrants in conjunction with debt financing

 

308,376

 

1,335,000

 

Origination of warrants in conjunction with equity financing

 

103,229

 

 

 

Origination of options in exchange for financing fees

 

 

27,367

 

Cashless exercise of options and warrants

 

 

164,075

 

Goodwill allocation adjustment

 

 

946,852

 

Conversation of preferred stock dividends to common stock

 

500,000

 

 

Conversion of preferred stock to common stock

 

125,476

 

 

Origination of embedded derivatives in conjunction with debt financing

 

679,624

 

 

Origination of embedded derivatives with preferred stock

 

1,434,004

 

 

 

The accompanying notes to the condensed consolidated financial statements are an integral part of these statements.

7




BIO-KEY INTERNATIONAL, INC. AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2006 (Unaudited) and December 31, 2005

1.   BASIS OF PRESENTATION

The accompanying unaudited interim consolidated financial statements include the accounts of BIO-key International, Inc. and its wholly owned subsidiary (collectively, the “Company”) and are stated in conformity with accounting principles generally accepted in the United States, pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”).  Pursuant to such rules and regulations, certain financial information and footnote disclosures normally included in the financial statements have been condensed or omitted. Significant intercompany accounts and transactions have been eliminated in consolidation.

In the opinion of management, the accompanying unaudited interim consolidated financial statements contain all necessary adjustments, consisting only of those of a recurring nature, and disclosures to present fairly the financial position and the results of its operations and cash flows for the periods presented. It is suggested that these unaudited interim consolidated financial statements should be read in conjunction with the financial statements and the related notes thereto included in the Company’s Annual Report on Form 10-KSB/A for the fiscal year ended December 31, 2005, as amended (the “Form 10-KSB”).

Recently Issued Accounting Pronouncements

In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans,” an amendment of FASB Statements No. 87, 88, 106, and 132R. SFAS No. 158 requires an employer to: (a) recognize in its statement of financial position an asset for a plan’s overfunded status and/or a liability for a plan’s underfunded status; (b) measure a plan’s assets and its obligations that determine its funded status as of the end of the employer’s fiscal year (with limited exceptions); and (c) recognize changes in the funded status of a defined benefit postretirement plan in the year in which the changes occur. The implementation of SFAS 158 is not expected to have a material impact on the Company’s financial statements.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” which is effective for calendar year companies on January 1, 2008. The Statement defines fair value, establishes a framework for measuring fair value in accordance with Generally Accepted Accounting Principles, and expands disclosures about fair value measurements. The Statement codifies the definition of fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The standard clarifies the principle that fair value should be based on the assumptions market participants would use when pricing the asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. The Company is currently assessing the potential impacts of implementing this standard.

In September 2006, the SEC staff issued Staff Accounting Bulletin (SAB) Topic 1N (SAB 108), “Financial Statements — Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” which is effective for calendar year companies as of December 31, 2006. SAB 108 provides guidance on how prior year misstatements should be taken into consideration when quantifying misstatements in current year financial statements for purposes of determining whether the financial statements are materially misstated. Under this guidance, companies should take into account both the effect of a misstatement on the current year balance sheet as well as the impact upon the current year income statement in assessing the materiality of a current year misstatement. Once a current year misstatement has been quantified, the guidance in SAB Topic 1M, “Financial Statements — Materiality,” (SAB 99) should be applied to determine whether the misstatement is material. The implementation of SAB 108 is not expected to have a material impact on the Company’s financial statements.

8




In June 2006, the FASB issued FIN No. 48, “Accounting for Uncertainty in Income Taxes—An Interpretation of FASB Statement No. 109, which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 will be effective for the Company’s first interim period beginning January 1 2007. The implementation of FIN 48 is not expected to have a material impact on the Company’s financial statements.

Comprehensive Loss

Comprehensive loss consists of net loss and other gains and losses affecting shareholders' equity that, under generally accepted accounting principles, are excluded from net loss in accordance with Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income." The Company, however, does not have any components of other comprehensive loss as defined by SFAS No. 130 and therefore, for the three and nine months ended September 30, 2006 and 2005, comprehensive loss is equivalent to the Company's reported net loss. Accordingly, a separate statement of comprehensive loss is not presented.

Reclassifications

Certain amounts in the 2005 consolidated financial statements have been reclassified to conform to the 2006 presentation. These reclassifications had no effect on the previously reported net loss or stockholders’ equity.

2.  LIQUIDITY AND CAPITAL RESOURCE MATTERS

Broad commercial acceptance of the Company’s technology is critical to the Company’s success and ability to generate revenues. The Company has only recently begun to generate significant revenues, has suffered recurring losses from operations and has a working capital deficit.

During the three months ended September 30, 2006, the Company raised approximately $2,000,000 in gross proceeds through private issuances of equity securities (pursuant to the Securities Purchase Agreements with Trellus Partners L.P. and The Shaar Fund, Ltd.), of which $1,500,000 was received in cash and $500,000 was paid in declared and unpaid dividends.

The Company may still be in need of additional capital however, and is currently considering various alternatives related to raising additional capital including new funding from other sources.  No assurance can be given that any form of additional financing will be available on terms acceptable to the Company, that adequate financing will be obtained to meet its needs, or that such financing would not be dilutive to existing shareholders.

The accompanying financial statements have been prepared in conformity with accounting principles generally accepted in the United States, which contemplate continuation of the Company as a going concern. The matters described in the preceding paragraphs raise substantial doubt about the Company’s ability to continue as a going concern. Recoverability of a major portion of the recorded asset amounts shown in the accompanying balance sheet may be dependent upon the Company’s ability to obtain additional financing, meet its financing requirements on a continuing basis, and succeed in its future operations. The accompanying financial statements do not include any adjustments that may result from the uncertainty regarding the Company’s ability to continue as a going concern.

3.  STOCK BASED COMPENSATION

Effect of Adoption of SFAS 123R, Share-Based Payment

Prior to January 1, 2006, the Company’s employee stock compensation plans were accounted for in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related interpretations. Under this method, no compensation expense was

9




recognized as long as the exercise price equaled or exceeded the market price of the underlying stock on the date of the grant. The Company elected the disclosure-only alternative permitted under SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), as amended by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure” (SFAS 148”), for fixed stock-based awards to employees.

On December 31, 2005, the Company accelerated the vesting of certain of the outstanding options to purchase shares of the Company’s common stock with option exercise prices greater than the fair market value of the Company’s common stock on such date. The acceleration applied to all such options outstanding as of December 31, 2005 under the Company’s 1996 Stock Option Plan, 1999 Stock Option Plan and 2004 Stock Option Plan, except for options held by the Company’s executive officers subject to Section 16(b) of the Securities Exchange Act of 1934, as amended, and the members of the Company’s Board of Directors. Options to purchase up to 897,614 shares of the Company’s common stock, or 14% of the total shares of the Company’s common stock subject to outstanding options, with a weighted average exercise price of approximately $1.09 and varying remaining vesting schedules, were subject to this acceleration and became immediately vested and exercisable as of December 31, 2005. The number of shares, exercise prices and other terms of the options subject to the acceleration remain unchanged.

As of January 1, 2006, the Company adopted SFAS 123R using the modified prospective method, which requires measurement of compensation cost for all stock awards at fair value on date of grant and recognition of compensation over the service period for awards expected to vest. Accordingly, financial statement amounts for the prior periods presented in this Form 10-QSB have not been restated to reflect the fair value method of expensing share-based compensation. Under this application, we are required to record compensation cost for all share-based payments granted after the date of adoption based on the grant date fair value estimated in accordance with the provisions of SFAS 123R and for the unvested portion of all share-based payments previously granted that remain outstanding which were based on the grant date fair value estimated in accordance with the original provisions of SFAS 123. The majority of our share-based compensation arrangements vest over either a three or four year vesting schedule. The Company expenses its share-based compensation under the ratable method, which treats each vesting tranche as if it were an individual grant. The fair value of stock options is determined using the Black-Scholes valuation model, which is consistent with our valuation techniques previously utilized for options in footnote disclosures required under SFAS 123, as amended by SFAS 148, and requires the input of highly subjective assumptions. These assumptions include estimating the length of time employees will retain their vested stock options before exercising them (the “expected option term”), the estimated volatility of our common stock price over the option’s expected term, the risk-free interest rate over the option’s expected term, and the Company’s expected annual dividend yield. Changes in these subjective assumptions can materially affect the estimate of fair value of stock-based compensation and consequently, the related amount recognized as an expense in the consolidated statements of operations. As required under the accounting rules, we review our valuation assumptions at each grant date and, as a result, are likely to change our valuation assumptions used to value employee stock-based awards granted in future periods. The values derived from using the Black-Scholes model are recognized as expense over the service period, net of estimated forfeitures (the number of individuals that will ultimately not complete their vesting requirements). The estimation of stock awards that will ultimately vest requires significant judgment. We consider many factors when estimating expected forfeitures, including types of awards, employee class, and historical experience. Actual results, and future changes in estimates, may differ substantially from our current estimates. The compensation expense recognized in connection with the adoption of SFAS 123R increased the Company’s net loss by $239,136 with no effect per share for the three months ended September 30, 2006 and increased the Company’s net loss for the nine months ended September 30, 2006 by $529,055, with a $0.01 effect per share. There was no impact on cash flows from operations, investment, or financing in connections with the adoptions of SFAS 123R. As the Company uses the full valuation allowance with respect to deferred taxes, the adoption of SFAS 123R had no impact on deferred taxes.

10




The following table presents share-based compensation expenses for continuing operations included in the Company’s unaudited condensed consolidated statements of operations:

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2006

 

2006

 

 

 

 

 

 

 

Cost of services

 

$

15,468

 

$

40,236

 

Selling, general and administrative

 

167,769

 

370,165

 

Research, development and engineering

 

55,899

 

118,654

 

 

 

$

239,136

 

$

529,055

 

 

Valuation Assumptions for Stock Options

For the nine months ended September 30, 2006, 324,000 stock options were granted. The fair value of each option was estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:

 

 

Three Months Ended
September 30,

 

 

 

2006

 

2005

 

Risk free interest rate

 

4.91-5.08

%

4.16

%

Expected life of options (in years)

 

4.0-7.0

 

7.0

 

Expected dividends

 

0

%

0

%

Volatility of stock price

 

92-118

%

132

%

 

 

 

Nine Months Ended 
September 30,

 

 

 

2006

 

2005

 

Risk free interest rate

 

4.53-5.08

%

3.95-4.18

%

Expected life of options (in years)

 

4.0-7.0

 

6.5-7.0

 

Expected dividends

 

0

%

0

%

Volatility of stock price

 

72-129

%

132-134

%

 

The stock volatility for each grant is determined based on the review of the experience of the weighted average of historical daily price changes of the Company’s common stock over the expected option term. The expected life represents the weighted average period of time that options granted are expected to be outstanding giving consideration to vesting schedules and our historical exercise patterns; and the risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for periods corresponding with the expected life of the option.

Fair Value Disclosures — Prior to SFAS 123R Adoption

The Company did not recognize compensation expense for employee stock option grants for the three and nine months ended September 30, 2005, when the exercise price of the Company’s employee stock options equaled the market price of the underlying stock on the date of grant.

The Company had previously adopted the provisions of SFAS 123 as amended by SFAS No.148, “Accounting for Stock-Based Compensation – Transition and Disclosure” through disclosure only. The following table illustrates the effects on net income and earnings per share for the three and nine months ended September 30, 2005 as if the Company had applied the fair value recognition provisions of SFAS 123 to share-based employee awards:

11




 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2005

 

2005

 

 

 

 

 

 

 

Net loss

 

 

 

 

 

As reported

 

$

(447,347

)

$

(1,371,016

)

Fair value-based expense, net of tax

 

(218,054

)

(654,162

)

Proforma net loss

 

$

(665,401

)

$

(2,025,178

)

 

 

 

 

 

 

Loss applicable to common Stockholders

 

 

 

 

 

As reported

 

$

(519,979

)

$

(1,632,168

)

Fair value-based expense, net of tax

 

(218,054

)

(654,162

)

Proforma net loss

 

$

(738,033

)

$

(2,286,330

)

 

 

 

 

 

 

Basic and diluted loss per common share

 

 

 

 

 

As reported – Basic

 

$

(0.01

)

$

(0.04

)

As reported – Diluted

 

$

(0.02

)

$

(0.09

)

Proforma – Basic

 

$

(0.02

)

$

(0.05

)

Proforma – Diluted

 

$

(0.05

)

$

(0.10

)

 

1996 Stock Option Plan

During 1996, the Board of Directors and stockholders of the Company adopted the 1996 Stock Option Plan (the 1996 Plan). Under the 1996 Plan, 750,000 shares of common stock are reserved for issuance to employees, officers, directors, and consultants of the Company at exercise prices which may not be below 100% of fair market value for incentive stock options and 50% for all others. The term of stock options granted may not exceed ten years. Options issued under the Plan vest pursuant to the terms of stock option agreements with the recipients. In the event of a change in control, as defined, all options outstanding vest immediately. The Plan expired in May 2005.

1999 Stock Option Plan

During 1999, the Board of Directors of the Company adopted the 1999 Stock Option Plan (the 1999 Plan). The 1999 Plan was not presented to stockholders for approval and thus incentive stock options are not available under the plan. Under the 1999 Plan, 2,000,000 shares of common stock are reserved for issuance to employees, officers, directors, and consultants of the Company at exercise prices which may not be below 85% of fair market value. The term of nonstatutory stock options granted may not exceed ten years. Options issued under the Plan vest pursuant to the terms of stock option agreements with the recipients. In the event of a change in control, as defined, all options outstanding vest immediately. The 1999 Plan terminates in August 2009.

2004 Stock Option Plan

On October 12, 2004, the Board of Directors of the Company approved the 2004 Stock Option Plan (the 2004 Plan). The 2004 Plan has not yet been presented to stockholders for approval and thus incentive stock options are not available under this plan. Under the terms of this plan, 4,000,000 shares of common stock are reserved for issuance to employees, officers, directors, and consultants of the Company at exercise prices which may not be below 85% of fair market value. The term of stock options granted may not exceed ten years. Options issued under the Plan vest pursuant to the terms of stock option agreements with the recipients. In the event of a change in control, as defined, all options outstanding vest immediately. The Plan terminates in October 2014.

12




Non-Plan Stock Options

Periodically, the Company has granted options outside of the 1996, 1999, and 2004 Plans to various employees and consultants. In the event of change in control, as defined, certain of the non-plan options outstanding vest immediately.

Stock Option Activity

The following table summarizes stock option activity for the nine months ended September 30, 2006:

Number of Options

 

 

1996 Plan

 

1999 Plan

 

2004 Plan

 

Non Plan

 

Total

 

Range of
exercise
price

 

Weighted
average
exercise
price

 

Weighted
average
remaining
life
(in years)

 

Balance, as of December 31, 2005

 

150,000

 

1,062,125

 

2,052,860

 

3,082,850

 

6,347,835

 

 

 

 

 

4.52

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Granted

 

 

 

748,000

 

1,050,000

 

1,798,000

 

0.67-0.75

 

0.72

 

 

 

Exercised

 

 

 

 

 

 

 

 

 

 

 

 

Expired or cancelled

 

 

 

(42,610

)

(14,850

)

(57,460

)

0.93-1.17

 

1.04

 

 

 

Balance, as of March 31, 2006

 

150,000

 

1,062,125

 

2,758,250

 

4,118,000

 

8,088,375

 

0.19-6.42

 

0.87

 

5.41

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Granted

 

 

 

92,000

 

 

92,000

 

0.61

 

0.61

 

 

 

Exercised

 

 

 

 

 

 

 

 

 

 

 

 

Expired or cancelled

 

 

(132,456

)

(102,000

)

 

(234,456

)

0.35-1.10

 

0.62

 

 

 

Balance, as of June 30, 2006

 

150,000

 

929,669

 

2,748,250

 

4,118,000

 

7,945,919

 

0.19-6.42

 

0.88

 

4.96

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Granted

 

 

135,000

 

97,000

 

 

232,000

 

0.38-0.40

 

0.39

 

 

 

Exercised

 

 

 

 

 

 

 

 

 

 

 

 

Expired or cancelled

 

 

(69,669

)

(124,500

)

 

(194,169

)

0.60-1.17

 

0.92

 

 

 

Balance, as of September 30, 2006

 

150,000

 

995,000

 

2,720,750

 

4,118,000

 

7,983,750

 

0.19-6.42

 

0.86

 

4.81

 

Available for future grants September 30, 2006

 

 

714,257

 

1,279,250

 

 

1,993,507

 

 

 

 

 

 

 

 

The options outstanding and exercisable at September 30, 2006 were in the following exercise price ranges:

Options Outstanding

 

Options Exercisable

 

Range of exercise prices

 

Number
of
shares

 

Weighted
average
exercise
price

 

Weighted
average
remaining
life
(in years)

 

Aggregate
Intrinsic
Value

 

Number
of
shares

 

Weighted
average
exercise
price

 

Weighted
average
remaining
 life
(in years)

 

Aggregate
Intrinsic
Value

 

$0.19

 

60,000

 

$0.19

 

$1.90

 

$15,000

 

60,000

 

$0.19

 

1.90

 

$15,000

 

.29-.40

 

937,000

 

0.34

 

3.15

 

98,380

 

840,000

 

0.33

 

2.72

 

94,500

 

.46-.69

 

2,566,000

 

0.58

 

4.71

 

 

1,360,332

 

0.53

 

3.67

 

 

.75-1.11

 

2,626,250

 

0.94

 

5.70

 

 

1,396,249

 

1.07

 

5.20

 

 

1.17-1.62

 

1,746,500

 

1.30

 

4.71

 

 

1,428,162

 

1.30

 

4.61

 

 

6.42

 

48,000

 

6.42

 

1.37

 

 

48,000

 

6.42

 

1.37

 

 

 $0.19-6.42

 

7,983,750

 

 

 

 

 

$

113,380

 

5,132,743

 

 

 

 

 

$

109,500

 

 

The weighted average remaining contractual life of options exercisable at September 30, 2006 was 4.05 years.

The aggregate intrinsic value in the table above represents the total intrinsic value, based on the Company’s closing stock price of $0.44 as of September 30, 2006, which would have been received by the option holders had all option holders exercised their options as of that date. The total number of in-the-money options exercisable as of September 30, 2006 was 900,000.

13




The weighted average fair value of options, as determined under SFAS No. 123R and SFAS 123, granted during the three months ended September 30, 2006 and September 30, 2005 was $0.31 and $0.84 per share, respectively, and during the nine months ended September 30, 2006 and September 30, 2005 was $0.53 and $1.09 per share respectively.

The total intrinsic value of options exercised during the three-month period ended September 30, 2006 and September 30, 2005 was $0 and $15,600, respectively. The aggregate intrinsic value of options exercised during the nine-month period ended September 30, 2006 and September 30, 2005 was $0 and $136,688 respectively.

As of September 30, 2006 future compensation cost related to nonvested stock options is approximately $688,791 and will be recognized over an estimated weighted average period of approximately 3.0 years.

4.  EARNINGS PER SHARE COMMON STOCK (“EPS”)

The Company’s basic EPS is calculated using net income (loss) and the weighted-average number of shares outstanding during the reporting period. Diluted EPS includes the effect from potential issuance of common stock, such as stock issuable pursuant to the exercise of stock options and warrants and the assumed conversion of convertible notes and preferred stock. For the three and nine months ended September 30, 2006, diluted per share computations are not presented since this effect would be antidilutive.

The reconciliation of the numerators and denominators of the basic and diluted EPS calculations was as follows for both of the following three and nine month periods ended September 30:

 

 

Three Months ended September

 

Nine Months ended September

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

 

 

 

 

 

 

 

 

Numerator:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

(6,232,732

)

$

(447,347

)

$

(11,101,996

)

$

(1,371,016

)

 

 

 

 

 

 

 

 

 

 

Convertible preferred stock dividends and accretion

 

(369,200

)

(72,632

)

(581,877

)

(261,152

)

Income (loss) available to common stockholders (basic EPS)

 

(6,601,932

)

(519,979

)

(11,683,873

)

(1,632,168

)

 

 

 

 

 

 

 

 

 

 

Adjustment for interest expense and debt conversion features

 

 

(356,879

)

 

(2,890,686

)

Loss as adjusted (diluted EPS)

 

$

(6,601,932

)

$

(876,858

)

$

(11,683,873

)

$

(4,522,854

)

 

 

 

 

 

 

 

 

 

 

Denominator:

 

 

 

 

 

 

 

 

 

Weighted-average shares used to compute basic EPS

 

50,733,960

 

45,476,802

 

48,752,262

 

45,129,000

 

Effect of dilutive securities:

 

 

 

 

 

 

 

 

 

Convertible notes

 

 

8,384,793

 

 

6,888,328

 

Weighted-average shares used to compute diluted EPS

 

50,733,960

 

53,861,595

 

48,752,262

 

52,017,328

 

 

 

 

 

 

 

 

 

 

 

Earnings (loss) per share

 

 

 

 

 

 

 

 

 

Basic

 

$

(0.13

)

$

(0.01

)

$

(0.24

)

$

(0.04

)

Diluted

 

$

(0.13

)

$

(0.02

)

$

(0.24

)

$

(0.09

)

 

The following table summarizes the potential weighted average shares of common stock that were excluded

14




from the diluted per share calculation, because the effect of including these potential shares was antidilutive.

 

 

Three Months ended 
September 30,

 

Nine Months Ended
September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

 

 

 

 

 

 

 

 

Preferred Stock

 

14,364,171

 

6,796,942

 

9,146,462

 

7,152,538

 

Convertible Debt

 

11,952,895

 

 

13,250,644

 

 

Stock Options

 

247,461

 

1,300,446

 

530,681

 

1,675,586

 

Warrants

 

6,668

 

54,908

 

440,647

 

580,125

 

 

 

 

 

 

 

 

 

 

 

Potentially dilutive securities

 

26,571,195

 

8,152,296

 

23,368,434

 

9,408,249

 

 

Items excluded from the diluted per share calculation because the exercise price was greater than the average market price of the common shares:

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

 

 

 

 

 

 

 

 

Stock options

 

6,986,750

 

4,136,600

 

5,941,750

 

2,196,350

 

Warrants

 

14,124,486

 

13,058,042

 

10,226,475

 

9,383,042

 

 

 

 

 

 

 

 

 

 

 

Total

 

21,111,236

 

17,194,642

 

16,168,225

 

11,579,392

 

 

5.  EQUIPMENT AND LEASEHOLD IMPROVEMENTS

Equipment and leasehold improvements at September 30, 2006 and December 31, 2005 consisted of the following:

 

 

September 30,

 

December 31,

 

 

 

2006

 

2005

 

 

 

 

 

 

 

Equipment

 

$

530,120

 

$

458,847

 

Furniture and fixtures

 

187,984

 

179,349

 

Software

 

116,011

 

104,414

 

Leasehold improvements

 

198,888

 

170,955

 

 

 

1,033,003

 

913,565

 

 

 

 

 

 

 

Less accumulated depreciation and amortization

 

(568,586

)

(365,298

)

 

 

 

 

 

 

Total

 

$

464,417

 

$

548,267

 

 

6.  GOODWILL AND OTHER INTANGIBLE ASSETS

The Company’s goodwill resulted from the acquisition of Public Safety Group, Inc. and certain assets and assumed liabilities of the Mobile Government Division of Aether Systems, Inc. in 2004. As provided by SFAS No. 142, the Company has elected to perform the annual assessment of the carrying value of all goodwill as of September 30 of each year using a number of criteria, including the value of the overall enterprise. As of September 30, 2006, the Company believes no material impairment exists. Future impairment charges from existing operations or other acquisitions, if any, will be reflected as an operating expense in the statement of operations. As of  September 30, 2006 and December 31, 2005 goodwill totaled $11,389,654.

15




Other intangible assets as of September 30, 2006 and December 31, 2005 consisted of the following:

 

 

September 30,

 

December 31,

 

 

 

2006

 

2005

 

Copyrighted software

 

$

1,181,429

 

$

1,181,429

 

Customer relationships

 

1,009,000

 

1,009,000

 

Trademarks

 

807,872

 

807,872

 

Developed technology

 

710,000

 

710,000

 

Marketing agreements

 

605,340

 

605,340

 

Patents and patents pending

 

333,255

 

283,779

 

 

 

4,646,896

 

4,597,420

 

 

 

 

 

 

 

Less: accumulated amortization

 

(1,943,237

)

(1,295,597

)

 

 

 

 

 

 

Total

 

$

2,703,659

 

$

3,301,823

 

 

Aggregate amortization expense for the nine months ended September, 2006 and 2005, was $647,640 and $1,474,979 respectively.

7.    Deferred financing costs

Deferred financing costs are amortized based upon the lives of the respective debt obligations.  The gross carrying amount of deferred financing costs at September 30, 2006 and December 31, 2005 was $335,828 and $1,763,238 respectively, and accumulated amortization was $103,949 and $200,900, respectively.  Amortization of deferred financing costs is included in interest expense, and was $46,633 and $14,999 for the three months ended September 30, 2006 and 2005 respectively, and was $167,275 and $29,621 for the nine months ended September 30, 2006 and 2005 respectively.

8.    CONVERTIBLE DEBT FINANCING

Long-term obligations consisted of the following as of:

 

 

September 30,

 

December 31,

 

 

 

2006

 

2005

 

2004

 

 

 

 

 

Convertible term notes

 

$

3,016,655

 

$

5,992,304

 

Discount

 

(553,812

)

(2,134,340

)

FMV of embedded derivatives

 

580,575

 

421,317

 

FMV of warrants

 

352,634

 

828,095

 

2005

 

 

 

 

 

Convertible term notes

 

1,800,000

 

5,284,723

 

Discount

 

(490,025

)

(3,569,793

)

FMV of embedded derivatives

 

494,091

 

590,226

 

FMV of warrants

 

290,721

 

655,416

 

2006

 

 

 

 

 

FMV of warrants

 

122,722

 

 

 

 

5,613,561

 

8,067,948

 

 

 

 

 

 

 

Less current portion

 

1,481,611

 

6,584,437

 

 

 

 

 

 

 

Total

 

$

4,131,950

 

$

1,483,511

 

16




2004 and 2005 Senior Notes Amendment and Waivers

Effective as of January 23, 2006, the Company entered into an Amendment and Waiver (the “January Secured Notes Amendment and Waiver”) with Laurus Master Fund, Ltd (“Laurus”) in connection with the Secured Convertible Notes (the “Secured Notes”) then held by Laurus.

Under the January Secured Notes Amendment and Waiver, the Secured Notes issued by the Company to Laurus on September 29, 2004 in the aggregate principal amount of $5,000,000 (the “September 2004 Note”) and on June 8, 2005 in the aggregate principal amount of $2,000,000 (the “June 2005 Note”) were amended as follows: (i) the maturity date of the September 2004 Note was extended to January 1, 2008, (ii) the maturity date of the June 2005 Note was extended to December 1, 2008, and (iii) the fixed conversion price under each of the Secured Notes was reset from $1.35 to $0.85 per share. In addition, the exercise price of all warrants to purchase Common Stock of the Company held by Laurus was reset to $1.00 per share.

The Company also issued 150,000 shares (the “Newly Issued Shares”) of the Company’s Common Stock to Laurus in connection with the January Secured Notes Amendment and Waiver. In connection with the issuance of these shares, Laurus agreed to waive the provisions of the Secured Notes regarding any adjustment of the fixed conversion price that would otherwise be triggered as a result of the issuance of these shares and certain other securities which have a conversion price of $0.70 per share.

Effective as of August 10, 2006, the Company entered into a further Amendment and Waiver (the “August Secured Notes Amendment and Waiver”) with Laurus in connection with the Secured Notes. Under the August Secured Notes Amendment and Waiver, the September 2004 Note and June 2005 Note were amended as follows: (i) the principal amounts due and payable under the September 2004 Note and the June 2005 Note for the months of August and September 2006, respectively, shall be paid in shares of the Company’s Common Stock priced at $0.50 per share; and (ii) the principal amount due and payable under the September 2004 Note for the months of October, November and December 2006 is deferred until January 1, 2008, the final maturity date of the September 2004 Note, and the principal amount due and payable under the June 2005 Note for the months of October, November and December 2006 is deferred until December 1, 2008, the final maturity date of the June 2005 Note.

Pursuant to the August Secured Notes Amendment and Waiver, the Company issued 150,000 shares of its Common Stock to Laurus as consideration for the principal payment deferral.

2004 and 2005 Subordinated Notes

Effective as of January 23, 2006, the Company also entered into an Amendment and Waiver (the “Subordinated Notes Amendment and Waiver”) with certain holders (the “Subordinated Note Holders”) of its Subordinated Convertible Promissory Notes (the “Subordinated Notes”).

Under the Subordinated Notes Amendment and Waiver, the Subordinated Notes issued by the Company on September 29, 2004 in the aggregate principal amount of $5,288,221 (the “September 2004 Notes”) and on May 31, 2005 in the aggregate principal amount of $3,244,723 (the “May 2005 Notes”) were amended as follows: (i) the maturity dates were extended from September 29, 2007 and May 31, 2008, respectively, to January 1, 2009; (ii) the interest rate was fixed at fifteen percent (15%); (iii) all principal amounts are due at the maturity date and shall be paid in shares of Common Stock priced at $0.70 per share if the average closing price of the Common Stock for the thirty (30) trading days immediately preceding the maturity date is greater than $1.10; (iv) interest shall be paid, at the Company’s election, in cash or shares of Common Stock, with the Common Stock priced at the average closing price of the Common Stock for the ten (10) trading days immediately preceding the repayment date; and (v) the currently applicable fixed conversion price was amended to $0.70 per share. In addition, the exercise price of all warrants to purchase Common Stock held by the Subordinated Note Holders that currently have an exercise price greater than $1.00 per share was reset to $1.00 per share.

17




Effective as of August 10, 2006, the Company also entered into a Securities Exchange Agreement (the “Securities Exchange Agreement”) with the Subordinated Note Holders. Under the Securities Exchange Agreement, the Subordinated Notes were exchanged for shares (the “Series C Shares”) of the Company’s Series C Convertible Preferred Stock, which shares are initially convertible into Common Stock at $0.50 per share, having an aggregate value equal to the principal amount outstanding under the Subordinated Notes, plus accrued and unpaid interest thereon, and certain liquidated damages payments owed by the Company to the Subordinated Note Holders.  

2004 and 2005 Senior Notes

The Senior Notes contain features that are considered embedded derivative financial instruments:  Principal’s conversion option:  The Notes are convertible at the Holder’s option at any time at the fixed conversion price of $0.50 per share; Monthly Payments Conversion Option:  Holders have the option to convert the Notes’ monthly payment at a $0.50 per share conversion price if the common stock price is higher than 110% of the conversion price ($0.55), as long as the amount converted is not higher than 25% of trading volume for the last 22 trading days. If the Notes’ monthly payments are not converted, the payments will be paid in cash at 102% of such amount; Interest Rate Adjustment provision:  For every 25% increase in common stock value above $0.50 per share, the interest will be reduced by 2%.  The interest rate may never be reduced below 0%; Default provision: In the event of default under the terms set forth above, the Senior Lenders will be entitled to specified remedies, including remedies under the Uniform Commercial Code.  These features have been bifurcated and recorded on the Company’s balance sheet at their fair value.

The accounting treatment of the derivatives and warrants requires that the Company record the derivatives and the warrant at their relative fair value as of the inception date of the agreement, and at fair value as of each subsequent balance sheet date.  Any change in fair value will be recorded as non-operating, non-cash income or expense at each reporting date.  If the fair value of the derivatives and warrants is higher at the subsequent balance sheet date, the Company will record a non-operating, non-cash charge. If the fair value of the derivatives and warrants is lower at the subsequent balance sheet date, the Company will record non-operating, non-cash income.

As of September 30, 2006 and December 31, 2005, respectively, the derivatives were valued at $1,074,666 and $1,011,543.  Conversion related derivatives were valued using the Binomial Option Pricing Model with the following assumptions: dividend yield of 0%; annual volatility of 73% to 118%; and risk free annual interest rate of 2.89% to 4.9% as well as probability analysis related to trading volume restrictions. The remaining derivatives were valued using other binomial models and measuring the impact of the derivative on the expected interest payment amount over the life of the Note. The Warrants issued with the 2004 and 2005 debt financings classified as liabilities were valued at $643,355 and $1,483,511, as of September 30, 2006 and December 31, 2005 respectively, using the Black Scholes Option Pricing model with the following assumptions: dividend yield of 0%; annual volatility of 82%-88% and risk-free interest rate of 4.6%, and dividend yield of 0%; annual volatility of 98% to 111%% and risk-free interest rate of 4.4%, respectively. 

The initial relative fair values of both the derivatives and the warrants were recorded as discounts to the Notes and are being amortized to interest expense over the expected term of the debt, using the effective interest method.  At September 30, 2006, the unamortized discount on the Notes was $553,812 and $490,025 for 2004 and 2005 notes, respectively.  The effective interest rate on the Notes for the periods ended September 30, 2006 and December 31, 2005 ranged between 15% and 136% based on the frequency of principal payments as well as actual payments made. At December 31, 2005, the unamortized discount on the Notes was $2,134,340 and $3,569,793 for 2004 and 2005 notes, respectively.

2006 Notes

The Company entered into a Securities Purchase Agreement (the “Securities Purchase Agreement”), effective as of January 23, 2006, with The Shaar Fund, Ltd., Longview Fund, L.P. and Longview Special Finance (collectively, the “Purchasers”).

18




Under the Securities Purchase Agreement, the Company issued to the Purchasers Convertible Term Notes (the “Convertible Notes”) in the aggregate principal amount of $1,000,000, bearing interest at 15% per annum. The Convertible Notes converted into shares of the Series B Preferred Stock of the Company on February 23, 2006 (see Note 10), which shares are convertible into shares of the Common Stock of the Company at a fixed conversion price of $0.50 per share.

In connection with the Purchasers’ purchase of the Notes, the Company also issued warrants to the Purchasers (the “Warrants”) to purchase up to an aggregate of 500,000 shares of the Company’s Common Stock (subject to adjustment as set forth therein) at a per share exercise price of $0.50 per share. The proceeds from this transaction will be used for general working capital purposes. 

The Warrants were classified as liabilities and were valued at $122,722 as of September 30, 2006, using the Black Scholes Option Pricing model with the following assumptions: dividend yield of 0%; annual volatility of 93% and risk-free interest rate of 4.6%. 

Aether Note Amendment

The Company entered into an Amendment No. 1 to Subordinated Secured Promissory Note, dated as of January 23, 2006 (the “Aether Note Amendment”), with Aether Systems, Inc. (“Aether”).  Pursuant to the Aether Note Amendment, the Subordinated Secured Promissory Note issued by the Company to Aether on September 30,2004 in the aggregate maximum principal amount of $6,884,588 (the “Aether Note”), was amended to increase such aggregate maximum principal amount to $7,884,588. The Aether Note evidences a contingent reimbursement obligation of the Company to Aether and a surety fee payable by the Company to Aether, in each case with respect to a letter of credit maintained by Aether for the Company’s benefit in connection with the Company’s acquisition of the Mobile Government Division of Aether on September 30, 2004. The Company’s obligations under the Aether Note remain secured by a security interest granted to Aether in all or substantially all of the Company’s assets subordinated to the security interest of Laurus pursuant to the Secured Notes.

Default on 2004 and 2005 Notes

With respect to the convertible notes issued in 2004 and 2005, the Company is required to make interest payments or issue registered shares in lieu of interest payments on a monthly basis. 

During the nine-month period ended September 30, 2006, the Company failed to make such payments or issue such registered shares to subordinated debt holders. The failure to make the required monthly payments caused the subordinated debt to default, and in accordance with the provisions set forth in the subordinated convertible note agreements, the interest rate on the subordinated notes was increased by an additional 2.0% per annum. 

In connection with the exchange of subordinated debt for Series C Convertible Preferred Stock pursuant to the Securities Exchange Agreement, as described above, the then current interest liability of the note holders was exchanged for Series C Convertible Preferred Stock.

During the nine-month period ended September 30, 2006, the Company made the required payments to the 2004 and 2005 senior debt holder, Laurus.  However, due to the non-payment of subordinated interest described above, the Company incurred, in accordance with the cross-default provisions of the senior debt agreements, an additional 2% default interest penalty relating to the senior debt.  Total accrued interest expense and default interest as at September 30, 2006 was $664,678 as related to the 2004 and 2005 senior convertible notes.

Total accrued interest for all convertible debt as for September 30, 2006 amounted to $664,878.

19




9.    ACCRUED LIABILITIES

Accrued liabilities at September 30, 2006 and December 31, 2005 consisted of the following:

 

 

September 30,

 

December 31,

 

 

 

2006

 

2005

 

 

 

 

 

 

 

Contract costs not yet invoiced by vendors

 

$

2,092,615

 

$

3,654,440

 

Compensation

 

649,475

 

614,934

 

Royalties

 

473,460

 

294,512

 

Interest

 

845,932

 

684,253

 

Other

 

332,390

 

272,376

 

 

 

 

 

 

 

Total

 

$

4,393,872

 

$

5,520,515

 

 

10.      REDEEMABLE PREFERRED STOCK

Series B Convertible Preferred Stock

The Company issued 1,000,000 shares of redeemable Series B Convertible Preferred Stock on February 23, 2006, upon the conversion of certain convertible term notes. Each share of Series B preferred stock has an Original Issue Price of $1.00 per share. The holder has the option to redeem the shares of Series B preferred stock at any time for a number of shares of the Company’s common stock equal to the Original Issue Price plus accumulated and unpaid dividends divided by the fixed conversion price of $0.50 per share of Common Stock. The conversion price is subject to adjustment if common stock is issued by the Company subsequent to the original issue date of the Series B preferred stock, except for other conversions, options, warrants, dividends paid in stock or pursuant to an acquisition by the Company, at a price less than the conversion price. Mandatory conversion of all Series B shares will be automatic if, for the 30 trading days prior to January 1, 2009, the average closing bid price for one share of common stock is at least $1.10. The shares shall be converted at the conversion price then in effect. If the average bid price for the 30 trading days prior to January 1, 2009 per common share is less than $1.10 the Company shall mandatorily redeem all remaining outstanding Series B preferred stock by paying cash equal to $1.00 per share with all accrued and unpaid dividends.  The Company may, at its election, redeem any or all of the remaining outstanding Series B shares in cash at a conversion price equal to $1.20 per share, together with all accrued and unpaid dividends upon giving 30 day notice. Holders of the Series B preferred stock are entitled to cumulative, prior and in preference to holders of common stock dividends equal to 15% per annum of the Original Purchase Price still outstanding, payable quarterly commencing April 1, 2006. In any liquidation of the Company, each share of preferred stock is entitled to a liquidation preference in pari passu with the Series A and Series C Preferred stock before any distribution may be made on the Company’s common stock. 

During the three months ended September 30, 2006, $52,603 of dividends ($0.053 per share) was declared payable to the holders of Series B Convertible Preferred Stock, of which $28,932 was paid in cash during the period. As of September 30, 2006, 1,000,000 preferred stock shares are authorized, issued and outstanding, at a par value of $0.0001 and a liquidation preference of $1.00 with accumulated dividends in arrears of $37,808, which have been accreted to the principal balance of the Series B preferred stock.

The Preferred Stock contains features that are considered embedded derivative financial instruments:  Preferred Stock’s conversion option:  The Preferred Stock is convertible at the Holder’s option at any time at the fixed conversion price of $0.50 per share; Quarterly Dividends Conversion Option:  Holders have the option to convert the Stock’s quarterly dividend payment at a conversion price of the average 10 days

20




closing price prior to the dividend payment date.  These features have been bifurcated and recorded on the Company’s balance sheet at their fair value.

As of September 30, 2006 the derivatives were valued at $200,466.  Conversion related derivatives were valued using the Binomial Option Pricing Model with the following assumptions: dividend yield of 15%; annual volatility of 39%; and risk free annual interest rate of 4.69% as well as probability analysis related to trading volume restrictions. 

An amount equal to the original value of the derivatives was recorded as a discount to the Preferred Stock.  The discount is being accreted to the principal balance of the Preferred Stock, using the effective interest method, over the expected term of the term of the Preferred Stock.  At September 30, 2006, the unamortized discount on the Preferred Stock was $284,579. 

Series C Convertible Preferred Stock

The Company issued 592,032 shares of redeemable Series C Convertible Preferred Stock on August 10, 2006, upon the exchange of certain convertible term notes. Each share of Series C preferred stock has an Original Issue Price of $10.00 per share. The holder has the option to redeem the shares of Series C preferred stock at any time for a number of shares of the Company’s common stock equal to the Original Issue Price plus accumulated and unpaid dividends divided by the fixed conversion price of $0.50 per share of Common Stock. The conversion price is subject to adjustment if common stock is issued by the Company subsequent to the original issue date of the Series C preferred stock, except for other conversions, options, warrants, dividends paid in stock or pursuant to an acquisition by the Company, at a price less than the conversion price. Mandatory conversion of all Series C shares will be automatic if, for the 30 trading days prior to January 1, 2009, the average closing bid price for one share of common stock is at least $1.20. The shares shall be converted at the conversion price then in effect. If the average bid price for the 30 trading days prior to January 1, 2009 per common share is less than $1.20 the Company shall mandatorily redeem all remaining outstanding Series C preferred stock by paying cash equal to $10.00 per share with all accrued and unpaid dividends.  The Company may, at its election, redeem any or all of the remaining outstanding Series C shares in cash at a conversion price equal to $12.00 per share, together with all accrued and unpaid dividends upon giving 30 day notice. Holders of the Series C preferred stock are entitled to cumulative, prior and in preference to holders of common stock dividends equal to 15% per annum of the Original Purchase Price still outstanding, payable quarterly commencing September 1, 2006. In any liquidation of the Company, each share of preferred stock is entitled to a liquidation preference in pari passu with the Series A and Series B Preferred stock before any distribution may be made on the Company’s common stock. 

During the three months ended September 30, 2006, $51,093 of dividends ($0.086 per share) was declared payable to the holders of Series C Convertible Preferred Stock, of which $30,371 was paid in cash during the period. As of September 30, 2006, 600,000 preferred stock shares are authorized, issued and outstanding, at a par value of $0.0001 and a liquidation preference of $10.00 with accumulated dividends in arrears of $72,990, which have been accreted to the principal balance of the Series C preferred stock.

The Preferred Stock contains features that are considered embedded derivative financial instruments:  Preferred Stock’s conversion option:  The Preferred Stock is convertible at the Holder’s option at any time at the fixed conversion price of $0.50 per share; Quarterly Dividends Conversion Option:  Holders have the option to convert the Stock’s quarterly dividend payment at a conversion price of the average 10 days closing price prior to the dividend payment date.  These features have been bifurcated and recorded on the Company’s balance sheet at their fair value.

As of September 30, 2006 the derivatives were valued at $1,186,772.  Conversion related derivatives were valued using the Binomial Option Pricing Model with the following assumptions: dividend yield of 15%; annual volatility of 39%; and risk free annual interest rate of 4.69% as well as probability analysis related to trading volume restrictions. 

An amount of $1,073,537 equal to the original value of the derivatives was recorded as discount to the

21




Preferred Stock.  The discount is being accreted to the principal balance of the Preferred Stock, using the effective interest method, over the expected term of the term of the Preferred Stock.  At September 30, 2006, the unamortized discount on the Preferred Stock was $1,011,250.

Together with the above transaction, the terms of certain warrants held by the Company’s investment bankers and their associates were modified. The incremental value of the modification was calculated to be $110,453, and was allocated against the proceeds of the Series C Convertible Preferred Stock as a cost of financing, and will be accreted to the principal balance of the Preferred Stock, using the effective interest method, over the expected term of the term of the Preferred Stock.  At September 30, 2006, the net amount remaining to be accreted was $104,056.

11.     STOCKHOLDERS EQUITY

Common Stock

During the three months ended September 30, 2006, investors converted accrued interest on convertible term notes of $27,806 into 55,950 shares of the Company’s common stock.

Pursuant to the Amendment and Waiver with Laurus mentioned above in Note 8, the Company converted principal payments owing on the 2004 and 2005 Senior Notes for August and September 2006 to 1,016,141 shares of the Company’s common stock.

Pursuant to the Securities Purchase Agreement with Trellus mentioned above in Note 2, the Company  issued and sold 3,000,000 shares of its Common Stock to Trellus, at a purchase price of $0.50 per share, for an aggregate purchase price of $1,500,000.

Pursuant to the Securities Purchase Agreement with Shaar mentioned above in Note 2, the Company issued and sold 1,000,000 shares of its Common Stock to Shaar, at a purchase price of $0.50 per share, for an aggregate purchase price of $500,000, which was paid by exchanging Shaar’s rights in an aggregate amount of $500,000 in accrued and unpaid dividends on the shares of Series A Convertible Preferred Stock then held by Shaar. In addition, Shaar converted $67,201 of unpaid dividends owing on the shares of its Series A Convertible Preferred Stock into 134,402 shares of the Company’s common stock during the period.

Convertible Preferred Stock

During the three months ended September 30, 2006, $606,968 of dividends ($17.070 per share) was declared payable to the holders of Series A Convertible Preferred Stock. $500,000 of the amount payable to Shaar was used to pay the purchase price of the 1,000,000 shares of Common Stock, as mentioned above, and $67,201 was converted into shares of the Company’s common stock, also as mentioned above.

As of September 30, 2006, cumulative dividends in arrears related to the Series A preferred stock were approximately $14,320, which have been accreted to the principal balance of the Series A preferred stock.

22




Warrants

The following table summarizes the warrant activity for the nine month period ending September 30, 2006:

Balance, December 31, 2005

 

13,188,280

 

 

 

 

 

Granted

 

500,000

 

Exchanged

 

 

Exercised

 

 

Expired or cancelled

 

(25,000

)

 

 

 

 

Balance, March 31, 2006

 

13,663,280

 

 

 

 

 

Granted

 

11,123

 

Exchanged

 

 

Exercised

 

(26,250

)

Expired or cancelled

 

 

 

 

 

 

Balance, June 30, 2006

 

13,648,153

 

 

 

 

 

Granted

 

533,333

 

Exchanged

 

 

Exercised

 

 

Expired or cancelled

 

 

 

 

 

 

Balance, September 30, 2006

 

14,181,486

 

 

12.                                 SEGMENT INFORMATION

In the fourth quarter of fiscal year 2005, the Company’s consolidated operations were divided into three segments: Law, Fire and Biometric. Prior to this segmentation of the business, management evaluated the business as one consolidated operation. For presentation and comparability purposes the allocation of costs between segments for prior periods have been estimated.

The Company evaluates performance and allocates resources based on revenues and operating loss. Operating loss for each segment includes selling, general and administrative expenses directly attributable to the segment in addition to those allocated as a percentage based on the segments revenues. The segmentation of operating loss as noted above and detailed below reflects how management evaluates its business.  Assets for the Company are commingled and are related to all operating segments. Management does not evaluate or identify the operating assets of the segments separately.

Geographically, North American sales accounted for approximately 100% of the Company’s total sales for three and nine month periods ending September 30, 2006 and 2005.

23




Summarized financial information concerning our reportable segments is shown in the following table:

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

 

 

 

 

 

 

 

 

Revenue:

 

 

 

 

 

 

 

 

 

Law

 

$

2,864,104

 

$

2,357,086

 

$

7,764,316

 

$

8,261,127

 

Fire

 

1,232,667

 

804,202

 

2,736,459

 

2,315,553

 

Biometrics

 

103,327

 

71,183

 

681,284

 

280,934

 

Consolidated Revenue

 

$

4,200,098

 

$

3,232,471

 

$

11,182,059

 

$

10,857,614

 

Segment operating profit/(loss)

 

 

 

 

 

 

 

 

 

Law

 

308,709

 

(944,211

)

(353,101

)

(2,874,821

)

Fire

 

(99,655

)

(325,474

)

(1,277,850

)

(1,320,430

)

Biometrics

 

(890,257

)

(764,040

)

(2,237,302

)

(2,333,900

)

Total Segment Operating Loss

 

(681,203

)

(2,033,725

)

(3,868,253

)

(6,529,151

)

Reconciliation to net loss

 

 

 

 

 

 

 

 

 

Interest expense

 

(586,689

)

(1,605,771

)

(4,915,445

)

(2,992,780

)

Interest income

 

 

6,908

 

 

35,958

 

Loss on extinguishment of debt

 

(5,493,701

)

 

(7,815,717

)

 

Derivative and warrant fair value adjustments

 

547,752

 

3,210,057

 

5,548,604

 

8,160,305

 

Other expense

 

(18,891

)

(24,816

)

(51,185

)

(45,348

)

Net loss

 

$

(6,232,732

)

$

(447,347

)

$

(11,101,996

)

$

(1,371,016

)

 

13.                                 EXTINGUISHMENT OF DEBT

To address certain liquidity issues, on January 23, 2006, the Company issued convertible debt, common stock and warrants in consideration for certain modifications of its outstanding 2004 and 2005 Notes, as explained in Note 8.

In addition, the Company also entered into a Securities Purchase Agreement (the “Securities Purchase Agreement”), effective as of January 23, 2006, with The Shaar Fund, Ltd., Longview Fund, L.P. and Longview Special Finance (collectively, the “Purchasers”), also as explained in Note 8.

In accordance with the Emerging Issues Task Force of the FASB No. 96-19, Debtor’s Accounting for Modification or Exchange of Debt Terms (“EITF 96-19”), the Company recorded a non-operating loss on extinguishment of debt of $2,322,016.  The loss mainly relates to the accounting for the effect of the modification of certain embedded derivatives, extinguishment of previously recorded deferred financing fees and changes in the present value of debt.  In accordance with EITF 96-19, the New Notes are recorded in the Company’s balance sheet at fair value at the date of the modification.

Furthermore, on August 10, 2006, the Company exchanged convertible debt for preferred stock, and issued common stock and warrants in consideration for certain modifications of its outstanding 2004 and 2005 Notes, as explained in Note 8.

In accordance with the Emerging Issues Task Force of the FASB No. 96-19, Debtor’s Accounting for Modification or Exchange of Debt Terms (“EITF 96-19”), the Company recorded a non-operating loss on extinguishment of debt of $5,493,701.  The loss mainly relates to the accounting for the effect of the modification of certain embedded derivatives, and changes in the present value of debt.  In accordance with EITF 96-19, the New Notes are recorded in the Company’s balance sheet at fair value at the date of the modification.

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ITEM 2.                MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS

CAUTIONARY STATEMENT FOR FORWARD-LOOKING STATEMENTS

The information contained in this Report on Form 10-QSB and in other public statements by the Company and Company officers include or may contain certain forward-looking statements. All statements other than statements of historical facts contained in this Report on Form 10-QSB, including statements regarding our future financial position, business strategy and plans and objectives of management for future operations, are forward-looking statements. The words “anticipate,” “believe,” “estimate,” “will,” “may,” “future,” “plan,” “intend” and “expect” and similar expressions generally identify forward-looking statements. Although we believe that our plans, intentions and expectations reflected in the forward-looking statements are reasonable, we cannot be sure that they will be achieved. Actual results may differ materially from the forward-looking statements contained herein due to a number of factors. Many of these factors are set forth in the Company’s Annual Report on Form 10-KSB under the caption “Risk Factors” and other filings with the Securities and Exchange Commission. These factors are not intended to represent a complete list of the general or specific factors that may affect us. It should be recognized that other factors, including general economic factors and business strategies may be significant, presently or in the future.  Except as required by law, we undertake no obligation to update any forward-looking statement, whether as a result of new information, future events or otherwise.

OVERVIEW

The following should be read in conjunction with the financial statements of the Company included elsewhere herein.

We develop and market proprietary fingerprint identification biometric technology and software solutions. We also deliver advanced identification solutions and information services to law enforcement departments, public safety agencies and other government and private sector customers. Our mobile wireless technology provides first responders with critical, reliable, real-time data and images from local, state and national databases.

We pioneered the development of automated, finger identification technology that can be used without the aid of non-automated methods of identification such as a personal identification, password, token, smart card, ID card, credit card, passport, driver’s license or other form of possession or knowledge based identification. This advanced BIO-key™ identification technology improves both the accuracy and speed of finger-based biometrics and is the only finger identification algorithm that has been certified by the International Computer Security Association (ICSA).

Since our inception in 1993, we have spent substantial time and effort in completing the development of what we believe is the most discriminating and effective finger biometric technology available. During the past two years, our focus has shifted to marketing and selling this technology and completing strategic acquisitions that can help us leverage our capability to deliver identification solutions. We have built a direct sale force of professionals with substantial experience in selling technology solutions to government and corporate customers.

CRITICAL ACCOUNTING POLICIES

For detailed information on our critical accounting policies and estimates, see our financial statements and notes thereto included in this Report and in our Annual Report on Form 10-KSB, as amended, for the fiscal year ended December 31, 2005.  There have been no material changes to our critical accounting policies and estimates from those disclosed in our amended 10-KSB filed on June 19, 2006.

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With the adoption of SFAS 123R at the beginning of the Company’s first fiscal quarter of 2006, we added “Stock-Based Compensation” as a critical accounting policy.

Stock-Based Compensation

As of January 1, 2006, the Company adopted SFAS 123R using the modified prospective method, which requires measurement of compensation cost for all stock awards at fair value on date of grant and recognition of compensation over the service period for awards expected to vest. Accordingly, financial statement amounts for the prior periods presented in this Form 10-QSB have not been restated to reflect the fair value method of expensing share-based compensation. Under this application, we are required to record compensation cost for all share-based payments granted after the date of adoption based on the grant date fair value estimated in accordance with the provisions of SFAS 123R and for the unvested portion of all share-based payments previously granted that remain outstanding which were based on the grant date fair value estimated in accordance with the original provisions of SFAS 123. The majority of our share-based compensation arrangements vest over either a three or four year vesting schedule. The Company expenses its share-based compensation under the ratable method, which treats each vesting tranche as if it were an individual grant. The fair value of stock options is determined using the Black-Scholes valuation model, which is consistent with our valuation techniques previously utilized for options in footnote disclosures required under SFAS 123, as amended by SFAS 148, and requires the input of highly subjective assumptions. These assumptions include estimating the length of time employees will retain their vested stock options before exercising them (the “expected option term”), the estimated volatility of our common stock price over the option’s expected term, the risk-free interest rate over the option’s expected term, and the Company’s expected annual dividend yield. Changes in these subjective assumptions can materially affect the estimate of fair value of stock-based compensation and consequently, the related amount recognized as an expense in the consolidated statements of operations. As required under the accounting rules, we review our valuation assumptions at each grant date and, as a result, are likely to change our valuation assumptions used to value employee stock-based awards granted in future periods. The values derived from using the Black-Scholes model are recognized as expense over the service period, net of estimated forfeitures (the number of individuals that will ultimately not complete their vesting requirements). The estimation of stock awards that will ultimately vest requires significant judgment. We consider many factors when estimating expected forfeitures, including types of awards, employee class, and historical experience. Actual results, and future changes in estimates, may differ substantially from our current estimates. The compensation expense recognized in connection with the adoption of SFAS 123R increased the Company’s net loss by $239,136 with no effect per share for the three months ended September 30, 2006 and increased the Company’s net loss for the nine months ended September 30, 2006 by $529,055, with a $0.01 effect per share. There was no impact on cash flows from operations, investment, or financing in connections with the adoptions of SFAS 123R. As the Company uses the full valuation allowance with respect to deferred taxes, the adoption of SFAS 123R had no impact on deferred taxes.

RECENT ACCOUNTING PRONOUNCEMENTS

In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans,” an amendment of FASB Statements No. 87, 88, 106, and 132R. SFAS No. 158 requires an employer to: (a) recognize in its statement of financial position an asset for a plan’s overfunded status and/or a liability for a plan’s underfunded status; (b) measure a plan’s assets and its obligations that determine its funded status as of the end of the employer’s fiscal year (with limited exceptions); and (c) recognize changes in the funded status of a defined benefit postretirement plan in the year in which the changes occur. The implementation of SFAS 158 is not expected to have a material impact on the Company’s financial statements.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” which is effective for calendar year companies on January 1, 2008. The Statement defines fair value, establishes a framework for measuring fair value in accordance with Generally Accepted Accounting Principles, and expands disclosures about fair value measurements. The Statement codifies the definition of fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market

26




participants at the measurement date. The standard clarifies the principle that fair value should be based on the assumptions market participants would use when pricing the asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. The Company is currently assessing the potential impacts of implementing this standard.

In September 2006, the SEC staff issued Staff Accounting Bulletin (SAB) Topic 1N (SAB 108), “Financial Statements — Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” which is effective for calendar year companies as of December 31, 2006. SAB 108 provides guidance on how prior year misstatements should be taken into consideration when quantifying misstatements in current year financial statements for purposes of determining whether the financial statements are materially misstated. Under this guidance, companies should take into account both the effect of a misstatement on the current year balance sheet as well as the impact upon the current year income statement in assessing the materiality of a current year misstatement. Once a current year misstatement has been quantified, the guidance in SAB Topic 1M, “Financial Statements — Materiality,” (SAB 99) should be applied to determine whether the misstatement is material. The implementation of SAB 108 is not expected to have a material impact on the Company’s financial statements.

In June 2006, the FASB issued FIN No. 48, “Accounting for Uncertainty in Income Taxes—An Interpretation of FASB Statement No. 109,” which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 will be effective for the Company’s first interim period beginning January 1 2007. The implementation of FIN 44 is not expected to have a material impact on the Company’s financial statements.

27




RESULTS OF OPERATIONS

THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2006

AS COMPARED TO SEPTEMBER 30, 2005

INTRODUCTION

In the fourth quarter of 2005, the Company restructured its operations into three business segments: Biometrics, Law Enforcement and Fire Safety. Each segment is headed by a General Manager and organized to quickly respond to market needs as well as to drive down costs to achieve profitability. Management believes that this initiative will lead to increased opportunities throughout 2006 as the General Managers continue to develop their business units. During the quarter ended September 30, 2006 the Company continued to stay focused on its objectives of increasing revenue and managing expenses.

Consolidated Results of Operations - Percent Trend

 

 

Three Months Ended September 30,

 

 

 

2006

 

2005

 

Revenues

 

 

 

 

 

Services

 

77

%

77

%

License fees and other

 

23

%

23

%

 

 

100

%

100

%

Costs and other expenses

 

 

 

 

 

Services

 

15

%

16

%

Cost of license fees and other

 

4

%

4

%

Selling, general and administrative

 

59

%

88

%

Research, development and engineering

 

39

%

55

%

 

 

117

%

163

%

Operating loss

 

-17

%

-63

%

 

 

 

 

 

 

Other income (deductions)

 

 

 

 

 

Total other income (deductions)

 

-131

%

49

%

NET LOSS

 

-148

%

-14

%

 

The Law Enforcement and Fire Safety segments were purchased during 2004. Prior to this segmentation of the business, management evaluated the business as one consolidated operation. For presentation and comparability purposes the allocation of costs between segments for prior periods has been estimated.

28




The Company evaluates performance and allocates resources based on revenues and operating income (loss). Operating income (loss) for each segment includes selling, general and administrative expenses directly attributable to the segment in addition to those allocated as a percentage based on the segments revenues and other factors. The segmentation of operating income as noted above and detailed below reflects how management now evaluates its business. Assets for the Company are commingled and are related to all operating segments. Management does not evaluate or identify the operating assets of the segments separately.

 

 

Three months ended

 

 

 

 

 

 

 

September 30,

 

 

 

 

 

 

 

2006

 

2005

 

$ Change

 

% Change

 

 

 

 

 

 

 

 

 

 

 

Revenues

 

 

 

 

 

 

 

 

 

Law Enforcement

 

 

 

 

 

 

 

 

 

Service

 

$

2,352,940

 

$

1,730,843

 

$

622,097

 

36

%

License & other

 

511,164

 

626,243

 

(115,079

)

-18

%

 

 

2,864,104

 

2,357,086

 

507,018

 

22

%

Fire Safety

 

 

 

 

 

 

 

 

 

Service

 

849,369

 

727,288

 

122,081

 

17

%

License & other

 

383,298

 

76,914

 

306,384

 

398

%

 

 

1,232,667

 

804,202

 

428,465

 

53

%

Biometrics

 

 

 

 

 

 

 

 

 

Service

 

23,874

 

38,752

 

(14,878

)

-38

%

License & other

 

79,453

 

32,431

 

47,022

 

145

%

 

 

103,327

 

71,183

 

32,144

 

45

%

 

 

 

 

 

 

 

 

 

 

Total Revenue

 

$

4,200,098

 

$

3,232,471

 

$

967,627

 

30

%

 

 

 

 

 

 

 

 

 

 

Cost of goods sold

 

 

 

 

 

 

 

 

 

Law Enforcement

 

 

 

 

 

 

 

 

 

Service

 

$

349,940

 

$

373,890

 

$

(23,950

)

-6

%

License & other

 

100,521

 

101,350

 

(829

)

-1

%

 

 

450,461

 

475,240

 

(24,779

)

-5

%

Fire Safety

 

 

 

 

 

 

 

 

 

Service

 

240,841

 

121,330

 

119,511

 

99

%

License & other

 

7,419

 

18,665

 

(11,246

)

-60

%

 

 

248,260

 

139,995

 

108,265

 

77

%

Biometrics

 

 

 

 

 

 

 

 

 

Service

 

21,660

 

8,623

 

13,037

 

151

%

License & other

 

40,335

 

5,618

 

34,717

 

618

%

 

 

61,995

 

14,241

 

47,754

 

335

%

 

 

 

 

 

 

 

 

 

 

Total COGS

 

$

760,716

 

$

629,476

 

$

131,240

 

21

%

 

Revenues

Law Enforcement

Service revenue for the segment for the three month period ended September 30, 2006 included $773,430 from a long-term project that the Company had participated in as a subcontractor.  The amount resulted from a cash payment of $570,546 along with $202,884 of revenue that was previously deferred until evidence of full acceptance by the end user was received by the Company.  That increase was offset by a reduction in revenue from other longer-term project work that was present in 2005, as the Company moves to more of a license-based model.  

29




Fire Safety

For the three months ended September 30, 2006, total revenue for the Fire Safety segment increased by 53%, over the same three months in 2005. The current year license revenue included $246,960 in license sales as part of a substantial county-wide implementation for one of our new customers. Both license and service revenue for the segment have shown steady growth quarter over quarter in 2006, and management expects to see continued growth in the Fire Safety segment.

Biometrics

For the three months ended September 30, 2006, the Biometric segment had revenues representing a 45% increase over the same period in 2005. However, sales in this segment continue to be choppy and less predictable as the market for the Biometrics’ products continues to develop at an inconsistent pace.

Costs of goods sold

Law Enforcement

License and other costs are attributable primarily to revenues derived from product sales, for which we are required to pay a royalty, and is primarily driven by the sales mix.

Due to the change in focus from long-term projects to licensing-based agreements, cost of goods sold in total for the segment decreased when compared to the same period in 2005 as labor costs, for both employees and consultants were eliminated as projects were completed.

Fire Safety

License and other costs are attributable primarily to revenues derived from product sales for which we are required to pay a royalty. These costs are solely dependent specifically on what products were sold.

Overall costs of goods sold for the Fire segment were higher in 2006 due to increased proportional sales volume in the period, which lead to a higher allocation of corporate expenses. Cost of goods sold are predominately employee salaries and associated expenses.

Biometrics

License and other costs are primarily related to the hardware costs related to sales of biometric fingerprint readers. The change in cost of goods sold is directly attributable to the product mix between types of readers sold and the volume of readers sold, as well as the addition of dedicated personnel for this segment.

Selling, general and administrative

 

 

Three months ended
September 30,

 

 

 

 

 

 

 

2006

 

2005

 

$ Change

 

% Change

 

 

 

 

 

 

 

 

 

 

 

Law Enforcement

 

$

1,196,641

 

$

1,792,514

 

$

(595,873

)

-33

%

Fire Safety

 

740,504

 

672,289

 

68,215

 

10

%

Biometrics

 

530,202

 

372,072

 

158,130

 

42

%

 

 

 

 

 

 

 

 

 

 

Total

 

$

2,467,347

 

$

2,836,875

 

$

(369,528

)

-13

%

 

30




As discussed previously, the Company restructured its operations into three business segments: Biometrics, Law Enforcement and Fire Safety in the fourth quarter of 2005.  For 2005, SG&A costs were allocated to the segments based on several factors including management’s estimates and percentage of revenue.  For 2006, sales expenses are a direct cost to the segment and G&A costs are allocated between business segments on fixed percentages that were established by management during the budgeting process.

The overall decline in total SG&A costs for the quarter ended September 30, 2006 as compared to 2005 are primarily attributable to the continued focus by management on cost reduction initiatives taken during the fourth quarter of 2005 after the acquisitions of Public Safety Group and Aether Mobile Government were completed. Management believes the appropriate resources are in place to support its strategic goals but also continues to analyze the expense structure and continues to explore ways to further reduce costs, through synergies and increased system efficiencies. During the quarter ended September 30, 2006, these reductions have been partially offset by additional costs related to reporting and compliance that the Company has experienced due to the amendments of our previously filed registration statements.

Research, development and engineering

 

 

Three months ended

 

 

 

 

 

 

 

September 30,

 

 

 

 

 

 

 

2006

 

2005

 

$ Change

 

% Change

 

 

 

 

 

 

 

 

 

 

 

Law Enforcement

 

$908,294

 

$1,033,543

 

$(125,249

)

-12

%

Fire Safety

 

343,558

 

317,393

 

26,165

 

8

%

Biometrics

 

401,386

 

448,909